Nov. 10, 2006 stands out as one of the memorable dates in the history of Nepali banking. On this date, throngs of people besieged Nepal Bangladesh Bank (NB Bank) to withdraw their hard earned money after newspaper reports a day earlier suggested that Rs. 13 billion in deposits was in jeopardy due to its reckless and inappropriate practices. Between Nov. 10 and 12, panicked customers took out more than Rs. 3 billion. The run on the bank ended on Nov. 12 when Nepal Rastra Bank (NRB) decided to take over its management.
Fast forward two years to the present and the global banking system is witnessing an unprecedented credit crunch and banks all over the world are fighting for survival. On Wall Street, a number of major investment banks and commercial bank holding companies have gone bankrupt. Household names like Bear Stearns, Lehman Brothers and Wachovia have all succumbed to one of the most massive and contagious financial crises in decades. Across the Atlantic, the story is the same. Week after week of bank bailouts and failures in Belgium, the UK and France. Though there hasn't been any reports of banks going belly up or being rescued in Asia, it would be naïve to assume that this won't have any consequences in this part of the world. Reports coming out of India suggest that anxious customers have started to take out their money from ICICI Bank - one of the leading Indian banks - despite reassurances from Indian Finance Minister P. Chidambaram.
With a global liquidity crunch and probably more bank failures to follow, there is widespread economic uncertainty; and experts are predicting a prolonged period of negative economic growth. Stock markets all over the world have seen significant sell offs for the last few weeks, and major indices like the Dow Jones Industrial Average (DIJA), Nikkei and S&P 500 have recently seen a lot of volatility - an indication of market uncertainty and risk. To sum it up, the global financial system has come close to a screeching halt. Credit has dried up everywhere; and confidence, the cornerstone of the credit market, is in scarce supply as big banks continue to bite the dust. In the heart of all this lies the complex world of financial derivatives, credit default swaps (CDS) and other arcane financial instruments.
Though Nepali banks don't have any direct exposure to these financial instruments, important lessons can be learnt from unfolding global events. A few days ago, NRB announced its new "cautious" monetary policy for the upcoming fiscal year with special emphasis on tackling inflation. In its report, NRB has also expressed concern over the real estate and stock market bubble. The Nepal Stock Exchange (NEPSE) -- the country's sole secondary stock market -- has seen significant recent growth with an exponential rise in public participation. The growth in the equity market is good for the overall development of the economy. However, speculative growth where the "fundamentals" of the underlying market are not sound creates a market bubble. There are no economic or financial statistics that supports the current boom in equity and real estate. Considering the growth rate of 2-3 percent for the last five years, a few significant national-level investment projects and a wounded economy staggering out of a decade-long conflict, it's hard to argue against the premise that the current share and land markets are a bubble.
All of this has coincided with the increased exposure of commercial banks and finance companies to equity and real estate. Responding to the public's interest in stocks and real estate, these financial institutions have been providing easy loans to people wishing to invest in them. This has helped to inflate share and land prices and create a market bubble. Bubbles inevitably lead to bust. Economists have argued that decade long housing bubbles in the United States, Europe and Australia is the primary reason for the current financial crisis and credit crunch. In the United States, easy access to housing loans and historical level of low lending rate led to an unprecedented real-estate boom. People with sub-par credit ratings and without any stable source of income easily walked away from bank with mortgage to buy a house. These subprime mortgages were then combined with other mortgages and sold to investors as Mortgage Backed Securities (MBS). Everyone was happy because everything was booming for a while.
However, when these house owners with sub-prime mortgage started to default on their monthly mortgage payments, things started to unravel quickly. MBS, which were a significant portion of banks balance sheet all over the world, lost value as investors realized its dicey origins. Quarter after quarter, banks with exposure to these MBS announced significant losses. Investors fearing further loss started pulling away their money from banks and investment, which exacerbated the situation and led to bank failures. In the Nepali banking context, there are reasons to be concerned about the exposure of commercial banks and finance companies to equity and real estate market. Because of lack of investment opportunities in other sector, financial institutions have been pouring money in real estate and equity market. While unprecedented remittance inflow has helped sustain the deposit mobilization growth even in the light of growing number of these financial institutions, there aren't enough areas for investment outlays to support the growing deposit base. Hence financial institutions don't have much of a choice but to provide loans for investment in equity and real-estate market.
Anticipating higher returns, people without any background in investment or any professional guidance are taking out loans to invest in these markets. Because of increasing competition, financial institutions are providing loans without proper credit and income check. All of these factors have helped to inflate stock and real-estate prices. However, when the bubble finally busts either in equity or real estate market, there will be an immediate impact on the balance sheet position of these financial institutions. The onus lies with the NRB to ensure proper health of our banking sector. First, there should be adequate regulatory framework to ensure that bank's asset base is sound and not inflated. Unless other areas of investment emerge, these financial institutions will continue to provide loans for investment in real-estate and equity market.
The NRB must have an effective monitoring and regulating mechanism whereby it can identify potential trouble in the assets base of these institutions. The recent global financial crisis is testament of how easily and rapidly asset value can deteriorate. Second, the NRB should address the important issue of conflict of interests when these financial institutions provide loans for investment in stock market. The majority of stocks traded in the NEPSE are those of financial institutions and these same institutions are providing loans to investors to purchase their own stocks. Third, the NRB must bring out safeguard mechanism to avoid a potential bank run, when the market crashes in the future and asset value of these institutions evaporate. In the United States the Federal Deposit Insurance Corporation (FDIC) insures deposit and certain category of money market funds up to USD 100,000. In the light of the recent crisis, the US congress is planning to extend the limit to USD 250,000 to bolster the weakening public confidence in banks. Similar mechanism exists in other countries to protect the deposit holders and small investors. The NRB should bring out similar kind of scheme in order to protect deposit holders and avoid another bank run in the future.
Published on The Kathmandu Post October 3, 2008
Link: http://www.kantipuronline.com/kolnews.php?&nid=162763
References and links to this article:
http://www.economicsofcrisis.com/economics_of_crisis/global.html
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