Nepali banks have varying strengths to cope with stress
JUN 20 -
A ‘stress test’ carried out by Nepal Rastra Bank (NRB) has revealed a mixed result of the capabilities of Nepali commercial banks to endure adverse situations. The central bank tested their capacity by subjecting five areas—credit quality, interest rate, exchange rate, equity price and liquidity in the third quarter—to hypothetical shocks.
Stress testing is a risk management tool used to evaluate the potential impact on a firm of a specific event and movement components like earning, liquidity and capital.
Most banks were found to be weak on credit quality. Their ability to endure shocks is tested by their capital adequacy ratio (CAR). CAR is defined as the ratio of bank’s core capital to its risk asset.
NRB carried out the tests on commercial banks at the end of the third quarter of this fiscal year after introducing stress-testing guidelines in January.
The first hypothesis under credit quality was 15 percent of a bank’s performing loans deteriorating to substandard, 15 percent of substandard loans deteriorating to doubtful and 15 percent of doubtful loans deteriorating to loss.
The NRB test found that the CAR of 22 out of the 32 commercial banks tested fell below 10 percent when this shock was applied. “This means that commercial banks need to do serious homework to mitigate this risk,” said Maha Prasad Adhikari, deputy governor of NRB.
However, bankers have countered that the result is not very alarming as the minimum CAR Nepali commercial banks are required to maintain is higher than the prudent international practice.
“According to Basel II, banks are required to maintain a minimum CAR of 8 percent,” said Sashin Joshi, CEO of NIC Bank. “But as per central bank regulations, Nepali commercial banks have to maintain a minimum CAR of 10 percent which is a cushion of 2 percent. Therefore, the CAR falling below 10 percent is not that worrisome. However, if it falls below 8 percent, it will be a big worry,” said Joshi.
Meanwhile, a majority of the commercial banks were able to withstand the second type of shock where all the substandard loans deteriorate to doubtful and all the doubtful loans deteriorate to loss. “The test showed that 30 commercial banks were able to absorb this shock,” said Adhikari.
The stress test also revealed that commercial banks are very fragile when it comes to absorbing the shock on real estate lending. However, in the third hypothetical scenario, where 25 percent of the performing real estate loans degrade to substandard, 29 commercial banks survived the shock.
Although banks performed pretty satisfactorily to this shock, they found the fourth shock very difficult to withstand. With regard to the fourth shock in which 25 percent of the performing real estate loans deteriorate to loss, only 19 commercial banks were able to survive it. “This result shows that the state of real estate lending could be more vulnerable than it is being depicted,” said Adhikari.
Joshi expressed reservations over those tests too. “We practice very stringent provisioning on the basis of the time frame while internationally, provisioning is done once the possible loss is figured out,” he said. “Therefore, the situation might not be as alarming as shown by the central bank’s stress test. Nevertheless, a few banks are really vulnerable considering their exposure and quality of real estate loans,” Joshi added.
Similarly, under the fifth hypothetical shock where loans to two big borrowers become substandard, 29 out of the 32 commercial banks were able to endure the shock. “The results of these shock tests show that there are still some banks where a handful of people are enjoying most of their lending,” said Adhikari.
Joshi agreed that there was credit concentration in some banks which is a very unhealthy practice.
“Although the test results have raised various questions, the only way to mitigate the risks is for commercial banks to diversify their lending portfolio, assess the credit quality and increase the capital cushion by further increasing the paid-up capital,” said Adhikari.
Meanwhile, most of the banks performed satisfactorily to other stress tests. Since Nepali banks and financial institutions do not bear interest rate risks as they pass them directly to their clients, they were found to be protected. Also, they were safe from exchange rate risks as the net open position to foreign currency is low for a majority of them.
As Nepali BFIs are not allowed to make equity investments except in their subsidiaries, they were very capable of enduring shocks due to fluctuations in share prices. Likewise, commercial banks were awash in excess liquidity when the test was conducted making them able to absorb the liquidity shock.
Source: The Kathmandu Post
