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IN JULY the Nepal Rastra Bank will announce its monetary policy for the coming year. It will do so against a peculiar backdrop. The country’s 20 commercial banks are sitting on nearly Rs9trn in assets, their deposit vaults swollen to a record Rs7.2trn. Yet private-sector credit grew by just 0.03% in the month to mid-May. Banks have a loan-to-deposit ratio of 72%, well below the regulatory ceiling of 90%. They are flush with lendable funds. They are not lending them.
The problem is not a lack of borrowers alone. It is also a question of which borrowers are asking, and for what. Businesses are not seeking capital-expenditure loans. Domestic demand remains subdued, and political uncertainty in Kathmandu does little to encourage long-term commitments. Instead banks are deploying their excess liquidity elsewhere. Investments in “other” instruments—debentures, corporate bonds, shares—surged by 19.35% year on year, to Rs812bn. The banking system is increasingly exposed to the capital markets, not as a source of funding but as a destination for it.
This rebalancing is in part a consequence of Nepal Rastra Bank’s accommodative monetary stance. The central bank has succeeded in flooding the system with liquidity, but transmission to the real economy has stalled. Banks are chasing yield in equities and bonds because the traditional lending channel is blocked. That creates a circular vulnerability: if the domestic stock market corrects, bank balance sheets will suffer a direct hit, bypassing the usual credit-risk channel.
On the surface, profitability offers comfort. Net profit for the sector stood at Rs56.47bn in mid-May, up 14.76% from the previous month. Net interest income expanded as the cost of deposits fell. Savings deposits, which cost banks an average of 2.87%, surged by 36.49% year on year. Fixed deposits, which cost 5.02%, contracted by 2.04% to Rs2.73trn. Depositors are preferring liquidity over lock-in periods, probably anticipating further rate cuts. The shift has lowered the average cost of funds, widening net interest margins without any corresponding improvement in lending activity.
But the quality of the loan book is more fragile than the headline numbers suggest. Non-performing loans stood at 5.41% at the end of mid-April, stable but elevated against historical norms. The more troubling figure lies in the interest suspense account. This is the interest owed on loans that borrowers have failed to pay but which banks have not yet classified as non-performing. It has ballooned to Rs53.02bn, a 165% increase from a year earlier. That sum is a leading indicator of future non-performing loans, a pipeline of stress not yet recognised on the balance sheet.
Provisions for watch-list loans surged by 79.51% year on year, to Rs12.5bn. Banks are preparing for deterioration even as they hold general provisions steady. Non-banking assets—properties seized against defaulted loans—grew by 41.75% to Rs46bn. Banks are becoming reluctant landlords, a role that ties up capital and creates operational drag. In a single month they wrote off Rs2.29bn of bad debt, a year-end housekeeping exercise that cleans the books ahead of the new fiscal year.
Capital buffers offer little room for error. Core capital as a percentage of risk-weighted assets stands at 9.64%, perilously close to the regulatory minimum of 8.5%. Total capital stands at 12.57%. Retained earnings are deeply negative, at minus Rs25.07bn. Banks have distributed heavy dividends in recent years while credit risk has risen. With core capital thinning and internal reserves exhausted, the system has virtually no capacity to absorb a systemic shock. If a significant portion of the Rs53bn in interest suspense reclassifies as non-performing loans during the new fiscal year audits, several banks could breach regulatory capital requirements.
The strategic response from banks has been to diversify income sources. Fee and commission income rose 10.29% year on year, driven by digital transactions and trade finance. Exchange income surged too, reflecting the importance of remittance inflows. Yet these non-interest streams, while growing, remain small relative to the core lending business. They cannot compensate for a prolonged credit drought.
The deposit base itself is now heavily retail-dominated. Commercial banks have Rs53.8m deposit accounts holding Rs7.2trn, implying an average balance of roughly Rs133,000 per account. That is a measure of financial inclusion, but also a source of fragility. Retail deposits can be withdrawn quickly, and the shift towards savings accounts, which are more liquid than fixed deposits, exposes banks to sudden outflows.
Mobile banking users reached 25.75m, nearly matching Nepal’s adult population, while internet banking users stood at 1.79m. Branches have stagnated at 4,963, suggesting that growth in digital infrastructure is now substituting for physical expansion. Credit cards remain a massively underpenetrated market, with only 325,236 in circulation, a future growth vector that banks have yet to exploit.
The weighted average deposit rate has fallen to 3.35%, with fixed deposits yielding 5.02% and savings accounts 2.87%. The weighted average lending rate is 6.73%, implying a spread of 3.38 percentage points. That spread is being sustained by a faster drop in deposit costs than in lending rates. The contraction in fixed deposit rates, down roughly 200 basis points year on year, is effectively subsidising bank profits. But the trend is downward. As rates continue to fall, banks will find it harder to maintain margins, even as the cost of funds compresses.
For investors, the current environment poses a dilemma. Bank stocks offer high dividend yields, supported by the artificial widening of net interest margins from deposit repricing. But that support is unlikely to last. A selective approach is warranted: banks with low exposure to real estate and construction, high current and savings account ratios, and minimal capital-market investments offer a safer haven. Banks relying on treasury profits to mask underlying credit weakness should be avoided.
The new fiscal year will bring the annual audit cycle, and with it, the likely reclassification of a big portion of interest suspense into non-performing loans. The central bank faces a difficult choice: tighten provisioning norms to reflect the true state of the loan book, or maintain the current framework to avoid sparking a capital crisis. Either path carries risks. Nepal’s banking system is not in crisis, but it is not robust either. It is a system waiting for a trigger and the trigger may be closer than the balance sheets suggest. ■
