If our returns shrink, wariness of share investors will heighten... This will create turbulence in the stock market

Kathmandu, August 13

A new central bank provision has fuelled concerns about sustainability of the banking business, as it is expected to wipe at least Rs 15 billion off the net profit of commercial banks and shrink returns to a record low of around 11 per cent.

Bankers started harbouring doubts about prospects of the banking sector following a sweeping change made by Nepal Rastra Bank, the central bank, to interest spread calculation method last week.

Before the formula was revised, interest spread was calculated by deducting deposit rate from the sum of lending rate and interest earned from government securities. Based on this formula, average interest spread of 28 commercial banks stood at an estimated 4.3 per cent in mid-July, which was below the regulatory requirement of 4.5 per cent.

Now banks cannot factor in yields generated from investment made in government securities, such as bonds and treasury bills, when calculating interest spread. When this policy change was made, NRB also directed banks to reduce interest spread to 4.4 per cent by mid-July 2020. This means if banks have collected deposit at an average of 10 per cent, then average lending rate should not exceed 14.4 per cent by mid-July. Earlier, banks could offer loans at slightly higher rates and still meet the regulatory requirement on interest spread because they had the option of factoring in interest earned from government securities.

So, the new interest spread ceiling of 4.4 per cent is similar to interest spread of around 3.3 per cent under the older regime, which will hit income of banks, states the Nepal Bankers’ Association, an umbrella body of commercial banks.

Banks have called the new policy ‘unfair’ as around 20 per cent of the deposit they collect is used to purchase government securities. Banks must invest in government securities because of regulatory requirement on statutory liquidity ratio and the central bank provision that bars financial institutions from lending more than Rs 80 of every Rs 100 they collect as deposit.

If the cushion provided by inclusion of returns generated by government securities  when calculating interest spread is removed, the net profit of banks will plunge by around 25 per cent and return on equity will squeeze to around 11 per cent, the Nepal Bankers’ Association stated.

The NBA has already flagged these issues to NRB. But the central bank has defended its decision and is not in a mood to rescind the policy.

“This policy is not unique to Nepal, as more than 90 countries in the world use the same formula to calculate interest spread,” said NRB Spokesperson Laxmi Prapanna Niroula, calling “concerns” expressed by banks “exaggerated”. Bankers, on the other hand, have requested the central bank to get a grip on reality of the situation in Nepal before emulating international practices.

“In Nepal, one can easily get a 10 per cent return by simply parking money in banks. So, it is no-brainer to risk billions of rupees every year just to generate a return of 11 per cent,” a veteran banker and Nepal Investment Bank Chairman Prithivi Bahadur Pandé told THT. “If the central bank thinks its new policy is good for the country then it can take over all the banks. I’d happily sell my bank to the government at cost price and invest the money in other lucrative sectors such as hydropower.”

The returns of commercial banks have shrunk from around 18 per cent just four years ago to around 14.5 per cent in fiscal 2017-18. The returns have dropped because of hike in paid-up capital from Rs 2 billion to Rs 8 billion.

A total of 28 commercial banks are expected to generate returns of around 15.5 per cent in fiscal 2018-19, which ended in mid-July, with net profit standing at Rs 60.6 billion. But if the new interest spread calculation is applied, the net profit will slump to around Rs 46.4 billion and return on equity will dip to 11.9 per cent, according to calculation made by the NBA.

“This shows the extent of losses we will have to incur,” said NBA President and Nepal Bangladesh Bank CEO Gyanendra Prasad Dhungana, adding, “The central bank should not have become so harsh on us especially at a time when our overhead costs are jumping because of the need to step up IT compliance and the government’s request to set up branches in all 753 local bodies. If our returns shrink, wariness of share investors will heighten because financial sector contributes to over 70 per cent of the share market. This will create turbulence in the stock market.”