Nepal’s central bank said it would be launching an in-depth on-site loan portfolio review for the largest 10 banks assisted by independent international third-party auditors by the end of April.

A report released by the International Monetary Fund (IMF) on Wednesday said Nepal Rastra Bank has started preparations for the portfolio review of the 10 largest banks.

The report prepared in the context of the Third Review Under the Extended Credit Facility Arrangement by a staff team of the IMF, based on the discussions with Nepali authorities, said that Nepal’s central bank established a project team and finalised a “concept note” outlining the main elements of the loan portfolio review.

After the post-pandemic credit boom, vulnerabilities in the banking sector have slowly started to become more apparent.

The non-performing loans (NPLs) across all types of banks almost doubled compared to the level in July 2022. Over the same timeframe, the banking system’s core capital position has slowly eroded from 10.8 to 10.6.

The report said that Nepal’s central bank has assured that to optimise the exercise, it would phase the qualitative and quantitative part to allow for the use of end-July data that also incorporates the implementation of the loan portfolio review.

The IMF said in the report that Nepal Rastra Bank in preparation for this exercise, would finalise the related terms of reference by the end of December 2023.

The loan portfolio review aims to ensure that loans are classified and managed in line with the new regulatory framework, paying special attention to loan classification and provisioning, evergreening, group borrowing, and concentration risks.

The review is expected to be completed by December 2024.

After the completion of the review, Nepal Rastra Bank says it will develop a plan to act upon the review’s findings by the end of February 2025 and any bank with capital shortfalls will be required to submit timebound capital management plans setting out how they will return to full compliance with regulatory requirements.

Nepal witnessed a sharp drop in credit growth. This essentially reflects several factors, including weak demand, credit overhang, weak real estate markets, tighter regulation of working capital loans, and capital adequacy requirements of a few banks approaching regulatory limits.

Credit growth dropped to a low of single digits in the fiscal year 2022-23—after exceeding 30 percent in 2021-22 spurred by the Covid stimulus and rising NPLs.

The NPLs for commercial banks have increased from 1.3 percent in June 2022 to 3 percent as of August 2023, reflecting higher lending rates and the unwinding of forbearance measures and longstanding evergreening practices.

The IMF said that as monetary policy transmission appears weak in the context of balance sheet repair and an elevated inflation, although declining, maintaining the current cautious and data-dependent monetary policy is appropriate for preserving price and external stability.

The financial policy should remain vigilant and focused on building regulatory frameworks to avoid further boom-bust cycles and establish a more stable, pro-growth financial sector equilibrium.

Implementation of the financial sector reform agenda should continue with a view to aligning the local framework more closely to international standards, the IMF said.

The international financial institution said that improving the anti-money laundering/combating the financing of terrorism (AML/CFT) framework and its effectiveness in line with international standards and peer evaluations is urgently needed to maintain smooth access to the global financial system.

Reforms to implement the 2021 IMF Safeguards Assessment recommendations regarding the Nepal Rastra Bank Act and its audit are a priority.

The amendments to some laws relating to the AML and the Business Promotion Bill will expand oversight and data collection in this area.

“Continued progress on the structural front is also needed to foster investment and more inclusive growth. These include improving the business climate, building human capital, and continuing to improve social safety nets, in particular, the coverage of the child grant programme,” the IMF report reads.

The IMF has also flagged concerns about the vulnerabilities of the cooperatives as the authorities intend to establish and operationalise a specialised regulatory authority to regulate and supervise financial cooperatives.

It said that the growing importance of financial cooperatives and their interconnectedness with the banking sector requires more effective oversight.

Currently, there are over 14,000 savings and credit cooperatives, which represent around 7 percent of total lending, with some exceeding the size of Class B and C banks.

These cooperatives are regulated by the Department of Cooperatives or local authorities without the necessary data to assess the risks of these institutions.

The IMF said that the audit of the Nepal Rastra Bank 2022-23 financial statements is underway without the participation of auditors with international experience in auditing central banks.

The 2023-24 audit, however, will involve auditors with such experience.

The IMF staff provided advice to modernise the Nepal Rastra Bank Act to strengthen its mandate, autonomy, and governance in line with international best practices.

In the fiscal sector, the IMF said Nepal is expected to recover to 3.5 percent in 2023-24—despite the November 3 earthquake in western Nepal—led by increased domestic demand, new hydroelectric capacity, and a continued recovery in tourism.

But the growth remains below potential.

The recent uptick in food prices is expected to abate with the upcoming regional harvest. External factors, including disinflation in India, would help bring down Nepal’s inflation towards Nepal Rastra Bank’s target of 6.5 percent by the end of the current fiscal year.

With imports gradually normalising after the sharp contraction in 2022-23, and remittance and travel service growth moderating, the current account deficit excluding grants is expected to widen to 2.5 percent of GDP in 2023-24.

The IMF said that imports are projected to rebound strongly in 2024-25 in line with growing capital expenditure and a rebound in GDP growth.