The International Monetary Fund (IMF) has asked Nepal Rastra Bank to have some of the country’s largest commercial banks audited by international auditing firms as it is suspicious about the quality of loans provided by them, a senior central bank official said.

Representatives of the IMF’s Article IV mission called for the audit to bring clarity about the state of the asset quality during a meeting with central bank officials.

Earlier, the international monetary advisory body had called for an audit of the central bank with the assistance of an international auditor to approve the extended credit facility (ECF) for Nepal.

“The Article IV mission suggested that we conduct an audit of 10 large commercial banks through international auditing firms,” a senior central bank official told the Post.

This is one of the conditions set by the IMF for approving the $395.9 million ECF facility.

As part of fulfilling the conditions, the central bank will need to ensure that there will be an in-depth on-site inspection of Nepal’s 10 largest banks.

“By March 2023, we will launch in-depth on-site inspections of the 10 largest banks assisted by a third-party international audit firm to review their loan portfolios in line with the new regulatory framework by paying special attention to loan and collateral valuation, evergreening, group borrowing and concentration risks,” stated the document containing Nepal’s commitment, a copy of which was obtained by the Post.

“We will seek International Monetary Fund support for the preparation of the terms of reference for the hiring of the third-party international audit firm and the design of the loan portfolio reviews. We will complete the reviews and have the review results endorsed by the board of Nepal Rastra Bank by September 2023,” the document said.

“We will develop a plan to deal with the review’s findings, and any bank with capital shortfalls will be required to submit capital management plans setting out how they will return to full compliance with regulatory requirements. We will prudently monitor the relevant reclassification of loans and proactively provide guidance on the prudential treatment of moratoria and non-performing loan management strategies.”

Any bank found to be undercapitalised based on the diagnostics will be required to present a recapitalisation plan, said the central bank official who conversed with the mission in Nepal in late February.

The IMF is particularly concerned about the quality of loans as large loans were sanctioned to firms under lax regulatory measures to help revive the economy.

“The global monetary advisor is concerned whether loans were given to the right borrowers and whether there has been evergreening of the loans,” the central bank official said.

These concerns are reflected in the press statement issued at the conclusion of the Article IV mission in late February.

“Bank asset quality [in Nepal] has deteriorated, reflecting a decline in the repayment capacity of borrowers due to higher lending rates and rising leverage, a concern that is moderated by banks’ capital-adequacy ratios that are above the regulatory minima,” the IMF said in the statement.

As per the IMF, discussions with central bank officials recognised the need for the central bank to ensure appropriate reclassification of loans and close monitoring of the impact of a potential deterioration in the repayment capacity of borrowers.

On paper, the non-performing loan (NPL) ratio of Nepal’s banks and financial institutions remains comfortable. The NPL ratio is the ratio of loans whose scheduled payments have been delayed or are unlikely to be repaid to total loans.

The average NPL ratio of Nepali banks and financial institutions stood at just 2.73 percent as of mid-January, according to the central bank.

The NPL ratio of finance companies is the worst among A, B and C class banks and financial institutions with an NPL ratio of 7.82 percent.

The NPL ratios of commercial banks and development banks stood at 2.49 percent and 2.82 percent respectively.

“The IMF wants to see whether it is a true picture of the financial health of the banks and financial institutions or it is worse,” said the central bank official.

As per the condition, Nepal’s central bank is required to customise its current bank reporting template to enhance the timely monitoring of the impact of Covid on the financial sector.

The central bank board also needs to approve an action plan for full implementation of the Supervisory Information System (SIS) for class A banks.

Nepal Rastra Bank is also required to draft amendments to the regulations to strengthen the identification criteria of NPLs, clarify the rules of asset classification and reclassification, including those for revolving loans and provide clear guidance on restructuring and rescheduling.

Last December, the central bank amended its Inspection and Supervision Bylaws 2017 by creating provisions for reporting systems under which banks and financial institutions are required to report to the Supervisory Information System.

In February this year, the IMF praised the central bank for continuing to advance reforms in banking regulations and supervision and ensuring bank asset quality; and further strengthening the central bank’s governance by amending the act in line with best international practices.

Nepal remains committed to implementing recommendations from the ongoing Anti-Money Laundering/Combating the Financing of Terrorism Mutual Evaluation conducted by the Asia Pacific Group, the IMF said.

At the same time, the IMF also called for monetary policy focused on maintaining a cautious and data-driven stance supported by macroprudential measures.

“This will help avoid large boom-bust credit cycles, which can create financial sector instability and are not supportive of sustainable growth,” it said.