How Much CounterCyclical Buffer is Optimum for the First Time Setting in the Context of Nepal?

The CounterCyclical Buffer is a regulatory measure implemented by central banks to ensure the stability of the banking system during economic fluctuations. It requires banks to hold additional capital during periods of economic growth and credit expansion, acting as a safety net. This extra capital can be released during economic downturns to absorb losses and support lending, stimulating recovery. The buffer amount is determined by the central bank based on factors like credit growth and financial system stability. It serves to prevent excessive risk-taking by banks during good times and promotes a resilient banking system that can continue providing support to individuals and businesses in challenging economic conditions. 

The current CD ratio of Commercial Banks stands at 81.69% as on July 13, 2023. Over the one-month period, the indicator has dropped by around 2.5% (84.19% as on June 2, 2023). If we observe the trend of Government Capital Expenditure for last 5/6 fiscal years, the last month of the fiscal year can always be considered to be the pleasant period for deposit outgrowth in the industry.

Commercial Banks are more focused on recovery and management of current portfolio rather than active lending activities during this period. The NBI has rescinded the Gentlemen's agreement and now the Banks can set the interest rates on deposit on their own. Enough liquidity available on hand and low pace of credit disbursement are the major rationales for this development. Interbank Interest Rate LCY (Weighted Average) has also dropped below 1% level.

NRB has issued the Reverse Repo Auction Notice for the consecutive fifth time in the month of Ashadh to manage the excess liquidity in the market. Nepal Rastra Bank has continuously been using the reverse repo as an instrument under Open Market Operation whenever the market has witnessed the excess liquidity situation.

Assuming the Commercial Banks will utilize maximum CD capacity at 89% along with all other eligible sources remaining unchanged that could be considered in the calculation of ratio including outstanding debentures, refinance volumes and borrowings from external sources; the loanable funds in the industry will reach around NPR 300-350 billion in coming period.

Adding to this, factoring the year end interest capitalization, we can roughly assume around NPR 95-100 billion will be added as the sources of loanable funds in the market. The principal repayment and other factors have not been incorporated here. Summing up, there could be around NPR 400-450 billion of excess fund available.

The interest rates on deposit are expected to further decline thereby decreasing the overall lending rate making the credit facility inexpensive. These all could possibly fuel the credit growth and we can guesstimate financial upswing is underway.

Development of such indicators points to expansionary phase of the financial cycle and increasing pressures on financial markets. With all these favorable space for further lending, Commercial Banks is expected to prioritize early booking of loan during the initial period of the impending fiscal year. This will help Banks to optimize their CD space and to cover the minimum provisioning expenses soon offering them an opportunity to book decent amount of profit with the interest income from the customers.

Periods of strong lending activity could be associated with gradual accumulation of cyclical risks, potentially manifesting themselves in an increase of non-performing loans as borrowers’ debt servicing capacity may decline in the event of future economic downturn and/or rise in interest rates. Prolonged low levels of interest rates could lead to a substantial increase in indebtedness, making the banking sector’s asset quality, profitability and capital position more susceptible to adverse developments in the economic environment.

Taking all these factors into account, the build-up of cyclical imbalances is expected to accelerate in the imminent period. Maintaining strong capital base is essential for Commercial Banks' capacity to easily sustain the consequences of potential worsening in the economic environment.

Introducing the CounterCyclical Capital Buffer (CCyB) rate during period of favorable economic conditions could help preserving and further strengthening the banking system, thus increasing the Banks resilience to future materialization of credit risk.

NRB via Monetary Policy 2079-80 had announced to implement Counter Cyclical Buffer from Shrawan 2080 which was continuously postponed from FY 2076-77 citing the emergence of Covid-19 pandemic. The decision on the first time setting of the countercyclical buffer rate has already been announced 12 months before coming into effect.

The Credit-to-GDP gap still seems favorable which remains close to 91 per cent. But in fact, during a post-crisis period that can be characterized by robust credit dynamics, the credit-to-GDP gap may underestimate the risks associated with excess credit growth.

Considering these entire scenarios, this could be the pre-eminent period for setting the CCyB in the context of Nepal. Current Core Capital/RWA stands at 10.10% and Total Capital/RWA at 12.95% as of Baisakh 2080, which provides additional 1.60% and 1.95% space for growth on respective ratios. But when we factor the potential growth on credit segment along with the expected capital position of the industry, the Total Capital/RWA is expected to dwindle approximately by around 1% in upcoming period.

Thus, the introduction of a 0.5%-1% CCyB rate at this stage is expected to have no material impact on credit or economic activity with roughly all the commercial banks equipped and prepared to absorb such an increase. Including the CCyB rate up to 1%, the capital position of the banking sector remains resilient and well above minimum regulatory requirements. There is scope for the banking sector to absorb the increase in the CCyB rate while minimizing the potential for the buffer implementation to have negative effects on credit supply and economic activity.

In the current juncture of increased uncertainty, the banking sector has a significant voluntary buffer above the current capital requirements even if the minimum rate is introduced as the additional regulatory prerequisite, while the banks’ profitability has been strong with the potential to surge further. Therefore, the potential effect on credit growth and the increase in lending margins is expected to be insignificant. Preserving part of the accumulated capital and profits in the form of CCyB would increase the resilience of the industry to the potential challenges should they materialize in the future.

Contributed by Subash Kafle, Branch Manager at Rastriya Banijya Bank's Branch Office Sanghutar(132). Dedicated to overseeing branch operations and delivering exceptional customer service.