Nepal: Banking Sector Growth Fails To Ensure

Financial Stability


Financial sector development in Nepal has been haphazard despite the rapid growth of the sector and the relative stability of the country�s banking sector, says an IMF report.
There has been a rapid growth of the banking sector in Nepal over the last few years. The financial system as of mid-January 2008 includes 23 licensed commercial banks (Class A institutions), 58 development banks (Class B institutions), 79 finance companies (Class C institutions), and other financial institutions, including 12 micro-credit development banks.The rapid growth of the financial system presents a number of challenges to maintaining financial stability in Nepal. The recent proliferation of financial institutions and credit growth has coincided with a sharp rise in stock market and property rices, warranting an added focus on the risk mitigation framework.The key risks to financial stability going forward include:
l Strengthening bank supervision and regulatory enforcement;
l Improving liquidity management and forecasting in the central bank�s conduct of monetary policy; and
l Addressing financial weaknesses of the large public banks.
Development banks and finance companies are not permitted to take demand deposits or undertake foreign currency business, but are otherwise treated similarly to commercial banks, and thus referred to as banks throughout this paper. Total assets of Nepal�s banking sector stood at 81 per cent of GDP in July 2007, increasing from 78 per cent of GDP in July 2006 and 62 per cent of GDP in July 2001.

Structure Of Financial System
State-owned institutions continue to dominate the country�s banking system. Despite a comprehensive restructuring process and the rapid entry of new private banks, state-owned banks still account for more than 30 per cent of total banking sector assets. The state-owned banks also have the largest branch networks, representing more than half of total bank branches in the country.
There are two large public commercial banks � Nepal Bank Ltd.  (NBL) and Rastriya Banijya Bank (RBB). Both banks have been under a restructuring programme supported by the World Bank since 2000.
The state also retains a stake of 65 per cent of the capital of the Agriculture Development Bank Limited (ADBL), which was recently upgraded to a Class A institution and is under a restructuring programme supported by the Asian Development Bank.
Equity market capitalisation has increased sharply while government debt markets remain underdeveloped. Between end-2006 and 2007, the stock market boomed, with the Nepal share price index more than doubling, causing market capitalisation to rise from 17 per cent of GDP to about 40 per cent of GDP at end-2007. Following a 20 per cent correction early in 2008, market capitalisation now stands at about 32 per cent of GDP.
The government debt market remains small with treasury bills and development bonds amounting to about 10 per cent and two per cent of GDP, respectively. About 25 per cent of treasury bills are held by the Nepal Rastra Bank (NRB) with little or no secondary market trading activity.

Institutional Vulnerabilities
Despite a challenging macroeconomic environment, the financial performance of the banking system has improved. The Financial Sector Reform Programme of the government was launched in late 2000 to address the legacy of politically motivated lending by state-owned financial institutions and weak supervision that allowed the build-up of a high volume of non-performing loans (NPLs) and brought the banking system to near insolvency. Key financial soundness indicators (capital, asset quality, and profitability) improved steadily in recent years.
Most commercial banks continued to maintain capital in excess of the minimum statutory capital adequacy requirement (CAR) of 11 per cent in January 2008, with the exception of the two large public banks, the ADBL and three other private commercial banks. The ratio of NPL to total loans fell by more than half since 2003, due to aggressive write-downs of bad loans and improved supervision, though rapid credit expansion in recent years has also contributed. Recent data suggests a continuation of this positive trend with NPLs declining in the first half of 2007-08. Total loan loss provisions have also increased to about 150 per cent of NPLs by January 2008.
Credit growth has been rapid, fuelled by a number of factors. Credit has grown by around 25 per cent at end-2007, compared to a trend growth of 22.5 per cent over 2000-01� 2006-07, with a 36 per cent increase in credit by private commercial banks more than offsetting a contraction of lending by the two large public banks as they undergo restructuring. While some of the growth reflects a natural deepening of the financial system, loose monetary conditions, intermediation of worker remittances to housing and consumer credit, and a proliferation of new institutions also played a role.
The number of licensed commercial banks, development banks and finance companies as of end-2007 reached 23, 58 and 79 (from 18, 38 and 34, respectively in the previous year). Minimum capital requirements have been raised as a response but demand for new licences remains strong, in part because of the profitability of the sector.

Risks To Bank Credit
The rapid increase in credit growth in recent years suggests growing credit risk. The rapid proliferation of financial institutions and credit growth has coincided with a sharp rise in stock market and property prices.
While the sectoral distribution of credit does not show a high exposure to the estate and stock market, partly as of loan classification limitations, the indirect exposure could be quite large. Nearly 60 per cent of bank loans are secured by real estate assets, thus making banks vulnerable to a sharp drop in real estate prices. In contrast to international best practice, Nepal banks can lend against stocks as collateral. While this so-called margin lending remains small (about three per cent of the loan portfolio of banks), its recent growth could be fuelling the stock market boom. The lack of detailed bank-by-bank sectoral NPLs and collateral held precludes a stress testing of these risks.
Growing competitive pressures and an uneven distribution of liquidity could also weigh on the financial sector. Banks have so far managed to increase profitability by maintaining relatively high spreads between deposit and lending rates but the recent proliferation of financial institutions, and thus increased competition, appear to have contributed to a narrowing of the spread. Liquidity management is also likely to be a growing challenge. The share of illiquid loans in bank assets is increasing throughout the system, and the average credit-to-deposit (CD) ratio for the banking system has increased from 60 per cent over 2000-2006 to 78 per cent by end-2007. Nearly 25 per cent of banking assets and 17 per cent of GDP are now held by small private banks with CD ratios exceeding 90 per cent � very high by international standards.
Stress tests suggest that banks are more vulnerable to asset quality and liquidity shocks than exchange rate and interest rate shocks.
l A 25 per cent equiproportional increase in NPLs at all banks reduces the aggregate CAR by 1.2 percentage points, and more so at the large public banks (1.8 percentage point as expected given their already large NPL ratios. In this scenario, the capital of one additional private commercial bank would fall below the minimum CAR.
l The largest negative shock would arise from the default of the banks� single largest borrowers. In this case, nearly all banks would cease to meet their minimum CAR, while a significant number of institutions would go insolvent if their largest 3 to 5 borrowers default.
l Banks� liquidity positions are not able to withstand standard shocks to deposits (e.g., 15 per cent of demand deposit withdrawn a day) under standard assumptions for market discounts on liquid assets.
l The sensitivity tests confirm that banks� balance sheets are relatively resilient to the direct effects of an exchange rate shock (vis-�-vis the US dollar) due to stringent open-position limits and low level of dollarisation.  Likewise, the impact of interest shocks would be limited. The impact of a 1.5 percentage point increase in interest rates on the CAR of all banks is only -0.3 percentage points (-1.2 percentage points for public banks) due to its modest effect on the net interest income on private banks given their profile of interest sensitive assets/liabilities.

Restructuring Of Banks
Weaknesses in the two largest public banks affect the performance and soundness of the banking system as a whole. The government has dropped earlier plans to privatise the largest two public banks and, instead, has opted for operational and financial restructuring, which has yielded some improvements over the past few years under a World Bank financial sector restructuring project. The operational autonomy provided to NBL and RBB has for the most part shielded the two institutions from politically motivated lending.
The two banks are now showing an operating profit that has helped reduce their negative net worth, though they still maintain a significant negative CAR. While loan recovery and write-offs have reduced the level of NPLs in these two banks and in the banking sector as a whole, loan classification is based only on aging of arrears and not on creditworthiness, possibly underestimating potential problem loans.
The overhead expenses of the two public banks � driven by high salaries and pension costs, reflecting difficult relations with the labour unions � continue to weigh heavily on their financial position. The management and governance of the two banks also suffer from uncertainty regarding the status of external management contracts put in place under the restructuring programme, and from gaps in expertise in finance and risk management. Overall, state involvement in the financial sector continues to risk undermining its efficiency and development by increasing the cost of finance due to weak operational efficiency of public banks, by weakening regulatory credibility, and by stifling financial innovation.
Addressing the capital deficiency of the public banks and improving debt recovery from wilful defaulters constitute key policy priorities. Capital adequacy is the pre-eminent anchor of banking regulation, and the continued inability of public banks to maintain adequate capital undermines both the credibility of banking supervision and the soundness of the banking system. Coupled with regulatory forbearance, it clouds the existence of a level playing field among banks.
As the current owner, the government should recapitalise NBL and RBB and ensure sound management practices given the past history of politically motivated lending and large stock of NPLs.
ADBL has recently received a capital injection of $58 million under a Rural Finance Sector Development Cluster Programme funded by the Asian Development Bank, allowing its CAR to reach 9.8 per cent as of end-January 2008.
The ADBL could thus meet the minimum CAR of 11 per cent when the government further reduces its shareholding as envisaged in its strategic plan approved in November 2007. In addition, improving debt collection from wilful defaulters, including through efforts by the Debt Recovery Tribunal, should remain a policy priority to maximise recoveries and instil credit discipline among borrowers. However, legislation aimed at setting up an additional bench at the DRT to expedite the large number of outstanding cases has been put on hold, delaying the timely disposal of pending cases.           



 

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