Political Instability, Civil War and Cost Efficiency of Banking Firms: A Case Study in Sri Lanka*

• Published date: 01 September 2021
• Author: Lalith Seelanatha
• Date: 01 September 2021
• DOI: http://doi.org/10.1111/asej.12250

Political Instability, Civil War and Cost Efficiency

of Banking Firms: A Case Study in Sri Lanka*

Lalith Seelanatha

Received 4 September 2020; Revised 2 May 2021; Accepted 7 June 2021

This paper investigates the effects of political instability resulting from successive

regime changes and the 30-year civil war on the cost efficiency of local banks in

Sri Lanka. A translog cost function was used to estimate bank cost efficiency, and

a multivariate regression model was used to investigate the determinants of bank

cost inefficiency. On average, the cost efficiencyof banks in Sri Lanka during the

study period was relatively high. Sri Lankan banks performed more efficiently

during the second political regime (2001–2004), which had more liberal political

and economic policies to promote the private sector compared with other regimes.

During this period, the government was involved in peace talks, leading to a

ceasefire agreement that temporarily stopped the violence. Furthermore, the posi-

tive coefficients for the dummy variables representing the third and fourth political

regimes showed that more restrictive economic policies can increase bank cost

inefficiencies. The results also indicate that immediately following the civil war,

Sri Lankan banks recorded a decline in cost efficiency. Cost inefficiency was posi-

tively associated with banks’risk aversion, credit risk, market share, interest rate

risk and increase in GDP and negatively associated with non-earning assets,

liquidity, bank size and concentration.

Keywords: banks, civil war, political instability, Sri Lanka, stochastic frontier

analysis, technical efficiency.

JEL classification codes: E44, G21, G28, N25.

doi: 10.1111/asej.12250

I. Introduction

In bank-based financial systems, the performance of banking institutions is

important for the mobilization of savings, efficient allocation of capital and pro-

vision of risk management instruments to economic decision-makers, all of

which ultimately enhance economic growth and the general wellbeing of citi-

zens. Similar to other economic sectors, the banking sector is vulnerable to

major changes in the political, social or economic environments. Therefore,

understanding the effects of political, social and economic events on bank

*Seelanatha (corresponding author): Victoria University School of Business, Victoria University,

300, Flinders Street, Melbourne, VIC8000. Australia. Email: lalith.seelanatha@vu.edu.au

© 2021 East Asian Economic Association and John Wiley & Sons Australia, Ltd.

Asian Economic Journal 2021, Vol.35 No.3, 294–316 294

operational performance is important. Over the past 40 years, Sri Lanka has

undergone a complex, multidirectional political, social and economic transfor-

mation. Therefore, this study aims to investigate how some of these events have

affected the operational performance of banks in Sri Lanka.

Previous researchers have used frontier techniques to assess the impact of

major economic events, such as economic crises and financial liberalization, on

the performance of firms. However, despite the availability of many banking

productivity and efficiency studies, there is a wide gap in the literature linking

bank performance with political, social and environmental issues.

The open economic policy introduced in Sri Lanka in late 1970 was aimed at

improving the banking and financial sector’s operational performance by

creating a competitive market environment. Deregulation of the financial indus-

try in Sri Lanka has focused on strengthening market forces to enable the effi-

cient and productive operation of the banking industry (Seelanatha and

Ihalanayake, 2019). Early reforms of the financial services sector were focused

on relaxing entry and exit requirements, reducing state-owned equity in the

banking industry, reforming financial institutions and instruments, allowing

interest rates to be set by market forces, permitting the allocation of credit based

on market signals, reducing the cost of financial intermediation, strengthening

the legal, accounting and regulatory frameworks of financial institutions, devel-

oping money, capital and debt markets and providing operational flexibility to

banks in the management of assets and liabilities.

However, initiatives aimed at establishing a free market through deregulation

of the market, including the financial services sector, were overshadowed by the

political instability resulting from the civil war and successive political regime

changes. In general, Sri Lanka experienced a more fragile political, social and

economic environment during this period (Seelanatha and Ihalanayake, 2019).

The political environment of a country is directly related to the institutional

structures that regulate the market. The quality of these institutional structures

can affect market performance. Thus, an understanding of how changes in politi-

cal structure affect the performance of economics units is warranted.

In 2009, the 30-year civil war in Sri Lanka came to an end (Seelanatha and

Ihalanayake, 2019, Country-Watch, 2020). Throughout the civil war, the coun-

try’s economic activities, especially in the northern and north-eastern regions,

were constrained. The cessation of the civil war in mid-2009 led to a significant

economic boom over the next five year period. With the end of the civil war, the

Sri Lankan Government recommenced the regulatory reforms in the financial

services sector that had begun in 1977 to enhance the industry’s operational per-

formance. These reforms aimed to maximize the use of financial resources for

economic development by enhancing the participation of the private sector. The

deregulation of the financial services sector triggered by the end of the civil war

transformed the operational environment of the banking industry by enabling

structural changes and enhancing private sector involvement. Following the end

of the civil war, there were positive developments in all sectors in the country.

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