research methodology

EFFECT OF INTEREST RATES ON LOAN DEMAND IN EQUITY BANK: (2014-2017)

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The importance of commercial banks in an economy is well known and so, their success and contribution to individuals and agencies in regard with financial services is something significant. In liberalized financial sector, one of the expected benefits is the narrowing of the interest rate spreads, i.e. the difference between the interest rate charged to borrowers and the rate paid to depositors (Folawewol & Tennant, 2008). Thus, wide deposit-lending interest rate margin could be indicative of banking sector inefficiency or a reflection of the level of financial development. The issue at hand is that, most countries in Sub Saharan Africa (SSA) are still confronted with high levels of interest rates, despite having undertaken structural adjustment reforms that led to the liberalization of interest rates in several countries in the region. In Uganda, the banking sector plays a dominant role in the financial sector, particularly with respect to mobilization of savings and provision of credit (Nampewo, 2013). However, the ever fluctuating interest rates more so, high rates seem to be affecting borrowers and economy at large.

Interest rate is thus defined as a rate which is charged or paid for the use of money (Turner, 2013). It is also viewed as the price paid for use of loaned funds. According to Ddumba (2011), ever since Bank of Uganda increased the Central Bank Rate to a staggering 23% from 13% in 2010, banks took advantage of the situation and hiked their prime lending rates accordingly. For instance, Stanbic Bank increased its lending rate to 34%, Centenary Bank from 19% to 23%, the once Crane Bank from 23% to 28%, dfcu bank from 23% to 27%, Standard Chartered from 18% to 34%, Barclays Bank from 17.5% to 30% and KCB from 18% to 28%. This situation has become a critical concern in the banking and lending industry in Uganda. Financial institutions have been accused of charging high interest rates and exploiting the consumers. This necessitated for the government through the Ministry of Finance passing a Financial Institutions Act with an aim of protecting the consumers.

In regard to loan demand, it is argued that when loans seem expensive as a result of high interest rates, the level of loan demand in commercial banks tend to be low. Rising and falling of interest rates directly affects consumer and personal financial decisions. Rising interest rates make saving relatively more attractive and borrowing relatively more expensive. Falling interest rates have the opposite effect. To borrowers, when interest rates are low, potential borrower would take up more loans and this would lead to decrease in price as the market for real assets improves (Ingram, 2011). This is because they find it relatively easy to repay their debt. When interest rates are high, people are reluctant to borrow because repayments on loans cost more. It is a widely shared argument that, interest rates are the only primary source of income for commercial banks however, high interest rates tend to have a negative effect on loan demand. If loan demand falls it equally affects the financial objectives of the bank. It becomes a paradox or a puzzle to gain competitiveness by increasing interest rates at the expense of falling loan demand.

In Uganda, during 2008 and 2009, several existing banks went on an accelerated branch expansion either through mergers and acquisition or through new branch openings and this was recorded to be the highest growth in the years. As far as October 2012, there were 24 licenced commercial banks in Uganda, with nearly 500 bank branches and a total of almost 600 automated teller machines (Bank of Uganda, 2013). Equity Bank Uganda (EBU) is among the commercial banks competing to have a share of this trade. EBU offers a full range of financial services, comprising savings, credit and money transfer. The reason for Choosing EBU is due to the fact that it is still struggling to deepen its services within Uganda. According to the Financial Report 2012 on Assets and Market share among some commercial Banks in Uganda, out of the 12 list of commercial banks, EBU was at the bottom with 135 million dollar assets, 2.2% Market share and 44 branches compared to Stanbic Bank 1,213 million dollar assets, 19.9% market share and 91branches. In this study however, focus is on determining the extent to which interest rates have affected loan demands at EBU.

1.2 Statement of the Problem

High interest rate spreads have continued to persist among commercial banks in Uganda which have affected loan demand levels by potential borrowers. As a result, commercial banks such as Equity Bank have experienced disturbing upshots following the rising interest rates. According to the article on 24th August, 2017 in Daily Monitor, it was revealed that, in 2016, loan interest rates were capped at 400 basis points above the signal rate, currently at 10 per cent and deposit rates at a floor of 70 per cent of the Central Bank’s rate. This resulted into an interest margin of seven per cent. In this respect, the growth of credit to the private sector fell further to 2.1 per cent over the 12 months to May 2017, according to CBK data; this was blamed on the rate caps. Though Equity Bank boasted of a client base of 11.7m however, in 2017 it announced a 7.4 drop in net profit. Consequently, the banks’ lending to micro, small and medium enterprises (MSMEs) fell by an estimated 5.7 per cent between August 2016 and April 2017. Findings by Standard Investment Bank (2017) revealed a decline in micro loan book; with the loss ratio, meaning that the bank was not pricing risk. Though the bank had forecasted full-year group loan book growth of five per cent, however, a significant drop from realised five-year average loan growth of 24.4 per cent was registered (SIB, 2017). It is upon aforementioned problems that have prompted the researcher to conduct this study.

1.3 Objectives of the Study

1.3.1 General Objective

To determine the effects of interest rates on loan demand: a case of Equity Bank,

1.3.2 Specific Objectives

The specific objectives of this study are

To establish the long run relationship between interest rates and loan demand in Equity Bank

1.4 Research Questions

The study will be guided by the following questions:

What is the long run relationship between interest rates and loan demand in Equity Bank?

1.5 Scope of the Study

1.5.1 Content Scope

The study is confined at determining the effects of interest rates on loan demand in commercial banks in Uganda using Equity bank.

1.5.2 Geographical Scope

Geographically, the study will be conducted at Equity Bank; this bank is specifically selected because of accessibility and its staggering financial performance.

1.5.3 Time Scope

The study will be carried out for a period of four years from 2014-2017.

1.6 Significance of the Study

This study is expected to benefit the following stakeholders:

It is expected that generated data may be used by policy makers such as Central Bank and Ministry of Financial and Economic Development in formulating policies to address existing gaps that account for high loan charges.

It is also expected that, commercial banks among other financial institutions may use the generated information in form of recommendations to improve on their policies to suit their clients.

Furthermore, it is expected that the generated data may add useful and updated information to already existing literature.

Finally, the study is expected to serve as a point of reference for future studies by students and other scholars who may wish to conduct similar studies.