Interest difference for banks in Sri Lanka
In the recent past banks and financial institutions in Sri Lanka have reduced interest on deposits on several occasions and now such rates have come down to very low levels comparatively. The interest charged on banking facilities too were reduced accoringly. However certain sections of the general public are puzzled; why can’t the banks also reduce interest rates charged on banking facilities, very close to deposit rates and why do banks keep a margin of around 4 per cent to 6 per cent between the deposit and lending rate, depending on the type of facility. This margin is called the” Interest Spread” and, yes it is high in Sri Lanka when compared to the countries in the developed world and some of the countries in the region. In developed economies the interest spread is around 1 per cent to 2 per cent.
It is important for the general public to know as to why Sri Lankan banks are required to charge an interest spread at current levels. There are few reasons for this:
Cash Holding Cost
A certain amount of cash that banks receive has to be held in the form of cash itself for its day-to-day counter transactions — ATMs operations, etc. Such funds cannot be invested in interest bearing assets. Hence it comes as substantial costs to the banks.
High Cost Borrowings
More often banks have to borrow funds in the open market when they run short of funds in order to meet their day to day transactions. Such borrowings are short term borrowings and they are called Inter Bank borrowings. The banks have to borrow these funds usually at high interest rates. Banks are very mindful of avoiding such borrowings, but due to any unavoidable reason if they have to borrow it becomes huge cost to the bank.
Statutory Reserve Requirement (SRR)
All banks are required to maintain Reserves with the Central Bank and this requirement is called Statutory Reserve Requirement (SRR). Certain percentage of total deposits of the bank has to be maintained with the Central Bank and presently this percentage is 6 per cent. The banks are therefore able to lend only 94 per cent of any deposit and the banks have no return on the 6 per cent of the deposit.
For example if the agreed Interest Rate on a Deposit is 6 per cent p.a, the actual cost for the deposit to the bank is much higher than 6 per cent p.a. It is calculated as follows:
6 x 100% = 6.38%
—–
94
This will be another additional cost to the banks. In most of the developed countries there is no requirement as such. In countries such as Australia, New Zealand, Sweden, and the United Kingdom this requirement is “Zero”. Canada abolished its Reserve Requirement far back in 1992. In Switzerland the ratio is only per cent. Even in India it is only 4 per cent.
Liquid Asset Ratio
This is another ratio; the banks have to maintain in order to establish its stability. According to this requirement, the banks have to maintain 20 per cent of its total Assets in form of Designated Government Securities and Cash. It is therefore obvious that only 74 per cent of the deposits are available for lending. The amount invested in Government Securities gives a comparatively low return due to its low risk nature whilst the cash holdings do not give any return at all to the bank.
Provisioning for NPAs
If any advance is not serviced by the borrower continuously for three months that facility is categorized as a Non Performing Advance (NPA) and the banks are required to make “Provisions” for such advances. A certain percentage of the amount of such advances, have to be provided out of its profits. This percentage varies depending on the Non Performing period and the availability of the Security for the advance. For an example any advance of below Rs. 5.0 million has to be provided fully, if it had been in the NPA section continuously for a period of 12 months even if it is covered by collateral. Similarly there are different methods of making provisions on Non Performing Advances which come under different categories. Presently this has become a huge cost for the banks and it eats up a substantial portion of the hard earned profits of banks. In banks, in developed countries, NPA volumes are minimal and therefore such provisioning do not make much of an impact on the profits of the bank.
Overheads
The overheads of a bank such as Salaries, Rent Security, etc are usually higher than that of other business organizations. Hence banks have to earn substantial profits in order to cover such costs.
Sign of Stability
In Sri Lanka the stability of a bank is reflected by the trends in profits over a period of time. People have the habit of comparing the profit earned for a certain period of the year with the profit earned for the corresponding period of the previous yer. If there is a negative growth in this figure, due to any reason, the general public tends to think that particular bank is passing through a difficult time. They may also lose the confidence they have on this bank and it will have a bad impact on banks business canvassing efforts. Even the share price of the bank may drop due to this public belief. Hence the banks always try to show a higher profit for a year than that of for the previous year.
Recent Requirement
Internationally all banks are required to maintain certain ratios in its Capital Adequacy. According to forthcoming BASELIII rules (BASEL is an internationally accepted regulation in respect of the adequacy of capital of a bank) the banks will have to have higher equity Tier I capital requirements than before. Therefore banks may have to transfer a considerable amount out of the profits earned by them towards the capital in future in order to meet this additional requirement. Whereas banks may have to curtail dividend payout to its shareholders. This is going to be an additional and unavoidable cost in the future.
Conclusion
When considering the above factors, it is quite obvious that there is a need for the banks in Sri Lanka to have a higher” Interest Spread” than that of the banks in the developed countries.
Some banks in our country earn larger profits than the other banks. Return on investment ratios of such banks are also higher than the other banks. They are able to achieve these results mainly because of their extensive usage of technology, high productivity levels and excellent customer orientation and not because of high “Interest Spread”.
(The writer is a Senior Banker. These are his personal views and has nothing to do with the bank that he works for)