Nepal’s Banking System Remains Stable, but Bad Loans Expose Deeper Vulnerabilities

KATHMANDU — Nepal’s financial system remained broadly stable and capable of absorbing ordinary shocks in fiscal year 2024/25, but rising non-performing loans and excessive dependence on a small number of borrowers and depositors have created vulnerabilities beneath the surface, according to Nepal Rastra Bank.

The central bank’s Financial Stability Report for fiscal year 2024/25 presents a banking sector with adequate capital, comfortable system-wide liquidity and rising profits. At the same time, its stress tests show that the position of individual institutions could deteriorate quickly if a few large borrowers default or major depositors withdraw their money.

This means the immediate concern is not necessarily a system-wide shortage of funds. The larger risk lies in the concentration of those funds. Credit is heavily exposed to certain borrowers and economic sectors, while some institutions depend disproportionately on a limited number of large deposits.

A shock affecting only a few major customers could therefore spread rapidly through the balance sheets of banks and financial institutions.

Bad loans continue to weaken asset quality

The non-performing loan ratio of banks and financial institutions reached 4.62 percent during the review period, according to the central bank.

More recent financial statements published by banks reportedly show the ratio exceeding 5 percent. This indicates that the deterioration in loan quality continued beyond the period covered by the annual figures.

A non-performing loan is a credit facility on which the borrower has failed to make scheduled payments for an extended period. As delays continue, loans move from watch-list categories to substandard, doubtful and ultimately loss classifications.

The increase in non-performing loans matters because banks must allocate provisions against risky credit. Higher provisions reduce the amount available for new lending and can weaken profitability, capital strength and investors’ confidence.

Bad loans also remain on bank balance sheets without generating normal interest income. When a growing share of assets becomes unproductive, banks may become more cautious and restrict lending even when they have sufficient deposits.

This helps explain why Nepal has experienced abundant banking liquidity alongside relatively weak private-sector credit demand and expansion.

Profit growth does not remove the underlying risk

Despite worsening asset quality, banks and financial institutions earned a combined net profit of Rs 77.53 billion during the fiscal year.

The figure was 10.07 percent higher than in the previous year. Based on the reported growth rate, the sector had earned approximately Rs 70.44 billion a year earlier.

The increase shows that the banking sector remained profitable even as bad loans rose. However, current profitability does not necessarily guarantee future balance-sheet strength.

If borrowers continue to miss payments, banks will have to make additional provisions or recognise losses. Their capacity to distribute dividends, expand credit and maintain regulatory capital could then come under pressure.

The apparent contradiction between rising profits and worsening loan quality therefore requires careful interpretation. Earnings remain positive, but the quality of the assets generating those earnings has weakened.

The report’s warning is forward-looking: if the present trend continues, today’s bad loans could become tomorrow’s capital problem.

Lending remains concentrated in consumption and trade

Consumer credit received the largest share of loans issued by banks and financial institutions, accounting for 20.60 percent of total credit.

Wholesale and retail trade followed with 18.48 percent, while agriculture, forestry and beverage production accounted for 16.62 percent.

Electricity, gas and water received 7.97 percent of total loans, while finance, insurance and real estate accounted for 7.88 percent.

Together, these five categories represented 71.55 percent of all credit. The remaining economic activities shared less than 29 percent.

The distribution shows that a significant portion of bank financing remains concentrated in consumption, trading and selected established sectors rather than being broadly distributed across productive industries.

Consumer and trade loans can support demand and commercial activity, but they do not always create the same long-term productive capacity as investment in manufacturing, export industries, infrastructure or technology.

The central bank noted that private-sector credit did not expand as strongly as expected. Weak capital expenditure, rising bad loans and subdued economic activity continued to limit demand for new borrowing.

Private-sector credit increased by 8.4 percent, while deposits grew by 12.6 percent. Deposits therefore expanded 4.2 percentage points faster than credit.

This gap suggests that banks collected funds more quickly than they could deploy them through new loans. It also helps explain the fall in market interest rates and the presence of excess liquidity in the financial system.

Two large borrowers could pressure nine commercial banks

The central bank’s stress test revealed significant concentration risk on the lending side.

If the two largest borrowers of each institution were to default, nine commercial banks could see their capital adequacy ratios fall below the regulatory minimum of 11 percent.

The result is one of the strongest warnings in the report. It suggests that the financial condition of a limited number of borrowers or business groups has the potential to affect a substantial part of the commercial banking sector.

When lending is widely diversified, the failure of one borrower can be absorbed without seriously affecting the institution. But when a large share of loans is concentrated among a few customers, even a small number of defaults can rapidly erode capital.

Such concentration also creates a wider economic risk. Large business groups frequently borrow from more than one bank. Financial trouble in a single corporate group can therefore affect several institutions at the same time.

The report indicates that Nepal’s banks need to assess not only their direct exposure to individual borrowers but also the connections among related companies, promoters and sectors.

The stress-test findings strengthen the case for stricter monitoring of large exposures and more diversified lending portfolios.

Rising bad loans could push banks below capital requirements

The central bank also tested how commercial banks would perform if currently performing loans deteriorated.

The supplied data indicate that several banks could fall below the minimum capital adequacy requirement under different loan-quality shocks.

Capital adequacy measures whether a bank has sufficient capital to absorb unexpected losses. When bad loans rise, banks must increase provisions, which reduces their capital base.

The system-wide capital adequacy ratio stood at 12.95 percent at the end of the fiscal year. This remained above the regulatory minimum, but the buffer was not equally distributed across all institutions.

The average ratio provides reassurance at the system level, yet it can conceal weaknesses at individual banks. Stronger institutions may hold considerable capital above the minimum, while weaker institutions may operate with much narrower margins.

The core capital ratio stood at 10.13 percent, while the leverage ratio of commercial banks was 6.46 percent.

These figures indicate that the system still has a capital cushion. However, the stress tests show that the cushion could shrink quickly if asset quality deteriorates sharply or major borrowers fail.

Deposit concentration creates liquidity risk

The structure of deposits presents another major vulnerability.

According to the central bank’s test, three commercial banks could fall below the regulatory liquidity requirement if their two largest institutional depositors withdrew their funds.

If the three largest institutional depositors withdrew, four commercial banks could fall below the minimum. If the five largest withdrew, six banks could be affected.

The result shows that some banks depend heavily on a small number of large institutions for funding.

Large institutional deposits can provide banks with substantial resources at a relatively low administrative cost. However, these deposits can also move quickly in response to changes in interest rates, investment opportunities or concerns about a bank’s condition.

A large number of small deposits is generally more stable because individual customers rarely withdraw all their funds simultaneously. Institutional depositors, by contrast, can transfer billions of rupees in a single decision.

The risk is therefore not simply the total volume of deposits held by a bank. It is also the degree to which those deposits are concentrated.

Rapid withdrawals could exhaust liquidity at some banks

Nepal Rastra Bank also simulated a five-day period of escalating deposit withdrawals.

Under the scenario, deposit withdrawals reached 2 percent on the first day, 5 percent on the second day and 10 percent a day over the following three days.

The test found that two of the 20 commercial banks could become completely illiquid under such conditions.

This is a severe scenario rather than a prediction. Stress tests are designed to reveal how institutions would perform during unusual but plausible shocks.

The result does not mean that the two banks are currently unable to meet withdrawals. It means their available liquid assets could be exhausted if deposit outflows occurred rapidly and continued for several days without sufficient replacement funding.

The finding highlights the importance of contingency funding plans, diversified deposits and ready access to liquid assets that can be sold or pledged during an emergency.

Development banks also remain exposed

Development banks were found to be vulnerable to both deposit withdrawals and declining credit quality.

Under the same deposit-withdrawal scenario, seven development banks could face liquidity problems.

The withdrawal of funds by the single largest institutional depositor could push three development banks below the regulatory liquidity threshold. The withdrawal of deposits held by their five largest individual customers could also affect three institutions.

The results suggest that some development banks rely on concentrated funding from both institutional and individual depositors.

Their smaller balance sheets may make them more vulnerable than commercial banks to the movement of a single large account.

Credit stress also presents a challenge. If 15 percent of performing loans moved into the substandard category, six national-level development banks and four provincial-level development banks could fail to maintain the required capital adequacy ratio.

The central bank also found that two development banks were already below the regulatory capital requirement before the simulated shock was applied.

This indicates that vulnerability is not limited to a hypothetical future crisis. Some institutions may already require closer supervision, capital restoration plans or restrictions on balance-sheet expansion.

Finance companies face the most severe liquidity threat

The stress tests presented a more fragile picture for finance companies.

If deposits were withdrawn at a rate of 10 percent a day for three consecutive days, all but one finance company could record a negative liquidity ratio.

Even a daily withdrawal rate of 5 percent could push most finance companies below the regulatory minimum liquidity ratio of 20 percent. At a withdrawal rate of 15 percent, nearly all institutions could face a liquidity crisis.

Finance companies were also exposed to concentration in real estate and housing loans.

If 25 percent of credit issued to the real estate and housing sector moved into the substandard category, seven finance companies could see their capital adequacy ratios fall below the required minimum of 10 percent.

The combination of concentrated lending and fragile deposit structures makes finance companies particularly sensitive to market disruption.

A slowdown in property transactions, falling collateral values or large deposit withdrawals could affect both sides of their balance sheets simultaneously.

This does not mean the entire finance-company sector is currently insolvent. It does, however, indicate that several institutions have less capacity than commercial banks to absorb severe shocks.

System-wide liquidity remains comfortable

Despite the vulnerabilities revealed by the stress tests, overall liquidity indicators remained above regulatory requirements.

The ratio of total liquid assets to deposits stood at 24.92 percent. This was nearly five percentage points above the minimum level of 20 percent.

The ratio of net liquid assets to total deposits was considerably higher at 34.33 percent, exceeding the minimum by more than 14 percentage points.

At the system level, these figures indicate that banks and financial institutions retained a meaningful stock of liquid assets.

The central bank’s concern is therefore not that the system lacks liquidity under normal conditions. The concern is that liquidity is unevenly distributed and could become insufficient at particular institutions during concentrated withdrawals.

A system can appear liquid in aggregate while individual institutions remain vulnerable. This is why institution-level supervision and stress testing are necessary alongside sector-wide averages.

Economic recovery provides a supportive background

Nepal’s economy expanded by 4.61 percent in fiscal year 2024/25, improving from growth of 3.67 percent in the previous year.

Electricity and gas, transportation and storage, and financial services were among the main contributors to growth.

The higher growth rate offers a more supportive environment for banks because stronger economic activity generally improves household income, business revenue and borrowers’ repayment capacity.

However, economic growth has not yet translated into a sufficiently strong improvement in loan quality.

This may reflect the delayed impact of previous economic weakness. Borrowers facing financial pressure over several years may continue to struggle even after broader economic indicators begin improving.

Weak public capital expenditure also limited the transmission of economic recovery to construction, manufacturing and other credit-dependent activities.

Inflation eases as remittances strengthen external stability

Average consumer inflation declined to 4.06 percent from 5.44 percent a year earlier.

The fall in both food and non-food inflation reduced pressure on household purchasing power and allowed the central bank to maintain a cautiously accommodative monetary position.

Remittance inflows increased by 19.2 percent, supporting household consumption, bank deposits, the balance of payments and foreign exchange reserves.

The increase in remittances was one of the main sources of financial stability during the year. A substantial portion of remittance income enters the formal banking system and contributes to deposit growth.

However, heavy dependence on remittances also creates a structural imbalance. Deposits may continue to rise even when domestic investment opportunities and private-sector demand for credit remain weak.

Broad money increased by 12.5 percent, closely matching the 12.6 percent growth in deposits. Private-sector credit, however, grew by only 8.4 percent.

The difference confirms that monetary resources accumulated more quickly than productive borrowing.

Fewer financial institutions, but concentration requires scrutiny

The number of banks and financial institutions declined to 106 by the end of the fiscal year as a result of mergers and acquisitions.

Consolidation can strengthen institutions by increasing capital, reducing operating duplication and improving management capacity. It can also make regulatory supervision more manageable.

However, fewer institutions do not automatically eliminate financial risk.

As institutions become larger, their failure can have greater consequences for the broader economy. Consolidation must therefore be accompanied by stronger governance, better risk controls and close monitoring of connected borrowers.

Banks and financial institutions held 78.66 percent of the total assets of Nepal’s financial system. Commercial banks alone accounted for 65.97 percent, while development banks held 6.09 percent.

The figures show that Nepal’s financial system remains heavily bank-centred. Weakness in the banking sector would therefore have a direct impact on credit availability, payment services, savings and broader economic activity.

Digital expansion increases access—and operational responsibility

Nepal had nine payment system operators and 23 payment service providers at the end of the fiscal year.

The use of real-time gross settlement, connectIPS, Fonepay interbank transfers, QR payments, mobile banking, internet banking, cardless cash withdrawals and point-of-sale transactions continued to expand.

The growth of digital payments has improved convenience and brought more people into the formal financial system. The expansion of bank branches into local levels has also improved geographic access.

However, increasing digital dependence brings new risks, including cyberattacks, service interruptions, fraud and failures of third-party technology providers.

Financial stability can no longer be assessed only through capital, liquidity and loan quality. The reliability of digital infrastructure has also become central to public confidence in the financial system.

Stable today, but increasingly exposed

The central bank’s report does not describe a financial system in immediate crisis.

Banks and financial institutions remain profitable, system-wide capital is above the regulatory minimum, liquidity is comfortable and the broader economy is improving.

But the stress tests reveal that resilience is uneven.

A few large borrower defaults could weaken the capital position of several commercial banks. The withdrawal of a limited number of large deposits could create liquidity problems at individual institutions. Development banks and finance companies face even greater sensitivity to these shocks.

The central issue is concentration.

Nepal’s financial sector has accumulated deposits, expanded digital services and survived economic disruptions. Yet too much lending remains linked to limited borrowers and sectors, while too much funding at some institutions comes from a small group of depositors.

The next phase of regulatory policy will therefore need to focus on improving asset quality, diversifying credit and deposits, strengthening recovery of troubled loans and requiring weaker institutions to rebuild capital.

The system remains stable, but its future resilience will depend on whether regulators and financial institutions act before concentrated risks turn into actual losses.