Priority lending is dragging down Nepali banks into huge bad debt

Nepal's banking sector is grappling with a surge in non-performing loans, with a significant portion originating from sectors designated for mandatory priority lending by the Nepal Rastra Bank (NRB). The central bank's policy, aimed at promoting financial inclusion and supporting productive investments in areas like agriculture and micro, small, and medium enterprises (MSMEs), has instead become a major source of bad debt.

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Loans extended by banks and financial institutions to sectors where the Nepal Rastra Bank (NRB) requires mandatory lending have emerged as some of the biggest sources of non-performing loans.

Over the past two years, banking data reveals a sharp deterioration in loan quality within these priority sectors. This trend is attributed to a broader economic slowdown, weak consumer demand, and shrinking household incomes, which have collectively undermined borrowers' ability to repay loans. Small entrepreneurs, often lacking alternative income sources or business diversification options, are particularly hard-hit when economic activity declines, impacting their capital base.

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Although these sectors were intended to expand financial inclusion and support productive investment, they have instead become increasingly vulnerable as slowing economic activity, weak demand and shrinking household incomes have undermined borrowers' repayment capacity.

In response to these growing concerns and the stress within the banking system, the NRB revised its priority sector lending framework in March. The updated policy broadened the list of eligible sectors to include tourism, information technology-based businesses, and export-oriented businesses utilizing domestic raw materials. Commercial banks are now mandated to allocate at least 10 percent of their total lending to agriculture and a minimum of 20 percent collectively to tourism, MSMEs, energy, IT, and specific export businesses. The existing requirement for at least 5 percent lending to deprived sectors remains unchanged, meaning banks must still direct at least 35 percent of their loans to regulator-specified areas.

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Commercial banks are now required to allocate at least 10 percent of their total lending to agriculture, while a minimum of 20 percent must collectively go to tourism, MSMEs, energy, information technology and export businesses that use domestic raw materials.

Ironically, these mandated sectors continue to exhibit the highest rates of loan defaults. According to banking disclosures up to mid-April, agriculture and fisheries alone account for approximately 23.5 percent of all non-performing loans. Construction-related lending, including hydropower projects, contributes about 10.5 percent, and wholesale and retail trade another 10 percent. Officials at the NRB acknowledge that these sectors have recorded comparatively higher default levels than many others, underscoring the persistent challenges in ensuring the effectiveness of the priority lending policy.

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Ironically, these are also the areas where loan defaults have become most pronounced.