Views of a Nepali Economist

Nepal’s financial industry needs to learn its lessons

By: Mukesh Khanal

Nepali financial market took a tumble between late 2009 until late 2011. Nepal Rastra Bank (NRB) urged some banks and financial institutions (BFIs) to merge. Some were allowed to go bankrupt, while some were rescued by the NRB. Despite these setbacks, however, banks and finance cooperatives have mushroomed continuously. Are these mushrooming BFIs adding any value to Nepal’s financial market and growth? Is Nepali financial market making any contributions to economic growth? If yes, how much is that contribution, and how can it be measured?

BFIs pay interest to depositors, and that interest is considered the “cost” that they incur. BFIs lend money to people and businesses, and interest charged on these is considered their “earnings”. The difference between earnings and cost is considered their “profit”, and this profit is considered to be their contribution to national economic growth. This consideration is disingenuous for a couple of reasons.

First, difference between earnings and cost is the value they have added to our money deposited with them. It is not their profit because some portion of this value addition is yet to be spent as “costs”. Some of this value addition is spent to pay for various evaluations and monitoring costs that BFIs incur while assessing, evaluating, re-evaluating and monitoring their high-risk loans. These costs are not paid by borrowers of loans, but by the BFIs themselves. So, BFIs end up spending a portion of their value addition on paying such costs. Therefore, the number that NRB and BFIs report as contribution of the financial industry to our economic growth is wrong. The actual contribution is much less.

This misleading figure is the reason why we suffer through liquidity crises, every now and then. In our recent liquidity crisis, the level of profit and savings that BFIs showed to their shareholders was distorted due to the above mentioned fudging of facts. They actually did not earn the amount of profit that they claimed to have earned.

Second, interest rates charged on mortgages issued by BFIs have been significantly higher than interests guaranteed on government issued long term bonds and treasury bills. Money for providing mortgages comes from money deposited by the accountholders. Since mortgages fetch high interests, BFIs tend to give higher returns to their depositors as well to lure depositors into depositing more money into their bank accounts. Therefore, entire financial system rests on the shoulders of depositors and how confident they are with their respective BFIs. A slight reduction in their confidence can mean a huge reduction in available funds for BFIs. Thus, our entire financial cycle has a very high risk associated with it. Rising instances of default—either by depositors or by mortgage holders—takes our entire financial market on a decline.

Many studies have disputed this general notion that risk-taking behavior of BFIs is a “productive activity”.  In 2011, Andrew Haldane and Vasileios Madouros analyzed the worldwide financial crisis of 2008, and discovered that investing capital in a risky asset did not contribute to productivity. This suggests that Nepali investors who purchase bonds from a company, or Nepali consumers who borrow from a bank to buy houses, are taking financial risks but contributing “zero” to economic activity. The reason for this being that nothing new is created from these transactions in our economy. There is simply a reallocation of available finances from one party to the other. Hence, loan portfolios have negligent contribution—if there is one—in growing our economy.

Another chronic problem with Nepali financial system is that consequence of risks is not borne by parties that take those risks but by others in the society. BFIs utilize our money in issuing risky loans with much higher returns than the interest they pay us for our deposits. If these risky loans get repaid, they make tons of money. CEOs and shareholders of those BFIs get rich. If these risky loans are not repaid, they go bankrupt. We lose most of our money that we deposited with them. CEOs and shareholders of those BFIs do not have to pay us the money that was ours but which they lost through their risky behavior. Where’s the balance in rewards versus punishment in our BFIs?

Nepali financial system is structured in a way where CEOs get away with their risky behavior without being held accountable for their actions. If BFIs go bankrupt, CEOs know NRB will rescue them i.e. the public will rescue them. If they earn ridiculous profits, CEOs know the profit will be solely their shareholders’. So CEOs do not have to pay for their risky behavior, and so they take more risks. Nepali financial system has created this “moral hazard” situation where society has been paying the price for the follies of BFIs.

These criticisms do not mean that our financial system is utterly useless and a zero contributor. Researches around the world have shown that world’s financial industries do provide some services, and hence they provide positive value additions. However, he also discovered that these value additions have been overstated. Contribution of any country’s financial industry—including Nepal’s—to its economic growth has always been overstated. Rapid growth in contribution to Nepali GDP by our financial sector in the last few years is a mirage.

Exceptionally high returns that Nepali financial industry experienced before the recent liquidity crisis was not a result of increasing productivity of our financial sector but a result of illusion of growth shown by high-risk lending and borrowing. If current trend of high risk-taking in Nepali financial sector continues, soon there will be another liquidity crisis worse than the one that lasted from 2009 until 2012. The reason Nepali financial market has not yet recovered fully from that crisis is because the risk-taking behavior continues even today.