Introduction to Nepalese Banking Industry

Nepalese financial system has witnessed a rapid growth both vertically and horizontally in last two decades. Increasing number of banks and financial institutions, their deposits, credits and total assets and other indicators have proved this fact. However, the efficiency of a financial system typically depends on several key factors, including its degree of integration, market competition, level of development and innovation capacity. Nepalese financial system has experienced many changes in the past few years such as arrival of new financial products, modern technology and new market participants. Nepalese banking industry has also changed significantly over the past few decades as a result of liberalization, deregulation, advancement in information technology and globalization. The financial sector liberalization resulted into entry of new banks in the market; deregulation widened the scope of activities and delimited the banking activities; advancement in technology resulted into new ways and tools to perform banking activities; and globalization added more pressure on competitiveness of individual banks. Moreover, the banks, nowadays are entering into non-banking markets and other financial institutions are entering into the banking markets that have traditionally been served by the banks. Banking firms serves various activities with an objective to survive in massive competition under the regulation of Nepal Rastra Bank (NRB). The NRB, as the apex body of banking system in Nepal, has been trying to ensure a healthy and efficient financial sector by improving regulation at par with international standard. As such, the implementation of the New Capital Adequacy Framework in Nepalese commercial banks has remained effective in terms of ensuring adequate level of capital in banking sector and almost all banks have developed reporting system. Similarly, the supervisory focus of the NRB in the latter days is on ensuring prudent banking practices in a self-regulated environment with more sensitivity towards various risks of the banking sector. The number of banks and financial institutions licensed by Nepal Rastra Bank has increased tremendously in last few years. Table below depicts the number of banks and financial institutions in Nepal.
Table 2.1: Number of Bank and Financial Institutions licensed by NRB (mid-Jan 2011)

S.N Type of Financial Institution 1 2 3 4 5 6 Commercial Banks Development Banks Finance Companies Micro Finance Development Banks Saving and Credit Co-operatives Non-Government Organizations Total

Class A B C D Non-classified Non-classified

2008 25 58 78 12 16 46 235

2009 26 63 77 15 16 45 242

2010 27 79 79 18 15 45 263

Mid jan 2011 30 87 79 21 15 45 277

(Source: Bank and Financial Institutions Regulation Department, Nepal Rastra Bank)

Performance of Commercial Banks

During the last two and half decades the Nepalese Financial System has grown significantly. The structure of financial assets/liabilities shows that Commercial Bank alone holds more than 75 percent of the total assets and liabilities of the financial system. As of Mid January 2011, Commercial Bank group occupied 77.9 percent of total assets/liabilities followed by Development Banks 10.5 percent, Finance Companies 9.9 percent and Micro-finance Development Bank 1.7 percent. Thus we can say that Commercial Banks are the major financial service providing firms in the economy. Commercial Banks held dominant share on the major balance sheet components of financial system. Of the total deposits Rs.799127.7 million in Mid - January 2011, the commercial banks occupied 78.5 percent. Similarly, finance companies held 10.2 percent, development banks 11.0 percent and micro finance development banks 0.4 percent. Likewise, on the loans and advances the share of commercial banks stood at 74.4 percent, development banks 11.5 percent, finance companies 12.2 percent and micro finance development banks 1.9 percent in Mid - January 2011. In the same year the share of commercial banks in the borrowings, liquid funds and investments constitute 62.4 percent, 62.5 percent and 89.7 percent respectively. The number of commercial bank branches operating in the country increased to 1063 in Mid January 2011 from 987 in mid July 2010. Among the total bank branches, more than 50 percent bank branches are concentrated in the central region alone. Entry of new banks in financial system along with increased in the business, the total assets i.e. sources of fund of commercial banks went up by 4.59 percent compared to 43.30 percent in the previous year. Assets of the commercial banks The total assets of the banks increased by 13.22 percent in the fiscal year 2009/10 compared to a growth of 36.23 percent in 2008/09. The total assets increased by 7.74 percent in the public banks and by 15.10 percent in the private banks in the review year. The growth of total assets of private banks is higher than public banks and is in increasing trend for last 5 years. By the end of this fiscal year, the total assets of commercial banking sector reached to Rs. 849412.40 million from Rs 812165.9 million in the last period.

Composition of Liabilities There was the increase in the total borrowing, deposits, and capital funds of the commercial banks compared to the previous year. The largest source of fund of commercial banks as on mid July 2010 was deposit, which amounted Rs.630.83 billion, of which Rs. 487.61 billion was held by private banks and rest by public banks. The year on year comparison indicated a positive change in the liabilities of the banking sector. Commercial banks were able to mobilize an additional deposit of Rs.66.69 billion during the year 2009/10 which was 131.37 billion in the previous year.

The analysis of the composition of liabilities of the private banks indicated a heavy concentration of 86.42 percent in the form of deposits while the capital, borrowings and others account for 6.79 percent, 1.28 percent and 5.50 percent respectively. The consolidated capital of the Nepalese banking industry showed positive trend during the review year. The capital increased from Rs.9.38 billion in 2007/08 to Rs.32.67 billion in 2008/09 and Rs.48.84 billion in 2009/10. In the same year; the growth in capital of private banks increased by 26.49 percent to Rs.51.44 billion, whereas, it improved from negative Rs.8 billion to negative Rs.2.6 billion in public banks. However, due to the large volume of negative reserves of the two public banks, the capital base still is a long way to achieve minimum capital requirement.

Deposit Total deposit of the commercial banks increased by 11.82 percent to Rs.630.83 billion in mid July 2010 compared to a growth of 30.36 percent to Rs.564.14 billion in the previous year. The deposit of the banking industry had been dominated by the savings deposit and term deposits. Loans and Advances Based on gross loan of the commercial banks, the loans and advances of the commercial banks increased by 15.42 percent to Rs.463.80 billion in 2009/10 compared to a growth of 28.13 percent in the previous year. Investment The investment activity of the Nepalese banks is found limited. The banks have been predominantly investing in the government securities like the treasury bills and government bonds. This investment in government securities provides liquidity benefits to the banks. The other areas of investment include inter-bank placement and investment in shares and debentures. Earnings The total income of the commercial banks increased by 35.28 percent to Rs.64.49 billion in 2009/10 compared to a growth of 40.96 percent to Rs.47.67 billion last period. Interest income, the significant proportion of income, constituted 87.81 percent of total income in the review year. The remaining portion was occupied by income from commission, other incomes, exchange income and non-operating income respectively. All banks managed to earn profits during the review year. Rastriya Banijya Bank Limited booked the highest profit of Rs.2.01 billion during the review year. The return from loan loss provision contributed 59.75 percent of net profit in Rastriya Banijya Bank Limited. The public banks, namely RBBL and ADBN were the most profit earning banks. Interest Rates of Commercial Banks Saving rates offered by the commercial banks were in the range from 2 percent per annum to 12 percent per annum at the end of mid July 2010. Deposit rates in time deposits were observed to be in the range from 1.75 percent per annum to 13 percent per annum. Similarly, lending rates offered by the commercial banks were in the range from 4 percent to 18 percent per annum.

Future prospects of Banking Industry

Nepalese banking sector gained momentum after the liberalization process started in mid-eighties. There has been rapid growth in term of number as well as transaction of the banks and financial institutions. Such a rapid increase in the number and transaction volume of the players has introduced the growing competitive pressures in the banking system. Banks and financial institutions have limited their activities in the urban and semi urban areas despite a very low level of financial access in the remote and rural parts of the economy. Uneven geographical distribution of the banks has further increased the level of competition in the urban areas. Banking business is turning into a global network of complex financial relationships. Nepalese banking system is integrating into global financial system day by day. So there are opportunities as well as challenges ahead for the development of Nepalese banking industries. Nepalese banks are promoting the self-regulations. Banks are risk-taking businesses. Risk is taken for the expectation of reward from the business. Risk taking behavior should be well supported by adequate level of sound risk management practices. Large number of stakeholders are involved in a bank; the interest of all the stakeholders should be matched. Some stakeholder at the cost of others should not exercise risk-taking activities. Therefore, risk management function is regarded as the prime responsibility of the board of directors of the banks. Principles on risk management require a bank should have adequate practices of board and senior management oversight, policies, procedures, limits, internal control and sound risk management practices in the baking business. Banks with adequate level of sound practices in risk management can promote self-regulation in banking. Nepalese banks and financial institutions are still dependant on Nepal Rastra Bank for the adaptation and implementation of international best practices. It is expected that bank should initiate the process to exercise the international best practices in the issues like corporate governance, risk management process, corporate social responsibilities beyond the minimum standard set by prudential regulations. Thus, promoting selfregulation in the Nepalese banking sector is another challenge for ensuring Self Regulation is the Best Regulation. There has been rapid change in pace of the development of technology, which helps in providing easier and simpler customer services and banks can improve their operations by adopting these technologies. Across the globe, but specifically in Nepal, current trend in private banking has been the consumer movement from traditional branch banking to more stand-alone banking. In other words, a move towards using e-delivery channels such as the Internet, telephone and mobile phones. Many banks are beginning to deliver credit and deposit products electronically. As banks venture into the electronic arena, however, they are finding new opportunities with new operational and strategic risks. But along with the advantages of technologies there will be challenges also.

In early 2000s banks major revenue was from cash and cheque services. Today banks are diversifying. Their revenues are coming from ATM card, Mobile- POS(point of sale), Credit cards (POS),Online banking. The banks investing in these new channels will emerge as winners. So we predict that banks will invest heavily in these sectors in future. Nepals membership to WTO adds the problem to financial institution. As per the provision of WTO, the foreign banks can establish their branches in Nepal from Jan 2010. Though the foreign banks have not yet established their branches, they are likely to do so provided there is political stability in the country. Therefore competition among the banking firms is probable to intensify. The domestic banks will face high level of risk and must enhance their competitiveness and efficiency through improving profitability and service quality. Also the size of domestic banks are small compared to the foreign banks, thus they might go for mergers and acquisition. Domestic banks are mostly operating in the urban areas so they are likely to initiate their operations at rural areas.

CONCLUSION Banking industry covers the major portion of the total financial system in the economy. It has huge contribution in the GDP and GNP of the country. Thus it is an important sector of the economy. Over the past few years the number of banking firms has been increasing rapidly. The number of commercial bank as licensed by NRB by mid of January 2011 was 30. Competition among the banking firms is getting stiffer and thus they should try to enhance their competitiveness and efficiency by improving profitability, service quality, customer responsiveness and public accountability. Today, services provided by the banks are overall similar such as e-banking, mobile banking, sms banking etc. Recently Nepalese banking industry has been struggling with liquidity crunch. Two major causes have been identified of the problem. First, there was a dramatic increase in imports, especially of gold. Contrary to popular belief, the rise in gold imports wasn't caused by a price differential with India. Actually, the import of gold coincided with the increase in the price of gold in the international market. It became a lucrative investment because gold is an extremely liquid instrument. Second, private sector credit growth is higher than deposit growth, which automatically results in tight liquidity. Large portion of this credit was locked up in the real estate sector.

But the good news is that the crisis has been resolved and banks can boast of liquidity surplus now. According to the latest half yearly review of the current fiscal year conducted by Nepal Rastra Bank, liquid assets of banks have increased by 24 per cent in contrast to a decrease of 15.3 per cent in the same period of the previous year. Relaxation on income declaration requirements, low credit flow, higher interest rates on deposits and elevated level of remittance inflows have contributed to the current improved liquidity position. Even though liquidity among banks has improved, the performance of the banking industry has been disappointing. The overall profit has declined by 25% as compared to the same period last fiscal year i.e. second quarter. The pervasive liquidity crunch induced banks to hastily raise the deposit interest rate ,a major cost factor in a banks profit and loss account and the inter-bank lending rate to double digit figures as they desperately tried to attract depositors. As a result, the average cost of funds of banks looms well above 8.5 percent, a figure that was inconceivable even three years ago when banks were offering an interest rate of 7 percent on fixed deposits and 1.5 percent on savings. This rising cost of funds resulted in a shrinking interest rate spread which, in turn, is taking a toll on the profit making abilities of banks. While examining the banks health, much depends on a financial performance metric return on equity, which effectively measures the profits a bank was able to generate on its capital. In the middle of the current fiscal, the actual return of commercial banks that are at least three years old was only 12 percent, compared with 19 percent in 2067. Further, the mandatory requirement of maintaining the credit-deposit ratio at or below 80 percent has restricted the ability of BFIs (banking and financial institutions) to lend the money at higher interest earning assets. Instead, the banks are now coerced to invest in low yielding, albeit more secured and liquid, government securities that currently earn less than a percent. Nepals membership of WTO is also likely to increase the competition to the banking sector. Thus mergers among the banks are expected in the future. Banking firms will have tough time in the future because of the low profitability, increase in cost and intense competition from international companies. In such situation, Darwins theory will come alive, fittest one will survive and weaker one will disappear.