Pressure Mounting on Banking Sector as Economic Activity Contracts

Kathmandu. The prolonged sluggishness in the economy, weak demand, contraction in investment, and policy uncertainty have impacted the banking sector.

As credit demand continues to weaken, investable funds are piling up in banks and financial institutions, while on the other hand, the capital adequacy limit has put pressure on the very capacity to convert available resources into loans. However, the current problem does not appear to have arisen from a weakening of the banking system's fundamental structure, but rather as a consequence of successive economic shocks witnessed in recent years.

Since there has been no major structural damage to key sectors of the economy, the banking sector is expected to regain momentum as economic activity begins to expand. The main challenge today is not a lack of money in banks, but rather the weak environment for channeling available resources into productive sectors. Declining credit demand, weakened investment capacity of the private sector, and sagging business confidence have prevented the mobilization of resources within the banking system.

In recent years, the economy has been enduring one pressure after another—the pandemic, high interest rates, fluctuations in real estate and the stock market, weak consumption, sluggish investment, and increasing youth migration abroad. This has affected production, trade, employment, and investment. When economic activity contracts, its direct impact falls on banks' credit expansion. With weak credit demand, banks are accumulating resources while opportunities to deploy them remain limited.

Another problem currently seen in the banking sector is related to investor returns. Although banks have earned substantial profits, complaints are growing that investor returns have not been attractive accordingly. Because investors within the bank's ownership structure do not have an easy exit route and the entry process for new investors is complex, problems have emerged in the free flow of capital. Regulatory provisions governing the trading of founder shares have created a situation where some investors who wish to exit cannot do so easily, and new investors who wish to enter also face a cumbersome process.

This has also affected capital restructuring in the banking sector. Even when there are new investors willing to invest in banks, the existing structure prevents their easy entry, and old investors cannot exit—reducing flexibility in bank ownership and capital management. Time-appropriate reforms in the existing system appear necessary to attract new investors capable of bringing required capital and taking on risk in the banking sector.

Regulatory risk has also become another factor affecting banks' decision-making capacity. The provision that creates tax liabilities when provisioning exceeds a certain threshold, and the risk that even directors and chief executive officers may lose their positions in regulatory actions following the regulator's vigilance, have made bank management more cautious. While regulation is necessary, if the perception of excessive risk grows at the decision-making level, it could affect credit expansion and business decisions.

Disputes related to collateral auctions have also further discouraged the banking sector. If legal and social disputes appear to escalate when banks initiate the process of selling and auctioning collateral in the course of managing bad loans, bank management may become more hesitant to take risks. This slows down the pace of bad loan management and increases the risk that banks will become more defensive in future lending.

The core of the economic sluggishness appears to be weak demand. When demand for goods and services in the market cannot increase, the private sector is unwilling to expand new investment. Without new investment, job creation weakens, income growth slows, and its impact falls back on consumption and demand. This very cycle poses the risk of keeping the economy sluggish for an extended period.

Demographic change is also linked to this. As a large number of young workers migrate abroad, not only has the domestic labor force decreased, but the foundation for production, consumption, and investment has also weakened. If an environment can be created to generate employment and entrepreneurial opportunities domestically for youth who would otherwise migrate, and to encourage those who have already gone abroad to return, it could help expand domestic demand.

The need to accelerate the use of natural resources, expand exports, and commercially utilize domestically available resources has also become apparent. From unused timber in the forest sector to other natural resources, there is a need to prioritize their use in production and