EFFECTS OF INTEREST RATE ON GROWTH OF FINANCIAL INSTITUTIONS: A CASE STUDY OF TRANSNATION SACCO

1.2 Background of the Study

It is of great concern to note that as the interest rates skyrocket, a positive impact sets in as far as the profitability of financial institutions comes into consideration. Institutions in the banking sector such as retail banks, commercial banks, investment banks, insurance companies, Saccos, and brokerages hold large amounts of cash due to customer balances and business undertakings (May and Tudela, 2015). Increases in the Federal funds rate directly increase the yield on this cash, and the proceeds find their way to earnings. We can use a situation like a case where the oil drillers realize a rise in prices of the oil they produce.Brokerages, commercial banks, and regional banks enjoy the benefit of inclining rates of interest. The institutions keep accounts for the cash held for their customers and use the same to pay out set interest rates below short-term rates. They profit off the marginal difference between the yield they generate with this cash invested in short notes and the interest they pay out to customers. However, when rates rise, this spread increases with extra income going straight to earnings (Alexander, 2008).

Whenever economic data or comments from central bank officials hint at rate hikes, these types of stocks begin to rally first (Edwards, 2008). Another indirect way in which interest rate hikes increase profitability for the banking sector is that the hikes tend to occur in environments in which economic growth is strong, and bond yields are rising. In these conditions, consumer and business demands for loans spike, which also increases earnings for banks.

As interest rates rise, profitability on loans also increases, as there is a greater spread between the federal funds rate and the rate the bank charges its customers. The spread between long-term and short-term rates also expands during interest rate hikes, because long-term rates tend to rise faster than short-term rates; This has been true for every rate hike since the Federal Reserve was established early in the 20th century. It reflects the strong underlying conditions and inflationary pressures that tend to prompt an increase in interest rates. This condition is an optimal confluence of events for banks, as they borrow on a short-term basis and lend on a long-term basis (Gachiri, 2012).

Notably, SACCOs can advance loans at interest rates lower than those charged by other financial providers. Also, SACCOs have the ability and opportunity to reach clients in areas that are unattractive to banks, such as rural or poor areas. This has made SACCOs more attractive to customers, thus deeply entrenching themselves in the financial sectors of many countries (Kamau, 2013). Importantly, the core objective of cooperative societies is to ensure that their members are empowered through the encouragement of savings and the provision of credit. In Kenya, for example, cooperative societies have mobilized over Kshs.200 billion in savings, which accounts for over 30% of the National Domestic Saving. For that matter, the proposed study seeks to establish the impact of interest rate provided by the cooperative societies on members’ deposits. However, performance of these SACCOs is determined by various factors.

One of the most significant factors that determine the performance of a SACCO according to Bernanke (2010) is the interest rate provided. Funkor affirms that this determines the level of deposits by the members. In Western Countries, classical theorists regard the interest rate as a factor which brings the demand for investment and the willingness to save. In a study done in the Southern African Development Community (SADC) region by Esaki et al., (2013) on influences of interest rates on the performance of financial institutions, it was established that high-interest rates are significant because they control the flow of money in the economy and more importantly encouraging customer deposits. This was also supported by Goodhart and Hoffman (2009) who carried out a study in the former Central Province of Kenya on “Impact of interest rates on saving the culture of the SACCOs’ clients” and established that high-interest rates will always motivate customers to save more while low interest will discourage savings.

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