BANkING

Journal of Institute of Chartered Accountants of Nepal, Vol.13, No.4

NePALeSe BANkING cRISIS exPLAINeD

chANDAN SAPkoTA* nepal has been struggling to maintain macroeconomic balance for a couple of years now. low growth rate, high unemployment, balance of payments deficit, ballooning trade deficit, and high and sticky inflation are some of the pressing existing macroeconomic challenges. now, add to that list banking and liquidity crises engendered largely by the bank and financial institutions (BFIs) themselves and to some extent by nepal rastra Bank (nrB), the central bankand its disastrous consequences in and beyond the banking system. the nrB ignored the unhealthy competition, questionable lending to few sectors, and governance in financial sector. In doing so it let new BfIs pop up without even evaluating if the economy needs so many of them, and took damage control measures of late. Meanwhile, the BfIs engaged in unhealthy and imprudent lending out of desperation to survive amidst cutthroat competition, which is getting nasty by the day. the BfIs inability to effectively cope with the pressure to increase deposit and lending, and to attain unsustainable profit targets is leading to a situation where all profits are private but losses are social, i.e. taxpayers pay the cost of reckless business practices of the BfIs in the form of expensive rescue packages. Without deep structural changes in the banking industry, nepal will see many northern rock moments and eventually a disastrous lehman moment as well. the tendency to seek short term, quick returns against long term viability and sustainability is leading the BfIs in a path of self-destruction. for a healthy banking industry, nepal needs fewer but stronger BfIs with sound corporate governance. furthermore, there has to be an enhancement of regulatory and supervisory capabilities of NRB. The playing field has gotten unnecessarily congested amidst less than proportionate growth rate in the number of depositors vis--vis BfIs.

NoRTheRN Rock AND LehmAN momeNTS

When Vibor Bikas Bank (VBB) knocked on the doors of nepal rastra Bank (nrB) on June 9, 2011 to either inject money in the development bank or to take over management, it rattled the banking industry and the already suspicious depositors. there were rumors and anticipation that due to excessive loan exposure to real estate, housing and construction sectors bank and financial institutions (BFIs) will land in the red sooner or later (sharma, 2011). the sudden move by Vibor made depositors panic and policymakers scurry to find a way to avert a Lehman momentthe day when us investment bank lehman Brothers collapsed (september 15, 2008) and triggered the global financial crisis that was ensued by the global economic crisis. In nepals banking history, the rescue of Vibor is a northern rock momentthe day when the Bank of England extended emergency financial support to the troubled mortgage lender on september 17, 2007 and saved it from collapsing.

* mr. sapkota is a researcher at south asia Watch on trade, Economics and Environment (saWtEE), Kathmandu

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BRIeF hISToRy oF BFIS GRoWTh

the initiation of formal banking system in nepal commenced with the establishment in 1937 of nepal Bank Limited (NBL), the first Nepalese commercial bank. the countrys central bank, nepal rastra Bank (nrB) was established in 1956 by an act of 1955, after nearly two decades of nBls existence. a decade after the establishment of nrB, rastriya Banijya Bank (rBB), a commercial bank under the ownership of the Government of nepal was established. after the financial liberalization in the 80s, a third commercial bank in Nepal, or the first foreign joint venture bank, was set up as nepal arab Bank ltd (now naBIl Bank ltd) in 1984. following this, two foreign joint venture banks, nepal Indosuez Bank ltd (now nepal Investment Bank) and nepal Grindlays Bank ltd (now standard Chartered Bank nepal ltd) were established in 1986 and 1987 respectively. In 1983 and 1993 there were two and eight commercial banks respectively. By January 2006, there were 17, including joint ventures. there were 4 development banks in 1993, which swelled to 29 in 2006. finance companies came into existence in 1992 and by January 2006, they numbered 63. figure 1: number of BfIs in nepal, 1980-2010

of the past decade.

STATUS oF BFIS
as of mid-July 2010, total assets and total deposits in banking sector amounted rs 996.1 billion and rs 795.3 billion respectively. the total loans amounted to rs 622.6 billion. the market share of total deposits of commercial banks has declined from 85.6% in midJuly 2008 to 79.4% in mid-July 2010, when the share of development banks, finance companies, and other BfIs was 9.7%, 10% and 0.9% respectively (Ministry of finance, 2011). In the last three years, there has been a slight decrease in deposits in commercial bank but increase in development banks and finance companies (see figure 2). Meanwhile, of the total loans, commercial banks market share has declined from 78.6% in mid-July 2008 to 74.2% in mid-July 2010. during the same period, the share of total loans of development banks, finance companies and other BfIs was 10.6%, 12.8% and 2.4% respectively. as of april 2011, nrB data shows that the total deposits at commercial banks stand at around rs 642 billion. of the total commercial banks deposits, demand deposits, savings deposits, and fixed deposits stand at 12%, 36%, and 52% respectively. they have liquid funds of rs 114 billion (cash in hand rs 16.2 billion, and deposits with nrB rs 39.3 billion). More than rs 110 billion is invested in real estate by the commercial banks alone. over 72% of commercial banks credit flows against fixed assets. figure 2: Market share of total deposit and lending (%), mid-July 2010

Source: Authors compilation using Bank and Financial Statistics 2010 and Economic Survey 2010/11 Currently, there are over 308 BfIs, including 31 commercial banks, 87 development banks, 80 finance companies, and 21 microfinance institutions. the growth in number of BfIs is unprecedented and not warranted by the economic and banking fundamentals

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Meanwhile, the BfIs sanctioned easy loans to real estate and housing sector borrowers without assessing their capacity to honor interest and principal payments in time. It led to rapid rise in demand for real estate and housing construction in urban areas and an escalation of its prices. When the abnormally high prices started to fall, the borrowers were unable to pay back interest and principal in time, leading to a shortfall of liquidity in the banking industry. simultaneously, category B, C and d1 BFIs were finding it hard to borrow more from category a BfIs because the inter-bank lending rate was almost above the average of BfIs normal lending rates. Worse, some BfIs have prepared a negative list to not lend money to BfIs which they think are on the verge of collapse. the liquidity crunch was, to a minor extent, also compounded by the governments inability to mobilize development expenditure, the big institutional depositors decision to pull out mature deposits from fledging BFIs, and a slowdown in deposits growth rate. the combined effect of all these factors hit hard banks such as Vibor that had substantial loan exposure to few sectors, compelling them to seek nrBs intervention. In effect, there is a serious erosion of confidence on the banking system, and a surge in demand for commodities like gold and silver.

Source: Economic Survey 2010/11 as a share of gross domestic product (Gdp), total deposit, total credit (including claims on government) and private sector credit are 51%, 54.9% and 43.6%, respectively (nepal rastra Bank, 2011). per person deposit as of mid-april 2011 was rs 20,100 and per person loan was rs 19,000 (Ministry of finance, 2011). Commercial banks deposit interest rate ranges from 2-12% and loans 7-18%. Interbank lending rate ranges between 10 to 14%. right now, the interest spread, which is the difference between lending and deposit rates, is also high. the wider it is, the more worrisome the state of BfIs. likewise, the high inter-bank rate shows that the banks themselves are reluctant to lend money to each other. some of the BfIs are yet to meet the revised capital adequacy ratio, which is the ratio of a banks capital to its risks, laid out by the nrB, keeping in mind their increasing vulnerability to excessive loan exposure to just a few sectors (nepal rastra Bank, 2010b).

TWo BUBBLeS
By overlooking the need for having a limited number of BFIs, the evolving depositor base, and financial penetration over the years, the nrB let too many BfIs to pop up. It created a BfI bubble. this was followed by intense competition of not only between banks in the same category but also between BfIs in different categories, leading to an informal war in offering high deposit rates and lending without differentiating markets, products, and borrowers creditworthiness. It reflected bad corporate governance, and a lack of innovation and r&d in the sector. the resulting lending surge in real estate and housing markets unnaturally swelled their prices, leading to a real estate and housing bubble.

BANkING TRoUBLeS SImPLIFIeD

Without a proportional increase in depositor base and diversification of investment portfolios, the unnatural growth in the number of BfIs led to cutthroat competition in enticing depositors (institutional, government and individual) and borrowers. Buoyed by rising remittances, the former were incentivized to cAUSeS oF LIQUIDITy AND BANkING cRISeS deposit cash at high interest rates rather than looking for there have been misleading and incongruous arguments alternative sources of investment, which is lacking right floating around about the causes of the ongoing liquidity now due to political instability and various non-economic and banking crisis. they are made by stakeholders who constraints.
1 Category A, B, C and D means commercial bank, development bank, finance companies, and micro-finance development banks.

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fail to see how their vested interest and incompetence is jeopardizing the future of the banking industry, and is potentially derailing an already unstable economy. first, bankers and businessmen are arguing that delayed budget and disbursement of development expenditures are causing liquidity crisis. this argument does not hold much water. It is true that budgets have been coming out late for two years now, and there has not been normal flow of money from the Ministry of Finance and other Ministries to the respective corners of the country via BFIs. This has definitely limited liquidity in the banking system. But it in itself is not the main cause. Instead, it is a minor stimulant to the liquidity crisis. If delay in development expenditure is the cause, then why did nepal not have liquidity crisis when similar episodes occurred in the past? second, the withdrawal of large amount of money by institutional depositors, especially nrB and nepal army, has drastically reduced reserves in BfIs, especially category B and C, vaults and squeezed available liquidity. this again is a stimulant to the liquidity problem, not its main cause. If just by pulling out a few millions of mature deposits by institutional depositors puts the BfIs in trouble, then there is something wrong with the way they are doing business. It points to bankers incompetence and inability to run BfIs. third, while some argue that people are either stashing money at home or are investing in commodities like gold and silver, others assert that the compulsion to divulge source of income on transactions above rs 1 million is restricting deposits. again, both are not the real causes, but stimulant to the liquidity crisis. these arguments are trumpeted by certain businessmen who are afraid of divulging their sources of income and dutifully pay taxes to the government. fourth, some argue that a decline in reserves, precisely monetary base (which is equal to currency in circulation and reserves of banks held in central bank), due to a slowdown in growth of remittances, led to a situation where credit growth was higher than deposit growth. they assert that it is resulting in a liquidity crisis, and to return to normal, the nrB should purchase bonds and treasury bills and lower cash reserve ratio and the already high capital requirements (all of which will help increase liquidity). of all the arguments, this holds some

truth. But increasing liquidity without correcting the distorted market would only postpone the inevitable. the main cause is that nepal has too many BfIs catering to too few customers (note that a 2006 study on financial penetration shows that only 26 percent of households in nepal have bank accounts (ferrari, Jaffrin, & raj, 2006)), meaning that in order to survive and meet ever-increasing profit targets, the BFIs have to have constant flow of money from all sources, that also in higher proportion than previous flows. The competition to attract deposits and give out loans intensified with the increase in the number of BfIs, who competed without much product and market differentiation. Without considering total deposits and their ability to fulfill demand for withdrawls, the BFIs lent unsustainable amount of loans to earn quick returns to meet profit target before the annual general meeting of shareholders and directors. this translated into real estate and housing sectors bubble, which sucked in as much as rs 110 billion of commercial banks deposit. Buoyed by easy finance and loans, real estate transactions and housing complexes rose rapidly. Sometimes artificial demand was created just to jack up prices. this is evident from the fact that our shaky economic fundamentals do not justify multifold increase in land prices in a matter of days. Moreover, money is pumped into this sector without properly assessing risks and the ability of borrowers to repay loans. the BfIs are hardly distinguishing between normal and subnormal loans. there is little product and market differentiation. this was assuaged by nrBs easy monetary policy, lax supervision (by near-retiring officials who had expectations of moving into private sector banking) and inflow of remittances, which is approximately one-fourth of Gdp right now. this created market disequilibrium, i.e. the supply of real estate and housing complexes outstripped demand, leading to decline in prices by as much as 30 percent. as prices dipped, borrowers are and will be unable to honor principal and interest payments on time, forcing the BfIs to restructure loans and variably increase lending rates. this in turn led to and is leading to buyers canceling bookings even after paying the minimum required down payment. soon the major urban centers will see ghost apartments, i.e. empty apartments waiting for customers to either buy or rent them. this will ultimately

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hit the BfIs even harder unless it goes fundamental restructuring and consolidation.

WeRe We WARNeD?
Many financial and economic analysts failed to perceive the rapid changes happening in the banking sector. similarly, business journalists utterly failed to even read clues of troubles starting more than a decade ago when the now liquidated nepal development Bank (ndB) was put under management review, and when the number of BFIs increased multifold in a matter of just five years.2 It might be unsurprising because a majority of business journalists in nepal do not actually have training in economics and business. they take on-the-job training on business reporting and are behind the curve in fathoming the economic fundamentals and troubles. that being said, some observers, journalists, analysts, and bankers did perceive the looming crises. the warning bell rang when the issue of willful defaulters and excessive non-performing loans of BfIs popped up in 2006.

calmed down. this should be followed by concrete steps to consolidate our banking system. the nepali banking industry has to go back to oligopoly, which is characterized by few banks but many depositors and borrowers market structure, if things are to get normal. International financial experience shows that few and strong BfIs with tight supervision lead to a less crisis prone financial system (Allen, 2011). Few but strong BfIs with tight supervision would lead to reduction in operating expenses, healthy competition, economics of scale and innovation in the banking industry. for a long term solution, nepal should have something like a Troubled BFI Relief Program. It could be a powerful body within nrB whose main purpose would be to rescue and restructure troubled BfIs so that the problem is not systemic, and depositors are not induced to run on BfIs. It could be given the authority to sell assets, change management, force merger or acquisition, and hold the majority of shares of troubled BfIs until they return to a healthy state. It would consolidate the banking sector, and potentially lead to fewer but healthier BfIs that are innovative in providing services to the public, and also not take excessive risks to derail the entire economy. If troubled BfIs seek help from the nrB or the government, then they should be directed to use the facilities provided through this program. When they do, they should be forced to undergo structural changes. the program could have authority to sell assets, change management, force merger or acquisition, and hold majority of shares until it returns to a healthy state, among other measures after the BfIs knock on its doors for assistance. a program like this one is needed because the nrB cannot simply extend loans and refinancing facilities at the expense of taxpayers money and by increasing money supply each time BfIs get into trouble. Meanwhile, the BFIs also cannot inflict damage to third party due to their own shortcomings. this could be a permanent solution to the recurring problem. It should last as long as the BfIs and banking system are not cleaned. later on it could be given more teeth such as supervisory or advisory role in fine-tuning of banking sector.

movING FoRWARD
the nrB cannot afford to play such a cat-and-mouse game each time the BfIs irresponsibly increase credit without assessing the creditworthiness of borrowers and their deposit growth. The repeated introduction of refinancing facilities will not resolve the recurrent problem. It will only defer the inevitable restructuring of the entire banking sector. Meanwhile, one way or the other, the cost of such refinancing facilities will have to be paid by taxpayers. It is tantamount to bailing out troubled BfIs who got into the mess due to their own incompetence, not due to the publics desire to withdraw deposits and invest in commodities like gold and silver, and durables. there is a problem of moral hazard in the BfIs, i.e. they are recklessly lending to earn quick profits and by knowing that if they go belly up, the government will bail them out. for the short term, the nrB should use all its tools to increase liquidity so that anxious depositors are

2 see sapkota, 2009a; sapkota, 2009b; sapkota, 2011; sapkota, 2007 for further discussion on the developments in the banking industry.

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