Financial Times

Do banks still have high spreads?
By Dinesh Weerakkody
According to analysts the government's attempts at reducing bank spreads have met with limited success. They say what needs to be done is to remove the banks' stranglehold on the financial system as the sole provider of finance. A strategy would be to develop the corporate bond market on a priority basis.

In Sri Lanka as we all know banks make too much profits because of their healthy margins. Banks quite naturally make their profits by borrowing at very low rates currently around seven percent and lending their money at very high rates, currently retail lending is around 15 percent. Such a huge disparity in interest rates are unique only to Sri Lanka and that is why banks in Sri Lanka occupy that enviable niche in the business sector in Sri Lanka where high profits are guaranteed, come what may.
This is quite evident in the Business Today top ten rankings, where five of the companies ranked in the top ten were either banks or DFIs.

herefore the government's move to get banks to cut their lending rates in line with improved monetary and macro economic conditions is a step in the right direction.
The time has come for the government to exercise a more positive role in regulating banks and banking practices because stable interest rates are critically important to facilitate economic growth and development.

However, implementing this through legislation or interest rate controls may not be the answer. On the other hand conventional wisdom was that a higher number of banks would ensure competition resulting in lower rates and better service. This is however not true beyond a point, because the additional cost of running all these banks have been passed on to the public. Therefore, the government may need to facilitate a process to force banks to improve efficiency rather than follow the path of least resistance and also to increase the banks capacity to manage risks.

Despite the recent decline in the Central Bank and government Treasury Bill and Bond rates the interest charged by the commercial banks to their corporate and retail customers have not declined sufficiently to enable business recovery and future growth. A recent study done by a group of SMEs indicates that banks still charge rates as high as 17-18 percent for retail customers and 10-14 percent for corporate customers.

The Minister of Finance has made several requests to the commercial banks to reduce their lending rates by operating on smaller margins but the response has been limited. There is a general perception in the market amongst customers that the banks are operating on unreasonable margins.

The banks have however pointed out that they are severely affected by the high cost of technology and the high percentage of non-performing loans. The interest spread of a bank represents the difference between the average interest rate earned and the average interest paid on funds. The spread covers the reserve costs, provisioning costs on non-performing loans, operating costs and profit.

An examination of interest spreads in the market reveals that private commercial banks are operating on spreads as much as 5-6 percent whereas in other markets in the region the spreads are as thin as 1-3 percent. The global benchmark is around 1-2 percent.

According to our research banks are still inclined to keep their customer lending rates high in order to cover their high loan loss provisioning, high administration costs and profit margins. This is representative of an inefficient financial system.
The more efficient private commercial banks are in fact reaping record spreads and this includes a number of foreign banks.

This is why some of our top commercial banks make more than 20 percent return on investment, when some of the top banks in the world only make around 12 percent. The state and domestic banks in particular are carrying cost-income ratios that are far too high. The banks are defending their case for thick spreads on the basis of "costs" including administration costs. Effectively speaking, customers are paying for the inefficiencies in the banking system.

In the final analysis reductions in the lending rates to the commercial sector and also to the retail sector are essential to develop our industrial sector and our country. So it is high time our banks realize that it does not function in a vacuum and that its success is dependent on the fulfillment of certain obligations to society.

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