Banking Reform: Handing Over the Crown Jewels to Foreign Hands?

The two largest commercial banks of Nepal, Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), have been handed over to foreign management teams recently. Over the last two years, much criticism has been raised about this move. Some have cried out against handing over the crown jewels of Nepal's banking system to foreign hands. Some asked why we need expensive foreigners to do the job. There is national pride in these sentiments and that is understandable. Others still suspected that this was a ploy to write off many bad loans and let the defaulters off the hook. Even part of the "grand design"? Some thoughtful people argued that it does not seem to address the real problem. A good point. Unspoken, but the strongest resistance seems to have come from those who fear that many skeletons may be uncovered from the closets of RBB and NBL, and that sources of easy money would be shut down.

Pawning the crown jewels

First let's look at the banks themselves. RBB has suffered from very common inefficiencies of a state-owned enterprise and political pressures (rather than commercial considerations) to approve loans. It has not been run like a real commercial bank. NBL's ills are slightly different. Basically, it suffered from insider lending. Powerful private shareholders, who became majority shareholders by 1998, have lent money to themselves or borrowers closely associated with them. When the borrowers make the lending decisions, the discipline of a hard-nosed banker goes out the door. But because people feel that their deposits are implicitly guaranteed by His Majesty's Government (HMG), both banks continue to receive new deposits and hence do not have any problem meeting day-to-day needs for cash. In truth, however, neither bank is worth very much.

The central bank (NRB) has not been entirely innocent. The weak supervision by NRB is of course not an accident. The larger political environment clearly found it convenient to keep NRB weak and hence make it easier to facilitate misuse of RBB and NBL deposits.

Management teams – an answer or a problem?

Let's look at the "selling out" theory. RBB and NBL have been prominent institutions, and had illustrious histories. Among its employees in the past, NBL, for instance, boasts no less than Tanka Prasad Acharya, who was at least temporarily hired as a clerk, long before becoming a Prime Minister! However, after many years of poor management, these banks are no longer crown jewels of the Nepali financial system.

Why foreign managers? The two management teams for RBB and NBL will cost NRB maybe as much as US$4 million a year. Are there not good Nepali managers who would cost much less? Undoubtedly yes, but the real value that foreigners bring to the table is indeed their foreignness – being outsiders in Nepali society, they are not subject to its influences in doing what must be a professional and yes, hard-nosed job.

Let's examine the "grand design" theory. This theory seems to suggest that these managers were brought in to write off bad loans, for they would not have to worry about scrutiny later, by CIAA, PAC, or public opinion. The notion that HMG is eager to write off all the bad debt, for some political reason, is not credible. Writing off bad debts would mean that HMG will have to come up with the money to protect the depositors. This, in turn, would mean making some painful and politically unpopular cuts in its budget. So, there is an incentive for HMG to crack down on defaulters. Besides, HMG knows that it will have to turn to some donors to help finance the clean up, and such help will not come unless donors are convinced that maximum loan recovery efforts have been made.

So what of those who say this is "missing the real problem"? This is a very legitimate concern. Management takeover by external teams at RBB and NBL is not a solution in itself. Unless the regulatory, and the broader political, environments are improved, RBB and NBL will continue to face pressures to ignore good banking practices. To change this, NRB must be strengthened. Sadly, for the very same reasons why RBB and NBL have been weakened, NRB had never been allowed to be a strong and professional central bank. Recent amendments to the Central Bank Act have given NRB much greater independence and the legal authority to be an effective central bank. An important part of the banking reform program will focus on developing the institutional capacity of NRB. But above all, the culture at the political level needs to change, so that even politically influential individuals will not feel free to interfere with the professional operations of NRB as well as commercial banks. Such a change can come only with strong signals from the highest political levels. HMG, including successive Prime Ministers, have expressed commitment to such a reform package. It is on that basis that the World Bank and DfID believe it is worthwhile supporting HMG with advice and funding.

Expect a lot from management teams, but not miracles

Management teams will not in themselves make RBB and NBL suddenly profitable. Because of bad record keeping and reporting, it is unclear how poor the financial health of RBB and NBL is. When a significant part of their loans are not generating income, it becomes mathematically impossible to make profits. Since many bad loans from RBB and NBL are unlikely to be recoverable, even the best management teams cannot be expected to defy mathematical impossibility. But, for the large fees they will be paid, one should expect them to deliver a lot.

First and foremost, the management teams should be expected to stop bad banking practices at RBB and NBL. They should ensure that loan defaulters are pursued with utmost vigor and that fraudulent or poorly screened loans are not tolerated. This should lead at least to profitability on new loans and improved performance of existing loans.

The second thing one should expect is a realistic plan to restructure RBB and NBL. Such a plan may involve salvaging the best parts of RBB and NBL and turning them into viable commercial banks, run by "fit and proper" owners. If one or both banks prove unviable, liquidation may have to be considered.

So it will cost Rs. 750 million or more for two years for just that? Yes, but consider this: Inaction in the past is costing billions each year in losses and accumulation of new bad loans. Outside management teams could potentially pay for themselves by simply slowing these drains of money that HMG is likely to end up paying for in the future. Besides, for safeguarding some Rs. 75 billion in deposits from misuse, this may not be such a high price.

Why does the World Bank, an institution dedicated to poverty reduction, worry about the banking system?

True, most of the poorest in Nepal do not have many dealings with commercial banks. But reforming Nepal's banking system is very important for poverty reduction. There are at least four reasons.

First, unattended, the problems of RBB and NBL will multiply and would eventually result in a major banking crisis, similar to the crises in Thailand, Indonesia, and other East Asian countries a few years ago. Such a crisis would cause severe dislocations in the economy and hurt the poor. Second, in contrast, a well-functioning financial system does accelerate economic growth, without which poverty reduction has proven virtually impossible in any country. Third, HMG will have to spend money to fix these banks at the expense of programs that would help the poor more directly. Delaying the resolution of the problem will result in accumulation of more losses, eating further into future HMG resources for poverty reduction. Fourth, RBB and NBL were poorly managed because the "old ways" allowed the unscrupulous and corrupt to raid public resources for private gains as well as private resources held in trust (such as bank deposits). Changing this culture will be critical for improving the effectiveness of the government. Stopping such practices in banking will be an important step in changing all this.

As RBB and NBL are brought under external management teams, an important beginning has been made to reform the banking system. But, how far these teams can go in fixing the problems at RBB an NBL will depend critically on how far they are allowed, by HMG and larger political forces, to run these banks professionally. The World Bank, DFID, and other interested external development partners will watch this process closely. As tax-payers, and in some cases depositors, you should also watch this closely. Those who milked the system have a lot to lose and have many skeletons to hide. HMG will have to be prepared for as fierce and dangerous a battle as any it has faced in the past.