The Problem of Non-Performing Loans
Non-Performing Loans
(NPLs) are those that
are in default or close to
being in default. The financial sector reform in Nepal was launched by the government in year 2000 to address the heritage of politically influenced lending by state-owned banks and weak supervision that allowed the accumulation of high volume of NPLs. The two major state owned banks, namely Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB), which have roughly 30 percent of share of the total banking assets, had been plagued with mounting NPLs since the 1990s. As such, reducing the NPLs at these banks became a daunting task for the government. At one point in the early 1990s, the ratio of NPL stood at 7 percent of the country’s GDP. High risk and connected lending practices, lack of appropriate credit appraisal mechanism and monitoring system led to undermine the banking systems’ credit portfolios.
Figure 1 shows the overall trend of declining NPLs in the commercial banks. As it shows, the ratio of overall NPL to loans has fallen by more than half since 2003.
The public sector banks have been under a restructuring program supported by the World Bank since 2000. As part of the restructuring program, loan recovery, aggressive loan write-offs and improved supervision have contributed to the significant fall in the level of NPLs in these banks.
Foreign joint venture (JV) banks and private sector banks have fared much better in terms of NPLs compared to their state counterparts. Majority of the private sector commercial banks have maintained NPL at 4 percent or below. Recent data suggests a continuation of this positive trend with NPLs declining further.
The overall NPL figure of Nepal’s commercial banks in 2008 was about 6 percent and is comparable to those of China (7 percent) and India (2 percent). The Chinese and Indian data are taken from the World Development Indicator (WDI) of the World Bank.
Capital Adequacy Ratio (CAR) Performance
Capital adequacy is the pre-eminent anchor of banking regulation, prescribed by the Basel Accord and determines the capacity of a bank to meet its time liabilities and other risks -- credit, operational etc. It is expressed as a percentage of a bank’s risk weighted, credit exposures or assets. Banking regulator in most countries define and monitor CAR, thereby maintaining confidence in the banking system.
The CAR prescribed under Basel II norms is 9 percent. In 2007, Nepal’s central bank raised the minimum capital requirements to 11 percent of the total assets (weighted by risk) as a response to the growing number of financial institutions in the country. Most commercial banks continued to maintain capital in excess to the 11 percent required with the exception of three public and three private sector commercial banks. The continued inability of the public banks to maintain adequate capital undermines the credibility of banking supervision. Having said this, the overall capital adequacy ratio of all commercial banks in Nepal finally turned positive to 4.04 percent in 2008, as against the continued negative figures in the preceding years. Figure 2 shows the capital adequacy ratio across public, private, and foreign JV financial institutions.
Fig 1: NPLs as Percentage of Total Loans
Source: Nepal Banking and Finance Statistics – NRB 2008
Fig 2: Capital Adequacy Rati o
Figure 2 shows that although the aggregate CAR is improving, especially the public sector banks are in desperate need of recapitalization.
Stress Test to Assess NPL and CAR Shocks
A stress test conducted by the IMF in 2008 (IMF Country Report No. 08/182 June 2008) suggests that banks in Nepal are more vulnerable to asset quality and liquidity shocks than exchange rate and interest rate shocks. The sensitivity tests showed that financial institutions are moderately flexible to the direct effects of exchange rate (versus the USD) shock due to low level of dollarization. Similarly, the impact of interest rate shocks would also be limited. For instance, the stress test showed that the impact of a 1.5 percentage point increase in interest rates on all banks is only -0.3 percentage points (-1.2 percentage points for public banks) reduction in CAR, due to the increment’s humble consequence on the net interest income on private banks given their profile of interest sensitive assets and liabilities.
The test showed a 25 percent increase in NPLs at all banks reduced the aggregate CAR by 1.2 percentage points. In large public banks the reduction is 1.8 percentage points which is as expected given their already large NPL ratios. In this scenario, the capital of one additional private bank would fall below the minimum CAR.
Limits on large single credit exposures are moderately sloppy, which leaves the banks vulnerable to credit concentration risk and to defaults by their largest borrowers. In this case, nearly all banks would cease to meet their minimum CAR, while a significant number of banks would go bankrupt if their largest 3 to 5 borrowers become evasive. Finally, banks’ liquidity positions are not even able to withstand standard shocks to deposits (for instance, 15 percent of demand deposit withdrawn a day) under standard assumptions for market discounts on liquid assets.
In conclusion, it would then be right to say that especially the public banks still maintain a high NPL figure and a significant negative CAR, therefore addressing the NPL and capital deficiency of the public banks should be the government’s priority. The government should recapitalize (by injecting capital) NBL and RBB (A IMF study in 2007 showed that this amount would constitute to about 5 percent of Nepal’s GDP) to bring all of them above the minimum CAR level of 11 percent,and ensure sound management practices, creditworthiness of borrowers, and implement robust collection mechanism to address defaults, given the history of politically influenced lending.
(Poudyal recently completed one-year MBA course at Indian Institute of Management, Ahmedabad)
