Nepal has the highest number of banks and financial institutions in the region compared to the size of its economy, and there is much scope to bring down the number to improve the efficiency of the banking system, a central bank report says.

As of mid-March 2022, there were 27 commercial banks, 17 development banks, 17 finance companies, 66 micro finance institutions, and one infrastructure development bank in the country.

Nepali banks have been joining together, but mergers will not lessen competition, according to the report entitled "Optimal Number of Banks and Financial Institutions in Nepal" published by Nepal Rastra Bank on Sunday,

Nepal’s banking sector is less concentrated than other regional economies, and concentration ratios have declined between 2015 and 2020. This means there is an adequate level of competition in the banking industry, and the market power or monopoly of individual banks is comparatively low, the report says.

“In Nepal, there is high competition among commercial banks, but their monopoly is less,” said Prakash Kumar Shrestha, executive director of Nepal Rastra Bank, the author of the research paper.

“If the number of mergers increases, the numbers of banks will decline, helping to concentrate on efficiency gain,” Shrestha said.

Commercial banks are the largest part of the financial system comprising 54.5 percent of the assets followed by Nepal Rastra Bank with 17.6 percent. The share of development banks, finance companies and micro finance institutions is 5.1, 1.6 and 4.1 percent respectively. On the non-bank side, the share of insurance companies is 5.5 percent and the share of cooperatives is 4.5 percent, according to the report.

In India, as of March 2022, there were 34 commercial banks. Among them, 12 are public sector banks and 22 are private sector banks. Similarly, there are 11 small, 15 finance banks and 43 regional rural banks. There are 46 foreign banks currently in operation in India.

The study shows that the financial consolidation process in Nepal has been effective in many respects, at least in the short run. It has resulted in higher credit as well as deposit growth, higher earning power and improvement in the risk management capacity.

“However, operational efficiency of the banking sector has not significantly improved,” the study said.

Shrestha says if there are many mergers, the monopoly of banks will increase, and that too is not good as they can increase interest rates freehand.

“Eleven to 15 commercial banks will be an appropriate optimal number in Nepal,” said Shrestha. The study, however, does not say what would be a good number.

From the late 1950s to the 1960s, the government expanded the finance sector by opening new banks and financial institutions. The government opened Nepal Industrial Development Corporation (NIDC) in 1959, Rastriya Banijya Bank in 1966 and Agricultural Development Bank in 1968.

Until the mid-1980s, there were only four banks and a few insurance companies, all owned by the government.

The government was substantially involved in the management and operations of the banks. It imposed interest rate controls, selective credit policies and controls on the entry and exit of financial institutions, according to a separate report of the Asian Development Bank.

Due to lack of competition and government control, Nepal’s financial system was highly repressed.

From the late 1980s to the 1990s, the government implemented various liberalisation measures and increased the private sector’s role in the finance sector.

Prior to 1985, economic policies were centred on state-led protectionist strategies. By 2000, Nepal’s finance sector had mushroomed.

The liberalisation measures induced private sector entry and rapid sector expansion. Additional banks were all private banks. From 1994 to 2000, total banking credit increased from Rs23 billion to Rs96 billion. Access to banking services also improved, and the population served per bank branch rose from 36,000 to 42,000 during the same period.

The number of commercial banks grew from three in 1985 to 14 in 2000. That number grew to as high as 220 in 2012. However, with the introduction of merger policy in 2011, the number of such institutions dropped significantly.

In Nepal, merger and acquisition activities gained momentum after the introduction of merger bylaws in 2011. In 2012, there were 220 financial institutions including 32 commercial banks, 88 development banks, 77 finance companies and 23 micro finance institutions.

The study show that Nepal has progressed a lot during the last one decade in terms of financial access compared to its neighbours.

The private sector credit to GDP ratio has increased to over 88 percent, which is above many South Asian countries. Financial access has widened as shown by the higher availability of commercial bank branches and the percentage of adults having accounts.

According to Shrestha, banks and financial institutions that relied on commercial activities for decades are now gradually becoming capable of making large investments in infrastructure projects.

“By definition, commercial banks are meant to conduct commercial activities. Commercial banks in Nepal were by nature not the type of banks that make huge investments in projects,” Shrestha said.

With the increase in the paid-up capital and assets in recent years, many commercial banks have become able to invest in big projects on their own or with consortium partners.

"Infrastructure development banks have also been established to invest in mega projects," Shrestha said. "Mergers have enlarged the capital of banks, enabling them to invest more."

The report, based on a survey conducted among bank management and experts, says the merger process has produced many positive impacts, at least in the short run.

Of the respondents from banking and financial institutions, 79 percent said the merger process had enhanced the risk-bearing capacity of the banking and financial systems, 67 percent opined that it had increased the investment capacity, 51 percent opined that it had helped maintain healthy competition, and 52 percent opined that it had helped increase operational efficiency.

In addition, 52 percent of the respondents reported that the per employee operation cost had declined after the merger, 50 percent reported that per employee operating profit had increased, and 62 percent reported that employee productivity had increased.

Moreover, 69 percent of the respondents reported that the risk bearing capacity had increased, 58 percent reported that the quality of the assets had improved, and 46 percent reported that the spread rate had declined after the merger process.

These results imply that banking sector merger has been beneficial for banking and financial institutions. “However, there is a need for the regulator as well as the involved institutions to focus on operational efficiency gains of the banking and financial institutions in the post-merger phase,” the report said.