Time for debt capital market: For effective management

It’s time now to shift the regulatory mindset and the framework that allows and encourages banks to expand their traditional deposit-lending business towards deeper and wider financial market businesses

The progress of Nepal Stock Exchange in terms of participation, volume, digitization is remarkable and the current level of market capitalization of around USD 17 billion (almost 80% of GDP) truly reflects how far it has come.

The government’s roles and efforts to develop equity market in the country is commendable, and it is now time to extend our efforts for the development of the debt capital market for the country to effectively manage its funding for developmental needs.

Debt market provides more financial safety compared to equity market. Debt capital instruments are efficient source of funding that mobilize cheaper and deeper funds for financial institutions at the same time lowering the cost of financial services for investors and issuers.

Developed debt market broadens and stabilizes inter-bank money market by enabling wider participation of Investors & Intermediaries (I&I) and Non-Bank Financial Institutions (NBFIs) like Employee Provident Fund, Insurance Companies, Provident/Retirement Funds and Mutual Funds.

These new classes of investors typically have access to longer period funds and hence carry an appetite for longer maturity assets thereby helping prevent maturity mismatches.

Active debt market provides the platform for the financial intermediaries to manage the mismatch of funds by covering the short positions and funding of long positions in underlying instruments/securities, which is the absolute core function for assets and liabilities management.

Creation of a deep debt market serves the twin goals of diversifying institutional risk across the financial sector and also enabling the investors to access high quality long-term assets.

Debt market instruments in the primary and secondary markets help in enhancing liquidity and foster the price discovery by equilibrating imbalances between supply and demand of the market.

This ultimately facilitates the correct valuation of the market instruments and helps generate smooth and stable yield curves that are essential for accurate and appropriate pricing of other financial instruments. It additionally helps to efficiently allocate the capital of the financial markets.

Sourcing deposits and extending loans is the core business of traditional banking. Loans tend to have longer average maturity than deposits, and it is not easy to liquidate and monetize loans, hence banks in most cases, run the risk of liquidity stress when the depositors rush to withdraw at the same time.

Controlled regulatory frameworks as well as systemic issues in the banking sector at times interrupt the flow of funds from savers to investors.

Debt market provides the platform for banks to invest in various fixed income products and also helps to raise funds by issuing bonds, debentures, commercial papers, notes, etc.

Likewise, savers will have a wide range of investment options including wealth management products issued by banks and other institutions.

Funding the loans with non-deposit sources will provide greater flexibility to smaller banks that were constrained by the limited deposit base.

However it entails, expertise in financial markets will be crucial for banks of all sizes to effectively manage the wider options of investment opportunities and efficient funding sources that will provide the potential to transform how banks do business and how the “competitive advantage” will be defined.

For various issues like taxation, broker commission, manual processes and lack of infrastructure, secondary market for government debt securities is not seen to be functioning in Nepal. Deriving the yield curve for period beyond one year tenor has also remained a challenge.

Lack of domestic debt instruments has led investors to heavily rely on bank borrowings to fund their business/projects.

Likewise, banks’ sources of funds are almost entirely drawn through customer deposits. This carries high concentration risk in the money market resulting in sharp swings on the liquidity position within short intervals triggering high volatility of interest rates for both deposit and lending products.

As a result of the current situation of intense competition for deposits, banks are inclined to set their deposit rates at the ceiling, which has impacted the interest rate market and made borrowing an expensive proposition.

Lack of instruments to hedge long term foreign exchange risk in the local market is one of the major bottlenecks for the foreign investors to invest in Nepal.

Given the high investment requirement for the development of the country’s infrastructural need, functioning and development of domestic debt market instruments is essential which to a large extent also reduces the over reliance on foreign investments.

Hence, advanced and liquid local currency debt market not only supplements bank credit but at the same time it also reduces the potential currency mismatches by issuing local currency debt instruments.

Furthermore, the longer dated instruments reduce the risk of concentration on the maturity profile.

It’s time now to shift the regulatory mindset and the framework that allows and encourages banks to expand their traditional deposit-lending business towards deeper and wider financial market businesses.

Bazgain is head of financial markets & financial market sales, Standard Chartered Bank Nepal Limited