The Intermediation Spread in Colombian Banks

After several decades of financial repression with some partial attempts at liberalization, Colombian policymakers set out to complete the liberalization process in the early nineties, reducing financial taxation, freeing interest rates, facilitating entry/exit, and eliminating capital account restrictions. As this was expected to increase efficiency and competitiveness of financial intermediation, an implicit objective was to reduce interest rate spreads, historically high by international standards. We estimate a profit maximization model using panel data on 22 Colombian banks with monthly observations during 1992-96 to analyze the determinants of the spread between loan and deposit rates. The average spread has been around 20-30 percentage points, 1/3 of which was explained by costs (resource plus financial taxation costs), another 1/3 by credit risk, and the remaining 1/3 by lack of competition or market power. With respect to market power, ownership was an important factor; while private banks exhibited significant market power, charging a markup of about 20% over marginal costs, state banks=B9 spreads were indistinguishable from marginal costs. With respect to costs, retail and state banks tended to have higher marginal costs by 4 and 9 percentage points respectively. A continuous decline in spreads was explained primarily by a reduction in financial taxation, since no significant gains in competition or efficiency occurred. Finally, bivariate tests suggested that banks exert their market power on the loan side, where competition from other types of financial institutions has not been as great.