Analysing Lender Of Last Resort Policy

The Nepal Rastra Bank (NRB) issued a Lender of Last Resort Policy on March 12. The policy aims at providing facilities for a financial institution in dire straits. Whenever a financial institution is in trouble to the point of collapse, the bank can be helped in averting the collapse through such a facility.  The central bank announced the policy at a time when Silicon Valley Bank, the 16th biggest bank in the United States of America, collapsed. The two other banks have also collapsed. This kind of development raised alarm bells in the Nepali banking sector as well. 

Some people have gone as far as to say that the NRB issued the policy for fear that Nepali banks may also fail and it intends to rescue such banks through the facility provided under the policy. But this is just a coincidence. Silicon Valley Bank did not collapse owing to bad loans. The bank invested 43 per cent of its deposits in loans and most of the remaining deposits in bonds when the interest rates were low in the market in hopes of reaping hefty profits. But the interest rates increased in the market and the prices of the bonds declined. This created trouble for the bank. 

Collapse of Silicon Valley Bank

To steer clear of the bad situation, the bank had to sell its bonds at a lower price. The bank also planned to sell bonds worth USD 2.5 billion. This sent a message to its customers that the bank was going to collapse, resulting in the run on a bank. The bank had a deposit base of USD 200 billion. On a single day, deposits were drawn to the tune of USD 42 billion. The bank suffered heavy losses due to increased interest rates. There was a slump in the growth of the tech industry where it had heavy investments. Moreover, the bank could not anticipate its liquidity position. With the trust of the customers in the bank gone, the bank collapsed.  

In the present context, there are problems with the country’s microfinance and cooperative sectors. There were also protests against rising rates of interest on loans disbursed by commercial banks. So it is but natural for some people to see the collapse of the American bank and the condition of Nepali banks through the same lens. Nepali banks are considered good banks in the South Asian region. From the perspectives of the available capital fund, liquidity, risk-weighted assets, etc., Nepali banks are in sound condition. As far as bad loans are concerned, the percentage of such loans is barely 2.5 per cent. As per international norms and regulatory provisions, the percentage of up to 5 per cent is manageable.

 In comparison, Indian banks have bad loans exceeding 10 per cent. In fact, Nepali banks are better than Indian and Bangladeshi banks. Loans are disbursed against adequate collateral by Nepali banks. The collateral is in the form of land and buildings, shares, stocks (for hypothecation loans), gold and silver and the like. When there is adequate collateral, loans are considered safe. Moreover, the NRB supervises the loan portfolios of banks. There are provisions for loan classification. When the due date of a loan exceeds three months, 25 per cent of the loan has to be provisioned. If the due date exceeds six months, 50 per cent provisioning has to be made. 

In like manner, if the due date exceeds one year, cent per cent provisioning has to be made. While making such provisioning, efforts at recovering such loans are also simultaneously made. Liquidity assets are the hallmark of strength of Nepali banks. The banks have 25 per cent liquidity assets on an average. There is a slim chance of a bank collapsing owing to a liquidity crunch. The combined capital fund of Nepali commercial banks, development banks and finance companies stands at Rs. 700 billion. Microfinance institutions alone have a capital fund of Rs. 62 billion. 

Coming back to the policy, BFIs can avail themselves of the facility under the policy by paying an additional 2 per cent penal rate over the prevailing bank rate. This provision of an additional two per cent was not there in the previous policy. In fact, this policy is an amended version of the Lender of Last Resort Policy, 2011. Till date, only one bank has taken such assistance. The NRB provided Vibor Bank with a short-term loan of Rs. 500 million under the previous policy in 2011 and rescued it from the problem arising out of a liquidity crunch. 

Liquidity

When BFIs are unable to manage necessary liquidity through the inter-bank market, daily liquidity facility, open market transactions or standing liquidity facility, they can have recourse to the facility under the policy. They can enjoy it even when they are unable to meet immediate obligations for lack of marketable assets. Also, when they are unable to return large amounts of deposits, they can rely on this facility. They can also get this facility under other circumstances such as challenges to the economy and financial sector due to the systemic risk posed by a financial institution; decline in public trust in the banking and financial sector leading to the run on a bank; financial obligations remaining unfulfilled owing to natural disasters, national or international crises or impending liquidation; and other such factors. 

Opponents of the Lender of Last Resort Policy, however, argue that BFIs may misuse the facility under the policy. They may take unnecessary risks, driving the banking and financial sector haywire. But proponents of the policy reason that not having such a policy is worse than excessive risk-taking by BFIs. Anyway, such a policy is necessary. No one can exactly say what is in store for BFIs. Such a policy would also reassure the general people that their deposits are safe and helps maintain their trust in the banking and financial sector.     

(Maharjan has been regularly writing on contemporary issues for this daily since 2000.)