Saturday, June 11, 2011

State of Nepali banking system & a case for new BFI relief program

The Nepal Rastra Bank, Nepal’s central bank, acting as a lender of last resort, extended short-term loan of Rs 500 million to the troubled Vibor Development Bank. This is the latest saga of troubled banks in Nepal. Earlier, six BFIs landed were in the red: Gorkha Development Bank, Samjhana Finance, United Development Bank, Nepal Share Markets, Nepal Bangladesh Bank, and Nepal Development Bank were in trouble. The central bank liquidated Nepal Development Bank, restructured Nepal Bangladesh Bank, and is taking corrective management measures in others. These kinds of episodes are going to pop up again if decisive measures are not taken soon.

Status of bank and financial institutions (BFIs)

There are over 295 BFIs, including 31 commercial banks, 78 development banks, 79 finance companies and 18 microfinance institutions. While deposits at commercial banks stand at around Rs 642 billion (as of April 2011), development banks and finance companies have deposits around Rs 56 billion and 67 billion respectively (as of mid-July 2009). Loans and advances of development banks stand at Rs 52 billion and that of finance companies at 70 billion (as of mid-July 2009).

As of April 2011, the estimated total deposit in commercial banks was Rs 642 billion. Of this demand deposits, savings deposits, and fixed deposits account for 12%, 36%, and 52% respectively. The commercial banks have borrowed Rs 15.8 billion. They have liquid funds of Rs 114 billion (cash in hand is just 16.2 billion and deposits with NRB Rs 39.3 billion). Meanwhile, loans and advances of commercial banks stand at Rs 655 billion. Of this claims on government and on private sector account 12.7% and 84.3% respectively.

Commercial bank’s deposit rate ranges from 2-12 percent as of April 2011, and loan from 7-18 percent. Interbank transaction rate is as high as 10.2 percent.

Over 72 percent of commercial bank’s credit flows against fixed assets. Lending to land and buildings sector account for over 58 percent of total loans.

Total loans was around 52 percent of GDP (at producer’s current prices) as of mid-July 2009.


What is the problem?

There is liquidity crunch in the market. Interest on inter-bank lending has been above 10 percent. Overall, over 50 percent of total loans is going to land and housing sector. This is a huge risk. Loan portfolio of the BFIs is in terrible shape, with concentration in a few sectors. As the number of BFIs multiplied unnaturally (it was not matched by the growth rate of customer base--according to a 2006 survey, only 26% of households have bank account), there was and is intense competition to entice individual, institutional and government deposits. This means that there is an informal war of offering high interest rates on deposits. Many outlandish deposit schemes were invented. The Nepal Banker’s Association (NBA) even tried to cap interest rates with a “gentlemen's agreement”.

Meanwhile, loan was doled out to few sectors as there wasn’t (and isn’t) much investment opportunities. Since deposit rates were already high, the lending rates had to be higher to make up for ever-increasing profit target. This was assuaged by NRB’s 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. Easy loans and financing measures led to real estate and housing bubbles in urban centers. But, real estate bubble started to lose air since the end of last year. Borrowers could not payback interest and principal in time, which meant increase in lending interest rates as penalty and doling out more new loans to pay previous loans.

The BFIs are in trouble because each time they had to provide additional loans to cover up previous interest and principal payments. At some point there won’t be enough deposits and money circulating around to dole out new loans to cover up previous ones. Profits get squeezed and depositors can’t get their own money when bank’s vaults are empty. Thus there is (and will be)  a crisis, whose cause is perceived to be liquidity crunch instead of fundamental mismatch among deposits, lending, risk management and available stock of money.

In principal, there was both adverse selection and moral hazard. First, since lending interest rate is too high, the pool of borrowers are always those that play with high risk. So, BFIs lent money to a lot of borrowers without assessing if they can payback loans to the banks. This was a gamble they played because of their incompetence and lack of banking knowledge (especially board of directors and management who ran after short term profits against long term viability). Second, after the loan was given on certain terms and conditions, borrowers simply reneged on those. The BFIs cannot control that. Borrowers simply default if things get nasty. Also, some borrowers were simply not able to payback due to decline in real estate and housing prices.

BFIs mushrooming in Nepal

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 country's central bank, Nepal Rastra Bank (NRB) was established in 1956 by Act of 1955, after nearly two decades of NBL’s 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 called as NABIL Bank Ltd ) in 1984. Following this , two foreign joint venture banks, Nepal Indosuez Bank Ltd (now called as Nepal Investment Bank) and Nepal Grindlays Bank Ltd (now called as Standard Chartered Bank Nepal Ltd.) were established in 1986 and 1987 respectively.

In 1983 and 1993 there were two and eight commercial banks respectively, and 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.

Now, there are over 295 BFIs, including 31 commercial banks, 78 development banks, 79 finance companies and 18 microfinance institutions.

This is like Nepali BFIs on steroids and the NRB being its doctor just waited to cure the disease instead of preventing it from happening at the first place.

What about delay in development expenditure?

Since fiscal budgets have been coming out late for two years now, there has not been proper and normal flow of money from MoF and other ministries to the respective corners of the country via the banks. It is reducing liquidity in banking system. But, this itself is not a prime cause of liquidity crunch. This is a minor stimulant to the liquidity problem. We simply have way too many BFIs catering to too few customers, meaning that in order to survive and meet higher profit targets, they have to have constant flow of money from all sources that also in HIGHER proportion than previous flows. The problem largely is of the BFIs themselves, not the delay in budget and development expenditures.

What about the NRB?

The NRB definitely made a mistake initially by letting way too many BFIs pop up and by not complementing this with strengthening of regulatory and supervisory capabilities. It was already too little, too late when it started clamping down on the errant BFIs and correcting the course of the banking system. That being said, credit has to be given to the present governor Dr. Yuba Raj Khatiwada for his active and decisive role in righting the deviants.

Why is it happening now?

Because of cutthroat and dirty competition. There are too many BFIs (some A category banks are too big given their loan portfolio) and not a proportional increase in depositor base and investment opportunities. High profit targets meant that lending rates shot up the roof (that also arbitrarily jacking up rates via SMS and phone calls) and loans were doled out without properly assessing creditworthiness. The main source of income for BFIs is real estate and housing sector loans. Loans were doled out without properly differentiating junk and subprime loans from not-so-risky loans. Loan and risk portfolios of BFIs were and are not adequately diversified.

But, real estate and housing sectors are cooling off right now, especially in major urban centers. Borrowers are finding difficult to honor interest and principal in time. The BFIs are seeing squeeze in profits, making shareholders and board of directors angry for not meeting profit targets. Already, inter-bank lending is close to the mean of various lending rates. The BFIs with limited deposits but excessive exposure to one or two sectors are feeling the heat as big banks with comfortable deposits and loan portfolios are refusing to lend them more money. Hence, the crisis that was bubbling underneath is surfacing, unnerving the banking sector and the NRB. The failure to borrow money from banks themselves despite high inter-bank rates is acute now, and the big institutional depositors are pulling money out of B and C category BFIs and putting them in A category banks. This happened at the same time and is the problem is precipitating now. This was to happen sooner or later.

Were we warned before?

Yes. The warning bell rang when the issue of willful defaulters and excessive NPL popped up in 2006. Then came successive banking fiascos with excessive risk taking and liquidation of Nepal Development Bank (in fact, NDB’s financial position was a headache a decade before it was liquidated). Then came the ceiling of salary of CEOs and real estate loans. It was followed by a warning about the impending financial disaster. The NRB knew it better than anyone else. But, it still waited too long to take decisive action. Now, the governor is showing strong resolution to tackle this issue. There will be pains in BFIs but ultimately gains to the country, if corrective actions are taken.

What have the central bank and government done so far?

It liquidated Nepal Development Bank and forced management changes and restructuring in couple of other troubled banks. It extended Rs 500 million loan against good loans and assets of Vibor. It capped real estate and housing loans. It regulated salary of CEOs to dampen excessive risk taking. Now, it has opened a special refinancing facility for 120 days with 7 percent interest rate (below the inter-bank lending rate). The commercial banks, development banks and finance companies can now receive refinancing facility up to 60 percent of their core capital to manage liquidity. Previously, the central bank was providing refinancing (up to 40 percent of core capital) only to facilitate lending in the productive sector at lower interest rate.

In 2006, major commercial banks were rattled by loan defaults, especially by big business groups and businessmen. Six banks identified 80 businessmen that had defaulted Rs 12 billion. They were blacklisted and various measures were taken to recover loans.

Is this enough?

No, it is not. The latest moves by the central bank is geared toward restoring market confidence and to calm down worried depositors, whose increasing anxiety might lead to run on of not only fragile BFIs, but also banks with strong deposit and loan portfolio management. The latest NRB move is just a band aid to a deeper problem. Such refinancing, whose ultimate guarantor is the taxpayer if the central bank fails to recover loans, is going to, hopefully, avert systemic risk posed by the failure of a handful of B and C category financial institutions. The core of the problem is that Nepal has way too many BFIs, which mushroomed like malls around the country.This came without a proportional increase in depositors base (according to a 2006 survey, only 26% of households have bank account). It meant cutthroat competition to entice the same customers  (depositors and borrowers) nastily and disastrously playing with interest rates.

What is the solution?

I think short term refinancing schemes are not going to solve the core problem.  Nepal will see many BFIs (especially B, C and D categories) going belly up in the coming days. This might be systemic and could engulf even the BFIs with healthy balance sheets. There are too many junk and subprime loans in the banking sector. Risks are not adequately diversified. It is a recurrent problem and is going to resurface within weeks of dry up of refinancing facilities. The Nepali banking sector needs a clean up and the janitor cannot be BFIs themselves who mistakenly believe that a refinancing would give them a chance to restructure their loan portfolio within a quarter; it has to be the NRB and the MoF.

The existing banking problem is not the usual yada yada about the banking sector troubles and refinancing schemes. It is much more serious than that. I think Nepal should have something like ‘Troubled BFI Relief Program’. It should be a unit under the NRB and the MoF with initial capital equivalent to total loan of BFIs in the two most exposed sectors or the total value of junk and subprime loans of BFIs. The NRB and government should chip in 90 percent and the BFIs 10 percent to the fund (may be it can be taxed on such loans; the source and amount of fund for this program has to be adequately discussed as it might be equivalent to half the annual fiscal budget if it is made equivalent to the amount of loan in the two most exposed sectors). The 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 a bank.

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 will be forced to undergo structural changes. The program could have authority to sell assets, change management, force merger or acquisition, hold majority of shares until it returns to a healthy state, and so on AFTER the BFIs knock on its doors for assistance. It should eventually lead to fewer and healthy BFIs (note that oligopolistic competition in the banking industry fosters stability and innovation) and averting a situation where profits are private but losses are social.The program can be made profitable if designed and operated properly. It won’t and shouldn’t be a burden to taxpayers.

A program like this one is needed because the NRB cannot simply extend loans and refinancing at the expense of taxpayers’ money and by increasing money supply. 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 on fine-tuning of banking sector. Unless a program like this is created Nepal will continue to see troubled BFIs and worried depositors anxious to pull their deposits out of the banks and purchase commodities like gold and silver. The refinancing schemes cannot solve the recurrent problem.

Sounds like a crazy idea, but something like this is needed in Nepali banking sector. We can’t afford to play cat-and-mouse game time and again.