Corporate Governance and Financial Sector Reform in Nepal

Non-economic factors have exerted negative influence on the economy of Nepal in recent years. The negative growth of GDP in 2002, negative balance of payment and huge deficit in current account manifest the unpleasant positioning of the economy in recent times. Several factors are known to have contributed to the showdown in the economy. External factors include 9/11/2001 incident in the US, global recession and internal factors include security related problems emanating from Maoist struggle, political instability and weakness in corporate governance-poor institutional capacity, poor transparency and accountability, inadequate legal frame works and weak human resources that limited the country’s growth potential.

It is being increasingly felt that a sound and efficient system of government administration has a lot to do with the effective operation of the economy. The importance of these issues in Nepal is highlighted by the World Bank’s argument that central constraint on Nepal’s development over the last few decades has not been paucity of funds but lack of good governance and well functioning institutions.

The financial sector is by no means an exception to this. OECD sees poor corporate governance as one of the root causes of the ASEAN financial crisis of 1997. The crisis showed that good governance is essential not only for individual corporations to raise capital but also for economy to achieve sustainable growth. In realization of this, international agencies have come up with a number of standards and norms such as code of good practices and Fiscal transparency (IMF), International Accounting Standards (IASB) Principles of Corporate Governance (OECD) and Principles and Guidelines for Effective Inventory and Creditor Right System (World Bank).

NRB feels that strong corporate governance is necessary for the development of a vibrant and resilient financial market and is an effective tool to protect the interest of investors and depositors. Moreover, the ASEAN crisis of 1997 and more recent failures of companies like ENRON and Worldcom have attracted serious attention to the issue of corporate governance. Highly unsatisfactory performance of the two banks (RBB and NBL) and reports of rampant irregularities at a number of financial institutions have prompted NRB to initiate appropriate actions encouraging transparency and accountability.

Financial sector growth in Nepal

The establishment of NBL in 1937 marked the beginning of banking sector development in Nepal. NRB came into existence as the central bank of the county in 1956, which was followed by the creation of NIDC in 1959, EPF in 1962, RBB in 1966, NIC in 1967 and ADB in 1968.

The liberalization of financial sector started in 1984. The liberal policy adopted then and pursued more vigorously thereafter has helped the sector to grow rapidly and also had built foundation for the creation of a competitive environment in the financial market. Currently, there are 17 commercial banks, 16 development banks, 5 regional rural development banks, 54 finance companies, 36 micro credit institutions, 34 cooperative societies doing limited banking activities, 116 postal banks, 12 insurance companies, 1 EPF, 1 Citizen Investment Trust, 1 Deposit Insurance and Credit Guarantee Corporation, 1 Security Board and 1 Nepal Stock Exchange.

Performance of Commercial banks

Along with the number of commercial banks, increased the capital funds, deposits and loans and advances granted by these banks over time. Despite the quantum jump in deposit, the growth rate of it has decelerated a bit of late (17.3% in 2002, 1.7% in 2002). So is the case with liquid fund. Notwithstanding this decline, prevailing law and order situation and the consequential slower growth of loans and advances have given rise to a situation of excess liquidity.

The NPA of commercial banks shows a dismal picture standing at above 45% in case of RBB and NBL. Recent findings have shown that some private banks also have very high NPA. These new findings related to NPA have prompted NRB to go ahead with greater in-depth supervision and remedial measures for the private sector banks also without wasting much time. Indeed, Nepal can not afford to be complacent looking at the dismal performance of banks in countries like Japan and China.

Reform measures adopted by NRB

The liberalization and opening up of the financial sector started in mid 1980s in response to the wind of globalization and financial liberalization that blew across the planet. It was initiated under the Structure Adjustment Facility (SAF) program of the World Bank and IMF. It may be noted that prior to liberalization, NRB dictated deposits and lending rates, margin rates and statutory liquidity ratio. However, post liberalization period has witnessed an progressive shift toward indirect methods of control and deregulation. Some of the measures include allowing joint venture banks to operate in Nepal, greater recourse to open market operation to contain monetary aggregates, deregulating interest rates, conducting CBPASS, abolishing SLR, opening secondary market for auctioning at market determined rates of T-bills and development bonds and introducing a full convertibility of NRS in the current account. NRB has taken a decision to do away with priority sector lending by the commercial banks within the next five years and is determined to concentrate only on the core functions.

While the reform programs were in progress, three major developments created mounting challenges to NRB (i) ASEAN crisis of 1997, (ii) the volatile capital market where the price of shares skyrocketed during 1999/2000 and (iii) insolvency of RBB and NBL.

The ASEAN crisis originated in the financial sector in the form of currency crisis which culminated into economic crisis and caused political upheaval of serious magnitude and nature. Excessive short term borrowing from external sources for projects with a long gestation period, lax enforcement of prudential rules and inadequate supervision and attempts by governments to maintain the exchange rate of their currencies vis-a vis US dollar at an unrealistic level jointly bred the crisis. In 1990s there was a phenomenal growth in direct borrowing from outside sources by Indonesian corporations. Indeed, capital account convertibility fuelled the credit boom in Indonesia, Malaysia, however, introduced capital control measures. On hindsight the ASEAN crisis stopped similar crisis in our region by preventing untimely and hasty freeing of capital controls.

The Nepal stock market witnessed the most interesting movement in 1999 and 2000/2001, in which the stock exchange showed a sharp rise in terms of turnover as well as capital investment. The market price of shares of commercial banks skyrocketed, in most cases unjustified by their respective balance sheets. Inadequate knowledge of people about the share market led to this kind of situation. Further, due to poor accounting and auditing standards, some institutions were able to paint a far better picture than what the financial healthy actually was. In view of this, NRB issued new accounting policy directives in conformity with international accounting standard and Generally Accepted Accounting Principles (GAAP): Various disclosure requirements along with other regulatory and supervisory frameworks have contributed to make the share values of commercial banks stocks more realistic.

The stated objective of HMG/N has been that the financial sector reform should support the lead role of the private sector in economic development through increased resource allocation to the profitable sectors. The dominant role of the government as an owner and operator of NRB, RBB, NBL, ADB, NIDC is often blamed for the deterioration of the financial sector, which also limited the supervisory and regulatory authority of NRB.

The present NRB act has given it full autonomy and independence in discharge of its responsibilities as a supervisor of the financial industry and independent formulator of monetary policy. NBL and RBB management has been handed over to outside parties and NRB reengineering team is in place. Debt re3covery act has already been approved and an umbrella act covering all deposit taking institutions awaits approval. Moreover, necessary steps have been initiated to establish an assets reconstruction company. NRB has withdrawn its representatives from the BOARD of Directors of banks both private and public and has advised HMG/N to do so in regard to their representation, too. NRB also wants to make sure that no financial institutions should be opened with government or NRB’s stake in their equity. NRB has started reorienting its role from one of active participant in the conduct of business of financial institutions to that of a regulator.

Corporate governance is very weak in Nepal. Institutions suffer from unclear role and responsibilities of managerial bodies, boards, shareholders and other stakeholders. Lack of transparency in information sharing with the general public, absence of code of conduct for employees, managerial bodies, board members and stakeholders and irregularities and corruption are some of the characteristics prevalent in the financial system in Nepal.

Some of the measures undertaken to improve corporate governance include:

raising of paid-up capital to 1 billion from Rs. 500 million for opening a national level commercial bank,

participation (financial or technical) of a foreign bank a must for opening a national level commercial banks,

increasing capital participation in a national bank for foreign banks from 50 percent to 67 percent,

setting minimum qualification requirements for promoters interested in opening financial institutions,

directing commercial banks to maintain capital adequacy ratio of 12 percent based on their risk weighted assets by FY 2003/2004,

categorization of loans and advances as pass, sub-standard, doubtful and loss and requiring banks to maintain loan loss provision of 1, 25, 50 and 100 percent on each category, respectively.

Some other measures include:

in order to minimizing risk associated with associated with over concentration to a single party, directing banks to provide credit to a total of 25% of core capital on fund based items and 50% of core capital on non-fund based items to a single borrower, establishing code of conduct for Governing Boards of commercial banks and asking the management to establish an Accounting committee to support the management on financial matters and imposed restrictions on extension of credit to the Board of Directors and promoter shareholders having more than 1 percent stake in the equality and formulation and distribution of statutory forms based on International Accounting Standards to commercial banks to ensure transparency of financial information to the concerned parties.

in addition to above, NRB has issued regulations in regard to capital adequacy, liquidity, loan loss provision, single borrower limit, accounting and auditing requirements, sectoral credit limit and corporate governance to other players in the financial market e.g. development banks, finance companies, micro-credit agencies and cooperatives.

in addition to these reform measures, NRB has injected additional liquidity into the market which is effected through adoption of accommodative monetary policy. The earlier provision of cash reserve ratio (CRR) of 8 percent of shavings and demand deposits and 6 percent of fixed deposits was revised downward to 7 percent and 4.5 percent respectively. Refinance rates have also been adjusted downward. Refinance on export credit in hard currency is provided at 2 percent, 3 percent on credit for sick industries and 4.5 percent on credit in local currency for exports.

Conclusions

Corporate governance encompasses the relationship and pattern of behavior of all those involved in an organization. The ASEAN crisis has amply shown that good corporate governance is essential for sustainable growth of financial sector. Protection of shareholder rights, clarity in duties and responsibilities of all stakeholders, disclosure and transparency and legal framework to sufficiently address good governance mechanism are all important to ensure a healthy growth of financial sector. Withdrawing public sector involvement from the financial sector, developing sound legal frameworks, strengthening the central bank, strengthening accounting and auditing practices and finally enhancing competition among the actors of financial sector are some of the measures initiated to develop a vibrant and resilient financial system in Nepal.

Satisfied with the progress achieved thus far on the financial front as well as other areas, the World Bank decided to upgrade the Bank group’s lending program for Nepal from poor case (US $ 50 million per year) to base case (US $100 million or more).

The success achieved thus for is just a beginning. There are mounting pressures on NRB, which has to play a crucial role in the financial sector reform program. It is committed in spearheading the financial sector reform program. Prudential norms and regulations of central banks are often taken as unilateral squeezing of financial institutions at a time when the economy has experienced a contraction. But it should be remembered that it is the time for our institutions to strengthen and consolidate their position so that they could compete with agencies coming from outsides, keeping the cost of financial intermediation at a minimum. In order for our institutions to rise up to the need and expectation of the evolving competitive economic environment in Nepal, overall discipline and effective and prompt action to remove indiscipline should be the guiding principle which would also restore investor confidence.

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