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					               IMF – Singapore Regional Training Institute
                Workshop on Techniques of Stress Testing
                            Jan 8 - 12, 2007

Discussion paper on the specific risks of financial sector in Nepal and
             the system of assessment and monitoring.
                                                                            Rajendra Poudel
                                                                           Assistant Director
                                                                           Nepal Rastra Bank

         Nepal Rastra Bank (NRB), central bank of Nepal established in 1956, is incorporated
with Nepal Rastra Bank Act 2002. NRB's prime responsibilities are to regulate and supervise
banks and financial institutions. Its main approach to supervising banking and       financial
institutions (FIs) is to concentrate on corporate governments, market disciplines and
management oversight.
         NRB supervision has been following the core principles of effective supervision
developed by the Basel Committee. NRB assess the risk profile of the individual banks. The
financial sectors supervisory capacity of NRB has been improved significantly since 2000 with
the recruitment of professional manpower and training of supervisors, better supervisory
methodologies and improved reporting formats for off site supervision. An on- site supervision
manual has been introduced on the assistance of the World Bank. An international slandered
prudential regulation has been issued.

Role of Nepal Rastra Bank in minimizing of risk of banks and financial
                          institutions (FIs)

        There has been a tremendous growth in the number of banks and financial institutions
in Nepal for last two decades. At the beginning of the 1980 when financial sector was not
liberalized, there were only two commercial banks and two development banks performing
banking activities in Nepal. After the liberalization, financial sector has made a hall mark
progress in terms of number. There are 109 of financial institutions at present. With the
growing number of financial institutions, there are many risks they are subject to face. So the
NRB as the supervisory authority, has adopted risk based supervision. Risk based supervision
is a continuous monitoring and evaluation of risk profile of banks and financial institutions.
The NRB examines whether the banks and FIs are concerned over the identification,
measurement and monitoring the profile of different risks they might face.
NRB has established an adequate system of monitoring and reporting all kinds of risk
exposures. In the capacity of supervisor NRB receives and evaluates control process and the
system of monitoring and measuring various types of risks of banks and FIs by following

   -   On site examination
   -   Off site Review
   -   Discussion with management
   -   Review of work of Internal and external auditors
   -   Periodical reporting

        After the review, NRB takes appropriate action if it is not satisfied with the banks own
risk assessment and non-compliance of prudential norms. Such actions may include

   -   Increase monitoring
   -   Improve internal capital assessment program
   -   Asking a capital restoration plan
   -   Placing restriction on bank activities.
   -   Restricting the payment of dividends.
   -   Replacement of senior management and/or the board.

Risks associated with financial sector and assessment and monitoring
                          system in Nepal.

(A)    Credit risk:
       It is the risk that occurs if the borrower fails to meet the obligation on agreed terms. The
       NRB examines the process and procedure of loan sanctioning, disbursements, recovery
       system, sanction authority and limits, proper secured collateral and borrower's cash
       flow position. Following are the existing prudential regulation on credit.

       (1)     NRB has directed the banks to classify loan and advance on the basis of time
               period expire for due payment of principal and maintain provision for possible
               losses as follows.
               Pass loan (1 %) overdue up to 3 months.
               Sub standard (25 %) overdue up to 3 to 6 months.
               Doubtful (50 %) overdue up to 6 to 12 months.
               Bad (100%) overdue for more than 1 year.

       (2)     Additional condition for bad loan.
               In the following cases loan should be classified in bad category and maintained
               100% provision for possible loss.
               Inadequate collateral value.
               If the borrower becomes insolvent.
               If the borrower disappears.
      (3)    NRB has fixed the loan limit to single and related borrower for concentration
             risk at 25% of core capital in case of funded facility and 50% of core capital in
             non-funded facility. If banks and FIs facilitate more than given limit, 100%
             provision should be maintained.
      (4)    NRB has fixed 14 different economic sectors and directed the banks and FIs to
             present annual plan of sectoral exposure of loan if their plan is to provide more
             than 100% of core capital for a single sector.
      (5)    NRB has set up a credit information bureau and issued regulation on credit
             information and blacklisting. Its main objective is to minimize credit risk and
             ensure healthy financial system.
      (6)    NRB has banned to bank and FIs to facilitate loan and advance to their
             shareholder, directors, employee, auditor and their family since such loans
             provided in the past turned out to be non performing loan.

(B)   Market risk:
      Market risk is defined as the risk of losses arising from movement in market prices,
      which includes the risk pertaining to interest rate instrument and equities in the trading
      book, foreign exchange risk and commodities risk throughout the banks. The NRB
      examines the banks and FIs management’s ability to identify, measure, monitor, and
      control market risk, the banks' size and the nature and complexity of their activities and
      the banks' capital and earning in relation to their level of market risk exposure.

      As per the Nepal's banking law and NRB's directives, banks and FIs cannot trade in
      commodities. So they are not exposed to large fluctuation in commodity prices and
      banks are limited by NRB directives in their ability to invest in the equity of companies
      and therefore are unlikely to suffer severe consequences from price fluctuation. Thus
      exposure to market risk among Nepali banks and FIs would be most likely due to
      interest rate and foreign exchange rate movement.

      (1)    Interest rate risk
             NRB has directed the banks and FIs to adopt following measure to minimize
             interest rate risk

             (a)     For the minimization of possible loss from interest rate risk, all assets
                     and liabilities should be classified into five buckets for gap analysis.
             (b)     Banks and FIs have to monitor their each quarter's gap and cumulative
                     gap and proper system of ALM to be developed by themselves.
             (c)      The information regarding the assets liabilities gap to be submitted to
                     NRB within 15 days of quarter end.

      (2)    Foreign exchange risk.
             NRB has directed the banks and FIs to adopt following measure to minimize
             foreign exchange risk.

             (a)     For the minimization of foreign exchange risk, banks and FIs have to
                     monitor their open position daily and total open position should be
                     within 30% limits of core capital. Total net position exceeding 30% of
                     core capital should be brought in to limits within one month.
             (b)     Open position should be calculated for individual foreign currency.
             (c)     Out of total foreign currency revaluation gain, 25% should be
                     transferred to revaluation reserve.
             (d)     Information of foreign currency position to be provided to NRB on
                     weekly basis within next week in prescribed form.

(C)   Liquidity risk:
      Liquidity risk occurs if banks and FIs lose the capacity to meet the demand for payment
      on its obligation and to fulfill the credit needs of the community it serves.
      NRB examines the following factor in terms of liquidity risk management of the banks.

      -      Availability of assets readily convertible into cash.
      -      Access to money markets or other ready source of fund.
      -      Trend and stability of deposit.
      -      Compliance with statutory requirements prescribed by the NRB.
      -      The NRB assess the capability of the bank management to properly identify,
             measure, monitor and control the liquidity position, including the effectiveness
             of funds management strategies, liquidity policies, management information
             system, and contingency funding plans. NRB has directed the banks and FIs to
             adopt following measures to minimize liquidity risk.
             (a)     For the minimization of liquidity risk, banks and FIs have to classify all
                     assets and liabilities in to five bucket according to maturity period. This
                     gap represents assets / liabilities mismatch. The banks and FIs require to
                     complete a form showing quarterly gap going out one year in order to
                     minimize the banks' exposure to liquidity risk. A negative mismatch
                     pertaining to the first quarter may be large enough to cause concern, as it
                     is may indicate that the bank is going to have problems funding its
                     obligation coming due to in the short run.
             (b)     Banks and FIs have to monitor their liquidity position and proper system
                     of ALM has to be developed by them.
             (c)     The information regarding to ALM should be submitted to NRB within
                     15 days each quarter end.
             (d)     Detail of cash reserve ratio prescribed by NRB should be submitted on
                     weekly basis. If it is found shortfall to prescribed limit, banks and FIs
                     are liable for cash penalty.
             (e)     As per NRB directive, a bank or FI can accept only up to 20% of its total
                     deposit from a single corporate depositor
(D)   Operational risk:
      Operational risk is direct and indirect losses resulting from inadequate or failed internal
      process, people and system or from external events. To minimize operational risk of
      the banks and FIs, NRB evaluates all measure of security, accounting and internal
      control system, corporate governance and safety of computer devices, on the course of
      onsite supervision.

      NRB has directed the Banks and FIs to prepare and implement the following policy
      guidelines and manual for minimization of operational risk.
  -   Credit policy guideline
  -   Operational manual
  -   Investment policy guideline
  -   Fund management policy
  -   System and security policy
  -   Accounting manual
  -   Internal audit rule

  So banking business is full of inherent risks. To minimize these risks and develop healthy
  and sound banking and financial sector, as a supervisory authority NRB has adopted
  internationally accepted tools and techniques. However, stress testing, a widely used risk
  management tool in international banking, has not been used in Nepal yet. I believe that this
  workshop has helped us in expanding our knowledge about risks in banking and financial
  sector and the role of stress testing in their management.


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