The capacity of commercial banks to absorb various types of shocks is diminishing, as they are not adequately capitalised and risk emanating from their exposure to the real estate sector is still high, a latest report of Nepal Rastra Bank (NRB) says.

Stress test results made public recently showed that a standard credit shock would cause capital adequacy ratio (CAR) of 28 commercial banks, or around 90 per cent of class ‘A’ financial institutions, to fall below the minimum regulatory requirement of 10 per cent. The number of institutions whose CAR was susceptible to standard credit shocks stood at 28 in mid-January, 2013, and 27 in mid-July, 2013, says the NRB’s latest Financial Stability Report.

CAR gauges a bank’s strength to absorb shocks and ability to extend loans. If this ratio falls below minimum regulatory requirement, NRB immediately takes prompt corrective action and even declares such banks as ‘troubled’. Stress test conducted in mid-January also showed that CAR of nine banks would fall below the minimum regulatory level if 25 per cent of loans extended to real estate and housing sector turned into bad debts.

A stress test conducted in mid-July last year had shown that only five banks would see their CAR fall below 10 per cent level if 25 per cent of their performing loans turned sour.

This result shows that risk for banks exposed to real estate and housing sector has gone up. This is an indication that ‘credit quality of banks is deteriorating’ and ‘they are likely to face a difficult situation in case of slowdown in recovery, downgrade of loans to loss category and loan loss provisioning increases’.

One reason for deterioration in credit quality is practice of extending loans on the back of security. It is said over two-thirds of loans are collateralised by real estate. This poses a threat to banking sector as real estate prices have not recovered yet and many banks may fail to recover the loan amount even if they auction properties of defaulters.

The stress test also showed that 22 commercial banks may find themselves in a very difficult position if 15 per cent or more of their deposits are withdrawn. Similarly, 16 banks may land in soup if two per cent, five per cent and 10 per cent of their deposits are withdrawn in first, second and third days, says the report. The number stood at five in mid-July 2013.

“These findings show that the liquidity position of commercial banks did not improve much since mid-July 2013, despite excess liquidity.”

This calls for the need to raise capital base of banks and make them financially strong, as many are not adequately capitalised to absorb shocks, the report adds. However, banks are better equipped to cushion market shocks — shocks emanating from fluctuation in interest rate, exchange rate and equity prices — as all class ‘A’ financial institutions, except state-owned Rastriya Banijya Bank and Nepal Bank, could maintain CAR of above 10 per cent in case they face market risks.

source: the himalayan times,28 august 2014