Factors explaining high interest rates in Mongolia: A Markov Regime-Switching approach

This paper examines the dynamics of bank lending, deposit rates and interest rate spread in Mongolia using both accounting framework and Markov Regime-Switching approach. The empirical analysis suggests that the high lending rate in Mongolia is compatible with underdeveloped stock market, low savings ratio, inefficient operating costs of banks, high credit risk, high interbank market rate driven by unstable inflation, strong competition in deposit market and concentration in the loan market. Important findings stand out: (i) the accounting framework suggests that bank lending rate is high because of high deposit rate, while high interest rate spread mainly reflects operating costs and provision for loan losses; (ii) the results obtained from Markow Regime-Switching approach support the view that permitting asymmetry and non-linearity in responses of interest rate to changes in explaining factors are important in the interest rate analysis; (iii) effects of non-performing loan, inter-bank market rate and growth of money supply on the interest rate spread, bank lending and deposit rates differ depending on the regime, while structure of loan and deposit markets, business cycle fluctuations, budget expenditure and stock market capitalization significantly affect both bank lending rate and interest rate spread regardless of the regime; and (iv) market structure, risks associated with lending operations (credit risk, interest rate risk, the interaction between the risks and inflation) and industrial product affect the lending rate transmitting through the interest rate spread, whereas the growth of M2 money and financial sector development influence the lending rate channeling through the deposit rate.