A senior banker warned that private sector banks might not be able to lend next year, even if interest rates were to come down.

Incidentally, another senior banker said that the crisis facing the banking sector had nothing to do with the global credit crunch.

Getting loans from banks could be tough next year as the most taxed sector, the banking industry, is looking at constraints in granting of loans; not because interest rates are high, but because capital is hard to raise.

"In 2009 and 2010, banks will not be able to lend even if they want to as they will find it difficult to raise new capital because they continue to make poor returns on equity. They will not be able to lend even if interest rates were to come down," Nihal S. Welikala, Senior Advisor to NDB Bank, told a seminar last week.

With almost 60 to 65 percent of the profits taxed, banks have long said that it was difficult to raise new capital because investors received poor returns.

Banks face a dilemma as to whether or not they should pay their investors a reasonable dividend, or plough back enough profits for expansion.

The Central Bank tightened its monetary policy late 2006 in a bid to curb aggregate demand by controlling the creation of credit. This was done to reign in inflation.

This proved to be successful as interest rates increased making it too costly for the private sector to raise loans through the banking sector.

Welikala said the high interest rates discouraged the private sector from acquiring new loans.

"For the last five years, bank lending had grown by about 25 percent each year. But this year, growth in bank lending had declined to 8 percent. There clearly is a demand problem," Welikala said.

"Interest rates are set by the policy rates of the Central Bank, and there is no question that rates will continue to be high next year as well but the problem is in the taxation, with some bank paying as high as 68 percent," he said.

Welikala also said it was difficult for private sector to raise deposits which can be utilised to lend because state banks held about 70 percent of the country’s total deposits.

Private sector banks over the past few months have introduced new fixed deposit schemes with attractive features to attract public deposits.

Others have issued debentures and have made announcements to that effect in order to raise adequate capital to generate loans which is a bank’s main source of revenue.

Welikala said it was important for banks to consider the option of Consolidation as a solution to this problem.

"The private bank sector is too fragmented and is crowded out by state sector banks," he said.

Last month another senior banker said the country’s banking sector had failed to penetrate the rural masses and warned that banks would find it hard to survive if fundamental problems affecting the sector are not addressed.

"If banks are to expand and grow, capital built-up is prerequisite. Investors must be attracted in order to do this, however banks are not making enough returns and are facing a dilemma," Manoj Akmeemena, Senior Manager, Strategic Planning, Sampath Bank PLC said.

He said that the global financial crisis had not impacted local banks as the industry was not as sophisticated as their international counterparts but warned that domestic structural problems could pose problems in the years ahead.

Size does matter for survival and expansion and advocates of consolidation say that by consolidating, banks could reach economies of scale, rationalise infrastructure, ITC and HR costs and strengthen their capital bases enabling them expand and venture into regional markets.

"The question is, do we do this now or wait for things to get worse?" he asked.

"Banks cannot create enough returns to attract investors. Taxes are too high. But even if taxation is halved, banks will still not be able to create real value for investors," Akmeemena said.

According to the Asian Banker, in 2007 the average Return on Equity (ROE) of Sri Lankan banks amounted to 14.8 percent while Treasury bills and bonds had a return of 18 percent.