Nepali Banking at Crossroads

- By Madan Lamsal & Keshav Gautam

The Nepali banking sector is at a decisive crossroad. Some prominent bankers fear that the intensifying competition may turn out to be unhealthy based on rate cuts. Others say that the banks will become innovative and bring about more efficiency in financial intermediation and dismiss fears of unhealthy competition.

However, the negative concerns cannot be brushed off as a complaint of those already inside a crowded elevator asking the janitor to stop newcomers.

Going by recent experiences when bank failures had to be averted by expensive interventions from not just the central bank but also from international lenders, the concern is well-founded. However, there is also a consensus that the bank failures so far are rooted in the malfeasance of the boards of directors and managers in collusion with unscrupulous borrowers. So, stricter rules could help in avoiding further debates. Still one suspects that the future will be characterised by rate cuts as banks may be hard-pressed to get more business from a small market.

As new banks have to start with one billion rupees of share capital, the challenge they face will be to get enough business to utilise this capital so as to give the shareholders the market rate of return.

Till last year there were 18 commercial banks in the country (including the commercial banking wing of the Agriculture Development Bank). This year, Global Bank has already started operations while Citizen Bank has been licenced and is preparing to start soon. According to Nepal Rastra Bank sources, a couple of other applications are being processed too.

Meanwhile, a number of development banks have already announced plans to raise their capital to upgrade themselves to ‘Commercial Bank’ status. And there has been continuous expansion in the development bank category as well. While some new players have registered as development banks, some finance companies are upgrading themselves into this category too.

Going by theoretical logic, the competition that has been growing in the banking industry should be good for borrowers as well as depositors. But both these groups are complaining about the interest rate (too high for borrowers and too low for depositors). And some banks are in trouble even with such a high interest spread. The well-known examples are the Nepal Bangladesh Bank (NBB) and the Nepal Credit and Commerce Bank (NCCB) which have a capital-adequacy ratio (capital fund to risk-weighted assets) of less than the 11 per cent stipulated by the Nepal Rastra Bank.

At present in the state-controlled Rastriya Banijya Bank (RBB), Nepal Bank Ltd (NBL) as well as the private sector Lumbini Bank Ltd. (LBL), the capital-adequacy ratio is negative at the moment. But they are regarded to be exceptions as special restructuring plans are being implemented in these banks.

More importantly, people suspect the authenticity of the capital adequacy figures as these are self-declarations of the management and not audited by independent auditors. As one Chartered Accountant says, "One can be more confident about the capital adequacy figure of RBB, NBL and LBL as they are or were under surveillance of the Central Bank and that hopefully ensured proper accounting. But in the case of other banks, it only depends upon the confidence on the management."

Therefore, the expert opinion is that if strict international standards were applied, more than half of the privately owned banks, including some big names, would be struggling. "New generation banks should have had an advantage in learning from the mistakes made by older banks, but unfortunately, many of the second and third generation banks appear to be making the same fundamental mistakes like poor risk management and taking a short-term view. But the most serious issue is the problem of their boards being too involved in management," says one banking sector specialist.

The result is that the banks are still burdened with huge non-performing loans. Though this has been reduced to some 15 per cent in average now according to NRB data, it is still much too high when compared to the prudential banking standard of 5 per cent.

Banks with high NPA have low capital adequacy as well and the NRB prohibits such banks from extending big loans and accepting big deposits. This makes them extremely difficult to turn around unless the promoters themselves arrange the injection of further capital as the general investors would not be ready to commit further investment on such losing propositions.

But the central bank does not seem to be in a mood to restrict the entry of new players. As NRB’s Deputy Governor KB Manandhar says, “At present the policies being followed are based on the principle that the market knows best. So we have to presume that if some promoters are willing to invest a significant portion of their wealth in a proposed bank, they think it is viable.”

Added to all this, is the WTO deadline of 2010, by which Nepal's banking sector will have to allow foreign banks to open their branches here.

Preparedness

But there are silver linings in this environment. Looking at the difficulties of the banks burdened with non-performing loans and facing the problem of low capital adequacy, the Nepal Rastra Bank has prepared rules to regulate their mergers with healthier banks. Also, the banks themselves have begun to specialise in various sectors as a result of the competition.

Some banks have already started special schemes to lend to SME's (small and medium enterprises) with a view that foreign banks will be more interested in large size loans that go to big corporations. Laxmi Bank started SME lending soon after it started its operation about four and half years ago. The bigger and older Himalayan Bank, in its annual report for the fiscal year 2005-06, has revealed that it is starting a special lending service for small borrowers in cooperation with the International Finance Corporation. This body operates under the World Bank and lends to the private sector.

Machhapuchhre Bank too is following similar policies and has revealed that it is planning to expand to rural areas. Nabil Bank has plans to set up branches in remote areas too. It has already set up an alliance with the Postal Saving Bank to reach remote locations. Now with peace prevailing in the rural areas, Nabil's CEO Anil Shah hopes his bank will be able to move some of the ideas forward to benefit from the alliance with the postal bank.

Also, the newly operational Global Bank has planned to expand its operations to the rural areas starting with locations around Birgunj, where the bank has its headquarters.

Meanwhile, some banks (Standard Chartered Nepal and Laxmi) have started bancassurance - the business under which a bank sells insurance products in collaboration with an insurance company.

That's not all. Everest Bank Ltd. (EBL) and Standard Chartered Bank have been trying to start the mutual fund business. As EBL's new CEO Jaspal Singh Jass says (see interview in this section), his bank is waiting for NRB's approval to start mutual funds. However, StanChart’s CEO also says that at present his bank is hesitating in this as volumes required for that business may not be available. In turn, NRB Deputy Governor KB Manandhar says, as this matter is closely related with the securities market, NRB is waiting for the concurrence of Security Board before going ahead with the approval process.

Also Nabil's CEO Shah says his bank too is thinking of promoting mutual funds and adds: "When we are thinking of building a new Nepal , banks too need to think out-of-the-box, not just in terms of new concepts, businesses or strategies, but even in making a paradigm shift of banking philosophy."

However, none of the banks contacted by Nubiz for this report showed any interest in setting up a venture capital fund. While all of the respondents pointed to the lack of depth in the stock market for such a business to be viable, some were of the view it may cannibalise their existing products. StanChart’s Mundul says, “Being a commercial bank, venture capital business is not an area of our interest.”

Hydropower

Banks seem to be very keen in investing in hydropower projects. As it is general knowledge that the energy business can only grow from here, it is natural that hydropower is the first choice for Nepali bankers. And as the banks' records show, they have already put this sector in their portfolios.

For example Shah says, "Like most institutions our bank has also commenced serious relationships with hydropower developers." Ashoke Rana, CEO of HBL says, "Our experience in hydro-financing has been excellent. In fact, HBL is among the few banks that actually thought of channelling bank credit in hydropower projects."

But what they should keep in mind is that in three years' time, foreign banks with big capital will come into the equation as well. This fact has to be reflected in their strategies. Particularly, smaller banks that do not have foreign equity participation might not get their share of the hydel-pie if they muddle their strategies in this sector. For example when bigger foreign banks are allowed to open branches in Nepal, they will almost certainly take over the larger projects and many Nepali banks will have to be content with lending to small hydro projects or sharing a small part of the business with bigger banks.

There also is an inherent danger in lending to hydropower projects because promoters of hydropower in Nepal still do not know enough about how to asses risks properly. According to Sujit Mundul, CEO of Standard Chartered Bank Nepal , his bank has come across only a handful of serious promoters who understand and address the risks involved. In this regard Rana adds: "Many factors like the people behind the project, the total construction cost, the total construction period, power generation capacity, per unit cost, and most importantly, the contingency planning and power purchase agreements have to be taken into consideration before seriously thinking about hydro-financing." The expertise in these respects will differentiate between banks that survive and banks that don't.

Another factor that may be crucial in hydropower is the opening of an infrastructure development bank (IDB) as proposed by the government. Such a bank could lead the consortium through which other banks could participate in lending to big projects. Anil Shah says, "We all know that the development of the nation's infrastructure, especially with respect to the tapping of our huge hydropower potential, is the key to embarking on a journey of sustainable development. We see that a professional IDB could play a crucial role of a catalyst in this process. In fact Nabil Bank has already agreed to participate in the establishment of such a bank." Himalayan Bank's Ashoke Rana says that the bank too is 'positive' about the proposal.

The Rural and Agriculture Sectors

A serious allegation against banks in Nepal has been that they have not been able to reach the majority of Nepal 's population who reside in rural areas and are involved in agriculture. There seem to be two reasons for this. The first is obviously the political situation during the last decade while the second is that agriculture in Nepal is not commercialised enough for banking purposes. However, with the strong possibility of foreign banks entering the country after 2010, it is likely that Nepali banks will have to specialise in retail banking. Since retail banking is currently concentrated in city areas in financing vehicles and housing, this market is perceived to be overburdened. So, Nepali banks will have to go rural not only to grow, but also to be competitive when foreign banks come in.

A positive sign is that this is happening now. Banks like the Machhapuchhre Bank have started their operations in rural areas (it has set up an ATM machine in Jomsom). The alliance started by Nabil Bank last year with the Postal Saving Bank is another example. "The future of banking in Nepal depends on the extent to which we can penetrate the rural masses and capitalise on the opportunities in deposit mobilisation, as well as lending," claims Nabil's CEO Shah. He says that penetration into rural Nepal is the next paradigm shift in banking revenue generation and it may be one of the main engines of growth for the financial sector in Nepal . Nabil has already started an extensive survey from Mechi to Mahakali to determine where best to establish their points of representation. According to Shah, the new concept is not just opening branches in rural areas, but the formulation of a 'business model' that ensures the branch will be profitable in the shortest duration from opening, and then being able to generate sustainable revenues.

Also, HBL is keen on expanding operations inside the country where possible, according to its CEO Rana. Establishment of new branches is already on the cards. Talks are underway with the regulator in this regard. One of HBL's key focus is to increase SME financing for which Small Business Enterprises Loan has been developed," he adds.

Let banks fail

Another major concern in the banking sector is how to deal with bank failures. Nepal Rastra Bank has been taking control of troubled banks and turning them around, the latest example being its control of NB Bank. But Suman Joshi of Laxmi Bank suspects the outcome of this exercise. "I'm not sure if NRB has the wherewithal and expertise for this. Its past record in such exercises is not promising. If we are genuinely interested in meaningful financial sector reform, banks must be allowed to fail. It will be painful and the cost will be high. But then, aren't we incurring a huge cost on the ongoing lackadaisical financial sector reform activities? I believe that the reform brought about by the market forces will be far more effective and have a lasting impact."

Shah says: "This is unfortunately a situation in which the NRB is damned if it does and damned if it does not. If it does not intervene and allows sick banks to fail, then everyone will be up in arms and question why the NRB is not doing anything when thousands of people are losing millions of their hard earned deposits. On the other hand, if the NRB does intervene it sends a wrong signal that the depositors need not be careful while selecting the bank where they deposit their money."

The merger rules that the NRB has just formulated may help in this.

WTO

Of course, the big question on everyone's mind today is about the possible impact of foreign banks setting up their branches here. Experts say if proper regulations are not made by the NRB, then Nepali banks stand to lose a lot. For example, banks have been assuming that when foreign banks come in, they will only be interested in wholesale lending. But if the right rules are not set in place, nothing will stop foreign banks going into the retail sector. They might do it just to kill off competition and monopolise the Nepali retail sector which is profitable given the number of banks making profits in the retail business currently. The solution suggested is to adopt policies to prohibit foreign banks from entering the retail sector. And this is possible even under WTO, says Kim Norris (see the interview section of this issue).

---

Hydropower Financing
A Banker’s Perspective

- By Nirmal Dahal

Nepal has been blessed with huge hydropower resources. Its rivers have the potential to generate 83,000 MW of electricity. However, it has been estimated that commercially 43,000 MW of electricity can be generated. Estimates show that $69 billion (43,000 X $1.6 million per MW of generation cost) will be required to generate 43,000 MW of electricity. To meet the current demand of electricity, at least 50 MW needs to be added to the grid every year for some years to come. This translates into a financial commitment of $80.0 million per annum. So it presents tremendous opportunities for financial institutions.

Nepal has seen some developments in the involvement of domestic financial institutions in the hydropower projects promoted by the Independent Power Producers (IPP). Chilime, Khudi, Puwa Khola are some of the projects which were locally financed. Before IPPs came into the picture, all the dealings of banks in this sector were with the state owned NEA and only a few banks were given access to it. Now the scenario has changed. Most major banks are involved in financing the hydel sector in one way or the other. Some have financed the privatisation of the state's share in hydropower companies, some have financed the purchase of the shares of foreign investors in IPPs by domestic companies and some have provided direct financing to IPPs. In the first two types of transactions, the source of debt repayment was the cash flow of companies already in operation. In the last type of financing where banks have directly financed the IPPs, the element of risk is quite high as they will be involved from the initial stage of project construction.

Financiers and Project Financing:

Financing of hydropower involves long term commitments from commercial banks. However, traditionally banks have preferred financing with short term commitments. Furthermore, infrastructure projects like hydropower require longer construction periods. Due to the nature of the finished product (electricity), there has to be a confirmed buyer for the electricity produced (unlike the other traditional financing of merchandising nature in which products don't require particular long term contracts for the sale of goods produced).

The development of a hydropower project requires the involvement of various parties, developers, consultants, suppliers, contractors, operators, buyers, regulators, local bodies, etc. The duties and responsibilities of the parties involved are established through contracts. In this type of financing, the contract is the king. A lender has to go through all these contracts in order to understand the project.

As in other types of financing, the major risk for a bank is the credit risk (default risk)--the borrower may not service and repay the loan as per the commitment. Mere reliance on a contract will not be sufficient in addressing this risk. Hence banks request for various credit enhancements to mitigate it. Some common credit enhancement devices considered by commercial banks are:

• Direct Guarantees (Sponsors and Third Party or generally other project participants)
• Indirect Guarantees ( Take or Pay/ Take & Pay)
• Letter of Credit
• Surety Obligations ( bid bond, performance bond, payment bonds)
• Insurance (including Advance Loss of Profit/ Loss of Profit)
• Unrelated Fixed Assets Collateral

Due to the nascent stage of the financial sector in Nepal, it will take some time for banks to lend on pure project financing terms where the lending is secured purely by the underlying cash flow of projects and contracts. So the development will be a gradual process. First the market will have to be matured to a partial project financing mode where credit enhancement will be limited (requirement of personal guarantee of the promoters only till the time the project comes into operation and requirement for unrelated fixed assets).

Current Issues:

As far as commercial banks are concerned, hydropower financing represents a small portion of their total risk assets and they are still testing the waters (literally). Mostly the involvement in a project is below 50 per cent of their Single Obligor Limit (SOL). To raise money for 5 MW projects, more than five commercial banks will be involved. The following factors are responsible for the slow take off of hydropower financing:

1. Long tenure of loans

2. Longer construction period requiring interest capitalisation

3. Lack of understanding on the part of the lenders on technical aspects of projects

4. Absence of proper (credible) agency for verification of various costs (civil as well as electromechanical) and suitability of the equipment associated with the project.

5. Absence of proper dissemination of information on credit enhancement such as insurance

6. Political situation of the country. Contradictory messages from the responsible persons in political parties.

7. Over eagerness of promoters in reducing the cost of the project resulting in wrong choice of contractors/ equipment suppliers

8. Financial health of the only buyer of the product, NEA

9. Non clarity on the price escalation factor on PPA (for 100KW to 5000KW projects) after 2060/61, for power projects which have already signed PPAs with NEA (6 per cent per annum till then)

10. Case to case decision by NEA on the imposition of penalty if the commercial operation is not started as per the PPA.

11. Lack of close cooperation between the lenders and the borrowers resulting in various amendments in the agreements/contracts signed by borrowers (with civil contractors/ Electromechanical Component suppliers/ etc.)

12. Lack of clear distinction between promoters and contractors/suppliers.

Some of the issues can be taken care of by professional bodies (Association of Independent Power Producers and others) or bilaterally between borrowers and lenders. However, some of the constraints mentioned above need the involvement of agencies/individuals in a structured way. Independent institutions need to bridge the gap between the prospective lenders and borrowers. Financing in hydropower is still at a nascent stage and confidence building measures by these institutions will pave the way for greater involvement of the commercial banks in this sector.

Conclusion:

In Hydropower Project Financing, banks will prefer:

• Debt: Equity Ratio between 60:40 to 80:20
• Timely infusion of equity by the promoters
• Construction period of not over two years
• Grace period of three to six months
• Total loan period between seven to nine years (including construction and grace period)
• Detailed background checks on the suppliers, specially from emerging markets, and contractors (to ensure that they can fulfil the terms and conditions)
• Financial guarantees from sponsors to take care of cost escalations, if any, if the project contracts are not close ended
• Updated and on demand information on the project
• Clear separation of interests of the sponsors and contractors/suppliers (no conflict of interest)

Currently, banks are testing the waters in hydropower financing. The success or failure of the projects currently under financing will play a major part in setting the direction for lenders. All the stakeholders involved have high degrees of responsibility to ensure the success of these projects. If Nepal has to get on the economic growth train, then the development of hydropower is a must. The initiatives and confidence building processes currently being undertaken by various stakeholders are quite encouraging. Now is the time to walk the talk. Hence, stakeholders must ensure that unscrupulous parties do not derail this train.

(Dahal is the Manager, Credit Risk, at Laxmi Bank Ltd. The views expresses above are his and does not necessarily represent his employer's views)

---

"We're prepared for mutual funds"

Jaspal Singh Jass recently joined Everest Bank Ltd. (EBL) as its new CEO representing India's Punjab National Bank (PNB) which is the joint-venture partner in EBL. In this interview, Jass gives a glimpse of what strategies he is thinking about adopting in view of the existing challenges and opportunities. Excerpts:

What are you planning as the new CEO of Everest Bank Ltd. to outperform your predecessors who had very successful tenures?

We are planning for high growth in deposits and our profitability margins. We are aiming at a 35 per cent increase in profitability. And of course we also want better asset quality in our bank. Under our expansion plan, we are going to open three more branches this year — at Balaju, Nepalgunj and Biratnagar. We are also planning to go into insurance through an internal agency to increase our non-interest income. We are also looking to better manage our treasury operations to improve our productivity.

Last year EBL was exploring possibilities to start mutual fund management in cooperation with PNB. What are you planning in this line?

We have already sent applications to the Nepal Rastra Bank for permission to start mutual funds and we are following up on this issue. As soon as we get permission, we would like to venture into this field.

We have been asking each new CEO of EBL about how they are planning to expand the business in rural areas as PNB has done in India . How is your plan about this?

What I personally feel is that our exposure in the agricultural sector is not at the desired level. So, we will be focusing in these areas also. Our competency in Nepal is firstly in tourism and then in the trading sector. Maybe, after some time, it will be in manufacturing too. But as for agriculture, it continues to be a green turf for us. Because of the law and order situation, the loan recovery from the agricultural sector has not been good but hopefully with the improved situation, we would like to focus on this sector and we are also looking at the possibilities in village craftsmen and artisans.

What do you see as the main possible threats to the success of your plans that you just mentioned?

There is immense competition in the banking sector here and this is likely to increase further. More foreign banks will probably enter the arena also. If we go by the population per branch, the competition is more intense here than in India . Some banks are lending at rates that are not at par with their cost of funds. There is an interest rate war. That is a disturbing fact. We have to prepare ourselves for this by being innovative and considering the demands of our clients. We are strengthening our marketing efforts for this. We will have a marketing team in every branch, and at the corporate level.

Some observers say that real banking has not started in Nepal yet, especially in the rural areas. What is your response to this?

We still see traditional kinds of financing here. We are focusing more on collateral rather than the feasibility of projects. Even if an entrepreneur has an excellent plan, he might not be financed because of the lack of collateral. So, I expect this to change in the future.

Are there any regulatory hurdles that you would like to see removed so that EBL would be able to do much better?

The banking sector here is given sufficient freedom for operation. There are no irritants from the central controlling authority. The Central Bank is aware that the banks should enter new areas and they are processing applications from various banks in various sectors.

What about the challenges and opportunities ahead in view of the recent changes in the environment?

With peace and stability, every economic sector will get a boost, foreign direct investment will come into the country, and the banking sector will also be very active. Nepal is situated between two fast developing economies and we can also take advantage of that. Maybe we will have bigger players in the market and once manufacturing gets started, things will be more positive. Nepal has hydropower too and even though we do not have exposure in that area, we would like to look into it as well.

---

Financial Intermediation It’s Development in Nepal?

- By Sadaya Hamal

There are conflicting opinions regarding the relationship between financial intermediation and economic growth. Some have shown a positive relationship whereas others demonstrate an ambiguous linkage. Schumpeter argued that an efficient financial system assisted national economies in growing. McKinnon and Shaw outlined the constraints placed by an inefficient financial system on economic development and pointed that such economies are incapable in deriving benefits accruing from the liberalisation of the financial sector. On the other hand, Lucas held that the role of financial institutions is ‘overemphasised’ in promoting growth whereas Robinson maintained that the demand for financial instruments is actually the outcome of economic growth and the financial institutions simply fulfil that demand. However, recent academic researches across many countries point at the crucial role of developed banking sectors and capital markets in supporting and facilitating economic growth. The rationale is that fully-evolved financial systems allow national economies to reach their potential by channelling requisite resources to exploit profitable business opportunities that are ascertained by commercial ventures.

There should be accumulation of input factors (human and capital) in production process and technological innovations for economic growth to occur. Since capital and its accumulation is one of the input factors in the production process, financial development is distinctly related to this source of economic growth. Moreover, the influence of financial development on growth is transmitted via three conduits: (1) it can increase the savings rate of the economic units by promoting specialisation and greater risk-sharing; (2) it can improve resource allocation; and (3) it can reduce financial intermediation costs that accrue when larger portion of savings is utilised for investment purposes. A robust and functioning legal system appears pertinent for strong economic growth because it often helps in lowering information and transaction costs to the financial institutions, which may lead to better resource allocation, increased availability of funds to worthy borrowers and investment projects, and further reduction in risks. It may, ultimately, enhance the process of financial intermediation, thereby fostering economic growth. This leads to a query: what is the developmental stage of the financial intermediary institutions within the Nepali financial system?

Usually financial systems in most developing countries tend to be commercial bank-centric. The capital and stock markets are likely to be underdeveloped in these countries and as a result, the financial system is dominated by the commercial banks. And Nepal ’s case is no different. The financial sector in Nepal is marked by increased complexity and depth, at least, from the viewpoint of the available institutional framework since the late 1980s. Before this period, two state-owned commercial banks and two state-promoted development banks had a monopoly over the financial sector. The financial reforms, initiated during the mid-1980s, saw interest-rate deregulation and gradually opened the financial sector. During this period, joint-venture commercial banks entered the Nepali financial sector and by January 2006, the number of commercial banks, in the private sector and as joint ventures, reached 17 (in 1983 and 1993, there were two and eight commercial banks respectively). At the same time, there were 29 development banks in operation by January 2006 (there were only four in 1993). The reforms also promoted alternate institutional arrangements in the financial sector. Finance companies came into existence in 1992 and by January 2006, they numbered 63. Cooperative societies (with limited banking licence) increased to 35 in 1998 from their beginning in 1994. However, only 19 were in operation in January 2006. Non-government organisations (with limited banking licence) initiated their operations in 1995. By January 2006, there were 47 of these institutions.

Of the total assets in the Nepali financial system, about 65 per cent is owned by depository institutions (banks) and other depository institutions (finance companies, and non-government organisations and cooperative societies). The commercial banks have the lion’s share of over 50 per cent. The share of the commercial banks in total deposits liabilities is over 80 per cent whereas their share in total credit is over 70 per cent. They also have a high share of the above 80 per cent in total investments and liquid funds. This dominance of the commercial banks is understandable since their scope of activities is much wider compared to other financial institutions and this makes them better-placed for investment purposes. The geographical spread of the commercial banks is also unparalleled (over 400 bank branches) and this allows them to tap a wider resource base at significantly lower costs and also invest on a national scale.

A comprehensive banking and financial survey is not readily available in Nepal . However, the Nepal Rastra Bank conducts banking surveys (consisting of financial data of monetary authorities, commercial banks and other depository institutions) to estimate liquid liabilities of the Nepali financial system. Because of unavailability of money-definition inclusive of deposit liabilities of other depository institutions, narrow money () and broad money () 2 serve as proxy for overall magnitude of the financial system. Apart from these limitations, we have to depend on monetary survey data to measure financial development and we can only interpret banking system indicators. For easier comprehension, all the ratios are listed in Exhibit 1.

The simplest indicator of financial development is Monetary Aggregate/GDP ratio. We have a choice to either use narrow money or broad money aggregate. Money is capable of providing both payment services and saving services. Narrow money stock (M1) reflects payment services whereas broad money stock (M2) reflects the saving services. We can see in Exhibit 1 that M1/GDP has increased from 8.06 per cent in FY 1974/75 to 18.27 per cent in FY 2004/05. This indicates the growing monetisation of the economy.

The liquid liabilities of the banking system are represented by broad money (M2) of the banking system. When M2 is divided by the GDP, we obtain a second measure of financial development. Since M2/GDP helps determine the extent of the penetration of the banking system in mobilising savings, this ratio serves as a measure of the size of financial intermediaries in the economy. This ratio also reflects the extent of monetisation of the economy. Exhibit 1 indicates that M2/GDP has increased from a lowly 12.44 per cent in FY 1974/75 to 55.09 per cent in FY 2004/05.

Theoretically, all other things remaining the same, narrow money (M2) should rise when economic transactions increase but broad money (M2) should register increases at a faster pace if financial deepening is taking place. On an annualised basis, the average growth rates of M1 and M2 are about 16 per cent and 18 per cent respectively. On the basis of this crude parameter, it appears that financial deepening is taking place.

Though M2/GDP and a higher average growth of M2 show that financial deepening has indeed taken place in Nepal , this may not be a true reflection of the provision of financial sector services in the economy. This is because both the central bank and the commercial banks may provide credit in the economy. Therefore, we need to estimate the extent to which the commercial banks allocate credit in comparison to the central bank. For this purpose, CREDIT Combank is computed. The increasing trend of the ratio indicates the growing role of the commercial banks in credit allocation in the economy in comparison to the central bank. We can see in Exhibit 1 that has increased to 90.6 per cent in FY 2004/05 from 57.13 per cent in FY 1974/75. It appears that the prospect of the commercial banks to provide financial sector services is higher than that of the central bank in Nepal .

However, CREDIT Combank possesses inherent flaws on two accounts: (1) the commercial banks may also lend to the government, not just to the private sector; and (2) other financial intermediaries may also provide equally efficient financial sector services comparable to that of the commercial banks. Thus, CREDIT Private is considered the most appropriate measure of financial development since it exclusively focuses on the role of financial intermediaries in channelling resources to the private sector. Exhibit 1 reveals that CREDIT Private increased to 68.84 per cent in FY 2004/05 from 40.26 per cent in FY 1974/75 in a span of three decades. CREDIT Private recorded impressive growth from FY 1989/90 to FY 1994/95, which had actually declined significantly during FY 1979/80 to FY 1984/85. During this period (FY 1989/90 to FY 1994/95), the number of joint-venture commercial banks offering better quality services had increased dramatically and were rapidly expanding. Due to the political change in the early 1990s, the government embraced broad economic liberalisation in Nepal and accorded priority to the private sector. This provided further impetus to the commercial banks to provide credit to the private sector. However, increase in this ratio has been negligible during the FY 1999/2000 to FY 2004/05. This period was marked by extensive political instability and widespread destruction of physical infrastructure; as a result, it exerted negative repercussions on the economy and business confidence was at the lowest here.

In addition to CREDIT Private , CPSEC % also analyses the credit to the private sector. In CPSEC % , credit to the private sector is computed as a percentage of nominal GDP . Exhibit 1 shows that this ratio has increased from 4.72 per cent in 1974/75 to 36.92 per cent in 2004/05.

PVT/TOT shows the proportion of commercial banks' total credit diverted to the private sector. In CREDIT Private , the highest growth was recorded from FY 1989/90 to FY 1994/95 and it recorded a decline during FY 1999/2000 to FY 2004/05. This indicates that proportionate lending of the commercial banks to the government and state-owned enterprises has declined continuously over the three decades. In other words, the major portion of lending by the commercial banks is channelled into the private sector.

Credit to the private sector is considered the most significant of all indicators of financial development. The reason being that credit channelled into the private sector is more likely to be used for productive purposes. Moreover, the private sector is more likely to obtain bank credit only after it spots profitable business opportunities. Therefore, increased credit to the private sector may ultimately lead to economic growth.

Even when quantitative measures signal growing financial intermediary development, it can be misleading. As our calculations show, these measures only considered the banking sector data and not the securities markets and non-bank financial institutions. The importance of non-bank financial institutions and securities markets tend to be more in the developed countries. It also suggests that financial development measures, based on monetary aggregates and bank credit, suffer from downward biasness. Perhaps a broader definition of financial assets may address this inaccuracy to a large extent; however, framing such a definition and measuring financial assets in the economy is difficult. In the absence of a definition, one of the suggested alternate measures is a ratio of broadly-defined money and narrowly-defined money (M2/M1).

From Exhibit 2, we can see that the ratio has been continually rising in Nepal except between FY 1984/85 and FY 1989/90, and between FY 1999/2000 and FY 2004/05. It appears that this ratio is positively-related to financial development in Nepal during the long-term. It also indicates that, in the long-term, bank-deposits of the saving nature are increasing more rapidly than bank-deposits of transactional nature.

The second suggested measure is the ratio of securities market outstanding to broadly-defined money (Securities Outstanding /M2 ). However, there are technical difficulties and data constraints in computing this ratio. The securities market in Nepal is limited to equity, government bonds and Treasury bills. In the equity market, over 90 per cent of trading is concentrated in the financial institutions' group stocks. Additionally, stock trading is largely limited to the Kathmandu Valley . The government bonds targeted to the public are purchased for investment purposes because they offer safety and higher interest rates (compared to bank deposits). But they were not listed in the stock exchange earlier, thus the secondary market was almost non-existent. The government bonds targeted to financial institutions are purchased by the commercial banks and other non-bank financial institutions with a view to 'park' money because of the lack of investment opportunities and the secondary market for these instruments are almost non-existent. And only including outstanding equity in the stock exchange to estimate the securities market outstanding will distort this measure.

Note:

Credit Combank = Commercial Bank Credit
Commercial Bank Credit + Domestic Credit of the Central Bank

Credit Private = Credit to the Private Sector
Total Domestic Credit – Central Bank Credit to Commercial Banks

CPSEC % = Credit to Private Sector
GDP

PVT/TOT = Commercial Bank’s Credit to Private Sector
Total Commercial Bank Credit

There are two more qualifications before we conclusively assert that financial development has taken place in Nepal . Firstly, although the private sector credit is suggested as the strongest measure of financial development, there are some reservations against this because the Nepali experience shows a different picture. The disproportionate amount of non-performing assets (NPA) of two oldest commercial banks is a strong indicator that the private sector has not utilised bank credit prudently. Continual and excessive political interference, corruption within the commercial banks, lax evaluation, monitoring and supervision mechanism, and inept personnel have contributed significantly to the high amount of NPA in these banks. It is also true that some portion of susceptible loans have been rescheduled and counted as 'good quality' private sector credit. Recently, the Nepal Rastra Bank had to intervene to take control of the NB Bank's management to avert widespread financial instability because of its massive NPA. Thus, only increasing the amount of credit given to the private sector cannot be taken as a reliable measure of financial development when the question regarding quality remains unanswered.

The second reservation arises from the use of broad money in computation of financial development ratios. M2 includes M1 and time deposits. Both savings and fixed deposits constitute time deposits and they earn interest for the depositors. There is an 'automatic' or a time-bound increase in M2 after a certain period (because of interest earned in savings and fixed deposits) even when fresh deposits are not actually infused into the banking system. Such an 'automatic' increase cannot signal the increase of financial development or increased financial sector penetration. However, there haven't been any studies in Nepal to estimate the percentage of M2 that increases every year on this account. Therefore, without proper adjustment, any ratio based on M2 is likely to incorporate upward biasness and overstate financial development.

Because of technical difficulties and data constraints, we are not in a position to compute more representative ratios to measure financial intermediary development in the Nepali context. With the available data and financial development measures, it appears that financial development has occurred in Nepal to some extent. However, these ratios should be interpreted with caution.

(Hamal is a Lecturer in the Management Campus of Purbanchal University)