The Non-Performing Loans Crisis in Nepal: An Analysis of Current Indicators and IMF Concerns

Non-Performing Loans (NPLs) have emerged as a critical factor in assessing banking crises worldwide, serving as a barometer for financial stability. Recent analyses by the International Monetary Fund (IMF) underscore that NPL ratios surpassing 7% can signal significant banking distress. Nepal, with its evolving financial landscape, is now facing scrutiny under this global lens, with the IMF initiating an audit of its major commercial banks to gauge the true extent of potential risk.

NPL Trends and Regulatory Framework in Nepal

Non-performing loans refer to loans where the borrower has failed to make scheduled payments for a specified period. In Nepal, NPLs have been on the rise due to various factors such as economic downturns, poor credit assessment practices, and external shocks like the COVID-19 pandemic. These loans not only affect the banking sector but also ripple through to impact the broader financial ecosystem, including the share market. Nepal Rastra Bank (NRB) defines loans as Non-Performing if payments are overdue by three months or more. To manage risks, NRB mandates financial institutions to set aside provisions based on the loan category, with varying percentages for different types of non-performing assets. Recent changes, post-COVID, saw NRB adjust provisions for 'Pass' loans to 1.3% while maintaining higher provisions for 'Watch list,' 'Sub-standard,' 'Doubtful,' and 'Loss' loans, reflecting the duration of repayment delays.

Historically, state-owned banks in Nepal had higher NPL ratios compared to private banks, though these ratios have seen a dramatic decrease from 8.31% in 2010/11 to 1.86% by mid-2021/22. Conversely, private banks have shown a rising trend in total annual NPL amounts, indicating potential vulnerabilities despite relatively lower ratios. This discrepancy highlights a broader trend influenced by aggressive credit growth and fluctuations in the real estate sector.

In a significant development, the International Monetary Fund (IMF) has issued a directive emphasizing the need for stringent management of non-performing loans (NPLs) by commercial banks. This guidance comes in the wake of concerns raised by the Nepal Rastra Bank (NRB) regarding the haphazard lending practices of commercial banks, which have contributed to a notable rise in non-performing loans. This situation has profound implications for the banks' distributable profits and their ability to distribute dividends.

The IMF Directive: Addressing Non-Performing Loans

The IMF's instruction highlights the critical need for Nepalese banks to focus on the effective management and resolution of non-performing loans. These problematic loans not only erode the financial health of banks but also impact their ability to generate and distribute profits.

The IMF's guidance underscores the urgency of addressing this issue to prevent further deterioration in banks' financial positions and to safeguard overall economic stability.

Haphazard Lending Practices: A Contributing Factor

Over recent years, many commercial banks in Nepal have adopted aggressive and often indiscriminate lending practices, extending credit to a broad range of sectors without adequate risk assessment. This lack of prudence has led to a surge in non-performing loans, as borrowers from various sectors struggle to meet their repayment obligations.

The haphazard approach to lending has had several adverse consequences:

• Increased Default Rates: The influx of non-performing loans has led to higher default rates, which strain the banks' financial resources and affect their balance sheets.
• Diminished Asset Quality: With a growing proportion of loans becoming non-performing, the quality of banks' asset portfolios has deteriorated, impacting their overall financial health.

Impact on Distributable Profits and Dividends

The rise in non-performing loans has a direct impact on the distributable profits of banks. Non-performing loans generate no income for the banks, and the provisions required to cover potential losses further erode profit margins. This reduction in profit translates into reduced distributable profits, limiting the funds available for dividend distribution.

Several key effects include:

• Lower Profit Margins: Banks facing high levels of non-performing loans must allocate a significant portion of their earnings to provisions for loan losses, which reduces net income.

Reduced Dividend Capacity: With diminished distributable profits, banks find it challenging to sustain their dividend payments to shareholders. Lower dividends can affect investor confidence and the overall attractiveness of bank stocks.

IMF Concerns and the Audit Directive

The IMF's staff-level agreement with Nepal indicates a cautious approach towards the nation's financial health. Despite official NPL ratios appearing manageable, the IMF has expressed concerns about deteriorating asset quality and rising borrower defaults due to higher lending rates. An audit of 10 major commercial banks by an international firm has been mandated to assess the true financial state and validate the stability reported on paper.

The IMF’s historical research suggests that during banking crises, NPL ratios often double, with recovery times extending over several years. Applying these findings, Nepal could face a protracted recovery period if current trends indicate underlying weaknesses. This would be exacerbated by factors such as high government debt and significant credit growth.

Implications and Recommendations

The audit, while crucial, is just one part of the broader financial oversight needed in Nepal. NRB must continuously ensure accurate loan classification and monitor borrower repayment capabilities. Additionally, monetary policy should adopt a cautious stance, focusing on data-driven strategies to avoid extreme credit cycles that could destabilize the financial sector and impede long-term economic growth.

In summary, while Nepal's reported NPL ratios may appear under control, the IMF's audit is a critical step towards uncovering potential hidden risks. Ensuring robust regulatory practices and prudent monetary policy will be essential for maintaining financial stability and supporting sustainable economic development in the face of evolving global and domestic challenges.

The IMF's instruction to address non-performing loans marks a critical step towards stabilizing the financial sector in Nepal. By heeding the IMF's guidance and implementing robust risk management practices, Nepalese banks can work towards mitigating the adverse effects of non-performing loans and restoring financial stability. In conclusion, the IMF's projection of a strong rebound in Nepal's imports for 2024-25 underscores a positive economic outlook for the country. This anticipated growth aligns with a forecasted increase in capital expenditure and an upturn in GDP growth. Such developments are indicative of a robust economic recovery, supported by increased investment and expanding economic activity. As Nepal continues to navigate its path to growth, these factors will likely play a critical role in driving import demand, further fueling economic momentum and stability.

As banks navigate this challenging environment, a focus on prudent lending, effective loan recovery, and transparent reporting will be crucial in safeguarding their financial health and maintaining their ability to provide returns to shareholders.

Article By: Dipesh Dhakal