Private commercial banks said a reduction in lending rates would not come overnight as cost of funds and regulatory capital requirements narrow profit margins, however, prime corporate clients are enjoying the benefits of lower rates, much lower than is offered to the rest of the economy.

This week the Central Bank further slashed policy interest rates in a bid to bringing down interest rates to stimulate credit expansion to the private sector—earlier the government ordered state-owned banks to reduce lending rates to a minimum of 8 percent and maximum of 12 percent to priority sectors such as tourism, agriculture, construction and SMEs.

"Private commercial banks would not respond with similar rate cuts, and we will not see bull-in-a-china-shop type behaviour. Instead we would see rates responding much slower than expected by the Central Bank," a dealer said.

Long term fixed deposit rates still carry high rates of interest which do not make it possible for most commercial banks to cut rates immediately. "Cost of funds—deposit interest payments—are still too high," dealers said.

Dealers said, however, that cost of funds, were not the only cause for concern.

"The sectors that are prescribed for state-bank rate cuts are generally considered to be high risk. According to BASEL II, commercial banks are required to set aside adequate capital in proportion to the volume of high risk lending, and raising capital in Sri Lanka is not easy," an analyst said.

BASEL II is the second instalment of international laws and regulations for banking supervision adopted in Sri Lanka in 2008.

Dealers said that when lending rates are low banks should be extra vigilant in evaluating credit worthiness of borrowers.

"When lending rates are relatively high there are not many borrowers who come forward applying for a loan as it acts as a disincentive. But when lending rates are lowered everybody would be applying for a loan and banks have to be careful and evaluate the credit worthiness of each borrower.

"After all we are dealing with depositor funds and banks are under obligation to make responsible and wise credit decisions," a dealer said.

Private commercial banks are facing stiff competition for deposits with their much larger counter parts, the state banks.

"Some even say the Colombo Stock Exchange is better place to invest in when deposit rates fall, which means commercial banks will be under pressure to mobilise deposits from this front as well," a dealer said.

Economists point out that the government had to force a rate cut on the industry by ordering state-owned banks to bring down their lending rates because the market determined interest rate system failed.

"Private commercial banks may see this as a political move, a temporary move, but the fact is banks were not lending to the economy despite the policy rate cuts, reduction in benchmark Treasury bill rates and all the while holding excess liquidity positions," a dealer said.

"A perfect example as to how private banks operate can be seen in the prime lending rates. These rates have come down significantly. But this only is an indicator to what the top corporate clients are being charged as interest for their loans. The rest of the economy does not enjoy these rates," he said.

As of November 13, 2009 the average weighted prime lending rate was 12.64 percent.

Over the weeks after the state bank rate cut was announced, several private commercial banks have also announced rate cuts, but only to specific sectors and for new loans.

"It is one thing to advertise a rate cut and it is another to actually grant a loan," a dealer said.