National 8 (Spotlight Weekly)

Financial Challenges in Nepal

By Sukhwinder Singh

A strong, well-functioning financial sector is crucial for any economy—be it industrial, emerging market, or even developing. It is essential for healthy sustained growth. As an economy grows and matures, its financial sector must grow with it. It must be able to meet the increasingly sophisticated demands that are placed on it.

Experience around the world has shown—repeatedly—that governments are not best placed to assess risk and economic potential in the private sector. And why should they be? Why should governments be able to determine which industrial sectors or firms will make the greatest contribution to economic growth? History in both developed and developing countries is full of examples of surprising success stories—of firms who could not attract government support, who found it hard to raise finance but who managed somehow to turn a profit and be successful.

The role of domestic policymakers is clear. A healthy efficient financial sector is a vital component of economic growth. Putting the necessary measures in place to ensure the banking system is sound, that non-bank financial systems are well-managed, and that risk in the system is clearly identified, might not always be easy in the short-term. But such measures will undoubtedly bring significant rewards in the medium and longer term.

Role of the IMF

The IMF has an important role to play here. Our central task, according to our mandate, is the promotion of international financial stability. A stable international financial system is a vital ingredient in promoting the sustained rapid economic growth that brings rising living standards and poverty reduction. International financial stability is essential for the expansion of trade that makes growth possible.

But international financial stability cannot be sustained if there is weakness at national levels. So nowadays we in the Fund pay ever closer attention to the health of the financial sector. We try to assess the robustness of the financial sector in a variety of ways. We pay close attention to banks' balance sheets and the extent of NPLs. We also examine the extent to which risk is clearly defined in the financial system as a whole. And we look at the degree of competition within both the banking system and the financial sector as a whole: competition should improve the efficiency of credit allocation, it should also help diversify financial risk and cut borrowing costs. We look for mis-matched exposures since these can be a source of instability.

The breadth of financial instruments is also important; as is the transparency of the system which enables more accurate assessments to be made of the asset and risk position of individual institutions. And a strong, effective regulatory regime, following international best practice, is vital.

Let me mention some of the actions we have taken in these area. The Financial Sector Assessment program (FSAP) was introduced in 1999 by the IMF and the World Bank. The FSAP program—which is a joint program with the World Bank when low-income countries are involved—aims to help member governments strengthen their financial systems by making it easier to detect vulnerabilities at an early stage; to identify key areas which need further work; to set policy priorities; and to provide technical assistance when this is needed to strengthen supervisory and reporting frameworks. The end result is intended to ensure that the right processes are in place for countries to make their own substantive assessments. The work carried out under an FSAP program involves a broad range of financial experts, many of them from outside the Fund. A large number and a wide range of our member countries have now had an FSAP program. We hope that an FSAP could be undertaken in Nepal soon, perhaps in the next fiscal year.

We have also worked with the World Bank to develop a system of Standards and Codes—using internationally-recognized standards—that result is Reports on Standards and Codes (ROSCs). These cover twelve areas, including banking supervision, securities regulation and insurance supervision. The financial sector ROSCs are an integral part of the Financial Sector Assessment program and are published by agreement with the member country. They are used to sharpen discussions between the Fund, World Bank, and national authorities.

Financial Sector Reform in Nepal – The Immediate Challenges

Many of the issues I’ve mentioned could verily describe Nepal’s history; heavy government ownership and intervention with direction of credit and controlled interest rates, high non-performing assets, weak regulation and supervision, and inadequately developed financial markets. Moreover, we are all familiar with the range of other problems that have characterized the sector: weak corporate governance, lack of a competitive environment resulting from fragmentation of the system, a poor banking culture, lack of reliable financial information and transparency, and of course ineffective banking services for the rural sector.

That is a daunting agenda before us, made all the more urgent by the competition in financial services that will come from Nepal’s membership of the WTO. Moreover, it is being implemented at a very difficult time for the country where the insurgency is imposing an enormous toll on economic activity, which of course has affected banking performance. But a crisis also offers opportunities. I am encouraged by the financial sector reforms that are underway in Nepal and the Nepalese authorities should be congratulated for their efforts. The government has committed to reduce its ownership in the financial sector, controls on interest rates have been removed and directed credit is being phased out. The operations of the two largest banks are being overhauled and, despite some of the misleading information one reads in the press, there is little doubt their performance has improved. The central bank is being modernized. New legislation is in place for the financial sector that is improving managerial and financial governance. The tools for loan recovery have been strengthened. And many of you are trying to implement sound banking practices.

In my view, all these reforms in the financial sector are ultimately about better governance. They are about improving the trust between depositors and their banks, and between those being regulated and the regulators. They require a new way of doing business where political or insider interference is eliminated, and there is transparency and accountability in bank operations. Better governance, including improved disclosure, will improve credit decisions which is good for growth and for the safety of depositors money. And the biggest beneficiaries of better governance will be the poor – they often are the biggest losers from a banking crisis - left bereft of their small deposits, and the causalities of cuts in development spending and higher taxation required to finance salvage of the wrecked system.

But we still have a long way to go in Nepal. The political leadership of Nepal must really believe in these reforms. And a change in banking culture is required. The IMF is very willing to help but Nepal must also be ready to help itself. Let me briefly mention what I see as a few of the immediate challenges going forward:

First, dealing with non-performing assets and privatization of public banks. NPAs of at least 7-8 percent of GDP or $450 million – the same as last year’s entire development spending - are clearly unsustainable and present a major risk to the banking system and to the budget. Most of course are with the public banks - RBB and Nepal Bank Limited (NBL) – which have been raided by unscrupulous elements and are technically insolvent. But I understand the problem extends to other banks in the system which poses a threat to banking stability even beyond restructuring of the big two.

Over the past two years, the management teams in RBB and NBL have been able to stem their operating losses, recover significant amounts of outstanding loans, and improve transparency. However, after failed efforts to reach amicable solutions with some of the largest defaulters, their subsequent efforts have encountered serious obstacles, described by those who are more familiar than myself with the working of the Nepali judicial system as highly irregular court decisions. And, on occasion, there appears also to have been political interference in the loan recovery effort, and what others have described as covert pressure from powerful quarters. Both the World Bank and IMF have appealed to the government and judiciary to do all it can to tackle this grave national problem and I also sense a growing consensus on the urgency of this matter among the wider donor community. This is a problem for the nation – why should government and the general public of this country pay the price for the excesses and corruption of a minority? But up to now these big defaulters remain defiant and even confident in their ability to continue with their delay tactics. The recent statements of the government suggest this issue is being taken seriously, but one can really only judge by the results. And for the sake of this country, results are urgently needed. I also urge the banking community to unify and take a consistent position with these borrowers, some of whom appear able to continue their operations despite being blacklisted. Strengthening of bank supervision, the credit information system and adhering to blacklisting rules is crucial in this effort.

But we also need to look beyond the NPA recovery effort, towards privatization of public banks to “fit and proper” owners, as is the government’s stated policy. We need to work quickly towards this, which requires further progress in areas such as excess bank staffing and computerization. Improvement in these banks’ performance should not be seen as reason to delay the process, but to accelerate it. And at some point down the road, we have to start thinking of moving some assets to the Asset Management Company. Finally, work on a write off policy for the banking sector should begin in earnest.

Second, further improving the regulatory framework. In parallel with efforts to clean up the past, we must focus on avoiding these problems in the future. There have been significant improvements in the legal framework for the financial system. We now have a modern central bank act. And the Banking and Financial Institutions Ordinance that was promulgated last February brings together the disparate legislation in place previously. While it no doubt strengthens the NRB’s supervisory powers over the financial sector, there remain areas where further improvements are necessary to ensure the BFI provides the legal framework for the implementation of 25 Basle Core Principles. In particular, we need to look at a clearer delineation between banks and non banks, further clarity on ownership of banks and their investments, strengthen current provisions on licensing including the responsibilities of directors, clearer provisions on foreign banks, and governance and reporting requirements. The IMF and World Bank are closely involved in this process and will consult the banking community on changes. Related to this, the NRB must be allowed to exercise its supervisory and regulatory function, and it would concern me greatly if the central bank’s actions against delinquent institutions were unjustifiably blocked by judicial or political interference, or by mismanaged banks. Equally, the central bank must disseminate the results of its supervision to the banking community in a timely manner. Finally, improved governance in banks must be matched by better corporate governance. The building blocks such as better company’s legislation are ready, but need to be brought into force quickly. But it is obviously not enough to have good laws – they must be implemented and enforced. Too often in Nepal, we see world class legal and regulatory frameworks, but the problem lies in the application. That leads me to my third emphasis.

Third, strengthening the central bank. Considerable efforts have been underway in recent years to modernize the Nepal Rastra Bank, and I believe there has been progress. The IMF has been heavily involved in these, as has the World Bank. The aim has been to engineer a central bank that can develop and implement sound monetary and supervisory policies, and command the complete confidence of the banking system. This respect cannot be ordered or demanded by its power, but must be earned by its capability. Its staff must be highly professional and competent officials familiar with modern banking practices, led by management who have a clear vision of how to develop the financial sector as an engine of growth. The bank must be a transparent, independent but accountable, institution that applies its mandate in an even handed way. And it should concentrate on core central banking functions. For an effective partnership to develop, the central bank must listen carefully to, and learn from, the banking community. At the same time, Nepal’s banks should facilitate healthy competition and ensure the timely provision of information required for the NRB to do its job.

Fourth, improving access to banking services for the rural poor. This is undoubtedly a crucial area of the Nepal’s poverty reduction strategy, although not one that the IMF has been involved in heavily. Following decades of efforts, a plethora of public, private and informal institutions exist, none of which are in a particularly viable state. The experience with public micro finance institutions in particular has not been very encouraging with limited success in reaching the poor, and eroded capital. So there is need to restructure institutions such as ADBN, and other regional development banks. Moreover, in my view, the NRB’s involvement in this sector also needs to be reduced, in terms both of ownership and remaining restrictions on lending and interest rates that undermine efficiency of microfinance institutions. Global experience also suggests private MFIs operated on a commercial basis are likely to be more sustainable. And while the largest public banks undergo restructuring, we must look at the role the rest of the banking system could play, while accepting that opportunities are being constrained by the conflict. In particular, active participation of commercial banks is important for addressing the financial needs of the upper segments of the rural financial markets that demand a range of products that ADBN and MFIs may not be able to provide. I believe support is being considered for improving the banking sector’s capacity to provide rural finance, as well strengthen supervision and regulation of rural and MFIs. And finally, as we seek to diversify the economy, we must place emphasis on the SME sector – both urban and rural.

(Excerpts of speech delivered by IMF Resident Representative to Nepal at the program of Nepal Bankers' Association held on November 30,2004)