Blinkered Policy

In la-la land, there are two banks “Mean and Lean (M&L)” and “Fat and Profligate (F&P)” who had similar balance sheets and profitability figures five years ago. Over the last five years, the two banks have focused on completely different strategies. While F&P has been more aggressive and often reckless in seeking growth, M&L has focused on prudent banking practices.

Over the last five years, the total asset of M&L has grown at a cumulative average growth rate (CAGR) of 15 percent. The top management, including the chief executive officer (CEO) of M&L has focused on quality over quantity while pursuing growth. M&L has maintained excellent lending standards, with rigorous credit analysis, while providing loans to its clients. Their credit analysis not only involves determining the client’s “ability” to pay but also their “willingness” to pay. Often, M&L has rejected loan requests because of either dodgy business proposals or because of the client’s past track record. Moreover, M&L has worked

on maintaining a diversified

lending portfolio.

In line with its prudent strategy, M&L has focused on growing its deposit mix judiciously focusing on both current and savings accounts (CASA) to lower its cost of funds and time deposits to address a potential asset-liability mismatch.

To maintain its rigorous banking standards, M&L has concentrated on retaining and hiring experienced staff; however, it has not indulged in a hiring spree to push its loan products. M&L’s perks and benefits for its staff are on a par with the average industry standards, and its Human Resource (HR) department has devised new and innovative, yet cost effective, ways of retaining quality manpower. Moreover, because of a large number of experienced and long serving staff, the top management of M&L has been able to seamlessly convey its strategic vision to middle and lower level management, which has resulted in operational synergies.

Over the last couple of years, lots of new banks and financial institutions have emerged in la-la land, and, as a result, staff attrition in the banking sector has increased rapidly. However, because of M&L’s focus on quality over quantity, flexible working hours and a not so strenuous job schedule, it has been able to minimize the employee turnover level. Experienced staff coupled with a motivating work environment has increased M&L’s staff productivity, helping to increase its bottom line.

M&L’s focus on quality over quantity in their loan portfolio has helped it to keep its non-performing loans (NPL) to a bare minimum level. Its judicious deposit mobilization has helped it to maintain its interest spread. As a result, the net profit of M&L has increased at a CAGR of 25 percent over the last five years. Shareholders of the

bank have been satisfied with the management’s ability to grow profit and deliver above average returns on equity.

Compared to M&L, F&P’s total asset has grown at a CAGR of 30 percent over the last five years. In order to purse this high growth, F&P has pursued a different strategy to that of M&L. The lending practice of F&P has been lax at best; and often, loan requests have been approved without proper due diligence. While seeking high growth, the top management of F&P has ignored maintaining a diversified loan portfolio. As a result, its portfolio is highly concentrated among a few vulnerable sectors (such as real estate).

In order to pursue rapid growth, F&P has poached a lot of staff from other banks by offering them a higher salary, which has resulted in higher than average salary expenses. However, the top management of F&P has not been able to properly convey its strategic vision to middle and lower level management resulting in lack of organizational coherence. Moreover, long working hours and a demanding schedule have taken their toll among F&P’s staff, reducing their productivity.

Recently, because of a sudden slowdown in the real estate sector, a few major loans of F&P have come under scrutiny. This, coupled with higher staff compensation, has severely undermined F&P’s bottom line. As a result, the net profit of F&P, after growing at a CAGR of 30 percent for the first three years, has decreased at a CAGR of 17 percent over the last two years.

Ignoring other financial information, for comparative purposes, the total asset of F&P is approximately 2.5 times that of M&L currently, while the total staff expense of F&P is two times that of M&L. However, the total profit of F&P is only half that of M&L.

Now, why on earth does Nepal Rastra Bank (NRB), given the above mentioned hypothetical yet plausible scenario, want to have the CEO of F&P earn a higher salary than that of M&L? To put it more bluntly, why does NRB want to have more F&P-like banks and less M&L-like banks in the future? Because by linking the CEO’s compensation to the total asset and average salary expense, NRB has paved the way for formation of bloated financial institutions with the management’s mandate to seek total asset growth irrespective of other factors.

This article was first published on 20th December 2010. Permanent Link:

http://www.ekantipur.com/2010/12/20/business/blinkered-policy/326772/

Fighting Inflation

Inflation averaged 13.2 percent in the fiscal year 2008-09, 10.5 percent in 2009-10 and, according to the Monetary Policy for fiscal 2010-11, is expected to be 7 percent in fiscal 2010-11. Given the persistently high inflation in Nepal for the last couple of years, the Nepali people, I feel, have started to take higher prices as given and adjust with them accordingly. However, having said that, one needs to think about the adverse impact of an inflationary environment and its wide ranging impact on export competitiveness to national savings to the exchange rate.

But before I get into the details of the adverse impacts of inflation, it’s interesting to compare and analyze the government’s inflation projection—set by Nepal Rastra Bank at the start of the fiscal year in its annual Monetary Policy announcement—and actual inflation for that particular year.

For fiscal 2008-09, NRB had projected an annual inflation rate of 7.5 percent; but the actual inflation for that fiscal year was, as mentioned above, 13.2 percent. Similarly, for fiscal 2009-10, NRB had projected an annual inflation rate of 7 percent while the actual inflation for the last fiscal year was 10.5 percent. For this fiscal year, NRB has again projected an inflation rate of 7 percent. What the average annual inflation for the current fiscal year will be remains to be seen. However, given the central bank’s track record, your guess is as good as mine.

Given the above mentioned context of a huge gap between the projected and actual inflation

rates during the last couple of years, it’s easy to realize that

NRB has lost its credibility especially in terms of fighting inflation. Keeping the supply side constraints aside, which is the inevitable excuse that NRB uses when the actual inflation is higher than the projected inflation, if NRB has projected inflation to reach a certain level, why then doesn’t it fight to keep it at that level?

If at the start of the year, I believe that inflation will be 7 percent (guided by NRB), I will plan accordingly; i.e., if I am a wage earner, I will demand a minimum 7 percent wage hike to at least maintain the purchasing power of my income. Similarly, if I am the owner of a manufacturing company, I will increase my product’s price by a minimum 7 percent so that my firm’s profit will at least remain the same in real terms.

However, if at the end of the year, I realize that inflation actually increased to 13.2 percent, then I will be worse off irrespective of whether I am a wage earner or the owner of a manufacturing

company. Hence, at the beginning of the next fiscal year, I start to mark up NRB’s inflation projection by a certain percentage so that I won’t be worse off again. If every decision maker, i.e., individuals and businesses in the country, starts doing the same, then the inflation level will shoot up and become unmanageable.

High inflation then has a multiplier effect throughout the economy. High inflation decreases after-tax real return and reduces the people’s incentive to save and invest. For example, if the tax rate is 25 percent, the interest rate on a one-year taxable bond is 10 percent and the inflation rate is 5 percent, then the before-tax real return will be 4.76 percent, and the after-tax real return will be 3.57 percent (this is what an investor actually cares about).

Now, if the inflation rate rises by 5 percent to 10 percent and the interest rate on a one-year bond also rises by 5 percent to 15 percent, then the before-tax real return will be 4.55 percent, and the after-tax real return will be 3.41 percent.In the latter case, even if the nominal return has increased to 15 percent, the after-tax real return is lower than in the former case because of high inflation, discouraging people from saving and investing.

High inflation also makes a country’s products less competitive in the international market and reduces exports. Because of its adverse effects on exports and imports, in the long run, it also puts downward pressure on the country’s currency.

This article was first published in the Kathmandu Post on Dec 6th 2010

Permanent Link: http://www.ekantipur.com/2010/12/06/business/fighting-inflation/326079/

Dissecting the budget

After much hue and cry and a delay of almost four months, Minister of Finance Surendra Pandey finally tabled the budget of Rs 337.9 billion for the Fiscal Year 2010/11 on Saturday.

Amidst the cacophony of political wrangling, it’s relieving to finally have a budget, which lays out key fiscal policies, irrespective of its form or issuance mechanism. Having said that, lets then discuss what this year’s budget has to offer and, after much ado, are there things to be cheerful about?

Segregating the composition of budget, Rs 190.32 billion has been allocated for recurrent expenditure, Rs 129.54 billion has been allocated for capital expenditure and Rs 18.42 billion has been allocated for principal repayment of foreign loans. In terms of sources, the government expects to raise Rs 216.64 billion from revenue collection, mobilise Rs 87.57 billion from foreign rants and loan, and borrow Rs 33.68 billion internally. To up the ante on revenue collection, the budget has focused on expanding revenue net and has proposed 2011 as ‘Tax Implementation Campaign Year’.

During the last fiscal year, Nepali economy reeled under Balance of Payment (BOP) crisis and had to seek help from the International Monetary Fund (IMF) under its rapid credit facility program to maintain external sector stability. While huge growth in imports of gold were largely to blame for the BoP crisis, which at one time was in deficit of almost Rs 24 billion. There were other glaring trends; for example, Nepal imported livestock worth Rs. 15 billion during the FY 2009/10.

Given the current mismatch between the import and export growth (in the FY 2009/10, Nepal’s merchandise export declined by 9.7% to Rs 61.13 billion while imports increased by 33.2% to 378.8 billion), Nepal will have to perennially face BoP crisis if the government doesn’t act to either revive Nepal’s export or curb import. Hence, this year’s budget should have focused on import substitution and export expansion programmes. However, few, if any, such specific programs can be found in the budget.

During the last few years, education sector has received substantial budgetary allocation and it has paid off handsomely as Nepal has made rapid headway in literacy rate. This year also, 17.1%, which is the highest sector allocation of the total budget, has been allocated for the education sector.

One of the factors for the underperformance of Nepali economy over last couple of years is lack of proper roads and transportation related infrastructure. Given the growth constraints due to lack of transportation related infrastructure, budget has proposed construction of Railway and Metro to kick start the development of mass transit system in Nepal. The focus on development of four- and six-lane highways in and around Kathmandu and border towns near India will however help to ease supply bottlenecks. Moreover, to tackle

the energy crisis, this budget has allocated funds for completion of Trishuli-3, Chameliya and Kulekhani-3, among others.

Recently, the government has shown adequate concern to revive the flagging capital market. Slew of new regulations (Mutual Fund and Central Depository System) have been issued during last couple of months to streamline and institutionalise security market. This budget has also introduced several new programs such as allowing Non Resident Nepalis (NRNs) to invest in capital market, regulating the commodity and derivative market and introducing regulation pertaining to credit rating mechanism. These will certainly help to move the capital market in the right direction; however, going forward, government should also allow overseas investors to invest in domestic capital market, as the mutual fund regulation already allows 25% of total Asset under Management (AUM) of a mutual fund to be invested in overseas market.

The budget has also proposed tax incentives to encourage merger and acquisitions (M&A) among financial institutions and insurance companies. One of the bones of contention while pursuing M&A in Nepal have been the issue of fixed asset revaluation and consequent capital gain tax on such revaluation. Hence, I believe, finance minister’s proposed tax incentive is likely to address this issue, among others.

Keeping in the mind the Nepal Tourism Year-2011 (NTY-2011), this budget has proposed various programs for a successful NTY-2011. However, with less than one and half month’s time before the start of the NTY-2011, it’s debatable whether there is sufficient time for implementation of these programmes. And, this brings home the point which has plagued fiscal policy making in Nepal for quite some time-lack of proper implementation of proposed program due to less time period after the budget announcement and before the end of the FY.

Recently a high level commission called ‘Commission to review Government Budget Management and Expenditure System’, submitting a report to Finance Minister Pandey, recommended the government to bring budget before May; i.e., at least one and half months before the end of the FY. As many programs announced in the budget goes either un-implemented or are implemented hastily towards the end of fiscal year to toe the line of budget’s speech, the aforementioned commission’s report rightly urged the government to table budget early so that it leads to better implementation.

Traditionally, in Nepal and unlike international practices, budget for the upcoming fiscal year is brought only towards mid July; i.e., towards the end of the fiscal year. And if there is change in government or any other political wrangling, budget, like this year, gets delayed jeopardising the whole economy. Hence hopefully, going forward, the upcoming government (when and if it gets formed) will heed the Commission’s advice and brings next fiscal year’s budget early.

First published in the Kathmandu Post on November 21, 2010
Link: http://www.ekantipur.com/the-kathmandu-post/2010/11/20/money/dissecting-the-budget/215085/

Yen and Yuan

In the years following the end of World War II, the Japanese economy witnessed tremendous growth which is often referred to as an “economic miracle”. Japan’s rapid industrialization in the post-war years embraced technological progress and Japanese industry focused on producing high-end technological equipment, innovative electronic products and most reliable automobiles. Rising economic productivity, because of technological progress, coupled with strong exports of renowned international products, such as Sony, Toyota

and Honda, among others, boosted Japan’s economic growth. Japan’s economy grew at an average annualized rate of 10

percent during the 1960s, 5 percent during the 1970s and 4 percent during the 1980s.

However, in order to boost their export related industries, the Japanese government had fixed the exchange rate between the Japanese yen and the US dollar at 360 yen to US$ 1 in 1949. But a high volume of Japanese exports to the US and Europe started causing international tensions in the 1970s. The global stagflation and oil crisis of the 1970s were causing economic woes in the US and other major developed economies in Western Europe. And because of an acute balance of payments crisis, the US had to withdraw from the gold standard and abandon the convertibility of its currency into gold in 1971.

Due to international pressure, Japan finally revalued the yen from 360 to 308 per US$ 1 in December 1971; and later, in February 1973, adopted a floating exchange rate system. However, in order to protect Japan’s industry, the Japanese government kept on intervening in the foreign exchange market and managed to keep the yen at around 250 to 300 to US$ 1. As a result, Japanese exports kept on surging — the share of exports in Japan’s gross domestic product increased from 11.7 percent in 1973 to 14.5 percent in 1984.

Flush with excess foreign

currency, the Japanese government bought US treasuries which helped keep the yields on US government bonds low.

Around that time, while Japan was enjoying economic prosperity, the US was facing economic problems. Although the US had emerged from a series of economic recessions in the 1970s and early 1980s, the artificially low exchange rate of the Japanese yen and the Deutsche mark were undercutting the competitiveness of American industry and stifling a full-fledged economic recovery. As a result, there was a lot of political pressure from the Americans on the Japanese to let the yen appreciate.

To followers of international policy issues, these events of the 1980s sound eerily familiar with what is happening now in terms of the Chinese yuan. The Chinese government, like the Japanese government in the past, has kept its currency artificially low for a number of years to promote Chinese exports. And the weak yuan has paid off handsomely to China as export-led economic growth has propelled China to the second largest economy in the world — a place which was till a few months back occupied by Japan. And like Japan in the 1970s and the 1980s, due to massive influx of foreign currency, the Chinese government has been buying US treasuries and helping to keep yields on US government bonds low. Although the US has been pressuring China for a long time to let the yuan appreciate, the current state of the US economy, with an unemployment rate in excess of 9.5 percent, has compelled US policymakers to raise their voice against a weak yuan.

During the recently held annual meeting of the World Bank and the International Monetary Fund, the major discussions revolved around China’s currency policy. Given the state of the US economy and China’s massive trade surplus with the US, Americans feel that, by keeping the yuan artificially low, China is taking away jobs from the US. But China hasn’t budged so far. Recently, Chinese President Hu Jintao said that allowing the yuan to appreciate too quickly would undermine the competitiveness of Chinese industry and cause social unrest in his country as a lot of workers were dependent on it. A look back at what happened to Japan after it caved in to US demands gives an idea about why Chinese officials won’t bow to US demands.

In the mid-1980s, due to pressure from the US government, Japan had to yield. Amid growing geopolitical tension, the governments of Japan, the UK, West Germany, France and the US signed an agreement at the Plaza Hotel in New York City on Sept. 22, 1985, whereby they decided to intervene in the foreign exchange market to weaken the US dollar against the yen and the Deutsche mark. After the signing of the Plaza accord, the US dollar weakened against the yen by over 50 percent between 1985 and 1987. However, to keep its economy moving along, the central bank of Japan reduced the interest rate to prop up domestic demand which, however, adversely created an asset price bubble in Japan in the late 1980s. After the bubble burst in the early 1990s, Japan’s economy has been perennially underperforming for the last two decades.

China, with the benefit of hindsight, has understood

that allowing the yuan to appreciate too quickly would undermine its economic performance. Moreover, China, because of the size of its population, is nowhere near Japan — when it signed the Plaza accord — in terms of per capita income and has a lot of catching up to do. Hence, it’s unlikely that there will be a

Plaza-like agreement in the coming days, and more ugly exchanges between US officials and their Chinese counterparts are likely to persist for the foreseeable future unless another viable compromise can be reached.

This article was first published in The Kathmandu Post on 25th October 2010
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/10/24/money/yen-and-yuan/214110/

Unusually Uncertain

"Unusually uncertain” were the two words that Ben Bernanke, the Chairman of the Federal Reserve of United States, said about the state of economic recovery on July 21st 2010. After the remarks were released, the US stock market fell sharply which were followed later with subsequent fall in the Asian and European markets.

After showing signs of recovery in early 2010, the global economic outlook has deteriorated during the last couple of months. Economic growth in major advanced economies has been tepid at best, and the much talked about “green shoots” of recovery witnessed during mid 2009 hasn’t materialized into full scale economic expansion.

The unemployment rate in the US hasn’t budged from 9.5 percent to 10 percent range during the last one year. The high unemployment rate shows that business confidence is still low and companies aren’t hiring despite the recent surge in their profit. Household consumption accounts for over 70 percent of the US Gross Domestic Product (GDP) and because of struggling job market, households are chary of spending. As a result, savings rate in the US has increased after the global economic crisis: from a pre-crisis negative savings rate, the US household savings rate has recently increased to over 6 percent. One of the major reasons of global economic crisis was over-consumption of US households; hence, the increment in savings rate is good for the long run. However, in the short run, the US economy desperately needs its consumers to spend more to boost its growth prospects, which looks unlikely given the current US job market situation.

And, if leading experts are to be believed, US job market won’t improve any time soon. Mohammed El-Erian, chief executive officer and co-chief investment officer of PIMCO - the largest fixed income manager in the world - recently said that the US will witness a “lost decade” of jobs growth. Bill Gross, founder and Managing Director of PIMCO was first to coin the term “New Normal” in early 2009 to describe a prolong period of slow growth and high unemployment for the US economy.

When leading economists and central bankers from around the world gathered recently in Jackson Hole, Wyoming to discuss the future of the global economy, the mood amongst the members of this elite group was reported to be much somber. Having already taken unprecedented steps to bolster economic performance

after the crisis, central bankers have plenty to think about

given the daunting prospect of ‘double dip”. Speaking at the Jackson Hole Symposium, Bernanke reiterated his earlier comments about uncertain course of economic recovery and added that US growth will remain subdued for rest of the 2010 and that US economy will grow, albeit slowly, in 2011.

Few significant events have contributed to uncertain business environment which subsequently had an impact on economic performance of major economies. When the “green shoots” of the recovery first emerged during the second half of 2009, business confidence started to recover. However, much of the progress was dented when credit problems surfaced in Dubai in late 2009. Before the problems in Dubai were sorted out, Europe started to have its own debt problems. Overnight, the Credit Default Swap (CDS) - a risk measure of bond’s likely default - on the sovereign bonds of Portugal, Ireland, Greece and Spain (so called “PIGS” countries) increased to unprecedented levels. Much of the first quarter of 2010 was plagued with sovereign debt issues of Europe.

All these events have made businesses and investors wary about the next round of problems. As a result, business confidence has come down. And this has been reflected in the slow growth numbers. Recently, the US revised its second quarter economic growth from 2.4 percent to 1.6 percent. Japan grew at an annualized rate of paltry 0.4 percent. Yields on the US government bonds are incredibly low indicating investors’ flight towards safety.

What then does this slow growth and uncertain environment mean to the rest of the world, especially to emerging economies? If the recent economic performance of India and China is to be believed, then not much. India recently clocked an 8.8 percent growth in April-June quarter - highest growth figure after 2007. Indian policymakers are talking about the need to raise key policy rates to tackle high inflation. China has also been growing at its usual rapid pace. These are signs that, maybe, some of these emerging economies have started to decouple from the developed ones. However, it will be premature to assume that China, India and other emerging economies have fully decoupled from the US and other developed economies. One only needs to go as far as 2008 to see how the whole “decoupling” theory was turned on its head. Hence, as of now, “unusually uncertain” seem the right choice of words.

First published on the Kathmandu Post on Sept 13, 2010.
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/09/12/money/unusually-uncertain/212689/

The suspense is Killing Me

Do we have an incredibly resilient economy or are we on the verge of an economic collapse because of a disconnect between policymakers and the rest of the nation? I really hope that it’s the former and not the latter because it’s not very hard to comprehend what would happen to the level of business confidence and the state of the economy if any other country’s political situation were in as bad a shape as ours. Despite the insurgency, Tarai unrest, labour union problems, energy crisis and other exogenous problems, the business community in Nepal has preserved and continued with their operations.

Some factories have closed down; the manufacturing sector in particular has suffered especially due to chronic labour problems and the energy crisis; but the overall economy has moved on, albeit slowly. But how long can we go on like this? Yes, we are a resilient bunch of people; and we have taken messy politics, numerous bandas, labour union problems and the energy crisis in stride and continued with our day-to-day affairs. However, instead of policymakers recognizing the past and current plight of the business community and working towards facilitating business through new policy measures, they have been perpetuating a policy vacuum created by the political stalemate which is worsening by the day.

During the last two months, we have failed to elect a new prime minister after holding elections for the umpteenth time. And because of the delay in the formation of a new government, our annual budget—where the government announces key fiscal policy measures for the coming fiscal year—is in limbo. The business community eagerly awaits the annual budget as major policy changes are mentioned in it—such as those related to taxation, foreign trade tariff, infrastructure and agriculture, among others. Moreover, the budget also gives an idea about the economic policy rationale of the policymakers, i.e., whether the incumbent government is more market friendly or has a socialistic ideology.

Businesses plan their next projects incorporating these policy changes. However, due to the delay in the formation of a new government and announcement of the budget, which is overdue by more than two months, there is uncertainty in the business community. And this is the catch: Uncertainty kills business activities.

When the business community is confident that a particular government will last for a certain period of time, they can plan and invest accordingly. They can rest assured that the prevailing policies will be maintained and that their investment won’t be put at risk because of sudden changes in economic policy due to a change in government. However, when there is uncertainty whether a certain government will last or not, business persons generally prefer to wait and watch.

This results in lack of investment and other business activities, and stifles economic growth. In Nepal’s context, there is no certainty as to when a new government will be formed and how long it will remain.

Since the restoration of democracy in 1990, Nepal has had 17 different governments, 16 prime minister changes, a decade-long Maoist conflict, direct rule under former king Gyanendra, the April movement of 2006 and numerous strikes and bandas. Political parties have split to merge again, and political leaders have left their respective parties only to return subsequently. Because of the frequent changes in government, there hasn’t been any continuity in economic policy. The lust for power among political parties has made Nepal one of the most politically unstable countries in the world. It’s no wonder then that over 60 percent of the respondents to an enterprise survey of Nepali industry for 2009 conducted by the International Finance Corporation (IFC) have identified political instability as the major obstacle to their business.

Despite this, our economy has moved on largely due to the perseverance of the business community. The business community has persevered hoping that things will change for the better some day. But then at some time, the policy vacuum caused by the political instability will start to take its toll. In fact, I believe it has already started to happen. While our neighbouring countries are witnessing a dramatic economic growth because of business-friendly policy changes, we are languishing in uncertainty. But for how long can we afford to suffer thus? This resilience won’t last indefinitely.

This article was first published on Aug 31st, 2010 on the Kathmandu Post
Permanent Link:
http://www.ekantipur.com/the-kathmandu-post/2010/08/30/money/the-suspense-is-killing-me/212212/

Analyzing Deposit Insurance

At the height of the financial crisis of 2008, the US Federal Deposit Insurance Corporation (FDIC) decided to increase the deposit insurance limit from US$ 100,000 to US$ 250,000 to stem the general public’s eroding faith in the financial system. Many other countries followed suit. Australia and New Zealand, which did not have deposit insurance then, decided to introduce a 100 percent deposit insurance scheme.

As countries have realised the importance of deposit insurance, a number of countries with some form of deposit insurance scheme has increased multifold over the years. According to the International Association of Deposit Insurers (IADI), as of June 2009, 104 countries have instituted some form of explicit deposit insurance, up from 12 in 1974. Moreover, the IADI states that another 17 countries are considering implementing explicit deposit insurance in the near future.

With the recent introduction of the Deposit Guarantee Bylaw by the Deposit Insurance and Credit Guarantee Corporation (DICGC), Nepal will soon join the club of countries with deposit insurance. According to preliminary reports, Nepali banks and financial institutions (BFI) can now voluntarily decide to insure their deposits. However, the insurance scheme only applies to deposits of natural persons and not institutions or corporations. A ceiling of Rs. 200,000 per person has been applied, and BFIs registering for deposit insurance will be charged 0.2 percent or 20 paisa per Rs. 100 of deposit.

This is a welcome initiative as it will boost the general public’s confidence in the banking system. Deposit insurance is one of the most important tools to increase the public’s faith in the banking system. Diamond and Dybvig’s seminal research on bank runs and financial crises identified deposit insurance as the most viable tool to prevent bank runs and reduce contagion risk in the banking system. A run on the bank happens when the general public believes that a bank is about to go under and their deposits are at risk. As depositors rush to the bank to get their money out, the troubled bank isn’t able to fulfil all the withdrawal requests at once as a majority of their deposits are invested in long-term loans. The bank’s inability to pay its depositors creates further panic, and more depositors rush in to withdraw their savings, which ultimately leads to bank failure. Moreover, a bank run is contagious in the sense that it spreads from a troubled bank to the whole financial system like wildfire even when other banks are financially sound.

However, with deposit insurance, depositors know that they will get their money back, to the extent of the insurance coverage, even in the case of a bank failure; and there is no reason for depositors to participate in the bank run. Hence, to a large extent, deposit insurance helps prevent bank runs and contagious banking crisis by building depositor confidence. As the social and economic cost of a bank run and financial crisis are very high, institutions such as the International Monetary Fund (IMF) have been recommending deposit insurance as part of best financial practices for developing countries.

Having said that, deposit insurance, however, does create perverse incentives for both depositors as well as BFIs. Without deposit insurance, depositors are expected to carry out due diligence before putting their savings in any bank. Depositors punish financially weak and risky banks by asking for a risk premium in the form of a higher interest rate. The riskier the bank, the higher will be the risk premium, so banks are compelled to be financially sound and stable. With deposit insurance, however, depositors will no longer have to monitor the performance and activities of their bank as they will be compensated even if it were to fail. As banks face less scrutiny from depositors, they are free to indulge in risk-taking activities—a so-called moral hazard problem in economics. Banks are more than happy to pay nominal premium for deposit insurance as they no longer have to pay a higher risk premium for taking great risks.

Moreover, voluntary deposit insurance, like the one proposed in Nepal, creates another serious problem of adverse selection. The problem of adverse selection can be illustrated by the link between smoking status and mortality (adapted from Wikipedia). Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurance companies do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers. The average mortality of the combined policyholder group will be higher than the average mortality of the general population. From the insurer’s viewpoint, the higher mortality of the group which “selects” to buy insurance is “adverse”. The insurer raises the price of insurance accordingly. As a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than if they could buy it at a lower price to reflect their lower risk. The reduction in insurance purchase by non-smokers is also “adverse” from the insurer’s viewpoint, and perhaps also from a public policy viewpoint.

The same scenario can arise in the context of Nepal with voluntary deposit insurance where riskier banks may buy more deposit insurance while less risky banks may buy less or opt out of deposit insurance. Even with insurance premiums adjusted for risk-based capital fund of banks, historical evidences have shown adverse selection to be a problem for voluntary deposit insurance schemes. In a classic paper published in 1995, Kumbhakar and Wheelock found that adverse selection was one of the major problems with voluntary deposit insurance. Their study found that risky banks are more likely to join voluntary deposit insurance despite the presence of insurance premiums that were inversely related to the bank’s capital to deposit ratio.

The problem of adverse selection is due to asymmetric information where the management of a bank has a better picture of the true risk level of its balance sheet than the regulators; and depending on the riskiness of the bank’s assets, it can decide whether to enrol in deposit insurance or not. In such a context, penalising banks with higher insurance premiums on the basis of their capital adequacy ratios, as is being prescribed in Nepal, may not work.

Because Nepal is entering such a scheme, these are invaluable lessons. From a public policy standpoint, riskier banks dominating the deposit insurance scheme will be a disaster as taxpayers will have to later foot the bill if these banks were to fail down the line.

This article was first posted in the Kathmandu Post on July 21st 2010.
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/07/20/oped/analysing-deposit-insurance/210683/