Nepal’s Financial Sector Faces Structural Challenges Alongside Emerging Opportunities

Despite significant progress made through financial sector reform programs, Nepal’s financial system continues to face a mix of structural challenges and emerging opportunities. Improvements in financial infrastructure, institutional strengthening, access expansion, and operational efficiency have been substantial. However, policymakers acknowledge that unresolved weaknesses within the system still demand sustained monetary and regulatory attention.

In response, the central bank has continued refining its monetary and financial reform agenda. Measures such as interest-rate-based monetary operations, effective implementation of the interest rate corridor, permanent deposit and lending facilities, and modernization of open market operations have strengthened policy transmission. At the same time, regulatory provisions—including working capital loan guidelines—have been introduced to improve credit quality and discourage misuse of bank lending.

A key concern remains the disconnect between credit growth and real economic output. While bank lending has expanded, domestic production has not increased proportionately. This imbalance has raised questions about credit efficiency and resource allocation. To address this, authorities have increasingly relied on macro-prudential tools aimed at controlling excessive risk-taking while guiding credit toward productive sectors.

Nepal’s banking system continues to experience volatility in liquidity and interest rates, largely because credit has not been sufficiently channeled into industrialization and productivity-enhancing activities. In response, directed lending policies have been introduced to promote priority sectors. However, limited development of the institutional bond market has left the economy overly dependent on banks for financing, placing additional pressure on short-term deposits to fund long-term investments.

Although the number of capital market participants has grown rapidly in recent years, the absence of a well-functioning corporate and government bond market has restricted diversification of financial instruments. As a result, even institutions that should raise capital directly from the market remain dependent on bank deposits and interest income. This overreliance has increased the burden on the monetary system and amplified expectations placed on the central bank—despite the inherent limitations of monetary policy.

External sector vulnerability remains another pressing issue. Nepal’s balance of payments stability is closely tied to remittance inflows and tourism earnings, while the export base remains narrow. Any slowdown in remittances or tourism could widen the current account deficit and intensify pressure on foreign reserves. Until a sustainable export foundation is established, fluctuations in foreign labor markets will continue to have a direct impact on external stability, highlighting the need for accelerated reforms in the capital and external sectors.

Recent months have also seen challenges in loan recovery, contributing to a rise in non-performing loans. In this context, maintaining financial stability without undermining capital adequacy has become a delicate balancing act. Policymakers face the dual challenge of preventing further deterioration in asset quality while simultaneously expanding credit to revive economic activity.

Strengthening internal control systems and enforcing regulatory compliance have therefore become top priorities. Enhancing governance standards within banks and financial institutions is seen as essential to restoring confidence. At the same time, rapid digitization in banking has exposed gaps in digital financial literacy among customers, creating new operational and reputational risks that require careful management.

Cybersecurity and consumer protection have emerged as critical focus areas. While Nepal has made significant progress in digital payments and fintech integration—both domestically and with regional and international systems—these advancements have also increased exposure to cyber threats. Building cyber-resilient systems, improving financial awareness, and strengthening customer protection mechanisms are now central to maintaining trust in the financial system.

Institutional governance remains another unresolved challenge. Many banks continue to struggle with effective risk management, excessive concentration in limited sectors, blurred boundaries between bankers and business groups, and governance interference by boards in daily operations. Addressing these issues is essential for creating a sound and transparent banking environment.

Legal, institutional, and financial infrastructure gaps further compound the challenges. The absence of a fully integrated customer identification system and a comprehensive credit scoring mechanism—especially for individuals—limits risk assessment. While efforts are underway to modernize credit information systems and simplify loan recovery processes, progress must accelerate, particularly as digital banking expands into rural areas where infrastructure and financial literacy remain limited.

Overall, banks and financial institutions play a far broader role than deposit mobilization and credit delivery alone. Because financial services are deeply intertwined with every sector of the economy and society, maintaining public trust is critical. International practice emphasizes that financial institutions must remain sustainable and avoid losses, as public deposits form the backbone of the system. Any erosion of depositor confidence due to institutional weakness could threaten overall financial stability.