As the deadline for publishing second-quarter reports approached, there were speculations about the level of non-performing loans (NPLs) banks would disclose in their financial statements. When the reports were made public, only four commercial banks reported NPLs exceeding 5%, while 12 banks reported NPLs above 4%. Compared to the previous fiscal year, NPLs have increased for 19 banks, with Everest Bank being the only exception.

Even before the second-quarter results were released, it was clear that bad loans of banks would surpass those of the previous fiscal year. The published results confirmed this expectation. The average bad loan ratio of commercial banks rose to 4.5%, making a 1.08 percentage point increase from the 3.40% recorded during the same period last fiscal year.

The financial data also highlighted a deepening crisis: as the economy continues to underperform, bad loans have surged, profits have declined and net interest income has plummeted. Seven commercial banks reported negative distributable profits, leaving them unable to provide returns to their shareholders.

Profitability Takes a Hit

The rise in non-performing loans across commercial banks has directly affected their profitability. According to the unaudited financial statements for the second quarter, profits of commercial banks declined by 4.62% in the first half of 2024/25 compared to the same period in 2023/24. Net profits fell from Rs 28.76 billion in the second quarter of 2023/24 to Rs 27.43 billion in the same quarter of 2024/25. While 11 out of 20 commercial banks saw an increase in net profit, the remaining nine experienced a decline.

Some banks have faced particularly steep profit drops. For example, NIC Asia Bank’s net profit plummeted by 92.03% compared to the previous fiscal year. The bank, which earned a net profit of over Rs 1.9 billion in the second quarter of the last fiscal year, reported just over Rs 150 million this fiscal year. NIC Asia’s NPL also surged sharply, rising from 1.19% in the second quarter of last fiscal year to 4.61% this year.

The severity of the NPL crisis is further underscored by the fact that banks have set aside Rs 24.67 billion in loan loss provisions as of the second quarter of the current fiscal year—an amount nearly equivalent to their total net profit. This sharp increase in provisions has significantly eroded profitability of banks.

Rising NPLs: A Growing Concern

The second-quarter financial statements reveal a widespread surge in non-performing loans. Out of 20 commercial banks, 19 reported an increase in NPLs compared to the previous fiscal year, with Everest Bank being the only exception. The average NPL ratio for commercial banks now stands at 4.5%, up significantly from 3.40% during the same period last year.

Everest Bank stands out as its NPL ratio decreased by 0.11 percentage points, dropping from 0.77% in the second quarter of last year to 0.66% this year. Meanwhile, Kumari Bank has the highest NPL ratio at 6.96%, followed by Prabhu Bank, Nepal Investment Mega Bank, and Laxmi Sunrise Bank, all of which have NPL ratios exceeding 5%. However, some skeptics argue that the actual NPL figures are higher than what the banks have disclosed.

The rise in NPLs has been attributed to challenges in loan recovery and higher provisioning requirements. Santosh Koirala, President of the Nepal Bankers Association and CEO of Machhapuchchhre Bank, noted that banks are now focusing on improving loan recovery mechanisms. “All banks are currently working on making loan recovery more effective,” he said.

Credit Demand Remains Subdued

Despite ample liquidity in the banking sector and declining interest rates, loan demand remains weak. Anal Raj Bhattarai, CEO of Nepal Development Fund, attributes this to the lack of aggregate demand in the economy. “Ideally, lower interest rates should boost lending, but the real issue lies in the lack of aggregate demand,” he explained.

The credit-deposit ratio (CD ratio) has dropped to 79.4%, reflecting sluggish credit growth. Bankers report that the slowdown in economic activity, particularly in the real estate sector, has constrained their ability to expand credit. However, there are signs of gradual recovery in the real estate market, which could provide some relief to banks in the coming months.

Net Interest Income Declines

Banks' financial statements highlight two primary reasons for the decline in profits. First, there has been a notable decrease in net interest income. In the first half of the current fiscal year, the 20 commercial banks reported a combined net interest income of Rs 92.21 billion, down from Rs 96.29 billion during the same period last fiscal year.

The Nepal Rastra Bank’s efforts to absorb liquidity from banks using various instruments have further impacted their net interest income. Additionally, declining interest rates on government bonds, development bonds and treasury bills have also contributed to the reduction in banks' interest earnings.

However, a few banks, such as Everest, NMB and Prime Commercial, have bucked the trend by reporting increases in net interest income. Everest Bank saw an 18.38% rise, Prime recorded a 14.06% increase and NMB Bank's net interest income grew by 13.72%.

Despite lowering deposit interest rates to reduce expenses, banks’ net interest income has been squeezed by high liquidity levels and reduced yields on government securities. The government-owned Rastriya Banijya Bank and Agricultural Development Bank, as well as private banks, such as Standard Chartered Bank and Nepal SBI Bank, have experienced sharp declines in their net interest income.

Struggling with Recovery

Banks are grappling with challenges in loan recovery, leading to higher provisions for loan losses. Delayed repayments and difficulties in liquidating mortgaged assets have compounded the problem. The economic slowdown has not only increased loan defaults but also reduced the value of collateral, making it harder for banks to recover funds.

“Banks have primarily approved loans based on collateral rather than assessing borrowers' repayment capacity,” said a banker who requested anonymity. “This focus on short-term gains and portfolio expansion has backfired, leaving banks entangled in their own challenges.”

A Call for Reforms

Despite the ongoing difficulties, bankers see the current crisis as an opportunity for systemic reform. They emphasize the need for swift action by policymakers and regulators to address risks and strengthen the financial system. Measures such as implementing robust insolvency laws to expedite loan resolution and fostering the growth of asset reconstruction companies (ARCs) could significantly improve recovery processes and alleviate the burden of NPLs.

Former banker Bhuvan Dahal believes the situation, while challenging, is not as dire as it may seem. “The slowdown in the banking sector was largely driven by a decline in real estate activity. However, real estate is now showing signs of gradual recovery,” he said. Dahal also noted that the government’s recent ordinances have instilled a sense of optimism in the private sector, which could stimulate economic activity and offer some relief to banks.

A Necessary Correction?

Some experts view the current challenges as a necessary correction for the economy. Bhattarai noted that the banking sector has experienced substantial growth over the past decade, with total loans surging from Rs 1,300 billion in 2015 to Rs 5,300 billion in 2024. However, this rapid expansion has been marred by mismanagement, as a significant portion of bank profits is now being diverted to loan provisioning.

“This seems more like a necessary correction phase for the economy,” Bhattarai said. “While there are mixed sentiments about the impact on the banking sector, recent government ordinances have brought optimism, particularly in the private sector. The banking sector should seize this opportunity to align itself with the evolving economic landscape.”

(This report was originally published in  February 2025  issue of New Business Age Magazine.)