Banks biting off more than they can chew?

Nepal’s banks have once more entered the dark tunnel of scarcity of loanable funds. Commercial banks have misinterpreted the monetary environment for three years in a row -- they lend aggressively during the first quarter, and run out of steam thereafter until the final quarter of the fiscal year.

The seeds of the trouble were sown five years ago. As the IMF puts it in its most recent South Asia Regional Update, ‘Loose monetary conditions, along with a fourfold increase in banks’ paid-up capital in the two years to mid-2018 required by the Nepal Rastra Bank (NRB), have fueled a strong credit expansion. Private sector credit growth has averaged 22% (y/y) in the past two years, even as the NRB maintains ceilings on banks’ loan-to-deposit ratio and the loan-to-value ratio on car loans.’

Nepal’s financial landscape is heavily skewed towards banking. According to a recent World Bank report, banks account for 87% of financial sector assets in Nepal. Private equity and venture capital space are still in nascent stages. The private sector thus largely depends on bank debts, and in their absence, businesses have had to postpone plans or slow down operations. This has resulted in increased cost or lost opportunities.

Recurring credit crunches, which last several months every year, have impacted the economy as a whole. Key responsible parties here are:

• Government of Nepal for its inability to spend on capital expenditures
• NRB for instigating the crisis and then offering regulatory forbearance that encourages banks to push prudential boundaries
• Banks which appear to be driven with the sole objective of servicing increased capital

Nepal’s economic growth over past two decades has been largely led by the private sector, in spite of ineffective governments and inefficient bureaucracy. Banks should refrain from pointing fingers at NRB or the government. The NRB has not always been pro-active, its regulatory approach has often been ‘one step forward two steps back’. The government’s norm has always been to bulk up capital expenditure towards the end of the year. We want NRB and the government to be more responsive, but it will be a gradual process at best. And frankly, the banking business has thrived even in this environment, so let’s be reasonable.

Read also: Banking Crisis Explained, Suman Joshi

As the most transparent sector of the economy, the onus is on the banks collectively to manage public perception and repair the community’s battered image. Here’s a list of items they need to consider:

1. Anticipate better, and get your basics right. Will the market offer sufficient new deposits to fund growth in loan books? Nepal may be more stable politically, but with compromises from bureaucrats and politicians, it will be a while before their Key Performance Indicators align with Nepal’s aspirations for rapid economic growth. It is unrealistic, this early, to expect government spending to veer from tradition to follow a desired timeline that match banks’ need for new deposits.

2. Who is winning that debate in the boardroom? Most banks appear to have adopted a strategy to grow lending books aggressively to meet shareholder expectations of return on equity. The impact of this on their lending behavior is worrisome. What is the quality of loan assets banks are booking when they are expanding at 22% while the economy grew at 3-4% annually over last few years? Also the continued contribution of banks to real estate buoyancy may someday come back to haunt them. Excessive reliance on real estate as collateral has affected a loan officer’s approach to lending. Under the current loan loss provisioning norms and multiple banking context, it is possible to keep masking bad loans, which raises doubts about quality of profits. The IMF has singled out this challenge and suggests: ‘Rapid credit growth underscores the need to accelerate banking sector reforms. Building on the recent amendments to the regulatory framework, loan classification, provisioning, and banks’ risk management practices should be upgraded.’

3. Is it possible that many banks have bitten off more than they can chew by expanding their operations and branch network rapidly? Frequency of operational risk events suggests that quality of human resource and internal control mechanisms need significant improvement.

Banks have finally acknowledged the need to adopt digital channels of delivery. Better late than never. Even so, there is little chance of sufficient investment happening here. It is not enough to link bank systems to a digital payment platform. A key driver for consumer uptake is a cultural shift within individual banks to champion digital banking services.

Read also: Nepal's budding e-commerce ecosystem, Sikuma Rai

Clearly, Nepal is an over-banked economy with smaller banks struggling to stay relevant. Industry experts agree that there is a case for reduction in number of banks. Market prices are currently at interesting levels for more capable banks to consider acquiring other institutions. It may be easier said than done, but if there is an industry-wide resolve, the ducks will line up.

Suman Joshi is a former banker and Founder and Chairman of True North Associates, a private equity firm.