Commercial banks are once again facing shortage of cash to provide loans to borrowers. As in the last fiscal year, the problem cropped up after banks could not strike a balance between deposit collection and credit disbursement. Banks are lately witnessing deceleration in deposit growth due to decline in remittance income and slow public expenditure. On the other hand, there is huge demand for credit from investors and consumers, as business climate is improving. Currently, banks are allowed to extend 80 percent of their total deposit and core capital as loans. This is referred to as the credit to core-capital-cum-deposit (CCD) ratio. As of last week, that ratio stood at 77.13 percent, while CCD ratio of five commercial banks had jumped past 79 percent. Rupak D Sharma of The Kathmandu Post caught up with Nara Bahadur Thapa, executive director of the Research Department of the Nepal Rastra Bank, the central bank, to discuss ways to contain this recurring problem. Excerpts:

The problem of shortage of loanable fund has recurred again this year. How is the central bank assessing the situation?

The country’s economic growth stood at 7.5 percent in the last fiscal year. The surge in growth has propped up investor confidence and raised demand for loans. Also, reforms are taking place in the political sector. These reforms include implementation of federalism, which led to successful completion of three phases of elections. This has given a lift to private sector confidence, which has raised credit demand. However, stock of money that could be provided as loans has not gone up at a desired pace because of decline in remittance inflow and slow public spending, especially capital spending. These two factors have played important roles in deceleration of deposit growth rate. Deposit growth stood at 14.7 percent in the first half of this fiscal year whereas credit growth hovered around 17 percent. This imbalance in deposit and credit growth has created shortage of loanable funds and raised interest rates.

Another reason for shortage of loanable funds, as said by many, is the use of credit to purchase rights shares of banking institutions in the last fiscal year. The rights shares were floated to raise minimum paid-up capital of banks and financial institutions as per the instruction of the central bank. What does the central bank have to say?

I don’t think this is the reason for liquidity shortage in the banking sector. There are three ways banks and financial institutions can expand credit: by increasing the stock of deposit, by raising capital or by borrowing. Whether the practice of using bank credit to meet the new capital requirement was appropriate can be discussed separately. But this practice did not create shortage of loanable funds.

But in this case, the money, which was borrowed from banks, was converted into capital. How did this enhance loan disbursement capacity of banks?

As I said earlier, there are three ways to expand credit and one of them is through expansion of capital. The manner in which promoters of banks relied on credit to replenish capital may have had other implications. We can discuss that matter separately.

With the onset of loanable fund crisis, CEOs of commercial banks entered into what they call “gentlemen’s agreement” to not increase interest on fixed deposit beyond 11-percent mark. This pact may have prevented anomalies, such as poaching of deposits, from taking place. But isn’t this practice against the spirit of free market economy? And why has the central bank not taken any action?

I don’t think CEOs of banks have formed a cartel to keep the fixed deposit rate unchanged. Banks are free to fix deposit rates. And the central bank never directs them to avoid competition in this area. But the central bank has prevented banks from revising their published deposit rates for a period of at least three months. This measure has been introduced to ensure deposit rate stability.

The private sector confidence has gone up with the completion of three phases of elections and installation of the new government. One of the priorities of the new government is to stimulate growth. How can Nepal achieve higher growth at a time when banks are facing shortage of cash to disburse credit?

The present situation has created hurdles to spur growth. But things will not remain the same in the coming days. For example, all three tiers of government have now started functioning and every level of government has been given the autonomy to make spending plans and execute those plans for which the central government will provide funds. Once all tiers of government start spending the budget allocated to them, liquidity situation in the banking sector will improve. However, we cannot say with certainty that the crisis of loanable funds that we saw last year and this year would not recur. But I am sure the magnitude of problem in the coming days would not be as severe. This is because subnational governments will gradually become mature and start delivering public goods and services to meet the demand of people. This hike in public spending will replenish cash in the vaults of banks.

But the public sector’s fund absorptive capacity is very weak in Nepal. So, all tiers of government are likely to sit on top of money rather than spend it. Won’t this create a problem?

Things will improve once laws and working procedures are framed for local bodies and provincial governments. This will provide clarity on scope of work of subnational governments. Also, capacity of human resources at the local and provincial level would be enhanced in the coming days, which will help subnational governments to execute various tasks. On top of this, subnational governments will have funds to perform various works. This means Nepal will have functional subnational governments soon. This will ramp up public spending and increase money circulation, which will benefit the banking sector.

Public spending does play an important role in increasing deposit stock of banks. But a bigger role is played by remittances, inflow of which has started declining because of fall in outflow of migrant workers. Isn’t this a bigger threat?

Remittance inflow has definitely started shrinking and this trend will continue in the future as well. However, this does not mean remittance will completely cease to flow into the country. Nepal’s remittance income fell by 0.5 percent in the first half of the current fiscal year. But Nepalis working abroad sent home Rs340 billion [in the six-month period between mid-July and mid-January]. This is a big amount. So, remittance will continue to remain a vital instrument to inject liquidity in the banking sector. Yet this does mean we should not look for alternative ways to earn foreign currency. Such alternative means could be tourism, foreign direct investment (FDI) and foreign aid. Over the months, Nepal has witnessed surge in FDI inflow; and tourism income has also gone up. These are positive signs. We need to introduce appropriate policies to increase our income through these sources. Also, development partners have expressed interest to provide billions of dollars in soft loans and grants to Nepal. The government should tap this opportunity by preparing appropriate project proposals and resolving problems related to delay in project implementation. Foreign income generated through these sources will keep our current account and balance of payments robust.

Does this mean the central bank will not make direct interventions even if the problem of shortage of loanable fund worsens?

The central bank can inject limited funds in the banking sector by providing refinancing facility to banking institutions. But the central bank will not dole out large amount of funds to banks and financial institutions to prop up their lending capacity.

Recently the government had formed a committee to conduct a study on feasibility of transferring a portion of its fund to commercial banks to resolve the problem of shortage of loanable funds. As a member of that committee, what do you think of this measure?

The idea was floated at a time when the government was maintaining a huge cash balance at the central bank. But with the formation of the new government, which is expected to bring stability in the political sector, spending of all tiers of government is likely to go up. So, the central government’s savings, in the coming years, may not reach the level seen in the last few years. This, therefore, is not a long-term solution.

A long-term solution, as prescribed by the central bank, to resolve the problem of shortage of loanable funds—which has given rise to various types of unhealthy competition—is merger. Is the central bank seriously thinking about this option?

The process of consolidation in the banking sector began in 2008-09. Since then, the central bank has used three instruments to consolidate banks and financial institutions: moratorium on opening of new banks and financial institutions, merger and acquisition, and regulatory provision to raise the minimum paid-up capital of banks and financial institutions by up to four-fold. These instruments have helped us to reduce the number of development banks to 35 from around 88. These tools have also enabled us to bring down the number of finance companies to 27 from 79. However, we have not seen much change in the number of commercial banks, as there are still 28 Class ‘A’ financial institutions. There are evidences that show high number of commercial banks are fostering unhealthy competition in the banking sector. The focus, therefore, is now on reducing the number of commercial banks. We think around 15-18 commercial banks would be ideal for a country like Nepal. This will curb unhealthy competition in the banking sector, help commercial banks to become more mature, enable the banking sector to reap benefits from economies of scale and bring stability in the banking sector. Countries like Malaysia and Sri Lanka have consolidated their banking sectors in the past. We hope reduction in number of commercial banks will take the banking sector consolidation process, which began about a decade ago, to its logical conclusion.

There is a school of thought that says further consolidation in the banking sector will lead to creation of ‘too big to fail’ banks and pose systemic risks. What is your take on this issue?

Today, all commercial banks have a paid-up capital of at least Rs8 billion. So, they are systemically important for the country. In other words, failure of a bank with a capital of Rs8 billion will pose systemic risks to the country. This means all commercial banks operating in the country are ‘too big to fail’. So, further consolidation will not make much difference.

But will this protect the interest of new commercial banks that are not well established?

There are those who say further consolidation in the banking sector will pave the way for well-established commercial banks to acquire new ones. But since all the banks now have paid-up capital of at least Rs8 billion, they are on an equal footing. So there is no small or big commercial bank in Nepal. I believe reduction in number of banks through merger and acquisition will enable the central bank to divert focus on other areas, as they are consuming too much of our time.

How will the central bank reduce the number of commercial banks?

We can request commercial banks to merge voluntarily. We can also direct commercial banks that continuously violate micro-prudential regulations, such as loan-to-value ratio and exposure limit in real estate sector, to merge. We can also initiate prompt corrective action against institutions. Currently, the central bank takes prompt corrective action only if banks breach the capital adequacy ratio. In the coming days, we can take prompt corrective action if banks breach liquidity ratio, credit to core-capital-cum-deposit ratio, leverage ratio and single borrower exposure limit. We can direct banks that continuously breach these regulatory norms to find a partner to merge with.

Why didn’t the central bank direct commercial banks to merge when it introduced recapitalisation plan in the banking sector? This could have barred banks from replenishing their capital by floating rights shares, which consumed a big chunk of bank loans. What is your take on this issue?

One policy instrument should have one target. Had we focused on merger as well as paid-up capital hike, the instrument would have failed to deliver result. The main objective of raising the paid-up capital was to strengthen the entire banking sector, including commercial banks, development banks and finance companies. So the policy was not only aimed at commercial banks. However, the policy did prompt development banks and finance companies to merge.

So by when the central bank intends to reduce the number of commercial banks?

NRB has not formally taken a decision on this matter. We can start a debate on this issue and see how it goes.