D.M.Jayasena

School of Management

RESEARCH STUDY PRESENTATION

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by

THE DETERMINANTS OF NET INTEREST MARGIN IN THE SRI LANKAN BANKING SYSTEM

Advisor: Dr. Winai Wongsurawat

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What do Banks do for Their Customers?

FINANCIAL INTERMEDIATION

$5,000$50 M

8%5%

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Efficiency of the Financial Intermediaries

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.

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Bank Interest Spread in Sri Lanka 1990 -2008

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 20080

4

8

12

16

20

24

14.10

9.89 5.27

21.46

8.95

Average Deposit Rate % Average Lending Rate %

Inte

rest

r

ate

%

Source: CBSL statistical database

Interest Spread

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Interest Spread in South Asian Countries 2002 - 2005

2002 2003 2004 20050

1

2

3

4

5

3.8

4.7

4.2 4.2

India Pakistan

Bangladesh Sri Lanka

%

Source: Central Bank Annual Report – 2006, Sri Lanka

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Bank Net Interest Margin in Sri Lanka - 2008

Bank Name Net Interest Margin % Bank of Ceylon 2.83

Commercial Bank Ltd 4.57

Hatton National Bank 4.97

People's Bank 4.77

Sampath Bank 4.80

Seylan Bank 4.68

Nations Trust Bank 4.29

National Development Bank 4.55

National Saving Bank 3.26

Pan Asia Bank 5.62

Union Bank 2.91

Source: Author’s calculation based on bank’s annual reports

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Where is the problem ?

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

?

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Data 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

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Dataset

11 major commercial banks including three state-owned banks.

Period from 1999 to 2008

103 bank annual observations.

Represented more than 85% of the deposit market and 72% of the loan market

Methodology

NIMi,t = + Bi,t + Ct + Mt + i,t

Net Interest Margin(NIM)

Bank characteristics (B), market structure (C), and macroeconomic variables (M) as regressors

GLS and Fixed effects regressionRobust clustered standard errors

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Dependent Variable

Net Interest Margin

Difference between total interest income and expenses over Total assets

NIM = (Interest income – Interest expenses) Total assets

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Independent Variables

Independent Variables (Explanatory Variables)

Explanatory Variables

Macroeconomic and industry

Specific Variables

Bank Specific

Variables

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Independent Variables

Bank specific variables

1. Operating Cost (OC) (+)

2. Credit Risk (CR) (+)

4. Opportunity Cost (OPT) (+)

5. Managerial efficiency (ME) (-)

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Independent Variables (Cont)

Bank specific variables;

6. Scale effects (SIZE) (-)

7. Diversification effect (NIIN) (-)

8. Market share (MSHARE) (+)

9. Bank ownership (OWNER) (Dummy)

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Macroeconomic and Industry specific variables

Market structure (CONA)

1. 3- bank concentration ratio in terms of total assets (CONA)(+)

Macroeconomic Variables

2. GDP growth rate (GDPR) (+)

2. Market interest rate (MIR) (+/-)

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  (1) (2) Base Model

Variables  Coefficient P >z Coefficient P >z

Constant -0.022 0.017 ** -0.013 0.394

OC 0.372 0.000 *** 0.695 0.000 ***CR 0.107 0.000 *** 0.125 0.000 ***NIIN -0.016 0.025 ** -0.031 0.000 ***

OPT -0.002 0.920 -0.008 0.534

ME -0.024 0.051 * -0.070 0.000 ***OWNER 0.001 0.772 0.002 0.306

SIZE 0.004 0.000 *** 0.004 0.000 ***

GDPR - - 0.129 0.000 ***MIR - - -0.055 0.004 ***CONA - - -0.015 0.508

R-squared 0.461 0.600

Wald chi2 63.1 138

Prob > chi2 0.000 0.000

Generalized Least Square (GLS) regression (Random-effects)

*** Significant at 1%; ** Significant at 5%; *Significant at 10%

Results

Where is the problem ? - Results

High Operations

CostHigh Credit

Risk

Size

Higher Demand for Loan

Interest Rate

Less competition

Inefficiency of the Management

Non-diversified income sources

?

High reserve requirements

Ownership

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Results (Cont)

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

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Results and Conclusion

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.

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Recommendations

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

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Recommendations (Cont)

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

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Future Research Directions

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.

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