Although the Nepali banking sector takes pride in effective regulation and adherence to prudent corporate governance practices, the latest report from the regulatory authority has cast doubt on this perception.
NewBiz Report
These revelations stem from the annual banking supervision report published recently by the Nepal Rastra Bank. Although the Nepali banking takes pride in effective regulation and adherence to prudent corporate governance practices, the latest report from the regulatory authority has cast doubt on this perception. The erosion of corporate governance in the banking sector has been a topic of discussion for some time. The annual Bank Supervision Report for FY 2022/23 only confirms this reality. Over the past few years, the Nepali banking system has undergone turbulence, moving from an acute liquidity position when interest rates went as high as 17-18%. Given the persistent volatility in Nepal's liquidity situation, insider lending by private sector banks has become a troubling practice, contributing to a crisis of corporate governance across the entire financial system.
The latest NRB report has highlighted the flaws within the banking sector. According to the report, the bank boards, which are supposed to uphold corporate governance standards at the highest level, have shown negligence in loan provisioning and in maintaining good governance practices.
Scrutiny of Bank Boards' Responsibilities
The report raises significant ethical concerns regarding the operations of the board of directors of banks and financial institutions. It has noted a disproportionate focus on loan issues and procurement matters during board meetings, with insufficient attention given to critical areas such as policy formulation, risk management, and governance of the bank. "Agendas of the board of directors of banks predominantly focus on credit appraisal, approval, recovery actions, and procurement-related matters, with comparatively less emphasis on policy issues, compliance, audit, and risk management functions," states the report.
The report highlights concern regarding the weak oversight function of bank boards amidst several challenges, including expanding asset size, post-merger and acquisition issues, declining asset quality, weak management practices, high staff turnover, instances of employee involvement in borrower transactions, and fraud. It notes that board discussions have not allocated sufficient time to address compliance issues with NRB directives, prevailing laws, and the implementation of directions from previous NRB inspections. Moreover, there is a lack of attention given to the status and implementation of recommendations from internal, external, and IT audit reports.
The report identifies shortcomings in the risk management functions of banks. It states that many banks lack sufficient Management Information Systems (MIS) to effectively support comprehensive risk management. Moreover, the report notes that recommendations from the Risk Management Committee (RMC) have often been overlooked by the bank board, and in many cases, the RMC's role in risk management is deemed insufficient. Additionally, some banks have failed to develop industry-specific risk profiles which exacerbates the deficiency in their risk management practices.
As per the Company Act, it is mandatory to have at least one woman on the board of directors of banks. Despite this requirement, many banks still lack female board directors. Additionally, the report notes that boards of directors often fail to evaluate the performance agreements made with the chief executive officer.
Misuse of Credit
The central bank's report exposes the misuse of credit flows, attributing it to a lack of effective credit supervision mechanisms within the banking sector. According to the report, loans disbursed by banks are being diverted from their intended purposes. "Weak post-disbursement monitoring mechanisms within banks have led to instances where loans are being utilised for purposes other than their intended use. Furthermore, there have been observed cases where borrowers settle existing loans and interest by obtaining additional loans, highlighting potential misuse of funds," states the report.
Credit misuse constitutes a criminal offence under the Banking and Financial Institutions Act. Despite this, NRB has not forwarded the information to Nepal Police or other investigative agencies for appropriate action against such offences. Concerned about the potential impact of this practice, known as evergreening, on the reported level of bad loans in Nepal's banks, the International Monetary Fund (IMF) has urged the government to commission audits of 10 major banks by international organisations. These audits are scheduled to occur in the next financial year 2024/25.
The banks have also been found neglecting a requirement to maintain separate current and loan accounts for borrowers utilising working capital credit facilities. Consequently, borrowers have been able to utilise funds deposited in the current account for purposes other than creating underlying assets. Additionally, the report states that banks are not updating the Business Site Visit Report (BSVR) and Collateral Site Visit Report (CSVR) regularly, indicating a lack of diligence in monitoring and assessing collateral and business operations.
Credit misuse constitutes a criminal offence under the Banking and Financial Institutions Act. Despite this, NRB has not forwarded the information to Nepal Police or other investigative agencies for appropriate action against such offences.
Some banks are neglecting the requirement to obtain Net Trading Assets (NTA) reports for loans exceeding Rs 50 million, as mandated by the Working Capital Guidelines issued by the NRB in 2022. Furthermore, there have been instances where borrowers' requirements were not adequately assessed, leading to over-financing. For example, some borrowers are allowed to operate without maintaining the required debt-equity ratio, exceed drawdown limits based on their net trading assets, and receive working capital loans despite having negative net trading assets (NTA).
The central bank also said in its report that banks were allocating Bridge Gap Loan (BGL) arbitrarily, with no clear establishment of prospective asset creation from such loans. Furthermore, there have been frequent extensions of the BGL without valid reasons following disbursement. Additionally, certain banks have granted personal loans exceeding Rs 5 million without a specified purpose, contravening the provisions outlined in the NRB Unified Directives. According to the report, some banks renewed loans without obtaining essential documents necessary for credit appraisal, including audited financial statements (with disclosures on Off-Balance Sheet exposures), tax clearance certificates, firm renewal documents, and business inspection reports.
The Environmental and Social Risk Management (ESRM) Guideline has not been effectively implemented, as instances of project financing were noted without obtaining the Environmental Impact Assessment (EIA) Report, says the report. “Moreover, many banks failed to consider credit rating reports for borrowers availing credit facilities exceeding Rs 500 million, as required by the NRB Unified Directives,” it added.
The NRB report has raised concerns regarding the liquidity management plans of banks. It noted that many banks were exhibiting high dependency on institutional deposits and relying heavily on a few depositors for large amounts of deposits, posing a risk of severe liquidity stress in the event of sudden withdrawals. Assets Liability Committees (ALCO) of banks have been primarily engaged in status reporting activities, lacking a proactive approach to asset liability management. Additionally, there is a general oversight of off-balance sheet items when assessing liquidity positions. Furthermore, stress test scenarios, assumptions, and results are inadequately discussed in ALCO meetings, according to the report. It has also identified significant maturity mismatches between assets and liabilities within given time buckets.
ALCO meetings predominantly focus on operational aspects such as revising interest rates on deposits and loans, publishing interest rates, and analysing market interest rate trends, rather than strategic considerations like reviewing investment portfolios and divestment strategies. Additionally, some banks lack a comprehensive policy for assessing and managing risks arising from interest rate fluctuations. The central bank found that certain banks were engaged in foreign currency placements in high-risk countries, while others were failing to obtain interest rate quotations from multiple counterparties for foreign currency placements. Moreover, many banks were not utilising interest rate risk measurement systems beyond Gap Analysis as prescribed by the Nepal Rastra Bank. Furthermore, a few banks lack practices for monitoring Risk Sensitive Assets (RSA), Risk Sensitive Liabilities (RSL), and accurately analysing interest rate sensitivity trends, NRB said in its report.
The NRB report also underscored the risk of money laundering within banks. When it comes to adhering to AML/CFT measures, most of the banks lack a robust mechanism to maintain an updated Politically Exposed Persons (PEPs) list. Many rely on third-party sources for obtaining PEP lists, and there's insufficient infrastructure to identify family details and close associates of PEPs, the report states.
"Instances have been noted where accounts belonging to board members and senior-level staff showed a significant volume of cash transactions. Additionally, there is a lack of periodic implementation of Enhanced Customer Due Diligence (ECDD) for high-risk customers," states the report.
According to the report, many banks lack updated details of the Beneficial Owner (BO) and lack mechanisms to effectively monitor BO transactions as required by the Unified Directives. Furthermore, the transaction monitoring mechanisms in most banks have been inadequate in capturing business transactions routed through personal accounts, the central bank said in the report.
The NRB has said that its off-site surveillance and on-site inspections have revealed instances of non-compliance of regulatory provisions by banks. "This non-compliance is often attributed to a lack of knowledge and carelessness among bank staff regarding regulatory provisions, as well as a tendency to exploit loopholes in these provisions," reads the report. "Discrepancies in the data reported by banks to the NRB could potentially lead to misinformation and affect decision-making processes. Therefore, ensuring effective regulatory compliance from banks remains a significant challenge."
