The banking sector disbursed less credit this fiscal, while economic growth rate for the year is projected at 5.15 per cent.

Doesn't this reflect a disconnect between GDP growth rate and credit expansion?

One of the drivers of the country's economic growth is agriculture. However, many farmers are still engaged in subsistence farming, which does not absorb funds from the formal banking channel. This means the banking sector's lending to the agricultural sector is still very low. That's why GDP growth and credit expansion are not always linked. To ensure higher credit growth, we have to identify areas where we have competitive advantage. Currently, we have been able to spot only few such areas, including hydropower, tourism and natural vegetation, like herbs. But sectors like hydropower require minimum of Rs two-three billion in capital, which is quite high, and gestation period is also long. So, the question on whether domestic banking institutions can finance big projects is being raised.

To finance large projects, domestic financial institutions need fresh capital, which has not entered into the banking sector lately, while mergers are only consolidating the old capital floating in the market.

Let's discuss this issue from two aspects. First of all, size matters because investors want to put money in bigger projects these days to reap benefit from scale. Nowadays, investors propose building hydro projects of at least 10 megawatts as against one MW a decade ago. In this regard, mergers are helping the banking sector, as they are not only consolidating capital of different units, but raising capital efficiency. Probably this is the reason why the regulator is also pushing for mergers these days. But to further build the banking sector's capacity we need fresh capital. However, to attract fresh capital, we need to assure higher returns. Currently, average return in the banking sector hovers at around 14 per cent. Considering, inflation of around 10 per cent and higher external risk factors, the returns cannot be regarded as great.

So what is the problem here? Is it soaring inflation or relatively lower returns?

We are facing stagflation, as the economic growth rate has stagnated at below five per cent, while inflation is at double digit. If economic growth rate had stood at eight or nine per cent, it would have created greater opportunities. These opportunities, in turn, could have paved the way to generate higher returns. So, higher economic growth is a must for sustainable growth of the banking sector.

But the economy is gradually growing. So can we expect greater exposure of banks towards the productive sector as demanded by the central bank?

From my understanding, the central bank wants us to extend credit to sectors where value addition is high, so that economic growth can accelerate. In this regard, banks have been told to extend 20 per cent of the total loans to the productive sector. Currently, commercial banks have extended around Rs 875 billion in loans till date. Of this, at least Rs 175 billion has to be allotted to the productive sector to meet the regulatory requirement on productive sector lending. However, as of now, productive sector has absorbed only 10-12 per cent of bank loans. This means we may have to recall loans issued to other sectors if we are to meet the regulatory requirement. Recalling loans probably would not have been a problem had there been demand for loans in the productive sector. But the problem is credit demand in the productive sector is very low. At a time when the real sector is reeling under problems of power shortage and infrastructure deficit, it has become a challenge for banks to meet the regulatory requirement on productive sector lending. In this regard, the central bank's strategy of exploiting monetary policy to attain higher GDP growth seems highly ambitious and is likely to create distortions in the economy.

But banks are also being accused of not being innovative in introducing new products to generate interest in bank credit and manage high liquidity?

Banks can extend funds at attractive rates; they may also come up with attractive terms and conditions and pledge to finance 90 per cent or even 100 per cent of the project cost. Further, banks can modify products and make them even more attractive. But if banks have to get engaged beyond that point and teach borrowers how to use the product, the product design cost will go up. In fact, teaching borrowers how to use credit products is the job of development banks. But since the concept of development banks could not be well implemented here, pressure is being exerted on commercial banks to assume that responsibility. Yes, commercial banks have lots of liquid money now, but we cannot think of doing lots of development works with this, as our involvement should be more in providing short-term working capital. In this regard, efforts have to be made to promote entrepreneurship.

NRB is soon coming up with a new monetary policy. What are the banking sector's expectations?

We need interest rate stability so that a situation does not arise wherein one party has to bear the cost of liquidity surplus or shortage. For instance, if there is high liquidity, we should not be told to extend certain interest to depositors just to cover the cost of inflation. So, policies should be more realistic. The reality is that the number of depositors here is higher than borrowers. This is because of shortage of entrepreneurs. So, whenever there is liquidity surplus, borrowers get the leverage to demand for better rates because of competition among banks to rope in limited number of customers. Same thing is happening at the moment and banks are being forced to carry the cost of high liquidity — as we can neither reduce deposit rates significantly nor raise lending rates. One of the reasons why we are being forced to carry this cost is because of regulatory provision on maintaining 20 per cent liquidity ratio.

Because of this, we have to invest 20 per cent of the total deposits in government securities, which offer below one per cent yields.

So you mean to say 20 per cent liquidity ratio is too high?

No, I didn't mean to say that. The provision on liquidity ratio should be there as it covers the risk of banks. Instead, a mechanism should be developed to absorb the cost incurred in maintaining the liquidity ratio.

This is also an issue of supply and demand, isn't it? When there is a lot of cheap money, NRB would also want to borrow funds at lower rates?

But it is the government which is borrowing the money. So, the problem should be addressed over a certain period of time.

Also, the swing in interest rate from the time when there was liquidity shortage to the period when there is liquidity surplus is quite big. Such issues need to be adjusted. Otherwise, risks will continue to persist in the banking sector.

What other areas do you expect the new monetary policy to touch upon?

The provision that bars banks from opening branches in urban areas without opening a certain number of branches in rural areas is not practical. It takes an average of two to three years for a branch opened in an urban area to reach breakeven point. In rural areas, we have to wait for years for this. Yet, many branches are being set up in rural areas just because of regulatory requirement. This is brewing up inefficiency in the banking sector. Besides, what is the impact of opening branches that are virtually doing no business? Banks cannot afford to continue adding loss-making branches.

Source: THT June 23, 2014 - Rupak D Sharma of The Himalayan Times spoke to Ajay Shrestha, CEO of Bank of Kathmandu, on factors that are suppressing credit demand and measures that need to be taken to boost lending.

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