Banks are a vital institution in modern economies that they perform two key functions. Banks manage the payment system of the economy and through intermediation they eliminate market inefficiencies and provide liquidity (funds) for the deficit units collecting funds from the excess units.
‘Creation of liquidity’ is defined in this article as providing credit to the deficit units by banks. Banks are required to maintain adequate liquidity in the form of money and near money on their balance sheets for transaction and precautionary purposes in Keynesian terms. These assets provide very little or no income to banks compared to their loan portfolio, assets invested for speculative purposes.It is a waste of valuable funds if the funds collected from t he savers are not advanced to the deficit units for investment. If the savings are greater than the investments, there will be a leakage of funds from the circular flow, which will result in a contraction of the economy and a misallocation of scarce funds.
DEMAND SIDE QUESTIONS
According to the Central Bank, one of the most serious economic problems Sri Lanka has faced with is the lack of liquidity creation (granting loans) by the banking system to business organisations. It is also reported that there is a large amount of excess of liquidity over the regulatory liquidity requirements just idling in the banks, which otherwise would have been invested in loans.
Banks in turn say that the lack of demand for funds from the business sector is the cause for excess liquidity. Why did the banks then collect such a large amount of excess funds if there is no demand?
According to the Central Bank, it is a supply side problem while it is a demand side problem from the point of view of the banks. Or is it a structural problem of the banking industry in Sri Lanka? Is it such a simple problem or are there many other independent variables causing the problem?
If there is no demand for funds from the business sector, it could be due to the higher opportunity cost of funds (interest rates). But the interest rate prevailing in the informal sector, sometimes exceeds 40 percent.
Lack of business opportunities may be another reason for the lack of demand. Sri Lankan entrepreneurs generally shy away from sophisticated industrial projects to trading activities. Interest rate may be exceeding the internal rate of return of the projects available for the business sector.
Economic environment could be another factor, where the expectations of the future are bleak, according to the business sector. Due to political, economic, social or security reasons, the business sector may not have confidence of the future of the economy.
Disintermediation may be another reason for lack of credit creation. Companies through debenture issues in the capital market by pass the banks in raising funds causing loss of market share of the banking sector. We can expect more disintermediation when the capital markets are more developed. All these demand side questions are valid to be raised.
SUPPLY SIDE REASONS
Likewise, there may be supply side reasons for the lack of credit growth. Traditionally Sri Lankan banks are risk averse and provide working capital requirements only for the business sector. They have no infrastructure set up to assume more risks of project financing. There are no adequate venture capital providers in Sri Lanka.
Banks are not generally aggressive in the recovery process as opposed to finance companies and they are overly risk averse. Banks may be satisfied with the present state of affairs because they are earning enough to justify their existence rather than trying to maximize shareholder wealth.
They are investing in the state sector in the form of loans and treasury securities to justify their efforts. Excess of liquidity available may be due to borrowing through debenture issues and foreign borrowings at the request of the government. May be the banks are collecting funds for the retirement of the bonds and other foreign loans when they become due.
Regulatory arbitrage practiced by the banks to maintain the Basal capital requirements may be another reason for excess liquidity. According to Basal 2 agreement, banks do not have to maintain capital adequacy ratio for the investments in the government securities but the loans and advances require 100 percent capital requirement.
If this large amount of excess liquidity is released as loans, the capital requirement will increase. Banks tend to invest in government securities rather than investing in loans and advances to satisfy Basel capital requirements without increasing equity capital to achieve the objective.
This practice increases insolvency risks of the banks in addition to misallocation of resources in the economy. If the entire excess of liquidity floods into the market in an orderly manner, the credit market may not be able to absorb it without disrupting general price levels.
COMPETITIVE MARKET SYSTEM
In a competitive market system, in theory, interest rates bring automatically the savings and investments into an equilibrium state. The Central Bank has reduced policy rates in order to spur the credit growth without much success. For some reason automatic equilibrium mechanism does not respond to interest rate changes.
Even if markets are competitive, automatic equilibrium mechanism may not work due to a credit crunch as prevailed in the US in 2008. Or, as Keynes said and what happened in Japan over the last three decades, economy may be in a liquidity trap without responding even to zero interest rate.
The Central Bank says that the financial markets are more than competitive and it is implementing a consolidating programme to reduce ‘disastrous’ competition. Business sector complains that the consolidation process may lead to an oligopolistic market in the banking sector.Even though we have over 20 banks, they may not be competing with each other in the market place as it is supposed to but accept the price leadership of a few huge state banks as in oligopoly. State banks are large and the others are comparatively small.
State banks are not efficient mainly due to bad debts and their higher interest rates are followed by the other banks without completing on price and reap economic rent. Therefore, the oligopolistic market structure may not be conducive for an efficient market place.
Therefore, there may be many economic and noneconomic reasons for the lack of credit growth in spite of the Central Bank’s intervention to spur the lending in the economy through the policy rates and persuasion. There are many unsubstantiated opinions for the lack of credit creation but the irony is that there has been no serious economic research conducted either by the Central Bank or the other interested parties to identify the reasons.