It was on July 23, 2015, when Dr. Chiranjivi Nepal was presenting the monetary policy for the fiscal year 2015/16 at Hotel Radisson, Kathmandu. It was his first monetary policy speech as the Governor of the Nepal Rastra Bank. Along with other stakeholders, (we), bankers were also listening to him attentively. During the speech, when he read point number 69 of the monetary policy, a sense of trepidation engulfed us.
It was because the central bank had raised the minimum paid-up capital for banks and financial institutions (BFIs) stating ‘to enhance financial stability and raise the necessary resources for long-term development by fortifying their capital base’. Under this requirement, commercial banks were asked to increase their paid-up capital to Rs 8 billion, national-level development banks to Rs 2.5 billion, development banks operating in areas covering 4-10 districts to Rs 1.2 billion, and finance companies operating on national level and in 4-10 districts to Rs 800 million and Rs 400 million, respectively, by mid-July, 2017.
Indeed, Governor Nepal dropped a bombshell when he announced the new paid-up capital requirement. For commercial banks, the sudden increase in the minimum paid-up capital from the previous Rs 2 billion to Rs 8 billion within just two years was a daunting challenge. The new paid-up capital plan for development banks and finance companies was equally unprecedented. This policy change took us by surprise and was considered almost unimaginable. The announcement that commercial banks need to raise their paid-up capital by fourfold to Rs 8 billion was akin to an earthquake for bankers and bank investors. The impact of this Rs 8 billion ‘quake,’ along with its subsequent effects, has been so significant that discussions and debates from various perspectives still continue even today.
In this article, I have attempted to delve into various details related to the impacts of the paid-up capital hike.
The History of Capital Growth of Nepali Banks
Nepal Bank was founded on November 15, 1937, as the first bank in Nepal and had an issued capital of Rs 2.5 million. However, the bank’s paid-up capital amounted to Rs 842,000. At that time, the government held a majority 60 percent ownership stake in Nepal Bank, while the remaining 40 percent was held by the general public.
Nepal Rastra Bank (NRB) was established on April 25, 1956, with an initial capital of Rs 10 million. Meanwhile, Rastriya Banijya Bank, a wholly government-owned commercial bank, officially began operations on January 23, 1966, with an authorized capital of Rs 10 million and paid-up capital of Rs 2.5 million. In the fiscal year 1974/75, NRB instructed both Nepal Bank and Rastriya Banijya Bank to raise their capital by Rs 40 million and Rs 20 million, respectively.
As the first commercial bank with foreign investment, Nabil Bank began its operations on July 12, 1984, as the Nepal Arab Bank. In 1985, Nabil’s authorized capital amounted to Rs 100 million, the issued capital was Rs 50 million, the called-up capital was Rs 30 million (at a rate of Rs 60 per share), and the paid-up capital was Rs 24.2 million. In FY 1984/85, the bank earned a net profit of Rs 535,000.
Due to the non-subscription of the shares issued, Nabil subsequently sold the remaining shares to its employees. Consequently, the bank’s paid-up capital reached Rs 30 million in FY 1988/89. It took until FY 1991/92 for the bank to fully pay up its initial issued capital of Rs 50 million. As of mid-July 2023, Nabil Bank’s paid-up capital increased significantly to Rs 27.05 billion with Rs 31.03 billion in its reserves and total capital of Rs 58.08 billion.
Other foreign joint venture banks, namely Nepal Indosuez Bank (now Nepal Investment Mega Bank), initiated operations in February 1986, and Nepal Grindlays Bank (now Standard Chartered Bank Nepal) began operating on February 28, 1987. Foreign banks held a 50 percent share investment in these three banks.
After the restoration of democracy in 1990, NRB implemented a policy to allow the establishment of commercial banks with foreign investments of less than 50 percent. As a result of this policy change, Himalayan Bank Limited, which began operations in February 1993, became the first bank to successfully secure over 50 percent of investment from the private sector, with only a total foreign investment of 20 percent. At its inception, the bank had an authorized capital of Rs 120 million and a paid-up capital of Rs 60 million.
In 1994, Nepal Rastra Bank introduced the following policy regarding minimum capital requirements for the establishment of commercial banks:
• For the establishment of a central office within the Kathmandu Valley, a capital of Rs 250 million was mandatory.
• To establish a central office outside the Kathmandu Valley, a capital of Rs 120 million was a prerequisite.
• To operate solely within five districts outside the Kathmandu Valley by establishing a central office, a capital of Rs 50 million was necessary.
In 1995, NRB implemented a revised minimum capital requirement policy for the establishment of commercial banks. Under the policy, a minimum capital of Rs 500 million was mandated for setting up a central office within the Kathmandu Valley, and a minimum capital of Rs 300 million was stipulated for operations solely outside the Kathmandu Valley.
In FY 1996/97, NRB issued a directive requiring commercial banks to increase their capital (including reserves) to Rs 500 million within five years. In the same year, the central bank for the first time introduced a licensing policy for establishing development banks, with minimum capital requirements starting from Rs 2.5 million to a maximum of Rs 160 million, contingent on the geographical area of operation, ranging from a single district to nationwide coverage.
In the same year, Nepal Development Bank was registered and became the first development bank to operate under the Development Bank Act of 2052, commencing its operations in February 1999. Prior to this arrangement, Nepal Industrial Development Corporation (NIDC) and Agricultural Development Bank (ADB) were already in operation as specialized development banks. NIDC subsequently merged with Rastriya Banijya Bank in May 2018, and ADB now functions as a commercial bank.
In FY 1993/94, NRB implemented a policy that specified a minimum capital requirement ranging from Rs 2.5 million to Rs 30 million for the establishment of finance companies, depending on their scope and service areas. As a result of this policy, finance companies began their operations in the same year. Over time, the minimum capital requirements for development banks and finance companies have also been subject to revision.
In 2003, the central bank raised the minimum paid-up capital to Rs 1 billion for establishing commercial banks. Additionally, existing banks were directed to meet this paid-up capital requirement by mid-July 2009. This provided banks with a timeframe of over seven years to double their paid-up capital.
The central bank’s liberal policy, designed to expand financial access, resulted in a rapid proliferation of development banks and finance companies within a short span of time and the number of commercial banks also grew substantially. However, the disparity between the lenient licensing policy and the supervisory capabilities raised concerns as some institutions grappled with severe corporate governance problems. This situation prompted worries about the safety of the public’s funds, making it a challenging period for the central bank to uphold public trust in the banking and financial system.
In FY 2008/09, NRB took an unprecedented step by revoking the license of Nepal Development Bank, which was the first bank to receive a license after the enactment of the Development Bank Act, 1996, and also initiated legal proceedings for its liquidation. As issues continued to mount for other institutions, NRB found it necessary to establish a Problematic Institution Resolution Division a few years later.
By mid-July 2009, a total of 181 BFIs, including 26 commercial banks, 63 development banks, 77 finance companies, and 15 microfinance institutions were operating across the country.
In the monetary policy for FY 2009/10, the central bank recognized a substantial rise in the number of BFIs in categories A, B, and C. Consequently, there was a realization that a reevaluation of the policy regarding the issuance of new licenses was warranted. “The central bank acknowledges the growing challenges related to the inspection, supervision, and financial stability of BFIs institutions. Furthermore, it is committed to ongoing efforts to uphold strong corporate governance within these entities. Priority will be given to the identification and resolution of issues within struggling banks. In addition, individuals and parties involved in activities that exhibit irresponsibility and unaccountability towards the public’s deposits and investments in the sensitive banking sector will also be subject to legal scrutiny,” reads the monetary policy.
Following the decision made during the 1079th meeting of the board meeting on July 31, 2009, NRB issued a notice within a week of the monetary policy release. The notice announced a temporary suspension of the registration process for the establishment of new BFIs. “The existing policies and procedural framework related to the establishment and financial operations permits issued by this bank in 2006 are considered in need of a review. Therefore, the acceptance of new applications for the establishment of BFIs has been temporarily suspended until a comprehensive study is conducted, and a report is generated. However, in accordance with the provisions of the current monetary policy, applications submitted by A, B, and C class BFIs for the establishment of their subsidiary microfinance institutions under the D category, aimed at facilitating loans in the deprived sector, will be processed and advanced in accordance with existing regulations,” NRB stated.
After issuing the notice, the central bank halted the process of accepting applications for establishing new institutions but allowed those complying with the regulatory requirements to come into operation. On May 8, 2011, NRB implemented a merger bylaw, providing an array of incentives to promote mergers among BFIs. The government, in parallel, extended tax exemptions and benefits to institutions opting for mergers within specific categories. In FY 2013/14, the central bank also introduced the Acquisition Bylaw, which facilitated acquisitions. NRB emphasized the enhancement of the capacity of its supervision departments responsible for overseeing commercial banks, development banks, and finance companies.
As the number of troubled institutions grew, coupled with the introduction of the Basel III framework in response to the global financial crisis of 2008/09, there were discussions regarding the central bank’s role in creating an environment conducive to significant mergers by raising the minimum capital requirements. There were rumors that the Chief of the International Monetary Fund was in Nepal at the time and suggested the central bank to increase the minimum capital requirements for BFIs.
In fact, within the banking community, there was a prevailing anticipation that the minimum paid-up capital requirement for commercial banks would be raised to Rs 5 billion in the final monetary policy under the tenure of then Governor Dr. Yuba Raj Khatiwada. Drawing from past experiences, bankers were reasonably confident that NRB would allow ample time for capital increment. However, Dr. Khatiwada refrained from raising the paid-up capital of BFIs.
Given the previous experiences, we had not even contemplated that the central bank would make an announcement in July 2015, instructing commercial banks to raise their paid-up capital to Rs 8 billion by mid-July 2017. As outlined in the NRB’s notice on August 6, 2015, the minimum capital requirements to be met by BFIs by mid-July 2017 were as follows:
- Commercial Banks: The required capital increased from Rs 2 billion to Rs 8 billion, marking a 300 percent increase.
- National Level Development Banks: The necessary capital rose from Rs 640 million to Rs 2.5 billion, reflecting a 290 percent increase.
- National Level Finance Companies: The mandated capital surged from Rs 300 million to Rs 800 million, constituting a 166 percent increase.
When the policy was introduced, requiring a finance company operating in a single district with a capital of Rs 10 million to increase it to Rs 400 million, and a development bank to raise it to Rs 500 million within a mere two years, one can only fathom the seismic impact it must have had on their operations. The circular explicitly stated that BFIs failing to meet the minimum capital requirement would be prohibited from accepting deposits and granting loans.
The central bank’s policy prior to 2015 aimed at a gradual reduction in the number of BFIs through various incentives and measures. However, the 2015 policy clearly set a more aggressive target to significantly reduce the number within a span of two years. This approach could be described as a form of a ‘forced merger’ policy. Notably, the capital requirements for Development Banks (Category D) operating in microfinance were not raised during this time, and the permission-granting process was ongoing. Following the Monetary Policy of FY 2016/17, the application process for establishing microfinance institutions also became more stringent.
The concept paper regarding capital increment issued by Nepal Rastra Bank in August 2015 also encompassed the following key points:
To reinforce financial stability, promote healthy competition, and address the risks observed in the financial sector arising from the presence of weaker institutions alongside its quantitative growth.
To facilitate BFIs in meeting the capital adequacy ratio, fortify their capital base for expanding financial services beyond loans, prevent constraints on opening overseas branches due to insufficient capital, support the expansion of their capital alongside economic growth, and bolster Nepal’s financial sector in building a robust and dynamic financial foundation in alignment with financial institutions in SAARC countries.
While there may not be a consensus on the ideal number of BFIs in any given country, the strength of their capital base is of paramount global importance. In terms of ease of management, reducing the cost of financial intermediation, the ability to operate with adequate capital for economic development, as well as for effective regulation and supervision, having fewer banks with substantial capital appears to be a preferable choice over numerous small-capital banks. In the ongoing discourse about whether the quantity of BFIs in Nepal exceeds what is optimally required relative to overall economic indicators, it is evident that these institutions need to merge judiciously and augment their capital through mergers. Consequently, it is imperative to bolster the capital base through mergers in order to align with international standards.
Numbers of BFIs:
To date, NRB has granted permission to operate 32 commercial banks, 95 development banks, 87 finance companies, and 103 microfinance institutions.
Currently, Nepal Infrastructure Bank Limited is functioning as the sole dedicated infrastructure development bank.
The table below provides insights into the number of BFIs at the time of the introduction of the multiparty system in Nepal in 1990, and the subsequent changes in their numbers every 10 years. It also includes the count before and after the introduction of the merger policy, as well as after the implementation of the Rs 8 billion paid-up capital policy:
Prior to the enactment of the merger regulations, four finance companies had already engaged in mergers with other institutions. Following the introduction of merger regulations and subsequently acquisition regulations, mergers and acquisitions (M&As) among BFIs gained momentum. The policy aimed at achieving substantial capital growth by mid-July 2017, further accelerated the prevalence of M&As. In FY 2016/17, a total of 60 BFIs participated in this process. Despite the various subjects mentioned in the central bank’s concept paper on capital growth, it is widely acknowledged as an ‘open secret’ that the policy to significantly increase capital within two years was primarily aimed at reducing the supervisory burden and maintaining public confidence in the banking sector through the M&A drive.
During their tenure as NRB Governors Deependra Bahadur Kshetry and Vijayanath Bhattarai had taken initial steps to curb the proliferation of BFIs. Dr. Yuvaraj Khatiwada introduced a policy to actively reduce their numbers and initiated the process, while Dr. Chiranjivi Nepal further accelerated these efforts.
Despite the substantial reduction in the number of institutions in the B and C categories under the leadership of Dr. Khatiwada and Dr. Nepal, the number of commercial banks only decreased by five during their tenure. However, the current Governor Maha Prasad Adhikari has successfully reduced the number of commercial banks by seven.
With Nepal’s adoption of a branch banking system and the imperative for a highly efficient risk management system in financial institutions entrusted with the public’s funds, it becomes evident that the number of BFIs granted permission to operate in Nepal exceeded what was necessary in relation to the country’s population. With this realization, NRB introduced the policy of mergers and acquisitions and also deregistered certain institutions. A dedicated Problematic Institution Resolution Division had to be established to effectively manage such institutions. Furthermore, a stringent policy was enacted to substantially increase capital within two years, with NRB offering various incentives to those involved in the M&A processes. The government also extended tax concessions and benefits under different categories for institutions choosing M&As.
The lingering question is whether the issuance of so many licenses was solely driven by the noble objective of expanding financial access, or if there were other motives at play. The Nepali public would greatly appreciate insights from any former official of the central bank who possesses a comprehensive understanding of this entire process and can shed light on this matter.
Status of Banks’ Capital
Following the policy of raising the capital requirement, BFIs have grown significantly in size. As of mid-July 2023, the bank with the lowest capital has exceeded Rs 16 billion, while the one with the highest capital boasts almost Rs 59 billion. In contrast, back in mid-July 2015, the bank with the lowest capital had only about Rs 2 billion, and the institution with the highest capital had only Rs 13 billion.
Bankers had concerns that the increased paid-up capital of Rs 8 billion through a right share issue might remain idle for an extended period. Consequently, there were multiple requests made to extend the two-year timeframe allocated for raising the capital, but these appeals were unsuccessful. The growth in various business areas, including loans, investments, off-balance sheet transactions, and more, has been so substantial that some banks are now contemplating issuing additional rights shares to sustain the core capital adequacy ratio, despite having substantial capital reserves.
Financial Access
Typically, after a merger, institutions tend to implement cost-cutting measures, which can raise concerns about a decrease in financial reach. The table below provides insights into financial access:
Presently, out of 753 rural municipalities, commercial banks offer services in 752 municipalities. Despite a roughly 75 percent reduction in the number of these institutions, there has been a proliferation of branches established by A, B, and C-class institutions.
In mid-July 2015, one branch of a bank was expected to cater to 10,150 Nepali citizens. However, by mid-July 2020, this figure dropped to 5,255, and as of mid-July 2023, the number declined further to 4,514. Considering the class D institutions, there are currently so many branches of BFIs that, on average, one branch serves only 2,517 people.
Technological advancements have allowed branches to efficiently serve a larger customer base, and the use of digital channels like QR codes, mobile banking, cards, and more has significantly increased in Nepal.
The data from June 2020 reveals that there are 32 million bank accounts, with 29.9 million being individual accounts. The data shows that 67.3 percent of Nepalis have at least one deposit account in the categories class A, B, or C institutions. However, only 3.85 percent of the total deposit accounts belong to individuals under the age of sixteen, even though this age group constitutes 29.91 percent of the population in Nepal. The majority, or 96.15 percent, of accounts, belong to individuals above 15 years of age. Since June 2020, approximately 20 million new accounts have been opened, including accounts for elderly individuals in villages due to social security allowances. Given these developments, the number of financially capable individuals above 15 years without a bank account in Nepal is now quite small.
Despite the reduction in the number of BFIs, there are still enough institutions in operation, which has intensified competition. The interest rate differential regulations have provided relief to depositors and borrowers, with the interest rate differential (spread rate) declining from around 5 percent to 4 percent. However, this has contributed to a decrease in the return on equity (ROE) of banks. Banks are making additional efforts to remain relevant, introducing new products, and integrating technology. On the other hand, the M&A policies have brought benefits for consumers as banks have opened a large number of branches, increasing competition.
However, bank investors have taken a hit from the arrangement. The average ROE of commercial banks, which was around 24 percent in FY 2014/15, dropped to 12 percent over the next five years.
Growth Rate of Debt
The five years of the implementation of the new capital requirement for BFIs saw massive growth in credit. Amid speculation that a significant portion of the debt has been channeled into the real estate and stock market sectors, which are considered ‘unproductive’, the following table shows the flow of loans to each sector.
Real estate loans have decreased by 0.72 percent point over the period from 2015-2020.
The annual growth rate (CAGR) of loans in the last five years was 19.15 percent, which is slightly lower than the average growth rate of 19.4 percent in the past 20 years. The non-performing loans of banks also remained low in the last five years, decreasing from 3.33 percent to 1.89 percent.
Impact on the Stock Market
Within the context of some banks’ shareholders themselves obtaining share loans to invest in right shares and the market fluctuations created by the issuance of right shares, the table below provides the increase in the share market during the period for issuing rights shares (from mid-July 2015 to mid-July 2017) and the preceding two years preceding.
The index of commercial banks increased by 65 percent from 2013 to 2015, and from 2015 to 2017, it increased by 71 percent. In the case of finance companies, there is an increase of only 40 percent from 2015 to 2017.
Status of Institutions Participating in M&As
BFIs were compelled to hastily seek partners for M&As to comply with the policy to hike their paid-up capital. With the policy in place, all institutions, whether they were performing well or struggling, had to identify another partner for M&A within a strict two-year timeframe. Some organizations even had to engage with more than one partner in this time frame. Although some institutions that have opted for M&As are thriving, it seems that the for majority of BFIs, the consolidation drive has not yielded the desired outcomes.
Many people in the banking sector still argue that the central bank should not have enforced a policy of capital injection through rights shares. If the issuance of rights shares had not been permitted, even more M&As would have taken place within the tight timeframe.
Commercial banks established with private investments that have refrained from participating in M&As appear to have demonstrated more effective management practices compared to the majority of those that have undergone such processes. This is further underscored by the central bank’s directive to infuse additional capital following an on-site inspection. The institutions that underwent M&A at the time when no concessions were available seem to have achieved comparatively lower returns. Notably, none of the banks actively engaged in M&As after mid-July 2015 attained a top seven position in terms of ROE for the FY 2019/20. While most banks involved in mergers and acquisitions have expanded in size, the question of whether they have improved in quality remains a subject of debate.
To this day, the central bank has been notably successful in regulating the number of BFIs despite encountering several challenges and obstacles. Presently, the nation’s economy faces sluggish growth, and non-performing loans in banks are on the rise, with growing number of auction notices of loan collaterals appearing in the newspapers. However, depositors in category A, B, and C institutions do not appear to be worried about the security of their funds. This achievement reflects a significant success for the central bank.
I recall the statement of an expert regarding the policy to substantially raise capital within two years: “As the financial sector was afflicted with a severe ailment, the central bank also administered a potent remedy. While there may be lingering side effects for a while, ultimately, the situation will improve.”
Conclusion
In the last eight years, BFIs have significantly grown in size. This expanded capital base has shielded them from minor shocks, driving a push to seek profitable opportunities in deposits and loans. The proliferation of branches has extended financial accessibility, leading to a notable increase in deposit and loan accounts. Competition has spread beyond major urban centers and district headquarters to smaller markets. Banks have made continuous efforts to enhance customer service through new technologies and products. Furthermore, there has been a substantial improvement in the ratio of deposits and credit to the country’s GDP.
The reduction in the number of BFIs has significantly alleviated regulatory pressures on the central bank. The need for the Problematic Institutions Resolution Division, which was established to manage distressed institutions, has diminished. Currently, there isn’t a noticeable trend of depositors losing money or shaky credibility in the banking sector. The central bank appears to be successful in fulfilling its crucial regulatory responsibilities. As a result, both the central bank and the BFIs that opted for M&As deserve appreciation. However, given the challenges emerging in the external and internal sectors of the country’s economy, they need to remain vigilant.
The expected benefits for customers, employees, and shareholders arising from the synergy created through M&As are yet to be realized. Some institutions undergoing these processes have not paid sufficient attention to crucial aspects like employee management and risk management due to the urgent need for substantial capital increases within a short period. It is imperative for these institutions to give special consideration to addressing these issues, and the guidance from NRB can provide them with valuable support in this regard. If the BFIs involved in M&As can adopt the best practices of well-established national and international banks and earn the trust of customers, employees, and shareholders, this would be the desired outcome that crowns their efforts.
Dahal is the former Chief Executive Officer of Sanima Bank Limited. He is currently the Chairperson of Financial Literacy Nepal.
