Nepal’s banking system is at a crossroads with banks engaged in a tug-of-war over interest rates. The row kicked off after NIC Asia Bank publicly refused to stick to the interest rate ceiling fixed by the Nepal Bankers’ Association (NBA) arguing that it was like creating a cartel. The NBA had capped interest rates at 8 percent on savings and 11 percent on fixed deposits. However, NIC Asia decided to pay 10 and 12 percent interest respectively, earning the ire of the other 27 commercial banks in the country who have stopped interbank transactions with it. They said that it could bring systematic risks in the banking system.

Growing problems

This is an example of the disorder in the banking system, and this is not the first time that something like this has happened. Almost every year, this sector is becoming more problematic which is not good for the financial health of the economy. Recently, banks are facing a liquidity crunch because they invested more than the required percentage in unproductive sectors, such as land, housing and motor vehicles.

Nepal’s banks and financial institutions (BFIs) are deposit-taking and contractual savings institutions. There has been an exponential growth in the number of financial institutions in Nepal in the last decade. After liberalisation in the 1980s, Nepal Rastra Bank issued licences to several private banks. In the initial stage, when the market was not very volatile and the regulations were not very strict, they were operating as they wished and making huge profits.

From a development perspective, the banking system performs a significant role because financial intermediation creates a conducive environment for transforming a traditional economy into a modern one. The good way to develop and boost the economy could be encouraging savings and investments in productive sectors like agriculture and hydroelectricity. Savings leads to capital accumulation and investment which leads to productivity, employment and an improved standard of living.

Nepal has been struggling to maintain macroeconomic balance for a couple of years. A low growth rate, high unemployment, balance of payments deficit, swelling trade deficit and high inflation are some of the pressing existing macroeconomic challenges. Nepal is rich in water resources and fertile land. However, a large amount of capital is invested annually to import food products and energy. Banks can contribute to economic growth and play a positive role in mobilising financial resources. Nepal has ample opportunities for investments. Hydroelectricity, tourism and services are three prominent sectors that investors like. But commercial banks and other financial institutions prefer medium and small projects, even though there are some examples of consortium financing.

Financial institutions are suffering a liquidity crunch because they neglected to maintain a proper loan-to-deposit ratio. Two large banks dominate the commercial banking sector: Nepal Bank Ltd, which is 40.5 percent government-owned, and Rastriya Banijya Bank, which is 100 percent government-owned. Together, they account for 11.8 percent of the deposits and 10.3 percent of loans in the entire banking system.

Strengthening the sector

BFIs issued easy loans to real estate and housing sector borrowers without assessing their capacity to honour interest and principal payments. This led to a rapid rise in demand for real estate and housing construction in urban areas and soaring prices. When the unusually high prices started to fall, borrowers became incapable of making repayments, leading to a liquidity shortage in the banking sector. The World Bank and the International Monetary Fund have advised Nepal Rastra Bank (NRB) to reduce the number of financial institutions. They recommended creating fewer but sturdier institutions. Accordingly, NRB developed policies like increasing the capital requirement and encouraging mergers and acquisitions, and guided BFIs to strengthen their position.

Despite the large number of BFIs in the country, banking facilities haven’t reached 70 percent of the population. Hundreds of local units are without banks. The banking network must be expanded in rural areas too. For a healthy banking sector, Nepal needs fewer but stronger BFIs with sound corporate governance. Furthermore, it is necessary to enhance NRB’s regulatory and supervisory capabilities in the provinces too as per the country’s new federal structure.

NRB overlooked unhealthy competition, dubious lending to a few sectors and bad governance in the financial sector. The continuous injection of liquidity by NRB through repo sale advocates a continuing liquidity crunch. Also, the existing level of non-performing assets (NPA) is not a good sign for the satisfactory growth of the banking sector. The time has come to properly devise a prudent strategy for reducing NPAs. The liquidity crisis has led to a decline in private sector credit while a growth in private sector credit is vital to create economic activities.

NRB cannot remain lenient when BFIs irresponsibly increase credit without assessing the creditworthiness of borrowers and their deposit growth. In the short term, NRB should use all its tools to increase liquidity so that anxious depositors will calm down. As a long-term solution, the central bank could be given the authority to sell the assets, change the management, force mergers or acquisitions and hold most of the shares of troubled BFIs until they return to a healthy state.

Shrestha is a former under-secretary at the Ministry of Finance and was associated with the United Nations Development Programme in South Sudan and Sierra Leone