Can High and Volatile Inflation Widen Bank Interest Spreads and Curtail Financial Development in Sri Lanka?

Abstract

Despite the notable progress of Sri Lankan economy in recent decades, the diminishing share of banking system assets relative to country’s Gross Domestic Product (GDP) is puzzling. Numerous factors can be held responsible for this. However, the effects of inflation on this scenario have not been sufficiently researched. Hence using exploratory data analysis techniques and a quarterly dataset concerning Sri Lanka during 1990-2010, this paper explored the ill-effects associated with high and volatile inflation on the bank interest spreads while shedding a light on the possible adverse effects this can create on the banking system development. Further, the paper argues that the researches aimed at investigating the ill-effects of inflation must take both the magnitude and the volatility of inflation simultaneously in order to arrive at appropriate judgments. Based on the findings, this paper argues that the uncertainty resulted from the turbulent inflation has widened bank interest spreads to enable the banks to cope up with potential pricing errors in the financial intermediation process and thereby has contributed to curtail the banking system development in Sri Lanka. These findings have credible implications on the banking system development in developing countries because most of economies in such countries are characterized with high and volatile inflation. Therefore, taming inflation remains as a vital goal for policy makers in those countries in order to foster a healthy banking system development.