Body blow for banks

By Mandana Ismail Abeywickrema

Economists and senior bankers warn that the country`s overall banking sector would be dealt a severe blow in relation to its earnings due to the Presidential directive to reduce interest rates of state banks.

The reduction in state bank interest rates are expected to compel private banks to follow suit shortly in order to remain competitive creating a shortage in funds.

Economists note that while interest rates should fall on market reaction, the present decline in interest rates brought about through a Presidential order would create a shortage in funds.

Bankers observed that the government should not try to introduce short-term solutions to long-term issues.

Economist Dr. Harsha de Silva said that the allocation of monies in state banks are no longer market based as it is now administration based. State banks will have a massive hit on its earnings as a result. The state banks would be compelled to borrow at a high rate and lend at a lower rate, he said. Also, the management would possess the power of deciding whom to give funds to.

Dr. de Silva observed that although consumers taking loans would have to pay a low interest rate, the depositors of state banks would be affected by a reduction in low interest rates, as it would entail them negative returns.
According to him, the economic theory of transmission mechanism of gradually falling rates need to be applied to interest rates.

Meanwhile, the Central Bank report released on October 23 states that during the 12-month period that ended on August 2009 the state banks` net credit to government has increased by 73% while net credit to the private sector has declined by 4.8%.

The President noted that the reduction in interest rates of state banks would encourage people to become more economically active.

HNB Chairman, Rienzie T. Wijethilleke noted that while the reduction in interest rates was a welcome move, HNB and other private banks would also have to follow suit in reducing interest rates.

However, Wijethilleke observed that the reduction in lending interest rates would result in a reduction in rates for deposits, which would have an adverse impact on the depositors who depend on interest income for survival.

He also pointed out that the banks would be faced with a serious problem in meeting payments to depositors in relation to commitments undertaken by the bank for a period of 12 months.

It is good to bring interest rates down. However, the government should not try to introduce short term solutions to long term issues, Wijethilleke said.