Nepal - Financial sector study

Report Number: 24959-NEP Document of The World Bank NEPAL C . 1 ., ~ * FINANCIAL SECTOR STUDY October 16, 2002 Private Sector Finance Division SASFP South Asia Region  CURRENCY EQUIVALENTS Currency Unit = rupee (NR) 1 rupee = US$0.01308 US$1 rupee 76.475 (December 2001) FISCAL YEAR July 16 - July 15 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank ADB/N Agricultural Development Bank of Nepal BOD Banking Operations Department (NRB) BTC Banker's Training Center CBA Commercial Banking Act (1974) CBO Community Based Organizations CBPASS Commercial Bank Problem Analysis and Strategy Study CEAPRED Center for Environmental and Agricultural Policy Research, Extension and Development CIB Credit Information Bureau CIT Citizens' Investment Trust CMF Center for Micro Finance CRR Cash Reserve Requirement CSD Center for Self-Help Development DBA Development Bank Act (1996) DflD Department for International Development (United Kingdom) DEPROSC Development Project Service Center ESGS Employees Savings Growth Scheme EPF Employees Provident Fund FCA Finance Companies Act (1985) FDI Foreign Direct Investment FIA Financial Intermediary Act (1998) FNCCI Federation of Nepali Chambers of Commerce and Industry FSSS Financial Sector Strategy Statement (or HMG/N) GBB Grameen Bikas Bank GDP Gross Domestic Product GNP Gross National Product HMGN His Majesty's Government of Nepal HR Human Resources HRD Human Resource Development IAS International Accounting Standards IDA International Development Association IFC International Finance Corporation IFI International Finance Institution IMF International Monetary Fund INGO International Non-Government Organization ISD Inspection and Supervision Department (NRB) L/C Letter of Credit LIC Life Insurance Company (of India) MCPW Micro Credit Project for Women MFI Micro Finance Institution MIFAN Micro Finance Association of Nepal MIS Management Information Systems MLD Ministry of Local Development MOF Ministry of Finance MOU Memorandum of Understanding NBFI Non-Bank Financial Institution  NBI, Nepal Bank Limited NCF National Cooperative Federation NEFSCUN National Federation of Savings and Credit Cooperative Unions Limited NEPSE Nepal Stock Exchange NGO Non-Government Organization NIC National Insurance Corporation NIDC Nepal Industrial Development Corporation NLGI Nepal Life and General Insurance NPA Non Performing Assets NPL Non-Performing Loans NRB Nepal Rastra Bank OCR Office of the Company Registrar PAF Poverty Alleviation Fund PCRW Production Credit for Rural Women PKSF Palli Karma Shahayak Foundation (Bangladeshi micro-finance NGO) RBB Rastriya Banijya Bank RN'IDC Rural Micro Finance Development Center ROSCA Rotating Savings and Credit Association RRBD Regional Rural Development Banks RSRF Rural Self Reliance Fund SAPPROS Support Activities for Poor Producers in Nepal SBI State Bank of India SCC Savings and Credit Cooperatives SCO Savings and Credit Organizations SEACEN South East Asian Central Bank Research and Training Center SEC Securities Exchange Center SEBO Securities Board of Nepal SFCL Small Farmers' Cooperatives Limited SFDP Small Farmer Development Program SLR Statutory Liquidity Ratio SMIE Small and Medium Enterprises SPO Sub-Project Office TA Technical Assistance VD)C Village Development Committee VRS Voluntary Retirement Scheme WDD Women's Development Division (of the MLD) This report is the result of work carried out over a series of missions during 2000 and 2001. The World Bank team consisted of Simon Bell (Team Leader and Capital Markets), Nagavalli Annamalai (Legal), Karma Tshiteem (Macro-monetary & Commercial Banks), Alain Vedrenne-Lacombe (Banking Supervision), Christopher Juan Costain (Insurance, Pensions and Provident Funds), Shakti Prasad Shrestha (Finance Companies), Mudassir Khan (Development Banks) and Md. Reazul Islam & Shamsuddin Ahmed (Micro Finance). The World Bank team worked with the staff from the Research Department of Nepal Rastra Bank led by Y uba Raj Khatiwada. The Lead Advisors/Peer Reviewers for this study are Tom Rose (World Bank) and Jeremy Carter & Wafa Abdelati (International Monetary Fund). Mr. Kenichi Ohashi is the Country-Director in the World Bank for Nepal. Marilou Uy is the Sector Director for Finance and Private Sector issues in the South Asia Region. Mieko Nishimizu is the Vice President for the South Asia Region.   iii Table of Contents EXECUTIVE SUMMAiRY ............................................... (i -xi) CHAPTER ONE - Macro Monetary Policy, the Central Bank and Overview of Nepal's Financial Sector 1. General Macro-economic Environment .I 2. Macro Monetary Policy .2 Trends in the Money Supply .2 Inflation .3 Exchange Rate .4 Government Domestic Borrowing .5 Banking System Credit .6 Excess Liquidity .7 3. Overview of the Financial System .8 Commercial Banks .9 Development Banks .10 Regional Rural Development Banks .10 Finance Companies .11 Micro-finance Institutions .11 The Nepal Stock Exchange .11 The Insurance Industry .12 Money Changers (Foreign Exchange Bureaus) .12 Postal Savings Bank .12 Employees Provident Fund .12 Citizens Investment Trust Mutual Fund .12 4. Nepal Rastra Bank .13 Background .13 Legal Position .13 Board of the Bank .13 Organizational Structure .14 Banking Supervision .14 Human Resource Management and Development .15 Instruments of Monetary Policy .16 Refinance Policies .18 Open Market Operations .18 The Clearing and Payments System .18 Auditing and Accounting of the Central Bank's Accounts .19 Taxation of Financial Institutions .19 Economic Statistics .19 5. Linkages Between the Real and the Financial Sectors .19 6. Issues .21 The Role of the Government in the Financial Sector . 21 The Role of Nepal Rastra Bank .21 A Weak/Fragmented Legal Financial Environment .21 Social Dimensions of Banking .22 A Lack of Competition .22  iv A Weak Accounting and Auditing Environment ....................................................... 22 Human Resources Development ................... ....................................... 22 Other Important Issues .......................................................... 22 7. Recommendations .......................................................... 23 CHAPTER TWO - The Legal Financial Environment 1. Introduction .......................................................... 25 2. Nepal Rastra Bank Act 1955 .......................................................... 25 Objectives and Payment System ................... ....................................... 25 Autonomy ........................ 25 Goverance .26 Lending to Government .26 Regulation of Financial Institutions .26 Regulatory Burden of NRB .26 Lending to Specified Sectors .26 Lender of Last Resort .26 Exchange Policy, International Reserves and Foreign Exchange Operations ......... .. 26 Developmental Role of the Central Bank ..................................................... ..... 27 Deposit Liability .......................................................... 27 Accounts and Audits .......................................................... 27 Overall Comment .......................................................... 27 3. Commercial banking Act 1974 .......................................................... 27 Poor Definition .......................................................... 27 Prompt Corrective Action and Remedial Powers ...................................................... 28 Governance .......................................................... 28 Ownership/Mergers/Deposit Protection .................................................................... 28 Enforcement .......................................................... 28 New Law .......................................................... 28 Tiered Regulation .......................................................... 29 4. Development Banks .......................................................... 29 5. Micro-finance and deposit taking NGOs ........................... ............................... 29 Loan Classification Reporting Requirements .......................................................... 29 Auditing, Supervision, and Rating ....................... ................................... 30 NRB's Role .......................................................... 30 6. The Financial Intermediary Act 1998 .......................................................... 30 Salient Issues .......................................................... 30 NRB's Role .......................................................... 30 7. Company Law .......................................................... 31 Governance .......................................................... 31 Director's Duties .......................................................... 31 Accounting Standards .......................................................... 31 Insider Dealing .......................................................... 31 Submission of lnformation .......................................................... 31 Foreign Companies .......................................................... 31 Major Policy Issues .......................................................... 32 Disclosure Requirements .......................................................... 32 The Company Board .......................................................... 32 Registrar/Enforcement .......................................................... 32 8. Insolvency and Liquidation .......................................................... 32 Current Insolvency Regime .......................................................... 33  v 9. Securities Regulation ................................ 33 10. Debt Recovery ................................ 33 Section 47A ................................ 33 Comment ................................ 34 11. Secured Transactions ................................ 34 Registration/Notice System in Nepal ................................ 34 Current Developments ................................ 34 12. General Implementation and Enforcement ................................ 35 13. Recommendations ................................ 35 CHAPTER THREE - Banking Supervision I. Introduction .37 2. Regulatory, Supervisory and Other Issues .37 Fragmentation .37 Poor Banking Culture .38. Excessive Government Involvement .38 Poor Governance and Transparency Procedures .39 Weak Supervision of Banks .39 An Inadequate Legal Base .40 Inadequate Organizational Structure .40 Limited Resources .40 Deficient Tools and Practices .41 3. Developing Banking Supervision .41 Strengthening the Supervisory Framework .41 Prioritizing .42 Meeting Pre-Conditions .42 4. Creation of New Framework for Supervision .42 Defining Regulations .42 Developing the Supervisory Capacity .43 Building Supervisory Authority .43 Enforcement .43 Sanctioning .43 5. Recommendations .44 CHAPTER FOUR - The Commercial Banking Sector 1. Introduction .45 2. Consolidated Financial Highlights of the Commercial Banks .46 3. The Government Established Commercial Banks .49 Nepal Bank Limited .49 Rastriya Banijya Bank .50 4. Issues in the Government Established Commercial Banks .51 Severe Governance and Management Shortfalls .51 Dysfunctional Lending Processes .52 Primitive and Flawed Accounting Practices .52 Absence of Strategic Planning and Poor Business Planning and Budgeting .52 Low Morale, Numerous Human Resources Issues .52 NBL is Trading in Negative Equity on the Stock Exchange .52 5. The Three Largest Joint Venture Commercial Banks .53 Nepal Standard Chartered Bank .53  vi Himalayan Bank .......................................................... 54 Nepal Arab Bank Limited (Nabil) ...................... .................................... 55 6. The Other Joint Venture Commercial Banks .......................................................... 56 7. Issues in the Joint Venture Commercial Banks .......................................................... 57 Restrictions on Foreign Ownership of Banks .......................................................... 57 Government Ownership and Representation on Boards of Joint Venture Banks ...... 57 Government Mandated Directed Lending Schemes and Branch Policy ........... ......... 57 Branch Policy .......................................................... 58 Cross Ownership of Private Banks by RBB, NBL and the Central Bank .......... ....... 58 8. Recommendations .......................................................... 58 Recommendations for the Government Established Commercial Banks .......... ........ 58 Recommendations for the Joint Venture Commercial Banks .................. .................. 58 CHAPTER FIVE - Development Banks and the Post Office Savings Bank 1. Introduction .......................................................... 62 2. The Agricultural Development Bank of Nepal (ADB/N) .................................................. 62 3. The Nepal Industrial Development Corporation (NIDC) .................................................. 66 4. Sector/institutional Issues .......................................................... 69 5. The Postal Savings Bank .......................................................... 69 6. Recommendations .......................................................... 70 The Agricultural Development Bank of Nepal (ADB/N) .................................................. 70 The Nepal Industrial Development Corporation .......................................................... 70 Other .......................................................... 71 CHAPTER SIX - The Finance Companies of Nepal 1. Introduction .......................................................... 72 2. Characteristics of Finance Companies .......................................................... 72 Services and Credits .......................................................... 72 Resource Mobilization .......................................................... 72 Investment in Government Securities ................................. ......................... 72 Profitability .......................................................... 73 3. Regulatory and Supervisory Framework for Finance Companies . ...................................... 73 Regulatory Framework .......................................................... 73 Supervision and Inspection .......................................................... 73 4. Issues .......................................................... 73 Low Credibility .......................................................... 73 Poor Regulatory Framework .......................................................... 73 Financial Sustainability .......................................................... 73 Higher Concentration and Growing Competition ...................................................... 74 Weak Supervision .......................................................... 74 Self Dealing ........... 74 5. Recommendations ........... 74 CHAPTER SEVEN - Micro Finance 1. Introduction .76 2. Overview of Institutional Players in Micro-finance .77 Informal Institutions and Arrangements .77 Formal Institutions .78  vii The Government Owned Formal Institutions and Programs ..................................... 78 Private Sector Owned Institutions .................................................. 79 3. The Regulatory Framework .................................................. 80 4. Challenges in Micro-credit Delivery in Nepal .................................................. 81 5. Issues .................................................. 82 Dominance of the Government and its Agencies in Micro-Credit ............... ............. 82 Restructuring of the GBB's to Reduce Public Sector Dominance ................ ............. 82 Limited Outreach in the Terai and Hilly Areas .................................................. 84 Diffused Focus .................................................. 85 Choice of Delivery Mechanism .................................................. 85 Role of INGO's, SCO's, and SCC's ............... ................................... 86 Role of Donors in the Development of the Sector .................................................. 86 Regulatory Framework .................................................. 86 Role of NGO's/MFI's .................................................. 87 Role of Apex Wholesale Institutions ................ .................................. 87 Sustainability and Lending Interest Rates ......................... ......................... 88 6. Recommendations ........................................ 89 CHAPTER EIGHT-Pension and Retirement Savings Schemes 1. Introduction ........................................ 91 2. An Overview of Institutions Involved in Pensions ........................................ 91 Social Security ........................................ 91 Provident Funds ........................................ 91 Employees Provident Fund ("EPF") ........................................ 92 EPF Investments ........................................ 94 EPF Pension Fund ........................................ 96 Private Pension Funds ........................................ 97 Civil Service Pensions ........................................ 97 Life Insurance ........................................ 98 National Insurance Corporation ("NIC") ........................................ 99 National Life & General Insurance("NLGI") ........................................ 99 Citizens' Investment Trust ("CIT') ........................................ 100 3. Issues ........................................ 102 Limited Investment Opportunities ........................................ 102 Poor Governance ........................................ 102 Concentration of Investments ........................................ 102 Government Influence in the EPF ........................................ 102 Introduction of Defined Benefit Plans ........................................ 103 Lack of Enforcement of Participation ........................................ 103 Tax Benefits ........................................ 103 Fiscal Burden of the Civil Service Pension Scheme ........................................ 103 Lack of Timely Production of Accounts ........... ............................. 103 4. Recommendations ........................................ 103 CHAPTER NINE - Capital Market Development in Nepal I. Introduction .105 2. The Nepal Stock Exchange .105 3. Recent Activity on the Nepal Stock Exchange .107 4. Problems with the Nepal Stock Exchange ............................. 110  viii Accounting Standards and their Enforcement ..................................................... 110 Listing Requirements ..................................................... 111 Corporate Governance ..................................................... 111 Mutual Funds ..................................................... 111 Permitting Government Bonds to be Traded on the NEPSE ....................11............... I Investment by Insurance, Pension and Provident Funds in the NEPSE .......... 11........ I Preponderance of Investment in Banking Stocks .................................................... 112 Poor Business Environment ..................................................... 112 5. Recommendations ..................................................... 112 CHAPTER TEN - Summary and Main Recommendations I. Summary. 114 2. Recommendations ........... 115  ix TABLES, CHARTS AND BOXES Chapter One Table 1.1 Monetary Survey, 1991 -2001 .................................................................3 Table 1.2 Outstanding Government Domestic Borrowing 1991 - 2001 .....................................................5 Table 1.3 Bank Credit, 1991 - 2001 ..................................................................7 Table 1.4 Liquidity of the Banking System (1990 - 2001) .................................................................. 8 Table 1.5 Total Financial System Assets, July 2001 ............................. .....................................9 Table 1.6 Nepal Rastra Bank: Assets and Liabilities, 1991 - 2001 ...................................... ................... 15 Table 1.7 Main Lending and Deposit Interest Rates, 1995 - 2001 .......................................................... 17 Table 1.8 Total Credit by Sector, 1990 - 2001 ..................... ............................................ 20 Chart 1.1 GDP Growth, 1994 - 2002 .................................................................I Chart 1.2 Money Supply Growth, 1990 - 2001 .................... ..............................................2 Chart 1.3 Inflation, 1985 - 2002 .................................................................4 Chart 1.4 Exchange Rate of the NR Against the USD, 1985 - 2000 .........................................................4 Chapter Three Box 3.1 Deposit Taking Institutions in Nepal ................................................................. 37 Chapter Four Table 4.1 Joint Venture Commercial Banks ................................................................. 53 Table 4.2 Sources and Uses of Funds, Commercial Banking Sector ...................................... ................. 59 Chart 4.1 Commercial Banks, Share of Total Assets 2001 ................................................................. 45 Chart 4.2 Commercial Banks: Breakdown of Deposits, 1994 - 2001 .................................. ................... 46 Chart 4.3 Commercial Banks: Sources of Funds, 1994 - 2001 ................................................................ 47 Chart 4.4 Commercial Banks: Uses of Funds, 1994 - 2001 ................................................................. 48 Chart 4.5 NBL: Assets, Deposits, Investment & Credit, 1994 - 2001 ...................................................... 50 Chart 4.6 RBB: Assets, Deposits, Investment & Credit, 1994 - 2001 .................................. ................... 51 Chart 4.7 Standard Chartered Bank: Assets, Deposits, Investment and Credit, 1994 - 2001 .......... ........ 54 Chart 4.8 Himalayan Bank: Assets, Deposits, Investment and Credit, 1994 - 2001 ................................ 55 Chart 4.9 Nepal Arab Bank: Assets, Deposits, Investment and Credit, 1994 - 2001 ............. ................. 56 Box 4.1 Commercial Bank Problem Analysis and Strategy Study (CBPASS) ................. ...................... 60 Chapter Five Table 5.1 Assets and Liabilities of the Agricultural Development Bank of Nepal (ADB/N) .......... ........ 65 Table 5.2 Total Investment in Agriculture (up to 2001) ................................................ ................. 65 Table 5.3 Assets and Liabilities of the Nepal Industrial Development Corporation (NIDC) .......... ......... 68 Table 5.4 Total Investment by Industry (up to 2001) . ................................................................. 68 Chapter Six Table 6.1 Financial Performance of Finance Companies ................................................................. 75  x Chapter Seven Table 7.1 Outreach of MicroCredit in Nepal .................... ................................................ 77 Box 7.1 Grameen Bank Has changed the life of Ms. Bhagia Devi ........................................................... 83 Box 7.2 A Savings and Credit Group in Darichoke Fisling, Chitwan ............................... ....................... 85 Chapter Eight Table 8.1 Breakdown of Membership and Accumulated Deposit by Industry Sector, July 1999 ........... 93 Table 8.2 EPF Membership by Year .................................................................... 93 Table 8.3 EPF Total Assets and Investment Distribution by Year .............................................. 95 Table 8.4 Calculation of EPF Pension Benefits .................................................................... 96 Table 8.5 Gratuity Calculation .................................................................... 98 Table 8.6 Citizen Investment Trust - Total Assets & Membership by Scheme .............................. 101 Table 8.7 Citizen Investment Trust- Asset Distribution February 2001 ...................................... 102 Chart 8.1 EPF Rate of Return vs. Inflation ............................. : 94 Chapter Nine Table 9.1 Nepal Stock Exchange Limited - Summary Sheet of Transactions - 2000 and 2001 ....... .... 108 Table 9.2 List of Top Ten Companies - Top Ten on the Basis of Amount Traded, 2001 ................... 109 Table 9.3 Nepal Stock Exchange - Basic Information, 1995 to 2000 ......................................... 109 Table 9.4 Comparative Table - South Asian Stock Exchanges - Basic Information, 2000. 110  xi ANNEXES Annex One Nepal's Financial System As Of Mid July 2001 ................................................. 118 Annex Two Financial Sector Strategy Statement ................................................. 122 Background ................................................. 122 The Banking Sector ................................................. 122 The Non-Banking Sector ................................................. 123 The Government's Role ................................................. 124 The Role and Strategy of Nepal Rastra Bank ........................................ ......... 124 Reform in the Financial Sector Legislation ................................................. 125 Strengthening Bank Supervision and Inspection ................................................ 125 Restructuring and Privatization of NBL and RBB ............................................. 125 Enhance Competition in the Banking Sector ................................................. 126 Reform on Auditing and Accounting Capabilities .............................................. 126 Board Based Banking ................................................. 126 Streamlining Ownership Structure ................ ................................. 126 Establishment of Bankers' Training Institute ................................................. 127 Restructuring of Credit Information Bureau ....................................................127 Establishment of Assets Reconstruction Company ............................................ 127 Revamping Research and Financial Monitoring Strength of NRB ........... ......... 127 Broadening and Deepening the Financial System in Nepal ................... ............. 127 Meeting Sector Financing Requirements ................................... .............. 127 Other Measures ................................................. 127 Establishment of Development Banks at Regional Level ..................... .............. 128 Strengthening of Rural Development Banks ................................................. 128 Establishment of Credit Rating Agency ................................................. 128 Timetable ........... 128 Annex Three Commercial Bank's Sources And Uses Of Funds ................................................. 129 Annex Four Finance Companies in Nepal ................................................. 144 Annex Five Case Studies of Micro-Finance in Nepal ................................................. 145 A Proxy Loan Put To Good Use ................................................. 145 A Well-Off Borrower Of Grameen Bikash Bank ............................................ 145 Successful Micro-enterprise Activity In Low Hills ........................................ 146 Sunila Lama ................................................. 146 Annex Six Institutional Players In Micro-Finance ................................................. 147 Annex Seven Contractual Savings Schemes ................................................. 155 Annex Eight Population and Population Charts ................................................. 156 Annex Nine Tax Treatment Of Pensions And Insurance ................................................. 158 Annex Ten Recommendations from the Report ................................................. 160 Macro Monetary Policy ................................................. 160 Legal Financial Environment ................................................. 160 Banking Supervision ................................................. 161 The Commercial Banking Sector ................................................. 161 The Development Banks and the Post Office Savings Bank ....................... ............ 162 The Finance Companies of Nepal ................................................. 163 Micro Finance ................................................. 163 Pension and Retirement Savings Schemes ......................... ........................ 165 Capital Market Development in Nepal ................................................. 165   Executive Summary Despite a small and underdeveloped economy, Nepal has a reasonably diversified financial sector with a large number of varied institutions playing active roles. In 1984, when Nepal began reforming its financial sector, all activity was dominated by the 2 state-owned commercial banks. Since then the financial system has grown to include 15 commercial banks, 8 development banks, 5 regional rural development banks, I postal savings bank, 48 finance companies, 30 non-government micro-credit institutions, and 35 non-government cooperative societies involved in limited banking activities. OVERVIEW OF THE ISSUES Although financial institutions have proliferated, the Nepalese people have not yet reaped the potential gains of the government's efforts to liberalize and reform the financial sector. There are four main reasons for this: excessive government involvement in the sector, a weak central bank, a poor banking environment, and a lack of adequate banking services for the poor. Excessive Government Ownership. At the heart of virtually all the problems in the financial sector in Nepal is the overwhelming dominance of the government. It owns the largest commercial bank (RBB), is the biggest shareholder in the second largest one (NBL), and holds significant shares in virtually all the joint-venture banks (all joint venture banks are 50 percent Nepali owned with shares generally being held by NRB, NBL, RBB or the Employees Provident Fund). In addition, the government owns the two largest development banks - the Agricultural Development Bank of Nepal and the Nqepal Industrial Development Corporation - insurance companies, pension and provident funds, regional rural development banks, and is heavily involved in micro-finance institutions. As in many countries, government ownership has led to poor internal governance, weak management, fragile financial health, and an unhealthy politicization of these state-owned institutions. There is thus an urgent need for the government to divest its ownership of most of these financial institutions and replace the public sector with "fit and proper" private owners and operators. A Weak Central Bank While the government has dominated the financial system as an owner and operator, it has failed to perform adequately as a supervisor and regulator of the system. Poor supervision by the central bank, Nepal Rastra Bank, is in part to blame for the severe problems oi the two largest commercial banks and for the general deterioration in the system. However, the central bank is in no position to adequately discharge its responsibilities. It is handicapped by a lack cf autonomy, an inadequate and outdated legal framework, and an excessive number of poorly trained and unproductive staff- as well as being in need of radical restructuring. Moreover, its direct participation in the financial sector through representation on bank boards and ownership of development banks has added to its diffuse responsibilities, created conflicts of interest, and undermined its credibility. The weak and outdated legal framework is among the main sources of the central bank's ineffectiveness. Adopted in 1955, the Nepal Rastra Bank Act was designed for a central bank operating in a government- controlled economy - and supervising government-owned banks - and is ill suited to the development of a complex, modern central bank and banking system. The act bestowed too little power on the central bank for effectively managing monetary policy, improving the financial infrastructure, strengthening and improving financial markets and their supervision, and facilitating the growth of the financial sector. Parliament recently approved a modern central bank law, however, which came into effect in January 2002. This new Act will largely address all of these concerns - if the Act is meaningfully enforced.  ii Poor Banking Environment. Outdated and inappropriate laws similarly lead to weaknesses throughout the Nepalese financial system. Other problems also plague the banking environment, including weak corporate governance, lack of competition, the absence of a sound banking culture, and asymmetries in information. Weak and Fragmented Legal Framework The Commercial Banking Act (1974) has critical gaps in coverage and needs to be replaced with a new law covering all deposit taking institutions in Nepal (a new draft Banking and Financial Institutions Act is currently under consideration). Other parts of the legal framework for the financial sector also need to be strengthened or amended, including the Financial Intermediary Act (1998), Company Law, and Insolvency and Liquidation Laws. Enforcement too needs to be strengthened. Anecdotal evidence suggests that court action against defaulters tends to be excessively delayed, and asset liquidation has rarely been successful. Without strengthened laws and proper enforcement, any intervention in the financial sector is unlikely to have a meaningful and long- lasting impact. Another problem is the proliferation of laws and regulations applying to specific institutions rather than generalized banking functions. For example, neither of the two largest development banks is governed by the Development Banks Act; instead, both operate under their own, institution-specific legislation. Such institution-specific laws and regulations have created a fragmented legal environment and, as a result, a fragmented financial system, thereby stifling competition. So at the same time that the legal framework is strengthened, it also needs to be rationalized and simplified. Weak Corporate Governance. Corporate governance is extremely weak in Nepal. There are no clear rules of engagement between a company's management, its board, its shareholders, and other stakeholders. Aggravating this situation are weak systems, poor procedures, and information asymmetry. Accounting and auditing traditions are also weak. Many banks cannot provide financial statements, and at times the accounts that banks do provide are un-audited - even though banks and finance companies are required to be audited annually by external auditors selected at general assemblies. The three largest banks - Rastriya Banijya Bank, Nepal Bank Limited, and the Agricultural Development Bank of Nepal, accounting for almost 60 percent of commercial banking assets - do not maintain up-to-date, externally audited financial data. One of them, Rastriya Banijya Bank, has produced no externally audited accounts or annual report for around seven years. The central bank serves as a poor role model for the system that it purports to supervise and regulate; it too fails to maintain good, up-to-date, externally audited accounts. The government's involvement in the sector as owner and operator inevitably leads to conflicts of interest, particularly for the central bank. Many banks and other financial institutions have interlocking ownership, with Nepal Rastra Bank playing a prominent role. Despite its supervisory role, Nepal Rastra Bank funds some development banking activities and holds shares in several banks. Several central bank officials, including some involved in banking supervision, represent the government on bank boards. Cross-holding of bank shares is also a major problem, as is the reported practice of insider or self-dealing. Lack of Competition. Although Nepal's financial system has grown rapidly over the past decade, it still lacks the competitive environment critical for ensuring that financial intermediation benefits borrowers, depositors, other users of financial services, and shareholders. The lack of competition reflects the fragmentation of the system, but it also stems from the dominance of the two large (but inefficient) government-established commercial banks, which account for more than half the commercial banking system's assets. The result is that the Nepalese people have enjoyed only marginal benefits from the liberalization of the financial sector. Only by taking action to increase competitive pressures will the government be able to ensure that banks provide more efficient and cost-effective services to the banking public. However, efforts to enhance  iii competitive pressure should rely on market-oriented approaches rather than mandates such as those for interest rate spreads and priority sector lending. Such directives have increased distortions in the market and further burdened financial institutions already having difficulty carrying out their normal business. While the objectives (smaller interest rate spreads and more lending to disadvantaged groups) are intrinsically desirable, they could be better achieved through more focused interventions and more market-oriented policies. Poor Banking Culture. The elements of a good banking culture are almost nonexistent in Nepal, whether among banks or among their customers. Banks find it difficult to make informed lending decisions because many of their private sector clients fail to maintain good financial information on their activities or are unwilling to reveal their true financial position. As a result, firm level data are largely unreliable, and banks are forced to reconstruct firm accounts from client estimates. Even when banks can undertake a proper financial analysis, they often extend credit on the basis of collateral rather than creditworthiness. Lenders always request primary collateral, and request secondary collateral or guarantees if needed. Nonetheless, they assess the value of the collateral only informally and do not re-evaluate it regularly. The Credit Information Bureau maintains a blacklist of customers to whom banks cannot extend credit. The bureau, however, established jointly by the central bank and the Bankers Association, is hindered in its operations by the inability or reluctance of the two largest banks to provide it with data. The apparent lack of follow-up by these banks when a customer defaults results in a downward spiral of poor banking behavior. Another part of the problem lies in the implementation/enforcement of the prudential regulations. To date, only a small number of banks have established satisfactory internal guidelines. These lending problems, which affect the largest financial institutions in Nepal, have important ramifications for the entire financial sector. The market leaders maintain high real interest rates and margin spreads to cover high operating costs and large losses, while private banks are able to earn substantial profits by hiding behind these high prices. As a result, private banks have not been forced to compete for more customers or to expand their activities outside a few main cities. They merely offer much better service at the prices set by the large banks. Information Asymmetry and Lack of Financial Sophistication. The public has limited knowledge of the financial position of banks, creating a situation of severe moral hazard. The general public is financially unsophisticated and most people have little access to financial information. When financial institutions' accounts and annual statements are disclosed, they are neither timely nor reliable - even if audited. Moreover, accounting and auditing practices in Nepal do not conform to international standards. Consider these striking illustrations of the poor public knowledge of financial sector issues. After public announcements were made that management teams were being placed in Nepal Bank Limited, the bank's stock price doubled - despite the general knowledge that the bank had a negative net worth. Depositors also continued to place funds in both Nepal Bank Limited and Rastriya Banijya Bank after a KPMG Barents Group consultancy report disclosed their extremely poor financial health and highly negative capital base. Also implicit in these examples is the banking public's belief that, althou,gh Nepal has no deposit insurance scheme, the government will provide a safety net in the event of a banking failure. Corruption. Given all these factors - poor supervision, a weak legal environment, poor corporate governance, lax accounting and auditing standards, and an underdeveloped banking culture - it is no surprise that corruption has been a big contributor to the poor financial health of many of the financial institutions in Nepal. Fraud, self-dealing, insider dealing, and improper evaluation of collateral have been among the reported abuses. Such actions have taken resources from the poor and given them to the rich.  iv Stemming corruption will require putting in place transparent systems, checks and balances at every level, and a system of continuous monitoring within and between financial institutions. Inadequate Banking Services for the Poor. Given the large number of poor people in Nepal, it is also no surprise that the government has emphasized the social dimensions of banking. Notwithstanding this, most of the policies aimed at benefiting the poor (directed credit, branch opening policies) are too broad, and they create considerable operating disincentives within the financial system while achieving a minimal or even negative impact on their intended target audience. These policies need to be more sharply focused to minimize their negative effects and enhance their benefits for poor and rural communities. At the same time, the delivery mechanisms for development banking need to be reformed, to work through, and with, private partners wherever possible. The current system of publicly owned development banks and state-dominated micro-finance institutions has failed to produce the intended results - while creating large contingent liabilities for the government. THE CENTRAL BANK - NEPAL RASTRA BANK A stronger, more effective central bank is essential for healthy financial sector development in Nepal. To play its role well, Nepal Rastra Bank needs significant internal restructuring and reengineering, including, most importantly, an overhaul of its human resource function. Among the core functions of the central bank, proper banking supervision is particularly important, to ensure prudent banking practices and to help develop healthy financial intermediation that can support the growth of the economy. NRB is being assisted in its re-engineering with support from the International Monetary Fund's MAE department and a World Bank Financial Sector Technical Assistance (FSTA) project. Need for Restructuring. The central bank has far more staff than it needs (particularly at lower levels), poor incentive mechanisms, a severely compressed salary structure, and inadequate training opportunities. If Nepal Rastra Bank is to develop, attract, and retain a professional workforce, radical reforms will be required. Although the bank is in urgent need of "right sizing," this step should be preceded by an in-depth assessment to identify the most appropriate organizational structure. A voluntary retirement scheme carefully tailored to the Nepalese environment should then be implemented, accompanied by a move to merit-based promotion rather than the current "time-in-grade" system of staff development. Removal of excess workers would allow the bank to decompress its salary structure so that it can adequately compensate professional staff. In addition to improving the benefits package, the bank should enhance the general working environment - with an emphasis on automation - to increase productivity. Deficiencies in Banking Supervision. A June 1999 assessment of Nepal's compliance with the Basel Core Principles for Effective Banking Supervision concluded that Nepal Rastra Bank fails to comply fully with two-thirds of the criteria and is unable to fulfill its supervision mandate. Moreover, almost none of the preconditions required by the Basel Committee exist in Nepal - an adequate legal framework and judicial procedures, sound accounting principles and auditing practices, a market-based banking business, exit and crisis management policies, and deposit insurance and safety net schemes. The accumulated weaknesses of the central bank inhibit management from taking action against problem banks even when the potential consequences of inaction are serious. The deficiencies in banking supervision are reflected in the poor and deteriorating state of the two largest commercial banks and of other weak institutions that have been permitted to conduct business without sanction by the government or central bank. Many financial institutions have a weak capital base and high levels of non-performing loans and even face allegations of corruption and of inappropriate action by management. Seven new banking regulations, issued in March-April 2001, address weaknesses in  v banking, but the central bank will need to ensure that the regulations are fully enforced if they are to have a positive effect on the Nepalese financial sector. Although the central bank is charged with regulating and supervising banks and financial institutions, the present system does not provide supervisors with adequate legal protection or with the operational independence and resources they need to perform their jobs well. As a result, supervisors are often unable or reluctant to enforce the corrective measures needed to prevent and resolve banking problems. Moreover, most of the old regulations allowed long delays before action, failed to define legal or financial penalties, and did not mandate specific actions to be taken by the banking authorities. The revised regulations of 2001 have attempted to correct the weaknesses in the old regulations, to provide greater regulatory authority to the central bank - but by early 2002 Nepal Rastra Bank was already encountering resistance to their implementation. The institutional setup for supervisory functions within Nepal Rastra Bank is also less than ideal. Responsibility for supervision is shared by four units, under two different deputy governors, and cooperation between them is weak. In addition, the central bank has limited capacity for supervisory work. Its staffing policy ensures the recruitment of quality staff, a good mix of MIBAs, chartered accountants, and economists. However, promotion is driven by seniority, staff are not appointed on the basis of merit and competence, and the salary scale is tied to low public sector levels - all of which have undermined morale and performance. Moreover, the central bank's policy of rotating staff among departments has been counterproductive; effective supervision requires stability to foster commitment among officers and allow them to develop skills, master techniques, and acquire experience. Off-site surveillance of financial institutions does not exist as a specific function. Reporting of information is neither timely nor comprehensive enough to permit a full analysis, and the integrity of the data remains doubtful. Most data are excessively delayed and, if collected, are not analyzed. The central bank imposes no sanctions for late reporting and has not enforced penalties for non-compliance with regulations except for those relating to the cash reserve ratio and directed lending. Supervisors do perform timely monitoring of the cash reserve ratio, interest rate spread, and priority and deprived sector lending, but none of these is a prudential issue. If supervisors spot a problem, they request additional information from the bank, essentially so that they can cross-check the data. If the problem remains, a penalty is finally debited from the bank's account with Nepal Rastra Bank. Role in Reform. It is important that the central bank play a lead role in implementing the financial sector reform program. An active role will not only provide first-hand experience - important for internal capacity building - but will also enable the central bank to clearly establish its authority as the chief regulatory and supervisory body. The central bank will need to pay especially close attention to banking supervision during the reform to curtail further deterioration in the system, reduce opportunities for looting and other abuses, and thus protect the funds of depositors. Continued support from the IMF, DFID, and the World Bank is expected to be able to assist NRB in meeting these objectives. NEPAL BANK LIMITED AND RASTRIYA BANIJYA BANK The problems faced by the two largest commercial banks warrant high priority, to stem further deterioration in these institutions. A comprehensive assessment of Nepal Bank Limited and Rastriya Banijya Bank, carried out under Nepal Rastra Bank's direction in June 2000 by the KPMG Barents Group, found serious shortfalls in all aspects of the governance, management, and operations of these banks. The KPMG report concluded that the banks' loan assets are highly overstated and extremely risky and that, as a consequence, the banks are technically insolvent. The report estimated the negative net worth of Nepal Bank Limited at NR 6-10 billion (US$85 to 142 million) and that of Rastriya Banijya Bank at NR 14-18 billion (US$200 to 255 million). This condition is of grave concern, since these two  vi banks account for about half the assets of the commercial banking system. The report also concluded that while the banks suffer from almost identical problems, those of Rastriya Banijya Bank are more severe. Key highlights include: * Years of political interference in senior appointments and lending and operational decisions in both banks have led to poor governance and management, exacerbated by a general lack of prudent, internationally experienced, and commercially oriented bankers in board and senior management positions. These problems are reflected in - and compounded by - the lack of a business strategy, the absence of financial management information, poor board and management practices, low morale, counterproductive union activities, and inadequate compensation packages. * Unsound banking practices have helped to undermine the banks' credit portfolios. The banks lack the policies, processes, and procedures needed to support profitable commercial banking practices, and the problem is aggravated by senior managers unconcerned about high-risk lending, boards more responsive to client pressures than to prudent practice, and poorly trained and motivated staff. * Information systems and accounting and record keeping practices are also extremely poor. Loan files, loan ledgers, accounting records, operational statistics, and data on human resources are poorly maintained and substandard. All this results in serious information gaps. * The banks undertake no strategic planning, in part because the units responsible for this function are inadequately staffed and have limited capacity. Budgeting processes are primitive, with little monitoring of variances and no well-defined penalty and reward system to enhance accountability. * A poor incentive system, below-market pay structure, and weak staff and management discipline have eroded the motivation and productivity of employees. With few opportunities for training that could provide exposure to international best practices, the skills of staff and management are likely to become even weaker. Strong unions have aggravated the situation by successfully pushing for the employment of an excessive number of unskilled staff at lower levels. * The government's approach to privatizing Nepal Bank Limited - providing workers with parcels of shares, which are now openly traded on the Nepal Stock Exchange - has effectively privatized the bank but has also resulted in widely dispersed ownership, with no strong strategic investor. As a first step in dealing with these two troubled banks, Nepal Rastra Bank has decided to recruit two international management teams to take over their day-to-day operation. The management teams are expected to help immediately stabilize the banks' operational and financial positions, bring in accounting teams to help strengthen their accounts, develop human resource programs (including a training program, a retrenchment program, and a more appropriate remuneration package for bank staff), and prepare the banks for privatization (or a satisfactory alternative). The management teams are likely to face strong resistance from many quarters - the boards, workers, unions, and influential private businesses - and even from the government, which may not consider liquidation, for example, a politically acceptable restructuring option. Thus the teams will need to be exceptionally professional and committed, and fully supported by the government, the central bank, and the donors. Reducing the excessive staffing in both banks, through a voluntary retirement scheme, must be a part of the bank's restructuring. This exercise should also try to professionalize the role of the unions, with a view to minimizing their often excessive interference in management and operational matters.  vii THE DEVELOPMENT BANKS While smaller than the two major commercial banks, the government-owned development banks - the Agricultural Development Bank of Nepal and the Nepal Industrial Development Corporation - face similar problems. The Agricultural Development Bank had long survived on concessional loans from the Asian Development Bank (ADB). However, the ADB has now stopped providing funding because of increasing concerns about the bank's operations, confirmed by an ADB-commissioned report that concluded that the bank is neither financially viable nor effective in meeting its objectives. The Nepal Industrial Development Corporation, funded by World Bank and German aid funds for nnany years, has also lost its external funding after having failed to meet the expectations of its financiers. The cessation of funding has led to a shift away from development banking activities. Many urban branches of the Agricultural Development Bank now conduct commercial banking activities - and these are reported to be growing rapidly. Moreover, because these two development banks are governed only by the statutes that incorporated them, they are conducting banking activities without being subject to either the Development Bank Act or the Commercial Banking Act. Their foray into commercial banking makes this situation a serious concern. This "legal arbitrage" must be corrected, and the two development banks brought immediately under the full supervision of the central bank. These institutions need close attention to arrest their deterioration until an adequate restructuring plan has been formulated. The Agricultural Development Bank embarked on an institutional reform program in 1997 that focused on improving collection rates and closing under- performing branches (32 were identified for closure). The reform program appears to have led to some increase in loan recovery, but the improvement is far from sufficient to sustain the institution or make it more effective. More comprehensive reform needs to be considered, perhaps including the privatization or even liquidation of the bank. Any reform within the ADB/N, however, must be fully coordinated with the on-going restructuring and reform programs within RBB and NBL. With no incoming funding, a weak and deteriorating loan portfolio, and poor internal governance, the Nepal Industrial Development Corporation is in poor financial and operational health. Given its relatively small size and an increasing belief that even long-term industrial lending could be undertaken as a commercial activity, there needs to be a thorough examination of whether any role remains for the bank. Its current performance and limited lending activity suggest that the most appropriate course of action may well be liquidation. Similarly, the government needs to revisit the rationale for the regional rural development banks (the Grameen Bikas Banks) owned in part by the central bank. Nepal Rastra Bank needs to cease its direct participation in these development banks, as in all financial institutions (and indeed this process did begin in early 2002). Consideration should be given to restructuring these banks (including re-capitalizing them) to prepare them for privatization. MICRO FINANCE Micro-finance will continue to pose big challenges in Nepal. The Grameen model of micro-credit delivery has brought some benefits to the terai (plain) region, which has larger population concentrations and greater endowments of physical infrastructure than the hill areas of Nepal. However, this model is unsuitable for extending micro-credit to the inaccessible hill and mountain regions of the country. These sparsely populated regions will require a different approach which involves greater participation by the local population; involves more focused government assistance in terms of infrastructural and other support; and can defray costs by spreading management responsibilities over wider areas.  viii While sustainability must be an important goal of micro-credit programs, the scope for achieving this in these inaccessible regions is limited in the short run. Incentives, grants, and concessional loan support will be required, to build the capacity and subsidize the operations of institutions working in these regions and to ease the interest burden on the very poor borrowers who are accessing funds from them. Care should be taken, however, that the support is provided through transparent means. It will also be important to ensure proper targeting of beneficiaries - so as to achieve maximum impact and avoid a mis- direction of subsidies to unintended groups. The delivery of micro-credit through public agencies in Nepal has clearly been unsatisfactory: the Grameen Bikas Banks are nearly insolvent, other programs have achieved limited outreach, and the hard- core poor have largely been excluded. Yet these outcomes are hardly surprising - public institutions all over the world have failed to effectively deliver micro-credit to the poor. The evidence suggests that the government of Nepal should consider leaving the business of micro-credit to the private sector and to nongovernmental organizations, which appear to have a comparative advantage in this area. To the extent that the Government wishes to pass subsidies through to these target populations, these should be explicit and channeled through these private institutions. Since the Grameen Bikas Banks are the largest micro-credit operations, restoring their operational and financial efficiency is particularly critical to the health of the sector. Steady deterioration in the quality of their portfolios, combined with continuing losses, has eroded their equity, making these five banks technically insolvent. Discussions with their management indicate many problems: * Central bank staff have been appointed as chief executive officers of the banks, resulting in a lack of ownership, commitment, and management efficiency. * Management is centralized, with little delegation of power or responsibility to departments or staff. * Management and personnel decisions are subject to strong political influence, which has led to the opening of unprofitable branches and the recruitment of incompetent staff in excessive numbers. Unions also interfere in the management of the institutions. * Loans tend to be large, with the size determined not by management advice but by board directives. * The institutions face funding shortages, since even the equity holders (Nepal Rastra Bank and commercial banks) are unwilling to lend to them for fear of losing their money. * Sources of funds for the banks are limited and interest rates are high. * The lending rate of the banks (10 percent) is inadequate to cover operating costs and thus to generate a surplus. * The institutions lack proper management information systems, training programs for staff, and career development programs. All these problems point to the need for a major restructuring of these institutions. The private Grameen Replicator Banks, which have been much more successful, may well provide an effective and sustainable model for micro-finance activities in Nepal. Building upon these successful examples will be important for the future growth of these Grameen Replicators.  ix OTHER ISSUES The financial sector also faces other issues that impede its development: * A poorly functioning credit bureau. The Credit Information Bureau functions poorly, largely because of the inability or reluctance of the two largest commercial banks to provide it with information on bad credit risks. Improving the bureau's ability to make comprehensive credit information easily available in Nepal could spur the development of the financial sector. * Risky finance companies. A study commissioned by the Asian Development Bank points to the risk of family combines using public deposits in finance companies to fund high-risk activities within their own companies (self-dealing). Another concern is that some weak finance companies are functioning like ponzi schemes, sustaining high interest payments on deposits through the inflow of new deposits. * Ceiling on foreign ownership. The 50 percent limit on foreign ownership of commercial banks (increased to 66 percent in 2001) discourages reputable international banks from entering the market, adding to the deterrent effects of the small market and difficult operating conditions. The presence of such banks could help improve discipline in the market, increase competition, enhance services, and add know-how. The government needs to lift this restriction as soon as possible while permitting the entry only of "fit and proper" bankers. * Limited financial services. Financial institutions offer only basic services, with lending based largely on collateral. Poor training and limited exposure to banking practices elsewhere have slowed the development of new products and services. If the financial sector is to provide more effective intermediation, it clearly needs to increase the range of services and products offered. * Poor accounting standards. Weak accounting and auditing standards are among the most important impediments to the development of the Nepal Stock Exchange. Many company financial statements are not credible - and some companies listed on the exchange have not produced accounts for several years, Nepal Bank Limited among them. When accounts are prepared, they are often of such poor quality that they provide no guidance on the company's true financial health. In some cases company accounts are purposefully misleading. These problems have led to a general disillusionment with investing on the exchange. * Limited use of information technology. Around the world, the financial sector is typically an early adopter of new information and communications technologies, for the big gains in efficiency and productivity that they offer. The excessive staffing, poor information management, and weak communications in many Nepalese financial institutions all point to the conclusion that increased automation could yield significant benefits. THE WAY AHEAD FOR FINANCIAL SECTOR REFORM The many serious issues in the financial sector are now widely acknowledged and well publicized in Nepal. In November 2000 the government issued a paper outlining its proposed financial sector reform program for the medium term - the Financial Sector Strategy Statement. The strategy statement touches on all the major issues and provides sufficient basis for undertaking far-reaching reforms. It also demonstrates the government's commitment to the reform program - and, most important, its commitment to withdraw from the sector as an owner and operator.  x Yet the strategy statement remains only a broad outline of intent. The government will need considerable support and resources to translate the FSSS into a fully implementable strategy and action plan. Developing such a longer term, more detailed, and action oriented vision for the development of the financial sector must, however, assume increasing importance within Nepal Rastra Bank. Given the wide-ranging reforms required, and the importance of the financial sector to the further growth and development of Nepal, donors must also stand ready to extend all available assistance to this reform initiative, closely coordinating their efforts. While the government's heavy hand has been largely detrimental to the development of the financial sector, one aspect of its ownership seems to have exerted a benign effect - the implicit assurance that it would rescue ailing banks. That assurance has kept a potential financial crisis in check. It is now time, however, to subject the financial markets to the discipline of the markets and to ensure their proper and prudent functioning. The recent issuance of new banking supervision regulations, the new Nepal Rastra Bank Act and the efforts under way to revise the Commercial Banking Act also bode well for the reform process and the establishment of an appropriate environment within which market oriented institutions can operate in an orderly manner. Sequencing reforms correctly can be critical, however, and these changes need to precede the full impact of reforms and further liberalization of the financial sector - even as reform commences in the two largest commercial banks. In the short term the government's financial sector reforms should center on five important principles: (a) Withdrawing the government from ownership of financial institutions - beginning with RBB and NBL - and bringing in ':fit and proper" bankers to replace it in this role. The reform program should begin by placing Rastriya Banijya Bank and Nepal Bank Limited under conservatorship arrangements so as to gain financial control - developing a sense of the balance sheets and profit and loss positions of the two banks as quickly as possible. The next step should be to control costs and increase profitability - by implementing a voluntary retirement scheme to downsize the two banks as rapidly as possible, cutting back on unprofitable bank branches, and introducing stringent loan recovery programs for defaulting borrowers. Once a modicum of financial control has been achieved, long-term plans should be developed to liquidate, further downsize, split, or privatize the banks - to ensure a fundamental change in their governance. Restructuring of these two large banks should be undertaken in conjunction with a program of complimentary reform within the Agriculture Development Bank of Nepal. (b) Significantly strengthening the central bank to make it afully professional institution. Radical restructuring should be undertaken to transform Nepal Rastra Bank into a professional central banking institution. The reform should focus initially on developing an appropriate structure, shifting to merit-based promotion, implementing a voluntary retirement scheme to reduce staffing to more appropriate levels, and decompressing the salary structure. Within the central bank, the establishment of a strong bank supervisory capacity - both on-site and off-site inspection - with fully implemented enforcement powers, will be critical to the evolution of a well functioning and prudently operated banking sector in Nepal. (c) Restructuring the ADB/N and Closing NIDC The reforms in RBB and NBL must also be undertaken in close coordination with the proposed restructuring plan within the ADB/N. With an equally large branch network and presence throughout Nepal - it is likely that important synergies will exist between the reform programs in these three institutions with respect to branch rationalization, staffing reductions, and the provision of banking services throughout the country- side. Close coordination and cooperation between these various efforts will require close involvement from the central authorities within Nepal Rastra Bank. As a deposit taking institution, the ADB/N also needs to be quickly brought under the purview of the bank inspection department of the central bank. In addition, given the dire financial position of the Nepal  xi Industrial Development Corporation, its lack of funding, its weak loan portfolio - in combination with its small size and the capacity of other financial institutions to provide industrial finance - the central authorities should give serious consideration to quickly closing NIDC and winding up its operations. (d) Creating an appropriate environment for establishing a sound financial sector. An effective system of checks and balances should be rapidly developed in the financial system, by: * Implementing the provisions of the new Nepal Rastra Bank Act and finalizing the new Banking and Financial Institutions Act as quickly as possible so that it can be enacted. * Strongly enforcing the new regulations on bank supervision - with no exceptions. Banks failing to comply with the regulations within the period specified should have their banking licenses revoked and/or be forced to merge with other banks. * Requiring all financial institutions to submit externally audited financial statements to the central bank within four months after the end of the year - or risk losing their license. Ideally, the auditing should conform to international accounting standards. * Requiring the central bank to dispose of shares in any institution that it supervises and to develop a five-year plan for disposing of shares in all financial institutions. (e) Developing an improved system of micro-finance. The government needs to determine how to deliver financial services to the poor more effectively as part of its poverty reduction efforts. To this end, it should investigate the immediate restructuring and privatization of the Grameen Bikas Banks and consider ways of ultimately providing sustainable micro-finance services through private sector institutions - building upon the good/sustainable micro finance examples which exist within Nepal and learning from the best practice examples which exist within the region. These steps are only the very first that must be taken - over the short to medium term - to begin restoring credibility and soundness to the financial system in Nepal. Only after these initial - but extremely difficult - steps have been taken will it be possible to devise a strategy for the longer term. Elements of this strategy can, however, be drawn from the other recommendations of this study (see Annex 10). Nonetheless, development of this longer term strategy for the financial sector will be an important next step in the long road towards true financial sector reform in Nepal. October 16, 2002   CHAPTER ONE Macro Monetary Policy, the Central Bank and Overview of Nepal's Financial Sector 1. General Macro-economic Environment Nepal is a landlocked country, wedged between China and India. It has a population of 24 million and its GDP at current prices in fiscal year (FY)' 2000/01 was US$5.6 billion. Its annual income per capita of US$220 is lower than the average for South Asia (US$336), and it is one of the poorest countries in the world. Almost 90 percent of the population lives in rural areas and are dependent on subsistence farming. With population growth of 2.3 percent; agricultural growth of 2.0 percent; and projected per capita GDP growth of only 3.1 percent in 2002; the absolute number of people living in poverty is expected to have been increased2. Low levels of investment, political instability, an underdeveloped infrastructure base, unskilled human resources, and poor institutional capacity have all limited the country's growth potential. In 1991, multi-party democracy was established, and the new democratic government gave increased momentum to the reform process, aimed at accelerating development and promoting a modem market-oriented economy, including deregulation and closer convergence of development programs and public needs. While the transition to democracy has resulted in a high degree of political instability (with a dozen governments between 1991 and 2001), the macro-economy has remained relatively stable with low rates of inflation and a reasonably stable (albeit slowly depreciating) currency. Some progress has been made on price reform, privatization, financial sector reform (partial deregulation), and trade liberalization. Nonetheless, the slow pace of structural reforms is largely to blame for the low rates of growth. As a result, GDP growth in Nepal faltered from an average rate of 5.5 percent over the period 1991 to 1994 to 5.0 percent in 1997; and 3.0 percent in 1998. It increased to 6.5 percent in 2000 and decreased to 5.3 percent in 2001. It is projected to decrease further to 3.0 percent in 2002. Chart 1.1: GDP Growth, 1994 - 2002 9 8 7 - _________ 5 3 2 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 Fiscal Years Source: IMF. The Fiscal Year begins on July 15. All years are quoted in fiscal years. 2 According to a 1996 World Bank estimate, 42 percent of Nepalis live below the poverty line  2 2. Macro Monetary Policy Trends in the Money Supply. Nepal's money supply has grown at an average rate of around 19 percent per annum over the period 1991 to 2001 (Chart 1.2). However, growth over this period has been erratic with very low growth in 1996 and 1997 - mainly as a consequence of a slow increase in net foreign assets during those two years. The major source of monetary growth over the decade has been an increase in lending to the private sector (claims on the private sector) which grew at an average annual rate of almost 25 percent per annum over this period. Whereas net foreign assets had been a major source of monetary growth in many of the years under review, its contribution to money supply growth has slowed more recently - increasing by only 10 percent in 2001 - and reflecting a slow down in export growth in Nepal. Another notable change in 2001 was the slow down in credit growth to the private sector and a jump in credit to the government (over 25 percent for the year) in line with the deteriorating fiscal position of HMGN. This compares to a growth rate of around 11 percent per annum in credit to the government in the earlier part of the period. This growth in the money supply was reflected in a faster rate of growth of broad money over the ten year period (19 percent per annum) compared to narrow money (15.7 percent per annum) - reflecting a deepening of the financial system as more financial sector assets moved into longer term instruments. Again this trend was reversed in the most recent year under observation. Nonetheless, the share of narrow money to broad money decreased from 43.2 percent in 1991 to 32.8 percent - indicating a movement of financial assets within the financial system into more longer term instruments. This is one indicator of a reasonably sophisticated system and one which was deepening and broadening over the course of the I 990s. It may also reflect, however, a lack of alternative investment avenues in Nepal. Chart 1.2: Money Supply Growth, 1990-2001 25- 20 15 c e10 a10 5- 0 , 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/00 2000/01 Fiscal Years Source: Nepal Rastra Bank  3 Table 1.1: Monetary Survey, 1991 to 2001 (in billions of rupees) Claims Net Claims Claims on Other Fiscal Foreign on On Public Private Time Assets Narrow Broad Year Assets Government Enterprises Sector Deposits Net Money Money 1991 16.2 16.8 3.6 14.1 21.4 12.9 16.3 37.7 1992 20.8 19.0 4.8 17.8 26.2 16.7 19. 5 45.7 1993 29.1 23.4 4.8 21.2 34.5 20.2 23.13 58.3 1994 36.2 23.5 4.7 29.6 41.3 24.3 28.5 69.8 1995 37.1 25.2 5.1 41.9 48.0 28.3 33.4) 81.0 1996 37.7 27.5 6.2 55.5 56.2 34.3 36.5 92.7 1997 40.2 29.2 7.0 64.7 65.3 37.4 38.5 103.7 1998 55.6 31.8 7.2 76.8 81.3 44.9 45.2 126.5 1999 65.0 34.9 9.1 90.8 101.7 47.1 51.7 152.8 2000 80.3 38.1 9.9 109.8 124.7 53.7 59.8 184.5 2001 88.3 47.7 11.4 127.9 143.6 61.5 70.2 213.8 (Annual Percentae Change) 1992 28.7 13.0 35.5 26.0 22.3 29.4 19.5 21.1 1993 40.1 23.4 -1.6 19.3 31.6 20.8 22.5 27.7 1994 24.4 0.2 -0.2 39.6 19.7 20.1 19.6 19.6 1995 2.4 7.3 6.6 41.7 16.3 16.5 15.7 16.1 1996 1.7 9.3 22.9 32.4 17.0 21.3 10.6 14.4 1997 6.6 6.2 13.2 16.5 16.2 8.9 5.4 11.9 1998 38.3 8.6 2.8 18.8 24.6 20.2 17 4 21.9 1999 17.0 10.0 26.1 18.2 25.1 4.8 13.1 20.8 2000 23.5 9.2 9.1 20.9 22.6 14.1 17 0 20.7 2001 9.9 25.0 14.9 16.5 15.1 14.5 17.5 15.9 Source Nepal Rastra Bank Inflation. In 2001 inflation declined to 2.4 percent - its lowest rate since 1985. Inflation averaged 9.2 percent over the past decade (1991-200). More significant, however, is that (with the exception of 1996 and 1999), inflation has been decelerating since 1992 - when was 21.1 percent. The 11.4 percent increase in 1999 was largely due to a sharp increase in the price of food products - caused by poor weather conditions in the region which increased the demand for rice while also causing shortages in essential products such as edible oils and fats and vegetables. The decline in inflation in 2000 to 3.4 percent reflected a reversion to more normal seasons - leading to a fall in the price of food and beverages as a result of a good monsoon and consequent better harvest of major crops such as rice and wheat. Inflation declined further to ,2.4 percent in 2001 but is projected to increase to 5.5 percent in 2002. See Chart 1.3 below.  4 Chart 1.3: Inflation, 1985 - 2002 25 0 20 0 e 15 0 50 00 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Fiscal Years Source. Nepal Rastra Bank. Exchange Rate. The Nepalese rupee is pegged to the Indian rupee at NR 1.6 to INR 1.0. As trade with India, formal and informal, remains the cornerstone of the Nepalese economy, the peg has provided a useful anchor. There is free convertibility between the Indian and Nepali rupees for all current account transactions. The fixed exchange rate regime has meant that interest rates in Nepal closely mirror those of India and the scope for independent monetary policy management is limited. As a result, the focus of monetary policy has been the control of credit expansion consistent with satisfactory international reserves and projected money demand. The underlying average depreciation of the Nepali rupee against the US$ has been about 10 percent per annum since 1986 but the depreciation has decelerated considerably since the 31 percent depreciation in 1992. The depreciation in 2000 was around 3 percent and in 2001 it was 3.2 percent reflecting a relatively robust currency in the face of a strong US dollar. Given the pegged exchange rate to the Indian rupee, the Nepali rupee's depreciation is reflective of the Indian rupee's strength against international currencies. The real effective exchange rate however has remained stable since the early nineties. Chart 1.4: Exchange Rate of the NPR Against the USD, 1985 - 2000 70 60 C2 50 40 i 30 20 =n 10 0 1985 1986 s87 1988 1989 1990 1991 1992 s93 1994 s95 1996 1997 1998 1999 2000 Fiscal Years Source Nepal Rastra Bank  5 Competitiveness appears to be intact as exports, remittances and, as a consequence, official reserves have all steadily increased over the period3. Since 1993, Nepalese are permitted to hold foreign currency accounts (based on foreign exchange earnings) in Nepal, although it was not possible to obtain an estimate of the size of these holdings. Government Domestic Borrowing. Fiscal management improved significantly in FYYI999 and 2000 mostly due to good revenue policy and improved administrative/collection measures. With revenues increasing by 34 percent in these two years, and less than anticipated developmental expenditures, the fiscal deficit was reduced to less than 5 percent of GDP in 2000 - with a subsequent lowering of the domestic financing requirement. These positive developments were, however, reversed in 2001 with wage increases on the expenditure side combined with difficulties in revenue collection, resulting in an increase in the fiscal deficit to nearly 7 percent of GDP and a sizeable increase in the domestic borrowing requirement (to 2.7 percent of GDP). Table 1.2: Outstanding Gove;nment Domestic Borrowing, 1991 to 2001 (NR billion) Nepal Fiscal Rastra Commercial Total Year Bank Banks Others * Borrowings 1991 9.9 7.3 3.9 21.1 1992 10.2 9.2 4.4 23.8 1993 13.9 10.0 4.9 28.7 1994 15.0 8.9 7.3 31.2 1995 17.4 8.2 7.5 33.2 1996 20.4 7.6 9.2 37.2 1997 21.9 7.8 10.1 39.8 1998 22.0 10.3 12.2 44.4 1999 22.8 12.7 14.9 50.3 2000 20.9 18.2 15.8 54.9 2001 23.6 25.4 17.6 66.6 * Individuals and institutions. Source Nepal Rastra Bank Total Government domestic borrowing grew at an average rate of around 12 percent per annum over 1991 to 2001. The growth has been erratic, ranging from a high of 21 percenl in 1993 and 2001 to a low of 7.0 percent in 1997. The NRB was the largest lender to the government until 2001 and has, on average, provided around 46 percent of total government borrowings over this period. Government borrowing from the NRB grew at an annual average rate of around 9.0 percent over the period although the growth rate decelerated significantly after 1996. In 1999, a decision was taken by the NRB and His Majesty's Government of Nepal to move away from the prior practice of settling the government's overdraft position by issuing non-marketable and non- negotiable securities to the NRB. This has helped constrain NRB's lending to the Government. As a result, there has been a shift between government borrowings from the NRB and the commercial banks from 2000 onwards. Borrowing from commercial banks averaged a higher growth rate of 13.3 percent over the period - with growth accelerating in the later part of the period. There have been extremely large fluctuations in borrowings from commercial banks - as high as 40 percent in 2001 and as low as negative 11 percent in 1994. Borrowings from commercial banks as a share of total domestic borrowing was 38 percent in 2001 - but averaged 3IMF Report, March 2000. A DflD study estimates that remittance inflows are over US$500 million per annum.  6 only 29 percent over the ten year period. Government borrowings from non-bank financial institutions grew at a significantly faster rate of around 16.3 percent over the period. Such borrowings have been above commercial bank borrowings, in absolute termns, for most of the second half of the 1990s. Banking System Credit. Banking system credit grew at 18.3 percent per annum between 1991 and 2001. However, in the four years up to 2000, credit growth slowed compared to the earlier years and has largely remained below the period average. In 2001, bank credit rebounded, growing at 18.7 percent - with the strongest growth being experienced in credit to govemment (27.5 percent). The strongest contributor to credit growth overall was credit to the private sector which grew by around 25 percent per annum over the period. Most of these gains came in the earlier years when the political situation was more stable. Growth in credit to the private sector has been erratic - from a high of 41.7 percent in 1995 to a low of 15.9 percent in 2001. Loan recovery operations of the two largest banks and a slowdown in the economy continued to limit the expansion of credit to the private sector in the latter part of the decade. In addition, a lack of viable projects, decline in imports, and insurgency in rural areas prevented commercial banks from seeking new opportunities in the hill areas (indeed, a large number of bank branches were closed in troubled areas). In terms of the share of total banking system credit, credit to the private sector increased steadily from 40 percent in 1991 to almost 70 percent in 2000 - before falling back to 67.6 percent in 2001. Growth in credit to the govemment averaged around 11 percent per annum over the period 1991 to 2001. After 1993, growth has been well below this average although this turned around in 1999 and, more particularly, in 2001 when it grew by 11.1 percent and 27 percent respectively. Part of the reason for this was the growth in government borrowing from NRB, non-bank financial institutions and the general public in the middle part of the 1990s. The turn around in bank lending to the central government in the late 1990s was a consequence of the change in policy after 1999 to reduce government reliance upon central bank financing and the conversion of the central government overdraft at NRB into treasury bills from March 1999. Notwithstanding this change in policy, the share of central government borrowing from the banking system has still registered a steady decline since 1991 - when it was over 49 percent - to 26 percent in 2001. Growth in credit to public enterprises has been shrinking over the period. Its share of the total was 10.2 percent in 1991 but only 6.4 percent by 2001. One potentially disturbing contributing factor towards credit growth, however, may well be interest capitalization on non-performing loans - which is certain to have figured prominently in the growth of credit in RBB, NBL and ADB/N - the three largest commercial banks.  7 Table 1.3: Bank Credit, 1991 to 2001 (NR billions) Fiscal Year Central Private Public Total Government Sector Enterprises Credrit 1991 17.2 14.1 3.6 34.9 1992 19.4 17.8 4.8 42.1) 1993 23.9 21.2 4.8 49.8 1994 23.9 29.6 4.7 58.2 1995 25.6 41.9 5.1 72.65 1996 28.0 55.5 6.2 89.7 1997 29.7 64.7 7.0 101.X1 1998 32.3 76.8 7.2 116.3 1999 35.9 90.8 9.1 135.83 2000 38.2 109.4 10.3 157.9 2001 48.7 126.8 11.9 187.4 Bank Lending (annual percent change) 1992 12.2 26.0 35.5 20.2 1993 23.2 19.3 (1.6) 18.7 1994 0.3 39.6 (0.2) 17.C0 1995 7.3 41.7 6.6 24.7 1996 9.2 32.4 22.9 23.5 1997 6.0 16.5 13.2 13.0I 1998 8.7 18.8 2.8 14.8 1999 11.1 18.2 26.4 16.8 2000 6.4 20.5 13.2 17.1 2001 27.5 15.9 15.5 18.,7 Bank Lending (percentage of total) 1991 49.4 40.4 10.2 100.0 1992 46.1 42.4 11.5 100.0 1993 47.9 42.6 9.5 100.0 1994 41.0 50.8 8.1 100.0 1995 35.3 57.7 7.0 100.0 1996 31.2 61.9 6.9 100.0 1997 29.3 63.8 6.9 100.0 1998 27.7 66.0 6.2 100.0 1999 26.4 66.9 6.7 100.0 2000 24.2 69.3 6.5 100.0 2001 26.0 67.6 6.4 100.0 Source: Nepal Rastra Bank Excess Liquidity. In Nepal, the only statutory liquidity requirement is the Cash Reserve Requirement (CRR) discussed later in this chapter. By this measure, there is considerable excess liquidity within the commercial banks. As of July 2001, there was around NR 76.D billion of liquid assets in the banking system representing 42 percent of total deposits. Of this, around NR55.0 billion was in excess above the CRR - or 25 percent of total deposits. However, over a third of total liquidity in the banking system is being held abroad and earns a rate of return - while around 6.5 percent remains as excess reserves with Nepal Rastra Bank. See Table 1.4 below.  8 Table 1.4: Liquidity of the Banking System (1990 to 2001) (NPR million) Liquid Assets As a % of Loans and Total Fiscal Year Total Deposits' Advances2 Cash Reserve3 Liquid Assets4 Deposits 1990 21,885.0 15,334.7 3,627.0 9,395.1 42.9 1991 26,687.5 17,067.4 4,836.5 15,022.1 56.3 1992 33,328.5 22,596.2 4,701.0 17,502.6 52.5 1993 43,543.1 26,223.6 7,164.8 25,111.3 57.7 1994 52,168.5 34,756.8 7,884.3 27,799.1 53.3 1995 61,045.5 46,914.7 9,509.9 25,710.7 42.1 1996 71,207.6 61,466.0 9,738.1 28,249.4 39.7 1997 81,542.4 70,765.6 12,737.4 35,450.9 43.5 1998 102,401.6 83,517.0 14,183.5 41,329.2 40.4 1999 126,773.6 99,309.7 15,860.7 50,369.3 39.7 2000 154,530.3 118,008.1 17,020.0 63,337.6 41.0 2001 181,203.4 135,526.4 20,767.5 76,036.7 42.0 'Excludes inter-bank deposits and government deposits but includes foreign deposits. 2 Excludes investments in Government securities and includes foreign bills purchased and discounted. 3Includes cash in hand, balances with Nepal Rastra Bank and foreign currency in hand. 4 Includes cash in hand, balances with NRB, foreign currency in hand, balance held abroad in transit, and government securities. Source: Quarterly Economic Bulletin, Mid-January, 2002, No I & 2, Nepal Rastra Bank 3. Overview of the Financial System Nepal has a reasonably diversified financial sector (as evidenced by the number and variety of institutions that play an active role in the sector) relative to its small and under-developed economic base. Unfortunately, the system remains unnecessarily segmented, with a negative impact upon financial system competition. As of July 2001, the financial system included 15 commercial banks4, 8 development banks, 5 regional (rural) development banks, I postal savings bank, 48 finance companies, 35 non-government cooperative societies involved in limited banking activity5, and 30 non-government micro-credit institutions. Nepal has made significant progress in developing its financial sector since financial sector reforms began in 1984. At that time, Nepal had only two state-owned commercial banks. The structure of the Nepalese financial sector is shown in Annex One. As of July 2001, total assets of the financial system (excluding assets of insurance firms that were not available) amounted to NR 415.2 billion or US$5.6 billion. Commercial banks comprised the largest share (55 percent), followed by Nepal Rastra Bank, (28 percent), development banks (7.5 percent), provident fund (5.1 percent), and finance companies (3.8 percent). 4 These include, Rastriya Banijya Bank, Nepal Bank Limited, Nepal Arab Bank Ltd., Indo-Suez Bank Ltd., Standard Chartered Bank, Himalayan Bank, Nepal SBI (State Bank of India) Bank Ltd., Nepal Bangladesh Bank, Everest Bank Ltd., Bank of Kathmandu, Nepal - Bank of Ceylon Ltd., Lumbini Bank Ltd., NIC Bank Ltd., Machapuchre Bank Ltd., Kumari Bank Ltd. 5There are also numerous informal (non-registered) credit cooperatives. However, as there is no data on these infornal institutions, it has not been possible to include information on them in this table.  9 Table 1.5: Total Financial System Assets, July 2001 NR million Percent Nepal Rastra Bank 114,196.1 27.5 Commercial Banks 226,219.3 54.5 Development Banks (ADBN and NIDC) 31,348.1 7.5 Provident Fund 21,000.0 5.1 Finance Companies 15,812.2 3.8 Others 6,637.4 1.6 Regional Rural Development Banks (1,996.7) (0.5) Other Development Banks (2,599.8) (0.6) Micro Finance NGOs (15.5) (0.0) Cooperatives (2,025.4) (0.5) TOTAL 415,213.1 100.0 Source. Nepal Rastra Bank Commercial Banks. There are 15 commercial banks in Nepal (including the recently opened Macha Puchri Bank Limited and Kumari Bank Limited). Total assets of the commercial banks, as of July 2001 was NR 226.2 billion - equal to around US$3.0 billion. Of the commercial banks, Rastriya Banijya Bank (RBB) and Nepal Bank Ltd (NBL) - with shares of 28 percent and 23 percent of total commercial banking system assets respectively - were the most dominant. The government owns the key commercial banks, including RBB, the Agricultural Development Bank of Nepal (the ADBN is Nepal's third largest bank) and, until recently, Nepal Bank Limited (NBL) where it still retains a 41 percent stake-holding. When ADB/N is also taken into account as a state-owned bank the Government's share of the total assets of the commercial banks is close to 60 percent. In contrast, the five largest joint-venture banks, some of which also have Government direct or indirect ownership - hold less than 32 percent of banking system assets. Rastriya Banijya Bank (RBB). RBB was established in 1966 as a fully government-owned commercial bank - and is the nation's largest commercial bank. The bank currently operates a country-wide banking network, in line with the Government's policy to provide banking access to the general public, through a network of 210 branches (although as many as 70 of these have been closed as a result of the Maoist insurgency). Despite the wide branch net work, a large proportion of the bank's total banking business is conducted in Kathmandu. The bank employs around 6,000 staff. In July 2001, the bank had total assets of US$852.9 million and a total reported capital (core and supplemental) of US$47.1 million (around 5.5 percent of total assets). Nepal Bank Limited (NBL). Nepal Bank Limited (NBL), established in 1938, is the oldest bank in Nepal and is the second largest bank after Rastriya Banijya Bank. Currently, the government owns 41 -percent of the bank after following a policy of parceling off shares of the bank to the workers as well as the general public in Nepal. In accordance with the government's policy of providing at least one banking facility for every 30,000 people, NBL also opened up many branches and sub-branches throughout the country. The bank grew to 235 branchies by 1990, which were serviced by 8,721 staff. However, a subsequent consolidation of the bank resulted in a reduction in branches to 211 and around 6,000 staff by the end of 1998. In common with RBB, the number of branches has been further reduced by the Maoist insurgency. NBL's total reported  10 assets in July 2001 amounted to around US$695.1 million, backed by reported capital (core and supplemental) of US$36.2 million (5.2 percent)6. Private Commercial Banks -Joint Venture and Private Nepali Commercial Banks. The private commercial banks represent 49 percent of the banking system (with approximately US$1,452.6 billion in assets). This group is dominated by three large banks - Standard Chartered Bank (9.4 percent of total commercial banking system assets), Himalayan Bank (9.3 percent) and Nabil Bank (8.5 percent). The joint venture banks are from the United Kingdom, Bangladesh, Pakistan, France, India, and Sri Lanka. The remaining 22 percent of commercial banking system assets is shared between the remaining ten smaller private banks in the system. Development Banks. The two government-owned development banks, the Agricultural Development Bank of Nepal (ADB/N) and the Nepal Industrial Development Corporation (NIDC), control about 7.5 percent of total financial system assets. In addition, 6 private development banks have been established since 1998. Three of these have begun operations since early 1999 - and, at this stage, very little is known about their operations. The Agricultural Development Bank of Nepal (ADB/N). The ADB/N was established in 1967 by the Agricultural Development Bank Act of the same year and was a successor institution to the Government-sponsored Cooperative Bank. It is the third largest bank in Nepal. Its mandate is to supply credit for agricultural development, small-scale irrigation projects, agriculture-based cottage and small industries, and credit for tenant farmers to purchase land. Ninety-three percent of the bank is owned by the Government through the Ministry of Finance. Other shareholders include Nepal Rastra Bank, individuals and cooperatives. The bank manages total assets of around US$227.9 million. It has branches in each of the 75 districts in Nepal, and 30 of its mainly urban branches perform commercial banking activities. The Nepal Industrial Development Corporation (NIDC). NIDC was established in 1959 to support industrial development. It is empowered under the NIDC Act to provide credit, guarantees, underwrite shares, and hypothecate loans. The Government of Nepal is the largest shareholder in NIDC and it dominates the Board of Directors. NIDC is, however, a significantly smaller institution than the ADB/N with only around US$36 million in total assets (July 2000). Historically, NIDC's main source of funding has been from donors - the World Bank and GTZ - however, this situation has changed radically in recent years and the bank has increasingly turned to the central bank to provide it with loanable funds. In 1999, borrowings from Nepal Rastra Bank represented 35 percent of NIDC's total liabilities. Borrowings from the Ministry of Finance represented a further 8 percent. While the NIDC does not accept deposits, it is pernitted to issue negotiable certificate of deposits. Regional Rural Development Banks. The larger scale developmental lending to agriculture and industry provided by the ADB/N and the NIDC is supplemented by a further five development banking institutions which provide micro-finance support in the five regions of Nepal. These banks control less than half of one percent of the total assets of the financial sector. They are modeled on the Grameen Bank of Bangladesh and were established between 1992 and 1996. All of these institutions aim at improving the socio-economic status of poor rural women by promoting the formnation of self-help groups and facilitating their access to formal credit. Operating autonomously in each of the five regions, each Regional Rural Development Bank (or Grameen Replicator Banks as they are also known) has a slightly different ownership pattern, 6 As discussed in the commercial banking chapter, however, both RBB and NBL have a serious problem of negative capital once adequate provisions have been made on their non-performing loans.  I1 although in each case the Government and Nepal Rastra Bank dominate - with an ownership stake of 75 percent in all five institutions combined. The two state-owned banks (RBB and NRB) have a further 10 percent ownership stake in these five banks. The remaining shares of the banks are owned by the private joint venture banks - which are encouraged to participate in these institutions, with any lending funds provided counted as part of their 12 percent directed lending requirement to disadvantaged sectors. Finance Companies. In addition to the private banks, there are 48 private finance companies operating in Nepal. These institutions have all commenced operations over the past six years since the Finance Company Act was promulgated. The Act permits these companies to offer installment credit for the purchase of vehicles, equipment, or durable household goods, for purchase or construction of residential buildings, for leasing financing, and for "operating industrial, commercial or other enterprises." As of July 2001, these 48 companies controlled around US$209.7 million in assets (representing around 3.9 percent of total financiial system assets) and are growing very rapidly. Micro Finance Institutions. There is a plethora of organizations involved in micro finance in Nepal - formal and informal - mainly cooperatives and NGOs. Credit cooperatives first emerged in 1956 and were registered under the Cooperative Act in 1959. With a view to limiting political intervention and to institutionalizing cooperatives, a new Cooperative Act was enacted in 1992. This Act specified that a minimum of 25 persons were required to form a primary cooperative. While there is reported to be around 5,000 largely credit and multipurpose cooperatives registered under the new Act, only 35 have obtained permission from the Nepal Rastra Bank to undertake limited banking functions (although many of the others do so illegally). Non-governmental organizations are also permitted to provide limited banking services in Nepal. To date, thirty NGOs have been licensed to conduct limited banking business of which two - Nirdhan and CSD - are Grameen replicator banks. NGOs are registered under the Societies Registration Act. As with the cooperative societies, there is little supervision and oversight of these institutions by the central bank. On the other hand, however, some of them, such as the two privately owned Grameen replicator banks, appear to be performing well. The Nepal Stock Exchange. The history of securities market in Nepal began with the floatation of shares in a jute mill and Nepal Bank Limited in 1937. However, very little market activity occurred after this point. This was then followed by the introduction of the Company Act in 1951 and the first issue of Government bonds in 1964. The Securities Exchange Center Ltd., which was designed as a Government broker and under writer for government bonds, was established in 1976. Before its conversion into a Stock Exchange in 1993, the SEC was the only capital market institution undertaking the job of brokering, underwriting, managing public issues, market making for government bonds, and providing other ancillary services. The Nepal Stock Exchange was created in 1993 as a non-profit organization operating under the Securities Exchange Act. The Nepal Stock Exchange (NEPSE) opened its trading floor on January 13, 1994. The NEPSE is owned by the Government (40.92 percent), the central bank (49.53), the Nepal Industrial Development Corporation (8.77 percent), and some other very small licensed members (0.78 percent). The Government had intended to sell the NEPSE to private interests within five years, however, there is not a lot of interest in investing in the Stock Exchange. The Board of Directors consists of nine members. Members of the NEPSE are permitted to act as intermediaries in buying and selling government bonds and listed corporate securities. At present there are 29 member brokers and 3 market makers, who operate on the trading floor as per the  12 Securities Exchange Act, 1983. The NEPSE had a market capitalization of US$615 million and a turn over of US$1.7 million in 2001. The Insurance Industry. There are 13 insurance companies. The total life insurance and non-life insurance premiums collected as of July 2000 was NR 6.61 billion (US$93.89 million). Of this, life insurance accounted for around 59 percent of the total, the remainder going to non-life insurance (car insurance, fire, etc). The largest insurance company is the National Insurance Company. It is listed on the NEPSE and the govemment is the majority shareholder - with only 12 percent of the shares being held by the general public. It has a near monopoly on govemment insurance business and its market share in 1998 was 40 percent. Other major insurance companies include the National Life and General Insurance Company (which is the only company to offer life insurance other than the National Insurance Company), Nepal Insurance, Himalayan General Insurance, and Neco Insurance. These five companies control almost 60 percent of the general insurance market. Of the 13 insurance companies, 11 are domestically owned and 2 are Indian owned. While these companies provide a variety of general insurance products, the industry still lacks the full range and sophistication of a well developed insurance business. Shortage of qualified actuaries is a particular problem. Money Changers (Foreign Exchange Bureaus). There are currently 200 NRB licensed money changers in Nepal, although not all of these are operational. Of these, 67 are located in Kathmandu. The foreign exchange bureaus provide money changing services for foreigners only (as Nepalese can only carry out such transactions through the commercial banks). The foreign exchange bureaus provide annual reports to the NRB. Postal Savings Bank. The Postal Savings Bank was established in 1975. It currently has branches in 121 out of a network of 3,590 post offices. The objective of the Postal Savings Bank was to cultivate a savings habit and mobilize small savings in rural areas. As such, these are mainly used by the small rural savers who earn 7 percent per annum on deposits. The funds from these schemes are re-deposited with Rastriya Banijya Bank. At present, the total postal savings are less than 5.0 million rupees (US$71,000). Employees Provident Fund. The employees provident fund was established under the Employee's Provident Fund Act of 1962. It is an autonomous corporate body having perpetual succession. The fund had total assets of NR 21 billion (US$278.5 million) as of July 2001. It has nearly doubled in size over the past four years. Currently most of the assets of the EPF are invested in deposits with state-owned banks (65 percent) and government bonds (15 percent). The remainder is given out as loans including syndicated bank loans, with maturities of up to eight years, and member loans. Citizens Investment Trust (Mutual Fund). The Citizen Investment Trust was created under a special Act of parliament to assist in the mobilization of savings. It offers two relatively small investment funds that help to mobilize the savings of small investors. Any employee can voluntarily participate in an investment plan sponsored by the Citizen Investment Trust called an Employee Savings Growth Scheme. Contributions of up to 10 percent of salary can be made. These contributions are tax deductible while the earnings on them are taxed at distribution. Apart from this, the Citizens Investment Trust operates two other schemes, the Citizen Unit Scheme, 1992 and the Investors Account Scheme. The total funds under the management of the Citizens Investment Trust were NR 895.8 million (US$12.1 million) as of February 2001. Around 48  13 percent of these funds are invested in fixed interest deposits, 38 percent in government bonds, 10 percent in term loans and the remainder in corporate shares and debentures. 4. Nepal Rastra Bank Background. The NRB was established as a non-profit organization fully subscribed by the government under the Nepal Rastra Bank Act, 1955 on April 26, 1956. It was established as an autonomous and corporate body having perpetual succession, although the Act allows the government to give directives to the Bank when it serves the national interest. It serves as banker to the government, maintains government deposits, and undertakes remittance and other banking services for His Majesty's Government. The NRB offers advisory services to the government for monetary and financial policies. The NRB has the authority to regulate and control foreign exchange operations and has the sole right to authorize other agencies to deal in foreign exchange. It is authorized to regulate, control and develop the banking system, license new commercial banks and financial institutions, and serves as a lender of last resort to commercial banks and financial institutions. It is mandated to supervise, regulate and monitor all commercial banks, development banks, finance companies as well as licensed NGOs and co-operatives engaged in micro-finance. In its prudential regulation and supervision task, the NRB sets norms for capital adequacy, liquidity, loan classification and provisioning, reporting requirements, and the auditing of the supervised financial institutions. It serves as a clearing house for inter-bank transactions. In addition the NRB's Development Finance Department manages the flow of credit to priority and deprived sectors. It provides capital to NGOs and the RRDBs. Legal Position. Until early 2002, the Nepal Rastra Bank derived its authority from, the Nepal Rastra Bank Act, 1955. This legislation had been a major source of weaknesses in the Nepalese financial sector. This law has been revised and up-dated, however, with the new law coming into effect as from January 2002. With the promulgation of a new Nepal Rastra Bank Act, the NRB is expected to enjoy greater autonomy in its operation, particularly from the Ministry of Finance. Some of the important factors in the revised law that will help to ensure NRB's autonomy are (a) the governor cannot be removed without cause; (b) there has been a change in the constitution of the Board of Directors to include a number of independent directors and only a non-voting Ministry of Finance director; and (c) other provisions such as formulation of regulations and initiation of remedial steps that the NRB can take without referring to the Ministry of Finance or obtaining its approval. Board of the Banks The NRB is currently governed by a seven member Board of Directors comprised of the Governor, four Directors nominated by His Majesty's Government I1HMG) and the two Deputy Governor's of the Bank. All the members are appointed by HMGN. The Board is the supreme policy making body of the NRB. The composition of the Board is shovm below. NEPAL RASTRA BANK BOARD OF DIRECTORS Chairman Dr. Tilak Bahadur Rawal, Governor Members Dr. Shankar Sharma Member, National Planning Commission Dr. Bimal Prasad Koirala Secretary, Ministry of Finance Dr. Parasar Koirala Professor, Tribhuvan University Mr. Bijaya Nath Bhattarai Deputy Governor, Nepal Rastra Bank Mr. Ram Babu Pant Deputy Governor, Nepal Rastra Bank Mr. Pradeep Kumar Shrestha Chairman, Federation of Nepal Chamber of Commerce and Industries  14 Organizational Structure. The NRB is made up of 20 departments (including the Bankers Institute). These departments are grouped by functions such as the Development Finance Department that focuses on development or social banking, including support to the various development banks and organizations in which the NRB is currently engaged. The Issue Department and the Banking Department are the principal operational sub-divisions of the Bank. The NRB also has 7 branches and I sub branch located in: Biratnagar, Janakpur, Birgunj, Pokhara, Siddartha Nagar, Nepalgunj and Dhangadi and one sub-branch office in Illam. It also has an office in Bhadrapur. The Bank operates with a total staff strength of 2,719 people (2,352 permanent and 367 contract employees). The seven branch offices and one sub branch office are comprised of two main units, Issue and Banking. The only difference between the branch and sub branch is the volume of work. The branches and sub branches have a Regional Research Center that focuses its studies and analysis of the economic and banking situation in that particular region. The branches also have responsibility for revenue collection and payments on behalf of the government. OrgnISouctwenofkeNepaIRair BDo |iCor Wdbr*d Dt l l OlG*& D | |G| m Ban ing Suevso.Anassmn o ea' omlac ih h ae orePinileo 3LtqDqt I I Effective Banking Supervision, conducted in June 1999, concluded that NRB does not comply with two thirds of these Core Principles and has experienced difficulties in fulfilling its supervisory mandate. The main weaknesses point to absence of operational independence, poor internal structure, problems of hierarchy, and inadequate legal framework. Some of the reformn measures necessary to correct these deficiencies and strengthen the NRB's supervisory capacity have been identified and are now being addressed. They include, inter alia, reorganization of the departments to provide for operational autonomy; creation of an institutional development plan for supervision functions, enhancement of regulatory functions including prudential guidelines,  15 accounting and auditing practices, and expansion of supervision of non-bank financial institutions. Table 1.6: Nepal Rastra Bank: Assets and Liabilities, 1991 - 2001 ( in NR billions) Assets 1991 1992 1993 1994 1995 1996 1997 Ms 1999 2000 2001 FC in hand 0 9 0 4 1.2 2.6 6.5 6.8 5.7 5 3 2.3 5.6 5 6 Gold 03 03 0.3 03 0.3 04 04 0.4 0.4 04 04 Foreign Assets 13.9 19.1 26.7 320 28.1 26.6 30.4 42.1 50.9 601 701 Advances to Govemment 9.9 10.2 3.8 15.0 174 20.4 21.9 220 228 204 233 Public Enterprises 0 7 0 8 0 06 0.5 0 7 1.1 1.5 1.6 1.7 1 6 1 7 Commercial Banks 003 0.03 0.05 003 0 02 0.4 0 007 0 006 0 006 005 0 1 Private Sector 0 6 0.6 0.5 0 5 0.6 0.9 1 5 1 2 1 4 2 1 3 3 Other Assets 3 5 4.3 4 4 3.9 5.0 5 7 6.7 7.2 8.3 8.8 9.7 Total Assets 29.8 35.6 47.6 54.8 58.8 62.3 68.1 79.9 87.8 99.2 114.2 Liabilities 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Notes and Coins 12 6 14 8 17 7 21.5 24 5 27.5 30.2 33 8 38 3 45 7 52 6 in Circulation Deposits Govemment 0.1 - - - - - - - - - Commercial Banks 3 5 3 1 5 5 5.6 7.0 6.7 9.3 10 5 11 9 12 8 16.0 Foreign 02 0.2 0.2 02 0.2 0.2 04 02 0 06 02 1 2 Private Sectordeposits 0.7 0.9 1.3 1 3 1 1 1 2 1.6 1.7 2 1 2 5 2 2 OtherLiabilities 47 67 122 139 11.7 101 10.4 129 131 146 156 Capital and Reserves: Capital 0 01 0 01 0 01 0 01 0 01 0.01 0.01 0.01 0 01 0 01 0.01 Reserve Funds 0 5 0.7 0 9 1.2 1 4 1.5 1.7 2.1 2.6 2.6 2 6 Other Funds 7.5 9.1 99 11.1 12.8 15 1 146 195 19.9 21.0 24.0 Total Liabilities 29.8 35.6 47.6 54.8 58.8 62.3 68.1 80.6 87.8 99.2 114.2 Source: Nepal Rastra Bank Human Resource Management and Development. Until late 2001, the NRB was operating with 2,352 permanent employees and 367 contract employees (almost all at the assistant level). The implementation of a VRS scheme, however, has reduced total staffing levels to around 2,200 - and all contract employee positions have been eliminated. Professional staff make up only 14 percent of the total. There are 824 employees (35 percent) working in the nine branches. The ratio of assistants to professional staff is 5.3 at the center and 9.2 at the branches. Based on this high ratio of professionals to assistants, the NRB still appears to be overstaffed - and especially at the assistant level - even after the implementation of the 2001 VRS. Moreover, it appears that this problem is more severe at the branch level. The presence of at least two staff unions (membership confined to non-professional employees) and their strong influence on personnel policies is but one explanation for the large number of low level workers in the NRB. These unions have strong political connections. As a result, they have a disproportionately large influence upon the human resource policies oi the bank, constraining hire and fire practices as well as asserting undue influence on issues o;f promotion and even automation in the workplace. While the union is also seen to have some positive impact in terms of being a watchdog over senior management, they have been counter productive and are partly to blame for the human resource problems faced by the Bank. Another reported issue is the  16 vacuum in the NRB as far as experienced professional staff are concerned. This was caused by a rule requiring mandatory retirement after 30 years of service. This rule was repealed in 1999 but the NRB still lacks an adequate cadre of professionals. It is evident that reengineering the human resources function is key to an efficient and effective NRB. Over the short run, a policy of not replacing retirees (being enforced, particularly at the lower level) is one way to keep staff numbers from growing (currently 560 - 24 percent - of all staff are in the age group 46-58 years, 58 being the compulsory retirement age), while a longer term strategy is put into place. Given the strength of the unions as well as the large numbers of staff that are likely to be impacted by any meaningful reform, incentives will have to be carefully structured and close communication with the unions will be required. Instruments of Monetary Policy. The main monetary policy instruments used by the NRB are the cash reserve ratio (CRR), the refinancing rate, and open market operations using treasury bills, repurchase agreements, development bonds and national savings certificates. At present, given the limited demand for credit by the private sector and the excess liquidity in the financial system, the available instruments do not provide NRB the necessary leverage to effectively conduct meaningful macro-monetary policy. In addition, there is limited range of debt instruments - although longer-term government securities were introduced in 1999 in conjunction with efforts to reduce government borrowing from the NRB. Since 1989, interest rate policy has been conducted primarily through moral suasion aimed at lowering lending rates while discouraging significant increases in yields on treasury bills. However, after observing a decade of sluggish economic growth, a high interest rate spread maintained by the commercial banks (largely the impact of the two large inefficient commercial banks), a slowdown in the growth of private sector credit, and increasing demands from the business community for lower interest rates, the NRB issued a directive on July 30, 1998 to the commercial banks to limit the interest spread to 5 percent. Cash Reserve Ratio. This is the main monetary policy tool of the NRB. Prior to mid April 1998, the CRR was 12 percent of total domestic deposit liabilities and the total Statutory Liquidity Ratio (SLR) including CRR was 34 percent. Since then, the SLR has been removed and the CRR has been revised downward. Up to December 2001 it was calculated as 8 percent of savings and demand deposits and 6 percent of fixed deposits. Thereafter it was revised to 7 percent of savings and demand deposits and 4.5 percent of fixed deposits. Banks are also required to maintain 3 percent of total deposits as vault cash. The reduction in the CRR was expected to release additional liquidity into the market and (due to lower cost of funds) lower the lending rates of the commercial banks. Licensed cooperatives are required to maintain 10 percent of their total deposits in liquid assets. Interest Rates. As indicated, interest rates were deregulated in 1989 with the proviso - since July 30, 1998 - that commercial banks maintain a maximum spread of 5 percent' between lending and deposit rates. Banks are also required to meet "priority sector and deprived sector" lending targets - currently set at 12 percent of their total loan portfolios, mainly targeted for agricultural loans, cottage industry loans and loans intended for the poor. A quarter of this must be allocated to the "deprived" or "hard core" poor sector (defined as those who borrow less than NR 30,000 - US$426 - per annum). While commercial banks have had difficulty in meeting this stipulation in the past (and paid penalties for the shortfall to NRB), it has become easier, with the growth of the 7The spread is calculated by the following formula - totai interest income divided by the total average loan minus total interest expense divided by total average deposits expressed as a percentage  17 RRDBs and other micro-finance institutions. The commercial banks provide these funds at between 10-15 percent. Table 1.7 below shows interest rates in Nepal over the past six and a half years. There has been a tendency for interest rates to fall over this period. However the extent to which this reflects "market conditions" (given the dominance of the three large state owned banks within the system) is uncertain. The most notable decline has been the interest rate on Government Treasury Bills which had fallen to 4.3 percent in July 2001 from 11.7 percent in January 1997. This was mainly a result of the existing legal and operations restrictions faced by the NRB such as restrictions on selling bills acquired from conversion of overdraft in the primary markets, limits on the level of gross sales of treasury bills, as well as a regulation linking rates in the secondary markets to the average auction rate of treasury bills of the preceding three months. The reduction in T-Bill interest rates is also in line with a reduction in the rate of inflation over this period. Table 1.7: Main Lending and Deposit Interest Rates, 1995 - 2001 Fiscal Year 1995 1996 1997 1998 1999 2000 2001 A. Government Securities Treasury Bills (3-month) 7.4 10.9 10.2 3.5 2.3 5.3 4.9 Treasury Bills (I year) - - 9.0- 12.0 5.9 - 7.3 4.7 - 7.0 5.5 -7.3 5.1 Nat'l Savings 9.0- 15.5 9.0 15.5 9.0- 13.25 9.0- 13.25 9.0- 13.25 8.5 - 13.25 8.5 - 13.25 Certificates Development Bonds 3.0- 10.5 3.0- 12.0 3.0- 12.0 3.0 - 12.0 3.0- 12.0 3.0 - 10.5 3.0- 10.5 B. Nepal Rastra Bank Refinancing Rates 11.0 11.0 9.0 9.0 9.0 6.5 - 7.5 4.0 - 6 5 C. Commercial Banks (a) Deposit Rates Savings Deposits 7.0-8.0 7.5 - 8.0 7.3 - 8.0 6.5 - 8.0 5.75 - 8.0 4.0 - 6.5 3.5 - 6.5 Time Deposits 3 Months 5.0 - 7.5 6.75 - 8.0 6.75 - 9.0 5.0 - 8.0 4.0 - 7.5 4.0 - 6.0 2.5 - 6.0 6 Months 6.0 - 8.0 7.25 - 9.0 7.25 - 9.0 6.0 - 8.5 6.0- 8.0 5.0 - 6.75 3.5 - 6.75 I Year 8.5-9.25 9.5- 11.0 9.5 - 11.0 9.0-10.5 7.25-9.5 6.0-7.75 4 5-7 75 (b) Lending Rates Industry 14.0 - 18.0 15.0- 17.5 15.0-17.5 13.5 - 17.0 11.5-17.0 10.5 - 15.5 7.0-15.0 Agnculture 13.0- 15.5 14.5 - 16.0 14.5 - 16.0 14.5 - 15.5 14.0- 15.5 12.0 - 14.5 12..5 - 14.5 ExportBills 12.0 - 16.0 13.0 - 16.0 14.5 - 16.5 12.5 - 16.0 7.5 - 15.0 7.5 - 15.0 7.0 - 125 Commercial Loans 12.0-19.0 14.5 -20.0 14.5-20.0 13.5-20.0 10.0-19.0 9.0- 18.0 7.0- 18.0 & Overdrafts Agricultural Development BankofNepal 12.0- 17.0 12.0- 17.0 12.0 - 17.0 13.0 - 18.0 13.0 - 18.0 11.0 - 16.0 10.0- 16.0 Nepal Industrial Development Corporation 15.0- 16.0 15.5- 16.0 15.0- 18.0 15.5 - 18.0 15.5 - 18.0 15.5- 18.0 13.5 - 14.5 Treasury Bills: annual weighted average. Source: Nepal Rastra Bank Lending interest rates are reported on an industrial/segmented basis that normally reFlects a state determined system which seeks to confer preferential lending rates on priority sector activities. It is uncertain why this practice is continued - given that interest rates are theoretically deregulated (subject to conditions on interest rate spreads). Nonetheless, given the current poor financial shape and lack of competition within the banking system it is, in any case, uncertain what benefits could be derived from a totally liberalized interest rate structure. Nonetheless, the segmentation of interest rates can have serious dis-intermediation effects upon a developing financial system.  18 The entry of new banks does not appear to have injected a significant degree of competition into the interest rate structure - with the new joint venture banks playing by the existing "rules of the game" - rather than acting as "market breakers". This lack of competition, even with the entry of new banks, reflects segmentation in the banking system plus the fact that the joint venture banks are able to hide behind the inefficiencies created by RBB, NBL and ADB/N. Lastly, most interest rates (both deposit and lending rates) have been positive in real terms, over the past two years as inflation has edged down below 5 percent. This is in marked contrast to 1999 when the dramatic increase in the rate of inflation resulted in most interest rates being, at least temporarily, negative in real terms. Refinance Policies. NRB has completely phased out the old practice of automatically providing refinancing for commercial banks against government securities. At present, refinancing is only provided under two broad categories: (a) under the Special category, refinancing is provided at 6.5 percent - this is mainly targeted at deprived sectors; and (b) under the general category - that covers items such as export credits - refinancing is provided at 7.5 percent. Open Market Operations. The NRB utilizes open market operations as an indirect tool for short-term liquidity management. Treasury bill sales through an auction system was first introduced in 1988. In addition to treasury bills, development bonds and national savings certificates are sold. The government sells 91-day and 1-year Treasury Bills on a weekly basis, typically issuing around NR 600 million per week. Issues of longer dated instruments are increasingly rare. In principle, Development Bonds are auctioned 3 to 4 times a year, however the last issue was in July 2000. The government has historically issued National Savings Certificates with maturities of up to 15 years, but more recently they have been with five year maturities. National Savings Certificates are only sold, to individuals, four to five times a year9 and there is a maximum holding per person of NR I million - although an exception is made for the EPF and CIT. National Savings Certificates were historically tax exempt but this was discontinued from May 2000. The government also issues Special Bonds which are generally private placements to entities such as Nepal Rastra Bank. While Treasury Bills are sold to the banking sector through an auction mechanism, all other bonds are sold through a fixed price re-offer, with pricing set by the Open Market Committee. The sales of bonds are generally open to all investors including foreigners (subject to the restriction on National Savings Certificates), however, some sales are made directly to entities such as the EPF for reasons of timeliness. Approximately half of all National Savings Certificates are sold through the NRB's nine regional branches and the rest by commercial banks'", a significant portion (15-25 percent) of each issue is sold outside of Kathmandu. In 1999 treasury bills amounting to NR 2,200 million, development bonds of NR 650 million and national savings certificates of NR 1,860 million were sold through open market operations. Since March 1997, the NRB also undertook repos in Treasury Bills. During 1999, the short term cumulative liquidity injected through repos amounted to NR 16.3 billion. The Clearing and Payments System. The main forms of payment are checks, drafts, telegraphic transfers and more recently, credit cards that are issued by a few of the newer ' This last issue was of NR 790 million of 3-year bonds with a coupon of 7 percent. 9 NR I billion was sold in January 2001 with a coupon of 8.5 percent and a maturity of 5 years. " Banks are paid a fee of 0.5 percent for retail sales and 0.1 percent for institutional sales.  19 commercial banks. Cash still remains the most popular form of payment. Government payments (including salaries) are made through a combination of cash and checks. Check clearing is undertaken through the Central Clearing House in Kathmandu and through NRB's branches. The clearing system appears to work relatively efficiently with reported clearance times of 24 hours within the Kathmandu Valley and up to a maximum of 3-4 days outside the capital. During 1999, a total of 242,697 checks for NR 129.59 billion (US$1.9 billion) were cleared. Compared to the previous year, the number of checks cleared increased by 11 percent while the amount increased by 24 percent. Auditing and Accounting of the Central Bank's Accounts. The accounts of NRB are audited twice annually, once by internal auditors and once by external auditors. The external audit is published at the beginning of the NRB's Annual Report - as required by law. The external auditors are firms licensed by the Auditor General's office of His Majesty's Governrent and are selected (annually) by the board of directors. The audited accounts are then submitted to the governor and the board of directors as well as the Auditor General's Office. In ache event of "irregular" findings, the Auditor General's office has the right and responsibility to raLise issues in parliament. NRB's account need to be strengthened considerably with a view to bringing them into line with internationally accepted accounting standards. Similarly, it would be worthwhile to review the panel of auditing firms eligible to carry out NRB's audit, to include more internationally reputed auditing firms. Taxation of Financial Institutions. Currently, financial institutions pay 30 percent corporate tax - while non bank financial institutions pay 25 percent corporate tax. With respect to provisioning, 3 percent of total outstanding loans is allowed as a one time tax deduction. In subsequent years, the 3 percent deduction is only allowed on the increase in outstanding loan levels. Economic Statistics. The NRB produces five reports along with the Annual Repolt - which is required by law. These are the Economic Report (annual), the Quarterly Economic Bulletin, the Monthly Report (main economic indicators) and the Monthly Report (economic; scenarios). There is a time lag of around one year for most information in the reports and the publications are typically produced within three months following the reporting date. The NRB also hosts a web- site where it posts, in addition to general information about its organization, the quarterly economic bulletin, economic notes and information on the development banks. 5. Linkages Between the Real and the Financial Sectors The importance of the financial sector is in its role as a provider of essential funding support for the real sectors of the economy. Table 1.8 provides a review of banking sector lending to the real sectors of the economy over the past decade. These tables indicate that the industrial sector has traditionally been the largest recipient of credit from the banking system, followed by the commercial sector. On the other hand, agriculture has only represented a relatively small amount of bank credit - and it has been declining over this period - in contrast to lending to the service sector which has been low, but on an upward trend. In fact, over the period, the service sector has experienced the fastest rate of growth in credit outstanding - growing at over 34 percent per annum over 1990 to 2001. This compares to 26.6 percent for industry; 24.1 percent for commerce; 18.6 percent for agriculture; and 10.1 percent for the miscellaneous "other" category.  20 Table 1.8 (a): Total Credit by Sector 11 (NPR millions) Fiscal Year Total Credits Agricultural Industrial Commercial Services Others2/ 1990 11798.7 1531.6 3817.6 3371.7 293.5 2784.3 1991 14009.0 1850.3 4545.6 4150.0 330.4 3132.7 1992 18797.6 2432.1 5389.3 6801.8 545.1 3629.3 1993 21477.1 3144.2 6621.1 7235.2 735.5 3741.1 1994 29339.1 3395.6 11046.9 9508.1 1271.8 4116.7 1995 40590.3 4923.8 15877.6 13305.7 1697.7 4785.5 1996 52619.8 3972.8 24212.6 17010.3 2674.4 4749.7 1997 60973.7 5599.9 26393.9 20401.0 2927.0 5651.9 1998 71244.2 6095.9 31775.2 23963.9 3439.1 5970.1 1999 84082.5 7868.5 38062.1 27654.9 4240.9 6256.1 2000 99453.8 8863.7 44885.3 32753.3 5713.6 7237.9 2001 112860.7 9999.4 51008.9 36200.2 7603.2 8049.0 Table 1.8 (b): Total Credit by Sector "(distribution - percent) Fiscal Year Total Credits Agricultural Industrial Commercial Services Others2/ 1990 100.0 13.0 32.4 28.6 2.5 23.6 1991 100.0 13.2 32.4 29.6 2.4 22.4 1992 100.0 12.9 28.7 36.2 2.9 19.3 1993 100.0 14.6 30.8 33.7 3.4 17.4 1994 100.0 11.6 37.7 32.4 4.3 14.0 1995 100.0 12.1 39.1 32.8 4.2 11.8 1996 100.0 7.6 46.0 32.3 5.1 9.0 1997 100.0 9.2 43.3 33.5 4.8 9.3 1998 100.0 8.6 44.6 33.6 4.8 8.4 1999 100.0 9.4 45.3 32.9 5.0 7.4 2000 100.0 8.9 45.1 32.9 5.7 7.3 2001 100.0 8.9 45.2 32.1 6.7 7.1 Table 1.8 (c): Total Credit by Sector (annual growth - percent) Fiscal Year Total Credits Agricultural Industrial Commercial Services Others2/ 1990 1991 18.7 20.8 19.1 23.1 12.6 12.5 1992 34.2 31.4 18.6 63.9 65.0 15.9 1993 14.3 29.3 22.9 6.4 34.9 3.1 1994 36.6 8.0 66.8 31.4 72.9 10.0 1995 38.3 45.0 43.7 39.9 33.5 16.2 1996 29.6 -19.3 52.5 27.8 57.5 -0.7 1997 15.9 41.0 9.0 19.9 9.4 19.0 1998 16.8 8.9 20.4 17.5 17.5 5.6 1999 18.0 29.1 19.8 15.4 23.3 4.8 2000 18.3 12.6 17.9 18.4 34.7 15.7 2001 13.5 12.8 13.6 10.5 33.1 11.2 V Loans, advances and overdrafts of commercial banks (excludes foreign bills purchased and discounts). 2/ Includes general use and social purpose. Source: Nepal Rastra Bank  21 6. Issues The Role of the Government in the Financial Sector. One of the main issues in the financial sector is the overwhelming role played by the Government as an owner and operator of financial institutions. Not only does it own the largest commercial bank, and hold the dominant shareholding in the second largest commercial bank, but it also owns shares in virtually every other commercial bank. In addition, it owns the two development banks (ADB/N and NIDC), insurance companies, regional rural cooperative banks, and is heavily involved in micro finance institutions. As in most developing countries, Government ownership has resulted in poor internal governance, weak management, fragile financial health, and an unhealthy politicization of these institutions. There is an urgent need for the Government to divest its ownerslhip in most of these banks and financial institutions - through either privatization or liquidation - and to replace the role which is overwhelming played by the public sector by "fit and proper" private sector owners and operators. At the same time that the Government has played a dominant role as an owner and operator it has failed to play an adequate role as supervisor and regulator of the financial system. Consequently, weak institutions have been permitted to conduct business without adequate government or central bank oversight and sanction - and have continued to deteriorate over time. Many institutions are characterized by a weak capital base, high levels of non-performing loans, poor internal governance, and allegations of corruption and inadequate management. Hence, there is a critical need for the Government to realign its role within the financial system away from being an owner and operator of banks to being a supervisor and regulator of financial sector activity. In doing so, however, it will need to take care that it does not replace its role as art inefficient owner/operator of the state banks with that of an overly bureaucratic supervisor, thereby replacing one form of excessive public sector influence with another. The Role of Nepal Rastra Bank. The NRB has only been partially successful in developing its core central banking functions. However, its development has been severely compromised by the inherent conflict of interest that has arisen between its role as an owner and as a regulator of the banking system. In addition, until the new central banking act was enacted, the NRB had no statutory independence from the Ministry of Finance, and was generally perceived as not having sufficient autonomy to properly perform its role, particularly with respect to the large, inefficient publicly owned banks. Also, the banking supervision system did not provide legal protection for supervisors, nor operational independence and adequate resources while on the other hand, the rapid growth in the number of financial institutions (and their technological advancement) has stretched the NRB's existing supervisory capacity. A number of additional areas need to be strengthened (after the legal reform) - including a restructuring of the bank, reform of its human resource function, and the introduction of improved incentive mechanisms. Such an exercise must include, but not be limited to, total divestment of all shareholdings in other financial institutions, withdrawal from the boards of all financial institutions, and the removal of development banking functions from NRB. A Weak/Fragmented Legal Financial Environment. The existing legal framework is insufficiently robust to support the sort of financial sector that the government would like to see in Nepal. Nepal has a proliferation of both laws and regulations that are institution, rather than function, specific. This has resulted in a fragmented legal environment that has not been conducive to competition. In addition operating incentives are seriously distorted by government priorities such as access to credit in rural areas or concerns over the competitiveness of the local banks vis a vis foreign financial institutions. In particular, the mandatory requirement for "priority" and "deprived" sector lending by the commercial banks targeted at farmers and small  22 borrowers needs to be addressed. In addition, there is also an issue of commercial banks being required to open branches in rural areas (with a stipulated ratio of one rural branch - or two branches in semi urban areas - for every urban branch). The imposition of such directives increases costs for commercial banks while their benefits, particularly to the rural population, are questionable. Social Dimensions of Banking. Given the large numbers of people living below the poverty line in Nepal, it is not surprising that the social dimensions of banking have been strongly emphasized. However, some of the current policies employed to achieve these objectives (directed credit, branch opening policies, and so on) are too broad and cause considerable. operational disincentives within the financial system while their impact has been minimal. There is clearly a need to revisit these policies to sharpen their focus so that any negative effects can be minimized while their impact on the poor and rural communities are maximized. Alongside these changes, there is also a need to reform the delivery mechanisms for development finance - utilizing and working with private partners wherever possible. Moreover, even if the government does decide to continue to be directly engaged in development banking in a limited fashion - it is important that the central bank withdraw from direct participation, given its supervisory role in the sector. A Lack of Competition. A key objective of reforms in the state owned banks, and the financial system more generally, should be to reduce fragmentation and increase efficient intermediation by financial institutions through increased competition. Market oriented approaches need to be developed to enhance competitive pressures rather than mandated efforts such as those developed with respect to controls on interest rate spreads. A Weak Accounting and Auditing Environment. The lack of a proper accounting and auditing environment - both in the financial and corporate sectors - is one reason why the problems facing the Nepalese authorities are so severe. A lack of timely and robust information, in the absence of strong enforcement, creates an ideal setting for the development of poor banking practices. Moreover, in such an environment, lending decisions become difficult for banks as they cannot be based upon good financial information. Thus a significantly strengthened accounting and auditing framework is essential for Nepal's financial system to operate in a prudentially sound and efficient manner. Human Resource Development. An important element in the strengthening of Nepal Rastra Bank is the successful reengineering of its human resource function. Human resource policies need to be revised to ensure professional development and the retention of quality staff. Such a change will have to include significant increases in allowances and benefits essential to attract and retain quality individuals. However, such a decompression of the (seriously) compressed salary structure will need to be preceded by a substantial exercise to shed large numbers of excess staff currently employed by NRB. Such an exercise will probably require donor support and will need to be carried out on a voluntary basis to ensure union "buy-in". Finally, new human resource policies will need to be implemented which focus on merit based advancement through the institution - and a move away from the current system of "time in grade" advancement. It is only with a radical chance in HR policies, the implementation of a Voluntary Retirement Scheme (VRS), and a decompression of the salary structure, that NRB can expect to become a fully professional institution. Other Important Issues. In addition, and in conjunction with the reforms envisaged above, it.is important to improve the functioning of the Credit Information Bureau to provide more comprehensive and easily available information about.borrowers in Nepal; the Banker's Training  23 Institute to provide for better training for participants in the financial sector; and the Banker's Association. Lastly, there is also a need to strengthen financial journalism in Nepal so that the general public is provided with better, more up-to-date, and insightful infonrnation on developments within the sector. 7. Recommendations Nepal's financial sector and its problems have been the topic of numerous discussions between the government, the donor community, (most particularly, the IMF, Asian Developmnent Bank, World Bank, DflD) and private organizations. In recognition of the fact that much needs to be done towards the establishment of an effective financial sector and to consolidate the progress already made during the 1990s, Nepal Rastra Bank issued a Financial Sector Strategy Statement (FSSS) in 2000 (see Annex Two) - laying out its vision for the future of the sector. The Financial Sector Strategy Statement provides a blue print for reform and has clearly identified the following priority areas to be addressed: * Implement restructuring plans for the financially-troubled large banks. * Strengthen the legal and regulatory framework covering the financial sector. * Strengthen NRB and its supervisory function. * Improve regulation of non-bank deposit taking institutions. * Strengthen the legislative and institutional framework for loan recovery. This has been a positive development and one that is necessary for reviving the health of the financial sector. Of great importance to this effort will be the further elaboration - in terms of concrete steps (including a timeframe) - for the implementation of this strategy. The following recommendations further complement the FSSS by pinpointing particular areas that should be addressed as part of the reform effort: (a) Remove direct participation by Nepal Rastra Bank - and the Government -- from the financial sector. (b) NRB should also rapidly move to shed its development banking functions. (c) Privatization of the banks, occasioned by a withdrawal of the government and NRB from these institutions, should be carried out with the twin objectives of attracting strategic investors who will strengthen the institutions and increasing competition in the financial sector. (d) Where appropriate, liquidation of bankrupt state-owned banks should also be seriously considered - particularly where successful restructuring appears to be unlikely. (e) Strengthen the financial legal framework to create less fragmentation, and enhance transparency in the sector. (f) Undertake a human resource reengineering exercise within NRB - including the implementation of a VRS, complete revision of existing HR policies, and a de-  24 compression of the salary structure - to encourage the development of professionalism within the bank. (g) Replace the support of rural and micro-credit schemes using directed credit and other mandatory requirements imposed on commercial banks with more targeted and market oriented measures. (h) Remove restrictions on foreign ownership of commercial banks to encourage the greater transfer of technology and to create enhanced competition. (i) Establish a second tier supervisory body for micro-finance activities. (j) Introduce internationally acceptable accounting and auditing standards. (k) Improve the functioning of the Credit Information Bureau to provide more accurate borrower information for financial sector participants. (I) Close cooperation and collaboration with the main donors will be critical in ensuring that the reforms, based on the NRB's Financial Sector Strategy Statement, issued in 2000, are successfully implemented.  25 CHAPTER TWO Legal Financial Environment 1. Introduction The legal system of Nepal has undergone significant change in recent years. Although the common law foundation remains, unlike other common law countries, it does not have a comprehensive set of laws or legal mechanism for the effective functioning of the corporate sector. In addition, the largely ineffectual Indian models have heavily influenced its legislation. The Government, supported by the donor community, has been introducing new legislation to fill the vacuum - and the process is ongoing. The Nepal banking sector consists of commercial banks, finance companies, merchant banks, and development banks, cooperatives and non-governmental organizations (NGOs) that have been licensed to undertake banking business. The Commercial Bank Act 1974 (CBA) governs the banks, the Finance Companies Act 1985 (FCA) governs the finance companies and merchant banks, the Development Bank Act 1996 (DBA) governs development banks, and the Financial Intermediary Act 1998 (FIA) governs the NGOs. The Nepal Rastra Bank (NRB) is the licensing and supervisory authority under these laws and it was, in turn governed by the Nepal Rastra Bank Act 1955 - until January 2002 when a new, modern Act was promulgated. Apart from these laws related to the banking sector, the Insurance Act of 1992 and the Stock Exchange regulations also govern the financial sector. 2. Nepal Rastra Bank Act 1955 This 45-year-old law that had been amended intermittently over the years, was revamped and replaced with a new law in 2002. The previous law was essentially designed for a central bank in a government-controlled economy with a bank supervisor to supervise government-owned banks. Hence the structure, architecture and legislative framework of the NRB Act was ill-suited for a complex and modern central bank and banking system. It did not bestow sufficient powers for effective management of monetary policy, improving financial infrastructure, strengthening and improving financial markets and their supervision, and facilitating the growth of the financial sector. The major deficiencies addressed by the new law are outlined below. Objectives and payment system. The previous law did not state the objectives of the bank. Generally, objectives should be unequivocally stated and prioritized in the law as it helps to monitor the performance of the central bank. In addition, since there is an intimate relationship between the efficiency and soundness of the payment system and soundness of the banking system, an explicit provision in the law empowering NRB to regulate the payment and settlement system was also needed. The new law addresses both these issues. Autonomy. Under the previous law, NRB was not autonomous legally or operationally. His Majesty's Government could issue directives with which NRB had to comply as long as it was considered to be in the national interest. In addition, the Governor, Deputy Governors and Board Members could be retired by the Government if circumstances warrant. The Government also had absolute power to suspend the Board of NRB if it was of the opinion that NRB was unable to carry out its functions. The new law provides for an autonomous central bank answerable to Parliament and the members of the Board are appointed by the Government upon the recommendation of a specially constituted committee. Removal of Board members has to follow  26 due process and the new law also provides for a mechanism for coordination between the government and the central bank. Governance. The previous law did not provide for rules for declaration of interest and avoidance of conflict of interest by Board members and bank employees. There was also no proper disclosure, transparency and consistency requirements in the activities of the central bank. The law was also silent on the decision making process at the Governor level. The new law states clearly the rules on conflict, the powers and duties of the Board and governor, the establishment of a management committee and an independent audit committee appointed by the Board and answerable to the Board. Lending to Government This is an important issue that determines the ability of the central bank to ensure domestic price stability and the old law placed no control over the lending amount and the duration within which such loans must be repaid. Section 75 of the new law caps the lending to secured lending of 10 percent and for a duration of 180 days. This is an important improvement over the old law. Regulation of Financial Institutions. The underlying rationale for the old law to regulate the financial system in Nepal was unclear. Various institutions were brought under the purview of the law without a clear delineation of the types of power that can be exercised over them. The new law provides clearer powers to NRB to license, regulate and supervise banks and other similar deposit taking institutions. Powers to supervise and specific powers to deal effectively with troubled bank has also been provided under the new law to address the inadequacy in the existing Commercial Banking Act of 1974. Regulatory Burden of NRB. Notwithstanding the new law, NRB is overburdened with regulatory authority under various laws - banks, finance companies, merchant banks, deposit- taking cooperatives, development banks, regional development banks, financial intermediaries, deposit-taking NGOs, and money changers, despite its limited ability to effectively supervise even the commercial banking component of the financial system. Hopefully this will be rationalized when the new banking law is promulgated. Furthermore, since NRB has limited resources, the regulation of micro-finance institutions needs to be brought within another regime of supervision. This is justified as micro finance has only a very small share of the financial system and has limited real impact on the soundness and safety of the banking system. Lending to specified sectors. The new law, in section 81 empowers NRB to issue directives to commercial banks and financial institutions to provide credit to sectors prescribed by NRB. Though this may not be ideal for a competitive banking sector, it not as damaging as directed lending. Lender of Last Resort. Section 23 of the old NRB Act was too broad as it empowered NRB to grant loans and advances to banks, finance companies and other financial institutions liberally and without collateral. The current law does not contain specific provisions on the power of NRB to act as lender of last resort. However, section 86 of the new law grants general power to NRB to take actions that are deemed necessary in the case of a troubled bank. Exchange Policy, International Reserves and Foreign Exchange Operations. The old Act was not clear on these aspects of the law. The new law specifies the role of the central bank and that of the Government in foreign exchange policy, e.g., who decides on the country's exchange regime, who determines the exchange rate, and who is responsible for foreign exchange operations and reserves management.  27 Developmental Role of the Central Bank. Although central banks in developing countries are repositories of expertise and finance and are relied on to carry-out many of the govemment's economic development aspirations, these must be limited to the development of the financial sector. The mandate and powers given to the NRB under the old law diffused the focus of the bank - which should be price stability and maintaining a sound financial system. The new law paves the path for the govemment to be weaned off this dependence. Deposit Liability. The old Act also permitted bailouts of financial institutions and amounted to explicit government guarantees to depositor funds. The new law has rectified this. However, it does not address the guarantee under the Financial Intermediary Act. NRB is still required to assume the deposit liabilities of those institutions under the Financial Intermediary Act. This provision requires further review. Accounts and Audit. Chapter 10 of the new law states the requirements for a proper accounting system within the NRB, the use of intemational accounting standards, the auditing of aLccounts by extemal auditors in addition to govemment auditor, and the submission of the annual report to the Govemment. Overall Comment. The new law provides a comprehensive framework for a modem and progressive central bank law. It has also addressed most of the deficiencies in the old law. The framework is empowering, forward looking and will certainly help to strengthen NRB and improve its ability to become an effective central bank and bank supervisor. 3. Commercial Banking Act 1974 The banking sector is currently beset with numerous problems, caused in large measure by the unhealthy and ubiquitous presence of the Govemment in almost every sphere of financial sector activity. Instead of providing oversight and regulatory control, the Govemment plays an active role as owner and participant in the sector. This in turn impedes Nepal Rastra Bank's ability to properly discharge its supervisory role. In addition, the existing limitations on foreign ownership of banks has not attracted foreign banks, particularly "good name" banks, that could have fostered technology and know-how transfers beneficial to the sector. Banks are generally poorly managed due to weak governance and lack of enforcernent. The system also suffers from cross ownership of financial institutions without proper regulatory control, lack of transparency and disclosure requirements, weak corporate governance, poor accounting and auditing standards, weak central bank supervision, and a problematic debt recovery system. These problems have been compounded by large gaps in the existing Commercial Bank Act (1974). Details of the major weaknesses are listed below. Poor Definition. There is insufficient precision in the definition of a bank within the CBA. A clear definition of a bank, as an entity engaged in the business of accepting deposits from the public and using such funds either to make extensions of credit or investments, needs to be included. Further, the law needs to differentiate the supervision and regulation of banks and similar institutions, from other depository institutions. There is also a lack of clearly defined criteria for applications for licensing, branching, capital increases, or mergers. Excessive interference by the NRB and govemment is provided for in bank management prerogatives regarding branching, collateral, interest rates, and subsidiaries, causing inordinate delays in approvals and inconsistent decisions.  28 Prompt Corrective Action and Remedial Powers. NRB also has insufficient powers to undertake appropriate measures necessary to address infractions of laws or regulations. The law only provides for the cancellation of a banking license - which is a protracted and ineffective means of taking corrective action or imposing sanctions on errant banks. There are also inadequate provisions for addressing bank insolvency in the law. Gradual enforcement provisions in the law are needed to address regulatory violations, apart from strengthening NRB's ability to take enforcement actions in a timely manner. In addition, provisions for dealing with depository institutions with insolvency problems, including procedures for dissolving such institutions, must be included in the law. Governance. The provisions related to governance of banks and other depository institutions with respect to NRB intervention in bank management, NRB approval of directors, credit documentation requirements, and risk management is not comprehensive in the law. Auditing requirements in the law need to be reinforced with comprehensive provisions. The existing legal framework for institutions that are not licensed as banks but still take deposits from the public also needs to be replaced. The law needs to stipulate that banks maintain their accounts in accordance with International Accounting Standards and be audited by independent external auditors. Ownership/Mergers/Deposit Protection. Cross ownership of banks and cross directorships should be expressly prohibited in the law to avoid monopoly and misrepresentation of capital. A progressive banking law also needs to have, inter-alia, a mechanism for the reconstruction, amalgamation and takeover of banks that is expedient and cost effective. These provisions should include a short cut for take-over through court sanction and vesting order that circumvents administrative procedures and costs without compromising the interests of concerned parties. Such powers have been effectively used in other countries with a similar legal tradition and have proved to be an effective tool, especially in dealing with the restructuring of banks. Another area of concern is the safety net and depositor protection. In the absence of a deposit insurance scheme and the absence of specific provisions on speedy winding-up of banks, it may be appropriate for the law to grant priority - in the event of a liquidation - to household deposits. Enforcement. A serious issue for the banking system is the lack of compliance by the two largest, majority government owned banks, Rastriya Banijya Bank (RBB) and Nepal Bank Limited. The NRB has been unable to effectively sanction the banks or take appropriate remedial action. The relative power of the government banks, their excessive politicization, the relationship between the central bank and the Ministry of Finance, and the weakness of the supervisory function within NRB, all impede NRB from taking action to resolve the problems in these banks. In addition, the 1974 Commercial Banking Act is outdated and does not provide an effective legislative framework for proper regulation and supervision of the banking system. The new Nepal Rastra Bank will be a major improvement on the current situation. New Law. Prudential supervision in Nepal has not been effective under the existing legal regime, and will not be effective under the current system where a number of depository institutions are operating. There is clearly a need for new legislation aimed at strengthening the banking system. The new law should encourage and enhance competition in the financial sector by reducing restrictions on activities or mergers between different types of financial institutions. It should also limit the regulatory and supervisory burden of NRB to systemically important institutions based on their link to the payments system (banks) or size (other depositories). The new law should also seek to strengthen corporate governance and discipline by the market - the two other means by which depository institutions can be encouraged to maintain their solvency, liquidity and profitability. A new draft Banking and Financial Institutions Act, drafted by Nepal  29 Rastra Bank with assistance from the IMF and IDA, is currently ready to go before Parliament for its consideration. Tiered Regulation. Banks and other significant depositories should be subject to comprehensive supervision and regulation in accordance with international best practices. Less significant depositories, however, should be subject to less comprehensive supervision and regulation i.e., licensing; stringent governance requirements; general prudential requirements; international accounting standards; publication of quarterly balance sheets and income statements; external audit; requirement to issue debt securities for market discipline; and a range of sanctions. Less significant depository institutions should not be required to obtain prior approval for mergers and acquisitions (unless with banks) or to have special risk management committees. Neithier should they be required to maintain specific balance sheet ratios (other than for capital and credit), to submit monthly returns, or be subject to prompt corrective action procedures narrowly defined. They should also not be subject to special trusteeship procedures in the Act for insolvency. The new draft banking and financial institution law should ensure that these important concerns are appropriately and adequately addressed. 4. Development Banks The Development Bank Act of 1996 provides for the establishment of financial institutions that have the mandate to operate in a more relaxed financial framework than the commercial banks. The banking functions of these development banks are limited to specific types of development activity to be undertaken in specified regions. The Rural Development Banks are registered under this act - which provides for regulation by NRB. It is an interesting anomaly, however, that the two largest development banks - NIDC and ADBN - are not subject to this laEw and are governed by the statutes under which they were incorporated. Consequently, in reality, these two banks are carrying on banking business without being subject to either the Developrnent Bank Act or the Commercial Banking Law. It is imperative that the regulatory arbitrage being enjoyed by these two institutions be removed and they be brought under the purview of the Commercial Banking Act as they are carrying out commercial banking activities. 5. Micro-Finance and Deposit-Taking NGOs There are no specific regulations that apply to MFIs in Nepal and, until recently, there was no single act that was pertinent to micro-finance. Instead, one or more Acts govern all institutions that are engaged in micro-finance in Nepal. Cooperatives operate under the Cooperative Act 1959 while some are licensed by the NRB for deposit taking under the NRB Act. NGOs operate under the Society Registration Act 1978, the Social Welfare Act 1991 and a few are licensed for deposit taking under the NRB Act. The degree of regulation for licensed non-bank MFIs is much lower than for banks. Since NGOs have no share capital they face no capital adequacy requirements but are directed by the NRB to limit their loans to less than NR 100,000 (IUS$1,440) per individual. They are also required to build a reserve fund through an allocation of l0 per cent of their operating profit, as a provision for loan loss. Licensed cooperatives have a minimum capital requirement for opening branches. In common with banks, they must maintain a capital adequacy ratio of 8 per cent of risk-weighted average assets. No liquidity requirements have been fixed by the NRB for NGOs involved in micro-finance. However, licensed cooperatives, such as finance companies, are nominally not allowed to collect deposits exceeding ten times their share capital. Loan Classification Reporting Requirements. While licensed NGOs are required to create a reserve fund for loan losses consisting of 10 per cent of their profits, cooperatives have more  30 stringent loan classification and provisioning norms than even the commercial banks. NGOs and cooperatives licensed by the NRB to accept deposits and carry out limited banking activity are all obliged to submit data on their financial operations to NRB. Through instructions issued from time to time, NRB requests institutions engaged in micro-finance to submit details on loan terms and conditions, interest rates, deposit terms, balance sheet and profit and loss statements, portfolio and outreach, and loan repayment and arrears. Auditing, Supervision and Rating. NRB also certifies auditors who audit the accounts of licensed cooperatives and specifies those who may audit NGOs. However, supervision of licensed MFIs by the Inspection and Supervision Department of NRB remains random and perfunctory at best. At worst, it is so lax as to be virtually non-existent. In this situation, the licensing of the MFIs becomes a precaution for the more responsible NGOs and a means of deluding the general public in the case of some of the cooperatives. The latter use this as a device to mobilize deposits. NRB's Role. With its over-stretched capacity the NRB would do well to focus on the effective prudential regulation and supervision of banks and finance companies and lay down only general prudential guidelines for micro finance institutions. Performance standards, rating and other initiatives to introduce 'best practices' and supervision ought to be left to professional organizations and possibly a second tier supervisory institution. 6. The Financial Intermediary Act 1998 The Financial Intermediary Societies Act, 1998 (FIA) provides for all NGOs engaged in micro- credit to be registered with and regulated by the NRB. Rastra Bank has the power to demand information, data or other documents that it considers necessary as part of its monitoring role. It also provides for "the final obligation to meet such financial liability relating to the financial inter-mediation of the Society as cannot be met from the Society's assets [to] vest in the Bank." At the same time, the Act is silent on the issue of deposit taking/savings mobilization from members or non-members by such societies. This has been interpreted by the NRB's legal department as a ban on deposit taking by all societies registered under the Act. Thus, the FIA has not really been a tool for facilitating micro-finance. Salient Issues. Under this Act, the NRB is empowered to issue, cancel and renew licenses, and recover its on-lent loans when NGOs are closed down. This Act prescribes accounting practices for licensed organizations and requires them to create a risk-bearing fund as a provision for possible loan losses. Another provision of this Act gives NRB the power to prescribe the level of administrative expenses to be incurred. The NRB also retains powers to issue directives to protect the interests of the ultimate borrowers if it finds, during investigation, that the licensed organization has taken some action that adversely impacts its borrowers or is misappropriating funds. NRB's Role. It is clear that NRB has been called upon to play an important role in the promotion of micro-finance and the development of systems for regulating and monitoring institutions in the micro-finance sector. However, considerable efforts and resources are required to implement the provisions of the Act - resources that the NRB does not have. Consequently, it is unable to discharge these responsibilities properly. Moreover, there are flaws in the Financial Intermediary Societies Act, 1998 that urgently need to be corrected. Only when these are appropriately addressed will there be the envisaged legal basis for the orderly conduct of micro-finance business in Nepal.  31 7. Company Law It is well established that an adequate legal foundation is necessary to provide the essential underpinning to the development of the financial, commercial and industrial sectors. Without such an underpinning the development of a market economy is severely prejudiced. There is a general consensus amongst Nepali stakeholders and a number of international consultants, that the present Companies Act of Nepal ("the Companies Act") falls short of what is required for an effective regulatory regime. The Act suffers from a number of serious shortcomings, both in terms of what is contained in the Act and what is omitted. Governance. The Companies Act is critically deficient in the area of corporate governance including, the separation of ownership (shareholders) and control (management board) in relation to a company and the protection of shareholder rights. In addition, the equitable treatment of all shareholders and the recognition of the rights of shareholders are absent. In addition, the board's accountability to the company and to shareholders and the requirement for the provision of timely and accurate information on all matters regarding the company is deficient. Directors' Duties. Directors' basic duties - namely their fiduciary duties (i.e. to act honestly and in good faith and in the best interests of their company), and duties of skill and care -- need to be expressly covered in the Companies Act. Apart from that, specific provisions including declaration of interest in contracts, restraints on directors' remuneration, approval and/or disclosure of substantial property transactions, disclosure of holdings and dealings by directors, loans to directors, etc. need to be clearly defined to help regulate potential areas of abu,se. Accounting Standards. Nepal needs to promulgate accounting and auditing requirements based on International Accounting Standards and International Auditing Standards. The Cornpanies Act should then require companies to prepare their accounts in conformity with the prescribed accounting standards. Insider Dealing. Insider dealing is a serious but common form of market abuse in Nepal. The Companies Act does not cover insider dealing, as such, and only deals with it indirectly through a prohibition against directors and other related individuals dealing in their company's shares. This provision is defective, and does not grasp the fundamentals of insider dealing. The Securities Exchange Act attempts to deal with insider dealing but its provisions in this context are also unsatisfactory and ineffective. There is however a new draft Securities Act (developed under the auspices of the ADB) which contains satisfactory provisions to counter insider dealing. If this draft proceeds through to enactment, then the matter will be adequately covered; if however it does not, appropriate provision to counter insider dealing should be incorporated into a revised Companies Act. Submission of Information. The Companies Act makes no provision for the use c,f electronic information technology either by companies or by the Registrar. In accordance with modrem business practice, the Registrar and companies should be permitted to maintain their records in electronic or other non-documentary form, provided that a legible copy can be produced when required. Foreign Companies with a place of business in Nepal (as opposed to companies mierely doing business in Nepal) should be required to register with the Registrar the name and address of a person in Nepal who is authorized to accept service on behalf of the company.  32 Major Policy Issues. The Companies Act (the Registrar) and the Securities Exchange Act (SEBO) both presently regulate prospectuses for the public issue of securities. This overlapping jurisdiction involves unnecessary expense and delay. The approval of prospectuses should fall within the exclusive domain of SEBO, but with a requirement on the issuer to file a copy of the SEBO approved prospectus with the Registrar of Companies - for public access. Disclosure Requirements. The compulsory preparation of annual audited accounts by a company, and their submission to shareholders, is a fundamental shareholder right. The Act should make clear, however, that the role of the Registrar with regard to their filing with the OCR is purely administrative and does not in any way imply "approval" by the Registrar. It is crucial that all companies (not just listed companies) be subject to a general disclosure obligation requiring them to inform shareholders of any major new developments. This includes any activity that is not public knowledge but whose information is necessary to enable shareholders to appraise their financial position, or which may materially affect the value of their securities. Similarly all major transactions, and inter-company transactions other than in the ordinary course of business, should be compulsorily disclosed to shareholders. The Company Board. The company board is currently tasked by the Companies Act with two disparate functions - an advisory function AND a function of hearing and determining minor offences. It is recommended that the Company Board should be confined to playing an advisory role - or alternatively be completely abolished. Registrar/Enforcement The office of Registrar is tasked with a very disparate group of functions (approval, registration, liquidation and enforcement) by the Companies Act. It is not, however, charged with the administration or enforcement of the Act. The powers of the Registrar under the Companies Act are reasonably comprehensive and adequate. Thus, the failure of the Office of the Registrar lies not in the inadequacy of its powers, but in its inability or unwillingness to enforce them. It is imperative that a revamped and professional Office of the Registrar be made statutorily responsible for the administration and enforcement of a revised and strengthened Companies Act. The Registrar's powers also need to be enhanced by the creation of automatic fixed civil penalties. He/she (or shareholder or creditor) should have the power to apply to the court for an order directing a company and its representatives to make good any default (and condemning them in costs). This needs to be coupled with a power for the court to disqualify a director in an appropriate case. The ADB is currently providing technical assistance to redraft the Companies Act and it is desirable that the issues discussed here should be addressed in this re-drafting exercise. 8. Insolvency and Liquidation An efficient insolvency law, along with efficient debt collection and security enforcement laws, helps to reinforce the responsible financial management of a corporation. If a corporation is in financial difficulty, the directors should be forced to take positive steps to deal with the problem or else suffer the consequence of action by creditors to enforce payment, to enforce securities or to liquidate the company. Both domestic and foreign investment is encouraged by the existence of an adequate corporate insolvency law regime. Lenders and investors need certainty and predictability and a good insolvency regime goes a long way in providing this. Thus, an adequate law for dealing with an insolvent corporation is important. Insolvent corporations should not be permitted to continue to trade without supervision, since it is highly likely that debts will increase or assets will be reduced. In either case, creditors of the corporation will be prejudiced. Furthermore, if there is inadequate or no laws to deal with insolvent corporations, corporate laws and regulations will lose their credibility and become ineffectual. In addition, the important goal  33 of proper corporate governance will be eroded if the management of an insolvent corporation is not required to take a responsible attitude toward the payment of corporate debts. Current Insolvency Regime. The existing insolvency law is inadequate to deal with the insolvency of such corporate business enterprises. There is neither comprehensive rules nor adequate skills in the office of the Registrar of Companies to effectively deal with insolvency. There is also a clear need for a more adequate law in Nepal to cover personal or individual insolvency. The existing law in that regard, which is part of the Legal Code (or Muluki Ain), is out of date, inefficient and largely ineffective (there have been very few instances of the employment of this law). There is a proposal that liquidation be covered in a new discrete Insolvency Act, or in a redrafted Chapter 10 of the Companies Act. It is crucial that all forms of corporate liquidation, whether compulsory or voluntary, be covered in the same legislation. In this regard, it is noteworthy that bank insolvency is being addressed in the new Banking and Financial Institutions Law. 9. Securities Regulation The stock market that was established with the help of IRIS in 1994 is far from dynamic. Some of the major problems experienced by the securities markets include a lack of timely and transparent financial reporting and non performance of due diligence requirements prior to issuance of new listings. This is a direct result of, amongst other things, poor regulatory and supervisory control by the Securities Board and the Nepal Stock Exchange (SEBO). There have been frequent cases of infractions of rules going unpunished. Other issues, such as problems with insider trading and manipulation of markets, arise due to a lack of an effective law prohibiting such abuses, and due to ineffective enforcement of existing laws. A notable example of such weakness in the current law is the penalty of forfeiture of shares for traders who unfairly exploit their positions. This is an insufficient deterrent. Another serious deficiency in the capiital market is the complete absence of legal provisions regulating corporate commercial paper and municipal bonds. Much needs to be done to support the growth of the capital market - including, most fundamentally, the development of a more effective and comprehensive set of laws. 10. Debt Recovery Debt recovery is presently neither effective nor expedient. The court system suffers from inordinate delays and enforcement of judgment is a serious problem for banks in the process of recovery. To address this, the NRB has proposed the establishment of a debt recovery tribunal through a Debt Recovery Act, that is expected to speed up recovery of the debts owed to banks. The draft law has been modeled along the Debt Recovery Act 1993 of India, which is more substantive than the Nepal version and which has undergone significant change since 1993. The proposed law purports to establish a parallel court system to handle the debt recovery cases of financial institutions. The rationale for the new law is not entirely clear as, according to the banks, Section 47A of the Bank Companies Act 1993 has been effective in dealing with debt recovery. Section 47A, however, is not applicable to cases where collateral is not involved. Section 47A. The Commercial Bank Act confers considerable power and privilege to a commercial bank regarding enforcement of a security. A commercial bank is afforded a power of 'self help' enforcement. Upon default by a customer in the repayment of a loan, the bank can sell any secured property and the bank does not have to obtain a court order. Further, in relation to secured property to which a registration and transfer recording system applies (for example, land), the legislation affords the bank the power to inform the appropriate office of a sale and such office is then required to record the transfer and consequent change in the registration  34 particulars. If a commercial bank is not able to sell the secured property it may require the relevant registration office to record a transfer of the property to the bank. Similar provisions are contained in the Finance Companies Act, 1986 and in the Development Bank Act, 1996. Comment. As of now, the proposed new law would only serve the narrow category of debt recovery cases where there is no collateral. However, experiences show that a debt recovery tribunal law can definitely assist in expediting recovery, provided the procedures in the law are simple and there is sufficient funding. To complement such efforts, judges and lawyers should be trained in the new law and appropriate infrastructure - buildings, equipment, personnel and enforcement mechanisms - must be established. A more viable alternative, however, would be to create a banking bench (after providing necessary training to selected judges) in the High Court to deal exclusively with debt recovery cases related to banks. In addition, measures need to be taken to introduce arbitration and alternate dispute resolution mechanisms in Nepal, thus expanding the range of legal avenues for banks to recover loans and resolve banking disputes. 11. Secured Transactions A properly constructed secured transaction regime that makes available property as security or collateral for credit is vital for economic development. It provides for a relatively 'safe' form of financing. In doing so it will help increase the availability of credit to a wider range of individuals and generally make more finance available. It will also lessen the cost (interest charges) of finance, and improve the conditions under which finance will be made available (for example, the length of a loan, conditions of default and so forth). Registration/Notice System in NepaL There is no system for the registration of movable property as security in Nepal. This is probably because of the almost total dependence on the possessory form of security. Registration of such a security is of little consequence since the fact of possession of the property by the creditor usually provides the needed protection. A non-bank lender who holds security is required to obtain a court order for the sale of the security and to conduct a sale of the property through the agencies of the state. This is an inefficient, time consuming and costly process. Another relevant issue concerns differences in the enforcement of a possessory and a non- possessory security and how a modern secured transactions regime might lessen those differences. The possessory type of security provides the creditor with possession of the secured property and, thus, facilitates the enforcement of the security. The creditor does not have to take steps or action to obtain possession of the property when enforcement commences. In contrast, the enforcement of a non-possessory security requires that the creditor obtain possession of the security property as a first step toward its sale. That can be difficult. A modem secured transactions legal regime can, however, assist in overcoming these difficulties. A final aspect of enforcement concerns protection of the debtor. Enforcement is a powerful remedy and a debtor requires some protection against possible abuse of the process. A balanced enforcement regime would require that notice of enforcement be given to a debtor and that any sale of the secured property be conducted in such a way as to ensure that a fair market price is obtained for the property. An efficient, but fair and balanced, enforcement regime should be the third aim of a secured transactions legal regime in Nepal. Current Developments. With the technical assistance of ADB, the government is taking necessary steps to introduce a comprehensive secured transactions legal regime.  35 12. General Implementation and Enforcement There is also a real need for the regulator of the banks, the insurance industry, the capital market and others to strictly apply and enforce the laws. In the absence of proper application and enforcement, laws serve a limited role in the regulation of a market. Hence, transparent and consistent application of the laws and regulations, observance of the procedures laid out in the law, exercise of discretion within the powers of the law, and vigilant monitoring and enforcement of the laws are important for inculcating a regulatory discipline into the market. This discipline will, in the long run, pave the way toward self-regulation. Given the administrative and institutional difficulties in imposing sanctions and prosecuting serious offenders, the concept of compounding offences can be introduced in the laws with sufficient procedures and safeguards. This alternative method has helped other countries in enforcing the law and meting out appropriate sanctions for non-compliance expediently and effectively. 13. Recommendations A strong legal framework is the most important foundation for development of a healthy financial sector but its main strength lies in its enforcement. Nepal needs to clearly establish the business that can be conducted by the various financial institutions, demarcate clearly the authority of regulators, and the jurisdiction of the laws - to avoid duplication and vacuum in the financial sector regulatory framework. It must also improve the adequacy of bank exit frameworks and policies and the institutional/legal framework for corporate bankruptcy, corporate restructuring, loan recovery, corporate governance incentives and practices, court systems and procedures and other general factors affecting access to credit. Regulators must be given sufficient legal and operational autonomy so that they can perform their roles well. Policy certainty and vigilant implementation and enforcement of transparent rules are essential to the statbility and development of the financial sector. The following are the main recommendations of this chapter: (a) The various acts under formulation need to be enacted as soon as possible, addressing the issues raised above. They then need to be followed up with proper enforcement. (b) NRB needs to develop a tiered regulation system in line with international best practices. (c) All development banks must be brought under the purview of the new Banking and Financial Institutions Act. (d) The Financial Intermediary Societies Act, 1998, should be amended to address the existing flaws that have made it ineffective. (e) The current insolvency laws need to be strengthened in dealing with both non-corporate bodies and individuals. (f) As the financial reform process moves forward, and the legal/judicial system starts to deal with a large case load of defaulting borrowers within the banking system - the court system will almost certainly emerge as a significant bottleneck. Hence, a bankcing bench should be established in the high court to deal exclusively with debt recovery cases related to banks. (g) Arbitration and alternative dispute resolution mechanisms, to increase legal avenues for loan recovery and banking disputes, should be expanded.  36 1 (h) There is a need for improvement in the enforcement of laws. The concept of compounding offences could be considered for improving enforcement.  37 CHAPTER THREE Baniking Supervision 1. Introduction Underdevelopment of the financial sector infrastructure, along with excessive government intervention, has not supported the creation of a credible supervisory function in Nepal. External analysis based on international standards has confirmed that the two largest banks, Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), are technically bankrupt, clearly demonstrating the need for improved financial sector - and particularly bank - supervision. For many years, the Nepalese Authorities have used the banking system as a major conduit for administering their development strategy. Although the market has been opened to foreign banks, this government policy has been essentially maintained, leading to the development of a largely inefficient banking industry. Currently, the banking sector is characterized by a broad range of institutions, scattered across the country, and a high concentration of banking assets in a few urban banks that are largely owned or controlled by the Government. Debt and equity markets, that companies could rely on to finance large projects and development, are not sufficiently deep, nor efficient to support long term business development. 2. Regulatory, Supervisory and Other Issues Fragmentation. A major outcome of the financial reform process, that began in the mid-I 980s, was the emergence of joint-venture banks which brought modern and efficient banking techniques to Nepal. The reform also resulted in the growth of a diversified group of deposit- taking institutions, not all of which are licensed by the central bank (see Box 3. 1). Box 3.1. Deposit-Taking Institutions in Nepal Public Private Private Nepalese Joint-Ventures Licensed by NRB Commercial Banks 2 4 9 Finance Companies 48 Development Banks 2 Micro-Finance Institutions Regional Rural Development Banks 5 8 Savings and Credit Cooperatives 35 NGOs 13 Not Licensed by NRB Postal Savings Bank I Micro-Finance Institutions Cooperative Societies 1,575 Community-based Organizations 25,000 This expansion does not appear to be the result of a deliberate strategy. Indeed, the banking sector operates under seven different laws and suffers from an excessive segmentation that is not conducive to the development of sound competition across the country. Apart frorn the two  38 largest commercial banks, NBL and RBB, most institutions offer banking services which are restricted to some regions or limited in scope. Commercial banks essentially finance industry and trade businesses with short and medium term credits. Joint ventures" and other private banks, as well as finance companies, operate in urban areas where most of the Kingdom's business is conducted, whereas development banks and micro-finance institutions generally provide services in a limited number of rural localities or districts. The two largest banks account for around 60 percent of all deposit and lending operations. Poor Banking Culture. A good banking culture is almost non-existent in Nepal. Prudential regulations do not require banks to define credit policies and procedures - and only a minority of banks have established satisfactory internal guidelines. Some banks are unable to provide financial statements and those that can frequently produce un-audited data - even though banks and finance companies are required to be audited annually by external auditors selected at annual general assemblies. Moreover, the Registrar of Companies is lax in requiring financial statement filing, and accessing filed statements is difficult. Due to problems of tax evasion, these figures are largely unreliable and banks reconstruct corporate accounts on the basis of client estimates. Even if some kind of financial analysis is made, credit is not extended on the basis of creditworthiness but relies heavily, instead, upon collateral. Primary collateral is always requested and, as required, secondary collateral or guarantees'2, the value of which is assessed informally and not regularly re-evaluated. Banks are prohibited from extending credit to customers that have been black listed by the Credit Information Bureau. However, the CIB, established as a joint entity by NRB and the Bankers' Association, is not fully functional as the two largest banks do not, or are not able to, provide it with requisite data. Loan classification and provisioning has been extremely lenient'3, as were income recognition rules that permit banks to record income on Government guaranteed non-performing loans. The legal framework for land records and bankruptcy is also inadequate. Court action against defaulters tends to be delayed and asset liquidation is rarely successful. As a result, an international audit review of NBL and RBB's July 1999 accounts confirmed that the two banks - which represent more than 50 percent of the banking assets of the country - were "technically" bankrupt and have no internal capability, nor resources to redress the situation. These problems have long been a systemic issue: real interest rate and margins spreads have been maintained at high levels to cover high operating costs and large losses, while private banks are able to follow their lead and record substantial profits. Consequently, private banks (including well managed ones) have not been forced to compete for more customers or expand their activities outside a few main cities. Excessive Government Involvement. Development priorities are reflected in many Government directives. Access to banking services in rural areas remains a concern of the authorities and commercial banks are required to open branches in rural districts whenever they expand their urban branch network. Traditionally, the state-owned or state-controlled banks maintained a large number of branches, but on-going security problems have forced the closure of more than a hundred units. Rural areas are also serviced by a large number of generally un-licensed and even un-registered small entities that collect deposits and provide loans with little professional capacity. Thus, promoters of cooperatives have taken advantage of this new situation to apply for banking licenses, liberally granted by the central bank or, even more freely, by the Ministry of Agriculture (under which they fall). "Full foreign ownership of banks is still prohibited in Nepal. 12 NRB guidelines request banks to maintain files on loans over NR 10,000, except for advances extended against collateral. 13 For example, loans overdue up to five years were classified as doubtful and provisioned at 50 percent, until recently.  39 Regulations also constrain bank operations - although some of these restrictions have been lessened with the reduction of the cash reserve ratio, the removal of the statutory liquidity ratio, and the newly authorized ability to maintain foreign exchange positions. Although deposit and credit interest rates are now substantially determined by market forces, limits on interest rate spreads have been set since 1999 and, since 1975, commercial banks have been obliged to finance priority'4 and deprived sectors'" of the economy. Poor Governance and Transparency Procedures. Governance principles and transparency practices are almost non-existent, leading to many cases of conflict of interest. For example, the Government maintains close control over financial institution activity and management through its own direct ownership. The Government owns the largest commercial bank, andl the two national and five regional development banks, and appoints members to the boards of most commercial banks including, in most instances, the position of chairman. Even the NRB, the authority in charge of supervisory functions, funds some development bank activities and holds shares in several banks. In addition, several NRB officials, including some involved in banking supervision, hold positions on bank boards as Government representatives. Lastly, bank boards have no leading shareholder and most directors are not professional bankers. Cross-holding of bank shares is also a major concern, as is the reported practice of insider-trading or self-dealing. Limited public awareness of the poor financial health of the banks has caused considerable moral hazard problems in the sector. Financial accounts and annual statements, when disclosed, are neither timely nor reliable, even if audited. Moreover, accounting and auditing practices in Nepal are not to international standards. In any case, even if information was reliable, timely and "best practice", the majority of the population has limited access to information, and a proper understanding of, financial issues. Some of this is reflected in the Nepal Stock Exchange's volatile prices which do not appear to reflect the true value of a company's capital and assets. The most striking example was seen in the NBL's rising stock price during the third quarter of 2000 when its net worth was negative - and publicly declared so - based upon the work of international auditors. Implicit in this is the speculators consideration that although no deposit insurance scheme is in place, a safety net will be provided by the central bank. However, the lender of last resort's function is neither restricted, nor even defined, in terms of scope and rules of intervention. Weak Supervision of Banks. An assessment of Nepal's compliance with the Basel Core Principles for Effective Banking Supervision was conducted in June 1999. It concluded that NRB does not fully comply with two thirds of the criteria and is unable to fulfill its supiervisory mandate. Many weaknesses confront the central bank and inhibit management from taking action against problem banks even when they are extremely serious. Moreover, almost none of the preconditions required by the Basel Committee exist in Nepal, in terms of the legal fratmework and judicial procedures, accounting principles and auditing practices, market-based banking business, exit and crisis management policies, and deposit insurance and safety net schemes. Although recent progress has been made in the definition of a regulatory framework and the implementation of banking supervision, the supervisory system remains largely ineffective. This disquieting conclusion was substantiated by weaknesses in all aspects of supervision: a leniently applied prudential legal and regulatory framework, insufficiently qualified staff; and poor organization, tools and equipment. 14 Guaranteed by the Deposit Insurance and Credit Guarantee Corporation. I5 12 percent of the outstanding portfolio for the priority sector of which 3 percent is targeted at the deprived sector.  40 An Inadequate Legal Base. The central bank is entrusted with regulating and supervising the banks and financial institutions in Nepal but, until recently, it had no autonomy from the Ministry of Finance. The legal system needs to provide protection to supervisors, operational independence and adequate resources for supervision. Past limitations in these areas have resulted in a general inability or reluctance to enforce corrective measures necessary to prevent and resolve banking problems. Moreover, most of the old regulations allowed long delays before action, did not define financial or legal penalties, and did not mandate specific actions to be undertaken by the banking authorities. New regulations, however, were issued in the first quarter of 2001 - and these have corrected the weaknesses in the old regulations by bestowing greater regulatory powers on the central bank. An Inadequate Organizational Structure. The supervisory functions are shared among four units placed under two different deputy-governors within Nepal Rastra Bank. The Banking Operations Department (BOD) is in charge of issuing licenses to banks and financial institutions, defining and enacting prudential regulations, and collecting statistical financial data (33 staff). The Inspection and Supervision Department (ISD) is responsible for on-site inspection, follow-up of recommendations and enforcement of sanctions, and special inspection of banks and financial institutions. Each of these units was split into two Departments in 1999, one in charge of banks and the other, non-bank financial institutions. Staff in the six branches of NRB also contribute locally to the surveillance of small financial institutions. Cooperation among the four departments is poor, and requires improvement. The procedure for bank licensing has been put on hold since 1996, but the number of new non- bank institutions is growing. Under political pressure, NRB has had to finally accept pending applications and it liberally grants licenses to local development banks in areas where commercial bank branches have been closed or do not operate. The Ministry of Agriculture also authorizes cooperatives to conduct some banking activities. Limited Resources. Current supervisory practices are geared toward ensuring that NRB instructions are complied with by the banks. Until recently, many of the regulations had no prudential content, and instead addressed Government policy issues such as priority and deprived sector lending, maximum spreads, liquidity, and the cash reserve requirement. Risk management processes, notably with regard to foreign exchange, were lacking in the examination procedure and no rating system of commercial banks has yet been defined. In addition, very few computers are available in the bank supervision departments and the level of computer literacy is low. Although the Government suspended new recruitment across the central bank, the banking supervision departments have been able to hire some new staff. In general, the staff policy does ensure the recruitment of quality staff, whose education profile is a good mix of MBAs, chartered accountants and economists. However, promotion is driven by seniority, appointment criteria are not on the basis of merit and competence, and the salary scale is tied to low public sector rates. These factors have contributed to low morale and poor performance. The rotation policy of the central bank (inter-departmental transfers) is also counter-productive for this important activity which requires stability for officers to develop skills, master techniques, acquire experience, as well as foster commitment. Training is provided mainly by the Bankers' Training Center (BTC) that caters to the needs of the NRB and the commercial banks. Courses are mostly designed for the latter group. A South East Asian bank supervision training center (SEACEN) in Malaysia is used by about twelve staff per year, but not all of the trainees remain as bank supervisors.  41 Deficient Tools and Practices. Off-site surveillance does not exist as a specific function. Information reporting is not timely nor comprehensive enough to allow full analysis - while the integrity of the figures remains do'ubtful. Financial data are mainly compiled for statistical purposes and published in the Central Bank's Bulletin. Some monitoring is conducted by ISD for individual entities - but again, these are not normally for prudential purposes (but rather for monitoring the CRR, interest rate spread and priority, and deprived sector lending). The regular bank reporting requirement to NRB include: reports on inter-bank treasury bill transactions and loans; weekly cash reserve requirement (CRR); monthly balance sheets, statements of loan and advances by purpose (notably priority and deprived sector lending), advances to public enterprises, deposits, foreign assets, and interest rate spreads; and six-monthly statements of overdue advances sector-wise, fixed deposits by amount, period and interest rates, and large exposures. However, major prudential ratios, such as capital adequacy, are only reported on a yearly basis and the collection of prudential reports is erratic 6. Most of these reports do not come in on time and, if collected, are not analyzed. There are no sanctions for late reporting and penalties for non-compliance with regulations are not enforced, except for the CRR'7 and directed lending. In the event of a problem, the bank is requested to provide additional information, basically to cross-check the figures, within a month. If the problem remains, a penalty is finally debited from its account with the NRB. With the exception of some joint-venture banks, financial institutions in Nepal suffer from weak organization, lack of qualified staff, insufficient equipment, and ineffective credit management and monitoring procedures. The largest commercial and development banks do not consolidate their accounts and do not centralize their operations. For that reason, on-site examinations are conducted at branch or sub-branch level, a practice which does not provide a clear understanding of a bank's overall situation"8. Moreover, given the physical environment, transportation logistics impose a heavy constraint on the bank supervisors. Private banks and financial institutions are meant to be inspected every two years on a global basis. Time lags between the examination reference date and the time of report issue is also excessive. Consequently, it is diffictilt for NRB to use the bank examiner's findings to substantiate sanctions for non-compliance. 3. Developing Banking Supervision Banks are supervised in order to achieve both long-term financial stability and sector efficiency. This is done through the promotion of safe and efficient banking practices and institutions - to support sound private business development and meet individual bank customer needs. A weak regulatory framework and poor supervision provide grounds for inefficient and unsafe banking practices, which increase the risk of bank failure. Preventing systemic risk, protecting small depositors, and containing financial crime are concrete steps in attaining these objectives. They require that the supervisor enforce fundamental discipline in the banking system with the support of well-crafted laws and regulations and the presence of strong in-house supervisory expertise. Strengthening the Supervisory Framework. With the support of the World Bank, the International Monetary Fund, and other donors, the Government and the central bank have to face the dual challenge of building a supervisory function and human resource capacities within NRB, while simultaneously restructuring the two largest banks. 16 It has proven difficult, sometimes impossible, to determine if some prudential reports were received from the banks. 7 However, the weekly CRR reporting, as an example, is based on the averaged positions four weeks earlier, and the report is due 15 days after the period. 18 In 1999, the first consolidated examination of NBL took almost one year to complete.  42 Prioritizing. The thrust of initial efforts should be to build up capacities in banking supervision functions that give the Central Bank management confidence and motivation to take all actions required to establish - and then preserve - the banking system's stability and soundness. This should be done by building on existing central bank supervisory activities while upgrading both the regulatory framework and supervision organization and practices to international levels. A related issue pertains to bank licensing. The existing supervisory capacity is being outstripped by a growing number and variety of financial institutions. It is important that the central bank apply stricter technical criteria when assessing applications for a bank or a non-bank license and before granting such licenses. It is essential that priority is given to these efforts by NRB's management. One important element of this should be the cessation of the rapid rotation of staff between central bank departments - at least those in the banking supervision area. Meeting Pre-Conditions. A program for strengthening banking supervision cannot be built in isolation and will not be successful if the preconditions for sound banking business do not exist. There is a need for IFIs, international NGOS and donors to continue programs that aim to streamline financial, corporate and commercial legislation; implement corporate governance principles; establish international accounting standards and audit practices; build institutional mechanisms and capacity in the judicial and law enforcement systems; improve infrastructure for payments and financial services delivery; and strengthen capital regulation and supervision. The central bank's formal bank supervisory function should, however, only cover commercial banks, finance companies, and development banks. These represent the main deposit-taking financial institutions whose failure could have systemic implications. Although it is not the central bank's function to organize the myriad of entities which operate at a micro level throughout Nepal, some micro-finance institutions take deposits, some are licensed by NRB, and some are large or weak enough to raise supervisory attention. Clear regulations for such institutions need to be provided by the central banking authorities, but supervision should be conducted by a second-tier regulatory authority answerable to NRB. 4. Creation of a New Framework for Supervision Defining Regulations. Seven new prudential regulations and guidelines were issued in March and April 2001. These include: capital adequacy, loan classification and provisioning, loans to one borrower or group of related borrowers, accounting, risk management (liquidity, interest rate, foreign exchange), enforcement, and good governance (code of ethics, duties and responsibilities of directors, prohibition of loans to directors, officers and employees). These regulations are rigorous and will be applicable to all deposit-taking institutions. A new minimum capital for banks (NR 500 million - or US$6.5 million), which was defined five years ago, came into force from July 2001. On March 24, 2000, NRB held a "interaction program" with the banking industry to collect opinions and suggestions for improvement on draft versions of these regulations. During this one-day session, discussions were very open, showing the banking community's awareness of the need for improved regulations. However, there was also a general concern regarding their implementation, including requests for extended delays or less stringent requirements. It is important, however, that Nepal move as quickly as possible to internationally accepted norms of banking regulations - and to ensure their adequate enforcement.  43 Developing the Supervisory Capacity. Initial efforts in strengthening the supervisoly capacity have focused on a bank supervision resident expert providing assistance in implemrenting the regulations, giving comprehensive in-house training courses, developing the off-site surveillance function, participating in the on-site inspections, and formulating an inspection manual. Since the weak banking environment in Nepal requires a strong and active presence of supervisoiy teams in the bank, support of additional consultants for the ISD to participate in on-site examinations is also required. A more focused and intensified inspection process should also be developed, with the objective of shifting examinations from bank branches to head offices. Off-site surveillance that carries out a permanent and overall assessment of banks and provides early warning indications of a bank's overall financial health, is an important aspect of bank supervision. Such off-site findings could then trigger, and better target, in-depth on-site inspections. NRB also needs to define reporting formats, to establish procedures to collate and analyze information, and to create a bank analysis function. Building Supervisory Authority. The new regulatory framework should force banks to invest large amounts in modernizing their MIS for proper accounting and timely reporting, and to substantially enhance their capital base to meet minimum capital, loan provisioning, capital adequacy and exposure limit requirements. Enforcement. The need for banks to significantly increase their capital is a major issue. Scaling down assets is an option, but this could reduce profitability and thus hinder intenial system upgrading. Issuing asset-backed securities cannot be considered for several years. Another alternative would be raising equity funds or issuing hybrid instruments. The latter solution could be implemented but only when new legal dispositions, which authorize and regulate such instruments, have been established. Thus, cash injections and floatation of new shares is likely to remain the only source of long-term funding for some time. The two largest commercial banks, RBB and NBL, are expected to be put under the management of two international teams during 2002. This major change in the Nepalese banking industry will require a close, active and professional monitoring by NRB supervision teams, in the form of on- site examination and follow up on a (minimum) annual basis. The restructuring process should be piloted by the central bank. It will, defacto, foster policy definition and build capacity and experience in bank exit and restructuring. Sanctioning. NRB must enforce the new regulations in a short period of time. Although it is important to take into account Nepalese realities, phase in periods should be as short as possible and the supervisory effort must lead to concrete results. Each inspection report should define up to five priority actions to be taken by a defaulting institution within one year. In case of a capital shortfall, or of any other regulatory inadequacy, Memorandums of Understanding (MOUs) must be drawn up with the banks which set out a short term sequenced timeframe to address the identified problems. Appropriate sanctions, including license removal, must also be taken by NRB should a bank fail to meet any of the requirements. After years of non-enforcement, more supervisory forbearance would send the wrong signal to the banking community. Nolhing must prevent the central bank from sanctioning banks that do not comply with prudential regulations. NRB's inspection teams should be able to complete on-site examinations of all private banks within two years. This will provide a precise view of their situation vis-a-vis the new regulations.  44 5. Recommendations Sustainable improvements in the banking industry will not be seen until NRB re-orients its function from directing the financial sector to acting as a regulator and supervisor in charge of preserving the soundness of banks and promoting competition among them. To achieve this, autonomy will be a key factor in ensuring freedom from political and other influences that have impeded their efficacy thus far. Moreover, Nepal has set ambitious objectives for itself in its Ninth and Tenth Five Year Plans such as lifting restrictions on foreign bank entry, facilitating mergers and takeovers, completing privatization of banks and non-banks and supporting the development of micro-finance institutions. While most of these remain to be done, the attainment of these objectives would only be desirable if it is preceded by a strengthened central bank that is capable of regulating and supervising the sector. In its absence, further liberalization of the Nepalese financial sector is ill advised. The specific recommendations of this chapter are: (a) Implement and enforce the new regulations (minimum capital requirements, provisioning policy, etc) on the same basis for all banks. (b) Given the importance of supervision (particularly at this crucial stage when the sector is undergoing significant reform), it is strongly recommended that the NRB utilize the support of experienced external consultants in the enforcement of the new regulations. (c) Define a program to include an annual review of RBB and NBL and biennial review of all the other banks. (d) Make inspection reports available one month after the on-site visit has been completed. (e) Stop rotation of banking supervision staff. (f) Apply stricter criteria in approving banking licenses. (g) Make human resource policy changes to include improved definition of criteria for advancing staff with potential, improved staff selection and career planning, and improved systems to facilitate greater knowledge sharing.  45 CHAPTER FOUR The Commercial Banking Sector 1. Introduction Until the mid-1980s Nepal's financial sector was closed to foreign banks and was effectively controlled by two state-owned banking institutions - Nepal Bank Limited (NBL) (established in 1938) and Rastriya Banijya Bank (RBB) (established in 1966). After 1984 the Government gradually liberalized and opened up the sector - resulting in the rapid entry of three new foreign banks - Nabil Bank Limited (Nepal-Arab Bank Limited) in 1984, Nepal Indo-Suez bank in 1985, and Nepal Standard Chartered Bank in 1987. Six additional joint venture banks and four Nepalese owned banks have subsequently entered the market'9. However, the financial sector remains dominated by the two majority Government-owned banks, NBL and RBB. The structure of the commercial banking sector is shown in the following chart. Total assets of the commercial banks, as of 2001, were NR 226.2 billion - equal to around US$3.0 billion. When the ADB/N is included - total commercial banking system assets increase to US$3.2 billion. The Government's direct share of banking system assets is around 50 percent - although its actual ownership is much higher than this if the state's direct and in-direct shares in the joint- venture banks are also included. The RBB and NBL (where government ownership is now 41 percent) together accounted for 52 percent of total banking system assets in 2001. Chart 4.1: Commercial Banks: Share of Total Assets, 2001 70,000 60,000 50,000 A 40,000 I30,000 20,000 - 10,000 U _ NBL RBB NABIL NISB STB HBL NSBIB NB Bank EBL BOK NBOC ADB/N Lurrbm NICB Commercial Banks Source: Nepal Rastra Bank The nine joint venture banks hold around 45 percent, with approximately NR 101.1 billion in assets (US$1,341.1 million). This group is dominated by three large banks - Standari Chartered Bank (formerly Grindlays Bank, with 9 percent of total banking system assets), Nabil Bank (8 percent), and Himalayan Bank (9 percent). The joint venture banks are from the United Kingdom, Bangladesh, Pakistan, France, India, and Sri Lanka. The remaining 3.7 percent of banking system assets is held by the four domestic owned banks. 19 Rastriya Banijya Bank, Nepal Bank Limited, Nepal Arab Bank, Indo-Suez Bank, Standard Chartered Bank, Himalayan Bank, Nepal SBI (State Bank of India) Bank, Nepal Bangladesh Bank, Everest Bank, Bank of Kathmandu, Nepal, Bank of Ceylon, Lumbini Bank Ltd., NIC Bank Ltd., Machapuchre Bank Ltd., Kumari Bank Ltd.  46 There are two distinct classes of banks within this group of joint venture banks. The first includes the "good name" banks, with an international reputation, which appear to be conducting fully professional banking activities in Nepal. On the other hand, there are banks from countries whose domestic banking systems are inadequately supervised by their own central banks, and where the institutions carry out, in some cases, non-prudent banking activities. Anecdotal evidence points to some of these banks being severely over lent to a single customer and available information shows that some of them are inadequately capitalized. In this regard, it is necessary to ensure that these banks comply, as soon as possible, with the newly approved NRB regulations - which broadly comply with international norms (albeit, in many cases, with a long phase-in period). These regulations provide a framework for determining provisions, allocating adequate levels of capital, and other regulations necessary to ensure that the banking system, as a whole, operates in a prudent manner. The role of the bank supervisors has historically been made difficult by the fact that the Government's own banks - the majority of the banking system - do not operate in a safe and prudent manner. 2. Consolidated Financial Highlights of the Commercial Banks Total assets of the commercial banks grew at an annual average rate of 18.5 percent over 1994 to 2001 - from NR 73,565 million to NR 241,948 million. The highest growth was recorded in 1998 - around 24 percent and the lowest in 1995 - around 14 percent. Since 1998, growth has been around the period average (See Table 4.2 at the end of this chapter). While the growth of assets has been significant, their quality is not known but is suspected to be poor (based on the problems of the two largest banks). During the period under review, the most notable development is the gains made by the joint venture banks at the expense of the two large banks. In 1994, RBB and the NBL accounted for around 72 percent of total banking assets. The corresponding figure for 2001 was 52 percent. Detailed, bank by bank information on sources and uses of funds is given in Annex Three. On average, deposits constituted 72 percent of total sources of funds over the review period, and grew at an average annual rate of around 19 percent. Deposit growth accelerated in 1998 and 2000 - but, in 2001, it declined to its 1997 level of around 15 percent. On average, fixed deposits accounted for 30 percent followed by savings deposits (28 percent) and current deposits (12 percent). The composition has shifted somewhat over the period with growth of savings outpacing others to constitute the largest component of total deposits in 2000 and 2001. Chart 4.2: Commercial Banks: Breakdown of Deposits, 1994-2001 180,000 160,000- 140,000 - 120,000 - 100,000 - 80.000 60,000 -- - 40,000 - 20,000 1994 1995 1996 1997 1998 1999 2000 200 Fiscal Years -4--Total Deposits Current Savings -X- Fixed - Call U Others  47 Capital Funds accounted for an average of 4 percent of total funds (5.5 percent in 2001) and grew at an annual rate of 26.5 percent over the seven years. The biggest contribution to capital build up over the period was not in paid up capital (which increased by 15 percent per annum) but statutory reserves (which increased by 48 percent per annum over the period). The single biggest increase in capital occurred in 2000 when the capital of the banking system increased by around 71 percent - largely in response to NRB's minimum capital regulations (although some banks still do not meet the minimum requirement of NR500 million). In addition, as a whole, the commercial banks are still not able to meet the capital adequacy ratio (8 percent of risk-weighted assets, of which 50 percent must be met from core capital ). Borrowings (from NRB, inter-bank and from abroad) remain negligible, constituting on average less than one percent of total funds. The "Other" classification - which includes provisions, sundry creditors, accounts payable, etc. - experienced an annual average growth of around 15.5 percent and constituted 21 percent of the total sources of funds in 2001. Chart 4.3: Commercial Banks: Sources of Funds, 1994-2001 200,000 180,000 160,000 140,000 . 120,000 "___ - 100,000 _ 80,000 60,000 -A__ 40,000 20,000 *w- 1994 1995 1996 1997 1998 1999 2000 2001 Fiscal Years -*-- Capital Fund -.Deposits 8U Borrowings Otr., Loans and Advances constituted, on average, 47 percent of total uses of funds. They grew by around 22 percent per annum over the seven year review period, and accounted for 45 percent of total assets in 2001. Ninety-six percent of all loans and advances was lending to the private sector - and only 2 percent was lending to the government and government enterprises. As a share of total deposits, loans and advances grew from 52 percent in 1994 to 63 percent in 2001. Loans and advances were as high as 71 percent of total deposits in 1996 and 1997. However, in general, the ratio of loans and advances to deposits is low - and appears to be symptomatic of poor intermediation within the banking system - nonetheless, the trend does appear to be positive. On the other hand, the relatively rapid growth of loans and advances could also be indicative of a poor quality loan portfolio. Liquid funds also grew relatively rapidly - at an average rate of around 18.5 percent - and made up to almost 19 percent of total assets in 2001. Given the mandatory reserve requirements of around 10 percent, there is considerable excess liquidity in the banking system in Nepal. In 2001, 33 percent of liquid funds were comprised of balances held abroad; a further 30 percent were held in call deposits; and 25 percent were held as balances with the central bank. Balances held  48 abroad grew at around 16 percent per annum over the period, however, they grew by a significantly higher 54 percent in 2000. Limited investment alternatives in Nepal - arising from a stagnating economy - appear to have fueled this growth in liquid resources. The Other category (sundry debtors, advance payments, advances to employees, stocks of stationery, non-banking assets, expenditure to be written-off, and contra entry) grew at around 23 percent over the period, making up 22 percent of total uses of funds in 2001. Investments were largely stagnant over the seven years under review. Investment share of total uses of funds has fallen from around 20 percent in 1994 to 6 percent in 2001. In the current environment of high excess liquidity, there is a need to introduce more and longer-term government securities to absorb some of these excess funds. The above review demonstrates that, while the assets of the commercial banks have been growing at a relatively rapid pace, they suffer from sub-optimal investments, as evidenced by high levels of liquid fund holdings, low loan levels (whose quality is suspect), and limited investment in securities. On the other hand, most of the deposits are savings and fixed term - implying a high cost of funds. The net interest margin is therefore very low. Banks also appear to have low levels of capital adequacy - and these numbers do not reflect the "true position" with respect to un-impaired capital. Moreover, substantial assets are tied up as "interest accrued" and "unclassified" - which is not an auspicious sign for a bank - as many of these assets are generally not recoverable. Overall, it is evident that the commercial banks are not providing efficient financial intermediation. Chart 4.4: Commercial Banks: Uses of Funds, 1994-2001 120,000 100,000 80,000 60,000 40,000 20,000 0 A 1994 1995 1996 1997 1998 1999 2000 2001 Fiscal Years | Liquid Funds -_-- Investments A Loans & Advances - Accrued Int. - Other  49 3. The Government-Established Commercial Banks Nepal Bank Limited (NBL) Background. Nepal Bank Limited (NBL), established in 1938, is the oldest bank in Nepal. In accordance with the government's policy of providing at least one banking facility for every 30,000 people, NBL pursued an active policy of opening up branches and sub-branches throughout the country. Although the bank had 211 branches and around 6,000 staff at the end of 1998 - by 2001, total branches numbered around 160 as many of them had been closed due to the Maoist insurgency. With total assets of NR 52.4 billion (US$695 million) - backed by a stated total capital (core and supplemental) of NR 2.9 billion (US$38 million), it accounted for 5.5 percent of total assets in 2001. Other estimates undertaken by KPMG on the 1998 accounts, however, indicate a substantial negative net worth. With a government divestment of 10 percent of its shareholding to the general public in 1998, the public share was reduced to 41 percent - making the bank a private institution in which the government is the largest single shareholder. The general public now has a majority of seats on the board. In addition, NBL holds shares in Standard Chartered Bank, the National Insurance Company, Nepal Oil Corporation, the RRDB's and NIDC. Financial Highlights, 1994-2001. The assets of NBL grew at an annual rate of around I I percent (the slowest among the commercial banks) over 1994 to 2001. Growth has fluctuated, from a negative rate of 3 percent in 1995 to a high of 30 percent in 1998, and followed thereafter by significantly slower growth rates of 17 percent in 1999; 5 percent in 2000; and 13 percent in 2001. Deposits constituted, on average, 74 percent of total sources of funds, and grew by 10 percent per annum. This growth has been erratic, ranging from a low of 5 percent in 1995 to a high of 31 percent in 1998. In 2000, deposits grew by only 8 percent and actually declined by 0.14 percent in 2001 (possibly as a result of a growing awareness of a serious financial problem within NBL after the KPMG Report was made public). The Capital fund is purported to have grown at an average annual rate of around 26 percent over the period. However, most of this growth came from supplementary capital and largely reflects provisions for loan losses - which are still not considered sufficient to cover the non-performing assets (NPA's) within the loan portfolio of the bank. Loans and advances constituted, on average, only 50 percent of total uses of funds over the period (44 percent in 2001) - growing at an average annual rate of around 14 percent. Liquid funds grew at an average annual rate of around 9 percent. Growth was highest in 1997 and 1998, but grew at a significantly reduced rate thereafter (minus 18 percent in 2001). They constituted 17 percent of the total funds on average, and 13 percent of total funds in 2001 - indicating that NBL was much less liquid than the banking system as a whole. Investments (in government securities, shares and debentures, and NRB bonds) shrank over the period, accounting for around 9 percent of total funds in 2001 from 27 percent in 1994. The growth rate trend has been extremely erratic, as high as 556 percent in 1998 and as low as a negative growth rate of around 66 percent the preceding year. Interest accrued grew at an annual rate of around 23 percent, growing at a faster rate since 1998 - its share of total funds was around 14 percent in 2001 compared to 7 percent in 1994. This may be indicative of a deteriorating credit porlfolio, even more so given that the average interest accrued as a share of total credit for the rest of the commercial banks - with the exception of the other troubled bank, RBB - was around 2 percent.  50 Chart 4.5: NBL: Assets, Deposits, Credit & Investment 1994-2001 60,000 50,000 0 40,000 30,000 Z 20,000 10,000 0 1994 1995 1996 1997 1998 1999 2000 2001 Fiscal Years | Total Assets Deposits A Investments X Credit Rastriya Banijya Bank (RBB) Background. RBB was established in 1966 as a fully government-owned commercial bank, and it remains so today. The bank currently operates a country-wide banking network, in line with the Government's policy to provide banking access to the general public, through a network of 210 branches - of which around 70 have been closed due to Maoist activity in the country-side. Despite this, a large proportion of the bank's total banking business is conducted in Kathmandu. The bank employs around 6,000 staff. As of July 2001 it accounted for 26.6 percent of total banking system assets. Financial Highlights, 1994-2001. Total assets of RBB grew at an annual average rate of 13 percent, from NR 27.6 billion in 1994 to NR 64.3 billion in 2001. Growth has been erratic and has slowed considerably since 1996 when it grew by 21 percent. In 1999 and 2000, growth only averaged 6.5 percent, but grew by 13 percent in 2001. Deposits constituted, on average, 58 percent of total sources of funds over the period, and grew at an annual average rate of 13 percent. Savings Deposit in particular grew relatively rapidly - an average annual rate of 22 percent over the period - to constitute 50 percent of total deposits in 2001 compared to only 29 percent in 1994. The reported Capital Fund grew at an average annual rate of around 18 percent, although its growth in 2000 was as high as 75 percent. In common with NBL, however, this does not reflect the unimpaired capital position of the bank which is also steeply negative. Nonetheless, according to this data from the NRB, it accounts for around 4 percent of total sources of funds (on average). Thus, even according to this generous interpretation of the capital position of RBB, the bank appears to still be unable to meet its minimum capital requirements. The "Other" category, which constituted around 37 percent of the total in 1994, and was as high as 44 percent in 1997, has reduced significantly over the years and comprised 34 percent of the total in 2001. On the uses side, loans and advances constituted 46 percent of total uses of funds over the period and grew by an average annual rate of 16 percent. Growth has been erratic and, since  51 1996, it has been less than the period average. In 2000, loans grew by 12 percent and by only 3 percent in 2001. Private sector lending made up 98 percent of total lending in 2001. Investments, mainly in government securities, have declined sharply over the period and constituted less than 5 percent of the total in 2001 compared to 13 percent in 1994. Growth of Liquid Funds fluctuated widely, as high as 55 percent in 1998 and as low as a negative growth of 44 percent in 2000. They declined by a further I percent in 2001. Over the period, liquid funds grew at an average annual rate of less than I percent - the lowest among all the commercial banks. Liquid funds comprised 9 percent of all uses of funds in 2001 compared to 19 percent in 1994. Interest accrued grew at an annual rate of around 17 percent and constituted 16 percent of total credit in 2001. As with NBL, this is likely to be indicative of a low quality and deteriorating loan portfolio. Chart 4.6: RBB: Assets, Deposits, Credit & Investment 1994-2001 70,000 60,000 50,000 E 40,000 e 30,000 20,000 10,000 0 X X X X_ 1994 1995 1996 1997 1998 1999 2000 2001 Fiscal Years - Assets n Deposits A Credit X Investments 4. Issues in the Govemment-Established Commercial Banks According to a comprehensive assessment of NBL and RBB, carried out with the support of the World Bank in June 2000 by the KPMG Barents Group20, NBL and RBB are technically insolvent and suffer serious shortfalls in all aspects of their governance, management and operations. The conclusions of the KPMG report show that the loan assets are highly overstated, extremely risky and that as a consequence, the banks are technically insolvent. The report, based on 1998 data, estimates NBL's negative net worth between NR 6-10 billion (US$85 to $140 million) and the RBB's negative net worth between NR 14-18 billion (US$200 to $260 million). This represents around 7 to 9 percent of Nepal's GDP. The situation is certain to have deteriorated significantly over the intervening four years. This is of grave concern given that these two banks represent around half of the total assets of the commercial banking system. The report also showed that while the RBB suffers from problems almost identical to NB]L, they are greater in magnitude. The report also highlighted the following: Severe Governance and Management Shortfalls. Years of political interference in senior appointments, lending, and operational decisions have been a major cause of poor governance 20 Nepal Banking Reform Project, Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), KPMG Barents Group, Kathmandu, June 2000.  52 and management. This has been exacerbated by a general lack of internationally experienced, commercially oriented, prudent bankers in Board and senior management positions. This is reflected in the absence of financial management information, a business strategy, poor board and management practices, low morale, counter-productive union activities, inadequate compensation, and so on, that have all conspired to further compound the problem (see Box 4.1). Dysfunctional Lending Processes. Unsound banking practices have helped deteriorate the credit portfolio, evident in the absence of policies, processes and procedures that support profitable commercial banking practices. Senior management that is not concerned with taking on inappropriate and unduly high risks, a Board that is more responsive to client pressures than prudential concerns, and poor incentives and ill-trained staff, have also helped to aggravate the situation. Primitive and Flawed Accounting Practices. Information systems, accounting, and record keeping practices are extremely poor. As a result, the banks suffer from both information gaps as well as gaps in the little information that they have. Loan files, loan ledgers, accounting records, operational statistics, and data on human resources, are ill maintained and sub-standard. Absence of Strategic Planning and Poor Business Planning and Budgeting. There are no strategic plans, and the units responsible for this function are inadequately staffed and have very limited capacity. Budgeting process are primitive with negligible monitoring on variances and no well-defined rewards and punishment systems necessary to enhance accountability and improve performance. Low Morale, Numerous Human Resource Issues and Active Counter-productive Unions. Poor incentives and penalties, combined with below-market pay structures and weak stafflmanagement discipline have seriously eroded employee motivation and productivity. With negligible training opportunities that could provide exposure to international best practices, staff and management skills that are already very weak, are expected to get worse. Strong counter- productive unions have aggravated the situation, resulting in an excess number of unskilled staff. Nepal Bank Limited is Trading in Negative Equity on the Stock Exchange. In addition to the above, there is also the issue of the government's privatization policy regarding NBL holdings. The government began divestment of its holdings in NBL in 1998 through the sale of parcels of shares. The sale of shares to the public - while effectively "privatizing" the bank - has resulted in a wide dispersion of share ownership and an absence of a strong strategic banking investor. In addition, dealing with this widely owned "negative-equity" will be an important challenge for the NBL restructuring process. Even though their financial woes are well publicized, both the banks do not appear to be suffering from these adverse findings (government ownership has been a positive factor in this respect). More recently, there has been withdrawals by some clients from RBB including a partial withdrawal by the Royal Nepal Army, one of its largest clients. The reason, however, was the more attractive rates on offer from the joint venture banks. In response, RBB increased its interest rates on deposits. To arrest further deterioration, external teams are now being recruited to take over the management of these banks. This is expected to stem further deterioration and pave the way for their eventual recovery and possible privatization - although liquidation should also be seriously considered if successful privatization is not considered feasible. A large part of the initial efforts will be focused on recovering on the existing loan portfolio and in human resources re-  53 engineering (shedding excess workers through voluntary retirement schemes and imiproving the overall conditions for remaining and new workers). 5. The Three Largest Joint Venture Commercial Banks. There are two distinct classes of banks within the group ofjoint venture banks. The first includes the "good name" banks, with an international reputation, which appear to be conducting fully professional banking activities in Nepal. The second group includes banks from countries whose domestic banking systems are not properly supervised by their own central banks. Table 4.1: Joint Venture Commercial Banks Name Foreign Equity Foreign Partners Nepal Arab Bank 50 National Bank ltd, Bangladesh Nepal Indo-Suez Bank Limited 50 Credit Agricole Indosuez, France Nepal Standard Chartered Bank Ltd. 50 Standard Chartered, UIC Himalayan Bank Limited 50 Habib Bank, Pakistan Nepal SBI Limited 50 State Bank of India, India Nepal Bangladesh Bank Limited 50 IFIC Bank, Bangladesh Everest Bank Limited 50 Punjab National Bank, India Bank of Kathmandu Limited 50 Siam Commercial Bankc, Thailand Nepal Bank of Ceylon 50 Bank of Ceylon Source: Nepal Rastra Bank Nepal Standard Chartered BankL Nepal Standard Chartered Bank was established in 1987. With assets of NR 21.3 billion (US$280 million), representing 9 percent of total banking system assets in 2001, it is the largest (and one of the most profitable) joint venture commercial banks in Nepal. It has six branches and, as a result of its attractive remuneration (significantly higher than most of the other financial institutions), it reportedly has staff with high technical skills. It also has a higher level of computerization in the workplace. Expatriates and foreign organizations are its main source of deposits21. Financial Highlights 1994-2001. Total assets of Standard Chartered Bank have grown at an average annual rate of 20 percent over the past seven years. Its share of total commercial banking system assets grew from 8 percent in 1994 to 9 percent in 2001. As with most of the commercial banks in Nepal, Standard Chartered Bank has not experienced very stable growth, with reported growth rates of around 29 percent in 1997 and 9 percent the year after. Deposits grew at an average annual rate of around 17 percent - slower than the growth in total assets - and thus the share of deposits to total sources of funds declined from around 85 percent in 1994 to 71 percent in 2001. Among the various types of deposits, savings deposits grew faster than fixed or current deposits and also made up a significant proportion (54 percent) of total deposits in 2001. Fixed deposits made up around 24 percent, and current deposits 20 percent of total deposits. On average, savings deposits constituted around 49 percent of total deposits over the period, a ratio that is highest among all the banks and suggestive of a high cost of funds. Capital funds grew significantly faster, around 27 percent annually over the period. As a share of total funds, capital funds constituted around 5.5 percent in 2001 compared to 3.7 percent in 1994. 2! A Review of the Financial Sector in N. epal, DFID, November 2000  54 Chart 4.7: Standard Chartered Bank Assets, Deposits, Credit & Investment, 1994-2001 25,000 20,000 m 15,000 a 10,000 5,000 1994 1995 1996 1997 1998 1999 2000 2001 Fiscal Year |4--Assets _ Deposits A Credit - Investment In terms of uses of funds, liquidity has grown at an annual average rate of 29 percent, over this period. Its share in total funding increased from 23 percent in 1994 to 38 percent in 2001. This growth was mainly reflected in a high growth of balances held abroad (an average annual growth rate of around 38 percent over the period and constituting around 90 percent of total liquid funds by the end of the period). This may be a reflection of the fact that Standard Chartered's main clients are expatriates and foreign organizations. Loans and advances grew at an average annual rate of around 18 percent over the period. However, the rate of growth has been decreasing since 1995. Loans and advances constituted only 27 percent of total funds in 2001 compared to 31 percent in 1994. Investments grew at an average annual rate of 3 percent over the period. Himalayan Bank. Himalayan Bank was established in 1993 by local businessmen in partnership with Habib Bank of Pakistan. It was the first joint venture bank under Nepalese management and with Nepalese shareholding control. It has a total of 8 branches - 7 urban and I rural. It was the first bank to introduce local credit cards, acquire the first automatic teller machines, and start tele- banking operations. In addition to commercial activities, it facilitates industrial and merchant banking activities. With total assets of NR.20.9 billion (US$280 million) in 2001, it is the fourth largest commercial bank in Nepal. Financial Highlights 1994-2001. Total assets of Himalayan Bank grew at a significantly high average annual rate of 41 percent over the period - in part, reflecting the very small initial start- up base. In 2001, total assets grew by 25 percent. In terms of sources of funds, deposits grew at an average annual rate of 39 percent (25 percent in 2001) and constituted 84 percent of total assets in 2001, compared to 91 percent in 1994. In line with other banks, savings deposits and fixed deposits grew at faster annual average rates of around 54 percent and 42 percent, respectively. Capital funds grew at 45 percent over the period and constituted 3.8 percent of total funds in 2001.  55 Chart 4.8: Himalayan Bank Assets, Deposits, Credit & lniestment, 1994-2001 25,000 20,000 *g15,000 a 10,000 5,000 0 1994 1995 1996 1997 1998 1999 2000 200 1 Fiscal Years |4- Assets Deposits Credit - InvestmentsJ On the uses side, loans and advances grew at 37 percent over the period. As a shan- of total funding, loans and advances have declined from 57 percent in 1994 to 44 percent in 2001. Their average share of the total during the period was 50 percent. Liquid funds grew at 45 percent per annum over the period, and their share in total assets increased from 28 percent in 1994 to 34 percent in 2001. Within liquid funds, there was a change in composition, with call deposits accounting for 82 percent of the total in 2001 compared to only 10 percent in 1994. Investments grew at 23 percent per annum over the period. Their share in total assets shrank from 11 percent in 1994 to 4 percent in 2001. Nepal Arab Bank Limited (NABIL). The liberalization of Nepal's financial sector began in 1984 with the establishment of the Nepal Arab Bank Limited, a joint venture with an Arab Bank. The bank operates with 12 branches - 8 urban and 4 rural (more than the other banks). NVith total assets of NR 19.2 billion in 2001 (US$250 million), its share of commercial banking system assets was around 8 percent (up from 7 percent in 1994). It is the fifth largest commercial bank in Nepal. Financial Highlights 1994-2001. NABIL's total assets grew at an annual average nrte of 20 percent over the period. Growth has fluctuated, tapering off from 33 percent in 1996 to 9 percent in 1999 and rebounding significantly to 35 percent in 2000. They grew by 16 percent in :2001. On average, deposits made up 78 percent of total sources of funding over this period. Growth in deposits averaged 17 percent over the period, with higher growth rates occurring in 1995-1996. Savings, fixed and current deposits made up 29 percent, 28 percent, and 26 percent, respectively, of total deposits in 2001. The capital fund grew by 29 percent on average and accounted for around 6 percent of total assets. NABIL is one of four banks that have met the minimum capital requirement. Loans and advances constituted 43 percent of total uses of funds in 2001, and grew at an annual average rate of 19 percent over the period. In 2001, loans grew by 10 percent. Liquid funds grew at a significantly faster rate - 27 percent - over this period. Their share of total assets increased to 32 percent in 2001 from 21 percent in 1995. Among the components of liquid funds, call deposits have been the largest, accounting for 89 percent of total liquid funds in 2001.  56 Investments declined over the period, and their share of total assets has fallen from 27 percent in 1994 to 5 percent in 2001. Chart 4.9: Nepal Arab Bank Assets, Deposits, Credit & Investment, 1994-2001 25,000 20,000