THE EFFECTS OF OPEN MARKET INTEREST RATES ON MALAYSIAN COMMERCIAL BANKS' INTEREST RATE SPREAD: AN EMPIRICAL ANALYSIS

Abstract

In this paper we investigate the effect of changes in open market interest rates on the interest rate spread of Malaysian commercial banks. This is performed by examining the causality and patterns of reactions of banking rates with respect to variation in open market rates. Based on vector autoregression analysis we show that there is one-way causation running from the open market rates to banking rates. Changes in open market rates significantly cause changes in the spread and deposit rates. However, no significant causation is identified for lending rates. The impulse response functions indicate that spread declines following positive innovation in open market rates and this is mainly due to the greater sensitivity of deposit rates to open market rates. The response of lending rates is shown to be low and to occur with some lag, thus, contributing to the decline in spread. We also provide evidence of a dichotomy between banks' asset and liability rates by failing to support causality between the two rates. It is argued that this imbalance of sensitivity is partly due to the uneven process of interest rate liberalization that frees deposit rates more than lending rates. These results suggest that for the Malaysian banking firms, increase in open market rates hindered their activities and could affect bank performance. The findings are consistent with the role of banks as brokers as well as asset transformers.

JEL classification: E44, G10, G21

Key words: Interest rate spread, Bank profitability, Vector autoregression