Demystifying Nepali Banking

Going by the fact that the service sector is open for foreign investment in only a few countries, Nepal can be considered much liberal as banks and finance institutions are opened for foreign investment for quite a long time now. As a result, the country now has 16 commercial banks – an enviable number even for economies much larger than Nepal. And the result is a lot of improvement in the banking facilities in the country (see a following article by Rabindra Man Shrestha). But the improvements are also accompanied with a number of anomalies.

Till a couple of years ago, any new bank opened in Nepal would be a joint venture with a foreign bank, even if such a foreign bank would be from a third world country like Bangladesh, India, Pakistan, Thailand or Sri Lanka. This trend now seems stopped, and also reversed. A couple of new banks were opened during the last four or five years, but none of them is bragging of any foreign collaboration. Moreover, some foreign banks have withdrawn their investment from Nepal.

While some analysts, such as Dr. Yuba Raj Khatiwada (who is now a member of the National Planning Commission and was the Executive Director of the Research Department of Nepal Rastra Bank, the central bank while this report was being prepared), think that the departure of the foreign banks has not caused any serious disadvantage to the Nepali economy (see interview in the box), there are some other observers who also see the withdrawal of foreigners as the result of some anomalies in the Nepali banking sector irrespective of what the withdrawing foreign bank would say officially to the Nepali authorities or the general public.

Meanwhile, the authorities are also going on with their campaign to bring the two largest and oldest banks of the country back to their health. One of them is in the hands of the foreign management, and the sources close to the foreigners say that they are indeed facing some very strange situations in managing the bank because of the intricacies of the Nepali social relations and the legal infrastructure which have a bearing on the portfolio management. Similarly, the central bank has also come up with a number of prudential banking norms for the banks to observe, though there are doubts expressed about the ability of the central bank to implement them effectively (see the excerpts from a report of the World Bank in following pages). In this context, an analysis of the present state of the affairs may be relevant.

And one of the bases for such an analysis would be this World Bank report. Though the report is general in its comments, we have gleaned some case examples (see below) consulting the analysts of the sector that prove the generalization.

• l   Banks are credit orgnisations based totally on the creditability of the people behind the organisation. But there is a commercial bank in Nepal (one of the very oldests and biggests) in which 50% of the shares are owned by a single party – an offshore company. But the general shareholders and depositors do not know who the real owners are of these majority shares, though the grapevine says the offshore company is owned by a Nepali business house. A mockery of transparency in banking that the NRB people say, they are trying to bring about!

• l   Two of the commercial banks are headed by ex-governors of the central monetary authority though the rule clearly prohibits this. There are examples of other former governors and senior officers of the central monetary authority getting significant shares in the commercial banks they helped to set up during their tenure in the central bank. It is regarded that these shares are received in exchange for the favours granted from their official position.

• l   Nepal Rastra Bank (NRB), which is the central monetary authority of the country, recently took over the management of one commercial bank alleging that the previous management did not observe the directives of the central bank and that it was indulging in practices which undermined the interests of the ordinary shareholders. The person appointed to head the new management is an employee of one of the major promoters of the bank (who was not in good relations with the previous management) and a protégée of the governor of the central bank.

• l   When one of the major promoters of a big bank (Mr. B) sold his stake to one of the existing promoters of the same bank (let’s call it bank A) the seller went to buy controlling stake in one of the other prominent commercial banks. In the process a couple of norms and rules were violated. For example, the buyer of the shares in the first bank (A) increased his stake to over 10% in it though such increase in the stake is against the rule. This was possible because he bought the shares indirectly. The shares were owned by a firm which was owned by the seller (Mr. B). He sold the firm to the buyer, who now controls both of his original shares as well as the shares now controlled by the firm that he has acquired.

• l   One of the banks owned by a business house is notorious across the business community and the general public for multitudes of anomalies. Still, the authorities do not take any action against it. The secret lies in that it has given employment to the son of one senior official in an anti-corruption body and to the wife of a senior officer of the central bank.

• l   The auditor of a new bank noted in his report that he was not able to comment on the authenticity of an amount of Rs. 15,031,705 written off by the bank management as expenditure because there were no supporting documents to prove that the amount was actually spent. The banking sector grapevine says that the amount was paid to various officers of the central bank to get the licence. It indicates that the public perception of a bank licence costing Rs. 15 million is right. The auditor who questioned the authenticity of the payment was penalised by not appointing him auditor for the next year.

• l   Sanchaya Kosh (The Employees’ Provident Fund) has almost 40% of its assets as NPAs. One of the main reasons is the Fund’s participation in consortium financing with NBL, RBB and NIDC. The projects of such consortium financing are Radisson Hotel, Gorakhkali Rubber and Fulbari. Since the Fund holds about 20% of the total deposits of the entire banking sector, any negative effect on its financial health will bring down the entire banking industry of Nepal. This is in addition to the fact that it is a social security fund.

• l   A family that now controls more than two banks had taken a loan from Himalayan Bank Ltd. some ten years ago against a guarantee from Agriculture Development Bank. As the group did not pay the loan, ADB had to pay it and ADB still carries the account as an NPA. Many of the people who were at the senior position in ADB then are now working in one of the banks owned by the family that borrowed the loan.

Though there also are very good banks in Nepal, these cases indicate the risk that these good banks are exposed to because the problems in the banking sector are contagious.

Banking sector observers say that Nepali banking industry is now very much under the grip of the mafia. That is the reason why the licence for a bank started commanding a premium price as indicated in a case listed above. And banking is the most lucrative business today because it is the easiest business, as can be seen from the same case examples. Some banks have been earning more than 100% return on capital and paying 100% cash dividend. Since the stock exchange in the country is not developed enough to offer competition to the banks in collecting funds, they are getting low cost deposits. They are also collaborating as a cartel to fix the exchange rates and interest rates. Though Nepal Bank Ltd. under the new management has somehow broken this cartel by fixing its own foreign currency exchange rate, this is a very recent development and it is yet to be seen how this is going to be sustained in the future.

Nepal Rastra Bank (NRB) has been coming up with different directives to the banks and other financial institutions. But there are doubts expressed about both the efficacy of these directives on the one hand and the intention itself of NRB. Efficacy of the directives is in doubt because, as the World Bank report also notes, the NRB does not have the required capabilities to monitor and enforce the compliance. Some bankers also question the intention of NRB in case of some points of the directives. In some instances, the central bank official have come up with stringent directive while a better monitoring would have sufficed. It seems, NRB officers just want to protect themselves. In case any instance of lapse in their monitoring comes up, they may hide behind the point of the directive.

The World Bank report depicts NRB as a toothless tiger that can only growl. Though the recent amendment in the NRB Act has made it more powerful and oriented it more towards monitoring activities, it is still handicapped by the lackings in many other relevant laws. The details that are listed in the following pages about Nepal Bank of Ceylon (NBOC) – which is now turned into Nepal Credit and Commerce Bank (NCCB) – are well-known to NRB as most of them are gleaned from reports of NRB itself. However, a couple of instructions issued by NRB to this bank are still waiting compliance and NRB has not been able to do anything for such non-compliance. Though a Himalayan Bank executive has tried to explain his bank’s position regarding the report by the central bank, NCCB officials refused to furnish any reply to our questions.

Recently, NRB completed detailed studies on various aspects of management in three banks – Himalayan Bank Ltd., Bank of Kathmandu Ltd. and Standard Chartered Bank Nepal Ltd. However the report about Himalayan Bank alone is in circulation for some time. Therefore its highlights as well as the reaction of the bank’s management are presented in the following pages. According to NRB sources, the central bank is about to take some decision regarding this report on HBL very soon – probably within the week of November 11-15. However, it is believed that whatever the NRB decides and instructs., one likely scenario is that the instruction will not be complied with by the bank concerned, as has been the trend so far.

Thus, the most important conclusion that can be drawn from the story is that reforms in the government-owned banks only will not be sufficient; similar package is required also for the private sector banks. The sooner the therapy is started, the better.

NPA & Private Banks

One recent news report quoting a study by Nepal Rastra Bank and Nepal Banker’s Association has informed the following about the non-performing assets of Nepal’s banks (though the banks when contacted have claimed the NPA to be much lower):

“Liberalization wasn’t done in a proper sequence” Yuba Raj Khatiwada Executive Director Research Department Nepal Rastra Bank, and President , Management Association of Nepal With so many banks in operation and also the finance companies, the natural expectation would be reduced rate of interest on banker’s lending and higher rate of interest to the depositors. But that has not happened in Nepal. What may be the reasons? The intermediation cost or the spread between lending and deposit rates of the banks and financial institutions used to be even more than 10 per cent for some institutions in the past. It has now come down to less than 5 per cent, on average, following the entry of more institutions into the financial system. However, it has not come down to as low as 2 or 3 per cent as is expected under a competitive financial environment.  The reasons are many. First, the financial system is still segmented with each type of institution specialized in certain services and no evolution of universal banking practice so as to introduce more competition. Second, the inefficiency of the two large commercial banks in which there is government involvement, has protected the other banks not to reduce their spread beyond what is prevailing in those inefficient banks. And third, the liberalization of the financial system was not in a proper sequence; we should have first restructured and reformed the banking system before deregulating interest rate administration. We did the otherwise and paid the ‘price’ by having oligopolist banking system. What are the anomalies that you see in the banking system of Nepal at present? First, there has been quantitative growth of the banks, but service diversification is yet limited. Conventional banking practices dominate many banks. Second, credit flow has increased but a large portion of the credit still finances trade and commerce. Agriculture, rural activities, and small business still remain neglected. Third, growth of non-performing assets (NPAs) has been faster than the growth of credit.  Fourth, management is not professional for many banks; they seem to be run by the strength of capital, not by the expertise. Fifth, even joint ventures particularly those with some South Asian banks, have not delivered desired outcomes. And sixth, every bank seems to go after a few lucrative business sectors or business houses and go for undue price war. This has disproportionately benefited a few business people at the cost of a larger section of the population. What are the problems for NRB that hinder it from effectively addressing these anomalies? NRB is part of the system. If governance as a whole is under problem, NRB alone cannot stand strong. There are legal, institutional and political reasons behind this. It is only with the enactment of the new NRB Act 2002 that the Bank got autonomy from the government. Still institutional strength is weak. In the past, the Bank went on licensing new institutions which was disproportionate to the growth of NRB’s institutional strength to regulate and supervise these institutions. Now, the weakness has been realized and reengineering of the Bank is in order. New regulations are in place, supervision has been streamlined, and human resource development is taking place. This would improve things in future. How effective has been the micro-financing system to address the financing needs of the rural areas. It is encouraging, although the coverage is limited to only a small section of the rural areas. The rural credit survey indicates that credit demand in the rural areas is at least Rs 40 billion a year. But micro finance institutions are catering not even Rs 5 billion a year. In particular, medium to large size credit demand in the rural areas is not met by any institution for the simple reason that commercial banks are retreating from the rural areas and, except for limited financial cooperative activities, no alternative institutions exist there. Micro finance is serving small loan demand of the selected areas and the rest of the country is still dependent on the informal system. Irrespective of the limited coverage, the outcome in terms of income and employment generation, social transformation and empowerment has been meaningful. However, high operating expenses, loan loss, and resource constraint has impeded the expansion of micro credit institutions. How is the situation about the enforcement of the prudential guidelines to the banks? The performance regarding capital adequacy, loan classification, loan loss provision, single borrower/sector exposure, accounting and auditing standard, disclosure, income recognition, profit distribution, code of conduct for the board and the manager, etc. are monitored regularly. Except for capital adequacy, there seems to be no reason why the regulations cannot be adhered to and in fact they are being adhered to. No doubt, for the two large banks, namely the RBB and NBL, adhering to the prudential norms has been difficult. How do you analyse the exodus of foreign investors from the banking sector of the country? Is not it a reflection of the lack of confidence of the foreign investors in the regulatory environment of Nepal? I do not think the exodus of the foreign banks from the banking system is due to loss of their confidence in the Nepali financial system. The Emirates Bank or the Grindlays Bank went for their own reasons. Bank of Ceylon withdrew just because it could not achieve the expected outcome everywhere. Credit Agricole’s case was a bit different and it was our delay in decision which discouraged the bank to remain in business in Nepal. It is an irony that, except for a few, we could not attract good banks as joint venture in Nepal and even if they go, we are not going to lose much. Regarding the asset management company (AMC) that is going to be set up, how can we expect that a single such company will be dealing fairly with the banks? For example, how can you be sure that the price that the AMC offers to the banks for the NPA that it is taking over will be fair? AMCs have a mixed outcome everywhere. In many countries AMCs are the vehicle to shift headache from the government to the institutions created by itself or in association with the private sector. Besides, AMCs would be successful if the loan is backed by safe collateral and if the collateral has marketability.  No doubt, the transfer of the NPAs from the banks to the AMCs would help restructuring the balance sheets of the banks and make them viable entities. There are threats of monopoly pricing and moral hazards also. Despite this, if the large non-performing loan portfolio of some of the banks in Nepal is to be cleaned, there is no alternative. To ensure that the property of the government (owned by the banks) is not disposed at a throw away price or the asset management company does not exercise undue monopoly power to exploit the banks, government involvement in the process has become essential in Nepal. Cannot the banks be forced to make more detailed disclosure regarding their NPAs? Or cannot the NRB itself make such disclosures? There is no doubt that the banks have to be transparent in their accounts including NPAs. There are strict regulations to this. The supervisory authority, i.e. the central bank is cognizant of the NPA position of each bank and makes disclosure of the situation in aggregate. However, the central bank should not go for individual banks in disclosing this. It is up to the bank that it makes its accounts transparent to the stakeholders. And, if even the audit of the accounts of the banks has not been completed for the last couple of years, enforcement for NPA disclosure requirement is still a distant dream.

Deficient Banking Supervision A June 1999 assessment by the World Bank of Nepal’s compliance with the Basel Core Principles for Effective Bank Supervision concluded that Nepal Rastra Bank fails to comply fully with two-thirds of the criteria and is unable to fulfill its supervision mandate. Moreover, almost none of the preconditions required by the Basel Committee exist in Nepal – an adequate legal framework and judicial procedures, sound accounting principles and auditing practices, a market-based banking business, exit and crisis management policies, and deposit insurance and safety net scheme. The accumulated weakness of the central bank inhibit management from taking action against problem banks even when the potential consequences of inaction are serious. The institutional setup for supervisory functions within Nepal Rastra Bank is also less than ideal. Responsibility for supervision is shared by four units, under two different deputy governors, and cooperation between them is weak. In addition, the central bank has limited capacity for supervisory work. Its staffing policy ensures the recruitment of qualify staff, a good mix of MBAs, chartered accountants, and economists. However, promotion is driven by seniority, staff are not appointed on the basis of merit and competence, and the salary scale is tied to low public sector levels – all of which have undermined morale and performance. Moreover, the central bank’s policy of rotating staff among departments has been counterproductive; effective supervision requires stability to foster commitment among officers and allow them to develop skills, master techniques, and acquire experience. Off-site surveillance of financial institutions does not exist as a specific function. Reporting of information is neither timely nor comprehensive enough to permit a full analysis, and the integrity of the data remains doubtful. Most data are excessively delayed and, if collected, are not analyzed. The central bank imposes no sanctions for late reporting and has not enforced penalties for non-compliance with regulations except for those relating to the cash reserve ratio and directed lending. Supervisors do perform timely monitoring of the cash reserve ratio, interest rate spread, and priority and deprived sector lending, but none of these is a prudential issue. If supervisors spot a problem, they request additional information from the bank, essentially so that they can cross-check the data. If the problem remains, a penalty is finally debited from the bank’s account with Nepal Rastra Bank. (From "Nepal Financial Sector Study Report", the World Bank, October 16, 2002)

From NBOC to NCCB

Nepal Bank of Ceylon Ltd. (NBOC) has now turned into Nepal Credit and Commerce Bank Ltd. (NCCB). But the problems of the bank due to the classic cases that this bank provides in banking sector anomalies are still there.

This is the largest commercial bank of Nepal in terms of paid up capital (Rs. 350 million), but this is also the only private sector bank with negative net worth, which means that it is running in loss and eating up the paid up capital.

NCCB was set up as a joint venture with Bank of Ceylon of Sri Lanka. But the Sri Lankan party has divested from the bank now, selling its stake in the bank to the local partner - the NB Group of Nepal, which already owns another commercial bank – Nepal Bangladesh Bank – and has decisive stake also in Nepal Bank Ltd.

NB Group is one of the very rare but most fortunate business houses of Nepal that has substantial holdings in more than one financial institution. NB Group controls two commercial banks (NCCB, NB Bank) directly. It has substantial stake in Nepal Bank Ltd. through NCCB, which owns enough shares to put one director in NBL board.

NCCB’s major client is NB Group itself and the Group’s subsidiaries. These borrowers pay the loan by issuing cheques on empty accounts they hold with NCCB itself. The Bank buys those cheques and adjusts the loan accounts of the borrowers. This way the loan accounts of the borrowers are clean qualifying them as best quality loans. Thus the need to make hefty loan loss provisioning is avoided though the loan would be accumulating in the other accounts of the companies. However, these tricks in window dressing have not helped the bank in reducing the accumulated losses which are eating into the capital base of the bank.

The existing rules say that the promoters of a bank cannot sell their shares in the bank before selling shares set aside for the general public. But the central bank was generous to remove this restriction in case of NCCB when the Sri Lankans sold their shares to NB Bank. The bank has not issued the shares to the general public as yet, but the officials in the bank say, it is now readying to do so very soon. The gullible nature of Nepali people may help the NCCB promoters. As the World Bank report (the excerpts from which are presented later in this sector) notes, the prices for shares of Nepal Bank Ltd. (NBL) had actually gone up when there was a report that a foreign consultant team would be entrusted its management. While it was only one possibility that the bank would get a foreign management, the hard reality was that the bank was declared technically insolvent by another foreign consultant (KPMG Barents).  Since the naïve Nepali investors were ready to pay higher even for the shares of a company such as NBL which was declared insolvent by international experts, similarly they can be expected to buy share also in NCCB which is in fact running in losses.

How NCCB got the berth on NBL Board has one interesting story. In fact NCCB does not hold enough shares on its own to be in NBL board. But it has formed an alliance with Nepal Insurance Company Ltd. (NICL) with which it has a Memorandum of Understanding signed providing for rotation of NCCB and NICL representative to be on NBL board. But NICL has not got the opportunity to send its representative to the NBL board as NCCB has usurped the right of NICL.

Interestingly, NICL itself is a subsidiary of NBL and the story of how NICL and NCCB could form the alliance to hold the shares in NBL is again interesting. It was thanks to the good offices of Gauri Lal Shrestha, the then General Manager of NBL. By virtue of being the NBL GM, he was also the Chairman of the board of NICL. The decision to buy shares in NBL in alliance with NCCB was taken by shrestha himself without consulting the NICL Board, say the sources. Shrestha was later made the General Manager of NCCB after he retired from NBL and it is said that this appointment was a reward for the services he rendered to NCCB in acquiring the crucial NBL shares.

Despite the good services he had rendered, Shrestha was removed unceremoniously from the General Manager’s position of NCCB a few months ago, and it is said that he is not in good health (he was not accessible to NBA to confirm the rumour) because of the psychological pressure he had to suffer under incumbent Chairman of the Board of NCCB, L B Shrestha, whose style of ‘management by psychological torture’ is attributed also to the loss of mental balance by two of the Sri Lankan representatives in the bank’s management in the past.  Reports say one ex-MD TVK Jayasuriya committed suicide by throwing himself under the wheels of a running train in Sri Lanka, while another ex-MD UO Jayaratne is said to be living with paralysis.

The high level Sri Lankan professionals lost their mental balance because they were made silent spectators of what was going on in the bank as all the recruitment committee, credit committee and management committee were controlled by NB Group while the Sri Lankans could do nothing. Jayaratne tried to please NB Group by doing every thing the group wanted. It was him who released the mortgage on Harisiddhi Brick’s land where there is NB Colony being constructed now. But the professional could not live comfortably with the guilty conscience later, it is said.

CEO turnover in NCCB is very high. Between October 2001 and October 2002, the bank had six persons as CEOs from Sri Lanka.

As a Director of Nepal Bank Ltd. Laxmi Bahadur Shrestha (LB) of NB Group (who is at present the chairman of NCCB) got approved a consortium loan of Rs. 100 million on the name of a hydropower company which is a subsidiary of NB Group. Though LB later presented legal documents showing that he was separated years ago from the family, the observers question his morality. The interesting thing about it was that the appraisal of the project was done by NB Bank in which NB Group has controlling stake. In fact, LB himself participated in the first few consortium meetings of the project as the representative of his family (i.e. as the executive director of the NB Group). The loan was directly approved by the board of NBL without the recommendations from the Business Promotion Sub-committee of the bank, which was normally required under the procedure of the bank. The sub-committee had discussed the hydro-project for nearly six months but had not recommended to the board, this implying that it was not a bankable venture.

NCCB bought the shares in Nepal Bank Ltd. at a price of around Rs. 1,200 per share whereas the going rate for the shares then was much lower than that. The objective was to be on the NBL board. The shares now are priced at less than Rs. 300. Even if LB and his family had not figured out in advance how to recoup such a loss, they started doing so by forced loans to a number of the Group’s subsidiaries including the hydropower company, say the observers.

LB is very much enthusiastic to develop the hydropower sector. Recently, he got Rs. 50 million approved from his bank to a hydropower development company owned by his nephew.

When the Sri Lankan investors withdrew from NBOC selling the shares to the existing local partner, NB Group, the buyer paid the foreigners by borrowing from NBOC itself, much like in the case of Harisiddhi Bricks & Tiles Factory. As may be recalled, when the group acquired the factory under the privatization process some 10 years ago it paid the government for the factory by borrowing from government owned banks and banks controlled by the group against the collateral of the factory's property. So if the factory goes bankrupt, NB Group will not be affected.

NCCB is suffering also from technological weaknesses. It uses Bancs-2000 as the system software but there is no sufficient technological back up in the bank. The system department is manned by only two persons.

Now the bank has made some management change bringing in Narendra Bhattarai as the CEO. Bhattarai is regarded as an efficient bank manager, looking at the track record of NB Bank Ltd. that he was previously managing. Though NB Group has controlling stake also in NB Bank, this has not affected that bank’s performance that much as in NCCB. For this the credit goes to Bhattarai who could resist the NB Group’s pressure very much though not entirely, opine observers. They also say that Bhattarai has taken over NCCB management staking his managerial reputation because NB Group has specifically promised not to interfere with the management any more. That may indicate for better days in the future for NCCB. But only the future will tell for certain.

Though NBA mailed a list of questions to LB regarding various points mentioned above, he refused to provide the answer despite repeated follow-ups from NBA.

Himalayan Bank Ltd. & NRB

Himalayan Bank Ltd. is one of the largest 500 banks in the Asia-Pacific region as listed by the Asiaweek magazine last year. And it is the second largest private sector bank of Nepal in terms of assets. The following snippets from a recent report (August, 2002) of an inspection team that Nepal Rastra Bank sent to the bank indicate to some serious problems that the bank suffers from. (The report says that the data pertain to January 13, 2002). If a bank of this stature is suffering these problems, the readers can only imagine of the condition in the other less professionally managed ones.

• l     The bank has no standard policy regarding the Trust Receipt (TR) loan. The practice was to decide on case-by-case basis. The custom clearance documents were missing from some TR files, indicating possibility of the foreign exchange misutilization.

• l     Overdraft facilities extended by the bank were not fully secured. These facilities were continuously rolled over at maturity and they were used to pay the interest and instalment on the other loan facilities, which is a practice against the NRB directives.

• l     The bank had neither loan application forms to be filled up by corporate borrowers nor a sheet of instructions indicating what documents must be appended to the letter of application. The bank uses a loan approval sheet that provides the results of the loan officer’s analysis of data provided by the applicant. Though some sheets analysed by the inspection team mentioned the credit risk as “moderate risk” and “low risk”, no explanations were recorded as to what led to such a conclusion.

• l     Loan collection management was entirely absent. There is no periodic analysis of the performance of the borrower’s ability to repay or intent to meet the past due obligations.

• l     One case of conflict of interest was found in which a promoter company was disbursed a loan by the bank.

• l     As regards to the loan classification and provisioning, the inspection team found a shortfall of Rs. 18 million in the amount provisioned for possible loan loss. Some of the loans were incorrectly upgraded. This inflated the half-yearly profit and loss statement of the bank publicised for the general shareholders.

• l     The bank had exceeded the single obligor limits in granting loans to at least three groups.

• l     Minutes of the Board of Directors Meeting had signatures missing from them thus invalidating the minutes.

• l     For two consecutive years, the Auditor for the bank was appointed by the Board of Directors, not by the AGM.

• l     The bank has no credit policy guideline.

• l     Financial rules of the bank fail to meet NRB guidelines.

• l     There is a lack of policies and procedures manual regulating the operation of the treasury.

But these things are not serious, say the Himalayan Bank officials. Shahid M Loan, the General Manager (who also represents the joint venture investor in the bank Habib Bank of Pakistan) told NBA that he had still not seen the report and that the situation in the bank was not as bad as mentioned in these points.

For example, he says, no documents are missing from the loan files. Regarding the overdraft facilities, he says there is a broad policy guideline from the board of the company, and only in some special cases and in small amount loans are the special considerations made. Loan denies the NRB team’s allegation and claims that the bank does have the loan application forms. Also in case of the loan collection management, Loan claims that the bank has a competent team of 10 personnel with a manager and assistant manager in charge. He did not deny that the bank has disbursed loan to a promoter-shareholder, but said that the bank has asked NRB for special permission, though it has not been received as yet. Regarding loan classification, he says it is a debatable issue. And about the single obligor limit being exceeded, Loan claims, it was before the rules came out restricting it. However, Loan accepts that there were “one or two” signatures missing from the Board minutes. Regarding the appointment of the Auditor, Loan says it is the practice across the banking sector to appoint the auditor by the board and later get it approved by the AGM. As to the allegation that the bank has no credit policy guideline, Loan says the bank has one in place though it needs updating.

An Overview of Nepali Banking

By The World Bank

Although financial institutions have proliferated, the Nepali people have not yet reaped the potential gains of the government’s efforts to liberalize and reform the financial sector, says a report that the World Bank released in October, 2002. There are four main reasons for this: excessive government involvement in the sector, a weak central bank, a poor banking environment, and a lack of adequate banking services for the poor.

Excessive Government Ownership

At the heart of virtually all the problems in the financial sector in Nepal is the overwhelming dominance of the government. It owns the largest commercial bank (RBB), is the biggest shareholder in the second largest one (NBL), and holds significant shares in virtually all the joint-venture banks (all joint venture banks are 50 percent Nepali owned with shares generally being held by Nepal Rastra Bank  (NRB), NBL, RBB or the Employees Provident Fund).

As in many countries, government ownership has led to poor internal governance, weak management, fragile financial health, and an unhealthy politicization of these state-owned institutions. There is thus an urgent need for the government to divest its ownership of most of these financial institutions and replace the public sector with “fit and proper” private owners and operators.

A Weak Central Bank

Poor supervision by the central bank, Nepal Rastra Bank, is in part to blame for the severe problems of the two largest commercial banks and for the general deterioration in the system. However, the central bank is in no position to adequately discharge its responsibilities. It is handicapped by a lack of autonomy, an inadequate and outdated legal framework, and an excessive number of poorly trained and unproductive staff – as well as being in need of radical restructuring.

The weak and outdated legal framework is among the main sources of the central bank’s ineffectiveness. Adopted in 1955, the Nepal Rastra Bank Act was designed for a central bank operating in a government controlled economy – and supervising government-owned banks – and is ill suited to the development of a complex, modern central bank and banking system. The act bestowed too little power on the central bank for effectively managing monetary policy, improving the financial infrastructure, strengthening and improving financial markets and their supervision, and facilitating the growth of the financial sector. Parliament recently approved a modern central bank law, however, while came into effect in January 2002. This new Act will largely address all of these concerns – if the Act is meaningfully enforced.

Poor Banking Environment

Outdated and inappropriate laws similarly lead to weakness throughout the Nepali financial system. Other problems also plague the banking environment, including weak corporate governance, lack of competition, the absence of a sound banking culture, and asymmetries in information.

Weak and Fragmented Legal Framework

The Commercial Banking Act (1974) has critical gaps in coverage and needs to be replaced with a new law covering all deposit taking institutions in Nepal (a new draft Banking and Financial Institutions Act is currently under consideration). Other parts of the legal framework for the financial sector also need to be strengthened or amended, including the Financial Intermediary Act (1998), Company Law, and Insolvency and Liquidation Laws. Enforcement too needs to be strengthened. Anecdotal evidence suggests that court action against defaulters tends to be excessively delayed, and asset liquidation has rarely been successful. Without strengthened laws and proper enforcement, any intervention in the financial sector is unlikely to have a meaningful and long-lasting impact.

Another problem is the proliferation of laws and regulations applying to specific institutions rather than generalized banking functions. For example, neither of the two largest development banks is governed by the Development Banks Act; instead, both operate under their own institution-specific legislation. Such institution-specific laws and regulations have created a fragmented legal environment and, as a result, a fragmented financial system, thereby stifling competition. So at the same time that the legal framework is strengthened, it also needs to be rationalized and simplified.

Weak Corporate Governance

Corporate governance is extremely weak in Nepal. There are no clear rules of engagement between a company’s management, its board, its shareholders, and other stakeholders. Aggravating this situation are weak systems, poor procedures, and information asymmetry.

Accounting and auditing traditions are also weak. Many banks cannot provide financial statements, and at times the accounts that banks do provide are un-audited – even though banks and finance companies are required to be audited annually be external auditors selected at general assemblies. The three largest banks – Rastriya Banijya Bank, Nepal Bank Limited, and the Agricultural Development Bank of Nepal, accounting for almost 60 percent of commercial banking assets – do not maintain up-to-date, externally audited financial data. One of them, Rastriya Banijya Bank, has produced no externally audited accounts or annual report for around seven years. The central bank serves as a poor role model for the system that it purports to supervise and regulate; it too fails to maintain good, up-to-date, externally audited accounts.

Lack of Competition

Although Nepal’s financial system has grown rapidly over the past decade, it still lacks the competitive environment critical for ensuring that financial intermediation benefits borrowers, depositors, other users of financial services, and shareholders. The lack of competition reflected the fragmentation of the system, but it also stems from the dominance of the two large (but inefficient) government-established commercial banks, which accounts for more than half the commercial banking system’s assets. The result is that the Nepali people have enjoyed only marginal benefits from the liberalization of the financial sector.

Poor Banking Culture

The elements of a good banking culture are almost nonexistent in Nepal, whether among banks or among their customers. Banks find it difficult to make informed lending decisions because many of their private sector clients fail to maintain good financial information on their activities or are unwilling to reveal their true financial position. As a result, firm level data are largely unreliable, and banks are forced to reconstruct firm accounts from client estimates. Even when banks can undertake a proper financial analysis, they often extend credit on the basis of collateral rather than creditworthiness. Lenders always request primary collateral, and request secondary collateral or guarant-ees if needed. Nonetheless, they assess the value of the collateral only informally and do not re-evaluate it regularly.

The Credit Information Bureau maintains a blacklist of customers to whom banks cannot extend credit. The bureau, however, established jointly by the central bank and the Bankers Association, is hindered in its operations by the inability or reluctance of the two largest banks to provide it with data. The apparent lack of follow-up by these banks when a customer defaults, results in a downward spiral or poor banking behaviour.

Another part of the problem lies in the implementation/enforcement of the prudential regulations. To date, only a small number of banks have established satisfactory internal guidelines.

These lending problems, which affect the largest financial institutions in Nepal, have important ramifications for the entire financial sector. The market leaders maintain high real interest rates and margin spreads to cover high operating costs and large losses, while private banks are able to earn substantial profits by hiding behind these high prices. As a result, private banks have not been forced to compete for more customers or to expand their activities outside a few main cities. They merely offer much better service at the prices set by the large banks.

Information Asymmetry and Lack of Financial Sophistication

The public has limited knowledge of the financial position of banks, creating a situation of severe moral hazard. The general public is financially unsophisticated and most people have little access to financial information. When financial institutions accounts and annual statements are disclosed, they are neither timely nor reliable – even if audited. Moreover, accounting and auditing practices in Nepal do not conform to international standards.

Consider these striking illustrations of the poor public knowledge sector issues. After public announcements were made that management teams were being placed in Nepal Bank Limited, the bank’s stock price doubled – despite the general knowledge that the bank had a negative net worth. Depositors also continued to place funds in both Nepal Bank Limited and Rastriya Banijya Bank after a KPMG Barents Group consultancy report disclosed their extremely poor financial health and highly negative capital base. Also implicit in these examples is the banking public’s belief that, although Nepal has no deposit insurance scheme, the government will provide a safety net in the event of a banking failure.

Corruption

Given all these factors – poor supervision, a weak legal environment, poor corporate governance, lax accounting and auditing standards, and an underdeveloped banking culture – it is no surprise that corruption has been a big contributor to the poor financial health of many of the financial institutions in Nepal. Fraud, self-dealing, insider dealing, and improper evaluation of collateral have been among the reported abuses. Such actions have taken resources from the poor and given them to the rich. Stemming corruption will require putting in place transparent systems, checks and balances at every level, and a system of continuous monitoring within and between financial institutions.

Inadequate Banking Services for the Poor

Given the large number of poor people in Nepal, it is also no surprise that the government has emphasized the social dimensions of banking. Notwithstanding this, most of the policies aimed at benefiting the poor (directed credit, branch opening policies) are too broad, and they create considerable operating disincentives within the financial system while achieving a minimal or even negative impact on their intended target audience. These policies need to be more sharply focused to minimize their negative effects and enhance their benefits for poor and rural communities. At the same time, the delivery mechanisms for development banking need to be reformed, to work through, and with, private partners wherever possible. The current system of publicly owned development banks and state-dominated micro-finance institutions has failed to produce the intended results – while creating large contingent liabilities for the government.

(Excerpted from the executive summary of Nepal Financial Sector Study Report, October 16, 2002, the World Bank. The report is, according to the bank, the result of work carried out over a series of mission during 2000 and 2001.)

Banks in Competition

by Rabindra Man Shrestha

Growing competition among commercial banks leads to increased customer bargaining power

After the deregulation of the commercial banking sector in 1985, two big banks of the nation, Nepal Bank Limited (NBL) and the Rastriya Banijya Bank( RBB), failed to remain competitive due to their inability to live up to the changing customer expectation of swiftness and customized services. New players such as Nepal Arab Bank Limited (Nabil), Nepal Indosuez Bank (NIB), Himalayan Bank Limited (HBL) and Nepal Grindlays Bank Limited (NGBL), now changed to Standard Chartered Bank Nepal Limited (SCBNL), posed new challenges to these two old banks. New technology, competent young workforce combined with the comparatively flexible and swift decision making process proved success for these new players. Highly conventional way of banking and highly bureaucratic structure remained as the key obstacles for NBL and RBB.

Success for these new banks can however be termed as ‘’easily achieved’’ as it came without much of the effort from these banks. Their success came largely due to the lethargy of NBL and RBB, who never reacted to the threats being posed by these new banks, though there could be many other unseen reasons as well for the lethargy of NBL and RBB management. Beside the non-reactive NBL and RBB, the economic liberalization also helped for the runway success of the new banks. Many new investment opportunities in manufacturing, trade and tourism sectors opened up between 1985 to 1995.

As a result, the share price of the banks rose to unexpected levels. For example, a share of Standard Chartered Bank Nepal Limited (SCBNL) having the book value of NPR 100, is today trading at NPR 1700. It had once reached even more than NPR 2500. Promoter shareholders along with other ordinary shareholders of the SCBNL not only received entire investment refunded in very short span of time, (less than 3 years), in the form of dividend and bonus shares, they are also getting extraordinary return in the form of 100% dividend year after year.  Employees too enjoyed very handsome salary and bonus. Some years they received bonus equivalent to 72 months of their salary. As a result they became the nuveau riches elite of the capital city without having to apply much of the pain to gain the wealth. However the honeymoon period seems to be over and it seems that the tough times are squarely facing the banking industry now.

By 2002 the number of commercial banks reached 16 and few more are in the pipeline. The rapid increase in the number of banks shows that many investors have found the banking business very attractive. But the recent activities of the banks such as offering housing and vehicle loans at an attractive interest rate of around 9% per annum are sending the signals to the market that the banks have now started to feel the stress arising out of the economic slowdown perpetuated by unrest at home and around the world. In other words, investment opportunity in areas such as manufacturing, tourism, trade and export business have declined. Commercial banks are now trying to shift their focus on personal sector such as personal loan for building houses or buying vehicles, the need for which is no doubt growing with the growth of unbanisation and changing life style, particularly in Kathmandu. However, only lord Pashupati Nath knows how much unplanned expansion in housing and uncontrolled growth in the number of vehicles can this cup-shaped valley accommodate.

The other lucrative sector for the commercial banks is the remittance business coming from Nepalis residing or working abroad and various foreign agencies operating in the country. Growing uncertainty at home and ruined domestic economy have lately forced additional Nepali to work outside the country. Approximately NPR 70 billion enters the country every year as remittances and it is expected to grow further, which is a large sum in the Nepali context. Currently SCBNL seems to have largest share of this business. This is obviously an attractive segment for commercial banks. It will be a fair assumption to say that the commission rate for remittance will be even more competitive due to growing competition and slowing down of other businesses. This competitiveness is already evident in the local remittance business carried out by various banks. Interest rate in term loans is already coming down in recent years. It has come down from 14% in an average a couple of years ago to now 10%. Now bankers are seen looking for appointments with executives in borrower organizations and offering various value additions. It was not imaginable only two years ago, when the borrowers would have to make the rounds to the bank offices.

Use of electronic currency is gaining tremendous popularity in the western world and also in many emerging economies. Nepal can not fall far behind in the race, though the pace of development will be slow here. Commercial banks of Nepal have recognized the need of such a convenient mode of payment and they have started offering Credit cards and, to a limited extent, also the debit cards. However there is huge potential in this business yet to be exploited. The credit card business is mainly limited to the capital and few other cities. The national coverage is still miles away and also penetration level in the capital is still very limited. SCBNL is lately seen going aggressively in this business. Technology and affiliation to the international banks seem to be the critical factors in this respect, which is why the SCBNL seems to have the edge over other commercial banks in this regard. However, banks are not liberal on issuance of credit cards. They still are very conservative compared to banks in other countries. For example, the marketing approach of the card business is very aggressive and liberal as well, but the interest rate and service charge is comparatively high. This is another area where the competition will grow soon and banks will be forced to provide better services and competitive rates.

Customer satisfaction is going to be the key success factor for all commercial banks. Speed, convenience and competitive price will be the driving forces, which will demand existing banks to be much more innovative and equipped with sophisticated technology and changed mind-sets to recognize customer as the king.

Cheer up valued customers, the long queues in front of the tellers is going to be shortened. Otherwise, it was much better to receive a token after handing over the cheque in NBL or RBB counter and go around the market for a while before coming back to collect the money. At least you did not have to strain your knee by standing on one place for so long.

(Shrestha is the CEO of Himalayan Snax & Noodles P. Ltd.)

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