Loan Loss Provisions: Are Nepali Banks Playing it Too Safe or Too Risky?

The critical role of Loan Loss Provisions (LLPs) in safeguarding Nepal's financial architecture has come under intense scrutiny recently. Following the tremors of a global economic crisis, the lingering aftershocks of the COVID-19 pandemic, and a notable surge in Non-Performing Loans (NPLs) across the banking and financial sector, a profound debate has emerged. 

Are Nepali banks clinging to an overly cautious 'safe' policy, or are they, perhaps inadvertently, drifting into a more 'risky' operational mode? A deeper, more incisive analysis of this pivotal issue is not just warranted but essential for the nation’s economic stability.

The Regulatory Framework: A Foundation for Stability

The Nepal Rastra Bank (NRB), as the central banking authority, has long anchored the financial system through its Unified Directive, meticulously outlining loan classifications and mandating minimum provision rates for all commercial banks. This regulatory bedrock ensures that financial institutions allocate a portion of their earnings to cover potential loan defaults, acting as a crucial buffer against economic downturns.

A significant shift is currently underway with the phased implementation of the Nepal Financial Reporting Standard 9 (NFRS-9). This new standard introduces the "Expected Credit Loss" (ECL) model, a forward-looking approach that fundamentally changes how banks assess and provision for risks. Unlike previous methods that often relied on historical loss data, ECL compels banks to anticipate and set aside provisions for future potential credit risks, demanding a more proactive and predictive risk management framework.

Currently, the prescribed provision rates illustrate a tiered approach to risk management:

• Pass Loan (Standard Loan): 1–1.3%

• Watchlist Loan: 5%

• Substandard: 25%

• Doubtful: 50%

• Loss Loan (more than 12 months overdue): 100%

The advent of NFRS-9 further accentuates this, requiring not only a strong categorization of existing loans but also a meticulous incorporation of prospective risks into the provisioning calculations. This move is designed to ensure banks are adequately capitalized to absorb potential shocks before they materialize into full-blown crises.

Recent Trends: A Closer Look at the Numbers

Nepal's banking sector has, in recent years, navigated a turbulent environment marked by a persistent liquidity crunch, a noticeable slowdown in credit growth, and increasingly arduous challenges in loan recovery. These headwinds have predictably manifested in the banks' asset quality.

Latest data for the third quarter of 2024 (FY 2080/81) paints a revealing picture: the average NPL rate across commercial banks has climbed to 4.83%, a discernible rise from 3.65% in the preceding fiscal year. This upward trajectory is particularly pronounced in some institutions; for instance, Himalayan Bank's NPL rate has reached 7.68%, and Kumari Bank's stands at 6.98%. These figures are more than mere statistics; they are critical indicators of mounting stress within the loan portfolio.

Paradoxically, during this period of escalating NPLs, banks collectively set aside NPR 35.07 billion in provisions – approximately NPR 4.8 billion less than the previous year. This discrepancy raises a crucial question: What does this signal for the health of the banking sector? It strongly suggests that while the challenge of recovering loans has intensified, banks appear to be prioritizing profit balance by strategically reducing their provisions. This tactical maneuver, while potentially boosting short-term profitability, carries inherent long-term risks.

The Dilemma: 'Overly Safe' or 'Risky'?

The current state of loan loss provisioning in Nepal presents a fascinating paradox, oscillating between what appears to be excessive caution and an increasingly bold appetite for risk.

The 'Overly Safe' Stance: Over-provisioning

Historically, Nepali banks have often leaned towards over-provisioning, setting aside more capital than strictly necessary to cover loan losses. This conservative approach, particularly noticeable during periods of instability such as the aftermath of the pandemic, saw banks earmarking substantial provisions even for 'Pass' and 'Watchlist' category loans.

The rationale behind this strategy is straightforward: while it admittedly reduces a bank's immediate dividend distribution capacity, it simultaneously fortifies its capital structure, providing a strong safety net against unforeseen financial shocks. The ongoing implementation of NFRS-9, with its emphasis on future risk estimation, could further entrench this conservative tendency, potentially leading to even greater provisions being set aside for anticipated credit losses.

The 'Risky' Aspect: Under-provisioning Trends

However, a contrasting and arguably more concerning trend has emerged. Faced with the recent slowdown in credit demand and mounting pressure on capital, some banks appear to have adopted a strategy of cutting back on provisions to enhance short-term gains. This 'leaner' provisioning approach is primarily driven by the desire to boost immediate profitability and satisfy shareholder expectations in a competitive market.

This strategy, while seemingly beneficial in the short run, carries significant systemic risks. Despite the persistently high NPL levels, a reduction in provision amounts means that banks might be under-reserved for potential future defaults. If NPLs continue their upward trajectory, the currently allocated provisions may prove insufficient to absorb the losses, potentially eroding the bank's capital base and triggering broader financial instability. While the Nepal Rastra Bank diligently monitors banks' Capital Adequacy Ratios, a sustained increase in NPLs without commensurate provisioning poses a palpable threat of escalating systemic risk across the entire financial system.

Banking's Core Conflict: Profit vs. Prudence

The direct impact of loan loss provisions on a bank's profitability is undeniable, creating an inherent tension between short-term financial gains and long-term stability.

• Higher provisions act as a drag on immediate profits, as more capital is held back. However, this prudence significantly enhances the bank's resilience and stability over the long haul.

• Conversely, lower provisions inflate immediate profits, which can be appealing to investors seeking higher returns. Yet, this short-sighted approach can fundamentally jeopardize the bank's long-term financial health, leaving it vulnerable to credit shocks.

Nepal's banking sector is characterized by fierce competition, where profitability often serves as the primary metric for bank valuation in the stock market. This creates a powerful incentive for banks to pursue a 'lower provision – higher profit' model. While this strategy might deliver ephemeral gains and appease investors in the immediate term, it ultimately introduces considerable systemic risk into the broader financial system, potentially undermining overall economic stability.

Regulatory Challenges and the Path Forward

The Nepal Rastra Bank's recent directive to implement the Expected Credit Loss (ECL) system is a pivotal step. This system compels banks to undertake a far more rigorous and comprehensive analysis of their loan portfolios, taking into account loan quality, the dynamics of credit flow, and specific industry-related risks to accurately estimate potential losses. This shift demands a higher level of analytical sophistication and data management from financial institutions.

It is noteworthy that international regulatory bodies, including the International Monetary Fund (IMF) and the World Bank, have also voiced their concerns regarding the rising NPLs and the evolving provisioning policies within Nepal's banking system. This external scrutiny underscores the urgency for Nepali banks to decisively prioritize long-term stability and strong risk management over mere short-term profit maximization.

Strategic Solutions and Recommendations

To navigate this complex landscape and ensure the enduring health of Nepal’s financial system, a multi-pronged approach is essential:

1. Full and Effective Implementation of NFRS-9

Banks must commit to the complete and effective implementation of NFRS-9. This means moving beyond mere compliance to genuinely integrating proactive risk assessment into their core operations, meticulously evaluating loan quality, inherent business risks, and prevailing market conditions to anticipate and provide for potential future losses.

2. Proactive and Stringent Regulatory Oversight

The Nepal Rastra Bank's role as a vigilant guardian cannot be overstated. It must rigorously monitor banks' capital adequacy, refine their risk management frameworks, and scrutinize provisioning trends to ensure they are aligned with actual risk exposures. This proactive oversight is critical to prevent the build-up of unaddressed systemic vulnerabilities.

3. Enhanced Transparency and Information Dissemination

Greater transparency is paramount. Banks should transparently disclose comprehensive details regarding their NPLs, the methodologies underpinning their provisioning, and precise data on loan distribution and recovery efforts. Providing timely and accessible information to investors, regulatory bodies, and the general public will not only foster greater trust but also enable more informed decision-making across the market.

4. Cultivating a Balanced Provisioning Strategy

The ultimate goal should be a balanced and risk-appropriate provisioning policy – avoiding both excessive 'over-provisioning' that unduly constrains growth and reckless 'under-provisioning' that imperils stability. The delicate equilibrium between strengthening the capital structure and minimizing economic risk must be diligently maintained to ensure the resilience of the financial sector.

Conclusion

Currently, Nepali banks are grappling with the inherent tension between financial'safety' and operational 'risk'. While NPL levels continue their upward trend, the discernible effort to balance profits by curtailing provisions presents a short-term solution with potential long-term repercussions. If Nepal aims for sustained financial stability, its banks must unequivocally pivot towards balanced risk provisioning.

The effective implementation of NFRS-9, coupled with the Nepal Rastra Bank's rigorous monitoring and an ongoing dedication to transparency from all financial institutions, will collectively forge a banking system that is not only healthy and reliable but also resilient and largely immune to undue risks. Ultimately, a profound and continuous improvement in banks' loan loss provision policies is imperative to lay a strong foundation for enduring financial stability and broader economic prosperity, transcending the allure of fleeting short-term profits.