Mar 29, 2017- A central bank provision that provides leeway to banks and financial institutions to extend credit beyond the regulatory lending limit has posed a threat to the financial sector stability and should be withdrawn promptly, the International Monetary Fund has said.

The Nepal Rastra Bank (NRB) recently allowed banking institutions to calculate credit to core capital-cum-deposit (CCD) ratio by deducting 50 percent of loans extended to the productive sector. Banks and financial institutions are allowed to extend up to 80 percent of the total deposits and core capital as loans. This is the maximum regulatory lending limit or, in technical terms, maximum limit on the CCD ratio.

The recent change means financial institutions will not be subject to regulatory action even if they breach CCD ratio by lending amount equivalent to 50 percent of the productive sector loans. The change made at the stroke of a pen immediately added at least Rs127 billion to the stock of loanable funds at banking institutions, considering the data of the first half of the current fiscal year when banks and financial institutions had extended around Rs254 billion in credit to the productive sector.

The NRB took this step to replenish the stock of loanable funds, which had depleted to a level never seen in the recent history of the banking sector.

Although the latest provision is valid till mid-July, the “temporary regulatory relief granted by the central bank would allow for continued rapid credit growth, raising macro-financial risks”, says the full-text of the Article IV Consultation Report of the IMF released on Tuesday.

This relief, the IMF says, should be “withdrawn promptly when it lapses in mid-July in order to moderate credit growth, normalise interest rates, discourage excessive risk taking, and reduce the impetus to capital outflows”.

The banking sector started witnessing rapid growth in demand for loans since the Indian blockade—which restricted consumer demand and spending—was lifted in February 2016. However, higher credit demand was not matched by higher collection in deposits largely due to deceleration in inflow of money sent by Nepalis working abroad.

This mismatch in deposit collection and credit extension created severe shortage of funds that could be immediately extended as loans. And in the end of January, commercial banks collectively breached the regulatory lending limit for the first time in recent years.One of the problems faced by the Nepali banking sector, according to the IMF, is laxness shown by the central bank to float instruments to absorb funds entering the country from abroad. This has “loosened monetary conditions in recent years”.

The central bank mopped up Rs 588.6 billion in liquidity through open market operations in the last fiscal year ended mid-July. And in the first half of the current fiscal year, liquidity of Rs101.1 billion was absorbed by using various instruments.

But the IMF has said the central bank’s “sterilisation of remittances has been insufficient to stabilise money market conditions”. This loosened monetary condition, coupled with fourfold increase in paid-up capital of commercial banks, has pushed private sector credit growth to a seven-year high of 31 percent in January 2017, says the IMF report.

“The increase in credit [has been] concentrated in overdrafts, which can be diverted to risky activities such as purchases of land, real estate, and stocks,” the IMF report says.

“The build-up of risks related to the rapid credit growth underscores the importance of accelerating financial sector reforms, through stronger supervision and more stringent loan classification and provisioning and upgrading of banks’ risk management,” it adds. NRB Spokesman Narayan Prasad Paudel said he still has not gone through the report. “But the relaxation on regulatory lending limit won’t be extended beyond mid-July.”

Source: The Kathmandu Post

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