Banking Sector Reforms In Nepal-I
Implications for Corporate Governance

Dr. Yuba Raj Khatiwada, Member National Planning Commission , Nepal 

The financial crisis of Japan in the early 1990s, a deeper financial crisis in Mexico in the mid 1990s and Asian financial and economic crisis in the late 1990s have indicated that such crises are inevitable in a financially liberalized and globalized economic system. But it has also been experienced that such crises are surmountable and the architecture of a sound financial system can minimize the risk of falling in such a crisis and also help for quick recovery from it. Although the Asian crisis in now over, it has incited us to learn at least a few things for the stability of financial system, for the sustainability of economic growth and for continued economic and social stability.

First, an economy growing over a weak financial architecture is prone to collapse any time for its own reasons and not necessarily due to "contagion".

Second, a financial system, which is unduly or disproportionately exposed to the global financial system, may fall prey to crisis in any corner of the world.

Third, as money, capital and foreign exchange markets are very much closely linked to each other, the regulatory and supervisory authority should be very much vigilant to the developments taking place in all the markets.

Fourth, there should be transparency in the operation of the financial institutions and credit flows should not be concentrated in a few business houses.

Fifth, accounting and auditing of the financial transactions and the balance sheets of the financial institutions have to be of international standard.

Sixth, the central bank should be autonomous or independent so as to be able to exercise monetary policy tools, fix exchange rates and regulate the financial system without any government intervention.

Seventh, financial institutions should maintain a reasonable debt equity ratio with portfolio match in term structure, liquidity structure and currency structure of assets and liabilities.

Eighth, there should be a degree of flexibility in the management of exchange rates and it should not remain overvalued for long.

Ninth, short term private capital is very volatile and if any financial system is overexposed to such short term borrowing, it may fall victim of foreign exchange hedgers and speculators.

Tenth, involvement of the private sector is essential to "bail in" the financial crisis of the companies exposed to foreign borrowing.

Finally, capital account liberalization should be orderly and accompanied by sound macro economic policies.

Key Issues in the Reform of the Financial System

The goal of the financial system development is to foster efficiency in trade in goods and assets, to ensure the stability of the system and to allow for an equitable and socially acceptable distribution of income and wealth. Thus the question that needs to be answered in this context is among others, how to ensure financial system soundness.

The revolution in the technology of telecommunications and information systems has underpinned and stimulated financial market integration and capital mobility along with domestic and international financial liberalization. As a result, markets for goods, services and assets have ever more integrated and developing economies have increasingly been drawn into these globalized markets.

The emerging market crises of the 1990s, in particular, the Asian crisis, have generated a perception of deep inadequacies in the international financial system and an intense debate on global financial reform, particularly regarding capital flows to emerging markets. It is now widely accepted that these crises resulted from both domestic policy failures exacerbated in some case by adverse external and political shocks and weaknesses in the international financial system.

Policy failures included traditional macroeconomic imbalances, such as overvalued currencies and current account or fiscal deficits, particularly in Thailand, Latin America and Russia. In addition, microeconomic weaknesses, themselves a result of inadequate regulation, poor risk management and implicit or explicit government guarantees, played an important role, taking center stage in the Asian crisis. These weaknesses manifested themselves in the increasing vulnerability of corporations and financial institutions to higher interest rates or depreciated exchange rates, or both, on top of signs of insolvency in corporate and banking sectors even before the crisis.

For creating a sound financial architecture, two kinds of reforms are proposed. The first includes improvements in domestic policies and increases transparency. This would both reduce the fundamental weaknesses that make countries vulnerable to financial crises and make it less likely that existing weaknesses could build up unnoticed for substantial periods. The second includes measures to address systemic risks and contain crises more directly. Such as improving international institutions, rules for debt workouts and the regulation of certain types of international capital flows.

There is now wide agreement that emerging markets could reduce their vulnerability to crises and encourage high-quality growth by strengthening financial regulation, improving the legal framework governing relations between creditors and debtors, enhancing data dissemination, doing away with implicit and explicit guarantees, strengthening macro-economic policies and public debt management and improving financial governance in general.

There is a consensus on data standardization and transparency. This is because international financial crises in recent years have underscored the importance of disseminating additional information on countries’ international reserves and foreign currency liquidity on a timely basis. This is expected to serve a number of purposes. One of them is that information on international reserves and foreign currency liquidity will best inform public and private decision-making if countries disclose it in a coherent, common framework.

Recent financial crises have revealed a number of data deficiencies, notably in pledged assets, deposits held in financially weak domestic banks and their foreign affiliates, valuation practices leading to bank valuation of assets being significantly different from market values and complicating assessments of the realisable value of reserve assets. Similarly, public information is lacking in many countries on the off-balance-sheet activities of the authorities that can affect foreign currency resources. There was a lack of information on the authorities’ financial derivatives activities. Also observed was the inadequate information on actual and potential foreign liabilities of the monetary authorities and central government. Financial sector reform envisages for measures for mitigating this information and data gap problem as well.

Reforms Envisaged in the Nepalese Financial System

Nepal initiated financial sector reform back in late 1980s with donor initiative and assistance. In this process, some progress was made in terms of re-capitalization of the government banks, divestment, branch consolidation, introduction of new regulatory and prudential norms and cleaning up the balance sheets of bad loan loaded banks. But the reform process was stalled in the later 1990s due to political instability and the government’s priority in areas other than the financial system. In between, the country observed, from very close by, the financial crisis in the neighboring region. Keeping in mind the financial crisis and its effect in the Asian region, the Nepal Rastra Bank is now focussing its attention on the reform measures in the financial sector as a drive towards new financial architecture. The major reforms measures include:

Restructuring Government Owned Banks: The major reform agenda in the financial system is the restructuring of Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), tow large banks with government involvement and taking more than half of the market share in banking services. These banks have been marred by huge portfolios of bad loans, losses due to high operational expenses and uneconomic branch expansion and very low capital funds. The restructuring process has to start from cleaning up the balance sheets, putting in efficient management, injecting capital, involving the private sector in capital ownership and management and enhancing sound corporate governance. Past experience has shown that re-capitalization alone will not solve the banks’ problem without restructuring the institution and improving corporate governance.

Headline | 5 Question  | Editorial | 2nd Impression | International | Past