For modern day banks, risk management is a major area of focus which is integrally tied to their success and failure. With the rapidly growing banking sector and introduction of new services, risk management has become crucial for Nepali banks. They have been availing services from international banking experts to enhance their performance in terms of risk mitigation and profitability. Dr Satish Shinde is one such expert who has been assisting Nepali banks in this regard. Dr Shinde, who is the Managing Partner of Pune, India-based firm Risk Management Associates, has over two decades of experience in training and consultancy alongside corporate lending and project financing.

Over the years he has extensively handled consultancy assignments of over 150 banks and corporate entities across South Asia and the Middle East. Dr Shinde has also worked in consultancy assignments of the World Bank Group and Asian Development Bank. A PhD in finance from University of Pune and a Post Graduate in Statistics and MBA from the same university, he has taught at various Indian and foreign educational institutions including University of Chicago, Illinois and National Institute of Bank Management, Pune. He recently conducted a training programme for a Nepali commercial bank in Kathmandu. In an email interview with New Business Age, Dr Shinde talked about risk management practices in the Nepali banking sector, regulatory compliance and new lending equipment to support the growth of micro, small and medium enterprises (MSMEs) and startups, among others. Excerpts:

What are your observations of risk management practices in Nepali banks?
I have been training bankers in Nepal for the last two decades. Nepali bankers are quite diligent and open to new ideas. Compared to India, the market conditions for banks here are more competitive and challenging. However, Nepal’s economy is poised for a steady growth and hence there are good prospects for the banking industry.

Risk management practices in Nepali banks are at various stages of development. Nepal Rastra Bank (NRB) has been proactive in issuing guidelines based on Basle II and III accords with suitable modifications. It has adopted a ‘Simplified Standardized Approach’ for credit risk and a ‘Basic Indicator Approach’ for operational risk, besides a small amount of capital to cover foreign currency risk. 

What areas do you think the banks in Nepal need to improve in terms of their risk management?
On an average, 93 percent of Nepali banks’ risk weighted assets consist of credit risk, followed by about 6.5 percent of operational risk and the remaining about 0.5 percent of market risk. Obviously, the focus has to be on credit risk, especially the risk rating models for corporate and SME borrowers. Banks that have already introduced rating models need to validate them based on the actual default data. The banks which have not introduced the rating systems may seek external help if needed. Buying readymade software packages for this purpose is not an appropriate solution. Rating models need to be customized based on the nature of business and credit appraisal skills available. Software support could be sought only after the rating models have been tested. In the next phase, credit scoring models should be developed for retail loans based on internal default experience.

Liquidity risk management is another area which needs strengthening. The recurring liquidity crisis in the Nepali financial market highlights its importance. Providing additional capital is not a solution. NRB may like to introduce ‘Liquidity Coverage Ratio’ as recommended by Basel III. However, the regulator may have to wait until the banks tide over the present liquidity crisis. Some other areas which the banks need to address are ‘Customer Profitability Analysis’ and ‘Risk Adjusted Return on Capital’ (RAROC). Banks should also strengthen their risk management culture, corporate governance and risk-based internal audit. NRB’s guidance to banks to spend 3 percent of their net profits on employee training and development could be looked at in this context. Our recently conducted training programs in the area of credit, risk management and risk based internal audit should help bankers in this process.

What is the role of regulatory compliance in this regard? How effective do you think are such compliances in Nepal for the banking sector?
Banks seem to have been complying with NRB guidelines, except for the liquidity ratios (due to the present liquidity stress in the market). However, bank managements should not look at the central bank’s guidelines only as a compliance exercise. The said guidelines need to be used more for business decisions, such as capital allocation for various divisions, pricing of loans and services, effective identification of risks, their management and control, etc. Incidentally, banks in Nepal seem to be well poised for compliance with the new capital adequacy requirements based on Basel III Accord. Luckily in their case, most of the capital is in the form of ‘Common Equity Tier 1 Capital’.

Over the years, you have conducted consultancy and training for a large number of banks and corporate entities across South Asia and the Middle East. Based on your observations, what major risks are institutions generally prone to? How can such risks be mitigated?
Credit risk forms the major portion of banking risks for most of the banks in South Asia and the Middle East. I have been doing extensive training and consultancy work in these markets. Besides the counterparty credit risk, banks should effectively address issues relating to ‘concentration risk’. Smaller banks are especially prone to this element of risk. Central bankers, during their review process, need to ensure that there are controls in place to effectively manage the concentration risk. Models such as ‘Herfindahl-Hirschman Index’, ‘Gini Coefficient’ may be used by banks to measure single borrower concentration, besides sectoral and geographical concentrations. Stress testing technique may also be useful in this context.

You have also worked for the transition from collateral based lending to cash flow based lending and entrepreneurship based financing in Sri Lanka and Bangladesh.
I have been associated with the World Bank Group in respect of two projects. One of them deals with ‘Movable Assets Based Lending’ (MABL) for micro, small and medium enterprises (MSMEs). It involves lending to MSMEs without insisting upon additional collateral. Many such enterprises are deprived of bank credit since they are unable to offer additional collateral, although they may have viable business ideas. MABL is a suitable product for such entrepreneurs. It incorporates more intensive control of the primary collateral, namely inventories, receivables, among others, and close control over the borrower’s cash flows. 

Through MABL techniques, banks can lend to such MSMEs without exposing themselves to additional risks. This is done through structured lending products such as supply chain financing, ware-house receipt financing, factoring, etc. MABL would also be a solution for meeting the credit needs of startups and MSMEs with not so strong financials but reasonably good business prospects.

The second project which I have been associated with the World Bank Group deals with lending to the services sector. In India, this sector contributes almost 57 percent of the gross value added. The position of services sector in other South Asian countries is almost similar. It is the fastest growing sector of the economy with high employment potential. Banks have been reluctant to lend to this sector due to non-availability of tangible security. Even in cases where tangible security is available, banks may not be able to readily dispose of those securities or the realizable value may be much lower than the book value. ‘Cash flow based lending’ and structured lending products may help the banks to exploit opportunities in the services sector. The Chandragiri Hills project in Nepal is an encouraging example in this regard.

What would you suggest for similar transition also in Nepal? 
Nepali banks will have to quickly adopt new lending techniques and products. In the process, they will facilitate economic growth and employment generation. Although closely engaged in various training and consultancy projects for the banks in South Asia in the areas of credit and risk management, I would frankly admit that the progress achieved is limited. Bankers by nature are conservative (and they should be). Nevertheless, they need to change their lending and risk management techniques in the light of the rapidly changing economic environment. I am confident that bankers in Nepal with their diligent and open approach would be able to successfully meet the emerging challenges.