Many were expecting commercial banks to incur losses in the second quarter of this fiscal year following erosion in debt servicing capacity of borrowers, whose revenue sources had dried up because of supply disruptions along Nepal-India border points. But unaudited balance sheets show that Class ‘A’ financial institutions have weathered through the difficult times, and even raised net profit by 2.06 per cent. Does this indicate all is well in the banking sector? Rupak D Sharma of The Himalayan Times caught up with Sashin Joshi, CEO of Nabil Bank, the largest private sector bank in terms of assets, to get an answer.

Banks have surprised many by booking profit in the second quarter. What is your take on this?

Banks were able to register profit mainly due to three reasons. First is the regulatory relaxation extended by Nepal Rastra Bank (to borrowers whose income sources had dried up because of supply disruptions). Because of this, banks did not have to set aside additional funds to cover potential lending risks, which helped banks to raise the profit level. Also, data of a few institutions have not been compared on like-for-like basis. What I’m trying to say is that data of entities that wrapped up merger process this fiscal year have been compared with balance sheets of the period when the consolidation had not taken place. This also helped some institutions to raise the profit level. Another reason is write back in funds allocated for possible losses.

In the second quarter, lending growth rate of banks fell to around 14 per cent as against almost 25 per cent in the same period a year ago. However, net interest income growth rate of banks has fallen moderately to 12 per cent in the second quarter, as against 15 per cent in the same period a year ago. Isn’t there some kind of discrepancy?

Net interest income of banks did not fall drastically because of three reasons. First is the provision introduced by NRB which paved the way for banks to capitalise on interest. This enabled financial institutions to book unpaid interest as earnings. Second is fall in deposit rates, which reduced expenditure of banks. Third is recovery of loans extended in the past, which includes principal as well as interest components.

The provision on interest capitalisation, as you said, has also given a lift to earnings. Do you think this provision will hit financial health of banks in the long run?

As you said, banks can now capitalise on interest associated with loans that have undergone restructuring process. This means banks can register unpaid interest as earnings. This, on the one hand, has expanded credit portfolio of banks and, on the other, pushed up interest earnings. Also, NRB has enabled banks to enrol payments received a month after the end of the second quarter as earnings of the second quarter. This facility has also raised the interest income of banks.

Will the provision on interest capitalisation hit financial health of banks, as chances of borrowers not being able to make payments on time following expiry of NRB’s relief package are high, isn’t it?

Banks are currently allowed to reschedule loan repayment for a period of up to a year. If borrowers seek to extend this facility, then banks have to get NRB’s permission. However, if borrowers fail to service the debt even after the grace period, then its impact will obviously be seen on balance sheets.

Do you think borrowers will be able to service the debt after a year?

Well, it’s hard to answer that question now. The problems seen in the bordering areas have been more devastating for borrowers than the earthquakes of April and May. The supply situation seems to be easing at the moment. But I think it will take at least three to six months for the situation to fully normalise. Besides, political situation is still fragile because demands placed by Madhesi parties have not been fully addressed. So, we’ll have to wait until the end of this fiscal year to get a clearer picture.

The fragile political situation, on the one hand, has reduced deposit rates, which has affected depositors. Fall in

deposit rates has also caused lending rates to take a dip, raising the spectre of capital flight. How can this situation be addressed?

I think depositors have been short-changed. They are the biggest losers here, but nobody listens to them. Currently, depositors are getting returns of two to three per cent on savings deposit accounts. Considering inflation of 12.1 per cent in mid-January, savings of depositors, in real terms, are depleting. To do justice to depositors, monetary tools have to be used. If not, this situation will give rise to other problems. This is because falling deposit rates have made loans cheaper. Availability of cheap credit will divert funds to relatively risky sectors, such as real estate, stock market and bullion. Worse, cheaper loans can trigger capital flight (because money obtained at low rates can be invested abroad or parked at overseas financial institutions where returns are higher). Capital flight may not occur if difference between interest rates in Nepal and India is in the range of one to two percentage points. But if the difference is bigger, possibilities of capital flight cannot be ruled out. We have seen this cycle repeating every four to five years. So, the central bank must use appropriate monetary tools to address this situation.

But the central bank is using money market tools to normalise the situation, isn’t it?

Yes, the central bank is conducting open market operations to manage the liquidity situation. But it hasn’t effectively used policy rate to bring about correction in deposit and lending rates. Is deposit rate of three to four per cent appropriate for the country? Shouldn’t we do justice to depositors? To deal with these problems, policy rate should be

effectively used.

Are you implying the central bank should introduce policy repo and reverse repo rates to inject funds into or mop up funds from banking sector?

Yes, NRB should do that. Interest rates have fallen to a very low level several times in the last five to seven years. However, even in low interest rate regime, credit demand has not gone up. The current lending rates are probably the lowest in the banking history of Nepal. Yet, credit demand has not picked up. This shows lower rates do not always raise credit demand. If NRB comes up with fixed policy repo rate and reverse repo rate, there will be convergence in rates. For instance, if NRB fixes policy reverse repo rate at six per cent and policy repo rate at seven per cent then banks will park money at NRB to get six-per-cent yield and borrow money at seven per cent interest whenever there is a need. This will lead deposit rates to go beyond six per cent, while lending rates will be higher than seven per cent. This policy shift will benefit depositors who are dealing with inflation of over 12 per cent.

But the latest bout of consumer price hike is cost-push and not driven by demand. So, it is believed inflation rate will come down once supply situation normalises. Don’t you think it would be wise to wait for a while?

Well, that’s why I didn’t say policy repo and reverse repo rates should be tied to inflation. And like you said we should also provide space to the market to let corrections take place on their own. But current distortion in interest rates can create instability. Deposit rates must go up to encourage people to save. Savings rate in proportion to the gross domestic product hovers around 25 per cent in China and India. In contrast, savings rate in Nepal stands at around nine per cent of the GDP. How can we expect capital formation to take place in a country where savings rate is at such a low level? And without capital formation how can an economy grow and how can jobs be created?

All these problems have erupted because of low credit demand, isn’t it? Do you think demand for loans is low here because the country has limited number of entrepreneurs? Can venture capital or private equity funds, which have the ability to churn out entrepreneurs, play any role here?

Yes, we do need venture capital and private equity funds. But they alone cannot produce entrepreneurs and raise credit demand. Nepal has not been able to see significant rise in investment because of lack of policy predictability and political instability. Besides, there are labour issues. Against this backdrop, investors cannot muster courage to inject funds in different sectors. There are other issues as well, like use of laws that are obsolete. Take the Foreign Exchange Act for example. It was introduced in 1962. Besides, foreign companies that have set up base here cannot leave the country easily. So, unless the investment climate improves, nobody is going to invest here.

Amidst this situation, NRB has given signals it may ask promoters to inject fresh capital in banking institutions rather than just opt for mergers. What is your take on this issue?

I don’t think investors would mind injecting fresh capital if institutions are in need of funds. In fact, banks that continue to grow will automatically feel the need to inject fresh capital. So, putting in funds is not a big problem. What we need is an environment to grow. And NRB should work towards creating an environment where banks can grow in a healthy manner.

Lastly, NRB is planning to conduct mid-term review of Monetary Policy this week. Do you have a wish-list?

NRB should effectively use fixed policy rates. If it is able to use this tool, deposit and lending rates will undergo corrections within two to three months.