1

2

$5,000 $50 M 8% 5%

Interest Spread Difference between the contractual interest rates charged on loans and rates paid on deposits Net Interest Margin (Ex post spread) Difference between banks' actual interest revenues and actual interest expenses to the banks’ average assets or total assets. 4

5 Source: CBSL statistical database Interest Spread

6 Source: Central Bank Annual Report – 2006, Sri Lanka

Bank Name Net Interest Margin % Bank of Ceylon2.83 Commercial Bank Ltd4.57 Hatton National Bank4.97 People's Bank4.77 Sampath Bank4.80 Seylan Bank4.68 Nations Trust Bank4.29 National Development Bank4.55 National Saving Bank3.26 Pan Asia Bank5.62 Union Bank Source: Author’s calculation based on bank’s annual reports

8 Size High Operations Cost High Credit Risk Low GDP growth Rate Volatility of Interest Rate Less competition Inefficiency of the Management ? High reserve requirements ? Ownership? Non-diversified income sources ?

Basically data was collected from the secondary sources including ; 1.Commercial Banks Annual Reports, 2.Annual publications of the Central Bank of Sri Lanka (CBSL) 3.Databases maintaining by Asian Development Bank and the World Development Bank 4.Online sources 9

11 major commercial banks including three state-owned banks. Period from 1999 to bank annual observations. Represented more than 85% of the deposit market and 72% of the loan market 10

NIM i,t =  +   B i,t +   C t +   M t +  i,t Net Interest Margin(NIM) Bank characteristics (B), market structure (C), and macroeconomic variables (M) as regressors GLS and Fixed effects regression Robust clustered standard errors

Net Interest Margin Difference between total interest income and expenses over Total assets NIM= (Interest income – Interest expenses) Total assets 12

Independent Variables (Explanatory Variables) 13 Explanatory Variables Macroeconomic and industry Specific Variables Bank Specific Variables

Bank specific variables 1.Operating Cost (OC) (+) 2.Credit Risk (CR) (+) 4.Opportunity Cost (OPT) (+) 4.Managerial efficiency (ME) (-) 14

Bank specific variables; 6.Scale effects (SIZE) (-) 7.Diversification effect (NIIN) (-) 8.Market share (MSHARE) (+) 9.Bank ownership (OWNER) (Dummy) 15

Market structure (CONA) 1.3- bank concentration ratio in terms of total assets (CONA) (+) Macroeconomic Variables 1.GDP growth rate (GDPR) (+) 2.Market interest rate (MIR) (+/-) 16

(1)(2) Base Model Variables CoefficientP >zCoefficientP >z Constant ** OC *** *** CR *** *** NIIN ** *** OPT ME * *** OWNER SIZE *** *** GDPR *** MIR *** CONA R-squared Wald chi Prob > chi Generalized Least Square (GLS) regression (Random-effects ) *** Significant at 1%; ** Significant at 5%; *Significant at 10%

High Operations Cost High Credit Risk Size Higher Demand for Loan Interest Rate Less competition Inefficiency of the Management Non-diversified income sources ? High reserve requirements Ownership

Coefficient of non-interest income reflects the importance of diversified income sources for a bank rather than depending on single source of interest income. Size variable proxy for economies of scale positively relates with NIM Negative coefficient of market interest rate variable (MRISK) shows that deposit rate in Sri Lanka relatively sensitive with falling interest rate than lending rate. Even though 3-bank concentration ratio or industry structure doesn’t allow to grab a higher margins, commercial banks in Sri Lanka use their market power for pricing decisions 19

Finally; The main root causes for higher interest margin and spread are high Operations cost Less competition of the industry Non–diversified income sources Absence of alternative financial sources. 20

Promoting competition and improve operations efficiencies areis an urgent matters for the industry. Displaying the lending rate and deposits rate in their business permission Promoting foreign entry may be a plausible solution to exert downward pressure on bank interest margins through improved operations efficiencies. Diversify bank’s business activities beyond the traditional core activities Promoting and developing other financial sources such as bond market is another plausible solution 21

Weak and cumbersome legal procedures add extra cost to the financial system. Therefore impose and enact necessary legal reforms are essential. Implement proper methods to assess credit worthiness of their customers based on the collateral or type of intended project, it would lead to reduce the intermediation margin. Authorities should monitor strictly capital adequacy standard and systematic supervision to maintain the stability of the industry. In addition to that, authorities should try to maintain stable macroeconomic environment 22

Some important variables such as effectiveness of legal system, policy changes in taxation etc can be included in this study Further, return on competing instrument and development of bond and capital market can be incorporated in to this model Extend the research to identify cross country determinants factors in the south Asian region. 23

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