Determinants of Bank Interest Spreads in Estonia

Abstract

The recent global financial turmoil increased bank interest spreads in Estonia to the highest levels recorded since the Russian crisis in 1998-99. The pure spread concept and the two-step estimation approach of Ho and Saunders (1981) have been used to break down the interest spreads in Estonia. The pure spread is determined mainly by risk aversion and the market structure of the banking sector, with money market interest volatility playing quite a modest role in the long-term equilibrium. The regulatory, efficiency, and bank portfolio effects bear roughly equal responsibility for the observed spread, whereas credit risk adds only a tiny portion to the interest markup. Strong liquidity and foreign capital permit lower spreads.