Thursday, June 16, 2011

Core of banking crisis in Nepal: BFIs bubble & real estate and housing bubble

  This was published in Republica daily. Here is a detailed discussion on the same issue.

Core of banking crisis in Nepal

The depositors in the banking sector are worried about the course of its future, while the borrowers are anxious about arbitrary increase in lending rates, forcing them to incur an unexpected increase in the cost of production. The bankers are worried about possible run on their bank and an increase in defaults. The government and Nepal Rastra Bank (NRB) are scurrying to avert a ‘Lehman moment’ in the Nepali banking industry. A thick cloud of uncertainty, impuissance, vested self-interests, and a lack of leadership is hovering over the banking industry in Nepal, whose soundness largely determines credit flows and monetary stability in the nation.

Since all stakeholders pretty much have vested interests in the banking industry, they are finger pointing at each other while dodging the blame pointed at them. The core of the problem is the fact that we have too many banks and financial institutions (BFIs) unhealthily competing for the same customer base without innovation and adequate research. The Nepali banking industry has to go back to oligopoly which is characterized by few banks but many depositors and borrowers market structure if things are to get normal.

At present there are over 295 BFIs including 31 commercial banks, 78 development banks, 79 finance companies and 18 microfinance institutions. In 1983 and 1993 there were two and eight commercial banks respectively, and by January 2006 there were 17 BFIs including joint ventures. Meanwhile, there were four development banks in 1993 which swelled to 29 in 2006. Finance companies came into existence in 1992 and, by January 2006, they numbered 63. This unnatural growth not justified by our economic fundamentals has come about without a proportional increase in depositor base. Note that a 2006 study on financial penetration shows that only 26 percent of households in Nepal have bank accounts.

You might be wondering what the problem is if economy has many BFIs. Well, this is the root cause for an existing liquidity crunch and an impending financial disaster for which the country seems to be awfully unprepared. Just on the basis of capital requirements the central bank has allowed too many financial institutions to pop up. Each successive year BFIs were given license to operate without considering the market condition. Businessmen and corporate houses established BFIs under their own brand names. Similarly development banks and finance companies were established without differentiation in services offered, regional operation, and customer base.

Opening a BFI became a lucrative business for many businessmen and corporate houses. Instead of borrowing money from established financial institutions, they used money from depositors to finance their own investments and encouraged many investors with doubtful creditworthiness to take out loans to invest in real estate and housing. Meanwhile, with hopes of landing on a lucrative private sector career, near-retiring officials at the NRB and Ministry of Finance (MoF) turned a deaf ear to the need for strong supervision. It led to mushrooming of BFIs in the country without commensurate strengthening of regulatory and supervisory capabilities. Our policymakers and regulators created a banking bubble.

A large number of BFIs and limited depositor base meant nasty cut-throat and unhealthy competition in the banking sector. The BFIs courted and coaxed the same institutional, government and individual depositors to park money at their institution by offering unusually high interest rates. In fact, there was, and is, an informal war among the BFIs to offer high interest rates on deposits. It comes with a pressure to adequately reward the depositors and shareholders in time. As there were limited investment opportunities due to prolonging political instability, the BFIs pumped a large quantity of money in a few sectors, mainly real estate and housing, from where quick return seemed highly probable. In effect, the BFIs created a bubble in these sectors. With easy loans from BFIs and increasing inflow of remittance, some agents deliberately jacked up prices each day, and hedged and speculated multiple times on the same piece of land and house. It is a tragedy that policymakers created a banking bubble and the BFIs created real estate and housing bubbles.

Alas, this bubble is losing air right now and is putting the BFIs in the red as they are unable to recover loans, especially the junk and subprime ones. The BFIs (B and C category) are low in cash to payback depositors. The inter-bank lending rate is as high as lending rates of BFIs. The situation is worsening so much that the BFIs themselves are hesitant to lend each other any amount of money.

The high number of BFIs and the ensuing cut-throat competition to meet profit targets and to dole out more loans means that there is a need for more liquidity than that which is normally warranted by the market. This is compounded by the failure of subprime borrowers to honor interests and principals on time, mainly due to decreasing real estate and housing prices. Unfortunately, it is leading to a situation whereby BFIs are giving more loans in order to enable borrowers to payback previous loans. Without progressive changes in banking fundamentals there is a need for higher liquidity just to float the BFIs from sinking, thanks to their own risky loan portfolios. The otherwise normal liquidity situation is made worse by sheer multiplication of the number of BFIs along with unsustainable and unhealthy competition. Our financial market is in a vicious cycle and a deadly crash course.

Hate it or love it, the policymakers have to let fledging BFIs file bankruptcy and initiate due process for liquidation. No doubt, there will be pain, but moving in the process of consolidation of BFIs is the need of the hour. The rampant adverse selection and moral hazards prevalent in the banking sector has to go with a decrease in the number of BFIs. Evidence shows that countries that had few BFIs with strong regulatory and supervisory capabilities like Canada and Australia escaped the financial crisis pretty much unharmed. Few strong BFIs and strengthened regulations and supervisory bodies are in the national interest of Nepal. This will eradicate unhealthy competition to some extent and foster innovation as well. At present too many BFIs are competing with each other to attract the same depositors leaving little or no room for R&D and innovation.

The core of the problem won’t just magically vanish by simply brining out refinancing facilities time and again. Nepal has to let go troubled BFIs and force mergers of BFIs with questionable balance sheets. This has to happen through a new program dedicated to looking after troubled BFIs. Or else, bankers will continue to gamble with the depositor’s money as long as they can. In a sensitive sector like banking, a rush for short term profitability over long term viability and sustainability signals disaster for the entire economy.

[Published in Republica, 2011-06-15, p.6]