The banking system in any economy is highly policy sensitive, and it is more tightly policed in comparison to other industries. Frequent interventions by the central bank are necessary to safeguard public deposits and maintain a healthy financial system. Any failure in this industry creates panic, not only among depositors, but the economy as a whole. So, even though the central bank gives banks a free hand to set interest rates and conduct other activities, the industry has to act within defined policy boundaries.

Nepal's central bank Nepal Rastra Bank is responsible for drafting such policies in Nepal. The monetary policy for the current fiscal year made it mandatory for commercial banks to maintain 25 percent of their paid-up capital by issuing long-term debt (debentures). This has got banks struggling to sell their debentures because investors are hesitating to put their hard-earned money in such debt capital. Let's see why investors are turning away from debentures.

Debt instrument

Debenture (or corporate bond) is a debt instrument that companies issue to raise capital. In Nepal, companies listed on the Nepal Stock Exchange can issue debentures. The corporate bond provides investors with a fixed interest rate on an annual basis. Debentures or bonds are construed as low-risk securities: The issuing company is legally obliged to pay interest on such bonds despite suffering losses. Therefore, in the developed capital markets, investors generally prefer debentures when expected interest rates (return on other investments) are likely to fall. This means debenture prices are highly sensitive to interest rates. Therefore, a thorough market analysis is needed before issuing debentures. But in Nepal, the central bank seems to have not done its homework before formulating such policy.

The argument is not whether debentures are good for banks or not. Of course, they are good. From the shareholders’ point of view, different capital structure theories have shown that the use of debt capital helps companies to increase their market value. However, what is important to take into account before deciding to go for debentures is the market interest rate and the overall performance of the stock market. For example, issuing debentures during high-interest rates elicits a high cost of capital, and issuing the same during low-interest rates may lead to lower market value and yield once the rates start increasing.

Though one of the objectives of Nepal Rastra Bank in making debentures mandatory is to inject financial institutions with loanable funds, the central bank did not make it mandatory to include debentures in the core capital plus deposit ratio. The prevailing high-interest rate in the market is what is making investors hesitant to buy such securities. This is because the interest rate banks are offering on debentures is the prevailing interest rate of about 10 percent on fixed deposits. And given the economic activities and frequent liquidity shortages in the market, these interest rates are not expected to drop. For example, even if liquidity is maintained, debentures having 10 percent cost as loanable funds are further likely to push up interest rates. Eventually, someone who is investing in such debentures will suffer from decreasing prices in the market.

Moreover, investors have to have a clear distinction between returns from such securities and others prevailing in the market. The interest rate is not high enough for investors to want to put money into debt securities issued by banks. Besides, given the underperforming stocks and return on equities, debentures may further degrade the performance of the capital market. From the shareholders’ point of view, debentures will put more pressure on the existing shareholders. For example, the high cost (interest expense) and the required debenture redemption fund will end up with reduced earnings available to the existing shareholders.

Uncertain returns

Similarly, when the capital market has long been underperforming, and investors are turning away from bank securities, debentures might signal imperfection of bank stocks. This move will further degrade the performance of the stock market because almost all banks will try to issue debentures as required by law. The oversupply and low demand for such securities will force banks to reduce issue prices, further increasing the cost of capital. In the same way, what is important to note is investors’ preference for short-term returns over long-term returns. This is because there is uncertainty in future returns. Therefore, investors will prefer other safer investments such as fixed deposits where they will not only receive an equivalent return but also collect their total investment. This is what is happening now.

This succinct picture of the capital market and the economy shows that debentures are not the present-day need. What policymakers have to understand is the timing. The present-day need is to revive the capital market and investor confidence in bank securities. For this, Nepal Rastra Bank has to put more emphasis on promoting or forcing banks to go for mergers and acquisitions. This will not only increase the performance of banks, but also the performance of their securities in the market. And, of course, once there is a healthy capital market enjoying strong investor confidence, this optimism can trickle down to debentures. Policies formulated in the developed markets may not necessarily always do good in imperfect capital markets like in Nepal. 

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