Net interest margins to come down

The Central Bank of Sri Lanka’s (CBSL) recent order to banks to bring down their interest rates on loans and advances will reduce the banking industry’s net interest margins (NIMs) and hurt their profitability, according to analysts and industry professionals. On 24 September, the CBSL ordered licensed commercial banks (LCB) to reduce interest rates on all loans and advances by at least 200 basis points by 15 October 2019, in comparison to the interest rates applicable as at 30 April 2019, subject to certain exclusions. A senior official from a leading private bank in Sri Lanka told The Sunday Morning Business that the CBSL’s move is unacceptable, even though the order is not a huge shock to the banks, given the banks’ lowering of rates since April. He added that these enforced rate cuts would affect banks’ NIMs negatively. “It is not a good move to raise or downgrade interest rates arbitrarily. However, since April 2019, many banks have reduced their rates between 100-200 basis points. So it will not be a complete shock since they are in that mindset already,” he added. In addition to this, the CBSL also ordered banks to reduce their Average Weighted Prime Lending Rate (AWPR) by 250 basis points by 27 December 2019, compared to its AWPR as published by the Central Bank as at 26 April 2019. By 1 November 2019, each LCB’s AWPR must be at least 150 basis points lower than its AWPR as at 26 April 2019. The official noted that the AWPR requirement is neither reasonable nor achievable as the reduction would only benefit a lower number of influential borrowers, but would not benefit average borrowers. According to an industry analyst, the banks would oblige with the CBSL’s order because they have no choice but would be reluctant to lend. Therefore, banks would complicate the lending process by adding more paperwork and make borrowing harder for the customer. “The bottom line will be that no bank will lend much, given that they can’t factor in the risk. This will result in only superficial changes to rates without serving the purpose of lower rates which is to encourage borrowing and investment,” analysts said. When asked whether banks have forced the CBSL to impose these rate caps by not reducing interest rates as requested over the past few months, the bank official responded in the negative saying that most banks had already reduced their interest rates. Meanwhile, issuing a press release on Friday (27), the Moody’s Investors Service noted that they expect banks’ NIMs to narrow after the lending rate cut since the cut’s immediate effect more than offsets a more gradual decline in funding costs because of the time lag in their pricing at the time of deposits. “Narrower margins will strain bank profitability, which is already weakened because of rising credit costs and a higher effective tax rate,” release noted. Further, Moody’s expects that among the three rated banks – Bank of Ceylon (BOC, B2 stable, b21), Hatton National Bank Ltd. (HNB, B2 stable, b2), and Sampath Bank PLC (B2 stable, b2) – the negative effect on margins and profitability will be more pronounced for BOC because its asset yields are lower than those of the other two banks. Moreover, the firm noted that the modest NIM reflects BOC’s already weak profitability, while its poor asset quality has contributed to high credit costs. When announcing the rate cuts last week, the CBSL said that it will continue to closely monitor the movements in market lending rates to ensure a more effective transmission of monetary policy through the financial system. The Central Bank also expects to review this order at end-March 2020. These measures follow a number of monetary and regulatory policy measures adopted by the Central Bank over the past 11 months to induce a reduction in market lending rates. These include the reduction of the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank by 100 basis points in two steps, the reduction of the Statutory Reserve Ratio (SRR) applicable on rupee deposit liabilities of Licensed Commercial Banks (LCBs) by 2.50 percentage points that released around Rs. 150 billion of additional liquidity to the financial market, and the imposition of caps on rupee deposit interest rates offered by licensed financial institutions that enabled them to reduce the cost of mobilising funds from the general public. The Central Bank said that it had taken these measures with a view of supporting economic activity, given well contained inflation and inflation expectations. Further slowdown observed in the economy following the Easter Sunday attacks has intensified the need for lower market lending rates. Meanwhile, the growth of credit extended to the private sector has decelerated sharply since the beginning of this year, and the non-performing advances (NPAs) have grown due to various factors. The Central Bank is of the view that, among these, excessively high nominal and real lending rates are a key reason for slowing credit expansion and rising NPAs. “In fact, Sri Lanka’s real lending rates are unacceptably high compared to its peer economies, and are not consistent either with the low inflation regime experienced by the country over the past 10 years and the expectations of 4-6% level of inflation envisaged under the proposed flexible inflation targeting framework,” the Central Bank noted.