With most financial institutions in the country, including some traditional heavyweight commercial banks, reporting poor financial performance for the second consecutive quarter of the current fiscal year, stakeholders of these institutions and the banking industry as a whole are expressing serious concerns about the future of Nepali banking.
As many as 24 out of 31 commercial banks have witnessed dwindling profits, the decline ranging between less than a percent to as much as 97 percent. Overall, profits have declined by almost 25 percent as compared to the same period last fiscal. And even those banks that have shown positive results have earned their profits from write-back of provisioning made earlier and not from their regular banking business. The question, therefore, is whether this is merely a temporary slump or does it mark the beginning of the end of the celebrated phase of Nepal’s banking sector.
To begin with, it is imperative to understand whether the expansion of the financial sector here was driven by fundamental reasons. A major reason behind the expansion was a belief that Nepali commercial banks, representing more than 90 percent of the total deposits and assets of the entire banking industry, were insulated from any adverse external factors. The euphoria was such that an IPOs of even untested banks would be oversubscribed, thanks to investors cutting across social segments—from ministers, to bankers, doctors, lawyers, farmers, plumbers, students, housewives, and even minors. Most of these investors put in their money believing the value of their stocks would soar in future and also allow them to reap the benefits of regular dividends. However, the fact is that banks are like any other businesses, and can witness a period of dismal performance as well.
And that is precisely what is being articulated by the current scenario. However, some of the factors behind the current decline are temporary and not insurmountable. For instance, issues that have adversely affected the earnings of banks like liquidity and credit crunch are products of sluggish business activities and could go away with a revival of the economy. Similarly, the realty sector bubble—fuelled by irresponsible risk taking, lax oversight, and fraud—is going through what can be called ´managed bursting´ under the aegis of the central bank that would mutually benefit both the lender as well as the borrower.
However, there seems to be certain other structural and fundamental factors that are adversely affecting the profitability of the sector in a more permanent way. And a lot of these factors have to do with more stringent regulations aimed at making the financial system safer and more resilient. For instance, restrictions on a bank’s credit-deposit ratio, which has left banks with lesser funds at their disposal for lending, is likely to remain for some time yet.
While some challenges faced by the banking sector may ease gradually, new regulations in the future could still affect its profitability.
Traditionally, Nepali banks generated higher returns through wide margins and core lending spread. However, the era of cheap-money under the low interest rate regime and high leverage banking model that delivered high returns with low risks through the last decade saw a decisive end because of the liquidity crisis last year. The pervasive liquidity crunch induced banks to hastily raise the deposit interest rate—a major cost factor in a bank’s profit and loss account—and the inter-bank lending rate to double digit figures as they desperately tried to attract depositors. As a result, the average cost of funds of banks looms well above 8.5 percent, a figure that was inconceivable even three years ago when banks were offering an interest rate of 7 percent on fixed deposits and 1.5 percent on savings. This rising cost of funds resulted in a shrinking interest rate spread which, in turn, is taking a toll on the profit making abilities of banks.
While examining the banks’ health, much depends on a financial performance metric—return on equity—which effectively measures the profits a bank was able to generate on its capital. For instance, if a bank made Rs 200 million in profits on Rs 2 billion of equity, its return on equity would be 10 percent. In the middle of the current fiscal, the actual return of commercial banks that are at least three years old was only 12 percent, compared with 19 percent in 2067.
Further, the mandatory requirement of maintaining the credit-deposit ratio at or below 80 percent, (aimed at strengthening the resilience of the financial sector, though perhaps at the cost of making financial intermediation somewhat more expensive), has restricted the ability of BFIs (banking and financial institutions) to lend the money at higher interest earning assets. Instead, the banks are now coerced to invest in low yielding, albeit more secured and liquid, government securities that currently earn less than a percent.
To make matters worse, fee-based income, another important component of BFIs’ revenue structure, is being challenged not just by stiff competition but also by regulatory intervention and lower business volumes. Some Nepal Rastra Bank guidelines on service charges issued in December 2010 are aimed at protecting the customer by curtailing undue charges levied by BFIs on their income, which are negligible though.
Hence, while some of the current challenges faced by the banking sector may ease gradually, the sector is likely to grapple with new regulations in coming years that could further affect its profits. As Dr. K.C.Chakrabarty—Deputy Governor, Reserve Bank of India—recently remarked, the financial industry around the world is witnessing a phase of re-regulation in which BFIs will operate under a tougher regulatory environment than they have experienced in recent times and Nepal is no island. Likely provisions will include making banks raise extra capital to increase their buffer against losses, and to use less short-term borrowed money to finance their businesses, which in turn would make them less vulnerable to crunches and crises. All these adjustments effectively make it impossible to go back to the era of high returns.
To sum up, low business volumes, rising funding costs and the increased regulatory costs of higher capital levels and liquidity buffers are the new ‘normal’ to banks in Nepal .However, amidst the pessimistic outlook, the fittest banks will no doubt make a Darwinian bid to survive as weaker ones falter.
The author is business development officer at Nepal SBI Bank Limited
bishalkchalise@nsbl.com.np
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