An interest rate is a charge for borrowing money, the amount charged when money is borrowed and received when money is invested. As there are a number of factors that impact interest rate and have a direct affect on consumers, banking system and country therefore the research includes the analyzing and understanding of commercial banks, microfinance, interest rates and their impacts.

For this purpose the factors that impact interest rates have been analyzed and preferences and opinions have been collected which include primary and secondary data. The primary data is collected in form of questionnaires and secondary data is collected through research articles, books and previous analysis.

This research will provide more knowledge about banking sector and interest rates especially when borrowing, lending and depositing while having impacts of interest rates in mind.

Problem Statement:

There are a number of factors that impact interest rate and have a direct affect on consumers, banking system and country. For this purpose the problem statement has been generated which is as under.

What are the impacts of interest rate on commercial bank and microfinance?

Background of study:

The research includes the analyzing and understanding of banking sector, interest rates and their impacts.

According to Oxford Advanced Learner’s Dictionary, interest is the extra money that you pay back when you borrow money or that you receive when you invest money. Interest is basically the charge for the borrowing of money, generally conveyed as an annual percentage rate.

According to ACCION (Americans for Community Co-operation in Other Nations), Interest rate is the amount paid by a borrower to a lender in exchange for the use of the lender’s money for a certain period of time.

Bank interest is on both as a charge for money that is loaned to borrowers and an amount paid for attracting deposits funds. Interest that is due on consumer loans must be calculated in Annual Percentage Rate (APR). Interest on loans may include annual, late payment and over limit charges. Interest rate is ordinarily conveyed as a percentage per annum which is charged on money borrowed or lent. The interest rate may be fixed or variable.

The name bank derives from the Italian word banco which means “desk/bench/counter”. Bank accepts deposits and makes loans and derives a profit from the difference in the interest paid to lenders and charged to borrowers. Banks as well make profit from fee charged for services. The three major classes of banks include central banks, commercial banks, and investment banks. Banks also enable customer payments thru other payment methods such as telegraphic transfer, EFTPOS, and ATM.

Commercial bank is a type of bank and a type of financial intermediary. A commercial banking is also called business bank which provides saving accounts, money market accounts, checking accounts and that accepts time deposits. Commercial banks also supply foreign exchange, international banking and trade financing. Commercial banks provide different types of loans which include secured loans, unsecured loans, and mortgage loans. A commercial bank as a financial institution provides a variety of services that are helpful for business and general purpose. Now-a-days commercial banks are using microfinance as a part of the institution because of its benefits and the market share it’s gaining.

Microfinance refers to the provision of financial services to low income individuals/clients, also including the self employed. Microfinance loans are either interest free or they carry interest which doesn’t compound. Furthermore they offer flexible repayment plans. “Microfinance” by its name clearly is about more than just credit, otherwise we should always call it microcredit. In developing world, microfinance is most common and it started in the 1970s in Bangladesh. The World Bank estimates that more than 500 million people have directly or indirectly benefited from microfinance associated operations. Microfinance provides different varieties of financial services in the developing world. People are moving to microfinance institutions day by day because of their excellent services and repayment future plans. Microfinance identified the problems relating to loans and needs of individuals or groups of a small scale. Microfinance is developing day by day in this developing world and now it is so common that everyone know about microfinance and its benefits. Microfinance has made itself very useful and common for low income clients specially the poor.

Today, microfinance is a dynamic sector which offers loans, sells insurance and provides remittance and savings services to about more than one hundred million of the poor people. Microfinance institutions have increased in multiplicity and complexity in income levels of customer which they serve. Commercial banks are facing competition increasingly in their retail markets which is causing the margin conflict. It also leads forward thinking banks to discover new possible markets which can generate the growth in numbers of clients with acceptable profit margins. As more and more commercial banks become fascinated by the thought of entering the microfinance market, the lessons learned from some of the more experienced players become useful in the decision making process. Some commercial banks are entering in the microfinance market due to growth opportunities and sustainable profit and commercial banks are investigating and inquiring for themselves. Many commercial banks have already identified the business opportunities of microfinance. Commercial banks have now ventured into microfinance in many countries where microfinance is at different stages of development. Some institutions normally meet only a small portion of microcredit demand in the regions they serve. Some microfinance institutions (MFIs) have been able to overcome this situation by gradually turning themselves into commercial banks specialized in microfinance. Banks and financial institutions have been entering the microfinance market in increasing numbers, ensuing in a growing number of formal regulated institutions partially or totally moving into microfinance.

The central bank also called monetary authority or reserve bank as well plays an important role. The central bank has been given the authorization to conserve price stability as its primary objective and has been granted liberty from government to make sure that short term Political considerations do not interfere with attaining this objective. Central bank charges interest on the loans made to borrowers, primarily the government and to other commercial banks as it acts as a lender of last resort to the banking sector. Its main responsibilities as well include controlling money supply, subsidized loan interest rates and implementing monetary policy.

According to Henry C.K. Liu, “The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines”. Central banks can influence market interest rates and can set rate to a fixed number. The central bank can simply announce its intention to raise or lower the relevant interest rate.

The structure of interest rates most frequent or common in an economy is of vital importance for economic decision making. The interest rate structure of the economy of Pakistan primarily consists of rates on banks deposits and lending schemes, yields on government securities such as treasury bills, PIBs and profit rates on national savings schemes, interest rates charged and offered by non-bank financial institutions (NBFIs) and rates of return on term finance certificates (TFCs).

Inflation is a general increase in prices as it is when the prices of most goods and services continue to crawl upward. Basically, inflation is a continuous decline in purchasing power of money and when inflation rate increases, governments or companies that issue debt instruments need to attract investors with a high interest rate. The central banks use interest rate to control the supply of money and, accordingly, the rate of inflation. When interest rate increases then the borrowings become more expensive.

Monetary policy is also an important tool. Monetary policy is the procedure by which the central bank or monetary authority of a country controls the money supply, availability of money, and rate of interest to achieve a set of objectives oriented towards the growth and constancy of the economy. Monetary policy is primarily associated with interest rate and credit. In some countries, the monetary authority may be able to authorize some specific interest rates on savings accounts, loans and other financial assets. A central bank can contract or decrease, under its control, the supply of money by increasing interest rate. Monetary policy is contrasted with fiscal policy which pertains to government borrowing, spending and taxation. Monetary policy can be of two types as expansionary policy and contractionary policy. Expansionary policy also known as easy monetary policy, used to combat unemployment by lowering interest rates and contractionary policy also known as tight monetary policy, involves raising interest rates to combat inflation.

Low interest rates compel banks to compete for loans therefore banks are able to offer attractive interest rates which appeal to customers to beat out the competition. At the same time that leads to new customers and the customer can do comparison for ensuring that the bank is offering him the best rate.

An economy consists of the economic system of a country which include capital, labor and land resources that participate in production, distribution and consumption of goods/services. When economy is growing then companies become profitable unemployment is low as consumers are spending money. Increasing interest rates result in slowing the economy because increasing interest rate means increasing borrowing costs for businesses and individuals which mean consumers have less money for spending. When the economy is slowing, the central bank will decrease short term rates as decreasing short term rates makes the borrowing less expensive and therefore businesses and individuals can spend and buy more which resulting in speeding up the economy.

Purpose of study:

The research is conducted in order to analyze the factors impacting interest rate regarding commercial bank and microfinance. Factors determining interest rate changes have a direct affect on consumer, banking sector and country therefore to analyze and understand the factors is a top priority. This research can also help in comparison and evaluation of interest rates and borrowing/lending of money for good.

Literature Review

Banks try to compete with other banks for loans and deposits as Kwangwoo Park and George Pennacchi (January, 2009) emphasize that small single market banks compete with large multi market banks. As large multi market banks are assumed to set retail interest rates across markets therefore loan competition increases and deposit competition decreases in concentrated markets. In context, Isil Erel (May, 2009) concur that bank competition influence banks to reduce the increasing ability of banks lending rates even when money market rates move up therefore the bank interest rates and the changes over time expect to depend on bank competition. Nishant Dass and Massimo Massa (2009) state that banks try to build strong relationship with firms by acquiring information about those firms which they lend to for improving borrowers corporate governance. With this procedure the firm value is affected and in financial markets the standard implications are developed. The fixed interest rate paid to a bank by private firms for industrial investment financing has an essential importance in the economy. When there is stronger loan market competition then larger bank spreads on current account and time deposits and the banks that are under competition they compensate for lowering their deposit rates. In context with that, banks borrow for increasing their activities, whether for lending or for investing, and for this service the interest is paid to clients. Both the levels of bank interest rates and their changes over time are expected to depend on the degree of competition. In concentrated markets, retail lending rates are substantially higher, while deposits rates are lower. Regarding the effect of competition on the way banks adjust their lending and deposit rates. Hannan and Berger (1991) find that deposit rates are significantly more rigid in concentrated markets. Especially in periods of rising monetary policy rates, banks in more consolidated markets tend not to raise their deposit rates. Emilia Bonaccorsi di Patti and Giovanni Dell’Ariccia (2004) concur that low interest rates also create a sense of urgency as if a consumer is saving for purchasing something, like a house, a low interest rate will play an intricate role in determining when he takes that financial plunge. This will cause the economy to expand because the consumer has more disposable income and more confidence when spending money.

Iris Biefang-Frisancho Mariscal and Peter Howells (2002) state that the role of central bank is reduced to set short term interest rates as central bank indicates commercial banks to keep the price that will make liquidity available as reserve to the banking system. Therefore according to market rates the price increases and decreases. In context with that, in the form of reserves or currency, banks are required for having certain amount of total deposits as percentage which are liabilities of central bank, and hence fully guaranteed. If the monetary policy makers desire to reduce supply of money then they will raise interest rate as making it attractive for depositing funds and reducing borrowings from central bank and if monetary policy makers desire to raise the supply of money then they will raise interest rate as making it attractive for borrowing and spending money. Some banks offer funds on basis of first come first serve especially commercial banks. If bank doesn’t have sufficient liquidity as according to customer demands, it can borrow the additional funds from the central bank. Central bank doesn’t favor any particular bank. Central banks may hold reserves of commercial banks based on ratio of commercial bank deposits. All commercial banks may be required to keep a deposit/reserve ratio as it is another means of controlling the supply of money. In context, Graeme Guthrie and Julian Wright (2004) concur that the central bank implements monetary policy by targeting short term interest rates to stabilize the money supply in the country. The target rate can be changed when preferred rate and current target rate reach to critical level. According to Jordi Gali, J. David Lopez-Salido and Javier Valles (2004), the discount rate keeps the banks from continuous borrowing which would disorder the money supply in the market and monetary policy of the central bank. Commercial banks will be mobilizing more money in system by borrowing more than necessary. The use of discount rate can be limited by making it unattractive while using frequently. Furthermore, David E. Rapach and Mark E. Wohar (October, 2005) indicate that inflation rates and real interest rates often together increase and decrease as government changes. Therefore the change in monetary policy is an important source of changing in real interest rates. In context with that, monetary policy affects nominal interest rate only that is unadjusted for inflation. Nominal interest rate is the combination of real interest rate and inflation premium. Monetary policy operates by influencing the price of money, i.e. the cost of borrowing and the income from saving.

Isil Erel (2009) emphasizes that usually high inflation leads to high interest rates. The interest rate for borrowing money will increase when demand of money is high and when interest rate changes then the borrowers feelings also changes because borrowers don’t like quick shifts in interest rates and inflation when shifts are not in their favor particularly. In context, inflation is caused by too much money chasing too few goods or too much demand for too little supply, which causes prices to increase. When the inflation rate is high, the interest rates are more likely to rise. It happens because the lenders will be demanding the high interest rates for compensation of the decreasing in purchasing power of money which will be repaid in future. Patrick Gagliardini, Paolo Porchia, and Fabio Trojani (October, 2009) state that the purchasing power of money loses during inflationary periods and with that each unit of currency is affected. If more money is available than needed to accommodate normal growth then consumers and businesses try to purchase more goods and services to produce with current resources causing upward pressure on prices and the market does not have time to adjust other prices downward in response therefore a short term increase in overall prices takes place. Changes in inflation rate cause corresponding changes in interest rates as inflation affects the value of lenders money therefore the interest rate increases to compensate the loss. According to David E. Rapach and Mark E. Wohar (2005), for controlling inflation, monetary policy has been chosen as the primary tool as its goal is to reduce the inflation. Inflation changes unpredictably and it can interrupt the economy which cause uncertainty in financial decisions. James D. Hamilton and Òscar Jordà (October, 2002) emphasize that level of federal funds rate is determined by the Federal Reserve which is one of the most anticipated and publicized economical indicator in financial world and it targets only rates in the federal funds market. In context, if Federal Reserve wants to decrease interest rates then it makes loans to banks (short term) in the Federal Funds market then the banks lend that money to investors with a profit. This lending process creates an effect of increasing the money which is in circulation. If the Fed increases the federal funds rate, it becomes more expensive for banks to borrow money from the Fed. The Fed will lower short term rates when the economy is slowing as lowering rates makes it less expensive to borrow money and consumers and businesses can afford to buy more products and services.

Graeme Guthrie and Julian Wright (2004) concur that the central bank, which is charged for maintaining the constancy and stability of the financial system, increases or decreases the short term rates in an attempt to maintain that stability. In response for economic ups and downs, the central bank takes these actions on a regular basis so that the country goes through on a pretty routine basis. If central bank changes interest rates at which banks borrow money then those changes passed on to the economy. In perspective, if the central bank decreases the rate then banks can borrow money for less and then the banks can decrease the interest rates they charge to individual borrowers as making loans more competitive and attractive. If an individual was thinking about buying something and the interest rates suddenly decreases then he/she might decide for taking out a loan and spend. As consumers spend more, the economy grows more. Antonio Argandoña (2003) and Alexander Konovalov (2005) emphasize that Federal Reserve is central bank of the United States of America and is accountable for determining interest rates. The function of central bank is to create the financial security and stability for the economy. Whether the rate is high or low, banks have to borrow from the central bank at the set interest rate. The banks are capable to pass some of the savings on to customers when interest rates are low and the customers will be paying more money for borrowing the money they need when interest rates are high. Borrowers don’t like to borrow money when interest rates are high which leads to economic decline. In context, interest rate frequently decreases during the slow economy which makes borrowings less expensive. The result of this interest rate change promote and encourage businesses and individuals to spend more money by borrowing more loans inducing economic growth but if economy grows too quickly then it will lead to economic decline and for that reason interest rate frequently increase, discouraging individuals and businesses as making borrowings more expensive which resulting in less borrowing and less spending. Daniel Horgos and Klaus W. Zimmermann (2009) state that for a central bank, changing interest rate is the way to help economy to move in direction of continuous economic growth. When central bank changes the interest rate, basically it doesn’t affect all consumers. Only those with credit cards and variable rate loans are affected. Interest rate changes, however, do affect the whole economy. In context, the affect of raising interest rate is that the banks increase the interest rates they charge their customers for borrowing money and through increasing in mortgage interest rates and credit card especially when they carry variable rate, individuals are affected. It affects the decreasing in the amount of money that consumers can spend. Therefore people can spend less money and that affects businesses as they have to pay bills and when bills are more expensive then they will be left with less amount of disposable income. Juvénal Ndayiragije (1999) emphasize that when Federal Reserve increases the interest rate, the stock market doesn’t have an instant and immediate affect. The stock market inclines when Federal Reserve decreases the interest rate and that is an indication to investors that companies will be increasing the production and creating more jobs and that people will buy goods and services more than before. In context, basically the raising interest rates causes the price of stocks to fall as the investors, in that case, will be purchasing fewer stocks. Soon, prices fall enough and encouraging the investors to start purchasing again which raises the stock prices. The stock demand increases when interest rate decreases, causing the price of securities to raise and it leads to economic growth. Amit Bubna and Bhagwan Chowdhry (2010) concur that the banks profit from difference between interest it charges by lending and interest that bank pays for the deposits. If bank is not lending then consumer is not spending thus the economy stagnates and economy can’t survive stagnating therefore central bank has to make some adjustments for economy to start and move in right direction. Furthermore, when people are having high disposable income then it means that people like to spend more than to save.

METHODOLOGY

As this research is related to the study of impacts of interest rates therefore Survey based research using Qualitative method was conducted.

In sampling technique, Stratified Random Sampling Method (Probabilistic Sampling) was used.

The banks are divided into two groups: Commercial Bank and Microfinance, which include 06 (60%) Commercial Banks and 04 (40%) Microfinance. 50 Branches of 10 different randomly selected Banks (05 Branches each) of Karachi have been selected randomly. The selected Banks and their Branches are as follows:

Bank AlFalah: MCB: Standard Chartered:

I. Chundrigar Road North Nazimabad Nazimabad Branch

Clifton PECHS SITE

Gulshan-e-Iqbal Saddar Abdullah Haroon Road

PECHS Gulshan-e-Iqbal Baloch Colony

Shahrah-e-Faisal Hassan Square Safoorah Goth

UBL Bank: Citi Bank: Askari Bank:

Corporate I. I. Chundrigar Road Saima Trade Tower

Baba-e-Urdu Road World Trade Centre Gulshan-e-Iqbal

City Shahrah-e-Faisal SMCHS

M. M. Khana Khyaban-e-Shahbaz Clifton

Bunder Road DHA Phase II Lal Masjid

Pak Oman Microfinance: Rozgar Microfinance: Tameer Microfinance:

Qayyumabad Clifton Malir

Kemari Iqra SITE

Orangi Town Taiser Town North Karachi

PECHS Dalmia KCHS

Mehmoodabad Shahrah-e-Qaideen Dak Khana

Network Microfinance Bank:

Shahrah-e-Faisal

Gul Tower

FTC

Shah Faisal Colony

Orangi Town

The research includes both primary and secondary data. The primary data was collected through 50 questionnaires from 50 Branches, filled by Branch staff members. The questionnaire, comprising a total of 15 questions was used and it includes questions relating to commercial banking and microfinance with relation to interest rates, using an interval five-point Likert scale ranging from (1) strongly disagree to (5) strongly agree.

The secondary data was collected through Journals, Research Articles, Books, Thesis, Published Reports, News Articles, Websites, etc.

Limitations of the Research:

Research data is not 100% accurate. Our research has certain limitations which include:

Lack of experience in survey based research, which was overcome with the help of keeping our teachers advice as well as the textbooks.

Another limitation was the availability and willingness of the respondents because people find no time out of their busy schedule.

HYPOTHESIS:

Two hypothesis were formulated in order with our objectives. There was one hypothesis for each segment we would consider in our sample which are as under.

Impact of interest rate on commercial bank is high.

Impact of interest rate on microfinance is high.

DATA ANALYSIS:

You prefer variable rate instead of fixed rate on deposit, lending, and borrowing.

Table 01

Particular

Commercial Bank

Microfinance

(1) Strongly Disagree

7

6

(2) Disagree

0

0

(3) Neutral

18

12

(4) Agree

1

2

(5) Strongly Agree

4

0

Total

30

20

Table: 01: The focus of this question was to determine the rate banks prefer, fixed or variable rate, for borrowing and lending. This question has great importance as different banks prefer different rates. As visible from the results, interest rate fluctuates after a certain period of time therefore most respondents (60%) prefer neutral in commercial bank and microfinance as interest rates may be fixed or variable.

There is a decrease in rate of interest due to bank competition.

Table 02

Particular

Commercial Bank

Microfinance

(1) Strongly Disagree

5

5

(2) Disagree

14

15

(3) Neutral

11

0

(4) Agree

0

0

(5) Strongly Agree

0

0

Total

30

20

Table: 02: This question was asked to find out the perception about interest rate changes due to bank competition. The results show that the most preference is given with 47% of respondents from commercial bank and 75% of respondents from microfinance as they disagree that due to bank competition there is a decrease in rate of interest.

You prefer variable rate when bank is under competition.

Table 03

Particular

Commercial Bank

Microfinance

(1)Strongly Disagree

0

0

(2) Disagree

0

0

(3) Neutral

9

6

(4) Agree

21

10

(5) Strongly Agree

0

4

Total

30

20

Table: 03: This question was asked to determine the rate banks prefer when they are under competition. The result shows that 70% respondents of commercial bank agree and 50% respondents agree from microfinance to prefer variable rate when bank is under competition. When the interest rate is low, the borrowing becomes less expensive and at that time people try to borrow and spend more therefore banks offer variable rate to attract more customers and compete each other.

The high interest rate creates problem in paying against borrowings.

Table 04

Particular

Commercial Bank

Microfinance

(1) Strongly Disagree

0

0

(2) Disagree

0

0

(3) Neutral

7

0

(4) Agree

13

10

(5) Strongly Agree

10

10

Total

30

20

Table: 04: This question was asked to determine that if high interest rates creating problem against borrowings. The results show that 43% respondents of commercial bank and 50% respondents of microfinance agree as when the interest rates are high, the borrowings become more expensive.

There is a decrease in bank lending due to high interest rate.

Table 05

Particular

Commercial Bank

Microfinance

(1) Strongly Disagree

0

0

(2) Disagree

0

0

(3) Neutral

0

0

(4) Agree

8

9

(5) Strongly Agree

22

11

Total

30

20

Table: 05: The focus of this question was to determine that if bank lending is affected due to high interest rate. The result shows that 73% respondents of commercial bank and 55% respondents of microfinance strongly agree as rising interest rate means rising borrowing cost which has the affect of lowering the amount of money that consumer can spend as consumer stops borrowing from banks because it becomes more expensive.

You prefer high interest rate on repayment of loans (including borrowing, lending, and deposit).

Table 06

Particular

Commercial Bank

Microfinance

(1) Strongly Disagree

0

0

(2) Disagree

19

12

(3) Neutral

11

8

(4) Agree

0

0

(5) Strongly Agree

0

0

Total

30

20

Table: 06: The focus of this question was to determine that if banks prefer high interest rate on repayment of loans. The results show that 63% respondents of commercial bank and 60% respondents of microfinance disagree that they don’t prefer high interest rate on repayment of loans as high interest rate makes borrowing more expensive.

You prefer borrowing from Central Bank instead of Public Deposits.

Table 07

Particular

Commercial Bank

Microfinance

(1) Strongly Disagree

18

14

(2) Disagree

3

2

(3) Neutral

7

4

(4) Agree

2

0

(5) Strongly Agree

0

0

Total

30

20

Table: 07: The focus of this question was to determine that if banks prefer central bank instead of public deposits for funds. The result shows that 60% respondents of commercial bank and 70% respondents of microfinance strongly disagree as the more customers bank will have the more market share it will capture.

Monetary policy stabilizes the interest rate in the economy.

Table 08

Particular

Commercial Bank

Microfinance

(1) Strongly Disagree

0

0

(2) Disagree

0

0

(3) Neutral

0

0

(4) Agree

22

13

(5) Strongly Agree

8

7

Total

30

20

Table: 08: This question was asked to analyze that monetary policy can stabilize the interest rate to make economy better. The result shows that 73% respondents of commercial bank and 65% respondents of microfinance agree as the central bank implements monetary policy by targeting interest rate to stabilize the supply of money in the country.

High operating cost creates problem in