The Impact of a Monetary Policy Easing Cycle on the Bank Balance Sheet Dynamics in Emerging Economies: The Case of Sri Lanka

Arguably, monetary policy decisions of central banks aim to significantly influence the banking sector. Empirically, an accommodative monetary policy has a lower impact on the banking sector as opposed to the impact seen in a tightening cycle. This chapter argues that banks in Sri Lanka would prioritize their balance sheet objectives—profit margins and cash flow—over the monetary policy stance in a monetary policy easing cycle. Such prioritization may result in banks being laggards in the transmission process reducing the potential transmission of policy signals to the markets via retail interest rates. We examine the banks’ role in the premise of a dominant banking sector of an emerging economy. Many East and South Asian economies have dominant banking sectors that are needed in monetary policy transmission. Balance sheet objectives of the Sri Lankan banking sector institutions are examined under four critical characteristics—the profit before taxation, net interest margin, loanable funds, and cash flow. This chapter uses a Generalized Method of Moments model that shows the presence of a robust balance sheet channel in effect. The outcome highlights the policymakers’ focus should be on not only the sector-wise aggregate performance but also on institutional performance, especially for economies where commercial banks are dominant players, such as in the case of the small, open economy of Sri Lanka.