Are Bank Interest Rate Spreads Too High? A Simple Model for Decomposing Spreads

In the first seven months of 1995, average bank spreads in Ukraine ranged from 46 percentage points to 84 percentage points. The size of these spreads might suggest that banks enjoyed a wide profit margin. But inflation was high in Ukraine, and its banking system had large stocks of nonperforming loans. Using a simplified model to make a "quick and dirty" estimate of the spread banks need to achieve a positive real return on equity, this Note shows that nominal spreads in Ukraine were, on average, below breakeven. It approaches the question from a methodological perspective, using a highly simplified model and applying international parameters for bank performance as a benchmark. The model is a static one based on quite restrictive assumptions, and it manipulates simple accounting identities without any consideration of the strategic behavior of market participants. But what the model can do is alert policymakers to possibly unsustainable situations and provide estimates of the effects of changes in the policy parameters of the size of the spreads. It can be a handy guide to assess bank spreads for a given bank or banking system anywhere.