Banking Consolidation: A Necessary Path for Nepal's Financial Stability and Economic Growth

While Nepal continues its steady progress on the road toward economic advancement, one worrisome aspect stands out amid our financial scenery: the abundance of banking and financial institutions that appears disproportionate given our size. With over a hundred financial bodies serving approximately 30 million residents, Nepal's banking realm seems rather fragmented and likely inefficient. This degree of disunity raises important inquiries relating to stability, productivity, and optimal allocation of resources to sustain genuine prosperity. The time has arrived for serious national contemplation about bank consolidation to construct stronger, more resilient financial bodies able to aid Nepal's aims of progress.

The Crowded State of Banking

The prevailing landscape unveils a troubling level of disunity within Nepal's monetary sector. As of mid-December 2024, Nepal hosts 20 commercial banks, 17 development banks, 17 finance companies, 52 microfinance institutions, and 1 infrastructure development bank, collectively operating through over 11 thousand branches nationwide. While this spread has helped accomplish 100% banking access across all 753 local administrations, it has created an unsustainable level of competition in a relatively small economy.

To put this in perspective, Nepal's banking density far surpasses numerous comparable economies. With over a hundred different financial institutions catering to a population of approximately 30 million people and a GDP of about $36 billion, the ratio of banking organizations to economic scale seems disproportionate with accepted efficiency benchmarks. This legitimately raises issues about whether these institutions can achieve needed economies of scale to make a profit while keeping prudent risk management practices.

The Demand for Consolidating

The Nepal Rastra Bank (NRB) recognized this problem over a decade ago when it presented merger guidelines in 2011, later updated as the Merger and Acquisition Bylaw in 2016. These policies aimed to bolster public assurance, enhance financial stability, strengthen capital positions, and safeguard depositors' interests. The outcomes have been promising but insufficient – the number of financial institutions has decreased from 213 to the present 107. This reduction illustrates advancement but still leaves Nepal with too many banking organizations competing in a restricted market.

Evidence strongly implies that consolidation produces tangible benefits. Research examining Nepalese commercial banks involved in merger transactions between 2013 and 2020 found that economic execution significantly improved post-merger, particularly in liquidity and leverage ratios. Even more compelling, studies demonstrate that merged institutions experienced enhanced profitability, better asset quality, lowered operating costs, and amplified capacity to handle risk.

Benefits of Stronger, Consolidated Institutions

Enhanced Financial Stability

Nepal's history with banking has seen unsteady patches, making the pursuit of systemic resilience absolutely crucial. Larger, well-funded institutions emerging from consolidation are better armed to withstand economic shocks. Research confirms that merged banks in Nepal demonstrate superior metrics of stability compared to smaller, independent bodies. This stability benefits not simply the institutions themselves but the entire financial ecosystem and hence, by extension, the broader economy.

Operational Efficiency and Technological Advancement

Consolidated banks accomplish economies of scale that smaller institutions cannot match. By spreading permanent costs over a bigger asset base, they can operate more efficiently. Moreover, larger bodies can better afford investments in cutting-edge financial technology. Studies demonstrate that technological progress in Nepalese commercial banks positively affects profitability – both the number of ATMs and branches correlate with elevated returns on assets and equity. Consolidation creates entities with the fiscal capacity to make these important technology investments.

Improved Corporate Governance

Board composition, diversity and independence each meaningfully affect bank performance according to numerous Nepalese studies. Larger institutions often implement sophisticated oversight frameworks, permitting superior risk management and monitoring. Such consolidation may foster governance enhancement across the sector.

Diversifying credit distributions

Perhaps the strongest argument for unification relates to lending habits. Nepal's progress necessitates substantial investment in productive industries, yet current allocation reveals imbalances of concern.

As of mid-July 2017, banks had directed a mere 18.22% of loans to productive sectors despite 25% targets. Agriculture, representing 32.40% of GDP, received only 4% of total loans in 2014. Newer data demonstrates agricultural credit even fell 0.7% in the period ending mid-December 2024 as other fields saw increases.

This mismatch between economic structure and credit distribution undermines Nepal's developmental potential. Consolidated banks, boasting stronger capital bases and enhanced risk assessment abilities, can more confidently expand credit to traditionally underserved but productive sectors. Their strengthened capacity for sector risk evaluation allows balanced portfolio construction.

Risks of Excessive Fragmentation

The current banking structure poses significant risks that prudent consolidation could wisely mitigate. First, regulatory oversight naturally grows increasingly complex with an overabundance of diminutive institutions. NRB's supervisory abilities are excessively stretched across 107 disparate entities, potentially allowing questionable practices to unwittingly evade detection. Amalgamated supervision of fewer, more substantial institutions would facilitate more stringent oversight.

Secondly, fragmentation inevitably breeds unhealthy rivalry that may drive perilous behaviors. When an overabundance of banks competitively chase an identical confined customer base, some understandably resort to compromising credit standards or proffering unsustainable interest rates to entice business. This race to the bottom ominously imperils system-wide stability.

Thirdly, talent dispersion remains a persistent dilemma. Nepal's comparatively small pool of banking experts must be disproportionately disseminated across over 100 institutions, rendering it implausible for any single entity to strategically accumulate the comprehensive expertise needed for sophisticated fiscal operations. Consolidation would allow for the concentration of talent, elevating the overall quality of human capital deployment in the sector.

Lessons from Previous Consolidation Efforts

Nepal's experience over the last decade with policies aiming to merge banking and financial institutions offers valuable lessons on consolidating the sector for stability and efficiency. Reducing the number of BFIs from 213 to 107 represents progress, but further combinations are still needed according to evidence. Studies consistently demonstrate merged entities outperforming their pre-merger selves across several metrics.

The link between consolidation and steadiness has been proven valid in Nepal, corroborating the premise that more substantial institutions with greater commercial worth tend to administer risk more prudently. This finding should give policymakers confidence in likely outcomes when pursuing additional consolidation moves.

The Path Forward

To hasten consolidation, Nepal Rastra Bank may consider enhancing incentives in the following ways: First, reinforce motives for voluntary mergers beyond the present framework. While existing rules prioritize willing unification, extra regulatory advantages for merged entities could quicken the process. Second, apply progressively more demanding capital demands favoring larger organizations, naturally motivating consolidation without direct orders. Third, look at tax reliefs for combined businesses in a transition time to offset considerable integration expenses. Fourth, more rigorously impose sector-specific lending aims while offering technical help to assist banks growing expertise in underserved sectors. Recent statistics exhibiting decreasing agricultural loans despite

Conclusion

A well functioning financial sector can play significant role in achieving economic prosperity of a nation like Nepal. The fractured configuration of today’s banking structure, for all the advances it may represent with respect to financial inclusion, is inefficient and risky and thus prevents the achievement of thisgoal.

Only now, the consolidation that would have served banks well in the high interest rate environment due to economies of scale and the potential for better stability, governance, technology and spread out lending is looking as if it may never happen. The empirical evidence derived from the experiences of mergers in Nepal also indicate better ROA, ROE, NPM as well as stability ratios for the consolidated firms which has led us to conclude on the basis of Nepalese experience as well.

Policymakers, bank stockholders and others need to realize that while multiple financial institutions may seem to be a competitive positive, that's not the case when the fragmentation is excessive because that only undermines the sector and the economy writ large. It can, however, be argued that strategic consolidation doesn’t reflect a shrinking banking sector, but rather one that is growing in a more sustainable manner, becoming more efficient and reducing the number of banks and financial institutions to a level that is appropriate for the economy and regulators to govern.

There is evidence now that such a strategy should be adopted as a key policy plank for financial-sector development and economic growth in Nepal. Because the corresponding alternative — persisting with a bloated, ineffective banking sector — risks undermining the very development goals the sector is intended to promote.

Article By:

Sandip Poudel