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Averting the 'Lehman Momentum' in Nepal

Hari Bansh Jha was ICCR Fellow at the Institute for Defence Studies and Analyses, New Delhi.
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  • July 18, 2011

    The health of Nepal’s banking and financial institutions has deteriorated drastically, causing panic among a section of depositors and government institutions.

    The banking and financial institutions (BFIs) in any country are considered to be the barometers of economic growth. The economy of a nation rises and falls in sync with the rise and fall of BFIs. Unfortunately, the health of BFIs in Nepal, which include all commercial banks, development banks, finance companies and cooperatives, has deteriorated drastically. Nepal has 31 commercial banks, 88 development banks, 79 finance companies and around 20,000 cooperatives (many of the cooperatives are also engaged in financial transactions). 1

    The first signs of trouble in the BFIs were observed in 2010, which have further aggravated in recent months. The lack of credibility of some of these institutions has created panic among a section of depositors and government institutions. Many depositors have already withdrawn their deposits from the BFIs; while the others are anxiously waiting to do so. Because of the trust deficit, the depositors are not satisfied with the assurances that the problem is temporary.

    In 2011, five financial institutions have so far been severely affected by liquidity crunch. The People’s Finance Limited (PFL), which was operating for more than 21 years, has had to shut down operations for some time. Keshab Prasad Bhattarai, the deputy chief executive of PFL declared, “We have surrendered to the central bank as we do not have the necessary liquidity to pay our deposits, and borrowers are not repaying on time.” 2

    Soon after the crisis in PFL, the Vibor Bikas Bank (VBB), a national development bank, was also affected by a liquidity crunch. It became difficult to save the VBB when it failed to receive inter-banking loans due to the lack of adequate security instruments such as treasury bills and bonds. The problem started when the Nepal Rastra Bank pulled out its deposits from the VBB. However, the Nepal Rastra Bank did save the VBB from further crisis by providing it a loan of Rs. 500 million, as the lender of last resort.

    It is not for the first time that the Nepalese BFIs have plunged into financial crisis. In the past, the Gorkha Development Bank, Samjhana Finance and even the Nepal Bangladesh Bank had faced serious liquidity problems. It was with great difficulty that these financial institutions were saved from liquidation.

    Today, the liquidity crisis among the BFIs has worsened to such an extent that certain banks have no option but to delay the dispersal of already committed loans. There have even been reports that BFIs have had to stop financing automobiles and the housing sector. As such, the imports of automobiles have plummeted by 40 per cent. Some 300 vehicles were stranded at the Birgunj customs point earlier this year due to the failure of the banks to provide finance. Not even a single housing project was approved in 2009-10 due to the liquidity crunch.3 The Himchuli Bikas Bank, Pokhara and Birgunj Finance, Kathmandu have been forced to merge and become H&B Development Bank in their bid to avoid future trouble. 4

    However, the crisis among liquidity-starved banking institutions somewhat stabilised after the central bank of the country intervened by providing them a special refinance facility from June 14, 2011. After this development, many of the panic-ridden depositors transferred their money from financial institutions to commercial banks. This has given the banks some breathing space, which in addition are planning to reduce the interest rate on deposits marginally by 1 per cent. Although this possible reduction in the interest rate on deposits is not significant per se, yet it might bring about a corresponding reduction in lending rates as well. In any event, these developments do not augur well for the financial institutions which have been losing deposits on each successive day.

    There are different schools of thought regarding the reasons for the liquidity crisis in Nepal. The most widely accepted reason is that the BFIs wrongly gave the major share of loans to the real estate and housing sector. Now, this sector is facing a downturn because of the fall in real estate prices. Consequently, investors have been finding it hard to repay their loans to the banks. The banks are unable to recover the loans -especially the junk and subprime loans. Most importantly, those BFIs which had made most of their investments in the real estate sector are the most affected. They are unable to raise deposits by increasing interest rates as they find that the investment climate in the country is risky.

    Another major reason for the liquidity crunch among the BFIs is the government's inability to spend. This has not only affected the people's purchasing power, but it has also affected the prospects for deposits. And no less important is the political uncertainty that has led to huge capital flight from the country. So the money that could have been deposited in the BFIs flowed into foreign countries.

    Cut throat competition among the banks, lack of strong supervision of BFIs by the central bank and other concerned units are also reasons for the financial crisis. Even the banks are not lending to each other due to the deterioration in the financial situation. Some financial institutions have been facing problems partly due to bad governance and partly due to their over dependence on institutional depositors. Besides, the lack of portfolio management is also a problem among many BFIs.

    At present, many depositors are worried about the safety of their deposits. They have little confidence in the banks or in the government. They have a feeling that the government is apathetic towards the economy and that it has put the economic agenda on the back burner. For their part, borrowers have their own reasons for worry. They fear that the higher lending rates might culminate in higher costs of production. In such a chaotic situation, the banks have become more worried about the growing number of defaults.

    Considering the liquidity crunch among the BFIs, it is suggested that the government and the people should avoid withdrawing large deposits from the banks and the financial companies5 as per the recommendations of the coordination committee for financial sector headed by the finance minister of Nepal. There is no harm in introducing reform plans such as the merging of banks or even the liquidation of banks after they return deposits to the depositors. All the concerned bodies in Nepal should try to avert the ‘Lehman momentum’ in Nepalese banking sector. As is well known, Lehman Brothers Holdings Inc., a global financial services firm in USA, declared itself bankrupt in 2008 following a massive exodus of its clients, losses in the stock and devaluation of its assets by credit rating agencies. The failure of Lehman Brothers jolted the US economy resulting in a recession. What happened in the US following the failure of Lehman Brothers Holdings Inc. should not be repeated in Nepal.

    Hari Bansh Jha is ICCR Fellow working at IDSA in New Delhi.

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