Active loan markets can propel the banking sector towards greater stability, resilience and growth.

The banking sector of the country seems to be in a turmoil currently with depositors rushing to withdraw their savings and panic gripping the financial cooperatives. Financial cooperatives across the country are struggling to cope with the significant outflow of deposits driven by uncertainty and fear within the financial sector. The crisis emanates from factors such as poor management of assets and liabilities and questionable investment choices as well as unregulated lending practices which have put us on edge of a full blown financial disaster. However, within this chaos lies an opportunity for reform and resilience. One innovative solution that can be implemented in this chaotic situation is the creation of an active loan trading market. This can recalibrate and strengthen our financial system, while providing a pathway towards stability and sustainability.

Overview of loan trading market 

Loan trading market is a financial playground where loans - once considered as illiquid assets - transform into tradable securities. In this marketplace, banks and cooperatives can sell their existing loans and convert these otherwise static assets into liquid capital. It provides an immediate financial infusion to financial institutions which help them satisfy the short-term demands of depositors. This staves off a potential banking collapse and provides some semblance of stability in the banking system. 

The immediate benefit that an active loan trading market offers in a banking crisis scenario is that it provides a lifeline of liquidity. As depositors rushed to withdraw their deposits, financial cooperatives struggled to meet this sudden demand. Had there been a loan trading market, these cooperatives could have sold a portion of their loan portfolios and generated the required cash to meet demands of their depositors. This would have prevented further deposit runs but helped maintain the cooperative's solvency, while also providing immediate stability to an otherwise unstable financial environment. 

Another feature of active loan markets is their role in risk intermediation. When financial cooperatives offload their loans, they essentially transfer default risks that may arise when borrowers fail to clear debts to investors who buy these debts or loans. This transfer creates a risk buffer, allowing the institutions to manage and reduce their risk exposure.

Underwriting Incentives 

Active loan trading market also holds significant implications for underwriting standards. Offloading of loans might raise concerns about moral hazard - the fear that banks and cooperatives may engage in lax underwriting, knowing that they can transfer the risk to others. However, the market naturally creates checks and balances against this. Like all investors, participants in the loan trading market will want high yields and low risks from their investments. They would naturally be attracted towards buying those loans which have been subjected to proper scrutiny during the underwriting process. A poorly underwritten loan, which carries higher risk, would fetch a lower price in the market or even fail to find buyers. This way, the market indirectly incentivises financial institutions to maintain high underwriting standards. This leads to a more resilient financial system.

Benefits for both sides

Active loan markets thrive on the synergy between the buy-side and sell-side participants. On the sell-side, banks and cooperatives stand to gain from immediate liquidity and effective risk management. The ability to convert loans into cash quickly enhances their capacity to meet immediate liabilities, such as depositor withdrawals. Likewise, the option to offload higher-risk loans provides an opportunity to prune their portfolios, allowing for better risk management. Conversely, on the buy-side, investors find an attractive prospect in loan securities. As a new asset class, these securities can offer higher yields compared to traditional investment options. The diversity in loan types also provides opportunities for investors to diversify their investment portfolios, thereby optimising their risk-return tradeoff. The result is a dynamic and efficient market, with risk and returns appropriately distributed among the participants.

During Sweden's banking crisis in the early 1990s, a secondary loan trading market called asset management companies or ‘bad banks’ was created to absorb non-performing loans from the balance sheets of banks.

Historical Lessons

The potential of an active loan trading market in stabilising a banking crisis is not purely theoretical. During Sweden's banking crisis in the early 1990s, a secondary loan trading market called asset management companies or ‘bad banks’ was created to absorb non-performing loans from the balance sheets of banks. These companies bought non-performing loans from banks, releasing the banks from the burden of bad debt. This enabled the banks to focus on lending again which helped not only to restore public trust in the banking system but also revived the stagnant Swedish economy.

Regulatory roles

Amidst the current crisis, it is crucial for the central bank and related government agencies in Nepal to implement measures to establish an active loan trading market. To begin with, the central bank must stabilise financial cooperatives through its supervisory role. If necessary, it should replace the management of certain cooperatives to rebuild trust and prevent defaults. Simultaneously, the central bank can coordinate with financial institutions and investors to set up a loan trading marketplace. This would entail facilitating negotiations, creating a loan exchange platform, and establishing temporary regulations.

On the government's part, it should take immediate steps to incentivise both sides of the loan trading market. For financial cooperatives, the government could provide risk guarantees for the loans they sell in the active loans market which can help reduce the risk perceived by the buyers. This risk guarantee could be limited to a certain percentage of the loan value and be applied for a specified period. Likewise, it can offer various incentives to encourage potential investors or the buy-side of the market. These can include tax exemptions on profits from loan securities or expedited processes for foreign investors looking to repatriate their profits. 

Furthermore, both the central bank and government agencies should work closely to ensure transparency in the entire process. They could do this by providing regular updates on the development of the loan trading market, disseminating clear guidelines on the trading process, and conducting frequent audits of the transactions. These measures can help mitigate the current crisis, provide the liquidity lifeline that financial cooperatives need and pave the way for the establishment of a thriving, robust loan trading market in Nepal.

Conclusion

The active loan market shines as a beacon of hope in the current crisis that the banking sector is currently facing. It offers a pathway to immediate stability through enhanced liquidity and effective risk management, and fosters a self-regulating financial ecosystem. While the journey to establishing an active loan trading market in Nepal will undoubtedly be complex, the benefits that it offers far outweigh the challenges. With careful planning, diligent execution, and, most importantly, collective determination, we can weather this storm and build a more robust and resilient financial landscape for Nepal. The active loan market, if realised, could prove to be a turning point in Nepal's financial history. It can provide a strategic lifeline that propels the nation's banking sector to new heights of stability, resilience and growth. 

(Rijal is the head of Quantitative Strategies at Cross River, an American financial services organisation that provides technology infrastructure to fintech and technology companies.)