13 Oct 2017
6 min read
Up until just a few months ago, Nepal's banks were offering interest rates of around 12 per cent to depositors. In the past, such rates hovered around the six to eight per cent mark. The banks had increased the interest rates for deposits as a measure to alleviate the problems to do with lack of liquidity that had plagued the banking sector since last year.
Around the autumn of 2016, Nepal's banking sector experienced the initial phase of what would eventually be known as a liquidity crunch. Most banks and financial institutions (BFIs) began to face a shortage in their deposits, which in turn began to affect their credit abilities, that is, their ability to offer funds to the general public in the form of loans. Therefore, most of these
banks were forced to scramble to acquire loanable funds in order to ensure that their lending activities were not affected.
There's no one agreed-upon reason behind this crunch. Many believe it was the result of aggressive lending by the banks to unproductive sectors, of their lack of proper asset-liability management and of the government's unwillingness to spend from its capital budget. Regardless, the impact of this crunch was felt across Nepal. The crunch affected not only the banking sector, but also the entire Nepali economy. Owing to the crunch, the banks grew more reluctant to lend to customers they deemed risky--which led to a decline in investments--major projects came to a halt due to lack of funding, and borrowers had to face higher interest rates against loans, all of which had a major impact on the economic growth of the country.
The crunch ended a few months ago. But if the banking sector is to not live through similar trying times again, say economists and bankers, stakeholders in the industry must show they have learned from their past mistakes--by implementing best practices as the norm, and not just as a reaction to banking practices gone awry.
The crunch's effects
With liquid-fund reserves for credit dwindling down, the BFIs faced the challenge of managing their lending. Therefore, the shortage in the supply of loanable funds had a significant impact on the interest rates. The commercial banks charged as much as 12 per cent per annum on their lending while the development banks charged as much as 13 per cent per annum. Both of these rates were almost double the rate that these institutions had been charging before the crunch had begun.
Such a rise in the lending rates had the most impact on small- and medium-sized loan borrowers. This rise meant that they now had to bear higher costs for the amounts they borrowed. The lack of stability in the cost of loans affected their earnings and discouraged numerous potential borrowers. On the other hand, as mentioned earlier, this situation was good news for depositors who had stored their money in banks.
Today, with the economy recovering from the crunch, these erratic interest rates have begun to stabilise. Borrowers face relatively lower rates on loans, and that has improved the investment situation in the country. In contrast, depositors, who had been reaping the benefits of the higher rates, now receive smaller earnings on their deposits.
The cause for the crunch
Before the crunch, say finance experts, the lending decisions taken by various banks and financial institutions were risky, to say the least. Most commercial and development banks dispersed credit faster than they were collecting deposits; by the midpoint of the 2017 fiscal year, in January, the banks had already provided approximately Rs 204 billion worth of credit to borrowers. However, they had collected deposits amounting to only Rs 154 billion in that period. This led to a situation where the banks had reached the limit on their Credit to Capital and Deposit (CCD) ratio, meaning that they could not lend any further without collecting more deposits. "This, in hindsight, was not the prudent thing for us to have done," says Anil Keshary Shah, CEO of Mega Bank Nepal Limited. "This was something that we should have controlled right from the beginning; we shouldn't have gone into this rapid
According to Shah and many other bankers, the reason behind this pattern of lending was the increase in the paid-up capital that the new monetary policy that Nepal Rastra Bank (NRB), the country's central bank, had imposed on the banks. The paid-up capital requirement had swollen from Rs 2 billion to Rs 8 billion. To meet this new requirement, most banks chose to issue additional common stock in the form of right shares and bonus shares. And to ensure that the shareholders' earnings and dividends did not take a back seat, the banks began to increase their credit offerings--in the hopes that they would gain additional revenues through the interest.
However, this cause-and-effect theory does not hold water with by many finance experts. Nara Bahadur Thapa, the executive director of NRB's Research Department, explains that the hike in paid-up capital did not lead to the crunch. "Liquidity comes to banks through various channels. One is deposit mobilisation, another is borrowings, and then there's the banks' own capital. So it does not matter which source they choose to focus on. They cannot undermine the regulatory policies such as the CCD ratio and the exposure limit," he says. "Acting on only profit motives means you're adding risk to the system."
To make matters worse, most of the loans that the banks had so rapidly dispersed were directed by the borrowers more towards what most consider to be unproductive sectors (meaning, the stock market, real estate and on auto loans) and less towards productive sectors (meaning, manufacturing and trading). By the end of the first six months of the 2016 fiscal year, lending to the unproductive sectors had amounted to twice the lending to the productive sectors. These unproductive sectors did not generate any significant level of economic activity, and in turn, caused the funds to be removed from economic circulation--they'd become stagnant.
There was another cause for that stagnancy. The Government of Nepal had also been unable to mobilise the funds that it had set for spending. The budget that it had prepared allocated approximately around Rs 312 billion for capital expenditure for the 2016 fiscal year. The focus of the expenditure was on post-earthquake reconstruction, hydropower, agriculture and education, among numerous others. The government's inability to release these funds aggravated the lack of liquidity in the economy. Had this fund, which was lying idle with the government, been spent as planned, it would have pumped liquidity into the system, say financial experts.
A familiar story
This was not the first time that Nepal's banks had lived through such a phenomenon. In 2011, the sector had seen an unprecedented boom in the number of BFIs in the country. By the period's peak, 88 commercial banks and 79 development banks had been established in the country. But the lack of a simultaneous growth in the depositor base caused the banks to engage in stiff competition among themselves to attract customers to their branches. They readily offered loans to borrowers without first carrying out proper assessments regarding the borrowers' ability to repay their loans. Eventually, the borrowers' inability to make the repayments on time created a shortage of liquidity in the sector.
The way out
So how did the sector find a way out of this situation? The NRB part came up with two solutions: monetary policy measures and macro-prudential measures. The monetary policy measures dealt with the circulation of funds in the economy. According to this measure, the NRB was to redeem the government bonds from the market. Typically, these bonds are issued by the government to raise capital for certain projects as well as to control the supply of money in the market. Since such bonds are considered to be devoid of risk--due to their affiliation with the government--the public faces no qualms buying them up. During the crunch however, the NRB attempted to redeem or, in other words, buy back the bonds, with the objective of injecting more money into the economy.
The macro-prudential measures had to do with mitigating the risks associated with the financial instability that came with the shortage of liquidity in the banking sector. Under these measures, the NRB sought to relax the CCD ratio--to calm the market. "The objective was to encourage credit flow to productive sectors. So 50 per cent of the loans made to productive sectors was waived for the calculation of CCD ratio," Thapa explains. "This enabled the smooth flow of credit from the banking sector to the real economy and ensured that there was no abrupt disruption of credit to the economy."
As for the commercial banks, they initiated new policies that would force them to restrain themselves while providing loans. The banks started adopting a more conservative approach, meaning that the lending would take place in accordance with their deposit growth. In accordance with those policies, most commercial banks and development banks started making provisions to tighten the loans that they provided; thus lending in the real estate, share market and automobile sectors (all unproductive sectors) declined.
A lesson for all
There are a few takeaways from this entire ordeal. The government's inability to spend from the capital budget was regarded as one of the primary reasons behind the lack of circulation of funds, and hence, the liquidity crunch. With the central government controlling most of the budget for the entire country, spending was almost non-existent in the first half of the past fiscal year.
However, change is certainly on the way with the formation of the new constitution and the division of the country into new provinces. Spending is likely to be more vigorous in the near future, as local governments now have the power to create individual budgets for each of their provinces. Capital expenditure is thus more likely to take place as planned--owing to the devolving of authority and accountability to local governments.
Commercial and development banks intend to continue with their conservative approach to lending. Now, the goal of the BFIs is to sync the rate of growth of lending with the rate of growth of their deposits. Also, banks now plan to monitor the government's spending and other actions that will affect their liquidity, and only then carry out lending. The direction of the lending will also be more towards productive sectors and less towards unproductive sectors.
Finally, it is the general public who ought to be more aware when it comes to conducting business with banks, since banks do not act prudently all the time. "The public must do their research and take the proper precautions when it comes to borrowing and depositing their money," says Sujan Subedi, former DGM of Siddhartha Development Bank Limited. "Especially after the recent liquidity crunch--where the borrowers were discouraged because of the changing interest rates and the lack of credit facilities--people must do their research to identify the banks that offer stability in their services."
Increase in paid-up capital minimums
Why was it raised?
In July 2015, the NRB directed the BFIs to raise their minimum paid-up capital by up to four times the original figures. The requirement for commercial banks grew from Rs 2 billion to Rs 8 billion, while the requirement for development banks grew from Rs 640 million to
Rs 2.5 billion.
One of the reasons for this increase was to reduce BFI's leverage and strengthen their capacity to extend loans. For a bank, leverage is the ratio of deposits to capital, and it poses considerable risk since a highly leveraged BFI is one that's prone to collapse. Therefore, the capital was raised to reduce this risk and to improve banks' lending abilities.
Another reason for this increase was to control and manage the number of BFIs in the sector. Since the entry of Nabil Bank, the first privately-owned commercial bank in Nepal, the banking sector has seen an overwhelming mushrooming of such institutions in the country. This was one of the major causes of the crisis that occurred in 2011, when the large growth in the number of BFIs led to intense competition and rapid loan distribution.
To control the number of BFIs, the NRB raised the paid-up capital requirements for all categories of BFIs--with the hopes that to meet the new requirements, BFIs would engage in mergers and acquisitions. And the idea worked to some extent. The number of development banks shrank from 88 to 37. And the number of commercial banks went down from 32 to only 28, with most banks opting to issue bonus shares and right shares to meet the new requirement. Many argue that this increase in paid-up capital and the issuing of new shares also contributed to the recent liquidity crunch. However, many others argue that this increase had no substantial effect on the crunch.
"Increments in capital provide extra cushion for the banks to manage the cyclical economic shocks and at the same time increase their appetite for funding larger projects. The banks' balance sheets have grown strongly and the increased capital will provide greater support for the banks and confidence to its stakeholders," says Adarsha Bazgain, head of Financial Markets & Financial Market Sales at Standard Chartered Nepal.
The most significant benefit of the increase in paid-up capital--besides improving banks' stability and controlling the number of BFIs--is that it has led to banks looking to enlarge their scale of operations. The increase in capital has led to a proportional increase in the banks' attempts to improve their customer base, offer diversified products and expand to newer markets.