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  • Background of the Study

There is no doubt a theoretical link exists between interest rates and the financial structure of firms. Interest rates operate through their influence on the cost of capital to the investor, as well as on returns to various groups of savers. A change in the interest rates affects the debt-equity choice of a firm, the overall cost of capital and real interest rates, and thereby sets in motion a chain of responses influencing the desired level of the capital stock and its productivity as well as the availability of savings and consequent speed of adjustment of the actual capital stock to its desired level. Hualan (2012) found that interest rate is one of the most important factor that affect the bank financial performance.

Interest rate is said to be the mechanism that equilibrates supply and demand in the financial sector (Colander, 2004). Both the channeling of saving into financial assets and the willingness of individuals to incur financial liabilities are strongly influenced by the interest rate on those financial assets and liabilities. The interest rate according to Mankiw (2007) is the price paid for the use of a financial asset. It is the market price at which resources are transferred between the present and the future; the return to saving and cost of borrowing.

Banks play the role of intermediary in the financial market as they take deposits from those who have surplus against some interest rate and lend to those who have deficit against another rate. The difference between these two rates is called interest rate spread that is the profit of intermediary party. This spread will affect both lender and depositor. The alternate opportunities of investing in financial market also affect the level of deposits (Amna and Muhammad, 2016).

Amna and Muhammad (2016) stated that when the interest rates as income of investor decrease spread will increases then it will decrease the savings. In the banking sector change in interest rate has significant impact on the profitability of banks. Interest is actually the fee that is paid for using the funds of another person. It is paid when we borrow and received when we lend. When borrower pays back the loan he also pays interest with principal payment. If there is no concept of interest no one would be interested to lend. Interest rate is usually expressed in term of percentage. Like 10% interest is agreed on annual basis then with principal amount of 1000 interest of 100 will also be paid.

Financial intermediation is important in the growth and developmental process of an economy since it leads to effective mobilization of investible funds. Inefficiency of financial intermediary causes high intermediation cost and increases loss of productive funds in intermediary process (Shahzad, Lodhi and Muhammad, 2012). Thus banking sector efficiency is crucial for the growth of any economy. A major indicator of banking sector efficiency is interest rate spreads which have been found to be high in Sub- Saharan African countries (Folawewo and Tennant, 2008).

Interest rate spreads is the interest rate charged by banks on loans to private sector customers minus the interest rate paid by commercial or similar banks for demand, time, or savings deposits according to World Bank (2015). As stated to Folawewo and Tennant (2008), interest rate spread is the difference between what a bank earns on its assets and what it pays on its liabilities. Beck and Hesse (2006) saw interest rate spreads as the difference between ex-ante contracted loan and deposit interest rate. Interest rate spreads measures the efficiency of the banking sector. The higher the size the less efficient the sector is.

The difference between the borrowed rate and the lending rate is called the spread. Spread is different from the rates because they are determined by the individual financial institution (Mlachila, 2010). Low rate or small spread helps the financial institution to remain competitive hence encouraged.

Due to the importance of interest rate spreads in the banking sector efficiency, the Central Bank of Nigeria (CBN) over the years have engaged in interest rate liberalization in order to narrow the size of interest rate spread in the country. The CBN liberalized the interest rate regime in 1987 with modifications in 1989.

In 1991, government prescribed a maximum margin between each bank’s average cost of funding and its maximum lending rates. Partial deregulation was restored in 1992 and the removal of maximum lending rate ceiling in 1993 saw an increase in interest rate which led to the restoration of direct interest controls in 1994. Total deregulation of interest rate was adopted again in October 1996. In 2001, CBN directed banks to exclude overheads as part of their cost of funding in determining their lending rates. In 2009, banks were requested to submit their pricing model reflecting detailed components that add up to their lending rates. Following the heterogeneity in banks pricing models, CBN issued a circular in 2010 allowing banks to recognize the overheads recovery rate into the of cost of funds by (Jibrin, Okorie, Okoro, Dada, Chiemeke and Owolobi, 2015).

Despite all efforts by the CBN to reduce the size of interest rate spreads over the years, the spreads kept rising. Many economists have found some macroeconomics variables to be the determinants of interest rate spreads. Samahiya and kaakunga (2014) found deposit market share, liquidity levels and operating costs as the determinants of interest rate spreads in Namibia. Obidike, Ejeh and Ugwuegbe (2015) observed that interest rate spreads has a negative but significant impact on bank performance in the long run.

According to Akinlo and Owoyemi (2012), cash reserve requirements, average loans to average total deposits, remuneration to total assets, gross domestic product, non-interest income to average total assets, treasury certificates and stocks are factors that determines interest rate spreads in nigeria. Jibrin, Okorie, Okoro, Dada, Chiemeke and Owolabi (2015) found that banks funding costs are determined by salaries and wages, cost infrastructure, banks’ risk premium, liquidity condition, inflation and money supply in Nigeria.


More so, Non-performing loan is a loan that is in default or close to being in default. Many loans become non-performing after being in default for 90 days, but this can depend on the contract terms. “A loan is nonperforming when payments of interest and principal are past due by 90 days or more, or at least 90 days of interest payments have been capitalized, refinanced or delayed by agreement, or payments are less than 90 days overdue, but there are other good reasons to doubt that payments will be made in full (International Monetary Fund, 2005). This tend to significantly cause an increase in the spread.

Bank size is said to be an important factors that influence profitability of banks. Some banks appear to have high profitability relative to other banks according to some clusters created by the researcher. Recently, almost all banks were forced to enhance their services and profits due to the high increase in local and international competition between banking markets and due to the changes in banking environment.

From the foregoing, the study tried to ascertain the impact of interest rate spread on profitability of banks in Nigeria (2005-2014).

  • Statement of the Problem

Interest rate spread remains a controversial area while some link it to market or individual banks inefficiency. There is a conflicting argument that spread is core to bank performance and those banks which manage to keep wider spread perform better than other banks holding other factors constant.  The interest rate spreads (measured as the difference between deposit and lending rates) not only indicate the level of inefficiency of the banking sector but show the level of development of the financial system.

Bank interest rate spreads have several important implications for growth and development of any economy. Specifically high interest rate spreads tend to discourage potential savers and thus limiting the quantum of funds available to potentials investors. A reduction in lending arising from low savings often leads to low investment and thus the economic growth rate. Incidentally, interest rate spreads in Nigeria increased by a large amount over the study period. However, not many studies have been undertaken to analyse the main factors underlying the high interest rate spreads in the country.

The rationale behind the need to control the interest charged on credit or any other financial instrument is based on the need to control economic patterns that has great effects to the society. Holding all factors constant, controlling and setting of rates has big economic implication to the economic growth hence creating for a need of a rational decision making process within the industry.

Most studies in the past involved less variables which affect banks financial performance. While some concluded that interest rate spread impact on banks financial performance. Most of the studies do not indicate the extent of the impact, that is, if interest rate spread have strong or weak relationship to banks financial performance. If impact of interest rate spread to banks financial performance will have a clear picture of what will happen if spread is regulated. Most of conclusions are drawn when considering determinant of interest rate spread. Hence, the study tends to ascertain the impact of interest rate spread on profitability of banks in Nigeria (2005-2014); using First Bank of Nigeria as a study.

  • Objectives of the Study

The broad objective of the study is to examine the impact of interest rate spread on profitability of banks in Nigeria. Specifically, the objectives of the study are:

  1. To ascertain the impact of non-performing loan on bank profitability.
  2. To investigate the impact of bank size on bank profitability in Nigeria.
  • To investigate the impact of bank operating cost on bank profitability in Nigeria.
    • Research Questions


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