The latest quarterly review by the Nepal Rastra Bank (NRB) paints a healthy yet concerning picture of Nepal’s economy. The surface is green—remittances have surged by 35.4 percent to a staggering Rs553.31 billion, foreign exchange reserves cover over 16 months of imports, and the central bank has slashed the policy rate to 4.25 percent to spur growth. But walking into any industrial estate or talking to any small- and medium-sized enterprise owner, a different reality is revealed: Banks are flush with cash, yet credit expansion is paralysed, non-performing loans climb and banks accumulate tens of billions of rupees in foreclosed property they cannot sell. This is a structural failure, with roots in incentives, governance and outdated business models.

The standard economic prescription would be straightforward: When there are excess reserves and lending stalls, ease monetary policy to lower borrowing costs and stimulate credit demand. NRB has done exactly that, trimming rates and narrowing the interest corridor. But monetary tools alone cannot fix what is fundamentally a supply-side problem in credit markets. The real constraints are institutional, not cyclical, as we have been thinking.

Pawn Shop Syndrome

For decades, Nepal’s banking model has been simple: ‘Bring a property ownership certificate, and we will give you a loan.’ This collateral obsession is primitive banking. It requires no analysis of cash flow and no understanding of business viability. This model has now hit a dead end. With the real estate market frozen, the collateral machine has jammed. The evidence is in the swelling non-banking assets. As noted by the Confederation of Banks and Financial Institutions Nepal, banks are being ‘squeezed’ by assets they cannot sell. They are fast becoming the largest realtors in the country, holding land that generates zero cash flow, while the credit-to-deposit ratio sits comfortably below the 90 percent limit, proving they have money but are afraid to lend it.

The recent preliminary findings of the audit firm hired to assess Nepal’s major commercial banks under strict IMF conditions have confirmed that the official bad loan figures are a lie. The auditors uncovered a systemic epidemic of evergreening, where banks issue new loans to delinquent borrowers solely to pay off old ones, keeping the books clean while the asset rots.

Loan swapping is another concerning issue with serious future repercussions. It occurs when borrowers move bad loans from Bank A to Bank B, artificially inflating the collateral valuation in the process to justify the switch. This is a Ponzi scheme financed by depositor trust.

Internal governance of the banks is another pertinent issue today. Both senior management in the banks and the board mingle for wrongdoings. Boards remain heavily influenced by promoter interests. Insider lending continues to distort credit allocation. Loans granted to related parties often enjoy preferential treatment and crowd out more transparent and competitive borrowers. Large discrepancies persist in loan appraisal standards, including significant inconsistencies in collateral valuation and underwriting. Governance failure in banking cascades into balance-sheet vulnerabilities. Only 30 to 35 percent of total lending flows to the productive sector in the economy today. This is not a credit market failure; it is a business model failure.

The governance purge

Nepal’s regulator is prescriptive but insufficiently enabling. It has detailed directives covering loan classification, provisioning, branch operations, interest spreads and service charges. But it lacks the market-based ecosystem necessary for banks to clean up their balance sheets efficiently.

Our regulator focuses on the wrong things. We suffer from a tick-box culture where compliance is mistaken for governance. NRB micromanages interest spreads and dictates product parameters, killing innovation. For example, why would a CEO invest in AI-driven credit scoring for collateral-free SME loans when their profit margins are fixed by a circular from the central bank? Nepal’s regulatory structure is designed to prevent a crisis, not resolve it.

Primitive banking

Many Nepali banks still operate as if they are in the era of manual ledgers and collateral-centric lending. Their product portfolios remain narrow, focused largely on consumer loans, overdrafts and real-estate-backed credit. Fee-based income, a major driver of bank profitability in global markets, remains underdeveloped in our ecosystem.

Digital adoption looks charming but is uneven. Actual fintech partnerships are rare. Big data or AI-based credit scoring models hardly exist, leaving banks with a blunt instrument with regard to assessing borrower risk. This not only limits financial inclusion but also suppresses innovation in micro, small and medium enterprise lending, where traditional collateral often does not exist. Nepal’s economy has dramatically changed over the past decade. But its banking sector has not.

Adverse selection problem

In a healthy market, banks screen borrowers to find the most productive projects. In the current distorted market, ‘safe’ borrowers are deleveraging or hesitant to borrow due to low demand. The borrowers who are desperate for cash are often those trying to service existing debts or speculate further.

This is compounded by the absence of efficient resolution mechanisms. In developed economies, if a loan goes bad, there are efficient bankruptcy laws and secondary markets for distressed assets. In Nepal, legal procedures for collateral liquidation are protracted, and political constraints discourage transparent auctions at market-clearing prices. Without a functioning asset management institution or a secondary market to absorb these bad assets, they sit on balance sheets like toxic waste, tying up capital that could otherwise support new lending. However, we should be cautious that such institutions should not be just another way of swapping in bad assets from one pocket to another.

Macroeconomic stakes

Nepal’s banking dysfunction is not merely a sectoral problem. It has cascading effects across the entire economy. When credit flows to speculation rather than productive enterprise, job creation stalls. Real estate lending generates temporary construction work but no durable employment; manufacturing, agribusiness and exports do. Nepal’s stubborn youth unemployment exists precisely because banks fail to channel savings towards labour-intensive sectors.

The majority of employment comes from micro, small and medium enterprises, yet they receive only a minority of formal credit, often with rationing or prohibitive terms. Financial inclusion via digital banking and alternative credit scoring cannot move forward as long as bank balance sheets remain clogged with bad assets. Banking fragility thus entrenches inequality, suppresses exports and wastes Nepal’s demographic dividend.

A moment to choose

Nepal’s banking sector is not on the brink of collapse. But it is trapped in a cycle of mediocrity that erodes state's economic potential. The challenge is not technical. It is institutional. We have liquidity, monetary space and the required infrastructure. However, what we lack is a modern, disciplined, innovation-driven banking architecture capable of allocating capital where it matters.

If Nepal chooses credible, sequenced, irreversible reform, the financial sector can become a true engine of growth. If not, the country will continue drifting towards a low-investment, high-speculation economy with rising systemic risks.