Over three months have passed since the central bank rocked the commercial banks with seven directives issued in two installments asking banks to start complying to the new strictures by mid-July this year or face grave consequences. Though blamed by many for the continued tumble in the prices of bank shares in Nepal Stock Exchange pulling the overall stock index down, the directives are not debated much in the public. Nepal Bankers Association (NBA) and FNCCI both have separately submitted their suggestions to Nepal Rastra Bank (NRB) for revision in the directives, and pleaded for relaxation in the time frame for their implementation, but neither of them openly criticized the principle behind the new strictures.

The difficulty to openly oppose the directives is understandable as NRB claims that these are based on the internationally accepted banking norms of Basle committee. Still the bankers are grumbling that these stringent directives are fired on them without allowing sufficient time for adaptation, and that they are likely to affect their bottom line. But observers also claim that these are the vested interests voicing their displeasure. The indication is to those (bankers and borrowers) who are having a nice time with their easy access to public money. "Some businessmen in the past availed loans by virtue of their involvement in the banks and such accounts are in arrears for the same influence of these businessmen, leading to the present unhealthy situation of the banks", says one director in a bank venting his anger about his colleagues and expressing pleasure that the new directive would stop such practices from being continued any further.

Some bank managers also point out that the genesis of the present problems (relating to low capital adequacy, overexposure to a single sector and single borrower and ownership of more than one bank by a single business house) in the Nepali banks can be traced back to a certain period with a specific leadership in NRB. It was during this particular period that NRB acquiesced to banks flowing their loan to a particular sector (e.g. sugar mills and hotels) and to particular business houses. Five sugar mills (Eastern, Sriram, Basuling, Everest and Mahalaxmi) financed during that period are said to have a combined bank debt of nearly Rs. 2,500 million and all of this is bad debt. Likewise, both of the two big hotels of this period (Fulbari and Taragaon) are problem accounts with about Rs. 3,000 million as bank loan stuck in them.

Similarly, it was during this period that the central bank allowed for bulk share transfer of banks and permitted a single business house controlling stakes at more than one bank. And these are the very flaws that the new directives of NRB aim to rectify.

However, the bankers' grumbling is not so easy to push aside. Narendra Bhattarai, Executive Director of Nepal Bangladesh Bank and who recently took over as officiating president of NBA, says, though the directives seem to be brought out with a good intention of improving the health of the entire banking sector, it is like administering antibiotic to a patient in an overdose. Therefore, in the third week of July, NBA strongly put forward to NRB a number of demands asking for relaxation in the directives. Then FNCCI too submitted its suggestions that it had prepared long ago.

If implemented strictly, the directives require banks to increase their existing combined capital fund from Rs. 12 billion to Rs. 18 billion within the first quarter of coming fiscal year that begins on July 16, 2001. That is simply not possible to achieve, argue banks demanding more time for adaptation. According NRB's tentative data, as of mid-April 2001, the total deposits of Nepal's 14 commercial banks operating then were about Rs. 168 billion of which nearly Rs. 108 billion was used in advances and loans and Rs. 14 billion in investments. Together with an estimated Rs. 60 billion in other exposures, the value of total risk assets with the banks then could be estimated to be around Rs. 180 billion. As NRB requires 10% of the risk assets to be covered by capital fund by September 16, 2001, banks have to have Rs. 18 billion as combined capital. Moreover, the directives also require the capital adequacy to be raised up to 12% by F/Y 200-03. That is too high, Bhattarai told New Business Age pointing out that only two countries in the world have that high requirement ( Philippines and one Latin American country). NBA suggests the requirement to be reduced to 9% from 10%, to be achieved by mid-January 2002 which means the total capital fund targeted comes to only Rs 16 billion. It is also demanded that the banks be allowed to raise it to 10% by the fiscal year 2002-03 and 12% by 2003-04.

However, even if NRB agrees to NBA, the target still remains difficult to achieve because banks that were content of having 8% of their risk assets covered by their capital as required by the exiting rules, will find that (because of more stringent definition of capital and risk assets circulated by NRB with new directives) only about 6% of such assets are now covered by their capital. That means they have to achieve massive increase in their capital and that they have to do pretty fast. The difficulty will be the highest for the three banks that have negative or rapidly eroding capital base because of the losses in their P/L account. The NBA demand, therefor is to relax the definition a bit so that the loan loss provision made also for bad, doubtful and substandard category of loans will be allowed to be considered for the calculation of supplementary capital. In the March directives, NRB has said that only the provision made for 'pass' category of loans will be recognized for this purpose. According to NBA demand, these three categories will gradually be phased out for calculation of supplementary capital so that the provision requirement aimed by the directives will be fully adopted by Fy 2004-05.

Such relaxation will surely give a breather for the banks, but the challenges will not be much reduced, both for the banks and the central bank. Since the consequences the banks have to face in case of noncompliance of the directives are very strict (e.g. restriction on accepting deposits and distributing dividend, among others), banks are expected to be disparate to meet the targets. And for this purpose they will have to issue additional shares, which is not possible for them in the short-run. Or they do not prefer to go for additional share issue simply because they will also have to pay the same dividend as in the past to the holders of the shares so issued. This becomes the more difficult as the business is not going to expand commensurately. The difficulty is understandable now when every banker is complaining of the lack of new investment projects.

Under such a condition, the other options open to the banks is to stop advancing loans so as to reduce the size of risk assets, be stricter in realizing the loans and stop distributing dividend so as to increase the capital fund. As a result there will be more funds with banks and it will be followed by still further downward revision in the already low interest rate to depositors. On the other hand, interest rate on loans will go up so as to reduce the size of risk assets. Consequently, the economy may face a situation of cash shortage if the transition to the new banking order is not properly guided. And this is the reason why FNCCI also started its lobbying recently though its recommendations were prepared weeks ago.

In another consequence, when banks will not be in a position to declare dividends, the share market will crash, because almost all of the active stocks in Nepal Stock Exchange are bank shares. The early warning signals of such an eventuality are already there, say bankers showing the trading figures of Nepal stock exchange as most of the bank shares were rapidly losing their price recently. The program needs very careful monitoring of the situation by the central bank, and people doubt whether it will pass this test given its track record.

One such monitoring problem is related to banks granting loans to clients blacklisted by other banks. The problem lies in sharing credit information among the banks. Under the existing mechanism, which is found not effective for the purpose, the Credit Information Bureau (CIB) within NRB collects the information and prepares the list. NRB's new directives require that the loan provided to a borrower blacklisted by CIB be categorized as 'loss' requiring higher amounts in provision for loan loss. Banks argue that this discourages them from blacklisting the defaulters. Regarding another point of the directives that requires the banks to classify as 'loss' those problem accounts that are under the process of legal action for auctioning the collateral, banks argue that it also discourages banks from initiating legal action, and thus the recovery will be badly affected.

The new directives also try to put a stop on the misuse of rescheduling and restructuring of old loans. This is a very important banking tool meant for some nobler purposes, but was heavily misused in Nepali banking sector as an window-dressing tool so as to avoid the burden of heavy provision for loan loss.

Another major problem with the new directives of NRB is in the single obligor limit which is to be brought down to 40% of the core capital by mid-July 2002. Though the requirement is quite logical (i.e. to protect the banks from being overexposed to a single business house), bankers complain that the definition of single obligor as given in the directive is simply not possible to monitor. Moreover, as the existing such limit is based on total capital, changing the base to core capital has made it very harsh, they argue and demand that the funded facility against fixed deposit receipt, government bonds and bank guarantees be excluded for arriving at the relevant percentages. Moreover, the definition of 'group of related borrowers' should not include public limited companies.

Bhattarai has yet another very serious point to make. One of the new directives requires the banks to account interest income on cash realization basis while the interest expenses are to be accounted on accrual basis. "This is clearly against the international accounting standard, fundamental accounting principal (matching principle) and country's income tax law", said Bhattarai who is a Chartered Accountant by qualification. NBA suggests that the income be recognized on one month deferred cash basis. Similarly, the requirement of the directive to charge bad debts to P/L account should be deleted as this is not permitted under the existing income tax law, says NBA.

According to the directives, banks have to publish in national level dailies the entire balance sheet, profit and loss account and cash-flow statement along with the specified 28 schedules. This "is very onerous", wrote NBA to NRB on May 2nd reacting to the first four sets of directives. NBA says that it should be sufficient if the banks publish nine specified schedules with the balance sheet and the P/L account. Still the daily newspapers can expect good business thanks to this provision though the opportunity will come only once a year.

Banks have objection also on the points of the directives related to the good bank governance. The central bank tries to hold a lot of control over the banks through these directives which require, among others, permission from the central bank for the appointment and remuneration of the bank CEO. And NRB also retains the right to dismiss any bank director if found not complying to the law and NRB directives. NBA wants to simply intimate NRB about the new appointment of CEO and any other exceptional developments.

The NRB directives were prepared in a haste, it seems. One of them was such that requires a bank CEO to be experienced in both in banking and non-banking field at senior level. Obviously, NRB intends to say that people with experience in either of the two fields would be acceptable. But the actual phrasing means something different, giving a further point for the bankers to complain with NRB. They want the word and replaced with or.

In another point regarding bank management, NRB directive put the ultimate responsibility of the activities of bank employees on the directors even when the authorities may be delegated to the employees. Such a rule would lead to the practice of centralizing authority and as a result the efficiency of bank management would suffer, the bankers argue, and want the word 'ultimate' be removed from the directive.

Despite the adverse consequences that the bankers say are likely to the economy and the banking sector, both NBA and FNCCI demand more phased out implementation of the directives, not daring to ask for outright cancellation. Banks are well aware that these rules are going to be enforced sooner or later, as these constitute an integral part of the financial sector reforms program which in turn is one part of economic reforms program being pursued with assistance from donors led by the World Bank. More importantly, future assistance to Nepal from donors is subject to such reforms. For that reason NRB officers say they are not going to amend the directives at all, though they also indicate possibility of time relaxation. "However, there will be no change in the basic parameters such as provisioning requirements, loan classifications, capital adequacy requirement and definitions of single obligor", said one NRB officer. This is in spite of repeated meetings with bankers over the directives, the added.

But whether these NRB directives are meant to be actually implemented is still doubtful. Going by the letters of the directives, three banks (Nepal Bank Ltd., Rastriya Banijya Bank and Nepal Bank of Ceylon) are to be banned from accepting deposits and extending loan, because they have negative or dwindling capital base and thus cannot meet the capital adequacy requirement. If such an action is really taken against them, the economy will really have a fund crisis, particularly because Nepal Bank Ltd. (NBL) and Rastriya Banijya Bank (RBB) are the only banks that have branches in most parts of the country. On the contrary, if NBL and RBB are spared the axe on the pretext of their so-called long history and contribution to the backward regions, the other banks too will start devising similar pretexts of their own and the very objective of the directives will be defeated.

Though a separate package is to be implemented for the rehabilitation of these old and dilapidated banks (declared "technically insolvent" by KPMG Barent Group in its study report submitted last year to Nepal Rastra Bank) by employing foreign consultants in their management, the package is being delayed, according to reports (see Business News column in this issue).

Still, these reasons should not be allowed to block the implementation of the new directives, opine banking experts. But there is still the possibility of resorting to so-called "judicious selection of cases" which effectively gives space for the authorities to bend the rules. The risk of such misuse of the discretionary power is very high as most of the banks have representatives from the government or NRB in their boards, and their so-called "good offices" are likely to be utilized to win such favours.

It leads to another aspect of banking reforms. As is being reported, steps are being taken to stop sending NRB and government representatives as directors in the banks and financial institutions. Similarly, the institutional reform of NRB itself is to be effected under the same package to strengthen its monitoring capabilities. An effective implementation of NRB's recent directives can be expected only when all the components of the reforms package are in place.