## _wp14105

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---

### Key context and objective
- Deposit-lending rate spreads in Solomon Islands are large compared with other Pacific Island countries.
- Paper examines determinants of interest rate spreads in Solomon Islands using quarterly bank-level data for 2009Q1-2013Q3 and macroeconomic aggregates from WEO and IFS.
- Focus: bank-level (three commercial banks: ANZ, BSP, WBC) interest margins using the broad definition: quarterly net interest income as a percentage of total interest-bearing assets.

### Determinants analyzed
- Bank-specific variables:
  - COST_STAFF: salaries and wages/total assets
  - COST_PCAPITAL: depreciation and occupancy/total assets
  - COST_OTHER: other costs/total assets
  - LOANS_GROWTH: quarterly growth rate of loans and advances
  - RISK_AVERSION: equity/total assets
  - CREDIT_RISK: net NPLs/total loans
- Industry concentration:
  - HH index: sum of squared bank loans/total loans (market shares)
- Macroeconomic variables:
  - INFLATION: actual inflation
  - INTEREST_RATE: three-month Bokolo bill
  - GROWTH: real GDP growth
- Legal/economic environment:
  - LEGAL: Index of Economic Freedom

### Visual and descriptive evidence (selected)
- Over 2009Q1–2013Q3, bank-specific interest rate spreads remained high and persistent.
- Positive visual correlations observed between spreads and:
  - COST_STAFF (Figure 5)
  - COST_OTHER (Figure 7)
  - RISK_AVERSION (equity/total assets) (Figure 9)
  - Market concentration (HH index) (Figure 11)
- Negative visual correlation observed between spreads and scale of operations (LOANS_GROWTH) (Figure 8).
- No clear simple visual relation between spreads and CREDIT_RISK (NPLs) (Figure 10).
- Relation between spreads and Index of Economic Freedom (LEGAL) ambiguous and led by outliers (Figure 12).

### Empirical methodology
- Estimation: pooled EGLS with SUR method and panel-corrected standard errors (PCSE) to account for cross-section heterogeneity.
- Four model specifications:
  - Model (1): bank-specific variables only.
  - Model (2): adds industry characteristics (HH index).
  - Model (3): adds macroeconomic variables.
  - Model (4): adds legal/economic environment index (LEGAL).

### Main empirical results (regression estimates and elasticities)
- LOANS_GROWTH coefficients (standard errors in parentheses):
  - Model (1): -0.008 (0.006)
  - Model (2): -0.014*** (0.004)
  - Model (3): -0.010*** (0.004)
  - Model (4): -0.010*** (0.004)
  - Interpretation: "an increase of 10 percent in total loans generates about a 1 percent decline in bank spreads."
- COST_STAFF coefficients:
  - Model (1): 0.582 (0.451)
  - Model (2): 0.762** (0.334)
  - Model (3): 0.531* (0.284)
  - Model (4): 0.557* (0.304)
  - Interpretation: "a fall in salary and wages ... of one percentage point would be associated with a drop in interest spreads by 0.5---0.7 percentage point."
- COST_PCAPITAL coefficients:
  - Model (1): 0.020* (0.011)
  - Model (2): 0.001 (0.010)
  - Model (3): -0.002 (0.011)
  - Model (4): -0.002 (0.011)
- COST_OTHER coefficients:
  - Model (1): 0.730*** (0.177)
  - Model (2): 0.659*** (0.152)
  - Model (3): 0.560*** (0.151)
  - Model (4): 0.558*** (0.152)
  - Interpretation: "a fall in ... other costs of one percentage point would be associated with a drop in interest spreads by 0.6---0.7 percentage point."
- CREDIT_RISK coefficients:
  - Model (1): 0.009 (0.014)
  - Model (2): 0.007 (0.010)
  - Model (3): -0.009 (0.011)
  - Model (4): -0.008 (0.012)
  - Interpretation: NPLs have an insignificant impact on spreads in all model versions.
- RISK_AVERSION coefficients:
  - Model (1): 0.022 (0.016)
  - Model (2): 0.020 (0.013)
  - Model (3): 0.021* (0.012)
  - Model (4): 0.022* (0.012)
  - Interpretation: "an increase in the ratio of equity to total assets of 10 percent generates an increase in interest spreads by 2 percent."
- HH index coefficients:
  - Model (2): 1.58E-03*** (1.72e-4)
  - Model (3): 8.10E-04*** (1.99e-4)
  - Model (4): 8.31E-04*** (2.38e-4)
  - Interpretation: Higher market concentration is positively correlated with bank spreads.
- INFLATION coefficients:
  - Model (3): -0.008 (0.017)
  - Model (4): -0.006 (0.018)
  - Interpretation: No robust evidence linking inflation and spreads in the sample period.
- INTEREST_RATE coefficients:
  - Model (3): 0.090*** (0.024)
  - Model (4): 0.086*** (0.030)
  - Interpretation: "a fall in the central bank interest rates of one percentage point would be associated with a decline of spreads by roughly eight basis points."
- GROWTH coefficients:
  - Model (3): -0.049** (0.023)
  - Model (4): -0.051** (0.024)
  - Alternative elasticity reported in text: -0.06 (statistically significant).
- LEGAL coefficient (Model 4):
  - -0.046 (0.180) — not statistically significant.
- Overall fit (from Table 2):
  - R-squared: Model (1) 0.561; Model (2) 0.853; Model (3) 0.914; Model (4) 0.913.
  - Adjusted R-squared: Model (1) 0.509; Model (2) 0.832; Model (3) 0.895; Model (4) 0.892.

### Impulse-response analysis (market structure and collusion tests)
- Structural VAR estimated with Cholesky identification (biggest bank ranked first).
- Impulse-response functions show coordinated responses:
  - An unexpected increase in spreads by Bank 1 leads to an immediate mild but significant increase in spreads by Banks 2 and 3.
  - Bank 3 often changes spreads by virtually the same amount as Bank 1 following shocks originating in Bank 1.
  - The largest bank (Bank 1) is not significantly responsive to shocks in other banks’ spreads.
  - Similar patterns when shocks are imposed on lending rates.
  - Alternative variable orderings produce similar impulse-response patterns.
- Interpretation: Results are consistent with significant influence of high banking market concentration and potential collusive behaviour.

### Conclusions and policy implications
- Main findings:
  - Bank spreads and overhead costs are significantly and positively correlated.
  - Scale of operations is negatively related to spreads: limited lending scale impedes lower borrowing costs.
  - High market power and bank concentration tend to increase the possibility of using market power/collusion and raise spreads.
  - Central bank lending rate increases are likely to increase net interest margins.
  - A less supportive legal and economic environment contributes to larger intermediation costs (coefficient not statistically significant).
- Policy recommendations highlighted:
  - Increase competition in the banking sector where feasible.
  - Promote financial deepening through development of non-bank institutions: finance companies, foreign exchange dealers, micro-credit institutions.
  - Advance financial inclusion initiatives such as lowering remittance costs and mobile phone banking.
  - Consider policies that reduce the cost of sterilization and lower Bokolo bill rates (greater exchange rate flexibility noted as a channel to reduce sterilization cost and interest rates).
  - Consider legal and economic environment reforms to improve access to credit (e.g., investor protection, property rights, land registration), even though the empirical coefficient was not significant.

*Source: Central Bank of Solomon Islands (CBSI) data and IMF staff calculations as presented in the source chapter.*

### References .............................................................................................................

### _wp14105 - References .............................................................................................................

### Tables
- 1. Selected Bank Indicators.................................................................................................. 8
- 2. Factors Explaining Interest Spreads ............................................................................... 19

### Figures
- 1.      Pacific Island Countries: Interest Rate Spreads of Commercial Banks ........................... 4
- 2.      Small States—Asia and Pacific Region: Financial Development and Inequality ........... 5
- 3.      Spreads of Commercial Banks (narrow definition) ......................................................... 6
- 4.      Spreads of Commercial Banks (broad definition) ........................................................... 6
- 5.      Average Spreads and Staff Costs ..................................................................................... 9
- 6.      Average Spreads and Physical Capital Costs................................................................. 10
- 7.      Average Spreads and Other Costs.................................................................................. 10
- 8.      Average Spreads and Scale Operations ......................................................................... 11
- 9.      Average Spreads and Risk Aversion.............................................................................. 12
- 10.    Average Spreads and Credit Risk .................................................................................. 12
- 11.    Average Spreads and Market Concentration ................................................................. 13
- 12.    Average Spreads and Economic Freedom ..................................................................... 15
- 13.    Relation between Banks Overhead Costs and Income .................................................. 17
- 14.    Impulse-Response Functions to Shocks on Bank-Specific Spreads .............................. 21

*Source: _wp14105 - References.*

### 15.    Impulse-Response Functions to Shocks on Bank-Specific Lending Rates ................... 21

### 15.    Impulse-Response Functions to Shocks on Bank-Specific Lending Rates ................... 21

### Key context and objective
- Deposit-lending rate spreads in Solomon Islands are large compared with other Pacific Island countries (figures and charts in source).
- Paper examines determinants of interest rate spreads in Solomon Islands using quarterly bank-level data for 2009Q1-2013Q3 and macroeconomic aggregates from WEO and IFS.
- Focus on bank-level (three commercial banks: ANZ, BSP, WBC) interest margins using the broad definition: quarterly net interest income as a percentage of total interest-bearing assets.

### Determinants analyzed
- Bank-specific variables: COST_STAFF (salaries and wages/total assets), COST_PCAPITAL (depreciation and occupancy/total assets), COST_OTHER (other costs/total assets), LOANS_GROWTH (quarterly growth rate of loans and advances), RISK_AVERSION (equity/total assets), CREDIT_RISK (net NPLs/total loans).
- Industry concentration: HH index (sum of squared bank loans/total loans) measured by market shares.
- Macroeconomic variables: INFLATION (actual inflation as proxy for expected inflation), INTEREST_RATE (three-month Bokolo bill), GROWTH (real GDP growth).
- Legal/economic environment: LEGAL (Index of Economic Freedom).

### Visual and descriptive evidence (selected)
- Over 2009Q1–2013Q3, bank-specific interest rate spreads remained high and persistent (Figures 3 and 4).
- Positive visual correlations observed between spreads and:
  - Salary and wages (COST_STAFF) (Figure 5).
  - Other costs (COST_OTHER) (Figure 7).
  - Risk aversion (equity/total assets) (Figure 9).
  - Market concentration (HH index) (Figure 11).
- Negative visual correlations observed between spreads and:
  - Scale of operations (loan growth) (Figure 8).
- No clear simple visual relation between spreads and credit risk (NPLs) (Figure 10).
- Relation between spreads and Index of Economic Freedom ambiguous and led by outliers (Figure 12).

### Empirical methodology
- Pooled EGLS with SUR method and panel-corrected standard errors (PCSE) to account for cross-section heterogeneity.
- Four model specifications:
  - Model (1): bank-specific variables only.
  - Model (2): adds industry characteristics (HH index).
  - Model (3): adds macroeconomic variables.
  - Model (4): adds legal/economic environment index (LEGAL).

### Main empirical results (regression estimates and elasticities)
- LOANS_GROWTH coefficients (from Table 2):
  - Model (1): -0.008 (0.006)
  - Model (2): -0.014*** (0.004)
  - Model (3): -0.010*** (0.004)
  - Model (4): -0.010*** (0.004)
  - Interpretation: "an increase of 10 percent in total loans generates about a 1 percent decline in bank spreads."
- COST_STAFF coefficients:
  - Model (1): 0.582 (0.451)
  - Model (2): 0.762** (0.334)
  - Model (3): 0.531* (0.284)
  - Model (4): 0.557* (0.304)
  - Interpretation: "a fall in salary and wages ... of one percentage point would be associated with a drop in interest spreads by 0.5---0.7 percentage point."
- COST_PCAPITAL coefficients:
  - Model (1): 0.020* (0.011)
  - Model (2): 0.001 (0.010)
  - Model (3): -0.002 (0.011)
  - Model (4): -0.002 (0.011)
- COST_OTHER coefficients:
  - Model (1): 0.730*** (0.177)
  - Model (2): 0.659*** (0.152)
  - Model (3): 0.560*** (0.151)
  - Model (4): 0.558*** (0.152)
  - Interpretation: "a fall in ... other costs of one percentage point would be associated with a drop in interest spreads by 0.6---0.7 percentage point."
- CREDIT_RISK coefficients:
  - Model (1): 0.009 (0.014)
  - Model (2): 0.007 (0.010)
  - Model (3): -0.009 (0.011)
  - Model (4): -0.008 (0.012)
  - Interpretation: NPLs have an insignificant impact on spreads in all model versions.
- RISK_AVERSION coefficients:
  - Model (1): 0.022 (0.016)
  - Model (2): 0.020 (0.013)
  - Model (3): 0.021* (0.012)
  - Model (4): 0.022* (0.012)
  - Interpretation: "an increase in the ratio of equity to total assets of 10 percent generates an increase in interest spreads by 2 percent."
- HH index coefficients:
  - Model (2): 1.58E-03*** (1.72e-4)
  - Model (3): 8.10E-04*** (1.99e-4)
  - Model (4): 8.31E-04*** (2.38e-4)
  - Interpretation: Higher market concentration is positively correlated with bank spreads.
- INFLATION coefficients:
  - Model (3): -0.008 (0.017)
  - Model (4): -0.006 (0.018)
  - Interpretation: No robust evidence linking inflation and spreads in the sample period.
- INTEREST_RATE coefficients:
  - Model (3): 0.090*** (0.024)
  - Model (4): 0.086*** (0.030)
  - Interpretation: "a fall in the central bank interest rates of one percentage point would be associated with a decline of spreads by roughly eight basis points."
- GROWTH coefficients:
  - Model (3): -0.049** (0.023)
  - Model (4): -0.051** (0.024)
  - Alternative elasticity reported in text: -0.06 (statistically significant).
- LEGAL coefficient (Model 4):
  - -0.046 (0.180) — not statistically significant.
- Overall fit (from Table 2):
  - R-squared: Model (1) 0.561; Model (2) 0.853; Model (3) 0.914; Model (4) 0.913.
  - Adjusted R-squared: Model (1) 0.509; Model (2) 0.832; Model (3) 0.895; Model (4) 0.892.

### Impulse-response (market structure and collusion tests)
- Estimated structural VAR with Cholesky identification (biggest bank ranked first).
- Impulse-response functions (Figures 14 and 15) show:
  - Banks respond in a coordinated fashion: an unexpected increase in spreads by Bank 1 leads to an immediate mild but significant increase in spreads by Banks 2 and 3.
  - Bank 3 often changes spreads by virtually the same amount as Bank 1 following shocks originating in Bank 1.
  - The largest bank (Bank 1) is not significantly responsive to shocks in other banks’ spreads.
  - Same pattern observed when shocks are imposed on lending rates.
  - Alternative variable orderings produce similar impulse-response patterns, supporting robustness.
- Interpretation: Results are consistent with significant influence of high banking market concentration and potential collusive behaviour.

### Conclusions and policy implications (from paper)
- Main findings:
  - Bank spreads and overhead costs are significantly and positively correlated.
  - Scale of operations is negatively related to spreads: limited lending scale impedes lower borrowing costs.
  - High market power and bank concentration tend to increase the possibility of using market power/collusion and raise spreads.
  - Central bank lending rate increases are likely to increase net interest margins.
  - A less supportive legal and economic environment contributes to larger intermediation costs (coefficient not statistically significant).
- Policy recommendations highlighted:
  - Increase competition in the banking sector where feasible.
  - Promote financial deepening through development of non-bank institutions: finance companies, foreign exchange dealers, micro-credit institutions.
  - Advance financial inclusion initiatives such as lowering remittance costs and mobile phone banking.
  - Consider policies that reduce the cost of sterilization and lower Bokolo bill rates (greater exchange rate flexibility noted as a channel to reduce sterilization cost and interest rates).
  - Consider legal and economic environment reforms to improve access to credit (e.g., investor protection, property rights, land registration), even though the empirical coefficient was not significant.

*Source: Central Bank of Solomon Islands (CBSI) data and IMF staff calculations as presented in the source chapter.*

### REFERENCES

### _wp14105 - REFERENCES

### Bank profitability, market structure, and efficiency
- Berger, Allen N., Gerald Hanweck, and  David Humphrey, 1987, ‘‘Competitive Viability in Banking:   Scale,   Scope,   and   Product   Mix   Economies,’’ Journal   of   Monetary Economics, Vol. 20, No. 3, pp. 501–20
- Berger,  Allen N., 1995, ‘‘The Profit-Structure Relationship  in Banking: Tests  of Market-Power and Efficient-Structure Hypotheses,’’ Journal  of  Money,  Credit  and  Banking, Vol. 27, No. 2, pp. 404–31
- Bolt,  Wilko, Leo  de  Haan, Marco Hoeberichts, Maarten  van  Oordt,  and  Job  Swank,  2012, ‘‘Bank  Profitability  During  Recessions,’’ Journal  of  Banking  and  Finance, Vol. 36, No. 9, pp. 2552–64
- Goddard,  John, Hong  Liu, Philip  Molyneux,  and John Wilson, 2011, ‘‘The  Persistence  of Bank Profit,’’ Journal of Banking and Finance, Vol. 35, No. 11, pp. 2881–90
- Mirzaei, Ali, Tomoe Moore, and Guy Liu, 2013, ‘‘Does Market Structure Matter on Banks’ Profitability  and  Stability?  Emerging  vs.  Advanced  Economies,’’ Journal  of  Banking and Finance, Vol. 37, No. 8, pp. 2920–37
- Park,  Kang H.,  William L. Weber, 2006, ‘‘Profitability  of  Korean Banks: Test  of Market Structure versus Efficient Structure,’’ Journal  of  Economics  and  Business, Vol. 58, No. 3, pp. 222–39
- Tregenna, Fiona, 2009, ‘‘The Fat Years: The Structure and Profitability of the U.S. Banking Sector  in  the Pre-crisis Period,’’ Cambridge  Journal  of  Economics, Vol.  33,  No.  4, pp. 609–32

### Interest rate spreads, banking spreads, and monetary policy interactions
- Brock, Philip, and Liliana Rojas-Suarez, 2000, “Understanding the Behavior of Bank Spreads in Latin America,” Journal of Development Economics, Vol. 63, No. 1, pp. 113–34
- Claeys,  Sophie, Rudi  Vander  Vennet, 2008, ‘‘Determinants  of Bank Interest Margins  in Central  and  Eastern  Europe: A Comparison  with  the  West,’’ Economic  Systems, Vol. 32, No. 2, pp. 197–216
- Gelos, R. Gaston, 2006, ‘‘Banking Spreads in Latin America,’’ IMF Working Paper 06/44 (Washington: International Monetary Fund)
- Honohan, Patrick, 2003, ‘‘The Accidental Tax: Inflation and the Financial Sector,’’ in: ‘‘Taxation of Financial Intermediation: Theory and Practice for Emerging Economies,’’ ed. by Patrick Honohan, (World Bank and Oxford University Press)
- Samuel, Wendell, and Laura Valderrama, 2006, “The Monetary Policy Regime and Banking Spreads in Barbados,” IMF Working Paper 06/211 (Washington: International Monetary Fund)

### Regional and country studies; small states and specific regions
- Crowley, Joe, 2007, ‘‘Interest Rate Spreads in English-Speaking African Countries,’’ IMF Working Paper 07/101 (Washington: International Monetary Fund)
- Davies, Matt, and John Vaught, 2011, ‘‘Interest Rates and Bank Profitability in the South Pacific.’’ Available via the Internet at www.pftac.org/page/resources/papers
- Tumbarello, Patrizia, Ezequiel Cabezon , and Yiqun Wu , 2013, “Are the Asia and Pacific Small States Different from Other Small States?” IMF Working Paper 13/123 (Washington: International Monetary Fund)

### Banking consolidation and financial stability
- Uhde,  André, and Ulrich  Heimeshoff, 2009, ‘‘Consolidation  in Banking  and Financial Stability  in Europe: Empirical Evidence,’’ Journal  of  Banking  and  Finance, Vol. 33, No. 7, pp. 1299–1311

*Source: _wp14105 - REFERENCES*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14105.pdf_