Financial sector : Unsustainable urban-centric growth

Financial sector liberalisation, partially initiated in mid-1980s, is going full steam, fuelled by aggressive policies and a large number of new entrants in urban centers since the economic liberalisation began in earnest in 1990s. The substantial increase in number of players

and transactions in financial sector continued in urban centres even during the time of the conflict, which could largely be attributed to migration and remittance inflow to the urban areas.

The mushrooming new establishments are invariably concentrated in urban areas whereas rural branches of the big banks often had to be closed down for security reasons. It is but natural that Nepali financial sector is urban-centric. Looking at the lack of accessibility to financial services in rural areas, restoration of peace alone will not suffice, rather it calls for pro-rural approach with flexible, micro-financial cooperative type mechanism, backed by independent and prudent regulation and supervision.

Surprisingly, the well-established cause and effect relationship between economic growth and financial sector development could not be validated in Nepal, where the financial sector has witnessed a boom even amid sluggish economic growth. Obviously, one cannot deny the role of easy money as taxless income in financial sector. It was an opportunity availed by the conflict.

Nonetheless, given the capital base, banks/financial institutions are easier to establish and operate in comparison to other sectors. Also it is difficult to use their absolute number as a measuring yardstick for the saturation point if they are fulfilling the mandatory norms and conditions. However, the potential size of the economy can be used as a better proxy to estimate the tentative size of financial sector. The beauty of the liberal economic regime is no doubt that individuals/groups are free to enter it if there is probability of good returns. Nevertheless, the merit of free exit cannot easily be compared with other sectors since the financial sector deals with public deposits. Mergers and acquisitions are some of the exit strategies in the financial sector, however they are not easily applicable due to matching and marking problems.

Looking at the mounting non-performing assets (NPA) level of banks/financial

institutions — and despite the window dressing of mandatory book writeoff and lack of the support of asset management companies — the chances of recovering bad loans are very slim. Similarly, the takeover of the collaterals of big defaulters could not be carried out due to various hassles and threats from the clients. The Debt Recovery Tribunal is ideal for bad debt recovery but lack of competent and sufficient manpower and resources is making the job very difficult.

Moreover, one can easily anticipate the likely impact of WTO commitments by the year 2010 if foreign banks with proven track record of maintaining spread rate of about two per cent enter Nepal with their advanced technology and high level of efficiency. It will pose a big challenge not only for banks/financial institutions who struggled to maintain even the weighted average spread rate of 5-6 per cent but also for their regulators.

Going by the improved capital base, the possibility of more new banks/financial institutions sprouting up in urban centres remains quite high. This is an early signal to review the criteria for establishment and management of urban-centric banks/financial institutions. A cursory survey of financial markets reveals that most of the big borrowers are either defaulters or the compulsion of banks/financial institutions to attract genuine clients through lower interest rates, exemption of service/processing charges besides efficient and quality service. The increased tendency to either swap loan between banks or repayments through further borrowing from other banks at lower rate(s) is clearly indicative of turmoil in the financial sector.

Since the historically low interest rate at present cannot be sustained for long, how can the urban financial institutions with high spread rates stay competitive if the remittances flow back into the rural areas? More mergers and takeovers will only make the financial sector harder to manage.

Moreover, the regulator’s unduly soft actions against the wrongdoing bank(s) — as has been the norm in recent times — might lead to a moral hazard. It is obviously about time for a thorough review of the financial regime in order to make urban sector

more competitive and compatible with international standards. This should include stern action against wrongdoers, which will serve as a lesson for other banks/financial institutions that are mulling deviant paths to remain afloat. The existing rural financial model is difficult to implement in areas where people are surviving through subsistence farming. A viable rural financial model is essential for peace and development.

Dr Paudel is an RBB Board member