Bank stress tests suggest improvement but weaknesses persist

The latest stress tests conducted by central bank for commercial banks show some improvement compared to a year ago but weaknesses persist.
Among the 32 existing commercial banks, a standard credit shock would push capital below the regulatory minimum in 20 banks, and a third of commercial banks would be under-capitalised, if real estate and housing loans are downgraded 20 against last year’s 22, the test revealed, adding that sustained deposit withdrawals over five consecutive days would render 14 banks illiquid compared to 19 in 2011, and liquidity ratios at a number of banks would fall below 20 per cent in the event of sudden large withdrawals, or withdrawals by institutions mainly due to the improvement in liquidity on the back of strong remittance inflows.
Standard credit shock has been defined as 15 per cent performing loans deteriorating to substandard, 15 per cent substandard loans deteriorating to doubtful, 25 per cent doubtful loans deteriorating to loss and five per cent of performing loans deteriorating to loss.

Likewise, Standard withdrawal shock is the withdrawal of customer deposits by two per cent and five per cent in the first two days and 10 per cent each in the following three consecutive days.

International Monetary Fund’s (IMF) article IV mission report also stated that based on Nepal Rastra Bank’s stress test fewer banks are vulnerable to liquidity and credit shocks in 2012 compared to 2011.

Stress testing is a risk management tool – started for the first time by the central bank – used to evaluate the potential impact on a firm of a specific event and movement components like earning, liquidity and capital. It is also thought to be helpful to stabilise the financial sector in the long run.
The central bank has also directed the banks to manage an additional one per cent capital in the capital adequacy ratio (CAR) as buffer capital to help absorb credit shocks. Currently, banks are required to maintain CAR at 10 per cent.

Similarly, the report noted some improvement in the response to credit shocks. In case of 25 per cent of performing loans of real estate and housing sector is directly downgraded to loss loans, CAR of only 11 commercial banks will come below the required 10 per cent level.

Commercial banks’ direct exposure to construction and real estate sectors has declined to around 16.5 per cent in 2011-12 from 19.5 per cent in 2009-2010, whereas indirect exposure through collaterals has also declined to 56 per cent from 66 per cent over the period.