1

BANK Of ZAMBIA S
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LB
B
A
A
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K
K
S
SD
D
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E
T
T
E
E
R
R
M
M
I
I
N

R
E
E
S
S
T
TR
R
A
A
T
T
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SI
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NZ
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n1.1 As Government has indicated its intention to shift monetary policy away from
monetary targeting towards interest rate targeting, the Bank of Zambia (BoZ) has embarked
on conducting preliminary research to assess the feasibility of an interest rate targeting
framework in Zambia. Gaining a thorough understanding of the interest rate decision-making
process undertaken by commercial banks in Zambia would not only assist in the
determination of an appropriate policy rate, but would also enable the Bank of Zambia to
ascertain the transmission channel through which the policy rate would be most effective.

1.2 Evidence from numerous interest rate targeting central banks indicates that the policy
rate should be aimed at influencing developments in the interbank rate, which is then

lending rates included: Treasury bill and GRZ bond yield rates; operating costs; cost of funds,
i.e. weighted average deposit rates; return on shareholder’s equity and the cost of non-
performing loans. The qualitative factors highlighted included, credit risk premiums, the
demand and supply for credit and the industry trend in base lending rates.

1.7 The survey results indicated that only half of the banks surveyed considered inflation
explicitly in their determination of base lending rates; although some banks indicated that
inflation was taken into account when calculating real returns. It was also found that almost
all the banks do not consider the interbank rate, or the BoZ overnight facility rate in their
calculation of base lending rates.

3 1.8 Furthermore, several of the banks stated that qualitative or “judgemental” factors
contributed significantly in the determination of their base lending rates. In particular, they
noted that large information asymmetries within the domestic market, as well as the high
default culture experienced in Zambia, resulted in large risk premiums being attached to key
macroeconomic factors, such as inflation and Treasury bill yield rates.

1.9 These findings have two key implications: the first being for implementation of an
interest rate targeting framework in Zambia, and the second being the prevalence of high
lending rates. Firstly, as the interbank market is expected to be the transmission channel for
the framework, a policy rate that is linked to the interbank rate or overnight rate may not have
the desired effects on interest rates in the economy, as it will have no bearing on the banks’
cost of funds. In particular, further analysis indicated that there is a weak correlation between
the weighted lending base rates and the interbank rate (0.50) while there is a stronger
correlation between the weighted lending base rates and the OMO rates (0.72). This suggests
that, as an alternative, a policy rate linked to the OMO rate may be more effective.


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2.1 The survey was undertaken using a structured questionnaire over the period 1
st
March
to 12
th
March, 2010. The questionnaire was supplemented with interviews between BoZ staff
and representatives from all the 18 registered commercial banks. The questions posed in the
questionnaire are listed below:

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3.1 This section presents the findings of the survey, based on the information provided by
each of the commercial banks. These are discussed in turn below.
Determination of Base Lending Rates
3.2 Taking all the commercial banks’ responses into account, we summarised the key
factors considered in the base lending rate decision-making process in terms of cost of funds,
economic conditions, market conditions and political risks. As can be noted from Table 1, the
most common factors considered in the rate setting process are cost of funds: cash reserve
requirements – namely, the statutory reserve ratio, core liquid asset ratio and the BoZ
supervisory fee; operational costs; and yield rates on Government securities. This is followed
by market conditions: credit risk, industry trend, interbank rate, overnight facility and
demand and supply of credit.

3.3 The survey results indicated that only half of the banks consider economic conditions,
in this case, inflation, explicitly in their determination of base lending rates. Furthermore,
while it is understood that the interbank rate represents the cost of short-term liquidity, it is
evident from Table 1, that all banks, with the exception of one bank, do not take the interbank
rate into account while four banks indicated that they consider the BoZ overnight facility rate
in their determination of the base lending rate.

3.4 It was also found that the ranking of factors depended primarily on the bank’s profit
motive. For example, while the Treasury bill yield rates are considered by all banks, and by
implication one is likely to rank them highly and thus give them a relatively larger weighting
in the calculation method, a fall in the yield rates should result in a fall in the base lending

Bank
I
H
G
F
E
D
C
B
A
J
K
L
M
N
O
P
Q
R
√
√
√
√
√
√
√
√
√
√
√
√
√

√
√
Statutory reserve
requirement
√
√
√
√
√
√
√
√
√
√
√
√

√
√
√

√
√
√
√
√
√
√
√
√
√
√
√

√
√
√
√
√
√

√
√
√
√

√

√
√
√

√
√
√
√
√
√

√
√
√
√ √
√
√
√

√
√
Weighted average
deposit rate


√
√
Operating costs
2

√
√
√
√

√
√
√
√
√
√
√
√
√
√
√
√

√
√

√
√

√

√
√
√

T-bill/GRZ bond rates
√
√

√
√
√
√
√
√
√
√
√
√ √
√
√
√
√
√
√
√
√
√

√
√
√
√

Exchange rate
√
√
√
√
√
√ √
√
√
√

√
√

Credit risk premium

√
√

√
√

√
√
Liquidity premium √
√

Overnight facility rate
√
√

√
√

√
√ √

√
√
√
√
√
√
√

√
√
√
√

√
√ Industry trend

risk premium
√
√

√
√
Table 1: Aggregate results of the factors considered in the determination of Kwacha base lending rates
7 Interbank Rate and Policy Rate

3.6 Since we have observed that the interbank rate is not a significant input in the
calculation of banks base lending rates, the introduction of a policy rate which is expected to
influence the interbank rate will not have the desired effects on commercial bank interest

0
10
20
30
40
50
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Weighted Lending Base Rate
INFLATION
Percent
8 Government Securities yield rates and Lending Rates

3.10 The relationship between the WLBR and Treasury bill yield rates, over the same 10
year period, is shown in Graph 2. As is evident from the graph, there is also a positive
relationship between the WLBR and Treasury bill yield rates, with a correlation coefficient of
0.89. This suggests that, as indicated by the banks, Treasury bill yield rates should play a
significant role in the determination of the base lending rates.

Graph 2: Weighted Lending Base Rate (WLBR) and T-bill yield rate, 2000 to 2009
40
50
60
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Weighted Lending Base Rate
91 day Treasury Bill yeild rate
Percent
9 3.14 In addition, it was found that most of the banks set their base lending rates
qualitatively during the Assets and Liabilities Committee (ALCO) meetings, which primarily
assess the borrowing and lending strategy of the bank, among other things, with the view to
attaining the profitability objectives of the bank. This suggests that interest rate adjustments
seem to be dominated by the banks profit motives rather than the developments in economic
fundamentals.
Large Information Asymmetries
3.15 The margins charged on loans and advances are, in some cases, excessively high. We
observed that this was partly due to the lack of accurate information on borrowers and the
“default culture” inherent in the Zambian market. The introduction of the CRB is therefore
expected to help in eliminating the information asymmetries, and thus reduce the credit or
default risk premium that is included by all banks in the determination of base lending rates.
3.16 Nonetheless, while the CRB was noted as a welcome development by most banks, the
survey results indicated that currently the CRB falls short of expectations. Banks were of the
view that the CRB’s scope of coverage was too narrow as it was restricted to information
provided to it by commercial banks alone. In this regard, it was suggested that the scope of
coverage be widened beyond commercial banks, in that information regarding the credit
history of clients and employees of other credit-providing institutions be provided to the CRB
as a statutory requirement.
Excess Liquidity in the Inter-Bank Market

highlighted specific concerns with regards to efficiency and returns on equity. Table 2 depicts
selected operating ratios for each of the commercial banks surveyed, from 2006 to 2009.
Efficiency refers to the ability of a bank to generate enough income to cover its non-interest
expenses.
3.22 Table 2 also shows that salaries and employment benefits continue to make up a
significant portion of operating costs. Although the average salaries to operating costs ratio
was between 30% and 50% from 2006 to 2009, salaries for several of the banks reached
approximately 60% of operating costs over the last 4 years.
3.23 Given improvements in technology and the relative increase in competition due to the
entry of more banks in the market, it is expected that the efficiency in the banking sector
should improve over time. Efficiency ratio of 60% or less is considered to be favourable.
3.24 The efficiency ratios presented in Table 2 indicate that operational efficiency within
the domestic banking sector has been unfavourable over the period. While it is understood
that the global financial crisis had a significant negative impact on the income-generating
ability of many banks in 2008 and 2009, several of the banks have had unfavourable
efficiency ratios for a number of years. For example, the operational efficiency ratio for Bank
H has been above 80% over the past four years, reaching 236% in 2009; and the efficiency
ratio for bank L rose from 85% in 2006 to 140% in both 2007 and 2008.
3.25 Further analysis of the relationship between the banking industry efficiency ratio and
the lending base rates, as indicated in Graph 3, shows that increased inefficiency partially led
to high interest rates. In 2006, based on the efficiency threshold of 60%, the industry was
inefficient and correspondingly the base rates were high. However, in 2007 the lending base
rate declined despite the efficiency ratio increasing. This can be attributed to the favourable
macroeconomic conditions experienced in 2007. In 2008, the lending base rate and industry
inefficiency increased and worsened in 2009, as a result of the global financial crisis.
11 Graph 3: Average Industry Efficiency Ratio and Base Rates, 2006-2009


25
30
35
40
45
50
17
18
19
20
21
2006 2007 2008 2009
G Efficiency G lending rate
Effiiciency (%)
Lending Rate (%)
12 Graph 5: Bank K Efficiency Ratio and Base Rates, 2006-2009 3.28 From Graph 6, it can be seen that the efficiency ratio for bank H was above 80%
from 2006 to 2009 and that the lending rate generally increased with increases in inefficiency
especially during the period 2007 to 2009.

Graph 6: Bank H Efficiency Ratio and Base Rates, 2006-2009 3.29 From the foregoing, it can be inferred that an increase in the efficiency ratio indicates
that a bank is using a larger percentage of its income to cover its expenses and the

H Efficiency H Lending rate
Efficiency (%)
Lending Rate (%)
13
3
Operating costs are also referred to as non-interest expenses.
4
Efficiency ratio = non-interest expenses/net interest and other income. Efficiency ratios below 60% indicate good operational efficiency, while those above may suggest that
the operations of the institution are inefficient.
5
In this case, a simple average is used.

2006
2007
2008
2009
Bank
Operating
Cost
3
/Total
Costs
Salaries/
Operating
Costs
Efficiency
Ratio

on
Equity
(%)
Operating
Cost/Tota
l Costs
Salaries/
Operating
Costs
Efficiency
Ratio
(%)
Return
on
Equity
(%)
I
-
-
-
-
-
-
-
-
0.95
0.41
1,492.0
-175.4
0.82

0.55
27.2
29.5
0.67
0.65
32.1
31.8
F
0.79
0.43
91.3
12.7
0.77
0.55
75.1
57.4
0.72
0.57
80.6
14.3
0.73
0.50
144.1
-82.3
E
0.92
0.47
86.4
17.2
0.91

-
-
-
-
-
-
-
-
-
-
-
0.97
0.50
-1,123.6
-58.3
B
0.82
0.35
54.1
57.8
0.79
0.43
53.1
42.4
0.78
0.42
49.7
43.5
0.72
0.43

-
-
0.98
0.32
519.2
-99.9
K
0.84
0.52
70.0
23.9
0.86
0.68
65.7
17.3
0.80
0.64
60.4
14.6
0.82
0.63
67.0
22.2
L
0.65
0.34
84.9
23.4
0.61
0.50

65.0
52.3
0.63
0.54
64.7
39.1
0.67
0.53
68.0
34.8
0.66
0.48
74.0
35.1
O
0.86
0.38
51.7
75.9
0.83
0.56
47.3
78.0
0.86
0.44
83.8
14.3
0.86
0.45
81.1

-
-
-
-
-
R
0.94
0.57
89.3
17.4
0.94
0.62
94.3
9.7
0.93
0.62
80.1
28.3
0.88
0.56
42.1
42.1
AVERAGE
5

0.77
0.37
64.6
39.0
0.75


Graph 7: Return on Equity and Actual Average Lending Rates – 2006

Source: IMF IFS and Global Financial Stability Report, 2010

10
20
30
40
50
60
70
Namibia
Zambia
Kenya
Mozambique
South Africa
Uganda
Return on Equity Lending Rate
Return on Equity and Lending Rates
Percent (%)
15
40
50
60
Namibia
Zambia
Kenya
Mozambique
South Africa
Uganda
Return on Equity Lending Rate
Return on Equity and Lending Rates
Percent (%)
16 Graph 10: Return on Equity and Actual Average Lending Rates – 2009

Source: IMF IFS and Global Financial Stability Report, 2010

3.32 As can be seen from the graphs, the returns on equity earned in the Zambian banking
sector have been very similar to those in Uganda and Kenya from 2006 to 2009; yet the
lending rates have been significantly higher than both countries over the period. For example,
in 2007, the average return on equity earned by banks in Zambia was 31.2%, similar to 31.4%
earned in Uganda, yet the lending rate in Zambia was 24.4%, compared to 19% in Uganda.
3.33 Furthermore, the graphs highlight that it is possible to earn significant returns on
equity without charging high lending rates. This is particularly evident in Namibia and
Mozambique, where returns on equity in 2008 were 52% and 45%, respectively, while
lending rates were 14% and 18%, respectively. Thus, holding other things equal, it can be
argued that that the profitability in the Zambian banking sector may be generated primarily
through high lending rates charged in the domestic economy, rather than through cost


Money Market
3.36 In order to fully assess the interest rate channel of the monetary policy transmission
mechanism, it is necessary to look at the interaction between commercial banks and the
central bank, developments within the inter-bank market, and developments in the deposit
side of the market (i.e. savers and the savings rate) to get a holistic view of the money market
and to assess how effective the interest rate targeting framework would be in the long-run.
Maturity of Financial Markets and Development of a Secondary Market
3.37 The survey also highlighted the fact that an interest rate targeting framework requires
well-developed financial markets to provide an effective transmission mechanism of
monetary policy. This would have to be supported by a well functioning secondary market,
which would result in the creation of a short-term yield curve that would allow banks to
appropriately price their loans and advances. The secondary market would also facilitate the
trading of Government securities of smaller size amongst commercial banks and other market
participants, and thus aid in the liquidity management of financial institutions.

Limitations of the Survey
3.38 While the lessons learnt from the survey provided valuable information that will be
used in assessing the way forward, it should be noted that there were a number of limitations
in gathering information from the commercial banks, notably that:
(i) Not all banks provided complete and comprehensive information to the questions
asked;

(ii) Some of the banks did not have a formal calculation method or formula for the
determination of the base rate;

(iii) Some of the factors mentioned as key to base rate determination process were not
actually reflected in the formulas provided; and,

(iv) Some factors were not disaggregated into various components, especially with

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4.1 The undertaking of this survey was broadly aimed at identifying the factors that
commercial banks consider in making decisions regarding their base lending rates. The
specific objectives were twofold:

(i) To assess to what extent the interbank market influences the cost of funds and
thereby the lending interest rates; and

(ii) To ascertain which factors have significantly contributed to the high level of
lending interest rates in Zambia.

18 4.2 From the foregoing, it is clear that there are common factors which all the commercial
banks take into account in the determination of base lending rates. These include cost of
funds, economic conditions, market conditions and political risks. The cost of funds include:
cash reserve requirements – namely, the statutory reserve ratio, core liquid asset ratio and the
BoZ supervisory fee; operational costs; returns on economic capital/equity and yield rates on
Government securities. This is followed by market conditions: credit risk, industry trend,
competitors’ base rates or the average base rate in the market, inter-bank rate, overnight
facility and demand and supply of credit. However, economic conditions and in this case
inflation was found to be directly taken into account in the determination of base lending
rates by only half of the surveyed banks. The exchange rate is included in the economic
conditions.


(iv) Improved communication of BoZ monetary policy strategy to help anchor
inflation expectations.
19 4.7 On the issue of the high interest rates, it is recommended that:

(i) There is need for banks to improve efficiency by lowering the operational costs.

(ii) Banks should be consistent in the use of macroeconomic factors, i.e., inflation,
exchange rates and Treasury bills, in determining lending rates. That is, other
things equal, it is expected that when inflation or Treasury bill rates are low,
lending rates should also be adjusted downwards.

(iii) While qualitative factors are important in the determination of lending rates, in a
liberalized economic system like Zambia, macroeconomic factors should be
dominant to the determination of rates. In this regard, commercial banks are
urged to develop formal frameworks for the interest rate decision making
process.

(iv) On the part of the BOZ, we will continue to foster competition by encouraging
the entry of new banks for the purpose of improving the provision of banking
services.