Banking Sector NPL Hits 5.66 Percent; Finance Companies Grapple with Alarming Default Rates

Nepal’s banking and financial institutions are confronting mounting asset quality pressures, with the average non-performing loan (NPL) ratio climbing to 5.66 percent of total credit as of mid-September. The latest macroeconomic and financial data released by the Nepal Rastra Bank (NRB) exposes a particularly severe vulnerability within finance companies, where the bad debt ratio has surged to an alarming 9.89 percent. In contrast, commercial banks and development banks maintain slightly lower, yet still concerning, NPL ratios of 5.56 percent and 5.77 percent, respectively. The stark 4.33 percentage point gap between finance companies and commercial banks indicates severe debt-recovery bottlenecks in the lower tiers of the financial system. Recognizing this risk, financial institutions have been forced to set aside substantial safety buffers. Consequently, overall loan loss provisioning has reached 5.76 percent of total credit, with finance companies provisioning a staggering 9.35 percent of their portfolios.

Despite the deteriorating loan quality, the financial system experienced a robust influx of deposits and credit expansion during the review period. Over a single month, total deposits across the sector expanded by Rs 91.23 billion (1.10 percent), propelling the total deposit base to Rs 8.38 trillion. Simultaneously, overall credit and advances grew by Rs 70.56 billion (1.19 percent) to reach Rs 6.01 trillion. The private sector was the primary beneficiary of this liquidity, absorbing Rs 74.35 billion in fresh credit, marking an 8.13 percent year-on-year growth in private sector lending.

A notable structural shift is also occurring in depositor behavior, characterized by a steep flight from fixed deposits to more liquid savings accounts. Over the one-month period, fixed deposits contracted by Rs 36.50 billion, dropping to Rs 2.90 trillion. Conversely, savings deposits swelled by Rs 77.73 billion to cross the Rs 4 trillion mark, while current and call deposits also saw healthy gains. Currently, savings accounts dominate the deposit structure with a 47.87 percent share, leaving fixed deposits at 34.61 percent. With commercial banks offering a meager weighted average interest rate of 4.82 percent on fixed deposits and 2.82 percent on savings, depositors appear unmotivated to lock in their funds for long tenures, opting instead for immediate liquidity.

This credit expansion and shift in deposit structure have marginally reduced the sector's liquid reserves. Overall liquid funds declined by 2.41 percent, settling at Rs 692.39 billion. Furthermore, financial institutions pulled back on safe-haven investments, reducing their holdings in government securities by Rs 40.85 billion, even as their alternative investments—particularly in shares and equities—expanded to Rs 583.55 billion. However, the systemic credit-deposit (CD) ratio remains highly comfortable at 71.21 percent, well below the central bank's regulatory ceiling, indicating that banks still have ample room to lend.

The central bank's data paints a complex picture of a financial sector flush with investable funds but hampered by latent credit risks. The dual narrative of aggressively expanding loan portfolios alongside rising default rates—particularly the near double-digit NPLs in finance companies—points toward systemic frailties in credit appraisal and recovery mechanisms. While the overall capital adequacy ratio remains relatively secure at 12.64 percent, the rising tide of bad loans means banks must divert a larger chunk of their operating profits toward loan loss provisions. If domestic economic activities and business cash flows do not accelerate adequately to support loan repayments, these historically bad loans will remain a dead weight, inevitably eroding the banking sector's profitability and dividend distribution capacity in the upcoming quarters.