Reforming Weaknesses Can Restore Confidence in Financial Intermediation

Nepal’s banking sector, which today operates through mobile apps and digital platforms, traces its roots to a handwritten ledger system introduced nearly nine decades ago. The establishment of Nepal Bank in 1937 marked the formal beginning of institutional banking in the country. Initiated under the leadership of then Prime Minister Juddha Shumsher, the bank laid the foundation for modern financial intermediation at a time when Nepal’s economy was largely informal and cash-based.

Nepal Bank was not merely a commercial institution; it functioned as the backbone of the country’s early financial system. Before the creation of Nepal Rastra Bank in 1956, Nepal Bank performed several central banking functions, including currency issuance, treasury management, and financial education. Concepts such as bank accounts, credit instruments, balance sheets, and basic accounting practices were introduced to the public through this institution, shaping Nepal’s early financial literacy.

For decades, Nepal’s banking sector remained dominated by government-owned institutions. Until the 1980s, four state-controlled entities—Nepal Bank, Rastriya Banijya Bank, Agricultural Development Bank, and the Industrial Development Corporation—held monopoly control. Banking during this period was conservative, product innovation was minimal, and competition was virtually absent. Lending decisions were often driven more by administrative considerations than by commercial risk assessment.

Liberalisation and the Rise of Modern Banking

The entry of joint-venture banks in the mid-1980s changed the landscape. Institutions such as Standard Chartered Bank and Nabil Bank introduced international banking practices, diversified products, and competitive service delivery. This marked the real beginning of modern banking in Nepal. While private and joint-venture banks rapidly adapted to market dynamics, state-owned banks struggled to reposition themselves, creating an uneven competitive environment.

Over time, regulatory frameworks strengthened, particularly after Nepal Rastra Bank adopted international banking standards such as Basel norms. Compliance requirements tightened, risk management practices improved, and capital adequacy became central to banking operations. However, despite regulatory improvements, structural weaknesses persisted beneath the surface.

A Sector Under Pressure

The banking sector has faced multiple external shocks in the past decade. The 2015 earthquake, the COVID-19 pandemic, global geopolitical tensions, and domestic economic slowdown tested the system’s resilience. During the pandemic, banks played a stabilising role by maintaining liquidity and extending credit support, preventing a deeper economic collapse. In this sense, the financial sector acted as a shock absorber for the economy.

However, the prolonged use of accommodative monetary tools to counter crisis effects has produced unintended consequences. Concessional loans, introduced to stimulate production, often flowed into unproductive sectors due to weak supervision. As economic activity slowed, loan utilisation efficiency declined, and asset quality began to deteriorate.

Slowing Economy and the Confidence Deficit

As Nepal emerged from the pandemic, external economic pressures intensified. Declining demand for goods and services reduced industrial capacity utilisation. Construction, manufacturing, real estate, and capital markets all experienced stagnation. The collapse of confidence in the cooperative sector further weakened financial stability, shifting excess liquidity into banks but without corresponding credit demand.

This paradox—high liquidity but low lending—has become a defining feature of the current banking environment. Businesses remain hesitant to invest despite falling interest rates, reflecting deeper structural concerns rather than cost-of-credit issues alone.

Interest Rates Without Investment Response

Economic theory suggests that lower interest rates encourage borrowing and investment. However, Nepal’s recent experience contradicts this assumption. Even as lending rates fell below nine percent, credit demand failed to recover. Consumption remained subdued, infrastructure investment lagged, and new industrial ventures did not materialise.

The private sector attributes this reluctance to frequent policy reversals, regulatory uncertainty, and weak government-led capital expenditure. Industries that rely on interconnected demand cycles—such as steel, cement, and construction—have been particularly affected. When public infrastructure projects stall, private sector confidence erodes, reducing loan absorption capacity.

Credit Growth and Economic Output: A Mismatch

Data from the past decade reveal a growing disconnect between credit expansion and economic growth. While bank lending expanded at an annual average exceeding 15 percent, GDP growth struggled to reach four percent. This widening gap suggests that credit was not translating into productive economic activity.

A significant portion of lending was channelled into speculative or consumption-driven sectors rather than employment-generating industries. The misuse of credit diluted its economic impact, resulting in rising non-performing loans and reduced lending capacity.

Shared Responsibility for Structural Weaknesses

Responsibility for the current situation is widely shared. Government instability and inconsistent policy direction have undermined long-term planning. Monetary policy alone could not compensate for weak fiscal execution, especially when capital expenditure remained low.

Banks, too, prioritised short-term profitability during periods of economic expansion, often overlooking credit utilisation quality. Risk assessment became reactive rather than forward-looking. Meanwhile, segments of the private sector focused on quick returns rather than productive investment, weakening the overall economic foundation.

Rebuilding Through Core Strengths

Experts argue that Nepal’s recovery must be anchored in its core comparative advantages—agriculture, tourism, and energy. Tourism infrastructure has expanded significantly, with hotel capacity growing and new destinations emerging. Improved connectivity through airports and road networks holds potential to elevate the sector further.

Hydropower has also reached a level of operational maturity. Domestic generation now meets internal demand, while export commitments with neighbouring countries offer long-term revenue prospects. Energy development remains one of the most promising avenues for sustainable growth.

Agriculture, however, continues to lag due to supply-chain inefficiencies and market access constraints. Without assured demand and price stability, banks remain cautious about agricultural lending despite policy incentives. Addressing these systemic issues is critical for inclusive growth.

The Path Forward

At its core, Nepal’s challenge is not liquidity scarcity but the absence of a credible investment environment. Policy stability, effective infrastructure spending, regulatory consistency, and confidence-building measures are essential to revive financial intermediation.

Strengthening coordination among government, financial institutions, and the private sector can restore momentum. If weaknesses are acknowledged and corrected, Nepal’s banking sector can once again serve as a catalyst for economic growth rather than a reflection of economic stagnation.