Systemic Problems or a Problem of Trust

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Systemic Problems or a Problem of Trust

Historical data shows banks can cope with NPLs,
but maintaining public trust remains a challengeBanks, as a business, bear a unique risk due to their practice of borrowing short-term funds and lending them out over longer periods of time. This results in the majority of their assets being tied up in long-term loans, while their deposit liabilities are short-term. As a result banks themselves as well as regulations mandate that banks allocate a certain percentage of their total deposit liabilities to liquid assets. This is achieved through various structural safeguards such as CD ratios, Liquidity Ratios, and Capital Adequacy frameworks. These measures ensure that banks can cater to daily withdrawals from their customers without difficulty. However, if all customers were to demand their deposits back simultaneously, no financial institution in the world would be able to handle such a bank run. No amount of structural safeguards can protest against lack of trust. The fragility of any monetary system is as fragile as the trust of the masses. Financial crises such as the Great Depression of 1929, the 2008 financial crisis, the collapse of the Weimar Republic currency in the 1920s, and Zimbabwe's trillion-denominated currency were all linked to a lack of trust in the financial and monetary system.
In today's globalised world, incidents of bank runs in a couple of state-based banks in the USA have sparked fears among depositors in Nepal. The concern is that this could lead to bank runs in Nepal as well. Are such fears baseless? Is this simply mass hysteria triggered by an uncorrelated event or are there underlying systemic problems yet to be exposed in our banking system that justify the fears? Can this fear shapeshift to loss of trust in our banking system? How shock resistant is our financial system? How safe are our deposits in our financial institutions?

The diagnosis
Credit is vital for economic growth, but excessive lending can lead to inflation, misuse of credit, aggressive lending practices, and lax risk management, resulting in high non-performing loans (NPLs). However, credit cycles in Nepal's history present a different story. In the past decade, governments aimed to achieve high GDP growth targets, leading to rapid private sector credit expansion. Despite this, NPA did not increase proportionately, and instead, have been on a decline since 2012, with almost stagnating at 2% since 2016. This anomaly could be attributed to two possible reasons: either banks were extremely cautious in loan disbursement and credit recovery, or they used credits to evergreen non-performing loans.
Similarly, high lending rate environments should also theoretically have a positive correlation with NPLs. However, between the years 2017-2020, despite high interest rates, NPLs remained low. One probable cause for this anomaly is the evergreening of loans and refinancing facilities provided to priority sectors affected by the COVID-19 pandemic. 

As of 2022, the NPLs in BFIs have started to increase due to rising interest rates and the withdrawal of COVID relief refinancing. Additionally, the provisions that were previously deemed sufficient to cover NPLs are no longer enough, as seen by the converging trend lines of NPL to Total Loan and Provision to Total Loan. Currently, allocated provisions can only cover the current NPL levels. If NPLs continue to rise, higher provision requirements may be necessary. However, the risk of insolvency for BFIs due to such requirements will depend on whether they have adequate equity to handle such contingencies.

Some smaller financial institutions, especially cooperatives, were unable to return deposits to their depositors, limiting withdrawals to only a few thousand at a time. Cooperative depositors were subject to withdrawal limits of 5%. These institutions faced issues as their deposits were tied to illiquid real estate assets, and the real estate sector was suffering from regulatory restrictions and liquidity issues.
Microfinance companies, which had previously operated independently and provided credit at high interest rates to low-income individuals, have seen an increase in their non-performing assets due to incidents of loan defaults. Additionally, these microfinance companies have been accused of predatory lending practices, triggering protests against them.
Meanwhile, Class A, B, and C BFIs are also facing their own problems. The signs of an economic recession, as well as slowing economic activity affecting businesses across the country, have caused an increase in NPAs for banks over the past few quarters.
Overall, trust in financial institutions is dwindling as all tiers of financial institutions are struggling in some capacity. 
The credit to GDP ratio in Nepal stands at 100.24%, indicating that the multiplier effect of 

credit seems to be ineffective in the Nepali economy. This may be another example of credit misutilisation. The Non Performing Loans (NPLs) of BFIs are at 2.63% as of February, 2023, totaling Rs 86.08 billion which is almost three times higher than the total NPL of Rs 28.8 billion in July, 2017. Some class A BFIs have seen their NPL climb as high as 4.5%. The central bank considers NPLs within the 5% threshold to be a safe zone for BFIs. While the industry average currently seems to be within safe limits, if any institution shows regulatory red flags, trust in the overall banking sector could falter.
The prognosis
Amidst all the fear and uncertainty, it was prudent to analyse the worst-case scenarios regarding banks' ability to withstand increasing NPLs and assess their liquidity position to determine their ability to return deposits to depositors and evaluate their vulnerability in case of bank runs.
Commercial banks
Currently, commercial banks hold Rs. 4,744 billion in deposits, out of which Rs. 354 billion are liquid assets and Rs. 748 billion are invested in securities, such as government securities, which can be made liquid at short notice. This provides a healthy cushion of 24% deposit refund capacity in case of bank runs in commercial banks.
Assessing the severity of increasing NPLs in commercial banks, we can see that the banks have adequate provision:

Even if the NPL doubles in the coming quarters, the total provision requirement would be Rs. 248 billion, requiring an additional Rs. 129 billion to be covered, for which commercial banks appear to be adequately capitalised. However, the additional provision would result in the average book value of commercial banks coming down from the current Rs. 163.65 to Rs. 130.79. Despite the chances of taking hits on profits and reserves in the near term, commercial banks have adequate capitalisation to withstand a significant rise in NPL.
Development banks
Currently, development banks hold Rs 533 billion in deposits, out of which Rs 52.5 billion is in the form of liquid assets and Rs 76.91 billion is invested in securities such as government securities that can be liquidated at short notice. This provides a cushion of 30% deposit refund capacity in case of bank runs. However, the severity of increasing NPLs in development banks is a matter for concern. They only have a provision of Rs 13.08 billion for Rs 14.65 billion in NPLs, with the NPL rate standing at 3.19%. Should the NPL double in the coming quarters, the total provision requirement would jump to Rs 26.11 billion, requiring an additional Rs 11.47 billion to be covered. Unfortunately, development banks lack adequate capitalisation to cover these additional provisions.
The additional provision would result in the average book value of development banks coming down from the current Rs 124.7 to Rs 96.14. The development banks will struggle with adequate capitalisation to withstand a significant rise in NPL and will take huge hits on profits in the upcoming quarters. The same is the case with finance companies whose liquid assets cushion in case of bank runs looks to be adequate, but the problem again lies in the rising NPLs and capital adequacy to cover for the provisions.  
(This article is prepared by iCapital, an asset management and advisory company which says it follows Value Investment Philosophy to generate compounding returns.)

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