Banks and financial institutions (BFIs) are the intermediaries of the financial system to bridge savers and investors and efficiently allocate the risks and returns between them. The lending source is primarily public deposit, which they should return upon demand.

The BFIs won't be able to return the deposit if the lending of the BFIs is not covered within the stipulated time. The price for the deposit they pay and of the lending they charge is determined based on deposit availability and lending demand, including the recovery of loans. Therefore, BFIs expand their primary banking business based on the deposit and lending growth.

Nevertheless, that did not happen in Nepal's financial market in the previous two years. In FY 2021/22, the loan growth was 28 percent against a deposit growth of 21 percent.

In December 2021, lending skyrocketed at a hooping 30 percent increase year-on-year, while deposits grew only by 16 percent, causing a huge resource gap within the financial system. A general layman's question is, why did the banks not observe their lending capacity and increase the lending rate so as to decelerate the lending growth and fair pricing mechanism between the savers and borrowers? We can see three major concerns: unfair competition, syndicated interest rate and conflict of interest.

Nepal's financial institutions peaked in 2011, with 88 B-class development banks, 79 C-class finance companies and 32 A-class commercial banks. While the objective of incorporating the different categorical banks was genuine, the prime banking business was duplicating, with malpractices, compliance and governance issues. Nepal Rastra Bank (NRB) introduced a moratorium in the licensing and introduced financial consolidation measures by encouraging merger/acquisitions and capital hikes.

This consolidation has led to the disappearance of 251 institutions to become 72 by the first half of FY 2022/23. B and C class BFIs substantially got reduced to 17 each, while commercial banks came down to just 26 in almost 11 years.

Encouragingly, 10 commercial banks have been merged in the last 30 days, with commercial banks now numbering 21. Lower-class BFIs either merged with or were acquired by commercial banks.

The urban-centric bank branches further mushroomed; even if BFIs merged, branches did not.

This has led to unfair competition for banking businesses to become 'first' in the industry and profitability, compromising ethical concerns. The number of deposit accounts in the financial system reached 1.5 times of the total population, while the loan account is hardly 1.8 million, indicating stern competition in deposit collection.

The NRB introduced caps and regulations to deposit, lending and even interest rates to contain unfair competition. While the banking business grew unsustainably, it affected the availability of quality human resources, and poaching/raiding became common as banks offered higher positions and benefits.

The focus on product innovation and quality services was compromised, leading to higher business targets for managers, and lending based on city-based real estate collateral as a condition of lending.

When banks only accepted land and building as collateral for even industrial loans, it inflated the fixed assets' monetary value, thereby limiting financial resources for other business activities. While the central bank introduced the 'reactive' policy to correct malpractices, banks continued to find new loopholes within the regulatory provisions that have continued like a cat-andmouse game even at matching the assets and liabilities.

Due to the upsurge in the banking business, Nepal has the highest financial deepening indicators in South Asia and low-income countries, with more than 100 percent deposit-to-GDP ratio and close to 100 percent credit-to-GDP ratio, like in the advanced economies. This is a result of skyrocketing property prices. The situation in which the general people without city-based property cannot get credit from the BFIs is of concern.

Nepal Bankers Association (NBA), an umbrella institution of commercial banks, has been fixing deposit interest rates. The NBA is becoming a platform to exercise power in regulating the interest rate, disentangling the central bank's indirect measures to pass through short-run interest to the deposit and lending rates. Even if this system might prevent interest rate volatility, the price should be based on the institution's risk and service quality, which cannot be the same across all BFIs. The regulator should not provide protection against such anti-competitive behaviour. The demand and supply forces should allow equilibrating the market while indirect approaches such as moral suasion may still apply to the regulator.

Nepal has an inherited ethical problem of conflict of interest in every public sector, including BFIs, government and politics.

Prominent industrialists and traders are at the bank board directly or in the shadow, often playing the double role of bankers and industrialists. The pressure to amend the working capital loan guideline to disguise the misuse is an example of an asset-liability mismatch, short-term loans invested in long-term assets. Some concerns also exist within the regulators, like holding equity shares, and immediate family members working at the policy level of BFIs.

Therefore, we need a brutal reformist not just to re-orient legal and institutional practices but also to transform the attitude and behaviour of the public and institutions, which may not be 'favoured' by the market initially. The overwhelming mergers amongst the commercial banks show hopes of fair competition in the products and services, but the regulator needs to be ready to counter the 'too big to fail' problem and address the concerns of the interest rate syndicate and conflict of interest to ensure macro and micro corporate governance.

Bhatta is Deputy Director of Nepal Rastra Bank

A version of this article appears in the print on January 27, 2023, of The Himalayan Times.