Financial Services Sector Assessment in

Nepal

FINAL REPORT

Prepared by [ Lene Hansen]

Table of Contents
1. 2. 3. 4. EXECUTIVE SUMMARY ...........................................................................................................................3 BACKGROUND AND INTRODUCTION ...................................................................................................3 APPROACH AND METHODOLOGY........................................................................................................3 THE SETTING FOR FINANCIAL SERVICES IN TIMOR-LESTE.............................................................4 4.1 COUNTRY PROFILE ..............................................................................................................................4 4.2 NATIONAL POLICIES FOR POVERTY ALLEVIATION & ECONOMIC DEVELOPMENT .......................................5 4.2.1 The MDGs....................................................................................................................................5 4.2.2 Legislation and Regulations for Private Sector Development ......................................................7 4.3 THE ROLE AND CONTRIBUTION OF MICROFINANCE ................................................................................8 4.4 THE SUPPORT INFRASTRUCTURE FOR THE FINANCE SECTOR.................................................................9 4.5 THE FUNDERS OF PRIVATE SECTOR DEVELOPMENT AND FINANCE ...................................................... 10 5. 6. THE DEMAND FOR FINANCIAL SERVICES........................................................................................ 11 5.1 SIZE AND COMPOSITION OF THE MARKET ........................................................................................... 11 THE SUPPLY OF FINANCIAL SERVICES............................................................................................ 13 6.1. THE STRUCTURE OF THE SUPPLY MARKET ........................................................................................ 13 6.2 THE KEY SUPPLIERS OUTREACH AND PERFORMANCE ..................................................................... 13 6.3 RANGE OF PRODUCTS AND SERVICES ............................................................................................... 15 6.3.1 Loan Products............................................................................................................................ 15 6.3.2 Savings Products ....................................................................................................................... 16 6.3.3 Other Financial Services............................................................................................................ 16 6.4 KEY CONSTRAINTS ........................................................................................................................... 16 7. OPPORTUNITIES FOR THE FUTURE .................................................................................................. 17 7.1.1 7.1.2 7.1.3 Institutional Support ................................................................................................................... 18 Bank Guarantees ....................................................................................................................... 20 Enhanced Coordination through AMFITIL ................................................................................. 20

Annexes
1. 2. 3. 4. 5. 6. 7. Scope of Work for the Assignment Final Work plan and schedule List of Persons Met List of Non-financial Donor Projects to explore for closer service-provision linkages Mapping of Outreach and Performance of Financial Service Providers Inventory of Financial Products and Services Background and Presentations for the MDG and MF Workshop, 7-9 December 2004

Financial Services Sector Assessment in Nepal

List of Acronyms and Abbreviations

ADB BDS BOP CGAP CTA FSP FSS GDP GtZ HMG INGO MBB MIX MDG(s) MFI MIS MoF MSME NDP NGO PaR RFA SHG SME TA UNCDF UNDP UNOPS USAID WB Asian Development Bank Business Development Services Bottom of the Pyramid, the poor and low-income population Consultative Group for Assistance to the Poorest Chief Technical Adviser Financial Services Providers Financial Self-sufficiency ratio Gross Domestic Product Gesellschaft fr Technische Zusammenarbeit (Germany) His Majestys Government of Nepal International Non Governmental Organization Micro Banking Bulletin Market Information Exchange Millennium Development Goal(s) Microfinance Institution Management Information System Ministry of Finance Micro, Small, and Medium-scale Enterprises National Development Plan (10th Plan 2002 2007) Non-Government Organization Portfolio at Risk Request for Applications Self Help Group Small and Medium-scale Enterprise Technical Assistance/Assistant United Nations Capital Development Fund United Nations Development Programme United Nations Office for Project Services United States Agency for International Development World Bank

Financial Services Sector Assessment in Nepal

1.

Executive Summary

The poor and low-income earners (Bottom of Pyramid (BOP)) in Nepal make up around 90% of the economically active population. While a significant number of potentially bankable clients among BOP have been mobilized by community development projects, they remain largely excluded from access to sustainable financial services, and thus form the core target group for the development of an inclusive financial sector. Assuming a 5% decrease in the BOP % over the next five years, a total of 2,200,000 households representing 13 million people should have access to financial services by the end of 2011, for the goal of a fully inclusive financial sector to have been reached. The financial sector in Nepal is quite diversified, with a large number of varied institutions offering a relatively wide array of financial services, but the outreach by the financial service providers (FSPs) to BOP remains limited. Some 37% of BOP access credit, while the number of voluntary micro-savings accounts is estimated at 800,000 or 40% of BOP households (Jan06). The present policy environment is fragmented, but presents no immediate constraints for financial service providers to develop and expand. Financial services to BOP have been driven by quantitative coverage targets supported by generous provision of subsidized loan capital facilities. Comparatively less attention has been paid to the quality of the financial services provided, the sustainability of the institutions providing the service, and in particular for the very poor in remote areas - the ability of borrowers to utilize credit for gainful enterprise, earn a profit and repay loans rather than increasing their debt. The business support infrastructure (training, audits, insurance, IT etc.) for financial services in Nepal has not developed strong commercially viable linkages with its customer base of Financial Service Providers (FSPs), largely due to distorting subsidization. There is much scope for increased coordination of investments, as good practices for funding of sector development takes root. At present, many FSPs serving BOP thus display significant institutional weaknesses, static methodologies, weak financial and portfolio management systems and limited product development. With coherent and focused institutional capacity building support, the financial sector should be able to increase its outreach to BOP by 10-15% per year, reaching a total of 1.3 million BOP borrowers (60% of projected BOP households) and mobilizing BOP savings in 1.85 million voluntary deposit accounts (80% of projected BOP households) at the end of the project. The level of capacity building required in order to attain these targets is considerable, both at the retail FSP level and at the meso- (industry-)level to enhance coordination, enable capture of the potential market of already mobilized bankable clients, and ensure transparency and accurate performance monitoring. Linking the demand for business services and the existing supply contribute to a more sustainable sector development and lower the cost of FSP operations.

2. 3.

Background and Introduction Approach and Methodology

Financial Services Sector Assessment in Nepal

4.
4.1

The Setting for Financial Services in Nepal

Country Profile

1. Nepal ranks 136 of 177 in the UN Human Development Index (2005)1, and the GNI per capita of US$ 260 in 2004 is the lowest in South Asia2. Despite its difficult geography, a feudal history, and a late start in development, the policy and economic reforms introduced in the mid 1980s resulted in significant if unequal economic progress, poverty reduction and improving human development indicators. 31% of the population of 25.2 million, growing at a rate of 2.3% per year, lives at or below the national poverty line, and some 90% of the poor are surviving on subsistence agriculture in the rural areas3. 2. The eight-year long Maoist insurgency and social conflict has escalated sharply since 2001. A constitutional crisis following the suspension of parliament in 2002 has created further instability. This, compounded by a more competitive external environment, has led economic growth to falter in the last three years. In 2004/05, the GDP grew by only 2%, down from 5.3% in 2001, primarily from agriculture and foreign remittances4. Inflation has remained relatively stable at 3% in 2004, as the national currency is pegged to the Indian rupee, but initial figures from 2005 indicate a sharp rise to around 8%. Foreign aid contributes 25% of the annual national budget, and as a result of the insurgency, security expenditure has increased from 9.8% in 1998 to 15% of the annual national budget in 20055. 3. The economy of Nepal is agrarian, with agriculture contributing some 40% to the GDP. Sectors which enjoyed substantial export led growth (e.g. manufactures such as garments and carpets) in the 1990s are now facing low demand. Tourism accounts for 4% of GDP, but is declining due to the political and social unrest, as is most of the service sector. The World Bank estimates that 38% of GDP output is contributed by the informal economy, which employs more than 90% of the 9.9 million strong domestic work force. Unemployment of up to 50% has been recorded, but foreign labor markets serve to absorb (primarily male) excess labor, assisted by government-subsidized loans for economic migration. Remittances from this foreign work force are contributing some 12% of GDP, which to some extent fuel the rural economy, while leading to a feminization of agriculture6. 4. The 10th National Development Plan/ Poverty Reduction Strategy Paper (2002-2007) seeks to address the historic inequalities in access to development benefits by focusing on the four pillars of broad-based high and sustainable growth, social sector development, targeted programmes with an emphasis on social inclusion, and improved governance. The Medium Term Expenditure Framework (MTEF) introduced in 2002 has been widened to improve the efficiency of public spending, and private sector competitiveness, agricultural modernization and growth of nonagricultural sectors has been emphasized. 5. Market value chains in Nepal are relatively flat, with limited activity and cash circulation, especially in the Hills and Mountains. Investment in infrastructure in the poor and excluded Western regions has lagged considerably behind, resulting in lower economic opportunities. Poverty limits payment capacity for products and services, depresses demand and impedes the opportunities available for rural income generation, and market linkages are limited. The primary challenge for Nepal is therefore to broaden and diversify the economy, and increase competitiveness, while sustaining the income from remittances from foreign labor and high-end
UNDP: Human Development Report 2003 World Bank: Nepals Economy at a Glance 3 CBS/WB as reported in UNDP: MDG Progress Report 2005. 4 World Bank: Nepal Financial Sector Study, October 2002 and World Bank: Development Policy Review, March 2005. 5 Ministry of Finance as reported in UNDP: MDG Progress Report 2005. 6 World Bank: Development Policy Review, March 2005; UNDP: MDG Progress Report 2005; Friedrich Echardt Stiftung: Nepal Annual Report 2005.
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Financial Services Sector Assessment in Nepal

services for a currently declining tourist industry, and expanding investments in small and mediumend production and services. 6. Starting late from a very low base of development, the poverty reduction efforts in the past two decades, while producing results, have not attained a sufficient level of growth to adequately address the legacy of geographic, social and ethnic exclusion. Literacy rates and access to basic social services remain low; lack of connectivity and infrastructure contributes to the regional disparities, and is compounded by the legacy of stratification based on gender, ethnicity and caste and the centralization of power. The political instability with frequently shifting governments in the 1990s has deteriorated with the suspension of democratic governance since 2002, and the intensifying insurgency. The conflict now threatens the gains made from the past decade of development.

4.2

National Policies for Poverty Alleviation & Economic Development

4.2.1 The MDGs

In September 2000 the member states of the United Nations issued the Millennium Declaration committing themselves to eight goals and a series of sub-targets for broader and more inclusive human development, known as the Millennium Development Goals (MDGs) most of which are to be achieved by 2015. Each country is responsible for setting appropriate targets to attain the goals and for reporting on the progress towards achieving the goals.
Text Box 1: The MDGs

The Millennium Development Goals:

Goal 1 Goal 2 Goal 3 Goal 4 Goal 5 Goal 6 Goal 7 Goal 8 Eradicate extreme poverty and hunger Achieve universal primary education Promote gender equality and empower women Reduce child mortality Improve maternal health Combat HIV/AIDS, malaria and other diseases Ensure environmental sustainability Develop a global partnership for development

Below is an overview of the ADB Assessment of Nepals Progress towards the MDGs:

Financial Services Sector Assessment in Nepal

Financial Services Sector Assessment in Nepal

4.2.2 Legislation and Regulations for Private Sector Development and Inclusive Finance
36. The Banks and Financial Institutions Ordinance, BFIO, (2004) currently regulates all commercial and development banks and finance companies in a tiered structure, with all microfinance development banks categorized in the lowest tier D based on minimum paid-up capital. Financial cooperatives must register under the Cooperative Act, which provides for limited banking services, if they also register with NRB under the Financial Intermediary Act, FIA (1999). With the high number of Cooperatives currently registered, the NRB has all but stopped the issuance of new limited banking licenses to Cooperatives. FINGOs must register under the Society Registration Act (1978) as well as with NRB under the FIA as amended in 2002 to allow for deposit taking from members. 19. The PRSP/10th Plan focuses on accelerating income and employment opportunities in rural areas and promoting inclusive development for backward and poor communities. Micro-credit is
Financial Services Sector Assessment in Nepal 7

used as a tool in supply-driven interventions to reduce poverty among targeted population segments, and is largely being provided as subsidized credit from HMG to the Poverty Alleviation Fund (PAF), the Rural Self-Reliance Fund (RSRF), and the Rural Microfinance Development Center (RMDC) also supported by ADB. 20. HMG plays a large direct role in the financial sector. It owns key financial institutions such as RBB, ADB/N, the Grameen banks, the largest insurance company, the stock exchange, the largest investment company and has shares in most other key institutions. This strong political influence in banking activities has contributed to the poor financial health of the system and many of the FSPs. HMG published a Financial Sector Strategy Statement (FSSS) in 2000, which included government divestiture, stronger corporate governance, and improved standards and discipline. HMG has demonstrated commitment to the FSSS and is moving ahead with the difficult agenda. Under a WB-supported reform project, the two largest banks are being privatized, and new shareholdings have been limited to 10%. 21. Until 2002, the central Nepal Rastra Bank was subordinated to the Ministry of Finance, and this historical lack of autonomy has hindered the NRBs ability to effectively supervise and regulate the banking system. The 2002 NRB Act provided basic autonomy, which was confirmed by the 2002 Banking and Financial Institutions Ordinance. The World Bank is supporting an ongoing reengineering process within the NRB to help move the financial system closer to international banking norms. NRB licenses, regulates and supervises the commercial, development and microcredit development banks, cooperatives and FINGOs, until recently under a proliferation of laws and regulations focused on institutions rather than functions. The financial system is currently being stream-lined with World Bank and ADB support. A Banking and Financial Institutions Ordinance (2004) now regulates the key suppliers in the sector. 37. A Microfinance Policy has been drafted by the NRB and consulted with stakeholders in 2005. It outlines the idea of a Second-Tier Institution to license, supervise and regulate MFIs and financial cooperatives, bringing all non-commercial bank financial service providers (Category D in the Banks and Financial Institutions Ordinance) under the same legislation, and possibly creating a sub-set of the classification. It also provides for the consolidation of several HMG-managed capital (and grant) funds into one Fund of capital for on-lending to Category D FSPs. Following the Policy, the NRB drafted the Microfinance and Cooperatives Ordinance, which is awaiting NRB Board approval for submission to the Cabinet.. In this Ordinance the two functions to be divested from the NRB appear to be combined into one semi-autonomous institution, the Microfinance and Cooperatives Center. If this will be the structure of the new institution, it risks inheriting the legacy of politization and conflict of interest.

22. A Microfinance and Cooperative Ordinance has been drafted by the NRB in consultation with industry stakeholders[gj1], and has been awaiting Cabinet approval since August 2005[gj2]. The draft Ordinance proposes the establishment of a Microfinance and Cooperatives Center which appears to have two distinct (and usually separated) functions: The licensing, regulation and supervision of microfinance providers (micro-credit, development banks, FINGOs, and financial cooperatives) as a Second-Tier Institution; The whole-saling of funds for microfinance services to the same retail providers. The funds currently held with the RSRF are to be folded into this new institution, which will have a governing board with a majority of government representatives.

4.3

The Role and Contribution of Microfinance

Microfinance services include micro credit, savings, money transfer, and insurance products. Over the past 20 years, microfinance has developed into a specialized method of providing these financial services at sustainable rates to the economically active poor households, who cannot access the

Financial Services Sector Assessment in Nepal

commercial banks of the formal sector, be it for socio-cultural, systemic, geographical, or other reasons. Target clients of the microfinance industry use and benefit from small savings and loans to grow rather than establish their micro-businesses. The key motivator for microfinance clients is access to (rather than price of) reliable and continuous financial services. The chief motivation for repaying a loan is the promise of future access to another loan and this is often re-enforced with social collateral such as group guarantees. This explains why microfinance can operate successfully in the informal sector without physical collateral, enforceable contracts, and commercial courts or enabling legislature. The laws of microfinance are embedded in good operating practices and reenforced by social contracts. Microfinance is not simply banking for the poor; it is a development approach with a social mission and a private sector-based financial bottom line that uses tested and continually adjusted sets of principles, practices and technologies. The key to successful microfinance lies in the ability of the provider to cost-effectively reach a critical mass of clients with systems of delivery, market responsiveness, risk management and control that can generate a profit to the institution. Typically, this profit is ploughed back to ensure the long-term survival of the institution, i.e. the continuous provision of services demanded by its clients. The two long-term goals of microfinance are thus substantial outreach and sustainability. Financial services, especially credit, are being delivered around the world without sufficient knowledge of or attention to these good practices but the short-term losses, and the longer-term unsustainable impact of such schemes ultimately harm the very clients that they were meant to benefit. The experience from past failures proves that direct provision of services by subsidized and non-profit bodies tends to result in limited outreach and unsustainable impact. This fact is, however, sometimes overlooked in the quest to combat poverty by availing cash to the poor through any available channel. Because money is a commodity well-known and managed by almost everyone, the technical skill and specialization necessary to provide this business service successfully is often not adequately recognized. Microfinance can be an effective and powerful instrument for poverty reduction, helping poor people to increase incomes, build assets, and reduce their vulnerability in times of economic stress. But it must be provided by institutions who strive to become effective business entities by developing a strategic vision for viability and the necessary professional skill and capacity. Often, promising microfinance institutions need support to address constraints during their first 2-5 years in order to secure their ability to provide market-responsive services in a viable manner.

4.4

The Support Infrastructure for the Finance Sector

The support infrastructure for the finance sector includes financiers (whole-sale lenders) and technical service providers (consultants, audit companies, IT companies, trainers etc.) as distinct from the providers of training and business development services to the micro-, small and medium scale enterprises themselves (the latter fall outside of the scope of this Assessment). 26. While technical assistance to the financial sector is available in Nepal, international financial services resources will be called upon to assist individual FSPs as well as the general process of industry building. For commercial banks interested in down-scaling, technical assistance will be sought e.g. from CGAPs Commercial Banking Retail Advisory Service (RAS), and for MFIs, the newly established MicroSave Asia as well as the EDA/MCRIL rating service from India may offer relevant services. Due to the proliferation of Self-Help Groups promoted in Nepal, technical assistance from experienced banks and NGOs in India could be useful in the process of linking SHGs to external credit as per demand. Policy makers and legislators e.g. from the Microfinance

Financial Services Sector Assessment in Nepal

and Cooperatives Center to be established, as well as donor staff and FSP managers could benefit from the CGAP trainings in Turin, Italy in July-August each year.7

4.5

The Funders of Private Sector Development and Finance

23. Numerous donor agencies and international organizations have been assisting Nepal in all sectors of the economy for decades, but the escalating conflict in the country has resulted in some donor agencies pulling out or reducing their aid 2002. The key donor agencies for financial sector development are World Bank and ADB; IFAD supporting large rural development projects which include provision of credit; and GtZ through their Rural Finance in Nepal (RUFIN) project, providing technical assistance to the Small Farmers Cooperatives and Bank. Seven of the UNDPsupported local development, sector development and micro-enterprise development projects include revolving credit funds, one of which (DLGSP) is co-financed by NORAD. CIDA funds a technical service providing NGO supporting cooperatives in the Hills and Mountains, and several other donor agencies are funding INGO to implement poverty reduction programmes with a financial component. Strategic Alliances 24. The UNDP-supported programme portfolio with revolving credit funds include the Decentralised Local Governance Support Programme (DLGSP co-financed by Norway), Micro enterprise Development Programme (MEDEP), Rural Urban Partnership Programme (RUPP), Rural Energy Development Programme (REDP), Mainstreaming Gender Equity Programme (MGEP), and the Participatory Conservation Programme (PCP). In these programmes some 30% of the resources (approximately US$ 6.7 million) have been allocated as grants to formalized local Funds, which have been revolved as loans to local communities (SCGs). Based on the recommendations of several reviews8, a re-alignment strategy is currently being formulated to convert the credit capital to grants managed by the Local Funds, as neither substantial outreach, good performance nor sustainability is achievable within the current structure. Under the projects, however, a vast number of rural poor have been mobilized in savings and credit groups (around 141,200 borrowers and 600,000 savers as at Jan 06), provided with business enterprise services (MEDEP) and market linkages (RUPP), and thus a number of these potential clients are ready to be linked to more specialized and sustainable FSPs. The re-alignment strategy includes linkages to FSPs, and enhanced coordination and collaboration would enable the UNDP-projects to focus on their core functions of service delivery, while facilitating the access by bank-ready clients to interested FSPs. 25. There are currently ongoing and planned financial sector development projects supported by the World Bank and the Asian Development Bank to coordinate efforts of building an inclusive financial sector as part of the overall policy-level efforts to stream-line and modernize the banking and financial sector in Nepal. Under the World Bank-supported Access to Finance study, Nepal will be included in the global World Bank Household Data Survey, which will improve the quality of data on household uses of financial services, and could act as a baseline for all microfinance support projects. A household survey on access to financial services will be undertaken in 2006.

7 8

See www.cgap.org/direct Clark et al.: Microfinance Portfolio Review Report, DLGSP, RUPP and MEDEP, February 2004; Mersland et al.: DLGSP Micro Credit Review Mission report, August 2005; Centre for Microfinance: Report on Micro-Credit Strategy for MEDEP, October 2005.

Financial Services Sector Assessment in Nepal

10

5.
5.1

The Demand for Financial Services

Size and Composition of the Market

13. The total population in the economically active age range in 2005 comprises 12.6 million people, used here as a proxy for the potential market for financial services in Nepal. This market includes 90% or 11,335,500 self-employed people, used here as a proxy for the poor and lower income segment (base of pyramid (BOP)) in 2 million households9 (see Figure 1). The BOP in percent of total population will decrease with employment generation efforts, even if partially offset by population growth, but the current turbulent political situation does not encourage optimistic trends. Assuming a 5% decrease in the BOP over the next five years, a total of 2,200,000 households representing 13 million people should have access to financial services by the end of 2011, for the goal of a fully inclusive financial sector to have been achieved. 14. As at January 2005, a total of US$ 3.440 million was mobilized in savings, 89% deposited with the commercial banks. Safe and sound savings services are crucial to BOP customers as means of paying for major life events (weddings, funerals), taking advantage of a business opportunity, and as a cushion against sudden shocks, such as illness or a bad harvest. Over time, savings can grow to build assets for investments. When the poor are excluded from voluntary deposit services in the financial sector, they save informally in livestock, at home, or in savings groups. Often, these informal savings are high risk. The majority of the current bank depositors in Nepal are not in the BOP category. However, the low minimum-balance on savings accounts in some of the more adventurous private banks10, and the budding interest in down-scaling to the urban micro-market11 expands the number of providers that could serve BOP. While the regulated micro-credit development banks, financial cooperatives and NGOs combined report a total of 530,775 savings accounts (Jan. 2005), only some 85% represent voluntary savings. The total current supply of voluntary deposit accounts to BOP is thus estimated at 800,000 accounts, representing access by 40% of the current poor and low-income households (Jan 2006). 15. The credit market is segmented, and commercial banks in general are reluctant to lend to BOP in rural areas. The estimated total outreach of credit services by financial services providers to the poor and low-income population comprise some 750,000 borrowers. To guard against poor families over-indebting themselves, credit services to BOP are often limited to one loan per household, and it is encouraging that MFIs are currently reaching 37% of BOP households (Jan 05). Demand for credit (which should not be confused with the general demand for money among the poor) will increase with economic opportunities. 16. Micro-credit is most appropriate where local economic activity is ongoing to generate sufficient household cash flow and borrowers use loans to grow rather than establish a business. Market and business development in Nepal continues to be a necessary ingredient in the fight against poverty credit cannot alone lift the BOP out of poverty. The chief motivation for repaying a loan is the promise of future access to more and larger loans and this is often re-enforced with social collateral such as group guarantees. This explains why microfinance can operate successfully in the informal sector without physical collateral, enforceable contracts, and commercial courts. The laws of microfinance are embedded in good operating practices and reenforced by social contracts. The key to successful financial service provision to BOP lies in the ability to cost-effectively reach a critical mass of clients with systems of delivery, market responsiveness, risk management and controls that can generate a profit to the institution. Typically, this profit is ploughed back to ensure the long-term survival of the institution, i.e. the continuous provision of services demanded by its clients. The two long-term goals of microfinance are thus substantial outreach and sustainability. When knowledge of or attention to these good practices

Population data and average size of households from projections for 2005 in the 2001 Census. For example The Bageshwari Development Bank Ltd. in Nepalgunj opening accounts at Rs 100 (US$1.5) 11 As seen for example in Bank of Kathmandu Ltd. having recently started collateral-free loans of US$ 4,200 to women drivers.
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Financial Services Sector Assessment in Nepal

11

are insufficient, the short-term losses and the longer-term unsustainable impact of such operations ultimately harm the very clients that they were meant to benefit. 17. In order for an inclusive financial sector to contribute to the overall goal of poverty reduction, it is important to invest in the FSPs serving the BOP to ensure that their technical skills and systems of delivery are sound, safe and strong enough to meet the demand for credit and other financial services, as it increases over time. This means maintaining a high portfolio quality (PaR of less than 5%), and attaining financial self-sufficiency (being able to cover all real and indirect costs of operations by income earned from the operations). To do so, financial services providers need to expand their customer base to a sustainable scale, while strengthening their systems. It is estimated that a feasible growth rate is 10-15% per year. 18. In Nepal, however, microfinance is largely interpreted as the provision of subsidized credit facilities for the poor and quantitative coverage targets are being promoted in response to a perceived huge demand for credit among the rural poor. This intense supply-drive, which is led by HMG but widely supported, extends to several donors, including UNDP, INGOs and NGO programmes which have embedded revolving credit funds in otherwise well-focused community development and social mobilization interventions. Comparatively less attention is being paid to the quality of the financial services provided, the sustainability of the institutions providing the service, and in particular for the very poor in remote areas - the ability of the borrowers to utilize the credit for gainful enterprise, earn a profit and repay the loan rather than increasing their debt. Potential Savings Market

Total population: 25,200,000 Maximum Market: Projected BOP goal for fully inclusive financial sector: 13,000,000 people

Minimum market: 40% of current BOP who have savings accounts: 4,500,000 31% of pop. poor: 7,812,000 people

90% of Econ Active Population of 12.6 million people is Self Employed

Potential Credit Market

Total population: 25,200,000 Economically Active Populatin: 12,600,600 (Includes 60% of projected BOP market)

Minimum market: 50% of economically active population: 6,300,000? 31% Financial Services Sector Assessment in Nepal of pop. poor: 7,812,000 people 90% of Econ Active Population of 12.6 million is Self Employed
12

6.

The Supply of Financial Services

6.1. The Structure of the Supply Market

Specialization

Commercial banks

Specialized microfinance institutions (MFIs)

Savings and Credit Cooperatives/Unions)

Multi-purpose NGOs and projects

Private financial companies, including buyers, traders.

Main providers:
- 17 Comml Banks; Full range of services

High income segment (5%)

Mid level (45%)

- 59 Finance Companies (hire purchase, leasing, housing) - 20 other Development Banks (credit, savings)

- 9 Rural/MC Devt Banks (savings, credit, insurance) - 47 FINGOs (credit and member savings)

The Poor and LowIncome segment (45%; 80 % rural)

- 21 Savings/Credit Coops Poverty line: 31% - Money lenders (credit) - 000s SCOs, NGOs, SHGs, Coops (informal credit and savings)

6.2

The Key Suppliers Outreach and Performance

Formal Financial Service Providers

7. In 1984, when Nepal began reforming its financial sector, two state-owned commercial banks dominated all activity. Since then, the financial system has grown to include 17 commercial (private joint-venture and state-owned) banks with 382 branches; 22 development banks; 5 regional rural development banks and 4 private microfinance development banks; 59 finance companies and a postal savings bank. In addition, 20 savings and credit cooperatives and 47 financial intermediary NGOs are licensed by the central bank (Nepal Rastra Bank, NRB) to provide limited banking services12. Numerous non-regulated NGOs and cooperatives also provide savings and credit

12

World Bank: Nepal Financial Sector Study, October 2002 and Nepal Rastra Bank: Banking and Financial Statistics No. 44, Mid January 2005.
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Financial Services Sector Assessment in Nepal

services to members. As such, the financial sector is quite diversified, with a large number of varied institutions. 8. Bank deposits have increased by 14.7% since July 2003 to US$ 3,440 million (48.6% of GDP) in January 2005 of which 52% represent savings, and 60% are individual accounts. The high liquidity rates of the banks have decreased, and lending to the private sector (mostly production) has increased by 12.6% per year to US$ 2.139.8 million outstanding (Jan 05). NRB enforces policies of targeted lending on the commercial banks, including 9% of total lending to priority sectors such as agriculture, domestic industries, power and services, and 0.25-3% to the deprived sector of rural and micro-enterprises. Priority sector lending requirement is being phased out by 2007, while required deprived sector lending will continue. Most commercial banks are based in Kathmandu, but 7 have branches in the 12-16 larger towns, and the two largest state-owned commercial banks Nepal Bank Ltd. (NPL) and Rastriya Banijya Bank (RBB) have branches in most districts. Together, NBL and RBB represent some 50% of the total banking sector assets, and also its largest liability; their accumulated deficits in 2003 amounted to around 7% of GDP13. 9. The Finance Companies serve primarily the urban markets with hire-purchase and leasing products and housing loans financed primarily by deposits. Collectively, they mobilized US$ 303.2 million in deposits, and had an outstanding portfolio of US$ 285 million in January 2005. Of the Development Banks, the state-owned Agricultural Development Bank is the market leader, providing 78% of the total loan portfolio of US$ 412 million, and mobilizing 83% of deposits totaling US$ 441 million. With a nation-wide branch network it has been the backbone of rural finance, but is now restructuring as a company, seeking refinance for its substantial non-performing portfolio, and is gradually off-loading its whole-sale lending to small farmers cooperatives to a newly registered Small Farmers Development Bank (registered by NRB as a micro-finance development bank). 10. The five regional rural development banks are all state-owned Grameen-replicators, serving the micro-market. Their total outstanding loans as at January 2005 is US$ 20 million in approximately 185,500 loans, while US$ 7 million is mobilized in some 232,000 accounts. Only two of the five banks are profitable. The six institutions registered as Micro Credit Development Banks by the NRB, include the Small Farmers Development Bank whole-saling US$ 11.3 million to some 126 cooperatives and the government and ADB-funded Rural Microfinance Development Centre (RMDC), which currently whole-sales to 41 MFIs. The other four include the retail banks of Nirdhan, DEPROSC, Chhimek and CSD which all started as NGOs. Only Nirdhan has transferred its total banking portfolio to its bank, while the other three continue to provide microfinance services by their parent-NGO as well as through the bank. The total outstanding portfolio of the four microfinance retailers is US$ 10.5 million comprising some 96,400 loans, financed in part by the US$ 3.5 million deposits mobilized in some 168,215 accounts (Jan 05). Microfinance 11. The Center for Microfinance in Nepal has registered 2,345 savings and credit cooperatives in Nepal, but only 20 are licensed and report to the NRB. These 20 mobilized a total of US$ 22.7 million in around 110,560 savings accounts, while lending out US$ 18.8 million reaching around 61,700 borrowers. Thousands of NGOs facilitate or provide financial services to their members in Nepal, but only 47 of these are licensed by NRB as Financial Intermediary NGOs (FINGOs). Their outstanding loan portfolio in January 2005 was US$ 3.2 million with some 35,550 borrowers. Mobilized deposits were not published by NRB in January, even if an amendment to the Financial Intermediary Societies Act (1999) in 2002 allow FINGOs to collect micro-savings. The savings

13

Nepal Rastra Bank: Banking and Financial Statistics No.44, January 2005. The NRB collects and publishes data on source and use of funds, interest structure and profit and loss, but does not require reporting on scale in terms of number of accounts nor average amount per account, so number of borrowers or savers have been compiled only where alternative sources of data are available.
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Financial Services Sector Assessment in Nepal

mobilized by the largest FINGOs in mid 2004 was estimated at US$ 442,860 in around 17,030 accounts14.

12. As numbers of accounts are not generally reported, it is difficult to estimate the total current

outreach in Nepal, but estimates from 200415 indicate a total portfolio of 655,000 micro-borrowers. Adjusting for growth and a small number of micro-borrowers being served by the finance companies and commercial banks, the outreach for loans is estimated at 750,000 loans as at January 2006. The current quantitative supply of savings accounts is harder to come by as the bulk rests with commercial banks who only report total amount of savings mobilized. As microfinance institutions (rural and micro-credit development banks, cooperatives and FINGOs) appear to provide voluntary savings accounts to some 85% of their borrowers, and as some banks have down-scaled deposit thresholds, the outreach of voluntary savings accounts to BOP is estimated at a slightly higher level of 800,000 accounts as at January 200616.

Comparison of Larger MFIs from the mix market

Yearly comparison : 2004
(All currency figures in US$)

Name

Country

Gross Loan Portfolio

Operational SelfSufficiency

Cost per Portfolio at Borrower Risk > 30 days Ratio

(31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04)

Number of Active Borrowers

1. BISCOL 2. CBB 4. DD Bank 6. Nirdhan 7. PGBB 8. SBB

Nepal Nepal Nepal Nepal Nepal Nepal

(31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04)

663,993 998,269

125.45%
(31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04)

(31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04)

9,043

96.69%

18 10 14 15 10

6.63% 4.19% 5.54% -

(31/07/04) (31/07/04) (31/07/04) (31/07/04) (31/07/04)

1,187,516 3,587,302 4,611,116 2,588,121

110.27% 100.73% 100.00% 143.00%

10,036 32,678 36,645 26,322

2.80%

6.3

Range of Products and Services 17

6.3.1 Loan Products

Interest rate of roughly 20%

14

Data from NRB: Banking and Financial Statistics. Numbers of loan and savings accounts have been estimated using the average outstanding balances reported in the CMFs chapter on Nepal for the Microfinance Information Exchange (MIX): A survey of Microfinance in South Asia, December 2005. 15 Shalik Ram Sharma: Development of MFIs and Reaching the Poor, December 2004. 16 The Mission sampled the largest MFIs and 2 banks to get the average no. of voluntary deposit accounts/total loans. A World Bank study on Access to Finance to be published in July 2006 would hopefully provide better data on the industrys outreach. See also Annex 2. 17 Nirdhan(NUBL) products and services are used as benchmark example of those offered by MFIs in Nepal and their rates. Sourced from MCRIL ratings report 04-05.
Financial Services Sector Assessment in Nepal 15

6.3.2 Savings Products

6.3.3 Other Financial Services

Insurance Products Offered by MFIs

Remittance Products offered by MFIs

6.4

Key Constraints

32. Poor banking Culture: The elements of good banking are not well developed in Nepal, whether among bankers or customers. Informed lending decisions are difficult as many clients fail to maintain or disclose good financial information on their activities. Even if data is available, commercial banks are over-reliant on primary collateral while microfinance institutions apply group guarantees rather than using appropriate loan appraisal tools. The two largest banks do not report
Financial Services Sector Assessment in Nepal 16

to the blacklist maintained by the Credit Information Bureau, and there is little follow-up when a borrower defaults. Corporate governance is extremely weak, accounting and auditing capabilities very limited, and in general, prudential regulations are only sporadically implemented or enforced. Political intervention, weak management and finances and a deeply entrenched culture of nonrepayment has characterized the formal financial sector for decades18. While the private MFIs display much better repayment rates, the cost of customer training is high, competition is sluggish, and the systemic risk is non negligible. Adding to the problem from a different angle is the sustained use of micro-credit by HMG and some donors as a service to be delivered to the rural poor to combat poverty. Outside of the microfinance industry there is very little recognition of or support for the necessary business aspects of providing sustainable financial services. 33. Capacity is limited: Financial institutions suffer from human resource and systems deficiencies. Most of the FSPs display significant weaknesses in financial, managerial and strategic management capabilities. In particular financial management, internal controls, and recording, analysis and reporting of key performance indicators is generally very weak, and has not been encouraged by the ready availability of cheap capital and the general supply-drive. Good loan tracking- and Management Information Systems are almost absent, and hence actual portfolio quality and profitability levels are largely unknown. The key to attaining sustainability for the FSPs is growth, increased efficiency and improved asset quality. In the process, some consolidation through mergers and divestiture of less successful portfolios to stronger institutions should be expected and indeed encouraged. 34. Coordination is very weak: Hitherto, financial service providers have not coordinated their efforts to any large extent, neither in terms of outreach (mapping, expansion planning) nor performance (no industry performance monitoring takes place). The top-down regulatory environment does not encourage lateral collaboration and protectionism and to some extent competition has been seen to hinder the sharing of experience for mutual benefit. Several networks or apex bodies exist for smaller groups of like-minded FSPs, including the Bankers Association, the National Federation for Savings and Credit Unions in Nepal (NEFSCUN) and the recently formed Grameen bank network. The microfinance network, MIFAN established in 2001 failed after a couple of years, chiefly due to a lack of clear vision, commitment and funding. At present, there is no network of FSPs serving the BOP. Limited coordination extends outside of the industry; coordination among donor agencies, with and within government is also weak. Overall consensus among all stakeholders and adherence to performance-based, results-oriented good practices in a sector approach to the development of an inclusive financial sector has yet to be attained. 35. The legislative framework is control-oriented: While not directly counter-productive to microfinance provision at its current level, the policy framework for inclusive finance is fragmented, and legislative and regulatory requirements are extended even to very small providers of financial services to members. There is even a debate on whether Savings and Credit Groups at village level should be registered and supervised to receive external credit. While consolidation and stream-lining is taking place under the reform projects and the limited supervision capacity of the central bank is recognized, the new Microfinance and Cooperative Ordinance appears to remove the supervisory responsibility for MFIs and SACCOs from the central bank, counter to their integration in an inclusive financial sector.

7.

Opportunities for the Future

27. High unmet demand: Significant growth of deposits and lending since 2002 suggests substantial excess demand and the subsidized micro-credit available does appear to replace higher-cost informal borrowing among the poor from money-lenders. While several studies have
18

See also World Bank: Nepal Financial Sector Study, October 2002 and World Bank: Financial Sector Restructuring Project Appraisal Document, January 2004.
17

Financial Services Sector Assessment in Nepal

quantified and monetized the demand for rural finance, and in particular for credit, there is little data available to indicate how many of the rural poor can in fact benefit from credit, i.e. have existing income streams or business opportunities. Savings services have not been as intensely promoted, but as savings benefit everyone, targets to expanding these services to replace higherrisk informal savings could be set. While there is clearly an unmet demand, it would be prudent to focus on the quality of the services provided, and the sustainability of the providers as their outreach expands, rather than directing their coverage to remote rural areas. 28. Supportive government: Government representatives are supportive of the development of microfinance as a part of an inclusive financial sector, and the 10th National Development Plan seeks to promote rapid, equitable and sustainable economic growth and the reduction of poverty. The overall financial sector reform programmes are yielding results, although much still needs to be done. 29. Critical mass of bank-ready clients: The sustained achievements of many local community development projects, including the UNDP-supported project portfolio, results in the existence of a large potential client base mobilized in SCGs, who have yet to be linked to providers of sustainable financial services. As they are known by promoting projects, linkages can be facilitated at much less cost and effort than it would require for the FSPs themselves to identify and train them. Promoting agencies continue to provide essential non-financial services. As government-affiliated agencies and institutions are targeted by insurgents, private and locally managed financial service providers appear to be better able to continue operations even in highly conflict-affected areas. 30. Business Service providers for FSPs exist: FSPs are essentially private sector businesses, whose commodity is money. Successful microfinance institutions maintain a social mission by targeting the low-income segment of the market while providing their services based on sound business approaches the so-called double bottom line. FSPs need a range of business support services (e.g. auditors, rating agencies, credit reference bureaus, cash-in-transit service providers, insurance agencies, IT support, trainers, consultants etc.). Nepal does have a small, but relatively well-skilled cadre of such business service providers, chief among them the Centre for Microfinance (CMF), which operates a list-serve, a library and provides TA and research for the industry. The significant level of subsidies for such business services chiefly by donor projects, however, has distorted the drive for commercial viability, and linkages between demand and supply are limited. 31. Sufficient and cheap capital for on-lending: The HMG funding structures supporting the delivery of micro-credit as targeted poverty reduction activities provide loan capital at sub-market rates to MFIs. The RMDC also provides some training and TA in-kind (contracted by the RMDC and paid by grant funds from HMG and ADB). In addition, many commercial banks invest the required percentage of portfolio for the deprived sector in MFIs[gj3], either as loans or equity. There is thus a plentiful supply of cheap capital for on-lending.

7.1

Institutional Support

40. While capital for on-lending is widely available to FSPs in Nepal, grant funds for institutional development and capacity building to FSPs that cannot yet afford these crucial investments have been scarce. Experience in Nepal and in other countries demonstrates that the constraints of appropriate client selection, human resource and institutional systems gaps, and weak industry standards and benchmarks need to be addressed coherently and concurrently in order for the financial sector as a part of the private sector - to advance rapidly through an expansion and consolidation phase to reach the majority of the population, and in particular the BOP: To attain high asset quality, reach substantial scale, and ensure technical and financial sustainability, retail financial service providers (FSPs) need appropriate packages of temporary operational funding including grants and Technical Assistance (TA) to improve their capacity and systems to manage growth, risk and product development while expanding their customer
Financial Services Sector Assessment in Nepal

18

base at a feasible rate. A one-stop funding facility (Fund), which combines the available grant funding resources for the microfinance industry under joint management by funders would ensure equitable access, enhance coherence and coordination, and save valuable time for funders and FSPs alike, by: Setting uniform and transparent standards and criteria for eligibility, selection, contracting, performance monitoring and reporting; Jointly issue calls for applications based on the FSPs own business plans, projections and needs assessments to establish a more demand-driven and performance-based development of potential market leaders within the financial services sector; Ensure uniform and technically competent appraisal, monitoring, and review of performance; Provide a joint decision-making forum for all funders; Enable multiple funders to jointly meet the needs of FSPs for different funding modalities (grants, TA), and larger amounts over longer periods of time. So as not to dilute the regulatory function of the proposed Microfinance and Cooperative Center, this funding facility should be established separately and outside of government in line with HMGs objective to divest direct service provision. Once the Center is established, close coordination will be ensured, and linkages to the credit capital fund foreseen would be pertinent to provide FSPs with appropriate packages of support as per identified demand. 41. The lack of coordination and mapping of current and potential outreach; and of agreed standards for performance based on current benchmarks and monitored over time through consolidation of reliable and accurate data from all providers of financial services to BOP hampers the building of a strong and accountable industry and increases transaction costs and risks, both for customers and providers. International experience demonstrates that the setting of standards, benchmarking and performance monitoring is most effectively done by a representative body of self-regulating practitioners (FSPs) within the framework of an agreed codex (Code of Conduct) for the industry. An industry network (Association) of FSPs serving the BOP equidistant from all FSPs with a representative and elected leadership and a functional secretariat could implement a work programme based on the demand for cost-cutting and time-saving coordination, facilitation of access to needed business services, and compilation and dissemination of regular performance data as per agreed indicators and reporting formats. Such an association could also serve as a coordinating forum for information exchange for the FSPs, and advocacy and dialogue with HMG and donor agencies, notably to promoters of the potential client base. 42. The business support infrastructure for the financial sector (training, audit, ratings, ICT, MIS), while existing in Nepal, needs strengthening so demanded services can be made available to the FSPs in a commercially viable manner. Currently, most business service providers are orientated towards their core client: donor projects, which contract providers directly for specific services to targeted clienteles, who often are neither involved in the task formulation nor in the payment. Business service providers therefore have little information about the current and developing demand within their customer base (the FSPs) and little contact to potential customers. Equally, FSPs demanding business services are often unaware of the existence, contacts, areas of specialization, quality, or price of existing business service providers. While a truly commercially viable market for these services can only fully develop when distorting subsidies are phased out, a widely available and regularly updated directory of service providers including a scoring system attained from evaluations by former customers will go a long way. Similarly, a regularly updated catalogue of FSPs demand, for example for training by topic, for audits following the CGAP guidelines for MFI auditing, for ratings etc. would enable the business service providers to specialize in demanded areas and offer more relevant services. As a specialized provider with deep roots in the microfinance industry, the Center for Microfinance would be well placed to ensure such improved business service market linkages between supply and demand.

Financial Services Sector Assessment in Nepal

19

7.2

Bank Guarantees

7.3

Enhanced Coordination through

_______________________

Financial Services Sector Assessment in Nepal

20