Banking should be boring—ideally. That is how it used to be in the good old days. Arguably, the early banking concepts began in the Middle Ages, when merchant banks financed grain production and trading. In the 13th and 14th centuries in Italy, institutions involved in the banking business took deposits and lent money. Initially, banking was strictly limited to accepting deposits at a certain interest rate and lending at a higher rate, earning the spread. Such credit creation remains the bread and butter of the banks. Yet, commercial banks these days provide a range of fee-based services, including safeguarding assets, mortgage loans, and investment banking.

Banking is no longer seen as a boring job; instead, it is hip to be a banker. Bankers are well compensated, and CEOs—most anyway—cherish publicity. Increasingly, present-day banks are deviating a bit too much from the original deposit-loan scheme. This entails risks and can sometimes exact a high price. Nowhere was this more evident than in the California-based Silicon Valley Bank (SVB) that collapsed last month. The 40-year-old bank unravelled in just two days. The SVB did not play in the big leagues—JP Morgan, Bank of America, Citibank, and Wells Fargo boasted between $3.2 trillion and $1.7 trillion in assets as of 4Q22—but with $209 billion in assets, SVB was no minnows either.

The SVB was the 16th largest bank in the US, where, as of 4Q22 (fourth quarter of 2022), there were 4,706 commercial banks, down from a peak of 18,083 in 1Q86. Regional and community banks comprise the majority, with 3,725 under $1 billion in assets and 761 under $100 million. So, when the SVB experienced a bank run, there was panic among the regulators, who witnessed SVB depositors yank $42 billion on March 9 alone; the next day, the Federal Deposit Insurance Corporation took over the bank. In addition, to stop this from spreading to smaller banks, the corporation guaranteed that even those holding over $250,000 would be made whole. In normal circumstances, deposits of up to $250,000 per person per bank are insured.

Trust is an essential concept in banking. For a long time, the SVB was a trusted bank—kind of a go-to lender for tech start-ups in Silicon Valley. Post-Covid, liquidity was aplenty. Private equity and/or venture capital firms were throwing tons of money at start-ups. The SVB, faced with swelling deposits, put a large portion of this into longer-term US treasury bonds and mortgage bonds. This was fine until the Federal Reserve left interest rates languishing near zero. Come 2022, the US central bank began to raise rates. Concurrently, start-up funding slowed, so these companies withdrew money to operate. To meet this demand, SVB was forced to sell some of its bonds at a loss. Once this news hit, customers panicked.

SVB lessons for Nepal

Modern banking is new in Nepal, with 12 of the 21 commercial banks currently operating formed this millennium. Very few bank CEOs and/or company boards have gone through a natural boom/bust cycle, let alone a deposit run. So there are lessons to learn from the SVB fiasco, particularly as the Nepal Rastra Bank, the country's central bank, has for a while now encouraged banks to merge and get bigger. Despite the several incentive carrots dangled, it took time before the banks organically felt the need to tie the knot. The ball got rolling in earnest once the Global IME merged with the Janata Bank in December 2019; there were 28 commercial banks back then. In fact, only a year ago, there were 27.

The merger mania is probably not over. After several deals over the years, the Global IME Bank leads with Rs35.8 billion in paid-up capital. The Nepal Investment Mega Bank, at Rs34.1 billion, recently bulked up to surpass the Nabil Bank at Rs27.1 billion, even as the Kumari Bank (Rs26.2 billion) and the Prabhu Bank (Rs23.5 billion), which both recently completed their own mergers, round out the top five. There are still seven with less than Rs12 billion in paid-up capital. Most notably, the NIC Asia Bank (Rs11.6 billion) must be under tremendous pressure to find a partner. It is difficult to tell what the right number of banks is. But with each merger, there are fewer and fewer operating, raising concentration risks.

Safer banks mean slower growth

One of the arguments for larger banks is that they will be able to fund large infrastructure projects individually. Gains through cost-cutting and efficiency constitute another benefit. They can also compete better with foreign banks domestically or may find it easier to branch into India. Conversely, big banks are precisely that—they are too big or too big to fail. US regulators could act with lightning speed to stop the SVB contagion from spreading because it was not too big to fail; they would have a big problem on their hands if, say, JP Morgan, the largest US bank with $2.3 trillion in deposits at the end of 2022, experienced a deposit run; the chain reaction it would unleash would be unthinkable.

Viewed this way, a small-scale banking system is preferable. But the merger genie is out of the bottle. The regulators, thus, must put in place a system to safeguard big banks from failing. As of mid-February, commercial banks in Nepal held Rs4.7 trillion in deposits, versus Rs4.8 trillion in nominal GDP in 2021/2022. In the event of depositor panic, there is just no way to backstop all the deposits. Tighten the rules while the going is good—by requiring the banks to hold more capital on their balance sheet. As of mid-February, commercial banks held Rs15 billion in retained earnings. In the fiscal year through mid-July last year, they took home Rs75 billion in profit, a big portion of which was doled out in dividends.

If banks are made to hold more capital, they will make fewer loans. That is the unfortunate tradeoff. In banking, there is a delicate balance between growth and safety. In addition, when deposits are pouring in and loan demand is not keeping up, the regulators must see to it that the banks are not taking undue risks in their investments, as was the case with the SVB, which also failed because of high concentrations of fickle corporate deposits. Banks are enablers of leverage. If they lack proper risk management measures, they risk hurting themselves and their customers and potentially the whole financial system. Too much deregulation raises the odds of bank failures sooner or later.