Homnath Gaire
The face of banking in Nepal is changing rapidly. The Competition in the industry is tough due to limited market and few investment opportunities in the country. For a healthy and flexible financial system, therefore, banks and financial institutions need to deal with important issues like improvements in effectiveness and efficiency in their overall operations, while achieving economies of scale through consolidation and exploring innovative cost-effective solutions.
There has been a large growth in the number of banks and financial institutions (BFIs) during the past two and half decates of liberalized period. But the indicators that are being examined to asses the impacts of banking development in the real sector of the Economy have not found satisfactory.
The service quality and expansion of the system have been improved a lot due to intense competition in the country and the BFIs commitment to provide better service to the customers. The overall performance of the banking industry during the period has remained satisfactory. The number of banks in the country is in rise.The capital adequacy of the banks has improved significantly and now only three banks i.e., Nepal Bank Limited (NBL), Rastriya Banijya Bank (RBB) and Nepal Bangladesh Bank (NBB) are to reach to the minimum level. Similarly, the assets quality of individual banks and the industry as a whole has also improved and non-performing loan (NPL) is declining. BFIs are coming up with advanced and sophisticated technologies and there is a trend to spread up banking activities beyond capital city and are exploring new markets in the suburban areas.
Besides these positive trends in the banking industry, there are some constraints, which are hindering the sound growth of the system. Even if the New Capital Adequacy Framework has been implemented in Nepal, effective implementation is a challenging task. At the same time moving towards advance approaches for capital allocation seems long way to go. The reform of government owned banks has not been happened as per the exception and it is challenging for Nepal Rastra Bank (NRB) to provide level playing field to all BFIs in the era of free market. With the shift in the trend in banking industry, Nepal has also experienced so many ups and downs in the financial system. Many new issues are emerging creating shorter and longer-term impact in the system. BFIs need to proactively assume their responsibilities and work on strengthening their capacity, bearing in mind the 21st century global struggle in the financial sector.
NRB, as the central bank of the country, is also highly aware that, for the achievement of the central bank objectives in the present dynamic environment, sustained progress and reform of the financial sector is of utmost importance. Continuously aware of this great responsibility, NRB is pursuing various policies, strategies and actions pertinent to the context.
Number of Bank and Financial Institutions (BFIs)
As of Mid-December, 2010, there are 272 BFIs operating in the domestic banking system under the license of NRB consisting of 30 commercial banks (Class A), 83 development banks (Class B), 79 finance companies (Class C), 19 micro-credit development banks (Class D), 16 Cooperatives and 45 NGOs. The cooperatives and NGOs are, however, licensed for limited banking transaction. Among these the number of public BFIs (owned by the government) is not as much of the BFIs run by the private sector. There are only 3 public commercial banks; NBL, RBB and Agriculture Development Bank Limited (ADBL) out of the 30 commercial banks in the national banking system. Like wise, the number of development banks and Finance companies owned by the government is nominal as compare to those run by the private sector.
Despite the fact that private sector BFIs are growing in numbers, their access in nooks and corners of the country is still inadequate. But they have started expanding their branches in the head quarters and business hubs of different districts after the monetary policy inducement and mandatory provisions laid by NRB, the central bank of Nepal. As a result, the population taking benefit per bank in the country is gradually decreasing; meaning the access of the population to the banking system is improving eventually. However, the public sector banks are still the largest banks in all aspects from deposit and credit mobilization to the number of branches in operation. Similarly, the growing financial activities in the rural and suburban areas due to the increasing flow of money remitted by the locals working abroad have been attracting the banks to go beyond their existing boundaries. At the same time, expansion of road network to the remote areas of the country has also played a pivotal role to attract the bank branches with an expectation of taping the virgin market. The deposit, loans and advances and total assets of the banking industry has been increasing gradually in recent years. From the latest figure, it is seen that the performance of public banks in terms of deposits, loans & advances, and total assets is somehow limited relative to private sector BFIs.
Access of Banking Services and Branch Network
According to the latest data of NRB, the total number of commercial banks' branches is over 1000, which on mid July 2009 and 2008 were 752 and 555 respectively. Out of total bank branches, more than one third branches are belonged to 3 public banks and remaining are belonged to the 27 private sector commercial banks. From the figure above, it is seen that, the banks with the largest number of branches are public banks: ADBL, RBB and NBL 145, 126 and 108 branches respectively. The number of branches of the private banks is on the rise, and the trend is towards going to the growing cities outside valley.
Large concentration of the branches is seen in Kathmandu valley. Most BFIs are looking to increase their number of branches in Kathmandu, which is a major economic hub of Nepal. Kathmandu, Kaski and Rupandehi are three districts with highest number of bank branches and cities with high branch concentration are Kathmandu, Lalitpur, Pokhara, Butwal, Birgunj, Biratnagar, Bhairahawa, Nepalgunj and Dhangadhi. Similarly, region wise, Central Development Region has the largest concentration of more than 400 branches with the major economic centers like Kathmandu, Lalitpur and Birgunj followed by the Western and the Eastern region. The regional distribution of the branches seemed to be much skewed.
Employment in the Banking Industry
The number of employees engaged in the commercial banks of the country is around 20,000 right now, which were 16,148 in mid July 2009. Out of the total number of employees in the commercial banks, the three public banks generate the majority of the employment as their operations are largely based on the manual system. Though, these banks have reduced their staff size almost in half since mid July 2001 under the various phases of Voluntary Retirement Schemes initiated under the reform process, gradually replacing the manual system through computerizing their operations, they still have a significant number. At the end of FY 2009/10, the number of employees in the three public banks and other private banks is more or less fifty-fifty. At the end of FY 2008/09, the three public sector banks were employing 8656 employees whereas the private sector banks had 7492, which as on mid July 2008 were 9278 and 5701 respectively. The growth in number of staff in private sector bank is due to the massive increment in their branches. However, the private banks, meanwhile, are steadily increasing their number of staff in direct alignment with the expansion in the business. Since the large portion of their system and procedure are automated, the number of staff employed by these banks is relatively small.
Services Offered by BFIs
Today the people of Nepal can avail of almost all types of banking services available in the developed countries. Similarly, they have options of both brick (branch banking) and click (Internet banking, tele-banking, ATM, Point of Sale (POS), different Cards, mobile etc) banking channels. The major products offered by the Nepalese BFIs include various types of deposits, loans, letter of credit and letter of guarantee, remittance, trust services, merchant banking, retirement fund management, investment banking and foreign exchange. In other words, it can be said that Nepalese BFIs are ‘financial department stores’ selling almost all types of financial services. It is however true that all the banks and financial institutions are not selling all the products mentioned above and level of product sophistication is low due to the nature of demand in the financial market. Once the market demands highly sophisticated products, the BFIs in Nepal are capable of introducing the same.
Negative Net Worth of Some Banks and Reform Measures
Some analysts say banking is nothing but management of the risks. Banks are exposed to mainly credit, operational, market and liquidity risk. Taking risk by choice, not by chance is the main mantra (theme) of banking. Unfortunately, risk management system in all public BFIs was poor due to poor corporate governance. Like most other public sector enterprises, government owned BFIs were not professionally run resulting in huge non-performing loans (NPL). Similarly, Nepal Bangladesh Bank Limited (NBB), Nepal Credit and Commerce Bank (NCC), Lumbini Bank Limited (LBL) and Nepal Bikash Bank limited along with some other private BFIs had negative net-worth due to undue interference of the promoters/directors in credit operations causing huge NPL. NRB has today adopted many measures to erase negative net worth of these BFIs and to safeguard the interest of the depositors.
This critical situation, however, is relatively low in private BFIs as compared to that of public. This is due to low political influence, high professionalism; more transparency along with the NRB's through screening of promoters at the time of awarding license and taken proactive measures as soon as the symptoms of the problems were sensed. The fate of semi/government BFIs was inevitable looking at the way the government offices in Nepal operate. Strong commitment of the government and support of judiciary is also a must for restoring good health of these BFIs. After the initiation of financial sector reform, various new acts relating to banking sector have been promulgated. Similarly, prudential regulations of international standard have been introduced. NRB's supervisory system has also been strengthened.
How the Banking System Promote Economic Growth?
To understand how the banking system might influence economic growth, we need to review the roles of the system in greater detail. First, the banking system mobilizes savings. This activity reduces the transaction costs associated with external finance for both firms and households. Second, the banking system allocates saving by determining worthwhile investment opportunities and judge the creditworthiness of borrowers at lower cost than the average small investor. The third role of the banking system is to reduce risk by spreading investors’ savings across many different investment opportunities. This reduction in risk encourages savings. Fourth role of the banking system derives from its ability to generate liquidity. Some investments with potentially high returns involve projects that require long-term commitments of capital. Fortunately, when the banking system pools the investments of many households, it allocates funds to both short- and long-term projects. Fifth, the banking system facilitates trade by extending credit and guaranteeing payments.
Additionally, letters of credit help firms order the inputs for current production when they experience delays in payment for past sales. The banking system also exerts corporate control and monitors managers. King and Levine (1993) noted that there is positive role of banking in innovation and production process probably for the first time, arguing that the services of financial intermediaries – mobilizing savings, evaluating projects, managing risks, monitoring managers, and facilitating transactions –stimulate technological innovation and economic development. Similarly McKinnon and Shaw (1973) concluded that alleviating financial restrictions in developing countries, by allowing market forces to determine real interest rates, can exert a positive effect on growth rates; they thus favored for financial liberalization which they felt would stimulate savings and would finally finance higher level of investment, leading to higher growth. They also found that one percent increment in liquid liability to GDP ratio of the nation would increase per-capita GDP by 0.15 percent in next period. The significant and positive impact of liquid liability to GDP ratio in one period lag cannot be discarded because of two reasons: (i) it measures the liquidity position of the nation which is essential for the investments; and (ii) the outcome of investment cannot be realized in the same period. However, in Nepal, the present level of liquidity to GDP ratio showed negative impact on GDP. Also, it is hypothesized that the lagged effect of liquid liability on growth could not take place due to the weakness in the domestic banking system. The loss in the business having investment in productive sector in Nepal would mean a marginal or even negative contribution to national output and hence to per-capital output.
Regulatory Framework
Nepalese banking system is under regulated environment. BFIs are given autonomy to allocate their resources in the most efficient manner. At the same time, they are also required to abide by the mandatory circulars and directives issued in different areas. The underlying philosophy is that BFIs should be free to allocate their resources according to market forces and shall be entitled to set terms and conditions for their operations in a competitive environment. However, strict regulatory norms should be set for BFIs behavior in order to protect depositors and other creditors and the financial system as a whole. Pursuant to this, the objective of BFIs supervision in Nepal is to promote and maintain the safety, soundness, and integrity of the Nepalese banking and financial system; while promoting confidence in the financial system through the implementation of policies and standards that are considered best in international practices.
Nepal Rastra Bank is the apex authority to regulate and supervise BFIs in the country. It has been enacting various policies, directives and circulars in line with its central banking objectives since its inception. The NRB Act, 2002 has empowered it as an autonomous institution to conduct regulatory and supervisory activities independently. It’s on the part of NRB to maintain financial stability in the country by raising confidence of both depositors and investors. Supervision function is performed by two different departments of the NRB namely Bank Supervision Department and Financial Institutions Supervision Department. The commercial banks are supervised by the Bank Supervision Department while the rest of the institutions are supervised by Financial Institution Supervision Department.
NRB has introduced many prudential guidelines governing the operations of BFIs. They mainly pertain to capital adequacy, risk management in credit and investment portfolio (single borrower/unit limit, single sector limit etc.), loan/investment classification and provisioning, income recognition, market risk management, liquidity management and corporate governance including disclosure norms and provision of Audit Committee. Further the bank is also equally responsible, together with BFIs to raise public confidence in the banking system. For this, the Bank Supervision Department is performing on-site examinations, off-site surveillance & analysis and policy and guidelines formulations in different issues for the achievement of the department’s objectives.
In performing the above role, the Bank, through the Banking Supervision Department strives to ensure compliance with the BFIs Act-2006 (BAFIA-2063) by banking institutions under its jurisdiction. In order to achieve the role of protecting the interests of depositors, NRB has crafted a number of prudential requirements to be complied with by BFIs. The prudential requirements advised on BFIs are designed to limit risk taking to levels that are manageable and that do not place the individual banking institution and the banking system at risk.
In addition to other prevailing laws of the country, the main legislative framework for supervision function includes:
• Nepal Rastra Bank Act, 2002 (2058)
• Bank and Financial Institutions Act, 2006 (2063)
• Company Act, 2006 (2063)
• Supervision By-laws, 2002(2059)
• Directives to commercial banks and financial institutions
• New Capital Adequacy Framework, 2007
NRB has continued to review the relevant legislation and regulations in order to put in place up-to-date regulatory framework that meets international standards and resolves the issues of the banking industry.
Challenges
• High Level of NPL and Risk Management System: Unaudited figures of mid January 2011 show negative net worth of above Rs. 15 billion in 2 commercial banks. Although the ration of NPL to the total outstanding loan of the industry is under the stipulated level, this is undoubtedly due to high level of NPL in those banks. Like wise, the NPL of Development banks and Finance companies is over Rs. 2 billion out of total assets of 200 billion. As a fiduciary of public money, current situation is unfortunate and collapse of a large bank may invite systemic risk. So, the challenge today is to erase negative net worth of the BFIs and to create an environment to avoid recurrence of such a situation in future. Current measures adopted by NRB have to be continued in case of problematic private banks. However, the structural changes are necessary in case of RBB and NBL. HR management and risk management practices of best managed private banks are to be applied in these banks. Strong commitment of government and strengthening judiciary in terms of commercial transactions are necessary to bring down NPL level of banking sector. There should not be political interference and cases of ex-parte injunction should be rare. There is a need of making Debt Recovery Tribunal strong and efficient including its expansion at least in major cities and setting up an efficient assets management company.
In addition to credit risk, BFIs can face adverse situation from other risks like market, operational and liquidity. It is sad to note that collateral based lending instead of cash flow based lending is still prevalent. This speaks the need of a comprehensive risk management system in a BFIs. All the BFIs need to work in this direction to assure the public that they have adopted all the possible measures to keep their money safe. Moreover, regulating authorities should create an environment whereby the banks can make lending decisions based on the financial statements of the borrowers.
• International Level Competition: Competition in the banking system is already tough with the presence of large number of BFIs including joint venture banks of international banks. Interest spread, exchange spread etc of the BFIs is constantly narrowing. The competition is expected to stiffen further with the government's commitment of allowing foreign banks to open their branches from 1st January 2010. When international banks come, they come with large capital, modern technology and an array of products. Experience of our neighboring countries suggests us not to panic with the arrival of international banks. We however need to focus on the following areas to remain competitive:
• Augmenting capital base: Mergers and acquisitions can be effective in this regard. Sadly, there is not a single case of M&A amongst the commercial banks except one with finance company and another between two finance companies. Current level of return on equity and traditional Nepalese 'sahu jee' culture are the major obstacles but the competition exerted by the international banks will force them to behave like international players.
• Develop expertise in various fields: International banks have better exposure mainly in treasury and credit area than local banks. The local BFIs thus need to focus on enhancing skills of their human resources in these areas.
• Adopt best human resource practices.
• Strengthen risk management system and corporate governance.
• Improve customer service quality.
• Maximize use of information technology.
• Focus on product innovation and cost management.
• Reach of banking services: Even after 7 decades of formal banking history, it is sad to note that 3/4th of population is far from the formal banking net. Poverty is one of the main reasons for fueling the social tension. Financial inclusion is a must for social and communal harmony. Banks need to work in coordination with micro credit institutions, local governments, NGOs and cooperatives to make financial service accessible to the common people across the country. Moreover, the banks can play a role in infrastructure development of the country. Proper management of remittance, attraction of remittance from high net worth NRNs, FDI and control of the capital flight can be a stable source of fund for infrastructure financing.
• Supervisory capacity of NRB: Currently, NRB stopped to give license to all those who meet its criteria for opening BFIs. NRB is not working in the direction of strengthening own regulatory and supervisory capacity rather than putting a cap in the number of BFIs citing it will be against the spirit of open market regime. As an autonomous body, it is free to adopt the policy it deems the most appropriate.
Way Forward
• As the situation of bank failures may invite systemic risk resulting in financial dis-intermediate, NRB needs to screen the integrity of promoters thoroughly before issuing a license. Utmost care should be exercised to avoid potential conflicts of interest while issuing license to promoters having other large business. Supervisory capacity of NRB should be strengthened to the required level so that we do not see the repeat of current scenario. To conclude, commercial banks of Nepal have made significant contribution to the economy. They however need to multiply their contribution for overall economic development of the country. As the country offers multitude of opportunities amidst various adversities, the banks have to plan their operation carefully to tap the opportunities. To achieve the broader goal of new Nepal, NRB and BFIs should work hand in hand. (Published in New Business, February 2011)
The face of banking in Nepal is changing rapidly. The Competition in the industry is tough due to limited market and few investment opportunities in the country. For a healthy and flexible financial system, therefore, banks and financial institutions need to deal with important issues like improvements in effectiveness and efficiency in their overall operations, while achieving economies of scale through consolidation and exploring innovative cost-effective solutions.
There has been a large growth in the number of banks and financial institutions (BFIs) during the past two and half decates of liberalized period. But the indicators that are being examined to asses the impacts of banking development in the real sector of the Economy have not found satisfactory.
The service quality and expansion of the system have been improved a lot due to intense competition in the country and the BFIs commitment to provide better service to the customers. The overall performance of the banking industry during the period has remained satisfactory. The number of banks in the country is in rise.The capital adequacy of the banks has improved significantly and now only three banks i.e., Nepal Bank Limited (NBL), Rastriya Banijya Bank (RBB) and Nepal Bangladesh Bank (NBB) are to reach to the minimum level. Similarly, the assets quality of individual banks and the industry as a whole has also improved and non-performing loan (NPL) is declining. BFIs are coming up with advanced and sophisticated technologies and there is a trend to spread up banking activities beyond capital city and are exploring new markets in the suburban areas.
Besides these positive trends in the banking industry, there are some constraints, which are hindering the sound growth of the system. Even if the New Capital Adequacy Framework has been implemented in Nepal, effective implementation is a challenging task. At the same time moving towards advance approaches for capital allocation seems long way to go. The reform of government owned banks has not been happened as per the exception and it is challenging for Nepal Rastra Bank (NRB) to provide level playing field to all BFIs in the era of free market. With the shift in the trend in banking industry, Nepal has also experienced so many ups and downs in the financial system. Many new issues are emerging creating shorter and longer-term impact in the system. BFIs need to proactively assume their responsibilities and work on strengthening their capacity, bearing in mind the 21st century global struggle in the financial sector.
NRB, as the central bank of the country, is also highly aware that, for the achievement of the central bank objectives in the present dynamic environment, sustained progress and reform of the financial sector is of utmost importance. Continuously aware of this great responsibility, NRB is pursuing various policies, strategies and actions pertinent to the context.
Number of Bank and Financial Institutions (BFIs)
As of Mid-December, 2010, there are 272 BFIs operating in the domestic banking system under the license of NRB consisting of 30 commercial banks (Class A), 83 development banks (Class B), 79 finance companies (Class C), 19 micro-credit development banks (Class D), 16 Cooperatives and 45 NGOs. The cooperatives and NGOs are, however, licensed for limited banking transaction. Among these the number of public BFIs (owned by the government) is not as much of the BFIs run by the private sector. There are only 3 public commercial banks; NBL, RBB and Agriculture Development Bank Limited (ADBL) out of the 30 commercial banks in the national banking system. Like wise, the number of development banks and Finance companies owned by the government is nominal as compare to those run by the private sector.
Despite the fact that private sector BFIs are growing in numbers, their access in nooks and corners of the country is still inadequate. But they have started expanding their branches in the head quarters and business hubs of different districts after the monetary policy inducement and mandatory provisions laid by NRB, the central bank of Nepal. As a result, the population taking benefit per bank in the country is gradually decreasing; meaning the access of the population to the banking system is improving eventually. However, the public sector banks are still the largest banks in all aspects from deposit and credit mobilization to the number of branches in operation. Similarly, the growing financial activities in the rural and suburban areas due to the increasing flow of money remitted by the locals working abroad have been attracting the banks to go beyond their existing boundaries. At the same time, expansion of road network to the remote areas of the country has also played a pivotal role to attract the bank branches with an expectation of taping the virgin market. The deposit, loans and advances and total assets of the banking industry has been increasing gradually in recent years. From the latest figure, it is seen that the performance of public banks in terms of deposits, loans & advances, and total assets is somehow limited relative to private sector BFIs.
Access of Banking Services and Branch Network
According to the latest data of NRB, the total number of commercial banks' branches is over 1000, which on mid July 2009 and 2008 were 752 and 555 respectively. Out of total bank branches, more than one third branches are belonged to 3 public banks and remaining are belonged to the 27 private sector commercial banks. From the figure above, it is seen that, the banks with the largest number of branches are public banks: ADBL, RBB and NBL 145, 126 and 108 branches respectively. The number of branches of the private banks is on the rise, and the trend is towards going to the growing cities outside valley.
Large concentration of the branches is seen in Kathmandu valley. Most BFIs are looking to increase their number of branches in Kathmandu, which is a major economic hub of Nepal. Kathmandu, Kaski and Rupandehi are three districts with highest number of bank branches and cities with high branch concentration are Kathmandu, Lalitpur, Pokhara, Butwal, Birgunj, Biratnagar, Bhairahawa, Nepalgunj and Dhangadhi. Similarly, region wise, Central Development Region has the largest concentration of more than 400 branches with the major economic centers like Kathmandu, Lalitpur and Birgunj followed by the Western and the Eastern region. The regional distribution of the branches seemed to be much skewed.
Employment in the Banking Industry
The number of employees engaged in the commercial banks of the country is around 20,000 right now, which were 16,148 in mid July 2009. Out of the total number of employees in the commercial banks, the three public banks generate the majority of the employment as their operations are largely based on the manual system. Though, these banks have reduced their staff size almost in half since mid July 2001 under the various phases of Voluntary Retirement Schemes initiated under the reform process, gradually replacing the manual system through computerizing their operations, they still have a significant number. At the end of FY 2009/10, the number of employees in the three public banks and other private banks is more or less fifty-fifty. At the end of FY 2008/09, the three public sector banks were employing 8656 employees whereas the private sector banks had 7492, which as on mid July 2008 were 9278 and 5701 respectively. The growth in number of staff in private sector bank is due to the massive increment in their branches. However, the private banks, meanwhile, are steadily increasing their number of staff in direct alignment with the expansion in the business. Since the large portion of their system and procedure are automated, the number of staff employed by these banks is relatively small.
Services Offered by BFIs
Today the people of Nepal can avail of almost all types of banking services available in the developed countries. Similarly, they have options of both brick (branch banking) and click (Internet banking, tele-banking, ATM, Point of Sale (POS), different Cards, mobile etc) banking channels. The major products offered by the Nepalese BFIs include various types of deposits, loans, letter of credit and letter of guarantee, remittance, trust services, merchant banking, retirement fund management, investment banking and foreign exchange. In other words, it can be said that Nepalese BFIs are ‘financial department stores’ selling almost all types of financial services. It is however true that all the banks and financial institutions are not selling all the products mentioned above and level of product sophistication is low due to the nature of demand in the financial market. Once the market demands highly sophisticated products, the BFIs in Nepal are capable of introducing the same.
Negative Net Worth of Some Banks and Reform Measures
Some analysts say banking is nothing but management of the risks. Banks are exposed to mainly credit, operational, market and liquidity risk. Taking risk by choice, not by chance is the main mantra (theme) of banking. Unfortunately, risk management system in all public BFIs was poor due to poor corporate governance. Like most other public sector enterprises, government owned BFIs were not professionally run resulting in huge non-performing loans (NPL). Similarly, Nepal Bangladesh Bank Limited (NBB), Nepal Credit and Commerce Bank (NCC), Lumbini Bank Limited (LBL) and Nepal Bikash Bank limited along with some other private BFIs had negative net-worth due to undue interference of the promoters/directors in credit operations causing huge NPL. NRB has today adopted many measures to erase negative net worth of these BFIs and to safeguard the interest of the depositors.
This critical situation, however, is relatively low in private BFIs as compared to that of public. This is due to low political influence, high professionalism; more transparency along with the NRB's through screening of promoters at the time of awarding license and taken proactive measures as soon as the symptoms of the problems were sensed. The fate of semi/government BFIs was inevitable looking at the way the government offices in Nepal operate. Strong commitment of the government and support of judiciary is also a must for restoring good health of these BFIs. After the initiation of financial sector reform, various new acts relating to banking sector have been promulgated. Similarly, prudential regulations of international standard have been introduced. NRB's supervisory system has also been strengthened.
How the Banking System Promote Economic Growth?
To understand how the banking system might influence economic growth, we need to review the roles of the system in greater detail. First, the banking system mobilizes savings. This activity reduces the transaction costs associated with external finance for both firms and households. Second, the banking system allocates saving by determining worthwhile investment opportunities and judge the creditworthiness of borrowers at lower cost than the average small investor. The third role of the banking system is to reduce risk by spreading investors’ savings across many different investment opportunities. This reduction in risk encourages savings. Fourth role of the banking system derives from its ability to generate liquidity. Some investments with potentially high returns involve projects that require long-term commitments of capital. Fortunately, when the banking system pools the investments of many households, it allocates funds to both short- and long-term projects. Fifth, the banking system facilitates trade by extending credit and guaranteeing payments.
Additionally, letters of credit help firms order the inputs for current production when they experience delays in payment for past sales. The banking system also exerts corporate control and monitors managers. King and Levine (1993) noted that there is positive role of banking in innovation and production process probably for the first time, arguing that the services of financial intermediaries – mobilizing savings, evaluating projects, managing risks, monitoring managers, and facilitating transactions –stimulate technological innovation and economic development. Similarly McKinnon and Shaw (1973) concluded that alleviating financial restrictions in developing countries, by allowing market forces to determine real interest rates, can exert a positive effect on growth rates; they thus favored for financial liberalization which they felt would stimulate savings and would finally finance higher level of investment, leading to higher growth. They also found that one percent increment in liquid liability to GDP ratio of the nation would increase per-capita GDP by 0.15 percent in next period. The significant and positive impact of liquid liability to GDP ratio in one period lag cannot be discarded because of two reasons: (i) it measures the liquidity position of the nation which is essential for the investments; and (ii) the outcome of investment cannot be realized in the same period. However, in Nepal, the present level of liquidity to GDP ratio showed negative impact on GDP. Also, it is hypothesized that the lagged effect of liquid liability on growth could not take place due to the weakness in the domestic banking system. The loss in the business having investment in productive sector in Nepal would mean a marginal or even negative contribution to national output and hence to per-capital output.
Regulatory Framework
Nepalese banking system is under regulated environment. BFIs are given autonomy to allocate their resources in the most efficient manner. At the same time, they are also required to abide by the mandatory circulars and directives issued in different areas. The underlying philosophy is that BFIs should be free to allocate their resources according to market forces and shall be entitled to set terms and conditions for their operations in a competitive environment. However, strict regulatory norms should be set for BFIs behavior in order to protect depositors and other creditors and the financial system as a whole. Pursuant to this, the objective of BFIs supervision in Nepal is to promote and maintain the safety, soundness, and integrity of the Nepalese banking and financial system; while promoting confidence in the financial system through the implementation of policies and standards that are considered best in international practices.
Nepal Rastra Bank is the apex authority to regulate and supervise BFIs in the country. It has been enacting various policies, directives and circulars in line with its central banking objectives since its inception. The NRB Act, 2002 has empowered it as an autonomous institution to conduct regulatory and supervisory activities independently. It’s on the part of NRB to maintain financial stability in the country by raising confidence of both depositors and investors. Supervision function is performed by two different departments of the NRB namely Bank Supervision Department and Financial Institutions Supervision Department. The commercial banks are supervised by the Bank Supervision Department while the rest of the institutions are supervised by Financial Institution Supervision Department.
NRB has introduced many prudential guidelines governing the operations of BFIs. They mainly pertain to capital adequacy, risk management in credit and investment portfolio (single borrower/unit limit, single sector limit etc.), loan/investment classification and provisioning, income recognition, market risk management, liquidity management and corporate governance including disclosure norms and provision of Audit Committee. Further the bank is also equally responsible, together with BFIs to raise public confidence in the banking system. For this, the Bank Supervision Department is performing on-site examinations, off-site surveillance & analysis and policy and guidelines formulations in different issues for the achievement of the department’s objectives.
In performing the above role, the Bank, through the Banking Supervision Department strives to ensure compliance with the BFIs Act-2006 (BAFIA-2063) by banking institutions under its jurisdiction. In order to achieve the role of protecting the interests of depositors, NRB has crafted a number of prudential requirements to be complied with by BFIs. The prudential requirements advised on BFIs are designed to limit risk taking to levels that are manageable and that do not place the individual banking institution and the banking system at risk.
In addition to other prevailing laws of the country, the main legislative framework for supervision function includes:
• Nepal Rastra Bank Act, 2002 (2058)
• Bank and Financial Institutions Act, 2006 (2063)
• Company Act, 2006 (2063)
• Supervision By-laws, 2002(2059)
• Directives to commercial banks and financial institutions
• New Capital Adequacy Framework, 2007
NRB has continued to review the relevant legislation and regulations in order to put in place up-to-date regulatory framework that meets international standards and resolves the issues of the banking industry.
Challenges
• High Level of NPL and Risk Management System: Unaudited figures of mid January 2011 show negative net worth of above Rs. 15 billion in 2 commercial banks. Although the ration of NPL to the total outstanding loan of the industry is under the stipulated level, this is undoubtedly due to high level of NPL in those banks. Like wise, the NPL of Development banks and Finance companies is over Rs. 2 billion out of total assets of 200 billion. As a fiduciary of public money, current situation is unfortunate and collapse of a large bank may invite systemic risk. So, the challenge today is to erase negative net worth of the BFIs and to create an environment to avoid recurrence of such a situation in future. Current measures adopted by NRB have to be continued in case of problematic private banks. However, the structural changes are necessary in case of RBB and NBL. HR management and risk management practices of best managed private banks are to be applied in these banks. Strong commitment of government and strengthening judiciary in terms of commercial transactions are necessary to bring down NPL level of banking sector. There should not be political interference and cases of ex-parte injunction should be rare. There is a need of making Debt Recovery Tribunal strong and efficient including its expansion at least in major cities and setting up an efficient assets management company.
In addition to credit risk, BFIs can face adverse situation from other risks like market, operational and liquidity. It is sad to note that collateral based lending instead of cash flow based lending is still prevalent. This speaks the need of a comprehensive risk management system in a BFIs. All the BFIs need to work in this direction to assure the public that they have adopted all the possible measures to keep their money safe. Moreover, regulating authorities should create an environment whereby the banks can make lending decisions based on the financial statements of the borrowers.
• International Level Competition: Competition in the banking system is already tough with the presence of large number of BFIs including joint venture banks of international banks. Interest spread, exchange spread etc of the BFIs is constantly narrowing. The competition is expected to stiffen further with the government's commitment of allowing foreign banks to open their branches from 1st January 2010. When international banks come, they come with large capital, modern technology and an array of products. Experience of our neighboring countries suggests us not to panic with the arrival of international banks. We however need to focus on the following areas to remain competitive:
• Augmenting capital base: Mergers and acquisitions can be effective in this regard. Sadly, there is not a single case of M&A amongst the commercial banks except one with finance company and another between two finance companies. Current level of return on equity and traditional Nepalese 'sahu jee' culture are the major obstacles but the competition exerted by the international banks will force them to behave like international players.
• Develop expertise in various fields: International banks have better exposure mainly in treasury and credit area than local banks. The local BFIs thus need to focus on enhancing skills of their human resources in these areas.
• Adopt best human resource practices.
• Strengthen risk management system and corporate governance.
• Improve customer service quality.
• Maximize use of information technology.
• Focus on product innovation and cost management.
• Reach of banking services: Even after 7 decades of formal banking history, it is sad to note that 3/4th of population is far from the formal banking net. Poverty is one of the main reasons for fueling the social tension. Financial inclusion is a must for social and communal harmony. Banks need to work in coordination with micro credit institutions, local governments, NGOs and cooperatives to make financial service accessible to the common people across the country. Moreover, the banks can play a role in infrastructure development of the country. Proper management of remittance, attraction of remittance from high net worth NRNs, FDI and control of the capital flight can be a stable source of fund for infrastructure financing.
• Supervisory capacity of NRB: Currently, NRB stopped to give license to all those who meet its criteria for opening BFIs. NRB is not working in the direction of strengthening own regulatory and supervisory capacity rather than putting a cap in the number of BFIs citing it will be against the spirit of open market regime. As an autonomous body, it is free to adopt the policy it deems the most appropriate.
Way Forward
• As the situation of bank failures may invite systemic risk resulting in financial dis-intermediate, NRB needs to screen the integrity of promoters thoroughly before issuing a license. Utmost care should be exercised to avoid potential conflicts of interest while issuing license to promoters having other large business. Supervisory capacity of NRB should be strengthened to the required level so that we do not see the repeat of current scenario. To conclude, commercial banks of Nepal have made significant contribution to the economy. They however need to multiply their contribution for overall economic development of the country. As the country offers multitude of opportunities amidst various adversities, the banks have to plan their operation carefully to tap the opportunities. To achieve the broader goal of new Nepal, NRB and BFIs should work hand in hand. (Published in New Business, February 2011)
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