Banking Sector Reforms in Nepal-II
Implications for Corporate Governance

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

Providing Autonomy to the Nepal Rastra Bank: The NRB Act 1955 was outlined in the context of a typical economic background of the country. Over the period, the economic situation has undergone a sea change. Hence, a dire need was felt for the revision in the NRB Act so as to include new objectives of monetary policy, to enable the central bank to undertake an effective supervisory role and for stabilizing the domestic and external value of the Nepalese rupee. This has been met with the recent revision of the NRB Act that ensures greater autonomy to the central bank to undertake its responsibilities.

Reforms in Financial Sector Legislation: The need or financial legislative reform involves, along with the amendment or promulgation of a new NRB Act, revision in the Commercial Bank Act, Foreign exchange Act and other financial institutions Act. These acts have also to be consistent and complementary to each other for the smooth functioning of the financial institutions. If necessary, consolidation of various acts into a few has also to be done. A crucial reform needed is the revision in cooperatives act that so far is performing licensing role without necessarily undertaking supervisory obligations. In this regard, an umbrella act covering all the deposit taking institutions is being drafted.

Strengthening Bank Supervision and Inspection: The strengthening of the supervisory capabilities and widening the scope for supervision of the Nepal Rastra Bank has to be emphasized under the financial reform program. This requires a more autonomous central bank act, enactment of effective laws, putting prudential norms of the international standard, strengthening the supervisory capacity of the Bank and enforcement of the rules and regulations.

Reform on Auditing and Accounting Capabilities: The recent auditing of some of the financial institutions by the international auditors has unfolded the weakness in domestic accounting and auditing standard. Besides, the supervisory role of the central bank is weakened by the absence of timelines and reliability of financial data reporting, particularly of public sector financial institutions. Thus, in order to operate the financial system efficiently, accounting and auditing standards of the financial institutions has to be strengthened. To cope with this, introduction of internationally accepted accounting and auditing standards for the banking and non-banking financial sector has to be initiated along with preparing domestic manpower in financial accounting, auditing and reporting.

Streamlining Ownership Structure: Appropriate policy action has to be taken to avoid undue concentration on the ownership of banks and financial institutions. As such, no single person and group may to be allowed for holding a controlling stake in more than one banking institution. Similarly, cross holding of commercial banking capital has to be done away with. The existing equity participation of some of the commercial banks in others has developed a collusive tendency in the banking system impairing healthy competition.

Developing Credit Information and Depositors’ Protection Systems: in order to protect the banks from potential bad customers and frauds, a network for disseminating information on loan defaulters among the banks in necessary. This requires restructuring of the existing credit information bureau and also establishment of credit rating agencies. Private sector institutions have already shown interest in establishing credit rating agencies. Similarly, for providing protection for the depositors, institutional arrangement has to be made for undertaking deposit insurance services and other regulatory measures, avoiding likely moral hazard and adverse selection problems emerging from such an institutional arrangement. The Deposit Insurance and Credit Guarantee Corporation has been working towards this direction.

Increasing Capital Base and Revising Capital Adequacy: Experience has shown that under-capitalized financial institutions are the ones that are first attacked by the speculators and hedgers at the time of crisis and create contagious effect on the other institutions as well. Besides, under-capitalized financial institutions cannot gain credibility and corporate growth even in normal times. This requires that financial institutions are adequately capitalized and possess resilience against attacks by dealers and customers. In this context, the capital adequacy norms are being revised upward as per the Basle Capital Accord. But increasing the capital base for loss making government owned financial institutions is not easy without involving private sector in the equity capital.

Text Courtesy: Corporate Governance in Nepal, Published by: Center For Development and Governance and Focal Point For Financial Sector Reforms.

Improving Corporate Governance

The banking system reform strategy has initiated strong corporate governance by ensuring that banks are owned and managed by private investors and professionals by implying the progressive withdrawal of the government from the ownership of all financial institutions and also refraining from promoting financial institutions with equity participation of the government or government enterprises.

The effect of financial liberalisation on the probability of banking crisis in economies with poor transparency is well established by empirical studies. With imperfect information banks cannot distinguish between aggregate shocks as well as the government’s policy and the firm’s quality. As a result, a sequence of positive shocks or non-transparent policy causes the banks to expand their credit above the optimal level given the underlying value of the firm. When banks realise their over-exposure, they are likely to roll over their bad loans rather than declare their loses. Such practice might defer crisis for the time being but it deepens the magnitude when it erupts. Empirical studies reveal that the probability of a crisis is higher in the period following financial liberalisation, significantly so in countries with poor transparency.

Poor corporate governance is widely regarded as one of the main factors bringing in crisis in Indonesia and then contributing to its severity and length. The domestic and international markets are still reacting negatively especially to the lack of transparency in the Indonesian banking and corporate sectors. In fact lack of transparency is nowhere accepted especially when a leap in information technology has made it possible to gain access more quickly, easily and inexpensively from diversified sources than ever before.

Investment decisions are based on information; and the quicker and more reliable the information, the less likely is the decision to be based on sentiment and herd instinct. For good corporate governance, a system of information dissemination and transparency has to be established and practised.

In many financial systems, including ours, corporate governance is seen as a compliance issue rather than a means of enhancing corporate performance; many corporations are family-owned or dominated; insider transactions have been common; disclosure has been weak and disciplinary mechanisms have been ineffective. Managers and directors have been largely immune from stakeholder accountability; a weak bankruptcy and judicial system has left creditors with little leverage over their debtors; and state financial institutions have been subject to political interference and weak monitoring. The regulatory and supervisory role of the central bank has been insufficient to run the financial corporation in a healthy way.

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