The financial landscape for Banks and Financial Institutions (BFIs) in Nepal has become increasingly challenging in recent years. While the COVID-19 pandemic severely disrupted global and local economies, Nepal Rastra Bank (NRB) – the country's central bank – introduced a series of proactive and accommodative measures to safeguard the real economy; however, without providing direct relief or compensation to BFIs. Much of the financial and operational burden of these interventions was shouldered by the BFIs themselves, resulting in prolonged stress on their profitability, asset quality and overall financial health.

In order to mitigate the economic impact of COVID-19 during FY 2076/77, NRB mandated a 2% interest rebate for majority of the borrowers. NRB also retained a low Cash Reserve Ratio (CRR) of 3% to ensure liquidity through a circular on Baisakh 16, 2076. At the same time, BFIs were permitted to provide loans up to 100% of time deposits with a remaining tenure of two years or more, encouraging aggressive, deposit-backed lending practices. Although this provided short-term relief to affected businesses and individuals, BFIs had to absorb the loss, directly diminishing their interest income and poor assets quality.

NRB circulated a notice to BFIs to enhance working capital limits by 10% to support struggling businesses on need basis. While this move aimed to inject liquidity into the market, it significantly increased credit exposure without corresponding compensation or risk-sharing measures. The circular also directed BFIs to waive penal interest and other charges and extend loan repayment timelines – measures that eroded potential income and further tightened margins.

Another major policy was the refinancing facility provided by NRB at a concessional rate, where BFIs were required to charge only 5% interest, even though their own cost of funds often exceeded this rate. While the central bank supplied the fund at a comparatively lower rate, the interest margin compression severely restricted BFIs' ability to cover operating expenses and maintain profitability.

NRB also rolled out subsidised lending policies to promote financial inclusion, such as Women Entrepreneurship Loans and other productive sector loans at a mere 2% risk premium and without security backed. Although commendable in terms of social impact, these directives allowed minimal flexibility for BFIs to apply proper credit risk assessments, putting them in a difficult position when managing potential defaults.

To prevent a sudden spike in defaults, NRB issued multiple instructions to restructure and reschedule loans, including relaxed provisioning norms and deferred repayment timelines. While these steps initially helped reduce the appearance of non-performing loans (NPLs), they also concealed deeper asset quality issues, many of which are now emerging as the economy returns to normal.

Further, the relaxation of regulatory parameters such as Debt-to-Income (DTI) and Loan-to-Value (LTV) ratios led to increased lending in higher-risk areas, including real estate and hire purchase, thereby weakening the overall asset quality of the sector.

Several developing countries have implemented innovative tools to support their banking sectors and ensure financial stability during and after economic crises, that is, COVID-19. For instance, countries like India and Bangladesh introduced targeted interest subvention schemes and partial credit guarantee programmes to reduce lending risk and encourage credit flow to MSMEs and priority sectors; while others, such as the Philippines, offered tax relief and regulatory forbearance to financial institutions. These tools collectively helped maintain credit flow, reduce default risks and support economic recovery while safeguarding the health of financial institution.

In hindsight, although NRB's COVID-era interventions were necessary for broader economic stability, the disproportionate burden on BFIs has led to significant challenges. As the temporary cushions wear off, BFIs now face rising NPLs, declining interest spreads, subdued credit demand and escalating operational costs – all of which are contributing to the financial difficulties currently confronting Nepal's banking sector.

Despite these challenges, no significant fiscal relief or incentive was provided to the BFIs themselves. According to NRB's Financial Stability Report 2024, the average return on assets (ROA) of commercial banks declined to 0.87%, while non-performing loans rose to 5.05% as on mid-April 2025. Additionally, Return on Equity (ROE) dropped below 9.67% in FY 2023/24 from 17.71% in mid-July 2018 – a sharp increase from pre-COVID levels – putting further pressure on net interest margins.

These indicators reflect that while BFIs were instrumental in supporting the economy during the crisis, they were left largely unsupported themselves – with no direct interest subsidy, tax incentive or suitable provisioning relaxation provided from the government's side.

However, the lack of direct fiscal incentives, risk-sharing mechanisms or structural support has left them exposed to prolonged stress on profitability, asset quality and operational viability. Going forward, the government must recognise BFIs not just as intermediaries but as critical economic enablers and must proactively collaborate with NRB to design targeted support mechanisms, such as interest subsidies, tax reliefs and more pragmatic regulatory frameworks.

Sharma is branch manager, Kumari Bank Ltd.