Friday, July 5, 2013

Financing conundrum: Capital, lending and merger in Nepal

An explanatory analysis, by Rupak D Sharma, about the issues surrounding the regulatory requirement to increase capital, financing (earning) requirement to increase lending, and at the same time ensuring higher cash dividends for shareholders. The message is that, as of now, consolidation of BFIs is the most viable path for a competitive and healthy banking sector. 

Excerpts from the article:

[…]sudden hikes in interbank rates – which clearly indicate credit tightness in the banking sector -- could precipitate a decline in private sector investment, make the banking and financial sector unstable, and eventually affect the real economy.
[…]commercial banks need to maintain a capital buffer -- known capital adequacy ratio -- of 10 percent. These ratios -- which are measures of the amount of capital held by banks and financial institutions in relation to risk-weighted credit exposures -- stand at 11 percent for development banks and finance companies.
[…]these buffers ultimately protect the interest of depositors, who park hard-earned money in banking institutions, and prevent financial risks from building up in the country’s banking system.
[…]however, the level of these buffers at banks and financial institutions has been gradually declining. The average capital adequacy ratio of commercial banks stood at 11.30 percent as of mid-April, according to Nepal Rastra Bank’s latest report. Although the figure shows holding of an extra 1.30 percentage points of capital fund by commercial banks, the discomforting part is the regulator’s instruction to maintain a capital buffer of at least 11 percent to be able to distribute cash dividend to shareholders.
[…]banks are currently operating with very little extra capital, which is constricting their ability to lend.
[…]Although one may argue there is not much credit demand these days due to the not-so-encouraging investment climate, banking institutions will gradually need to stimulate lending to meet the country’s target of attaining a seven percent growth rate till 2022 to graduate from the category of least developed country to developing country. And data shows there is ample room for credit expansion, as lending of banks and financial institutions as a percentage of GDP currently stands at only 59.2 percent.
[…]if the regulator asks banks to raise paid-up capital to, say, Rs 5 billion within the next three years, and to Rs 10 billion within next seven years, then this technique might not work for all, as many may not be able to earn such huge profits in such a short period of time.
[…]other options for raising capital, such as, asking promoters to inject cash, mergers, or leveraging -- that is issuing corporate bonds.
[…]Currently, many promoters are not as enthusiastic about putting money from their own pockets as return on equity is gradually declining. At the end of the third quarter of the current fiscal year, the average annualized return on equity of commercial banks stood at 14.75 percent as against around 20.66 percent around three years ago. This is because of fierce competition.
[…]This leaves banks and financial institutions with the only option of merger to raise capital, which is probably the fastest way of meeting the minimum regulatory capital requirement.
[…]merger of institutions with very little free capital would only expand the balance sheet size of the consolidated units without addressing the problems that can raise the specter of credit crises and ultimately destabilize the financial sector and the economy.
[…]This, however, does not mean mergers are ineffective in solving many problems faced by banking institutions, as they can expand single obligor limit that allows lenders to give bigger-sized loans to single parties. Mergers can also reduce operating cost, including fixed costs like salaries.

For a brief note on the financial sector vulnerability, see the policy challenge section of Asian Development Outlook 2013 Nepal chapter.