Development of Banking in the South Asian Region: Dimensions of the Transition

Siddhant Raj Pandey August 10, 2012http://niiss.org.np/index.php?option=com_content&view=article&id=14&Itemid=11

Finance is the linchpin of any development strategy.  Development of the financial sector in the South Asian Region (SAR) has contributed to poverty alleviation. However, the development that has taken place in the region, as note worthy as it may seem, has not yet been deep rooted nor endemic. 

 

Siddhant Raj Pandey

Board Member of the Nepal Institute of International and Strategic Studies and Chief Executive Officer of Ace Development Bank Ltd.

 

 

Abstract

Well functioning financial systems are central to meeting the challenges of accelerating economic growth in the region.  The nation states of the South Asia Region (SAR) have about the same time commenced on their reform measures in the banking and financial sector.  While some are ahead of the others, all have either under gone the same problems or are in the process of solving them. A few of the countries have led the way; India has been successful in developing the capital market, Pakistan in privatizing the banking sector, Bangladesh and Sri Lanka have made head ways in micro finance.  However, availability of long term capital and access to funds seem to be the biggest constraint to all.  This paper studies the process of reform by taking Nepal as an example and extrapolates the experience with rest of the SAR nations.  This is not an academic paper and it is rather based on the author’s experience as a banker.

 

 

Finance is the linchpin of any development strategy.  Development of the financial sector in the South Asian Region (SAR) has contributed to poverty alleviation. However, the development that has taken place in the region, as note worthy as it may seem, has not yet been deep rooted nor endemic.  The reform and development in this sector for the various nations of the SAR began about the same time; however, there have been neither inter-linkages nor integration in this sector amongst the nation states. The Banking and Financial sector is probably the most homogenous sector where international prudential regulations are either in practice or are in the process of being strengthened and implemented (i.e. Basel 2). This would normally have seemed to be an obvious reason for regional cooperation in the banking sector, but in reality there is very little interaction in this field amongst the SAR nations.  This paper attempts to delineate the reform measures in this sector by generally relating the development of the financial sector in the SAR region and particularly using the example of Nepal, which reflects the problems the region has faced and is facing in the course of development. 

The reform measures in the banking sector in the region began in the 1990s.  The problems across the region were similar with excessive state control over the banking and financial sector.  The main problems were: high rate of nonperforming loans, lack of strong regulatory control, poor access to finance, poor financial infrastructure, lack of coordination between the various government agencies and lack of good governance.  The reform measures commenced by starting with modernizing the central banks by improving financial sector regulation and supervision, reduced government ownership in state owned banks, allowed private sector banks to operate and compete, efforts were made to free up interest rates and credit allocations.  Gradually the capital markets were encouraged to develop and open the capital account.  In the region some countries have been more successful than others in the process of financial sector development, but all have gone through the process and some are ahead while others are beginning to show positive change.  One common problem all face is that long term financing for investment remains to be scarce.

The following will give an example of Nepal, which has been in the process of reform measures through the auspices of the World Bank, IMF and other related international agencies.  Nepal’s experience in the financial sector development is an example of the trend the region has undergone in the past two decades. A brief overview of some of the other SAR nations follows the following example.

 

Nepal’s Experience

According to the findings of the 2006 Access to Financial Services Survey by the World Bank et al., only 26 per cent of Nepalese households have bank accounts and 15 per cent have a loan account taken from the banks and financial sector.  In terms of numbers there has been an exponential increase of finance companies and banks: in 1984 there was 1 in 2007 there are 79.  Despite the high number of finance companies, they manage to only serve 2 per cent of the population.  Therefore, the expectation of mid-90s that the hordes of licenses issued for setting up finance companies would expand the reach has not been fulfilled. It has only increased the number of players who are competing with each other for a share from the same segment of the market.

 

Regulatory Development

Finance Companies Act in 1984 allowed the inception of finance companies, after allowing Merchant Banking activities in 1992 the only significant change in operations commenced in 2004 with the Banks and Finance Companies Act (BAFIA). Finally, finance companies, in addition to the limited activities were allowed to be a member of the check clearing house, transact in Indian Currency and were authorized to transact in real estate business.  Subsequent directives in 2005 allowed finance companies to be able to provide debit and credit cards by being a subsidiary member of a bank.  Finance Companies henceforth were expected to follow all prudential regulations that commercial banks were following.  One of the biggest changes, after the Umbrella Act came into operation, was on the balance sheet of finance companies. Henceforth NBFIs were to follow cash based accounting system as opposed to accrual based in the past along with strict provisioning and interest suspense allocations.  In turn, the effect on the balance sheet, in the first year for a majority of companies, used to ever greening bad debt, was considerable. The stringent reporting requirements also compelled them to upgrade their technology to be in compliance with NRB reporting standards.   This was a wakeup call to many of the finance companies which operated as a family run business.  Overnight prudential regulations were in effect compelling them to transform and be transparent.  The Umbrella Act was a beginning towards harnessing all the various players towards operating in a transparent and highly regulated system.  The Umbrella Act of 2004 narrowed the gap between a commercial bank, a development bank and a finance company.  However, none of the new directives were enablers to make the financial sector neither more endemic nor far reaching.  In contrast the new directives only increased the competition in an already overcrowded market, but has attempted to enforce prudential regulations on all.  Out of the three categories, category “C” group, finance companies may boast that not a single member company has been penalized for misconduct of operations or on any other issues by NRB.  A few banks in category “A” and “B” have been taken under NRB management due to misappropriation and non compliance to directives.

 

Constraints to reaching out:

If the mandate of the finance companies was to be an arbiter between borrowers and lenders for the masses then the whole exercise has not quite been successful, but if the intention was to create a parallel institution with lesser capital to cater to a segment the commercial banking sector avoided then finance companies have served that purpose. 

The constraints to reaching out to rural areas have been many:

  1. Loans are dependent on collateral of immovable assets and there are strict provisioning requirements.
  2. Project loans based on security of equipment is risky due to lack of secured transaction register
  3. Lack of monitoring capability and dearth of skilled manpower who are willing to re-locate
  4. Security and slow legal frame work
  5. Inconsistent directives from the Regulator

 

  1. The trend of loans and advances based on fixed collateral of immovable assets as a primary source of recourse to possible     default has been the biggest impediment in reaching out to the rural poor or to an entrepreneurial group that can produce no fixed security.  The other reason behind this is the NRB guidelines that require heavy provisioning for loans secured by any other means other than collateral of immovable assets and equipments.  This has been deterrence to the lending institutions who do not wish to take overt risks.
  2. Although the Secured Transaction Act was passed in 2006, safety of collateralized equipment is still not there due to lack of a transaction registry. The risk is that it is very difficult to track the equipment collateralized and the same equipment can be used as collateral in a number of lending agencies. Once the registry comes into operation, the problem is expected to be solved.
  3. There has been a dearth of skilled man power in this sector willing to go to remote areas to work.  The cost of monitoring projects outside the urban areas is high.  This, coupled with the security risks has acted as major deterrent in recent times.
  4. The financial sector has been the fastest growing industry quantitatively and as a result of new innovations and technology it is the most progressive. Unfortunately, the legal system has not been able to keep pace with this development.  Reform in the legal apparatus is much needed to facilitate quick decisions in this sector.  The debt recovery tribunal set up in 2001 has tried to address the legal problems on behalf of the financial sector, but the process is usually slow. Constant stay orders from the courts have been major impediments to due the process.
  5. Regulatory directives are not consistent and change at any pressure from vested interest parties.  Directives have been known not to be applicable to a few players and have been changed to facilitate them.  This will undermine the regulator’s capacity and cast doubt on the slogan of good governance being propagated.

Further to the above, long term capital is unavailable to match infrastructure development projects.  Nepal’s reform process is still in its nascent stage.

 

 

South Asian Experience

Over the past decade or so, the five largest countries in South Asia (Bangladesh, India, Nepal, Pakistan and Sri Lanka) have undertaken significant financial sector reforms.  Reforms have differed in timing, speed and content with various degrees of successes:

The common features are:

  •  Efforts to free up interest rates and credit allocation
  •  Modernize central banks
  •  Reduce government ownership
  •  Foster competition
  •  Improve financial sector regulation and supervision
  •  Develop capital markets and gradually open up the capital markets

 

India’s Experience

India has had gains from its financial sector development. They have been successful in elimination of segmentation across various markets, easing the liquidity management process and making resource allocation more efficient across the economy.  To facilitate this restrictions on pricing of assets have been removed, new financial instruments have been introduced and technological infrastructure has been strengthened. Furthermore, there has been relaxation in investment norms for financial intermediaries especially banks. The emergence of new institutions such as primary dealers and mutual funds has helped the market develop and diversify.  The gap between non bank financial institutions and the banking sector in its sector of allowed operations is very wide in India.  India has made the greatest development in capital market formation.

 

Pakistan’s Experience

One of Pakistan’s greatest achievements has been to privatize the banking sector. 80% of the banking sector in Pakistan is now under private control.  The two main constraints and challenges to achieving reform in Pakistan are that the financial sector has been less successful in allocating resources to small and medium enterprises (SMEs) and micro financing enterprises along with not having the capacity for long term lending.

 

Sri Lanka’s Experience

 Sri Lanka’s reform measure has reduced the government’s exposure as a direct promoter of financial services.  Rural sector finances have developed and access to the poor is increasing.  However, as in other SAR countries the reform measures need to strengthen the legal and debt recovery framework.  The regulatory frame work needs vast improvement.

 

Bangladesh’s Experience

Over the past decade Bangladesh’s banking sector has grown considerably while overall access to finance has been moderate.  As in the cases of the above mentioned nations, reform measures in Bangladesh commenced with privatizing one of the four state owned banks.  Reform measures have been impeded by high non performing loans in the banking sector along with lack of strong regulatory and supervisory controls.  Capital market is in its infancy and long term capital is unavailable.

 

China’s Experience

China as well commenced reform measures around the 1990s.  In 1994 the state owned commercial banks started the separation of public lending methodology as opposed to commercial lending. From 1998 interest rates were based on open market operations.  It wasn’t until 2005 that the capital market developed with the improvement in the Shanghai and Shenzen stock exchanges.

China’s experience in financial sector reform is slightly different than that of the SAR region.  State control is still widely prevalent and as a result there is internal integration.  China is embarking on widening the Micro small and medium enterprise lending with the help of the World Bank.  There could be enormous synergy if cooperation with the SAR region is extended in this area.

 

Challenges and Constraints

The obstacles that all the countries in the SAR region face in developing this sector are similar.  The common problems are state control of the banking sector, high non performing loans, lack of good governance, weaknesses in legal, regulatory and supervision and dearth of long financing. The large countries in this region are addressing the problem in different ways.  In the case of India, long term financing is addressed by formation of the capital market.  Pakistan has privatized most of its state controlled banks to allow prudential regulations and free market competition to work. Bangladesh and Sri Lanka have addressed the need for micro financing as a catalyst for poverty alleviation.  Nepal is undergoing reform measures across the board, but these measures are being delayed due to a weak judicial system and poor regulatory and supervisory role of the Central Bank.

 

Importance of Financial Market Integration

The Reserve Bank of India (RBI) in its report on financial market integration has conclusively written about the integration of the financial markets as a process of unifying markets.  The process of integration is facilitated by an unimpeded access of participants to various market segments. Harmonization of prudential regulations in line with international best practices is the core of integration. Integrated financial markets assume vital importance for many reasons. First, integrated markets serve as a conduit to transmit important price signals (Reddy, 2003). Second, efficient and integrated financial markets constitute an important vehicle for promoting savings, investment and economic growth (Mohan 2005). Third, financial market integration fosters the necessary condition for the region’s financial sector to emerge as an international centre.  Furthermore, integrated financial markets lead to innovations and cost effective intermediation, thereby improving access to financial services to members of the public in the region.

 

The Future Agenda

The awareness that privatizing the banking sector is not enough to make banking deep rooted and endemic has brought about the need to develop micro financing. Over the past decade, microfinance programs––designed to bridge the access gap by providing thrift, credit, and other customized financial services to the poor, typically against the backing of only social collateral––have attempted to fill the gap in financial access for the poor, albeit with different levels of success across countries. Organizations like the Grameen Bank, BRAC, and the Association for Social Advancement (ASA) in Bangladesh have shown impressive results in terms of outreach. India has seen the growth of successful organizations like Sri Mahila Sewa Sahakari Cooperative Bank (SEWA Bank), Swayam Krishi Sangam (SKS), and Bhartiya Samruddhi Investments and ConsultingServices Ltd. (BASIX), and the phenomenal growth of the self-help group (SHG)–bank link movement, which was pioneered by the National Bank for Agriculture and Rural Development (NABARD), along with NGOs like MYRADA and Professional Assistance for Development Action (PRADAN). The latest entrant to microfinance is Afghanistan, where experiences from other countries have enabled microfinance to get off to a running start. The region has witnessed the development of an array of institutions, methodologies, approaches, and products in microfinance.

A process of integration should be facilitated by an unimpeded access to finance.  Integrated financial markets in the SAR region will help channel capital and expertise from the advanced economies to the emerging ones. A very important factor for economic growth is the availability of long term financing.  The region’s infrastructure investment needs are in short supply.  The need of the hour is to develop the institutional investor base (pensions and insurance) alongside this development the corporate debt market needs to be given priority.  The only method of creating long term financing, as mentioned earlier in Nepal’s case, is to develop the capital market. 

 

Conclusion

A Common problem envelopes the region’s banking and financial sector. Policy reforms need to be undertaken to consolidate the gains of the past decade and they are: consolidation of the banking sector through privatization and later by mergers, implementation of Basel 2 Accord, tight control of credit and strong legal mechanism to recover bad debts. The respective Central Banks need to strengthen the regulatory and supervisory controls. Finally, in order to make the financial system sustainable, long term capital needs to be available. This can only be achieved if the capital market is developed. 

 


 

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