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THE EFFECT OF INTEREST RATE ON THE PROFITABILITY OF COMMERCIAL BANKS
THE EFFECT OF INTEREST RATE ON THE PROFITABILITY OF COMMERCIAL BANKS.
1.1Background to study
According to the historian, Paul Johnson, the lending of “food money” was common in the Middle Eastern civilization as early as 5000BC; the argument that acquired seeds and animals could reduce themselves was used to justifying interest. Also in the early 2nd millennium BC, since sliver was used in the exchange of livestock or grain could not multiply on its own law of Eshnunna instituted a legal interest rate specifically on deposit of dowry, early Muslims called this Riba (charging of interest rate). In the medieval economy loans were as a consequence of bad harvest, fire in a place, under those conditions, it was considered morally reproachable to charge interest. The first attempt to control interest rate through manipulation of money supply was made by Banque de France in 1847.the latter half of the 20th century saw the rise of interest-free Islamic banking and finance, a movement that applies the law to financial houses and economy, some countries including Iran, Sudan and Pakistan have taken steps to eradicate interest from their financial systems.
During the 1980s many African, Asian, and European countries have adopted McKinnon and Shaw financial model by eliminating or reducing credit control, giving autonomy to commercial banks, deregulating interest rate, permitting private ownership of banks, free entering into the banking sector, and liberalizing international capital flow. The Nigeria government in 1987 deregulates interest rate as part of a structural adjustment program. (SAP)
The financial system is composed of a network of financial markets, institution, business, households, and movement. There are many function of the financial system, with the basic function of transferring loanable funds (credit) from lender (saving surplus units) to borrowers(saving deficit units) (Rose et al, 1995) Lenders being those whose current income receipts exceed their current expenditure, giving them extra funds to lend to borrowers. This financial transaction can be carried out directly between lenders and borrowers or semi-directly, where a third party is involved. The shortcomings of direct and semi-direct financing have opened doors for third method-financial intermediation, which is done by financial intermediaries. Over the past years, the list of borrowers has expanded from merchants and governments to include landowners, other banks, industrial firms, and consumers. Banks have faced demand for credits from these new classes of borrowers. Satisfying their demands has led to higher yields but typically increased risk and reduced liquidity, especially mortgage lending, because of its long term maturity.
By almost any measure, the commercial bank is the most important financial intermediary serving the public today. They offer more services than the majority of other financial institutions, which include expanding the money supply by granting credits (loans) to borrowers. They accept deposits from saving surplus units (lenders) and grant it as credits (loans) to saving deficit units (borrowers). Loans and deposits are the major components of the bank’s balance sheet—Assets and Liabilities. The fee paid by someone for the use of someone else’s money is known as interest. It is received when money is lent and paid when money is borrowed. When the borrower pays off the loan, he has to pay the principal amount he borrowed as well as the amount of interest occurred on that principal. Moreover, when someone gives up the right to someone to spend his money and as reward received some compensation is called interest. By ignoring the interest, investors wouldn’t be interested to postpone their spending as well as lender to lent money.
The capability to predict and to avoid the risk to fulfil the losses due to the arisen risk is essential for the success of banks. The cheapest source of funding for competitive banking institution is profit and it is the major requirement of a banking institution. The rising competition in financial market makes it necessary for the success of banking industry. These key facts are the reasons to focus on the present issue of banks profitability. These key facts are influencing the efficiency and effectiveness of banks to handle their portfolios like assets and liabilities to attain profitability and discover the areas where it might have potential room for increasing their profitability.
In Cameroon, the African development bank is in charge of development and reconstruction plans. But since Cameroon is a member state of the World Bank, the international bank for reconstructions and development also have a role to play. The banking market in Cameroon is oligopolistic and a few banks dominate the market such as BICEC, SGBC, and AFB. Some banks are price taker and others have strong support from the government which includes BICEC and SGBC.
Interest rates in Cameroon is a major instrument of monetary policy with regard to the role it plays in the mobilization of financial resources aimed at promoting economic development and profitability of commercial banks
In 1986, Nigeria interest rate was as low as at 2.5%, it rose to 8.9% (CBN; 1990). Auction markets for government securities were introduced; capital adequacy standards were reviewed upward and the extension of credit based on foreign exchange deposits was banned (Hussainatu;2008). Nigeria’s interest rate fluctuates over time as the Central Bank was to regulate and supervise all interest rate re-administered. The monetary authority introduced indirect monetary instruments in order to control the interest rate and the rate of inflation. The interest rate has doubled through the period of 1997 and 2007 attaining a peak of 24.62 (CBN; 2002).
In the economic and monetary community of central African (CEMAC) decisions about interest rate are taken by the central bank of central African states monetary policy committee. The official rate in the central bank of central African states is the prime lending rate.
Cameroon as a member of the CEMAC region actual benchmark interest rate of 2.45%. however, the interest of 4.25% in July 2009 and record low of 2.45% in July 2015.
1.2 Problem statement
Many researchers have carried out research on the effect of interest rates on the profitability of commercial banks but no good work has been done to fill the effective interest rate on profitability of commercial bank.
The main objective of commercial banks is to maximize profit, which is the maximization of shareholder’s wealth. To make this profit, more loans must be given out. From this loan, interest is received and therefore, increases in profit.
The interest rate is the amount invoiced, calculated as a percentage to be paid on a loan granted to a borrower for the use of assets. Studies on the effect of the financial repression on investment and economic growth by Saw and McKinnon (1973) led industrialized countries to the liberalization of the financial system in general and the liberalization of the interest rate in particular.
Due to the competition among the bank’s interest rate remains in a comparable range. For tracking and managing the significant development interest rate is to be addressed a significant economic problem (Boulier, Huang &Taillard, 2001; Laubach, 2009). On the other hand, in the profit and loss statement interest rate also engage in managing the interest component entirely (Buiter & Panigirtzoglou, 2003).
The low and sometimes negative interest rate real interest rate discourage savings, increased the demand for loans able founds. The demand for fund soon exceeds the supply of funds while essential sectors of the economy were starved of funds (Obute, Asor and Idoko).
Bank charges in Cameroon are regulated by the ministry of finance. The lending rate is approximately 22%without taxes. (This has recently been increased from 17%) for exchange rate of 1.5 to 4% apply both to selling and buying. Deposit rate applies at a maximum rate of 8% with a base rate of 4.5%. Other charges apply, on average at a rate of 15% on the transaction amount. A single borrower’s limit must exceed 45% of the bank capital funds.
The economy of Cameroon is a mixed system implies that the banking sector (commercial banks) play a complementary role to enhance economic growth and development, thus their profitability.
Despite this the greatest desire of commercial banks in Cameroon is to maximize profit efficiently and effectively by charging reasonable interest. Never the less, there are any enough empirical studies available to guide policymakers, financial experts to carry out better reforms concerning interest rate in Cameroon.
1.3 Research questions
- What is the effect of interest rate on the profitability of commercial banks?
- What are other determinants of commercial bank profitability?
1.4 Objective of the study
- This study aimed at investigating the effect of interest rate on the profitability of commercial banks.
- To determine the determinants of profitability of commercial banks in Cameroon
1.5 Hypothesis of the study
H0: interest rate has no effect on the profitability of commercial banks.
H1: interest rate has an effect on the profitability of commercial banks
1.6 Significant of the study
The research is worth investigating because it will sign to the academic world, banks, investors/society and the government.
To begin with; this study will help provide useful information to Commercial bank in Cameroon as to what interest levels can lead to profitability. It will help the banking industry especially decision-makers involved in implementing interest rates for their banks, draw inference in developing mechanism and policies to take advantage of interest rates in the market.
More still, the study will help the government of Cameroon in formulation of their monetary policy with respect to evolving economic and political environment.
In addition, this study will effectively help in planning and stabilizing the economy to ensure steady economic growth. Central Bank being the regulator of operations of commercial banks, the study informs the BEAC formulation of policies geared towards regulation of interest rates in the banking sector.
The study is invaluable to management of the Commercial banks as they will be able to uncover the relationship that the interest rates have with the profitability of their organization.
To end with but not the least, the findings of this study can be useful to scholars and academicians who may wish to use the effect of interest rate on the profitability of commercial banks as a basis for further research on this subject.
THE EFFECT OF INTEREST RATE ON THE PROFITABILITY OF COMMERCIAL BANKS