The Impact of Interest Rate Liberalization on the Profitability of Commercial Banks

Abstract

This paper examines the multifaceted impact of interest rate liberalization (IRL) reform on the profitability of commercial banks. As a cornerstone of financial sector reform in many emerging economies, IRL aims to enhance capital allocation efficiency and improve the transmission of monetary policy. However, it also poses serious challenges to the long-established and previously protected traditional banking model. Using an extensive panel dataset of listed commercial banks, this study empirically investigates the relationship between IRL and bank performance. A fixed-effects regression model is employed to analyze the effect of liberalization on key profitability indicators-primarily Return on Assets (ROA) and Net Interest Margin (NIM)-alongside a comprehensive set of bank-specific and macroeconomic control variables. The results reveal a statistically significant negative relationship between IRL and both NIM and ROA, supporting the "margin compression" hypothesis. Increased deposit competition has intensified pressure on banks, leading to narrower lending-deposit spreads. Nevertheless, the findings indicate that banks have adapted by shifting toward more diversified business models, incorporating greater shares of non-interest income activities and improving operational efficiency. The study offers valuable insights for banking executives navigating the post-reform landscape and for policymakers tasked with managing the risks associated with financial liberalization. It underscores the urgent need for banks to strategically transform their operational approaches to sustain profitability in an increasingly market-driven environment.