‘Banks should be allowed to invest in foreign sovereign debt instruments’

Nepal Rastra Bank, the central monetary authority, recently surprised the banking fraternity by making radical changes to minimum paid-up capital requirement for banks and financial institutions. As per the provisions mentioned in the latest Monetary Policy, commercial banks will have to increase minimum paid-up capital from existing Rs 2 billion to Rs 8 billion by mid-July 2017. Likewise, national-level development banks will have to raise minimum paid-up capital from Rs 640 million to Rs 2.5 billion within that period, while national-level finance companies, including those operating in four to 10 districts, will have to increase minimum paid-up capital from Rs 300 million to Rs 800 million. Rupak D Sharma of The Himalayan Times caught up with President of Nepal Bankers’ Association Upendra Poudyal, who is also the CEO of NMB Bank, to discuss the latest change in capital requirement and other provisions incorporated in the Monetary Policy.

Nepal Rastra Bank (NRB) recently directed commercial banks to increase minimum paid-up capital by four-fold to Rs eight billion in the next two years. What is your take on the issue?

The central bank should have considered feasibility of the plan, as many commercial banks have just managed to raise the capital to Rs two billion. In this context, it would be very difficult for many institutions to expand capital base to the level fixed by the central bank. At present, the first two options available with banks to raise capital are issuance of bonus and rights shares. But this may hit returns of banks in the coming days. Downfall in returns, in turn, may erode confidence of stock investors in the banking sector, affecting the development of the entire secondary market. In this context, the only alternative to meet the new minimum regulatory capital requirement is merger. And the Monetary Policy also gives a hint that NRB wants to push for mergers. But how wise would it be to assume that all mergers would end up becoming a success? To raise the capital to the level recommended by NRB, commercial banks must merge with institutions of similar size, as consolidation with smaller institutions won’t help them achieve their goal. But big institutions have their own priorities, goals and policies. In that context, mergers may not be successful in integrating culture, human resources and operations. And failure on this front would hamper the entire business, raising doubts on sustainability of the consolidated unit. This will ultimately put the capital of Rs eight billion at risk. A study conducted recently by NRB had found that success rate of mergers is low in Nepal. I’m not sure about the number but success rate of mergers here stands at around 40-50 per cent. Even worldwide, 70 per cent of the mergers fail to yield desired results.

You mean to say forceful mergers may destabilise the banking sector because of different priorities of different promoters?

First of all, let me be clear that we are not against the NRB’s move to raise the capital. We, in fact, welcome this plan as it would eventually strengthen our financial position and enable us to think big. But the central bank should give us more time to raise the capital. That’s what we are asking for at the moment because we know the downside of forced mergers. So, banks need adequate time to raise the capital on their own. Currently, total paid-up capital of 30 commercial banks stands at around Rs 70-75 billion. If all banks are able to raise paid-up capital to the new level fixed by the regulator, total paid-up capital of commercial banks would reach at least Rs 240 billion in the next two years. In other words, there would be capital injection of around Rs 165-170 billion. But along with the rise in capital base, credit demand also needs to go up. With the existing level of capital, commercial banks have extended loans of around Rs 1.1 trillion. If the new capital requirement is implemented, banks will have to increase lending by three-fold. Is this possible? And does our economy have the capacity to absorb all these loans? I don’t think it has because the Monetary Policy of this fiscal year has targeted 20 per cent credit growth in the private sector. The credit growth target of this fiscal year is at a higher end because it is assumed that spending would go up in the coming days to finance reconstruction works in the aftermath of the earthquakes of April and May. This implies credit demand will not rise drastically in the coming days and years. So, raising the capital within the timeframe extended by NRB would only heap pressure on returns of banks.

So, how much time would banks require to raise paid-up capital to the level recommended by the central bank?

Banks must be given five to seven years to raise the capital, depending on their size. During this period, banks will have to retain the profit and issue limited amount of rights shares. However, it may not be practical to always convert profit into bonus shares, as investors also expect cash dividend to meet various financial needs. For instance, an investor who has acquired a loan to purchase stocks may require cash to service the debt. So, it may not be feasible to capitalise profit all the time. However, this is my personal statement, as it is ultimately the investors who have to inject capital. So, I think it also depends on how they react.

Well, the provision on minimum capital requirement is only one part of the latest Monetary Policy. What do you think of the entire Policy?

We have taken overall Monetary Policy positively. However, it has failed to properly address the issue of excess liquidity management. The biggest challenge faced by the banking sector at present is liquidity management. Commercial banks currently hold deposits of around Rs 1.5 trillion. Of this, 20 per cent has to be set aside to meet liquidity-deposit (LD) ratio. Also, there is provision on credit-deposit (CD) ratio — technically referred to as credit to core-capital-cum-deposit (CCD) ratio — of 80 per cent. Since banks do not wish to walk a tightrope, they maintain CCD ratio of around 75 per cent. This means we do not convert 25 per cent of the total deposit into loans. This is a big fund and we wish to invest this money in liquid instruments. One of such instruments is interbank lending. However, return on interbank lending has now fallen to less than one per cent, because there is no demand for it — thanks to excess liquidity. The other liquid instruments available in the market are treasury bills and gernment bonds. However, the government has not been floating enough of these instruments because of low public spending, especially capital spending. And considering the trend of public expenditure, there is no guarantee that capital spending will increase drastically in the coming days. This means chances of hike in domestic borrowing are low. In other words, the problem associated with excess liquidity will continue to haunt the banking sector in the coming days. In this regard, NRB and bankers must come up with a practical solution to address this problem.

Also, there is a misconception that banks can lower the portion of excess liquidity by increasing flow of credit at lower rates. But what many need to understand is that banks cannot convert these funds into loans because of regulatory requirement to maintain CCD and LD ratios. So, these funds must be invested in instruments approved by NRB. However, interest rate on many of the instruments floated by NRB stands at close to zero per cent. This means return on 25 per cent of deposits is almost zero, whereas banks are paying interest of 6.5 to seven per cent to depositors. This mismatch is raising cost of fund. And higher cost of fund not only hits profitability but forces us to squeeze deposit rates and raise lending rates. This problem needs to be addressed soon, as it is posing a question mark on sustainability of the banking sector.

So, it appears the problem of excess liquidity cannot be solved unless the government increases its capital spending, isn’t it?

Yes, the government must spend more in development activities. Government expenditure, on the one hand, pumps in liquidity and, on the other, creates demand for credit because industries have to give a boost to their capacities to meet the growing demand. Also, government expenditure in development activities generates employment opportunities, increases aggregate demand and ultimately pushes up gross domestic product. If this cycle functions properly, we can expect higher economic growth; and this will benefit every sector.

The Monetary Policy has envisaged bigger growth in government spending this year because of the need to rebuild parts of the country ravaged by quakes. Also, the government said it would borrow up to Rs 88 billion from the domestic market. Do you think this would address the problem of excess liquidity?

The government has allocated Rs 91 billion for reconstruction activities for this fiscal year. This budget is around Rs 10 billion more than last fiscal year’s actual capital spending of Rs 81.58 billion. So, there is no guarantee that the entire fund allocated for reconstruction would be utilised because the government’s fund absorptive capacity is very low. However, Finance Minister Ram Sharan Mahat has pledged to focus on budget implementation. So, let’s hope for the best.

Lately, NRB has also been using money market instruments, such as term deposit, to mop up excess liquidity, isn’t it?

Yes, NRB has been using these instruments to absorb excess liquidity. But the returns on these instruments are very low. Look at the return on 91-day treasury bills, which hovers around 0.2 per cent. Also, look at the return on 15-year development bonds, which stood at 2.65 per cent. So, these instruments are not helping the banking sector. These examples show the country’s weak liquidity management capacity.

But these instruments are auctioned and returns on these tools have fallen because of low rates quoted by banks and financial institutions, isn’t it?

Yes, that’s the case. But returns are falling because of low supply of these instruments. So, there is mismatch in demand for and supply of these instruments.

Lately CCD ratio of many banks is coming back to a comfortable level. This is providing them space to ramp up lending. So, shouldn’t banks also become more innovative and introduce credit products accordingly to generate demand in the productive sector?

CCD ratio of commercial banks currently hovers at around 74 per cent. But let’s not forget that we are talking about CCD ratio here, which means we are factoring in the sum of core capital and deposits while calculating the ratio. If you look at balance sheets of banks in developed countries, you’ll find them maintaining credit-deposit ratio of 65 to 70 per cent. And don’t forget this calculation is done without factoring in core capital. In other words, banks of developed countries maintain high level of liquidity. Such high level of liquidity provides cushion against shocks, such as heavy deposit withdrawal. So, the argument that CCD ratio of 74 per cent provides adequate space for lending does not sound very logical. Also, the argument that credit has not expanded is not valid. Last fiscal year, for instance, credit to the private sector grew by 17 per cent, as against lending growth of 15 per cent recorded in the previous year. What also needs to be taken into account is fluctuation in liquidity at short
intervals. Just several months ago, banks were forced to raise deposit rates because of tight liquidity situation. There is excess liquidity. Such fluctuations at frequent intervals exert pressure on interest rates. So, to create interest rate stability we have to maintain a comfortable CCD ratio.

This volatility in interest rates is also the result of asset-liability mismanagement, isn’t it?

Absolutely. But if there was adequate supply of instruments to mop up excess liquidity, we wouldn’t have faced this problem. So, if NRB or government can’t increase supply of instruments to mop up excess liquidity, banks should be allowed to invest in foreign sovereign debt instruments that provide fairly good yields. This way, we won’t be forced to continue purchasing domestic instruments that offer no returns. NRB should consider opening this window for us.

However, foreign sovereign debt instruments are not totally safe either. Look at Greece.

That’s true. So, NRB should open this window cautiously. For instance, Indian economy is performing well at the moment and returns on debt instruments there are also higher. And since our currency is pegged with that of India, investments in the country will carry no foreign exchange risk as well. So, the problem of excess liquidity can be partially addressed if we are allowed to invest in Indian sovereign debt or bonds issued by certain Indian banks.

Source: THT