The Good, the Bad and the Ugly



Nepal’s financial sector has seen exponential growth over the last two decades. Between 1990 and 2009, the number of commercial banks increased from five to 26, the number of development banks from two to 63 and the number of finance companies from zero to 77. Even during the insurgency period, from 1996-2006, the financial sector continued to do remarkably well and managed to prosper (See Figure 1 for details). The rapid expansion of the financial sector, wider access to financial products and better quality service delivery have contributed significantly to GDP growth and an improved standard of living in Nepal.

Rapid growth, however, also makes it difficult and complicated for potential depositors, investors and clients to distinguish between financial institutions on a range of characteristics. Nepal now has thousands of institutions spread between A, B, C and D categories with no one tracking their risk profiles for the benefit of the public. Nepal Rashtriya Rastra Bank (NRB) as the central bank doesn’t have the mandate to rank financial institutions to inform the public of their relative reliability. Hence, for an average depositor or a layman investor, there is little credible information available that objectively distinguishes between good and bad financial institutions. Given this context, there is an urgent need for a globally recognised credit rating agency in Nepal.

As the central bank of the country, NRB plays the role of a regulator; its role being to monitor and supervise financial institutions and take corrective action if it finds anything wrong. NRB doesn’t comment publicly on its issues with financial institutions during its supervisory and monitoring activities, unless something is drastically amiss. Therefore, there is a serious lack of an independent entity that ascertains the risk profile of a financial institution in Nepal.

A credit rating agency (CRA) evaluates the creditworthiness of an individual, a corporation, a corporate debt instrument or even a country. Based on rating models, an agency looks into asset quality, interest sensitivities, diversification of asset/liability portfolios, capital base, board structure, management and numerous other variables for evaluation. It then assigns a credit score to a particular financial institution. The ratings/score enables an investor to gauge the risk involved in investing with that particular entity. CRA rates not only a particular corporation but also various debt instruments of corporations, with the same bond issuer even having different credit ratings for different series of bonds.

Globally, credit ratings are used by investors, investment bankers, institutional investors and pension/welfare funds, brokers and government as a risk metric when allocating funds. The three most prominent rating agencies are Moody’s Investor Service, Standard and Poor’s and Fitch.

As mentioned above, ratings from a CRA enables investors to ascertain the creditworthiness of a particular institution. Internationally, investors rely on ratings when allocating funds among different asset classes. For example, a fixed income investor relies on bond ratings, a pension fund that is interested in investing in a debt issue of a particular country relies on sovereign ratings and an investment bank to crosscheck their portfolio’s risk. Ratings are useful not only for investors but also for corporations because a higher rating helps them raise funds at lower cost. The rating thus helps determine the interest rate of corporate borrowers — a key function in the capital market. For example, Moody’s rates a corporation or issuer by giving ratings described in Figure 2. “Aaa” rating is of the highest quality with the lowest risk while the rating “C” is of the lowest quality with the highest risk. They have grouped ratings into “Investment Grade” and “Speculative” as a broad barometer to distinguish different types of corporations or debt issues.

In Nepal’s context, a CRA is critical for further financial sector development. The growth of the financial sector has underscored the need for a CRA that distinguishes a good financial institution, through their ratings, from a bad one. The recent debacle of Nepal Development Bank and corporate governance issues in some commercial banks have underscored the need for an independent CRA that rates financial institutions and gives an opinion apart from the existing auditor’s government regulators and financial analysts.

Moreover, a CRA helps create a win-win situation for regulators, investors and rated institutions. For an investor, a credit rating will serve as an important risk metric during investment decisions. Investors, from depositors who deposit their money in financial institutions to those who buy stocks on the secondary market, can rely on ratings when depositing their money or buying stocks. For a good financial institution, it’s in their interest to have a strong credit rating distinguishing itself from others.

Credit ratings will put in place a culture of self-discipline and rigorous risk management systems among domestic financial institutions. It will encourage more prudent behaviour, stabilise the financial sector and help in the prevention of asset bubbles. In short, credit ratings play a key role in self-regulation.

Likewise, internationally accepted credit ratings will enable domestic banks to improve trade finance operations as good ratings enhance their trustworthiness to international correspondent banks and also pave the way for increased limits on lines of credit at lower cost. It will open the door for banks to raise capital from international capital markets and even to sell debt instruments. Furthermore, under the Basel 2 agreement, banks can use certain approved CRAs (called External Credit Assessment Institutions) when calculating their minimum capital requirements (as per the Pillar 1 of Basel 2).

From a regulator’s perspective, the recent growth in the financial sector has increased (and is likely to continue increasing with further expansion) the supervisory burden of NRB. Though it is imperative for NRB to further enhance its supervisory capacity, establishment of a globally recognised CRA in Nepal will be invaluable for NRB to distinguish between good and risky financial institutions. The internal assessment and a culture of self-discipline that credit ratings bring will also be welcome from a regulator’s point of view.

Apart from financial institutions, there are various other sectors where credit ratings will be necessary as the domestic economy expands and funding needs of companies increase. Under existing regulations, local corporations cannot raise capital from international capital markets. However, in the future, in order to mobilise large-scale funds necessary for infrastructure development, it may be necessary to liberalise the capital restrictions in Nepal. As the economy modernises and the need to develop new hydro projects, roads and other industrial projects increases, domestic corporations may have to look towards international capital markets to raise adequate funds.

Potential foreign investors in such large-scale projects will inevitably seek credit ratings (specifically known as project finance rating) from recognised CRAs when considering investing in such projects. Therefore, a culture of embracing credit ratings is imperative for Nepal to even have the option of entering the international market to raise capital. With the lack of appetite for Foreign Direct Investment in Nepal, it could prove to be the only way for Nepal to raise enough capital to develop and prosper in a major way.

This article was first published in The Kathmandu Post on Nov 17 2009

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