Key Takeaways
- The official NPL ratio is a lagging indicator of risk, not a leading one. The real danger lies in the vast, unquantified pool of “restructured” and “evergreened” loans that are technically performing but economically defunct, masking the true fragility of bank balance sheets.
- Evergreening is a deliberate strategy driven by regulatory arbitrage. By issuing new credit to cover old interest payments, banks avoid mandatory provisioning of 25% or more on substandard loans, artificially inflating quarterly profits and justifying management bonuses, all while paying dividends from capital that should be preserved.
- A mandatory Asset Quality Review (AQR) is no longer a matter of ‘if’ but ‘when’. The precedent set by India’s central bank in 2015 shows that when a regulator’s credibility is at stake, a system-wide audit becomes inevitable. For investors, this means current dividend yields for many banks are an illusion that is about to evaporate.
Introduction
The latest figures from Nepal Rastra Bank (NRB) paint a picture of a banking sector under manageable stress. The official system-wide Non-Performing Loan (NPL) ratio hovers around 4%, a number that, on its surface, suggests a resilient financial system weathering the aftershocks of a global pandemic, import restrictions, and a harsh monetary tightening cycle. Yet, for any CEO, supplier, or business owner navigating the on-the-ground reality of Nepal’s economy, this figure feels dissonant. It clashes with the palpable sense of distress in the market: the shuttered storefronts, the stalled construction projects, and the pervasive liquidity crunch crippling small and large enterprises alike. This dissonance is the single most important story in Nepali business today.
This is not a story about rising NPLs. It’s a story about the NPLs we cannot see. It is about the fundamental tension between maintaining the aesthetic of a healthy balance sheet and the brutal reality of widespread borrower insolvency in a post-inflationary, high-interest-rate environment. The official data points are merely the visible tip of an iceberg of distressed assets, artfully kept submerged through the widespread practice of “evergreening”—the financial equivalent of applying a fresh coat of paint to a rotting structure. This practice, transitioning from a short-term liquidity solution to a systemic crutch, is pushing Nepal’s financial sector towards a precipice.
The core of the issue is that the tools designed to provide temporary relief are now being used to indefinitely postpone a necessary reckoning. While this delays immediate pain, it creates a “zombie” economy where capital is trapped in unproductive assets, starving healthy, new ventures of the credit they need to grow. The hard truth, as we will explore, is that this state of denial is unsustainable. A comprehensive, mandatory Asset Quality Review (AQR)—a deep, forensic audit of bank loan books—is an approaching inevitability. When it arrives, it will not be a gentle course correction; it will be a shockwave that fundamentally re-prices risk and severely curtails dividend payouts for the institutions most exposed to the rot within.
The Anatomy of “Extend and Pretend”
At its core, evergreening is a simple, seductive deception: a bank issues a new loan to a struggling borrower, enabling them to use the fresh capital to service the interest payments on their original, distressed loan. On the books, the old loan remains “performing,” avoiding the dreaded NPL classification. No alarms are triggered. The balance sheet remains pristine. This is the “extend and pretend” strategy in its purest form—extend the loan term, and pretend the underlying business is viable.
What began as a pragmatic tool during the initial COVID-19 shock has metastasized into a systemic dependency. The incentive structure is powerfully aligned to favor this deception. For a bank’s management, classifying a major loan—say, to a real estate developer or a large trading house—as “substandard” has immediate and painful consequences. Under NRB directives, a substandard loan requires a 25% provision. A doubtful loan requires 50%, and a loss requires 100%. This provisioning is not just an accounting entry; it is a direct charge against the bank’s profits. By evergreening the loan and keeping it in the “pass” category (which requires only a 1.3% standard provision), the bank avoids this massive hit to its profitability. This, in turn, protects executive bonuses tied to profit targets and supports the share price, keeping shareholders content with steady dividend streams.
Consider the archetypal case of a hotel project initiated in 2018, financed by a NPR 1 billion loan. Post-COVID, tourist arrivals remain below pre-pandemic peaks, and occupancy rates are dismal. The hotel cannot generate enough cash flow to cover its interest payments. The economically rational decision would be to recognize the impairment, classify the loan, and potentially force a sale of the asset to a new operator at a realistic market price. However, this would force the bank to take a NPR 250 million provisioning hit (25% of NPR 1 billion) in a single quarter, wiping out a significant chunk of its profits. The alternative? The loan officer, under pressure from senior management, approves a new NPR 100 million “working capital” or “business expansion” loan for the same hotel. This new cash is not used for expansion; it is discreetly funneled back to the bank to cover a year’s worth of interest payments on the original NPR 1 billion loan. The problem has not been solved; it has been deferred and, worse, compounded. The bank’s total exposure to a failing asset has now increased to NPR 1.1 billion.
This cycle was sustainable, albeit dangerously, in a low-interest-rate environment where one could plausibly hope for a swift economic rebound. But Nepal’s recent bout of aggressive monetary tightening has shattered this fragile hope. With lending rates soaring, even previously healthy businesses are struggling to service their debt. For the “zombie” borrowers kept alive by evergreening, the increased debt burden is a fatal blow. The very medicine used to fight inflation—higher interest rates—is now exposing the deep-seated infection in the banking system’s loan portfolio. The pretense is becoming impossible to maintain as the underlying insolvency of borrowers moves from a temporary liquidity issue to a permanent state of economic non-viability.
The Regulatory Blind Spot and the Provisioning Paradox
The persistence of evergreening is not a sign of regulatory failure in a traditional sense; rather, it exploits a fundamental blind spot in a compliance-based, rather than risk-based, supervisory framework. Nepal Rastra Bank’s regulations are predominantly backward-looking. A loan’s classification is primarily determined by its repayment history—specifically, the number of days the principal or interest is past due. As long as a borrower makes their payments on time, the loan is considered healthy, regardless of the source of the funds used for that payment.
This creates a critical loophole. A bank can technically remain 100% compliant with NRB directives while actively engaging in evergreening. The new loan issued to the struggling borrower is documented as being for a legitimate business purpose. The funds are disbursed and then used, as if by coincidence, to service the old loan just before it crosses the 90-day overdue threshold that would trigger an NPL classification. From a paperwork and compliance perspective, no rules have been broken. The regulator, reviewing quarterly reports from its desk, sees a performing loan. This is the essence of regulatory arbitrage: using the letter of the law to defeat its spirit.
This arbitrage leads to what can be termed the “Provisioning Paradox.” The banks that are the most reckless—those most aggressively hiding their bad assets through evergreening—can, in the short run, report the highest profits and offer the most attractive dividend yields. By avoiding the 25% or 50% provisioning hits that a more honest assessment of their loan book would require, their Profit and Loss statements look deceptively strong. Unwitting investors, chasing high dividend yields and looking at seemingly low NPL ratios, may flock to these very institutions, believing they are investing in top performers. In reality, they are buying into a facade, where declared profits are not generated from sound lending but from the accounting gimmick of deferred loss recognition. These banks are, in effect, paying dividends not from recurring earnings, but from the capital that prudential norms dictate should be set aside to absorb future losses. It is a ticking time bomb, rewarding risky behavior and penalizing prudent banks that choose to recognize stress early.
NRB has not been entirely idle. Recent circulars aiming to tighten regulations on loan restructuring, limit single obligor exposure, and scrutinize working capital loans are tacit acknowledgements of the problem. However, these measures are akin to patching a dam that has structural flaws. They address the symptoms without curing the disease. Without a forensic, on-the-ground examination of a bank’s loan book—verifying the end-use of funds and assessing a borrower’s viability based on actual cash flow generation, not just timely payments—evergreening will persist. The regulatory framework is playing a perpetual game of cat and mouse with the banks, and the banks, with their intimate knowledge of their clients and sophisticated financial engineering, are winning.
The Indian AQR of 2015: A Glimpse into Nepal’s Future
To understand what is coming for Nepal, we need only to look south to the recent history of our largest neighbor. In the years leading up to 2015, the Indian banking sector was in a state of cognitive dissonance strikingly similar to Nepal’s current situation. Official Gross NPA (Non-Performing Asset) figures were contained, yet there was a pervasive, unspoken consensus among insiders that the real level of stress was far higher. Indian banks, particularly the state-owned ones, had perfected the art of “extend and pretend,” creating a legion of “zombie” corporations kept alive by an endless cycle of debt restructuring.
The turning point came not as a gradual policy shift, but as a decisive, top-down intervention. Under Governor Raghuram Rajan, the Reserve Bank of India (RBI) lost patience with the charade. It recognized that the credibility of the entire financial system was at stake. In 2015, the RBI initiated a mandatory, synchronized Asset Quality Review (AQR). This was not a routine inspection. The RBI dispatched special teams to all major banks with a single, ruthless mandate: to go through their loan books, project by project, and force a reclassification of assets based on their true economic viability, not their doctored repayment history. They looked at project completion timelines, cash flow projections, and sectoral health. Loans that had been “performing” for years were re-labelled as non-performing overnight.
The results were brutal and immediate. India’s official Gross NPA ratio, which stood at around 5.1% in September 2015, ballooned to 9.3% by March 2017. For public sector banks, the figure was an astonishing 12%. Bank profitability evaporated as they were forced to make colossal provisions they had been avoiding for years. Several prominent bank chairmen were unceremoniously replaced. Banking stocks, especially those of banks revealed to have been the worst offenders in hiding bad loans, were hammered on the market. It was a period of intense pain, but it was a necessary surgery. The AQR forced a clean-up, compelling banks to recognize the rot, recapitalize, and eventually begin the process of genuine resolution. It restored a measure of truth to balance sheets and, over the long term, rebuilt investor confidence in the sector’s health.
The parallel to Nepal is undeniable. NRB is facing the same credibility gap. International partners like the IMF and the World Bank are increasingly vocal about asset quality. Sophisticated domestic investors are growing more skeptical of official figures. As the delta between reported NPLs and economic reality widens, the pressure on NRB to act decisively will become irresistible. The Indian AQR provides a clear blueprint—not just for the process, but for the consequences. It demonstrates that when faced with systemic rot, incrementalism fails. A system-wide, invasive audit becomes the only viable tool to reset the system. Nepal’s banking leaders and investors should study the Indian AQR not as a foreign case study, but as a dress rehearsal for their own inevitable reckoning.
The Strategic Outlook
Predicting the exact timing is a fool’s errand, but the strategic direction is clear. The current equilibrium of high official profits and hidden systemic risk is inherently unstable. Nepal’s financial sector is heading towards one of two futures, with one being far more probable than the other.
The first, less likely scenario is a continuation of the “muddle through” approach. NRB may stick to incremental regulatory tightening, and banks will find new ways to circumvent the rules. This path avoids immediate, sharp pain but guarantees long-term stagnation. Capital will remain locked in unproductive “zombie” assets, and banks, technically solvent but practically impaired, will be too risk-averse to lend to new, innovative businesses. This would result in a Japan-style “lost decade” for Nepal, characterized by anemic credit growth and choked economic potential. It is a slow, creeping crisis that erodes prosperity over time.
The far more probable scenario is the “Big Bang”—a mandatory, RBI-style Asset Quality Review, likely initiated within the next 18-24 months. The catalyst could be a major corporate failure that exposes the rot, sustained pressure from multilateral agencies, or simply a new leadership at the central bank determined to restore credibility. This AQR will be the most significant event in Nepali banking in a generation.
When the AQR happens, the consequences will be swift and unforgiving. Investors and business leaders must prepare for the following cascade:
1. The NPL Shock: The official system-wide NPL ratio will spike dramatically. A jump from the current ~4% to a more realistic 8-10% is a conservative estimate. For individual banks that have been particularly aggressive in evergreening, the ratio could easily double or triple, exposing years of mismanagement in a single quarter.
2. The Profitability Collapse: The forced reclassification of loans will trigger massive provisioning requirements. Expect to see quarterly and annual profits for many banks—including some historically considered “blue-chip”—vanish or turn into substantial losses. The entire narrative of consistent, high profitability in the banking sector will be shattered.
3. The Dividend Drought: This is the hard truth for investors. For the most exposed banks, dividend payouts will be slashed to zero or near-zero for at least one to two fiscal years. With profits wiped out by provisions and regulators demanding capital conservation, there will simply be no distributable surplus. The era of banking stocks as reliable dividend-yield investments will come to an abrupt, painful halt for many.
4. The Capital Scramble and Consolidation Wave: Faced with depleted capital adequacy ratios, affected banks will be forced to raise fresh Tier 1 capital. This will be a difficult proposition in a market that has just been burned. It will likely lead to rights issues at a deep discount, diluting existing shareholders. More importantly, it will trigger a wave of forced mergers, as weaker banks with hopelessly compromised loan books are absorbed by the few stronger, more prudent institutions. This consolidation will be driven by regulatory necessity, not strategic choice.
For the astute investor and business leader, the time to act is now. The game is no longer about picking banks with the highest reported ROE or dividend yield. It is about forensically analyzing balance sheets to identify which institutions have the cleanest loan books, the most conservative provisioning, and the strongest capital base to withstand the coming storm. The AQR, while painful, is not the end of the story. It is the necessary, surgical cleansing that will finally separate the well-managed banks from the reckless. It will be the event that lays the foundation for a healthier, more transparent, and ultimately more productive financial system for Nepal. The pain is coming, but on the other side of it lies reality—and only from reality can sustainable growth be built.
