Nepal's banking industry is walking a precariously risky road not only because of a seasonal and often recurrent loanable funds crunch but due to a combination of factors ranging from poor regulation and supervision by the monetary authority to blatant compromises in corporate governance practices by the bank and financial institutions themselves in their operation and business.

A recent report by the International Monetary Fund (IMF) has categorically pointed to the ineffective regulatory and supervisory role of the country's monetary authority, Nepal Rastra Bank, resulting in a lack of "accurate assessment of the asset quality of banks and that better captures existing risks". It has also referred to the central bank's failure to fully implement the first phase of the Supervisory Information System aimed at class A (commercial) banks and proceed to the second stage and extend it to class B (development banks) and class C (finance companies).

Lack of proper data to enable effective (online) supervision and methods of calculating the non-performing loans were also detected by the visiting IMF delegation which finalised the IMF extended credit facility (loan) of about $396 million to Nepal. Interestingly enough, fiscal and financial sector stability is one of the three components where the loan amount will be utilised. Such a loan with a very short payback period of only three years should have ideally been utilised in more productive sectors of the economy than in reform-type expenditures.

Regulatory shortfalls

Over the years, Nepal's financial sector has substantially expanded. According to the latest Nepal Rastra Bank data, Nepal's financial system has 27 commercial banks, 17 development banks, 17 finance companies, 67 microfinance financial institutions and one infrastructure development bank under the central bank's supervision radar. The number of bank branches excluding those of microfinance institutions is 6,154, or more than 50 percent. Timely and effective supervision of them all, particularly on-site, is indeed a Herculean responsibility for an under automated supervisor like Nepal Rastra Bank with only 50 percent officer-level staff among some 1,000-plus employees.

Apparently, the poor regulatory framework has alarmingly increased incidences of regulatory arbitrage. Such phenomena are manifested in different forms. The provisionally reported profit of the 27 commercial banks during the first half of the current fiscal year has crossed Rs33 billion. The annual rate of return on the Rs285 billion total paid-up capital of these class A banks will cross 25 percent by the end of the fiscal year. The only interpretation of such high earnings of banks, despite the Covid-19 pandemic and incessant whining about a liquidity crunch, could be that the regulator of the monetary system, in essence, has failed to tame them.

There are larger structural issues that are blunting the regulatory teeth of Nepal Rastra Bank. The central bank as a federal entity exercises the sole authority of implementing Schedule 5 (5) of the constitution with regard to money and banking, and monetary policy. The central bank at present is performing a dual role of monetary authority and also the regulatory and supervisory authority of the country's financial system. The exercise of the powers of a monetary authority as an independent (of political interference) central bank is beyond question and in line with the best global practices. It is, however, a different matter of inquiry, as indicated by the aforementioned IMF report too, whether Nepal's central bank has positioned itself and behaved as a fully autonomous institution.

But regarding regulatory and supervisory functions, the monetary authority has badly bungled and exhibited the "I-control-everything" mindset of pre-reform era central bankers. Many economies have bifurcated the monetary policy function and regulatory functions and created separate dedicated institutions for each of these two distinct tasks so that the monetary authorities can more effectively focus on core central banking functions of inflation targeting and systemic risk analysis. This practice is proving to be more robust than the earlier one, thus it is rapidly gaining currency. But, in Nepal, even a meaningful discussion is yet to begin in that direction. The relevant authorities appear to be unaware of this necessity. The unwillingness of central bank mandarins to relinquish its traditional role as regulator and supervisor (as well) is at the heart of this inertia.

It is perhaps for this reason that Nepal Rastra Bank, while updating its laws and regulations after the country restructured into a federal policy, did not even consider creating adequate legal space for provincial governments to collaborate and provide support in its regulatory functions. This certainly would have created more desirable results in financial governance.

Crisis in banking

Despite the proud claims of industry players as the "most transparent" business in Nepal, primarily due to the fact that they are obligated to publish quarterly provisional balance sheets and trading on stocks report, the Nepali banking sector is gradually converting itself into a mere usury cartel—compromising almost all norms of corporate governance. Massive insider lending, utter disregard for apparent conflict of interest, "doctoring" books of accounts and pervasive corrupt practices in lending even in private sector banks are some of the perversions that have put the entire financial architecture at imminent risk of collapse.