Years of easy credit and compromised oversight have saddled Nepal’s banks with toxic assets and eroded public trust.

Nepal’s current malaise, where young people are increasingly unwilling to stay, job opportunities remain scarce, entrepreneurial drive is waning, cooperatives are embroiled in financial scandals and the broader economy appears deflated, has deep and complex roots. While political instability is undeniably a key factor, the crisis is equally shaped by sociocultural pressures, structural economic constraints and the far-reaching effects of globalization. Crucially, the country’s banking and financial systems have also played a significant role in creating this scenario.

In the race for profitability, Nepali banks have long prioritized aggressive loan disbursement. The logic was simple: the larger the loan portfolio, the greater the profit. This mindset led banks across the country to expand credit rapidly, often without adequate checks on borrower credibility.

Historically, Nepal's banking culture has lacked a nuanced approach to assessing individual creditworthiness.

In place of careful evaluation, banks learned heavily on collateral-based lending. The logic was simple. Without collateral, borrowers could easily default and flee, either across the open border or abroad, leaving no legal pathway for loan recovery. While this system functioned, albeit imperfectly, in Nepal’s small and more insular financial environment, it is now proving dangerously outdated. With default rates steadily climbing, it is time to ask: where did the banking sector go wrong? A thorough evaluation of its lending practices is long overdue.

Misplaced Credit Priorities

Following the 2015 earthquakes, Nepal saw a significant expansion of bank credit. Even during the economic turmoil of 2021/22, banks continued lending in hopes of supporting recovery amid the pandemic. However, by fiscal year 2022/23, this momentum had slowed, with lending growth shrinking to single digits. By late 2024, while banks sat on ample deposits, credit disbursement had slowed significantly.

A recent review by the International Monetary Fund (IMF) has revealed a troubling trend. Non-performing loans (NPLs) in the banking system had nearly doubled since 2022. A key reason behind this was the practice of evergreening—issuing new loans to help borrowers repay older ones. This accounting maneuver masked the real health of loan portfolios. Notably, few new businesses were launched during this period, yet loan volumes kept increasing, highlighting the widening gap between credit growth and real economic activity.

A major cause of today’s credit crisis is the misallocation of funds into low-productivity or speculative sectors. Real estate, personal consumption and housing loans dominated bank lending. These are the sectors that do little to boost productivity or create sustainable employment. Recent data shows that while the construction sector grew by 12.3% over the past ten months, overall credit growth stood at just 7.2%. This imbalance is worrying, especially since banks have been struggling to recover interest payments and EMIs from borrowers in the construction sector.

Data also shows that around 14% of total lending went to housing and vehicle loans. Margin lending, credit extended for stock market investments, also surged. As credit flowed into consumer finance and market speculation, vital sectors like small and medium enterprises (SMEs) and export-oriented industries were sidelined.

The consequences of this imbalance are now becoming clear. As speculative and consumption-driven sectors falter, the entire lending ecosystem is coming under stress—a classic case of short-term gains setting the stage for long-term instability.

Governance Gaps Deepen Credit Crisis

Governance failure across several banks have further deepened the credit crisis. Karnali Development Bank, which came under the control of the central bank, was found to have falsified its non-performing loan (NPL) records, concealing the true extent of defaults. Its reported NPL levels had been deliberately manipulated.

In early 2024, several private commercial banks received regulatory warnings for misclassifying defaulted loans and violating capital adequacy norms. One prominent bank was discovered offering preferential interest rates and backdated deposit accounts to its directors, while simultaneously under-provisioning for bad loans—an alarming breach of financial discipline.

NIC Asia Bank was formally cautioned by the central bank in January last year for multiple regulatory violations, including improper loan classification, capital requirement breaches and inadequate provisioning for risky assets.

In another high-profile case involving a government-linked bank, a shareholder complaint exposed the disappearance of Rs 20.4 billion. The subsequent investigation revealed widespread irregularities in SME loan accounts, including fake borrowers, collusion and large-scale misappropriation of funds, exposing deep-rooted governance failures within the institution.

The Liquidity Paradox

The banking system is also grappling with a liquidity paradox. Liquidity paradox refers to a situation where banks are flush with funds but are unable, or unwilling, to lend. Following the COVID-19 pandemic, the central bank adopted expansionary monetary policy to stimulate the economy by encouraging banks to disburse credit aggressively. But by late 2021, banks had already exhausted their lendable funds.

In response, the central bank tightened monetary policy. This, coupled with a cooling economy, led to a sharp decline in credit demand. Real estate prices plateaued, stock market indices corrected, and rising NPLs eroded business confidence. Borrowers grew more cautious.

Meanwhile, a surge in remittances and a decline in imports caused bank deposits to swell. By the end of 2023, banks found themselves with excess liquidity and limited demand for credit. The central bank responded by absorbing surplus funds through instruments like the Standing Deposit Facility (SDF) and targeted deposit collections.

But the deeper issue was already evident. During the boom years, banks failed to channel funds into productive investments. Instead of driving growth, they effectively hoarded liquidity, further widening the gap between capital availability and economic activity.

A Neglect of Productive Lending

Nepal’s economic stagnation and financial imbalances can largely be traced to the banking sector’s failure to prioritize lending to productive sectors. Instead, banks favored real estate, margin lending and personal consumption loans—forms of credit that are neither asset-generating nor growth-enabling. Real estate loans drove up land and housing prices without adding to productive capacity. Margin lending inflated stock market speculation, while personal loans fueled imports— from cars to luxury goods—without supporting domestic industry.

In contrast, genuinely productive sectors such as agriculture, which employs nearly 60% of the population, along with SMEs and export-oriented industries like textiles, carpets, tea and IT services, remained under-financed. Without adequate support, these sectors could neither modernize nor scale up.

Banks' reluctance to lend to such sectors stemmed from risk aversion, a lack of structured lending frameworks and the absence of reliable credit histories. But this systemic underinvestment has had dire consequences. Weak domestic production has widened the trade deficit, fueled labour migration and increased reliance on remittances. Industrial growth has stagnated, and the economy has become increasingly consumption-driven—without the foundational strength of a productive base.

Regulatory Response: Too Late, Too Cautious

The central bank eventually acknowledged these structural problems and took corrective steps—tightening regulations, capping interest rate spreads and mandating minimum lending quotas for the deprived sectors. In fiscal year 2023/24, it also facilitated the final wave of mergers involving weaker financial institutions.

But these measures came too late. Delayed enforcement allowed bad practices, like insider lending and evergreen financing, to become entrenched. NPLs were underreported under lenient provisions of the NRB Act. While NRB strengthened anti-money laundering and combating the financing of terrorism (AML/CFT) frameworks, and moved toward compliance with Basel norms and IFRS 9 standards, these reforms lacked timely implementation.

Further, revised working capital guidelines introduced by the NRB added procedural, especially for small businesses. While tighter supervision and liquidity absorption have stabilized some aspects, the reforms largely came after vulnerabilities had already surfaced.

There remains a critical difference between lending by regulatory compulsion and lending based on sound economic rationale. Though commercial banks are now compelled to lend in specific sectors, they have yet to be effectively steered toward organic, productivity-driven lending that supports sustainable growth.

Structural and Macroeconomic Headwinds

Nepal’s broader economic challenges are compounded by structural and macroeconomic weaknesses. GDP growth slowed to just 3.5%, nearly half the government’s target, exacerbating unemployment and underemployment. The country’s continued presence on the FATF ‘grey’ list and a rising public debt burden have eroded investor confidence. Frequent banking scandals and mounting bad loans have further shaken public trust. Meanwhile, cooperatives, which account for nearly 7% of lending, have been plagued by high interest rates, weak governance and misuse of deposits. The IMF has called for stronger oversight of this increasingly vulnerable sector.

The banking industry has also fallen prey to crony capitalism. Political interference remains widespread, undermining both regulatory supervision and institutional integrity. Promising sectors such as information technology, startups and business hubs remain unrecognized and unsupported. Rigid collateral requirements continue to dominate the loan approval process, even as real estate markets cool and stock markets underperform, further stalling credit expansion.

Way Forward

There, however, are signs of progress. The central bank’s proposal to establish asset management companies (AMCs) to purchase bad loans is a positive step toward systemic clean-up. Raising lending limits for micro and SME borrowers can also help channel credit to grassroots enterprises and support inclusive growth.

To enable non-collateral-based lending, robust credit rating systems for individuals and firms must be developed with government support. The central bank must also strengthen its supervisory capabilities through risk-based inspection mechanisms and modern IT infrastructure.

Recapitalizing state-owned banks is critical to restore trust in the public sector. While private banks have already strengthened their capital bases to meet higher risk-buffer requirements, public banks still require institutional reinforcement.

Financial literacy will remain fundamental to fostering responsible borrowing and lending behavior. Institutions like the Credit Information Bureau must become more technically advanced and operationally sound.

Above all, the focus must shift toward improving the quality of lending and reducing bad loans through sound credit practices. Nepal’s path to sustainable growth depends on greater transparency, stronger governance and a banking system that is aligned with the needs of the real economy.

(Regmi is Deputy Manager at Rastriya Banijya Bank Limited.)

(This opinion article was originally publihsed in   July 2025 issue   of New Business Age Magazine.)