Stability vs growth: Banking at a crossroads

The banking sector in Nepal is currently grappling with a multitude of challenges that have far-reaching implications for the economy. One of the most significant issues is a marked decline in dividend distribution. Historically, banks in Nepal were able to deliver a hefty number of dividends. However, in the last fiscal year, many institutions struggled to provide even a 10 percent dividend, with the sector-wide average falling below five percent. This decline has eroded investor confidence, prompting large investment groups to reconsider their stakes in the sector. The shrinking returns on both capital gains and dividends have exacerbated this hesitancy, underscoring the urgent need for reforms to restore trust and stability.

The decrease in dividend capacity is not a result of NRB policies but stems from the individual banks’ operational challenges. Efficient banks have still been able to distribute dividends, with some banks providing dividends of up to 26 percent, while others have not been able to do so. The banking sector’s struggles are primarily driven by external pressures, including market rumors, which have hindered the functioning of lower-level bank branches. This external pressure has added complexities to the financial ecosystem, and despite the solid capital base of the banks, non-performing loans have risen.

Regulatory changes, particularly the proposed amendments to the Bank and Financial Institutions Act (BAFIA), have further complicated the situation. A contentious provision restricting shareholders who hold more than one percent of a bank’s shares from obtaining loans from other financial institutions has raised concerns among stakeholders. Historically, industrialists have played a pivotal role in establishing banks, but such measures could compel them to liquidate shares or settle loans, leading to market instability. These regulatory changes, coupled with declining demand and operational strain, have stifled the sector’s growth potential. In this context, the Nepal Rastra Bank (NRB) has introduced provisions designed to protect the financial system and avoid a panic scenario. These measures are meant to ensure stability without stifling the long-term viability of the sector.

Economic downturns have also driven a sharp increase in non-performing assets (NPAs), a critical metric for assessing financial health. The average NPA ratio has risen from 1.67 percent two years ago to approximately 4.5 percent, with some ‘C’ category financial institutions reporting NPAs exceeding 10 percent. Even with loan restructuring facilities, NPAs remain near five percent, posing a significant threat to the sector’s stability and the broader economy. Weak loan demand and structural challenges continue to compound these risks, further destabilizing the financial system. This reflects the broader macroeconomic challenges, as well as the unique pressures faced by the banking sector.

The NRB recognizes these challenges and has been working on regulatory frameworks that aim to ensure the resilience of the banking system. While some banks have faced difficulties in profitability, it is essential to note that the NRB’s measures are intended to safeguard the sector, providing the necessary framework for long-term stability. For instance, while external issues have raised questions about profitability, it is clear that banks cannot operate without profitability, and returns on capital investments are critical for sustained operations. The NRB's efforts are geared toward ensuring that the banks remain operational and sustainable, even amid a challenging environment.

Profitability in the banking sector has significantly declined. The return on equity (ROE), a key indicator of financial performance, fell from 21.94 percent in FY 2021-22 to just 4.80 percent in FY 2023-24. Reduced net interest income, weak loan demand and regulatory constraints on fee and commission income have collectively strained earnings. Operational costs, particularly investments in IT infrastructure and compliance, have added to these pressures. While banks like Standard Chartered Bank and Everest Bank reported relatively higher ROEs, others, such as Nepal Bank, struggled to remain profitable. Despite these challenges, NRB’s approach to banking supervision is aimed at creating a balanced environment where the banks are supported through difficult periods without compromising the sector’s financial health.

Credit expansion has been stagnant these days mainly due to the lack of demand. A mismatch between liquidity and demand further compounds the problem, leaving banks with substantial liquidity but limited opportunities for productive lending. This scenario underscores the need for a balanced regulatory framework that promotes both stability and growth. While the NRB’s policies may limit some aspects of banking operations, they are designed with the long-term health of the sector in mind, ensuring the banking system remains solvent and resilient even during challenging periods.

Nepal’s broader economic structure adds another layer of complexity. The government faces a revenue deficit of Rs 170bn, low capital expenditure and high recurrent costs, all of which highlight fiscal imbalances. Federalism has introduced additional financial burdens without commensurate resources for development. High debt-servicing obligations strain the budget further, forcing the government to issue treasury bills even for routine expenditures. Stagnation in the real estate sector and declining investor morale exacerbate these economic pressures, highlighting the need for systemic reforms.

Leadership in the banking sector is undergoing significant changes. Younger leaders, often with decades of experience, are driving digital transformation and operational efficiency. At leading banks, approximately 80 percent of transactions are now digital, enhancing customer satisfaction and streamlining operations. However, aggressive lending strategies aimed at stimulating loan growth have often compromised profitability. A more sustainable approach that aligns banking operations with national development goals, such as job creation and productive investments, is essential for long-term stability.

While some macroeconomic indicators provide grounds for cautious optimism, the persistent lack of credit demand in productive sectors remains a concern. Stabilized foreign exchange reserves and declining interest rates offer a foundation for recovery. However, a comprehensive review of federalism’s fiscal structure, along with targeted expenditure cuts, is critical to avoid a potential debt trap. Transparent collaboration between the private sector and the state can help restore confidence and drive economic recovery.

To address these challenges, a multi-faceted approach is essential. Regulatory frameworks should be revised to strike a balance between stability and growth. Encouraging productive lending and reducing excessive constraints can create a more conducive environment for banking operations. Establishing high-level commissions to address systemic issues and promote transparent collaboration between the private sector and the state is crucial. Additionally, investments in technology and innovation will enhance operational efficiency and customer satisfaction.

The NRB’s policies are continually evolving to ensure the stability of the banking sector while navigating the external challenges it faces. The regulator remains committed to safeguarding the financial system’s integrity, ensuring that both stability and growth can coexist in the long term. Banks are expected to adapt to the changing economic landscape while continuing to contribute to national development. The NRB’s framework aims to foster a balance between operational efficiency, profitability and financial stability, ultimately enabling the banking sector to thrive in challenging economic times.

In a nutshell, while the banking sector in Nepal faces significant challenges, a concerted effort to implement targeted reforms and foster collaboration between stakeholders can pave the way for recovery and growth. By addressing structural inefficiencies and focusing on sustainable practices, the sector can overcome current adversities and emerge as a cornerstone of Nepal’s economic stability and progress. The path forward requires bold decisions, innovative solutions and a collective commitment to building a robust and resilient financial system that supports the nation’s aspirations for sustainable development.

The author is deputy director at Nepal Rastra Bank