- Suyog Shrestha
Development banks’ customer-centric approach comprising ease of access, support for small projects, faster turnaround times, and local representation helped build trust and increased financial inclusion in remote communities.
Background and reason behind licensing development banks
Even though the first bank in Nepal (Nepal Bank Limited) was established in 1936, and the central bank, Nepal Rastra Bank (NRB) 1956, two important milestones truly brought banking within the reach of the common public. The first was the financial liberalization of the 1980s which paved the way for private commercial banks. The second was the introduction of Nepal Development Banks Act, 1996, which enabled the operation of Development Banks in Nepal.
After nearly a decade of successful operations by private commercial banks, the government and NRB correctly envisaged that the public at large, mostly including the ones in the rural sector, could effectively be served by smaller scale banks. Thus the Development Banks Act, 1996, was enacted, marking the beginning of Development Banks in Nepal.
Development Banks vs other Banks
Globally, the term “Development Banks” refers to institutions that provide medium- and long-term financing for projects and infrastructure. However, in Nepal, Development Banks function more like Commercial Banks. They accept deposits from both individuals and institutions, and extend short- and long-term credit, creating considerable functional overlap with Commercial Banks. Where Development Banks distinguish themselves is in their service to rural areas and lower-middle-income segments. These banks are often more accessible and relatable to these communities, making them a preferred choice in such regions.
What a Development Bank can and cannot do
With the advent of Banking and Financial Institutions Act (BAFIA), the roles and restrictions of Development Banks were clearly defined. Section 49 of the Act outlines the functions that can be done by the entirety of the financial institutions. Accordingly, Development Banks can mobilise deposits, disburse credit and provide other services too, but have been prohibited from:
- Lending against hypothecation of loans;
- Certain government transactions;
- Buy and sell of gold and silver;
Although BAFIA allows Development Banks to engage in Letters of Credit (LC), NRB approval is required, a requirement that has not been fulfilled in practice.
Past and present contributions of Development Banks
Over the decades, Development Banks have played a crucial role in transforming Nepal’s banking landscape and spreading banking services to rural areas. Data shows that most Development Banks originated in rural regions and later expanded to urban centres.
Their customer-centric approach comprising ease of access, support for small projects, faster turnaround times, and local representation helped build trust and increased financial inclusion in remote communities. For many, the idea of engaging with formal banking institutions became a reality only because of the presence of Development Banks.
In a country like Nepal, where a significant portion of the population resides in rural areas, the contribution of Development Banks to financial literacy and accessibility cannot be overstated.
Challenges facing Development Banks
Development Banks currently face both internal and external challenges. Internally, many Development Banks have been merged into Commercial Banks, strengthening the latter while simultaneously diminishing the former.
Externally, the government’s and various institutions’ treatment of Development Banks as secondary entities has further weakened their standing.
Perhaps the most significant challenge is one of perception. Clients often view Development Banks as riskier than Commercial Banks, merely because they are classified as “Class B” institutions, while Commercial Banks are designated “Class A.”
How Development Banks can survive and flourish
- Classification impact: The classification of financial institutions as Class ‘A’, ‘B’, ‘C’ and ‘D’ has had an indelible effect in the perception of the public. Rather than the functions that these institutions can or cannot do, the impression that it has created, both prima facie and in the long run, is that Class A institutions are better, B is slightly poor and a bit risky, C even poorer and riskier and Class D are fraught with all the risks. This makes a huge impact in their selection for placement of deposits, where they feel that they would rather compromise in their deposit return than place it in B, C or D class institutions. This has taken away a huge factor in the level playing field. What needs to be understood is that these different classes of institutions are differentiated by certain parameters like paid up capital and the scope of operations. But all of them are governed and regulated by NRB and the capable inspecting personnel in NRB are rotated in the supervision departments overseeing these institutions. Moreover, all classes of financial institutions are governed by the same Unified Directives promulgated by NRB. Hence, it would make sense to remove the ‘A’, ‘B’, ‘C’ and ‘D’ classification and just stick with names ending with ‘Bank Ltd.’, ‘Development Bank Ltd.’, ‘Finance Co. Ltd.’ etc. to enable the clients and customers to identify the differentiation.
- Directed lending up to Rs. 2 crores: Commercial Banks are required to allocate at least 15 percent of their total loans to amounts up to Rs. 2 crores, a mandate that often leads them to disburse less-desirable loans just to meet regulatory requirements, thereby distorting market behaviour. This segment aligns more naturally with Development Banks’ strengths. Letting them serve this segment freely, without burdening Commercial Banks, would be a win-win.
- Letter of credit transactions: The current day National Level Development banks are almost equal to, or in some cases even bigger than Commercial Banks of the past. Advocating simply on the basis of size, it is high time that National Level Development Banks are allowed to deal in Letter of Credit transactions. They have the size to absorb that risk. Initially, NRB could put a restriction on the size of the LCs that Development Banks can deal in. The other logics in support of allowing LC transactions to Development Banks are as follows:
- This would give proper exposure to staff members of Development Banks too in LC transactions. The idea of people being trained should act as a big motivator to initiate this action, as this would enable such staff members to seamlessly make the transition to Commercial Banks too, should they want to do so at any time in the future.
- In the absence of LC transactions, Development Banks do not have sufficient transactions to justify purchase of SWIFT license. Currently, without SWIFT access, these banks cannot process foreign remittances, which dissuades account holders, especially migrant workers, from using Development Banks. In the long term, this creates a systemic disadvantage and marginalizes the sector further.
- Participation in deposit of local bodies: Historically, Development Banks have been the first point of contact for rural populations. Ironically, they are now excluded from receiving deposits from local government bodies. Ensuring their participation would promote a fairer, more balanced banking ecosystem.
- Deposits from other organisations: Despite having increased in size over the last few years and being regulated by the same regulator (NRB), there are still quite a few organisations that have put restrictions on placement of their deposit with Development Banks, by way of restrictive clauses in their Financial Bylaws or other documents. It is high time, and only fair, that Development Banks too, be given the same trust as Commercial Banks for placement of deposits of such organisations.
- Loan against hypothecation: Development Banks have the expertise and risk appetite to handle loans against hypothecation. Relaxing restrictions in this area would unlock new growth opportunities for them.
Conclusion
The banking market is big and diverse, where Development Banks, Commercial Banks, Finance Companies and Microfinance Institutions can co-exist. All that is needed is mutual understanding and respect. Development Banks came out of the chrysalis a long time back and given proper level playing field, there’s no reason why it cannot soar high in the sky.
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