Nepal's banking sector is experiencing an alarming paradox. While banks are flush with liquidity, as seen by a Credit-to-Deposit Ratio (CDR) of 78.58% as of December 7, 2024 (source: Nepal Rastra Bank), they are also grappling with an unprecedented increase in loan defaults. This excess liquidity, which under ideal conditions may drive economic growth, is mainly underutilized due to drop-in lending activity and an increasing burden of Non-Banking Assets (NBAs).
The Liquidity Conundrum
Despite having substantial cash reserves, banks are struggling to deploy funds profitably. Economic uncertainty and diminishing public trust have caused a dramatic slowdown in loan disbursements. Borrowers, concerned about financial instability, are hesitant to take on additional debt, while banks, burdened by growing defaults, are tightening lending standards.
Adding to these woes is the surge of NBAs—assets acquired by banks because of loan defaults, usually collateral such as real estate.As of mid-October, of this year, the NBA had grown from 21,384 million last year to 37,723 million, according to the NRB's Banking & Financial Statistics. However, in a sluggish real estate market, these assets are difficult to liquidate, leaving banks with non-productive holdings that put a further strain on profitability.
The Rising Wave of Defaults
The overall health of Nepal's banking sector has shown worrying trends over the past year. The average Credit-to-Deposit (CD) ratio of all classes of banks and financial institutions, which stood at 81.74% as of Ashoj end 2080 (mid-October 2023), dropped to 78.36% by Ashoj end 2081 (mid-October 2024), reflecting a decrease in lending activity (NRB). At the same time, the average Non-Performing Loan (NPL) ratio climbed from 3.66% to 4.42% during the same period, signaling a rise in loan defaults and deteriorating asset quality (NRB). To dive deeper, recent data from NIC Asia Bank(taking an example), reveals the sector's deteriorating condition. In just a few months, the bank's Net Non-Performing Loan (NPL) ratio rose from 0.45% to 2.08%, while its Gross NPL ratio skyrocketed from 1.19% to 4.24%. Loan provisions have also increased, with NPR 5.8 billion set aside for bad debts in the first quarter of 2081, up from NPR 2.3 billion in the same period the previous year.
Lending has slowed, which is equally worrying. From January to October, NIC Asia's loan and advance portfolio fell by 10.4%. This stalemate is the direct result of increased default rates, which have made both borrowers and lenders cautious.
Excess Liquidity Challenge in Banking Sector
Erosion of Public Trust
The financial sector's problems are exacerbated by a confidence crisis. Recent financial mismanagement scandals, such as that involving Karnali Development Bank, eroded trust even more. After the bank was found to have falsified its NPL data, the Nepal Rastra Bank suspended its authority to accept deposits and offer loans.
Such incidents not only harm individual banks' reputations but also call into question the integrity of the entire financial system. Such mistrust deters firms and individuals from doing business with banks, resulting in a vicious cycle of low activity and reduced profitability.
The Real Estate Bottleneck
Traditionally, real estate has been offered as a safety net for banks saddled by NBAs. However, the present crisis in real estate markets has prevented banks from selling these assets. As a result, banks are stuck with properties that lose value over time, delaying bad loan recovery and further limiting their lending capacity. This issue highlights the urgent need for reforms, such as the formation of asset management companies (AMCs) to help banks in disposing of NBAs. AMCs could serve as middlemen, facilitating a more efficient conversion of illiquid assets into cash and thereby rejuvenating banks' core operations.
A Perfect Storm
The convergence of rising NPLs, growing NBAs, slowing loan growth, and escalating provisions for bad loans poses a serious challenge to Nepal's banking sector. Excess liquidity, which should be a catalyst for growth and development, is being consumed by an increasing pile of unproductive assets.
When paired with public distrust and a sluggish real estate market, these challenges form a perfect storm that threatens not only the banking industry but the entire economy.
The Path Forward
Addressing these challenges requires swift and decisive action across multiple fronts. Strengthening regulatory oversight is crucial to ensure transparency and accountability within the banking sector, preventing incidents of financial mismanagement that erode public trust. This can be achieved by enhancing the capacity of regulatory bodies like NRB and enforcing stricter compliance measures. Additionally, the establishment of asset management companies (AMCs) could play a transformative role by streamlining the process of liquidating non-banking assets (NBAs). AMCs would enable banks to efficiently convert illiquid assets into cash, freeing up resources for productive lending activities.
Revitalizing the real estate market is another essential step, as it has traditionally served as a safety net for banks dealing with NBAs. Targeted policies, such as incentives for property buyers or measures to reduce transaction costs, could stimulate real estate transactions and create demand. Finally, banks must enhance their risk management practices by adopting more robust underwriting and risk assessment, as well as mitigation strategies. Improved risk management will help curb the growth of bad loans, fostering greater financial stability and resilience within the sector. Together, these measures can restore confidence in Nepal’s banking system and pave the way for sustainable growth.
Conclusion
Nepal's banking sector is grappling with a hidden but significant set of challenges. If we analyze recent reports, it becomes evident that many banks are facing similar issues, marked by rising defaults, increasing NBs, stagnating lending, and growing public mistrust. While the situation may not yet be dire and related for all banks, these underlying problems pose a serious threat to financial stability if left unaddressed. Immediate action is required to tackle these systemic issues and restore confidence. By doing so, the banking industry can reclaim its vital role in driving economic growth and ensuring a stable financial future.
