Lending Business of Banks in Nepal: A Legal Perspective 141

Lending Business of Banks in Nepal:

A Legal Perspective

Ramesh Rijal 

Abstract
Lending means to provide money temporarily on condition that the amount borrowed is
returned, usually with an interest fee. The lending is indispensable for the present business
world and is growing in Nepal and has also come forward several challenges for the banks
and debtors in Nepal. In the article, the author gives an account of loan, lending business,
and their categories and discusses about different aspects of bank lending, present
situations and legislative frameworks along with challenges and solutions

1. Meaning and Definition of Lending

The term 'lend' refers to allow the temporary use of (something), sometimes in
exchange for compensation, on condition that thing or its equivalent be returned,
or to provide (money) temporary on condition of repayment, usually with
interest. 1 Lend is to allow someone to use something for a period, or to lend
money against security. The term 'lending' refers to an act of letting someone uses
money for a time. 2 Lending means to provide money temporarily on condition
that the amount borrowed is returned, usually with an interest fee. Lending (loan)
is money lent to others for certain time period with the agreement to charge
interest on principal. 3 Bank and Financial Institutions are organized institutions
that collect deposits from their clients and lend the deposited money to the needy
persons. Lending is the core business of bank. The difference interest of between
deposit and lending is the main source of income of bank. 4 The terms 'lending',
'loan' as well as 'credit' are interchangeably use in banking sector. Lending is
central to a bank's business. In bankers jargon, loans are a bank's assets.
Depending on their nature, and in the absence of repayment problems, they can
produce a steady stream of income. 5 Deposits are the bank's principal liability.
Loans are the bank's principal asset. 6 When one belonging of one is advanced to

Ph.D. Scholar, Faculty of Law, Tribhuvan University, Nepal.
1
Brayan A. Garner (ed.) (1999) Black's Law Dictionary (7th ed.) St. Paul, United States of America:
West Group, pp. 912-913.
2
Stephen Curtis(ed), (2005) Dictionary of Bank and Finance (3rd ed.), London: A & C Black. p.201.
3
Hirday Bir Singh (2007), Banking and Insurance (3rd ed.), Kathmandu: Asian Publications (P.) Ltd. p.
254.
4
Ibid.
5
Ross Cranston, (2007) Principles of Banking Law (2nd ed.), New York, United States: Oxford
University Press Inc. p. 299.
6
Douglas W. Diamond & Philip H. Dybvig, (1986), Banking Theory, Deposit Insurance and Bank
Regulation. The Journal of Business, Vol. 59, No. 1. pp. 55-68 (57). See [Link]
[Link]/stable/2352687, (as of Oct. 16, 2012).
142 NJA Law Journal 2014

other to be used certain time is called loan. The basic objective of loan
advancement is to earn interest as the reward for lending the sum for specific
period of time. The interest is charged calculating certain percentages on the
principal. Loan is an act of lending; a grant of something for temporary use; or a
thing lend for the borrower's temporary use; especially, a sum of money lent at
interest. 7 Loan is money which has been lent or to lend something as a verb. 8

The term 'credit' refers to one's ability to borrow debts, a customer with good
credit; or the availability of funds either from a financial institution or under a
letter of credit (the bank extended a line of credit to the customer). Bank Credit
means that a bank makes available to a borrower. 9 Credit is a period allowed
before a customer has to pay a debt incurred for goods or services. 10 Under the
Credit Institutions Directive of the European Community, lending is one of the
two elements defining a bank (or credit institution as banks are called)-'an
undertaking whose business is to receive deposits or other repayable funds from
the public and to grant credits for its own account'. 11 A more varied but also
descriptive definition of 'credit' is given by the Economist Dictionary of Economics,
which states that credit is the use or possession of goods or services without
immediate payment, that credit enables a producer to bridge the gap between the
production and sale of goods and that virtually all exchange in manufacturing,
industry and services is conducted on credit. 12 "Credit" means a direct or indirect
promise to invest money and the right to recover such amount of investment in
return and the interest of such credit or payment of other charges, the refinance
given against the security of credit or investment restructuring and renewal of
credit, the guarantee made for repayment of credit or any other promise for such
repayment, and the word also includes any type of debt. 13 Likewise “credit” means
a direct or indirect commitment to supply funds, and in return therefor, the right
to recover the invested funds, and payment of interest or other charges on such
credit, refinance issued against the security of a credit or investment,
restructuring and renewal of a credit, security issued for the repayment of such
credit and other commitment made for such repayment, and this term also includes
any credit in whatever form. 14

For most people in commercial banking, lending represents the heart of the
industry. Loans dominate asset holding at most banks and generate the largest
share of operating income. Loans are the dominant asset in most banks’ portfolios,

7
Supra note 1, p. 947.
8
Supra note 2, p. 206.
9
Supra note 1, p. 374.
10
Supra note 2, p. 85.
11
Supra note 5, p. 229.
12
JoEtta Colquitt (2007), Credit Risk Management: How to Avoid Lending Disasters and Maximize
Earnings (3rd Ed.). New York: McGraw-Hill. p. 2.
13
Nepal Rastra Bank Act, 2002. Sec. 2(w).
14
Bank and Financial Institutions Act, 2006. Sec. 2(aa).
Lending Business of Banks in Nepal: A Legal Perspective 143

comprising from 50 to 70 percent of total assets. 15 A loan is a liability for the

individual or corporation receiving it, but an asset for a bank, because it provides
income to the bank. 16 Loans are typically less liquid than other assets, because
they cannot be turned into cash until the loan matures. Because of the lack of
liquidity and higher default risk, the bank earns its highest return on loans. 17 A
loan is a debt type; it is a form of contract between the debtor and creditor, where
the debtor repays a sum of money at a future date in return including interest
charges and/or fees. Most loans are bilateral contracts between the debtor and the
creditor. Syndicated loans involve multiple creditors, often banks or financial
institutions that co-operate to provide funding in the form of a large loan to a
large borrower. Syndicated loans involve a more complex organization, but reduce
concentration risk. 18

Bank provides loans against approved securities to the public and companies.
Loans can be granted in the form of cash credit, short term loan, overdraft,
discounting of bills and demand loans. 19 The banks make loans and advances out
of deposits, received from their customers. Most of these deposits are payable on
demand. As such the bank owes a greater responsibility to the depositors. Hence
bank should be extremely careful while granting loans. 20

The main functions of Bank are to accept deposit and lending. Lending is a risky
business. The bank lends the deposit to earn interest as the profits. However,
sometimes, it is difficult to the bank to reimburse the principal. To avoid such
situation, there should be strong lending regulation and management mechanism
of the bank. Most of the serious financial problems of bank spring from the
lending. 21 Form the above discussion there is not remarkable difference between

15
Timothy W. Koch. (1998). Overview of Credit Policy and Loan Characteristics, Bank Management
(3rd ed.), USA: The Dryden Press, Harcourt Brace College Publishers. pp. 629-630.
16
Frederic S. Mishkin & Stanley G. Eakins.( 2012). Financial Markets and Institutions (7th
ed.).United States of America: Pearson Education Inc. 402.
17
Ibid
18
Tony Van Gestel & Bart Baesens, (2009), Credit Risk Management, Basic Concepts: Financial Risk
Components, Rating Analysis, Models, Economic And Regulatory Capital. Oxford, New York:
Oxford University Press. p. 94.
19
See [Link] (as of Jan. 31, 2011). In case of overdraft, a person is
allowed to overdraw his current account to a certain limit as specified by the bank. The interest is
paid on the amount outstanding against his/her balance and not on the amount of loan
sanctioned. A bill of exchange is drawn by a creditor on the debtor specifying the amount of debt
and the date on which it is payable. Before the maturity of the bill, a debtor can get it discounted
from the bank paying a very small interest.
20
N. T. Somashekar.(2009).Banking. New Delhi: New Age International Publication. p. 239.
21
See. <[Link] (as of Jan. 31, 2011). In case of Overdraft, a person is
allowed to overdraw his current account to a certain limit as specified by the bank. The interest is
paid on the amount outstanding against his/her balance and not on the amount of loan
sanctioned. A bill of exchange is drawn by a creditor on the debtor specifying the amount of debt
and the date on which it is payable. Before the maturity of the bill, a debtor can get it discounted
from the bank paying a very small interest. Generally lending problems emerge from the following
144 NJA Law Journal 2014

the terms ' lending' and 'loan'. 22 However, there is slight difference between '
lending' and 'credit'. In this study the terms 'lending', 'loan' and 'credit' are taken in
the same meaning as lending. 23

2. Significance / Importance / Benefits of Lending

One of the primary functions of a bank is lending or to grant loans. Whatever
money the bank receives by way of deposits, it lends a major part of it to its
customers by way of loans, advances, cash credit and overdraft. Interest received
on such loans and advances is the major source of its income. The banks make a
major contribution to the economic development of the country by granting loans
to the industrial and agricultural sectors. 24 Lending is the most important
function of bank. It is the main source of income of bank. It is a catalyst for the
economic development of a country. In this context, the significance of lending
business of bank may be mentioned as follows: 25

2.1. Major Source of Revenue of Bank

A major chunk of a bank's revenue comes from its lending activity. This is borne
out by the fact that as much as 60 percent of the total assets of a bank is
comprised of 'advances' and as much as 80 percent of the revenue emanates from
interest and discount , income derived from advances, including bills purchased
and discounted 26. It will not be a matter of exaggeration to say that the dominant
bank lending inspires confidence in the depositors and prospective customers of
the banking sector. 27

2.2. Basis of Credit Creation

The credit creating power of banking system is of great economic significance. It
results to take place at a relatively steady rate. Bank's lending acts as the basis for
credit creation in the banking and financial system of a country. Credit creation
function happens by way of the bank crediting and creating deposits in the

reasons; lending has become uncollectable due to mismanagement, Illegal manipulation of lending,
misguided lending policies, unexpected economic downturn, etc.
22
You loan something - meaning you get money to pay for something else. But you have to
eventually pay that back. You lend something to someone else. That means you give someone some
cash or something. Lending means you let him borrow it. Loaning means you let him use it, but
you must be payed back with interest. For example: John loaned me $100. That means I must pay
him back $100, along with some
23
You loan something - meaning you get money to pay for something else. But you have to
eventually pay that back. You lend something to someone else. That means you give someone some
cash or something. Lending means you let him borrow it. Loaning means you let him use it, but
you must be paid back with interest. For example: John loaned me $100. That means I must pay
him back $100, along with some
24
Supra note 20.
25
Dr S Gurusamy.(2010).Banking Theory, Law and Practice(2nd Ed). New Delhi: Tata McGraw Hill
Education Private Limited. p 219.
26
Ibid.
27
Ibid.
Lending Business of Banks in Nepal: A Legal Perspective 145

customer's account the loan amount by accepting the promise to pay from
borrowers. These deposits result in an increase in the volume of money supply,
and the economy is stimulated. 28

2.3. Driving Economic Growth

Bank credit is significant in that it is responsible for driving the expansion of
productive facilities and operations, which would otherwise be limited, by the
amount of savings accumulated by the economy. The elastic bank credit is reared
to the seasonal demands of business. Hence, bank credit governs and supports the
growing and changing economy infusing elastic money supply. 29

2.4. Agents of Production/Development

Lending acts as an agent of production. By making possible financing of the
agriculture, industrial and commercial activities of the country, lending facilities
economic development of the country. Further, banks also help fuel consumption
activities by creating constant demand for consumer goods like houses, furniture,
appliances, etc. by actively pursuing credit. 30.

3. Classification of Lending
Bank makes a wide variety of lending to a wide variety of customers for different
purposes. In the USA loans are classified into six types based on their Uniform
Bank Performance Report (UBPR).They are real estate loan, commercial or
industrial loan, individual or consumer loan, agriculture loan, and loan and lease in
domestic offices and loan and leases in foreign offices. Lending may be classified as
follows: 31

3.1. On the Basis of Nature of Loan

3.1.1. Overdraft Facility: A fluctuating account that indicates the aggregate
amount, by which a depositor has overdrawn the account, is known as overdraft.
Available to the current account holders of high standing and integrity, the
arrangement enables a customer to draw over and above the balance standing on
the credit to the account. Overdrafts are provided to cover borrowing of a
temporary fluctuating nature that will be repaid on the receipt of expected funds.
If a borrowing request does not confirm to this definition, then the facility would
be best provided in the form of a loan. 32

28
Ibid.
29
Ibid.
30
Ibid.
31
Madhu Sundar Shrestha, (2009) Fundamentals of Banking (3rd Ed.), Kathmandu: Buddha Academic
Publishers & Distributors Pvt. Ltd. p. 194.
32
C. Nicholas Rouse.( 2002).Bankers' Lending Techniques.(2nd ed.).London: Financial World
Publishing. p. 36.
146 NJA Law Journal 2014

3.1.2. Clean Advances: Clean advances are unsecured loans granted for a short
period after taking into account the net liquid resources of the borrower. After
study of three Cs of the borrower, viz. character, capacity and capital and after
determining that the borrower can repay at a short notice, the party is consider
eligible for such credits. In this type of advance, banks insist on personal
guarantees of the borrower. Besides, personal guarantees of the borrower and
third parties are also given weightage while granting clean advances.

3.1.3. Demand Loan: Demand loan is a working capital loan provided for not more
than a year. It is a revolving type of loan, which once settled is reinstated by the
settled amount. This means the customer can settle and withdraw as many times
as s/he pleases within the expiry period of the loan. When s/he needs the fund
s/he must give a demand letter and for settlement as well s/he must give a demand
letter and for settlement as well s/he must give a request letter to settle the
desired amount.

3.1.4. Term Loans: Loans that are granted for a certain period are known as term
loan. The most basic is the term loan, where a specified maturity date sets the time
for ultimate repayment. They vary from the short term (bridging finance, working
capital, trade finance) through the medium term (two to five years for working
capital, some capital expenditure), to the long term (project finance, capital
expenditure). A term loan can have a fixed repayment schedule. It can also be a
revolving facility, in that during its term the borrower can repay amounts but then
re-borrow, so long as the overall limit of the facility is not exceeded. 33

Thus the revolving credit facility is akin to the overdraft, which is a loan facility
enabling a customer of a bank to make payments from its account not in excess of
a set ceiling. But there is a vital difference: while a revolving credit facility is for a
fixed period—indeed powerful borrowers might negotiate them for five to ten
years for general corporate purposes—the overdraft is generally speaking
repayable on demand. It has been a criticism of British banks that, unlike the
German and Japanese banks, they have favored overdraft lending at the expense
of providing more certain, and longer-term financial backing for business. 34

[Link] Loans: Sometimes, when a lending institution fails to disburse the

loans already sanctioned either for want of completion of documentation
formalities or for want of resources, a commercial bank is requested to extend
loans for a temporary period as a stop gap arrangements which is known as 'bridge
loan'. Some other bank bridges the gap in providing loan, hence it is called bridge
gap loan.

[Link] Loan or Consortium Loans: When the borrower's demand of

advance is somewhat large and when two or more banks agree to advance a large
33
Ross Cranston.( 2007). Principles of Banking Law (2nd Ed.). United States, New York: Oxford
University Press Inc. P 229.
34
Ibid.
Lending Business of Banks in Nepal: A Legal Perspective 147

term loan jointly to the borrower, in a certain agreed proportion, against a

common security, such loans are called 'participation loans' or 'consortium
finance'. They are also called 'consortium advances'. The proportion of each of the
participating banks is decided among the member banks of the consortium. Such
loans are extended to meet large-size credit requirements of trade and industrial
houses.

3.1.7. Hire Purchase Loan: In case of hire purchase loan, the article belongs to the
owner (bank) and is given on hire to the customer. The hirer (borrower) will pay
the owner (bank), the hire money agreed between them by installments normally
on (EMI) i.e. on equal monthly installment basis over a period of time. If the hirer
fails to pay any installments due, the owner (bank) will have unrestricted and
undisputed right to take over the possession of the article or vehicle given on hire.
Banks entertain for vehicles and costly durable goods such as refrigerators and
television on hire purchase agreements. Nowadays, machinery and equipment are
also being financed under hire purchase scheme.

3.1.8. Time Loan: Time loan is also a working capital loan, given for a period of less
than one year and has a fixed maturity date. Time loans can be one time specific:
the borrower is not allowed to withdraw once settled, and revolving: once the loan
is settled, further drawing is allowed within the validity of the limit.

3.1.9. Trust Receipt Loan: Trust receipt loan is provided to importers against import
letter of credit (hereafter LC) established by the bank to make payment for the
goods arrived through the LC. Each trust receipt loan is treated as a specific time
loan having fixed maturity date i.e.30, 60, or 90 days.

3.1.10. Pre-Shipment Loan: It is a time loan of revolving nature provide to exporters

to manufacture goods for export, against the security of an Export LC. Once the
export houses receive LC from the importer, it may approach the bank for
financing the purchase of raw material, cost of labor and overhead, settle upfront
charges or to pay sub-contractors. Such type of finance is known as pre-shipment
finance.

3.1.11. Post-Shipment Loan: After completion of manufacturing of goods, the

exporter ships the goods as per the LC terms and submits all required documents
to the bank and requests for a loan which is called post-shipment loan (as it is
provided only after shipment of goods). Pre-shipment finance entails less risk
when compared with pre-shipment finance. In case of post shipment finance the
exporter receives the export LC first. S/he approaches the bank only after
manufacturing the goods or buying the goods from the market and making
shipment according to the terms and conditions of the LC.

3.1.12. Mortgage Loan: Loans extended against the strength of fixed assets
(mortgaged properties) like land and building is known as mortgage loan.
Mortgage loan can be in the form of term loan as well as overdraft which entirely
148 NJA Law Journal 2014

depends on the borrower's request. The main feature of this type of loan is that
the borrower need not have a firm to borrow. The borrower's earning source and
value of property will be sufficient to obtain such loans.

3.1.13. Bills Purchased and Discounted: Bill discounting constitute another

important type of lending made by a bank. Banks discount genuine commercial
and treasury bills. Loan amount constitutes the face value of the bill minus the
discount charges. Discount constitutes the income earned by the bank. Investment
in these bills is generally referred to as to third line of defense for the banks. The
banker gets back the money lent on or before the bill period. A strong bill market
presence is required for strong and healthy money. In bills purchased and
discounted, the banker holds the bills till the maturity date of the bill. On the
stipulated date of maturity, the drawee pays the banker and takes back the bills of
exchange originally deposited by the trader. In the event of the drawee failing to
make payment, the drawer has to make payment of the bill. However, the banker
takes into account the financial position and the integrity of the drawers/makers
before undertaking bill discounting.

3.1.14. Cash Credit: Cash credit is a credit given in cash to borrowers. It is the most
popular method of lending. Under cash credit system, a limit, called the credit
limit is specified by the bank. A borrower is entitled to borrow up to that limit. It is
granted against the security of tangible assets or guarantee. The borrower can
withdraw money, any number of times upto that limit. Borrower can also deposit
any amount of surplus funds with him from time to time. The borrower is charged
interest on the actual amount withdrawn and for the period such amount is
drawn. 35 Cash credits are generally allowed against the pledge or hypothecation of
goods, against book debts or personal security.

3.2. On the Basis of Sector-wise Loan Distribution

3.2.1. Real Estate Loan: A loans secured by real estate is considered as real estate
loans. It is the short-term loans for construction and land development and
longer-term loans for the purchase of farmland, homes, apartments, commercial
structures, and foreign properties. Real estate loans are amongst the most
profitable type of loan at the time of prosperity and it represents the highest
percentage of total loan in the commercial banks in the US. 36

3.2.2. Commercial or Industrial Loan: Commercial or industrial loans are extended to

finance the business of a burrower. It can be for financing the working capital
need, purchase of fixed assets and various other seasonal or miscellaneous
requirements. The financing can be for short term and long term needs.

35
Supra note 20. p. 242.
36
Supra note 31.
Lending Business of Banks in Nepal: A Legal Perspective 149

Commercial loans can be secured or unsecured and are primarily classified into
three categories: 37

[Link]. Short-term business loans: Short-term business loans typically have a term
of less than one year and may be used for purposes such as purchasing inventory
or for a seasonal need. 38

[Link]. Long-term business loans: Long-term business loans are made for a term
longer than one year and may be used for purposes such as expanding a business
or purchasing equipment. They are usually repaid from business income in
installments. 39

[Link]. Line of credit: A line of credit is essentially a preapproved credit limit

against which the business borrows. A line of credit can be closed or open end. In a
closed-end line of credit, the business borrows and repays the funds within a
certain time limit. In an open-end line of credit, the business can borrow any
amount up to the approved limit, make repayments, and borrow again up to the
limit. 40

3.2.3. Individual or Consumer Loan: Individual or Consumer loans are extended to

individual borrowers. The average size of consumer loans is relatively small.
Consumer loans are provided to finance durable goods in hire purchase like car,
refrigerator, washing machine etc. Nowadays banks finance the education, medical
care, travelling expenses etc. of individuals. The individual borrower's default risk
is high compared to commercial loans. Hence, the interest rates on such loans are
high in comparison to other types of loans. Consumer loans are normally repaid in
installments consisting of principle and interest on equal monthly installments
(EMI) basis. As the interest is also paid every month, the actual cost of fund to the
borrower comes to be higher than other loans. Such loan is also called 'retail loan'.
Individual or Consumer loans can be divided into two categories: 41

[Link]. Installment credit: Installment credit is essentially a loan or credit account

on which the payments (including interest) are made at regular intervals. If the
interest rate is fixed for a set term (such as a car loan), the payments are for a fixed
amount, and the loan amount and interest are fully repaid by the end of the term.
Installment credit can be secured or unsecured. 42

37
Deborah K. Dilley.(2008). Essentials of Banking .Hoboken, New Jersey: John Wiley & Sons, Inc.
p.12.
38
Ibid.
39
Ibid.
40
Ibid.
41
Ibid.
42
Ibid.
150 NJA Law Journal 2014

[Link]. Mortgage loans: Loans with real estate as the security for loan repayment
are commonly called mortgage loans. A customer usually obtains a loan to
purchase real property. 43

3.2.4. Agriculture Loan: The loans to finance farm and ranch operations, mainly to
assist in planting and harvesting crops and to support the feeding and care of
livestock are known agriculture loan. Such loans are quite similar to commercial
and industrial loans because loan is provided to finance the short term seasonal
credit need of the customers. The loan is utilized in purchase of seeds, pesticides,
fertilizers, wages of farm workers and various other production costs. The loan is
repaid when other crops are harvested and sold. Long term financing is extended
for purchase of live stock, tractor, combine machine, equipments and land.
Agriculture lending is considered extremely volatile because the price of agro
products rises and falls depending on the demand and supply of national and
international markets.

3.2.5. Loan and Lease in Domestic Offices: In the USA, lease financing is the most
import single source of funds to support business expenditures for capital
investments. Lease financing means letting or renting a building, a piece of land,
or equipments for a fixed period against which the leasee pays a lease rental fee for
the period. The regular fixed rental fee is paid on monthly, quarterly, half yearly
basis as per the agreements between the leaser and leasee. When the lease contract
ends, the assets revert to the leaser. A leasee is an individual or a firm which uses
an asset without owning it.

3.3. On the Basis of Security

3.3.1. Secured Loan: Secured loan is granted on the security of tangible assets, Sec.
5 (a) of the Indian Banking Regulation Act, 1949, defines a ‘secured loan or
advance’ as a loan or advance, made on the security of assets, the market value of
which is not at any time less than the amount of such loan or advance. 44 When
loan is fully secured by 100% cash margin or by instruments equivalent to cash
such as Fixed Term Deposits, Foreign Currency Deposits, Deposits under certain
Saving Schemes, Provident Fund Account etc. held in the bank's own account, it is
considered as secured risk loan. A secured loan is one in which an asset, such as
inventory or property, is pledged against repayment of the loan. For example, a
secured line of credit used to purchase inventory can be secured by that same
inventory. 45

3.3.2. Unsecured Loans: An unsecured line of credit used to purchase the inventory
is not secured by the inventory; rather, the line of credit is granted primarily
because of the good credit history of the business. 46 Such a loan is granted without

43
Id. p.14.
44
Supra note 20, p. 246.
45
Supra note 37.
46
Ibid.
Lending Business of Banks in Nepal: A Legal Perspective 151

any security. According to Sec. 5 (a) of the Indian Banking Regulation Act, 1949 an
unsecured loan or advance means a loan or advance not so secured. 47

3.3.3. Sovereign Risk Loan: When loan is provided against government security such
as National Savings Bond, Development Bonds, Treasury Bills issued by central
bank or against government guarantee, it is considered as sovereign risk loan.

3.3.4. Bank Risk Loan: When loan is provided against the security of fund held in
some other bank, it is considered as bank risk loan. Loan against Fist Term
Deposit certificate issued by another bank or loan against Guarantee or Stand by
LC issued by local or foreign bank loan against funds placed at call with local or
foreign bank etc are the examples of bank risk loan.

3.3.5. Casual Risk Loan: When negotiable instruments are purchased casually such
as cheques, drafts, bills etc. and where the instrument itself serves as the security
for the advance, it is considered as casual risk loan. Regular facility is not provided
for such purchase facility.

3.3.6. Clean Risk Loan: Loans and overdrafts provided without any security in a
casual way falls in clean risk loan.

3.4. On the Basis of Purpose

For which purpose a loan is being taken? It may be for the following purposes: 48

3.4.1. Commercial Loans: This loan is taken to meet short term requirement of
capital e.g., working capital. 49

3.4.2. Consumer Loan: This loan is taken to finance household goods like fridge,
T.V., scooter etc. 50

3.4.3. Agricultural Loan: Such a loan is taken by the farmers to meet their short
term requirements like buying seeds, fertilizers, insecticides etc. 51

3.5. On the Basis of Time

3.5.1. Short Term Loan: Short term loan is taken for a period of less than one year.
For example, a loan taken to meet working capital requirements etc.

3.5.2. Medium Term Loan: Medium term loan is taken for a period ranging from 1
year to 3 years. For example, a loan taken to purchase equipments for
professionals or furniture etc.

47
Supra note 20, p. 246.
48
Ibid.
49
Ibid.
50
Ibid.
51
Ibid.
152 NJA Law Journal 2014

3.5.3. Long Term Loan: Long term loan is taken to meet long-term requirements
from 3 years to 20 years or more. For example, loans to purchase land, building,
plant and machinery etc. However, banks provide long-term loans to a very limited
extent only. 52

3.6. On the Basis of Fund

3.6.1. Funded: Funded loan facilities offered, cash is involved such as Overdraft
(OD) facility, Demand Loan, Time Loan, Short Term Loan, Long Term Loan etc.

3.6.2. Non-funded: Non-funded facilities, cash are not involved but only the
contingent liabilities increase. Letter of Credit, Guarantee etc. facilities offered by
bank is non funded facilities.

3.7. On the Basis of Form of Lending

3.7.1. Loans/Advances: A loan is a type of advance granted by a banker where by the
entire amount is paid to the borrower in one lump sum and at one time, either in
cash or by transfer to his shavings or current account. No subsequent debt is
ordinarily allowed except by way of interest, incidental charges, insurance
premiums, expenses incurred for the protection security, etc. Repayment happens
usually by installments. Interest is charged on the loan outstanding. 53

This is the oldest and very popular form of lending by the banks. In case of loans,
financial assistance is given for a specific purpose and for a fixed period. The
customer can withdraw the entire amount of loan in a single installment. As such,
interest is payable on the entire amount. In case he needs the funds again, he has
to make a fresh application for a new loan or renewal of the existing one.
Ordinarily, the loan is repayable in one installment. However, a customer may
return the loan in more than one installment also. 54

3.7.2. Overdrafts: A fluctuating account that indicates the aggregate amount, by

which a depositor has overdrawn the account, is known as overdraft. Available to
the current account holders of high standing and integrity, the arrangement
enables a customer to draw over and above the balance standing on the credit to
the account. Overdrafts are provided to cover borrowing of a temporary
fluctuating nature that will be repaid on the receipt of expected funds. If a
borrowing request does not confirm to this definition, then the facility would be
best provided in the form of a loan. 55

The security in an overdraft account may be either personal or tangible. The

tangible securities shares, debentures Government papers, life insurance policies,

52
Ibid.
53
Supra note Note 25.p. 225.
54
Supra note Note 20.p.241.
55
C. Nicholas Rouse.( 2002).Bankers' Lending Techniques(2nd Ed.).London: Financial World Publishing.
p. 36.
Lending Business of Banks in Nepal: A Legal Perspective 153

fixed deposit receipts, etc. An overdraft facility is granted to a customer on a

written request. Sometimes, it may be implied where a customer overdraws his
account and the bank honours his cheques. 56

Overdraft can be split into the following categories: 57

[Link]. Agreed overdrafts: Agreed overdraft limits fall into the following types:

[Link].1. Short-term to cover a specific requirement: Essentially a small bridging

facility and source and timing of the repayment should be made clear at the outset
consideration should be given to obtaining control over the source of repayment
by , for example, selling shares which are to be the source of repayment through
the bank's own broker. 58

[Link].1. Renewable / revolving: A facility that is essentially to be used as a standby.

Into this category fall Save and Borrow Accounts and Budget Accounts as well as
ordinary overdraft facilities. Assessment may be by way of credit scoring or
individual appraisal. With the latter it will be necessary for the lender to be
satisfied that a customer's future income will be sufficient to repay any temporary
borrowing. 59

[Link]. Unauthorized overdraft: For most customers there is a level to which a bank
would be prepared to allow an overdraft without insisting on a formal
arrangement. It is not cost effective or realistic in these days of readily available
consumer credit to require that a customer always asks before going overdrawn. 60
Banks generally have coped with this problem by setting an overdraft limit on
individual accounts that has not been advised to the customer. 61

[Link]. Temporary Overdrafts: Temporary overdrafts are unsecured overdrafts

granted by bankers for small amounts to customers having current accounts with
them. The facility is provided to salaried officials or persons engaged in trade or
industry. The extent of loan is limited to the expected monthly cash flow or the
borrower. Temporary overdrafts are granted against the reliable source of funds
available to a borrower for early repayment. The granting of temporary overdrafts
facility will depend on the continuity of the service of the employee concerned.
Strict control is exercised over such advances. Prior sanction from the authorities
is usually required for sanctioning such temporary overdrafts.

56
Supra note 20. p. 243. See also [Bank of Maharashtra Vs M/s United Construction Co. and Others
(1985) Bom. 432 A.I.R.].
57
Supra Note 55.p. 37.
58
Supra note 55.
59
Supra note 55.p.37.
60
Ibid.
61
Ibid.
154 NJA Law Journal 2014

3.7.3. Cash Credit: Cash credit is the most popular method of lending by the banks.
Under cash credit system, a limit, called the credit limit is specified by the bank. A
borrower is entitled to borrow up to that limit. It is granted against the security of
tangible assets or guarantee. The borrower can withdraw money, any number of
times up to that limit. He can also deposit any amount of surplus funds with him
from time to time. He is charged interest on the actual amount withdrawn and for
the period such amount is drawn. 62

It is essentially a drawing account against credit granted by the bank. It is operated

in the same way as a current account on which an overdraft is sanctioned. Cash
credits are generally allowed against the pledge or hypothecation of goods, against
book debts or personal security.

A cash credit is distinguished from overdraft in that a borrower is permitted to

withdraw cash from the account in the case of cash credit facility, whereas in the
case of an overdraft facility the borrower can withdraw only thorough cheques.
Under the overdraft system, the amount to the loan is credited to the account of
the borrower. Hence, the overdraft facilities are available only to the depositors of
the bank. As against this the amount give by way of loan under the cash credit
system is not credit to the current account to the borrower. On the contrary, a new
account is opened in the name to the borrower who is allowed to withdraw from
time to time small amount to money up to the prescribed limit.

3.7.4. Housing Loans: It is a loan provided housing finance activities. An important

form of advance provided by a modern banker is 'housing finance'. Housing loans
constitute a major segment of deployment of funds by a banker. In fact, a substantial
portion of the earnings of a bank emanates from the housing finance activities.

3.7.5. Loans to small Borrowers: These are the kind of loans advanced to small
borrowers such as the common person and self-employed persons, say doctors,
engineers etc. Banks under the 'social sector lending' advance such loans. The
purpose of granting such loans is to help the weaker sector of the economy to
improve their living standards. Loans are granted on the strength of borrower's
credit worthiness and capacity.

3.7.6. Project Financing: Project financing is often defined as financing of a major

independent capital investment without recourse to the borrower and secured
purely on the anticipated earnings of the project itself. In other words, the
sponsoring company has segregated the financing of the project from its assets
and general-purpose obligations. 63

62
Supra note 20.p.242.
63
Sang M. Lee & Hyun B. Eom.(1989).A Multi-Criteria Approach to Formulating International
Project-Financing Strategies. The Journal of the Operational Research Society, Vol. 40, No. 6, pp. 519-
528(519). See. < [Link]/stable/2583540>(as of Sept. 19, 2012).
Lending Business of Banks in Nepal: A Legal Perspective 155

Project finance is intended to finance specific large-scale, capital-intensive projects

such as the construction of a chemical plant or public infrastructure projects (e.g.,
hospitals, roads, and so on). It has become widely used for high-profile corporate
ventures, including the construction of Euro Disneyland in Paris, France, among
others. A project finance facility requires a high level of financial engineering,
because it must be structured so that the risk and reward allocations are
acceptable to the entire group of project parties involved. 64

Consequently, the intricacies of the facilities can be complex to arrange and

administer due to the number of different contractual parties involved. As the
construction of major building projects such as an oil and gas refinery involves the
contribution of so many participants, project finance transactions are structured
with risk-sharing matrices based on a complex set of contracts. Because of the
number of parties that can be involved, each of the project supporters will
naturally have different perceptions and risk appetites. This can affect the roles
played by each project participant, which in turn can lead to individual risk and
return issues. 65 For project financing to be successfully achieved, several types of
risks must be properly considered, monitored and managed throughout the life of
the project. 66

4. Approaches of Lending
There are various approaches to lend by the banks, such as (a) Security approach
(b) Need oriented approach (c) Project oriented approach and (d) Person oriented
approach. 67

4.1. Security approach

Security oriented approach offer credit against some tangible goods as security to
cover the advance. The borrowers are only those who already owned large
resources that are available for the security.

4.2. Need oriented approach

The need oriented approach of lending by banks is developed to meet the need of
working capital for the project of due importance but could not provide security.

4.3. Project oriented approach

Project oriented approach became necessary to finance the small projects where
the securities were not possible to be provided and the risk was also high. The
banks required to invent in small projects in various segments of priority sectors

64
Supra note 12.p.94.
65
Id.p.95.
66
Supra note 63. pp. 519-528(520).
67
Sunity Shrestha.(1995). Portfolio Behaviour of Commercial Banks in Nepal. Kathmandu: Sunity
Shrestha. p 51.
156 NJA Law Journal 2014

and other projects and try to make them capable of generating cash to repay the
loan instead of taking the tangibles security for loan.

4.4. Person oriented approach

The need oriented approach of lending by banks is developed to meet the need of
working capital for the project of due importance but could not provide security.

5. Principles of Good Lending

A banker should use his third eye and third ear (although the God has given him
only two eyes and two ears) while granting loans. In other words, banker must be
extra careful while granting loans. 68 The followings are the basic principles of
sound lending observed by banks. The ways in which the basic principles are
followed, of course, may be modified to suit the need of the hour. The main
principles of good lending may be mentioned as follows: 69

5.1. Safety
The most important golden rule for granting loans is the safety of funds. The main
reason for it is that the very existence of the bank is dependent upon the loans
granted by him. In case the bank does not get back the loans granted by it, it might
fail. A bank cannot and must not sacrifice the safety of its funds to get higher rate
of interest. For example, if a reputed credit-worthy businessman offers to pay 10%
interest per annum and on the other hand a pauper offers 15% rate of interest per
annum. Obviously as per safety rule, the banker should not grant loan to the
pauper although paying 5% higher rate of interest. 70

"Safety first" is the most important principle of good lending. When a banker
lends, he must feel certain that the advance is safe; that is, the money will
definitely come back. If, for example, the borrower invests the money in an
unproductive or speculative venture, or if the borrower himself is dishonest, the
advance would be in jeopardy. 71

Similarly, if the borrower suffers losses in his business due to his incompetence,
the recovery of the money may become difficult. The banker ensures that the
money advanced by him goes to the right type of borrower and is utilized in such a
way that it will not only be safe at the time of lending but will remain so

68
Supra note 20.
69
Yogendra Regmi. (2007). Modern Banking of Nepal (2nd ed.).Kathmandu: Eagle Eye Research
Institute (Pvt.).p. 122. See also Principles of Good Lending: Every Banker Follow-Loans. See. <
[Link] (as of
Feb. 15, 2012).
70
Supra note 20.p.240.
71
Supra note 69.
Lending Business of Banks in Nepal: A Legal Perspective 157

throughout, and after serving a useful purpose in the trade or industry where it is
employed, is repaid with interest. 72

5.2. Liquidity
The second important golden rule of granting loan is liquidity. Liquidity means
possibility of converting loans into cash without loss of time and money. Needless
to say, that the funds with the bank out of which he lends money are payable on
demand or short notice. As such a bank cannot afford to block its funds for a long
time. Hence, the bank should lend only for short-term requirements like working
capital. The bank cannot and should not lend for long-term requirements, like
fixed capital. 73

For example, an advance of Rs.50 lakhs on the security of a legal mortgage of a

bungalow of the market value of Rs. 100 lakhs, will be very safe. If, however, the
recovery of the mortgage money has to be made through a court process, it may
take a few years to do so. The loan is safe but not liquid. 74

It is not enough that the money will come back; it is also necessary that it must
come back on demand or in accordance with agreed terms of repayment. The
borrower must be in a position to repay within a reasonable time after a demand
for repayment is made. This can be possible only if the money is employed by the
borrower for short-term requirements and not locked up in acquiring fixed assets,
or in schemes which take a long time to pay their way. 75

The source of repayment must also be definite. The reason why bankers attach as
much importance to 'liquidity' as to safety' of their funds, is that a bulk of their
deposits is repayable on demand or at short notice. If the banker lends a large
portion of his funds to borrowers from whom repayment would be coming in but
slowly, the ability of the banker to meet the demands made on him would be
seriously affected in spite of the safety of the advances. 76

5.3. Purpose
The purpose should be productive so that the money not only remain safe but also
provides a definite source of repayment. The purpose should also be short termed
so that it ensures liquidity. Banks discourage advances for hoarding stocks or for
speculative activities. There are obvious risks involved therein apart from the anti-
social nature of such transactions. 77

72
Supra note 69.
73
Supra note 20.p.240.
74
Supra note 69.
75
Ibid.
76
Ibid.
77
Ibid.
158 NJA Law Journal 2014

The banker must closely scrutinize the purpose for which the money is required,
and ensure, as far as he can, that the money borrowed for a particular purpose is
applied by the borrower accordingly. Purpose has assumed a special significance in
the present day concept of banking. 78

A banker should thoroughly examine the object for which his client is taking loans.
This will enable the bank to assess the safety and liquidity of its investment. A
banker should not grant loan for unproductive purposes or to buy fixed asset. The
bank may grant loan to meet working capital requirements. However, after
nationalization of banks, the banks have started granting loans to meet loan-term
requirements. As per prudent banking policy, it is not desirable because of term
lending by banks a large number of banks had failed in Germany. 79

5.4. Profitability
Return or profitability is another important principle. The funds of the bank
should be invested to earn highest return, so that it may pay a reasonable rate of
interest to its customers on their deposits, reasonably good salaries to its
employees and a good return to its shareholders. However, a bank should not
sacrifice either safety or liquidity to earn a high rate of interest. Of course, if safety
and liquidity in a particular case are equal, the banker should lend its funds to a
person who offers higher rate of interest. 80

Equally important is the principle of 'profitability' in bank advance like other

commercial institutions, banks must make profits. Firstly, they have to pay
interest on the deposits received by them. They have to incur expenses on
establishment, rent, stationery, etc. They have to make provision for depreciation
of their fixed assets and also for any possible bad or doubtful debts. After meeting
all these items of expenditure which enter the running cost of banks, a reasonable
profit must be made; otherwise, it will not be possible to carry anything to the
reserve or pay dividend to the shareholders. 81

5.5. Spread
‘One should not put all his eggs in one basket’ is an old proverb, which very clearly
explains this principle. A bank should not invest all its funds in one industry. In
case that industry fails, the banker will not be able to recover his loans. Hence, the
bank may also fail. According to the principle of diversification, the bank should
diversify its investments in different industries and should give loans to different
borrowers in one industry. It is less probable that all the borrowers and industries
will fail at one and the same time. 82

78
Ibid.
79
Supra note 20.p.240.
80
Ibid.
81
Supra note 69.
82
Supra note 20.p.240.
Lending Business of Banks in Nepal: A Legal Perspective 159

For example, if it has advanced too large a proportion of its funds against only one
type of security, it will run a big risk if that class of security steeply depreciates. If
the bank has numerous branches spread over the country, it gets a wide
assortment of securities against the advances. Slump does not normally affect all
industries and business centers simultaneously.

Another important principle of good lending is the diversification of advances. An

element of risk is always present in every advance, however secure it might appear
to be. In fact, the entire banking business is one of taking calculated risks and a
successful banker is an expert in assessing such risks. Bank is keen on spreading
the risks involved in lending, over a large number of borrowers, over a large
number of industries and areas, and over different types of securities. 83

5.6. Security
A banker should grant secured loans only. In case the borrower fails to return the
loan, the banker may recover his loan after realizing the security. In case of
unsecured loans, the chances of bad debts will be very high. However, the bank
may have to relax the condition of security in order to comply with the economic
policy of the government. For example, loans to weaker sections of society may be
given without security if so directed by the government. 84

5.7. Margin Money

In case of secured loans, the bank should carefully examine and value the security.
There should be sufficient margin between the amount of loan and the value of the
security. If adequate margin is not maintained, the loan might become unsecured
in case the borrower fails to pay the interest and return the loan. The amount of
loan should not exceed 60 to 70% of the value of the security. If the value of the
security is falling, the bank should demand further security without delay. In case
it fails to do so, the loan might become unsecured and the bank may have to suffer
loss on account of bad debt. 85

5.8. National Interest, Suitability, etc.

Even when an advance satisfies all the aforesaid principles, it may still not be suitable.
The Central bank may have issued a directive prohibiting bank to allow the particular
type of advance. The law and order situation at the place where the borrower carries on
his/her business may not be satisfactory. There may be other reasons of a like nature
for which it may not be suitable for the bank to grant the advance. 86

Banks were nationalized in India to have social control over them. As such, they
are required to invest a certain percentage of loans and advances in priority sectors
viz., agriculture, small scale and tiny sector, and export-oriented industries etc.

83
Supra note 69.
84
Supra note 20.p.240.
85
Supra note 20.p.241.
86
Supra note 69.
160 NJA Law Journal 2014

Again, the Reserve Bank also gives directives in this respect to the scheduled banks
from time to time. The banks are under obligations to comply with those
directives. 87 NRB has also issued directives in this respect.

In the changing concept of banking, factors such as purpose of the advance,

viability of the proposal and national interest are assuming a greater importance
than security, especially in advances to agriculture, small industries, small
borrowers, and export-oriented industries. 88

5.9. Character of the Borrower

The bank should carefully examine the character of the borrower. Character
implies honesty, integrity, creditworthiness and capacity of the borrower to return
the loan. In case it fails to verify the character of the borrower, the loans and
advances might become bad debts for the bank. 89

6. Lending Criteria
The credit appraisal criteria may be discussed as follows: 90

6.1. Character
The most important factor to be carefully examined is the character of the
borrower. Character is the sum total of honesty, integrity, credit-worthiness,
capacity to repay, sense of responsibility, good habits and reputation enjoyed by
the customer. If he possesses these qualities he bears a good character and can be
considered creditworthy for the loan. 91

Past dealing of the customer, reveal the character in case of existing parties.
Character is not judged by the social or philanthropic work one does or the
exemplary literary or cultural achievements one has to his credit, but it is that
respect one commands in the business world. Good character is indicated by the
honesty of the borrower. Borrower should consider the banker as a financial
partner or financial doctor to counsel for which s/he has to present all business
information to the banker without any hesitation. Trust is important in credit. If
anything is hidden and later it comes to the notice of the banker, the credibility of
the borrower is lost or suspected. 92

87
Supra note 20.p.241.
88
Supra note 69.
89
Supra note 20.p.241.
90
Shakespeare Vaidya.(1999).Banking Management(2nd Ed.).Kathmandu: Monitor Nepal. p.75.
91
Supra note 20.p.246.
92
Supra note [Link]. 75-76.
Lending Business of Banks in Nepal: A Legal Perspective 161

6.2. Capacity
If the borrower is fully capable of running the enterprise and has necessary skill
and experience, his chances of success are high. As such there is little or no risk in
granting loans. 93

Capacity of borrower means his/her business acumen and managerial ability to

deal with mean and matters so that s/he would be able to make effective and
profitable use of funds thereby able to repay the dues. Qualifications, experience,
maneuvering skill, past dealings of the party in bank and enquiries reveal a great
deal about the capacity of borrowers. 94

6.3. Capital
An entrepreneur should have an adequate capital of his own. If his capital is
inadequate there are greater chances of failure of his business. As such, the banker
will not be able to recover his loan in such a situation. 95

Capital represents the funds invested in the business by owners. The extent of
funds provided represents their stake or involvement. More of the capital means
more of their stake. Loans given to such concerns are safe where the capital
provided is considerable. Where the capital is negligible and the business is mostly
carried on with borrowed funds there is likelihood of owners not so committed to
efficient management, since any loss would wipe off the borrower funds and does
not affect own money. Further, more capital means that most of the assets are
acquired from own funds. Thus the security of assets taken for advances provides a
lot of margin. In other words, capital represents margin for bank's security. 96

6.4. Soundness of the Project

The banker should carefully examine the project report to ascertain its viability
and soundness. If the project is sound and viable the banker will be able to recover
his debt. On the other hand, if the project is unsound the project will fail. The
banker will not be able to recover his loan. 97

7. Collateral / Security of Lending

Property or other assets that a borrower offers a lender to secure a loan. If the
borrower stops making the promised loan payments, the lender can seize the
collateral to recoup its losses. Because collateral offers some security to the lender
in case the borrower fails to pay back the loan. Loans that are secured by collateral

93
Supra note 20.p.246.
94
Supra note 92.
95
Supra note 20.p.246.
96
Supra note 92.
97
Supra note 20.p.246.
162 NJA Law Journal 2014

typically have lower interest rates than unsecured loans. A lender's claim to a
borrower's collateral is called a lien. 98

A mortgage is a security interest in real property held by a lender as a security for a

debt, usually a loan of money. A mortgage in itself is not a debt; it is the lender's
security for a debt. It is a transfer of an interest in land (or the equivalent) from
the owner to the mortgage lender, on the condition that this interest will be
returned to the owner when the terms of the mortgage have been satisfied or
performed. In other words, the mortgage is a security for the loan that the lender
makes to the borrower. 99 A debt instrument, secured by the collateral of specified
real estate property, that the borrower is obliged to pay back with a predetermined
set of payments. Mortgages are used by individuals and businesses to make large
real estate purchases without paying the entire value of the purchase up front.
Over a period of many years, the borrower repays the loan, plus interest, until
he/she eventually owns the property free and clear. Mortgages are also known as
"liens against property" or "claims on property." If the borrower stops paying the
mortgage, the bank can foreclose. 100

Loans with the collateral requirements are often referred to as secured loans.
Collateral, which is property, promised to the lender as compensation if the
borrower defaults, lessens the consequences of adverse selection because it
reduces the lender’s losses in the case of a loan default. It also reduces moral
hazard because the borrower has more to lose from a loan default. If a borrower
defaults on a loan, the lender can sell the collateral and use the proceeds to make
up for its losses on the loan. Collateral requirements thus offer important
protection for financial institutions making loans, and that is why they are
extremely common in loans made by financial institutions. 101

Collateral requirements are even larger for small businesses in developing

countries and in backward regions of developed economies. For instance, Harhoff
and Korting report that small firms from the former East Germany tend to pledge
collateral more often than their counterparts in the former West Germany. 102

98
Retrieved from <[Link] on 2 April 2014. If you get
a mortgage, your collateral would be your house. If you stop making your monthly house
payments, the lender can take possession of the home through a process called foreclosure and sell
it to get back the principal it lent you. In margin trading, the securities in your account act as
collateral in case of a margin call. Similarly, if you were to stop making your payments on an auto
loan, the lender would seize your vehicle. When you borrow money with a credit card, however,
there is no collateral, so credit card debt carries a significantly higher interest rate than mortgage
debt or auto loan debt.
99
See. <[Link] (as of Apr.2,2014).
100
See <[Link] (as of Apr. 2, 2014).
101
Michael Manove, A. Jorge Padilla & Marco Pagano.(2001).Collateral Versus Project Screening: A
Model of Lazy Banks. The RAND Journal of Economics. Vol. 32, No. 4. pp. 726-744(728).See.<http://
[Link]/stable/2696390> (as of Nov.25, 2012).
102
Ibid.
Lending Business of Banks in Nepal: A Legal Perspective 163

The main benefit of collateral in debt contracts is to temper moral hazard on the
debtor's side. Debtors have the incentive to engage in opportunistic behavior at
their creditors' expense, such as asset substitution, inadequate supply of effort,
and underinvestment, as shown by Myers, Smith and Warner, and Stulz and
Johnson, among others. 103

The debate about the pros and cons of collateral exemptions is part of the wider debate
about the balance to be struck between the protection of creditor rights and the
safeguard of debtor incentives. This debate is especially intense in connection with the
possible reform of bankruptcy procedures in the United States. 104

Intuitively one would think that riskier borrowers have to provide more collateral
and obtain less credit because banks try to reduce their exposure to such
borrowers. On the other hand good borrowers are more likely to pledge collateral
because in general they should have more assets available. This second view is
supported by Bester and Besanko and Thakor in their models of borrower selection
at the beginning of a bank-borrower relationship. Additionally, Boot and Thank or
demonstrate that the duration of a bank-borrower relationship has effects on
collateral as well as on interest rates. They show that borrowers have to pay high
interest rates and pledge collateral in early stages of the relationship, whereas they
get lower rates and do not need to pledge collateral later on, when successful
projects and thus good borrowers are identified. 105

Collateral is a powerful instrument in dealing with moral hazard even though it

imposes a (deadweight) repossession cost on the bank. We obtain sufficient
conditions under which riskier borrowers pledge more collateral. 106

8. Credit Rating Agency

A credit rating agency (hereafter CRA, also called a Ratings Service) is a company
that assigns credit ratings- rating of the debtor's ability to pay back the debt by
making timely interest payments and of the likelihood of default. An agency may
rate the creditworthiness of issuers of debt obligations, the debt instruments,
and/or in some cases, the servicers of the underlying debt, but not individual
consumers. 107 Debt instruments the agencies rate may include government bonds,

103
Supra note 101. pp. 726-744(729).
104
[Link]. 726-744(740).
105
Achim Machauer & Martin Weber.(1998).Bank Behavior Based on Internal Credit Ratings of
Borrowers. CFS Working Paper No. 98/08.p 6.
106
Arnoud [Link]; Anjan V. Thakor & Gregory F. Udell.(1991).Secured Lending and Default Risk:
Equilibrium Analysis, Policy Implications and Empirical Results. The Economic Journal. Vol.101, No.
406. pp.458-472(458).
107
See. <[Link] of Apr.2,2014).
164 NJA Law Journal 2014

corporate bonds, municipal bonds, preferred stock, and collateralized securities,

such as mortgage-backed securities and collateralized debt obligations etc. 108

Regulatory reform in the United States is to include tighter regulation of credit

rating agencies’ policies and procedures regarding subjects similar to those of the
new EU regime. Another idea under consideration is that there should be
increased civil liability for credit rating agencies, a move long resisted by the
agencies, which maintain that it would conflict with their right to freedom of
speech. Japan has also introduced reforms designed to achieve objectives similar
to those of the EU and United States. 109

The Basel Committee is reviewing Basel 2’s use of credit ratings in its procedures
for setting minimum regulatory charges for credit risk. In the context of Basel 2 as
a global standard reliance on such ratings is most important under heading of the
simplest Standardized Approach to setting minimum regulatory capital charges,
though ratings are also incorporated in other rules of the agreement such for the
charges for securitization exposures. 110

Rating agencies have been around since the beginning of the 20th century, but it
was only in 1936 that US bank regulators 111 required banks to invest only in bonds
that had ratings investment grade as recognized by those agencies, giving them
certain “regulatory power”. Another major shift occurred in 1975 when the
Securities and Exchange Commission (SEC) created the category of “nationally
recognized statistical rating organization” (hereafter NRSRO) and “grandfathered”
S&P, Moody’s and Fitch into that category, and institutionalizing “a legal
monopoly” that was extended to other 5 smaller firms in the next 25 years. John
Moody had established an “investor model” in 1909, but in the 1970s the NRSROs
switched to an “issuers pay” model, recognizing that it would be easier to get
business. 112

Both in the U.S. and in Europe, credit ratings are generally used for five key
purposes: (1) determining capital requirements; (2) identifying or classifying
assets, usually in the context of eligible investments or permissible asset
concentrations; (3) providing a credible evaluation of the credit risk associated

108
Alessi, Christopher. The Credit Rating Controversy. Campaign 2012. See.
<[Link] (as of Apr. 2, 2014).
109
Andrew Cornford. (2010).Revising Basel The Impact of the Financial Crisis and Implications for
Developing Countries. Research papers for the Intergovernmental Group of Twenty-Four
International Monetary Affairs and Development, G-24 Discussion Paper No. 59,
UNCTAD/GDS/MDP/G24/2010/2, United Nations: New York and Geneva. p 12.
110
Ibid.
111
The first regulatory reference to the ratings in the U.S. is found in 1931 in the Office of the
Comptroller of the Currency (OCC) and Federal Reserve examination rules, and was mainly based
on distinction between investment grade securities, generally rated BBB/Baa and above, and
securities of below-investment grade quality.
112
Abel Mateus. (2009). After the Crisis: Reforming Financial Regulation. Revista Finanças Publicas e
Direito Fiscal.p.16. See. < [Link] (as of Nov. 25, 2012).
Lending Business of Banks in Nepal: A Legal Perspective 165

with assets purchased as part of a securitization offering or a covered bond

offering; (4) determining disclosure requirements; and (5) determining prospectus
eligibility. Rating agencies themselves ascribe widespread use of credit ratings by
the market participants to the following attributes: (i) Independent: it is believed
to be unbiased towards any particular set of interests, (ii) Forward-looking:
required for investment decisions, thus ratings should serve as reliable indicators
of relative ability of bond issuers to honor their payment obligations upon
maturity of the bonds, (iii) Stable: ratings are meant to be driven by fundamentals
of the issuing entity and not much affected by economic cycles, (iv) Simple, and
easy to understand: just a letter symbol captures the essence of the risk category,
and (v) Broad: by covering a multitude of instruments and asset classes, the
system would allow for direct comparison of relative creditworthiness. 113

Now, it is widely recognized that the favorable ratings attributed by rating

agencies, eager to satisfy their issuers, and subject to “ratings shopping” problems,
fuelled the subprime mortgage crisis, by over-rating large amounts of
collateralized debt obligations (CDO). Thus, the problem of “rating inflation” to
solve is that regulators have “outsourced” regulation to rating agencies which
incentive is aligned to issuers (who pay them) that pretend to have the highest
possible rating for their paper. 114

Instead, investors in asset-backed securities rely heavily on rating agency analysis.

Moreover, regulators outsourced a large measure of oversight over the risk that
these investors take on to those rating agencies. Rating agencies, for example
Moody’s, Standard & Poor’s and Fitch, then apply their own proprietary risk
models to analyze the securitization. Like those entities that sponsor
securitizations, rating agencies rely on the originators to provide information on
the underlying assets. Indeed, rating agencies admit to conducting little
independent investigation of securitization beyond the information provided to
them by either originators or the firms sponsoring a securitization. Some rating
agencies have even admitted to conducting little analysis of underlying assets. 115

In Nepal ICRA Nepal Limited (hereafter ICRA Nepal) is the first Credit Rating
Agency. It is a Subsidiary of ICRA Limited (ICRA) of India. It was incorporated on
November 11, 2011 and granted license by the Securities Board of Nepal (SEBON)
on October 3, 2012. 116

113
Ibid.
114
Ibid.
115
Erik F. Gerding.(2009).The Outsourcing o Financial Regulation to Risk Models and the Global
Financial Crisis: Code, Crash, and Open Source. P.15. See <[Link] abstract=1273467> (as
of Jan. 18,2013).
116
See. <[Link] (as of Apr.2, 2014).
166 NJA Law Journal 2014

9. Law and Lending

The best thing that legislators can do for the development and efficiency of the
credit market is to grant a steely protection to the creditor right to repossess
collateral and eliminate bankruptcy exemptions (or reduce them to a
minimum). 117

We find that bankers allocate a significantly larger portion of their assets to risky
loans: (i) when they enjoy English common-law legal origin rather than French
civil-law legal origin; (ii) when creditors’ rights are weaker; (iii) when their banks
are larger; and (iv) when the largest shareholder has a lower percentage ownership.
We also find that bankers in developing countries, but not in developed countries,
allocate a significantly larger portion of their assets to risky loans when legal
enforcement of creditor rights is more efficient. Overall, these results provide
strong support for the theory of legal origin but provide only mixed support for
the “power” theories of credit. 118

Corporate finance flourishes in countries with legal systems that better protect
investors’ rights and support contract enforcement. In addition, the authors find
that a country’s “legal origin” is a fundamental determinant of investor protection.
“Legal origin” refers to the legal family from which a country’s legal system
evolved. 119

Secured loans have higher recoveries, especially when the collateral takes the form
of inventories and accounts receivable. Loans to borrowers with prior defaults
yield higher recoveries than first-time defaults and arranging a prepackaged
bankruptcy increases recoveries. Loan recoveries vary significantly with the length
of time to emerge and in a nonlinear manner. 120

9.1. The Judiciary and Lending

The ability of the judiciary to enforce the law is absolutely crucial in lending. 121 In
relation to debt investments, insolvency law and the rules governing security
interests are especially significant. A creditor must feel able to manage its risk in
the event that the debtor defaults. In relation to equity finance, corporate law
must enable parties taking part in a venture capital transaction to overcome any
117
Supra note [Link]. 726-744.
118
Rebel A. Cole, & Rima Turk-Ariss.(2008). Legal Origin, Creditor Protection and Bank Lending
Around the World. p.1. See. < [Link] (as of Jan. 13,20013).
119
Id.p.5.
120
Hinh D. Khieu, Donald J. Mullineaux & Ha-Chin Yi.(2012). The Determinants of Bank Loan
Recovery Rates. The Journal of Banking and Finance. pp. 2-39(30).See.<[Link]
abstract=2029923>(as of Jan. 20,2013).
121
Sophie Vermeille.(2012).The Legal System and The Development of Alternative Methods of
Financing to Bank Credit; Or How French Law Has Failed to Adapt to the Evolution of the
Economy and Finance .Researcher, Legal and Economic Department, Panthéon-Assas Paris II
University – P.R.E.S. Sorbonne Universités, Director of the Institute for Droit & Croissance / Rules
for Growth.p.55. See <[Link] com/abstract=2090036> (as of Jan. 17,2013).
Lending Business of Banks in Nepal: A Legal Perspective 167

difficulties, which might arise as a result of: (1) the significant potential for moral
hazard, (2) the existence of a high degree of information asymmetry, and (3)
potentially variable future cash flows. 122

This article will conclude in favor of a revision of certain French law and / or of
European law and in favor of a fundamental reform of the judiciary, in order to
facilitate financing on the financial markets and capital investment in risky
companies and projects. 123

9.2. Contract Enforcement regarding Lending

The rule of law - which means that the rights and privileges citizens are clearly
defined, impartially interpreted, and consistently enforced - is important to
encourage economic activity. Creating the rule of law, however, is a non- trivial
task. The actual demands on a legal system before it can reasonably be said to be
governed by "the rule of law" are sophisticated and complex.124

The laws and regulations governing secured creditors will affect secured creditors
only to the extent that the laws and regulations are enforced. Indeed,
comparatively lax creditor rights laws in conjunction with efficient property rights
enforcement may promote financial intermediary activities more effectively than
strong creditor rights laws with lax enforcement. 125

Countries that impose compliance with laws efficiently and enforce contracts—
including government contracts—effectively tend to have much better developed
financial intermediaries than countries where enforcement is more lax. 126 The data
suggest a strong, positive relationship between banking development and both the
rights of creditors and the efficiency of contract enforcement. 127 The major
conclusion of this theory is that the common law system provides the best basis
for financial development and economic growth, followed by Scandinavian and
German origin civil law and finally French origin civil law. 128

122
Id. p.1.
123
Ibid.
124
Omar Azfar. (2006).The New Institutional Economics Approach to Economic Development: A
Discussion of Social, Political, Legal, and Economic Institutions. The Pakistan Development Review.
Vol. 45. No. 4, Papers and Proceedings PARTS I and II Twenty-second Annual General Meeting and
Conference of the Pakistan Society of Development Economists Lahore, December 19-22. pp. 965-
980(973). [Link]:// www. jstor. Org / stable/41260662(as of Oct.10,2012).
125
Ross Levine. (1997) Law, Finance, and Economic Growth. Journal of Financial Intermediation. Vol. 8.
pp. 8-35(19). See. <[Link] of Oct.30,2012).
126
[Link]. 8-35(33).
127
Ross Levine.(1998).The Legal Environment, Banks, and Long-Run Economic Growth. Journal of
Money, Credit and Banking. Vol. 30, No. 3. Part 2: Comparative Financial Systems (Aug., 1998).pp.
596-6139(604). See.<[Link] [Link]/stable/2601259>(as of Oct. 28,2012).
128
Michael Graff.(2006).Myths and Truths: The Law and Finance Theory. Revisited. Review of
Economics, Bd. 57, H. 1,pp. 51-76(51). See.< [Link] 20715074>(as of Sep. 24,
2012).
168 NJA Law Journal 2014

An elevated risk of fraud is one cost of such profligate asset partitioning. A

second, equally important cost is that unsecured lenders to parent companies face
increased difficulty in monitoring the assets that bond their claims. Third cost is
the heightened complexity of bankruptcy proceedings, in which courts must
reconcile the competing claims of the parent company's creditors and the creditors
of hundreds of subsidiaries. 129

Without the basics of law enforcement, merchants would even be reluctant to

engage in spot transactions and fear for their very lives. Both good laws and their
reliable enforcement are needed to augment markets. Indeed, law enforcement
had a much larger effect on the development of capital markets than commercial
law, and law enforcement has an independent effect on economic growth as well as
an effect through the development of capital markets. 130

"Justice delayed is justice denied" is an insightful aphorism on the needs for efficient
justice. One of the most important weaknesses of many judicial systems is the
years and even decades it can take for cases to be decided. 131

First, individual bank characteristics explain a substantial part of the within-

country variation in financial intermediary costs. Second, bank regulations help
explain the cost of financial intermediation. Tighter regulations on bank entry,
restrictions on bank activities, and regulations that inhibit the freedom of bankers
to conduct their business boost bank net interest margins. These results hold
when controlling for banking sector concentration, bank-specific characteristics,
and the rate of inflation. Furthermore, complementary research does not find
countervailing benefits from regulatory restrictions on bank entry, activities, or
freedom in terms of (1) bank stability, (2) firms' access to external finance, (3)
bank valuations, or (4) overall financial development. Third, there is an important
caveat to the finding that bank regulations explain net interest margins and
overhead expenditures: bank regulations cannot be viewed in isolation from the
overall institutional frameworks. Bank regulations reflect broader, national
institutions associated with the protection of private property rights and the
freedom to compete in the economy. 132

129
Henry Hansmann, Reinier Kraakman & Richard Squire.(March,2006).Law and the Rise of the Firm.
Harvard Law Review. Vol. 119, No. 5. pp. 1333-1403(1401). See.
[Link] (as of Oct. 29, 2012).
130
Supra note 124.
131
Ibid.
132
Asli Demirgüç-Kunt, Luc Laeven and Ross Levine.(2004).Regulations, Market Structure,
Institutions, and the Cost of Financial Intermediation. Journal of Money, Credit and Banking, Vol.
36. No. 3, Part 2: Bank Concentration and Competition: An Evolution in the Making A Conference
Sponsored by the Federal Reserve Bank of Cleveland May 21-23, 2003 (Jun., 2004), pp. 593-
622(618). See. <[Link] stable/3838956> (as of Nov. 02, 2012).
Lending Business of Banks in Nepal: A Legal Perspective 169

10. Legal Framework of Lending Business

Mainly, there are three tiers or hierarchy of legal framework of lending business of
BFIs in Nepal. They are Acts and precedents, Directives of Nepal Rastra Bank
(NRB) and Individual BFIs Credit Policy Guidelines. In addition to other prevailing
laws of the country, the main legal framework 133 of lending business of BFIs
includes:

10.1. Legislations/ Statutes

10.1.1. Nepal Rastra Bank Act, 2002 134
10.1.2. Bank and Financial Institutions Act, 2006 135
10.1.3. Banking Offence and Punishment Act, 2007 136
10.1.4. Company Act, 2006
10.1.5. Insolvency Act, 2006
10.1.6. Debt Recovery of Bank and Financial Institutions Act, 2001
10.1.7. Negotiable Instruments Act, 1977
10.1.8. Secured Transaction Act, 2006
10.2. Case Laws
10.3. Directives and Guidelines
10.3.1. Unified Directives of Nepal Rastra Bank 137

133
Nepal Rastra Bank. (2010). Bank Supervision Report 2009. Kathmandu, Nepal. Bank Supervision
Department, Nepal Rastra Bank. pp. 1-11.
134
Nepal Rastra Bank Act, 2002. Sec. 79(Regulatory Powers of Bank),80(Banking and Financial
System and Credit Control),81(Credit to Prescribed Sectors),84(Inspection and Supervision),86B(
State of Problematic Commercial Bank and Financial Institution),86C(Bank can Take Action
Against Problematic Commercial Bank or Financial Institution),
135
Bank and Financial Institutions Act, 2006. Sec. 50(Banking or financial system and credit
control),51(Power of Rastra Bank to issue directives in relation to interest rates),52(Power of
Rastra Bank to inspect and supervise),56(Credit to be supplied), 57(Provisions relating to recovery
of credit),74(Punishment for violation of regulation of Rastra Bank).
136
Banking Offence and Punishment Act,2007. Sec. 7 states as: While availing or providing loans from a
bank or financial institution, no one shall commit the following acts as: (a) Avail or provide loans
by submitting a false, fake or unreal financial statement or by creating artificial business.(b) Avail
or provide over loans by way of unnatural over valuation of collateral security.(c) Avail or provide
loans by way of unnaturally hiking the project cost based on false details.(d) Avail or provide credit,
facility or discounts beyond the authority obtained or limit sanctioned.(e) Re avail or re provide
loans from or by other Bank of Financial Institution without having due release of the collateral
security once provided to a Bank or Financial Institution or in excess than the amount covered by
the collateral security against the same collateral security. However, this restriction shall not be
applicable in case of release of loans to be provided under consortium.(f) Avail loans through an
entity having established in the name of a person who, in fact, does not have financial capability to
run the business or, who is a person under undue influence or extend loans knowing the said facts.
(g) Extend credit more than the requirement compared to the customer's business transaction. (h)
Accept or provide any sort of undue benefit in return to granting credit facility.
137
Nepal Rastra Bank introduced new consolidated directives in accordance with the BFI Act. The
consolidated directives are guided under NRB Act 2058 and Basel II principles as well. The new
Directives included regulatory measures of international standards and practices in the areas of:
Capital adequacy; loan classification and provisioning; credit concentration and single obligor
limits; accounting policies and formats of financial statements; management and minimization of
risks; good corporate governance; policies relating to compliance with the directives issued after
170 NJA Law Journal 2014

10.3.2. Supervision By-laws, 2002

10.3.3. New Capital Adequacy Framework, 2007
10.4. Individual Bank Credit Policy Guidelines
10.5. International Instruments
10.5.1. International Agreements

The International Instruments regarding bank regulation are as follows:

[Link]. General Agreement on Trade in Service (GATS)

[Link]. Basel Accords (Basel I, II, III)
10.5.2. International Standards (Soft Law)
138
The international standards (soft laws) may me mentioned as follows;

14.5. 2.1. Basel Committee on Bank Supervision (BCBS or Basel Committee)

14.5. 2.2. International Organization of Securities Commissions (IOSCO)
14.5. 2.3. International Association of Insurance Supervisors (IAIS)
14.5. 2.4. The Joint Forum
14.5. 2.5. International Association of Deposit Insurers (IADI)
14.5. 2.6. Committee on Payment and Settlement Systems (CPSS)
14.5. 2.7. International Accounting Standards Board (IASB)
14.5. 2.8. Organization for Economic Cooperation and Development (OECD)
14.5. 2.9. Financial Action Task Force (FATF)
14.5. 2.10. International Monetary Fund (IMF)
14.5. 2.11. Financial Stability Board (FSB)

11. Problems in Lending Business of Banks in Nepal

The main problems regarding lending business of banks in Nepal may be
mentioned as follows:

11.1. Collateral related Problems

11.1.1. Inadequate Collateral Valuation System: The pre-valuation, valuation and re-
valuation system of banks are not scientific and transparent. The valuation of the
same property by different techniques or forms is diverse. Hence, property
valuation system of banks is subjective, obscure and unpredictable. 139

the inspection and supervision; investment policies; reporting requirements; provisions for the
purchase and sale of promoter shares; regulation on consortium financing; regulations on credit
information and blacklisting; provision for statutory reserve requirements; policies on branch
expansion; policies on interest rates; and policies on financial resources generation.
138
Heidi Mandanis Schooner & Michael W. Taylor.( 2010). Global Bank Regulation: Principles and
Policies. San Diego, California, USA: Elsevier Inc. p. 77.
139
Debt Recovery Tribunal.(2069 BS). Annual Report 2068/069. Kathmandu Nepal: Debt Recovery
Tribunal. p .20. See also Debt Recovery Tribunal.(2070 BS). Annual Report 2069/070. Kathmandu
Nepal: Debt Recovery Tribunal. p .25.
Lending Business of Banks in Nepal: A Legal Perspective 171

11.1.2. No Sufficient Collateral: In the cases where lending is made with taking
securities, the securities are found insufficient to recover the loan granted. 140

11.1.3. Collateral of Low Quality: The collateral obtained at the time of

disbursement of loan, are found very low quality or less valuable. Generally, it
happens due to the negligence of the banks on movable or fixed property. 141

11.1.4. Lending without Collateral: In some of cases registered in the debt recovery
tribunal, there is lack of security or mortgage for the lending. Some of lending had
been made in personal guarantee without taking property for security. 142 Most of
such cases the personal guarantor could not be found and even if found there may
be lack of property to recover the debt with the guarantor. 143

11.1.5. Weakness of Banks in Collateral Valuation: The main problems banks are to
make valuation of collateral. Most of the cases they make over valuation of the
collateral and disburse loan by taking property of low quality as collateral.
Sometimes, banks provides loan even in the fake property in collateral. 144 It is said
that there is misappropriation of collateral valuation of lending. In some such
cases some of the banks higher authorities were penalized in corruption cases,
especially in the state-owned banks.[see decisions] The banks are also blamed that
there is lack of skilled and specialized human resources in the field of lending. Due
to the misappropriation made by the bank authority, land without track or by path
or beaten track are also approved as the land of having motor able road, lands in
river bank are also regarded as good quality land and disbursing loan keeping them
in collateral. 145

11.1.6. Unable to reveal other Property of the Surety: Banks are unable to find out the
additional property of the surety to reimburse the insufficient/ remaining amount
of the loan after the auction. 146

11.1.7. No Protection of Collateral: There is lack of adequate protection of

collateral. 147 There is lack of monitoring of loan. Banks are unaware whether the

140
Debt Recovery Tribunal.(2069 BS). Annual Report 2068/069. Kathmandu Nepal: Debt Recovery
Tribunal. p .18. See also Debt Recovery Tribunal.(2070 BS). Annual Report 2069/070. Kathmandu
Nepal: Debt Recovery Tribunal. p .21.
141
Debt Recovery Tribunal.(2069 BS). Annual Report 2068/069. Kathmandu Nepal: Debt Recovery
Tribunal. p .18. See also Debt Recovery Tribunal.(2070 BS). Annual Report 2069/070. Kathmandu
Nepal: Debt Recovery Tribunal. p .22.
142
Debt Recovery Tribunal.(2069 BS). Annual Report 2068/069. Kathmandu Nepal: Debt Recovery
Tribunal. p .17.
143
Supra note 140..
144
Supra note 142.p.18.
145
Id.p.19.
146
Supra note 141.
147
Debt Recovery Tribunal.(2070 BS). Annual Report 2068/070. Kathmandu Nepal: Debt Recovery
Tribunal. p .26.
172 NJA Law Journal 2014

principal debtor utilizing the loan or not. They have no notice whether the
customer utilizing the loan for the same purpose as agreed in the loan deed.

11.1.8. No registry to record pledges on movable collateral: Pledges on immovable

assets are registered in the land registry, but there is no registry to register liens
on movable assets. Nepal’s parliament approved a secured transactions law in
2006, but the law cannot be implemented because no registry has been created.
Such a registry is crucial for ensuring that lenders that want to use an asset as
collateral can ascertain what rights other lenders may have over the same asset. A
centrally held, public registry also provides a convenient method for determining
the hierarchy of competing claims on the same asset by different lenders. 148

11.2. Regulation Related Problems

11.2.1. Inadequate Legal Infrastructure: The existing laws relating to lending
business of banks are not appropriate to resolve the present complicated
situations in Nepal. There is delay in deciding cases regarding lending that badly
affect the banks. The commercial benches are also not functioning as they are
expected. The benches are operating as the general benches. The Debt Recovery
Tribunals are also ineffective for the reimbursement of loan. 149 So, enforcement of
debt agreements is pathetic.

11.2.2. Inadequate provisions: The prevailing legal provisions regarding banking are
not adequate in Nepal, especially in the punishment of banking offences. The
provisions relating to punishment for the persons involving in banking offence are
inappropriate. If anyone commits any banking offense, he/she shall be punished
with a fine equivalent to the value of such collateral security and an imprisonment
up to a period of five years, depending upon the degree of the offense
committed. 150 Number 38(1) of Chapter of Punishment of Muluki Ain states that
'in determining the term of imprisonment in consideration for failure to pay a fine
where both punishments of fine and imprisonment have been imposed, the term
of imprisonment shall not be so determined as to exceed the term of more than
four years.' 151 According to the above provision the maximum punishment for a
person who commits the most heinous banking offence is only nine years
imprisonment. This punishment may be very less for a person who commits such
serious offence relating to banking. Such provision cannot control committing
banking offences. It is proved that there is no economic analysis of law in law
making process in Nepal.

148
Aurora Ferrari, Guillemette Jaffrin &Sabin Raj Shrestha. (2007). Access to Financial Services in
Nepal. New York: The World Bank, Finance and Private Sector Development Unit South Asia
Region. pp 34-35.
149
Rajan Bikram Thapa.(2007). Role of Nepal Rastra Bank to Resolve the Problems in Course of
Development of Banking in Nepal. Banking Prabardha. Year.12. No. [Link]. 22, pp 42-54.
150
Banking Offence and Punishment Act, 2007. Section 7(a) and 13.
151
Muluki Ain, 2020. Chapter of Punishment. Number 38(1).
Lending Business of Banks in Nepal: A Legal Perspective 173

11.2.3. Change in Prudential Regulation: Due to the instable political and economic
situation, wrong activities of banks, the directives of NRB are compelled for being
changing frequently. Many banks and principle debtors are being victimized due to
the frequent change in the directives. 152 Due to the frequent changes in the
directives of NRB the banking sector is volatile.

11.2.4. Weak in Self Regulation: Banks and financial institutions are required to
take risks for getting the anticipated rewards. The risk taking behavior should be
supported by adequate risk management practices. Banks have large numbers of
stakeholders and their interests need to be protected and that could include
avoiding excessive risk-taking. Risk management is a main responsibility of the
board of directors. Banks need to have adequate board and senior management
oversight, clear policies and procedures, limits, and adequate internal control and
risk management practices. Banks with sound practices in risk management can
promote self-regulation. The NRB believes that banks should initiate processes to
adopt the international best practices in corporate governance, risk management,
and adopting self-regulatory controls that go beyond the minimum standard set
by the central bank. Banks and financial institutions in Nepal still depend on the
NRB for implementing international best practices in the area of governance and
self regulations too. Thus, promoting self-regulation in the industry is also a great
challenge in banking supervision. 153

There are flaws in self regulation and control in banks. The banks are preparing
their plan and policies just following the law and directives of NRB and just show
for the general public. They are just showing ornaments of them. 154

11.2.5. Implementation of Basel Core Principles and Adoption of International Best

Practices: Modern Banking has become a complex network of global financial
relationships. Nepali banking system is also integrating into global financial
system and this makes it necessary for banks to adopt established global principles
and best practices. Nepal is in the process of implementing the Basel Core
Principles, which have been adopted and adjusted in national legislation,
prudential regulations, directives and guidelines. Nepal has implemented the new
capital adequacy framework based on the Simplified Standardized Approach of
Basel II. Offsite supervision is yet to develop Financial Soundness Indicators (FSIs)
with Early Warning Signals (EWS) as a tool to monitor performance and risks of
banks. Similarly proper framework for problem bank resolution has to be designed
to address the likely problem in financial sector in systematic manner. 155

152
Supra note 149.
153
Nepal Rastra Bank.(July 2013). Bank Supervision Report 2012. Kathmandu, Nepal: Nepal Rastra
Bank.p.48.
154
Supra note 149.
155
Supra note 153.p.45.
174 NJA Law Journal 2014

11.2.6. Inadequate Loan Loss Provisioning: Loan loss provisioning rules-especially

for short-term loans-are too lax and do not create the right incentives for
stringent monitoring of small business lending. NRB regulations for loans less
than a year require that only principal repayments be considered when calculating
arrears. Moreover, if a loan is secured with tangible collateral registered in the
appropriate office, provisioning is calculated as mentioned in the Unified
Directives 156 that small business lending is usually short term, that banks need to
test the capacity to repay of previously unbanked clients, and that to achieve
profitability on small business lending the portfolio at risk above 30 days has to be
very low, current low provisioning requirements could encourage banks to
undertake lax supervision of their small business loan portfolios. 157

On the other hand, provisioning requirements for loans secured only with
personal guarantees are too stringent—discriminating against small businesses
that cannot offer immovable assets as collateral. Most small businesses can offer
only movable collateral and personal guarantees as collateral. But because Nepal
has no registry for liens on movable assets for the purpose of calculating
provisioning, such loans are considered secured only with personal guarantees. As
such the loans are subject to an additional 20 percent provisioning requirement
even if they are serviced on time—making small business lending more costly for
banks. Although it is generally prudent to require tangible and registered
collateral, this discourages lending to small businesses. Priority sector loans
insured with the deposit insurance and credit Guarantee Corporation are exempt
from this higher provisioning requirement. 158

11.3 Supervision and Inspection related Problems

11.3.1. Inappropriate and Ineffective Supervision: It is a challenge for Nepal Rastra
Bank to supervise a number of banks. NRB is not able to focus on supervision of
banks from the very beginning of establishment of such banks. Furthermore, due
to the limited human resources, lack of modern technologies and skilled human
resources, supervision and inspection of NRB is being ineffective. 159

The easy licensing policy adopted over the last decade is the main reason behind
today’s problems, as everybody with certain income could open BFIs. However, the
supervisory capacity of the central bank remained same. Now, banks, one after
another, are being found involved in fraudulent activities which has hampered the
credibility of the banking sector. 160 In Nepalese banking sector, in relation to the
problem on corporate governance related to Regulators are: Lack of institutional

156
Nepal Rastra Bank.(2013). Unified Directive 2070/07. Kathmandu Nepal: Nepal Rastra Bank. p .34.
157
Supra note 148.p.35.
158
Id.p.34.
159
Supra note 149.
160
Kathmandu Post,(2011), Bad corporate governance: Major challenge Facing Nepali
[Link] from See.<[Link]
of Mar.26, 2014).
Lending Business of Banks in Nepal: A Legal Perspective 175

capacity for enforcement of laws, regulations, enforcement authorities themselves

lack good governance, lack of accountability of employees of regulating bodies
(need to have internal rules), lack of resources within regulator, transparent and
scientific licensing policy, lack of political and leadership will, court have
frequently intervened in regulatory enforcement. 161

11.3.2. Moving toward Risk Based Supervision (RBS): NRB has already designed and
implemented Risk Management Guidelines incorporating broader guidelines and
setting minimum standard for risk management based on the principles of Basel
Committee on Banking Supervision (BCBS). However, Nepal still faces challenges
in moving toward the Risk Based Supervision (RBS) approach. Developing Early
Warning Signals, having integrated online data reporting system, developing
forward-looking approaches are some issues that are to be addressed while moving
toward RBS. Likewise, acquiring new knowledge, skills and the resources needed
for adapting continuous changes in supervisory approaches has also posed
challenges to regulating and supervising body. 162

11.3.3. Frail Monitoring of Loan: If the facility is approved, the credit must be
subsequently administered by ongoing monitoring of the borrower’s performance
and industry trends. Credit facilities should always be reviewed on an annual basis
to include site visits, interviews, and verification of covenant compliances. 163
Monitoring of lending is weak in most of the banks. Most of the banks have not
update information whether the loan is using in the stated purpose or not.

11.3.4. Strengthening Supervisory Capacity: Supervisory capacity is a key to

strengthening safety and soundness of the banking system that are vital for
enhancing the public confidence in the banking system. The rapid growth in the
number of banks, nature of transactions, products and technological
advancements has led to introduction of new financial services. Supervisory
capacity needs to be strengthened to match the requirements of the fast-changing
business environment. There is need to increase numbers and enhance the
capacity of supervisory personnel, and to equip them with necessary resources and
tools for effective regulation and supervision. The supervisors need to have
knowledge and skills on banking, in general as well as specific technical skills as
per the need, and the necessary resources to carry out their functions. Knowledge
and skill about 'system audit' has become a key skill must be possessed by the
supervisors, these days, as most transactions are now performed electronically.
NRB has been offering opportunities to the supervisors for enhancing skills
through trainings and seminars both domestically and abroad. Capacity building is
a continuous process and therefore needs to be adequately resourced for enabling

161
Rajan Bikram Thapa.(2008). Corporate Governance: Need & Significance in Nepalese Banking
System. Paper to be presented to the International Conference on ‘Challenges of Governance in
South Asia’ in Kathmandu, Nepal on December 15-16..p .6.
162
Supra note 153.p.45.
163
Supra note 12.p.65.
176 NJA Law Journal 2014

supervisors to remain fully capable of responding to the fast changing business

environment. 164

11.4. Problems relating to Management

[Link] Corporate Governance: Generally, board members (non executive) are
liking to use power like executive or, executive director and executive chairperson
in the area of loan sanction, employee selection and daily office activities which is
again the against the Bank and Financial Institutions Act, 2063. 165 BoD members
are prohibited to take loan from own company however, it is general practice to
take loan directly or, indirectly. Similarly, board members are restricted to provide
collateral for loan purpose for own or, for others however, they try to do directly
or indirectly. Board members are inclined to authenticate the minutes after
finishing the vested interest. The company enjoying the practice of CEO and
Chairperson by the same person are ahead in noncompliance activities, big houses
are running many same nature businesses are manipulating public deposits and
transferring the fund within the group in their own interest, Banks running by
non-professional are in severe noncompliance practices. 166

The biggest problem facing the banking sector currently is bad corporate
governance. It was Nepal Development Bank to go into liquidation process and
then Samjhana Finance Company followed suit. Gurkha Development Bank and
United Development were declared crisis-ridden. One common factor behind the
misfortune of these institutions is bad corporate governance. 167 The Nepal Rastra
Bank (NRB) decided to send Samjhana into liquidation after seeing no possibility
of recovery of the crisis-ridden company. The common reason behind the financial
calamity in these three institutions is promoters’ and directors’ vested financial
interest. The Gurkha Development Bank fiasco was also because of the tussle
between promoters. 168

Many instances of bad governance have appeared in Nepal. The central bank
declared United Development Bank crisis-ridden as its directors were found to
have taken loans for themselves. Kunja Bihari Kayal, executive chairman of
Birgunj-based Public Development Bank (PDB), in collusion of Infrastructure
Development Bank (IDB) Chief Indra Humagain was found to have taken loans
from IDB by depositing his bank’s cheque which could not be cashed. 169 This

164
Supra note 153.p.45.
165
Bank and Financial Institutions Act, 2006. Sec. 24.
166
Supra note 161.
167
Kathmandu Post.(26 March , 2011), Bad Corporate Governance: Major Challenge Facing Nepali
Banking. See. <[Link] (as of Mar.26,
2014).
168
Ibid.
169
Ibid.
Lending Business of Banks in Nepal: A Legal Perspective 177

indicates that Board members are interested to use public deposits as their own
assets, which is against the Bank and Financial Institutions Act, 2063. 170

Boards need to have appropriate level of commitment to fulfill their

responsibilities. To ensure sound practice of corporate governance, both the board
of directors and senior managers need to have adequate knowledge and experience
in the banking [Link] issues prudential regulations on corporate governance
requiring banks to maintain minimum standards of operation. In addition to
compliance with regulations, they are expected to demonstrate robust corporate
governance based on NRB guidelines and international best practices. Over half of
all directors at banks are involved in businesses with little or no banking
knowledge and experience. The remainder has banking background or experience
in government service. The dominance of directors with business interests often
results in conflict of interest particularly because businesses are the main users of
funds and therefore there is a need for sound corporate governance. 171

11.4.2. Feeble Credit Risk Management: There seems to be a serious flaw with
lending mechanism of public banks. Although reforms in loan recovery process
have improved credit evaluation practices, still there is a lot to be desired in this
field. A rule-based approach needs to be replaced with practical approach. Due to
lack of expertise and inability to upgrade with the technology, the bank
administrators have not honed some crucial skills. The management has failed a
number of times in proper evaluation of a project scheme or idea. Large loans have
been handed out solely based on collaterals without much analysis of the credit
history of the lender, the viability of the project, or the lender’s ability to run the
project. Banks do not have effective screening mechanisms to rule out inept
borrowers or incompetent projects. 172

Banks have a large number of stakeholders: shareholders, depositors, creditors,

board members, employees and the community or the general public. Balancing
the expectations of all stakeholders is a challenging job for the management at the
banks. The commercial banks also need to put in place a comprehensive risk
management framework to identify, measure, monitor and mitigate risks. The
board of directors and senior management is expected to keep a close watch and
provide guidelines for risk management. 173

11.4.3. Feeble Management Information System (MIS): In some of the lending cases
of banks there is lack authentic document for identity of the principal debtor.

170
Bank and financial Institutions Act, 2006. Section 48.
171
Nepal Rastra Bank.(July 2012). Bank Supervision Report 2011. Kathmandu, Nepal: Nepal Rastra
Bank. p.67.
172
Manish Sapkota.(2012). Trend Analysis of Nepalese Banks from 2005-2010. Senior Honors Theses.
Paper 19: University of New [Link]. < [Link] [Link]/honors_theses>(as
of Feb. 2, 2013).
173
Supra note 171.
178 NJA Law Journal 2014

There lack of appropriate information of surety, as well. There is lack of

information about permanent and current address, phone number, copy of citizenship
certificate, details of three generations, etc. of the surety in the lending
documentation. 174 Even the available information about the principal debtor and
surety are not updated. This shows that there is problem of information asymmetric in
lending. Such lacking of information badly affects the recovery of debt. Specially, it
creates problem on issuance of notice and putting it into force (tameli). 175

Likewise, the supervisory strength depends on the timely collection, analysis and
interpretation of financial data. A strong MIS is required for tracking and
identifying problems on time to develop Early Warning Signals (EWS) and to take
Prompt Corrective Actions (PCA). Supervisors need to develop a mechanism to
monitor data related to capital and liquidity of financial institutions regularly and
that is facilitated by strong MIS and monitoring systems. Acquiring timely and
reliable data from bank remains a challenge. 176

11.4.4. Feeble Coordination and Cooperation: There is lack of coordination and

cooperation between/ among the related institutions involving in auction process
i.e. banks, land revenue office, district administration office, survey and
measurement office, local development offices, etc. It affects the auction process. 177

Ensuring effective coordination between banking supervisors and other regulators

of the financial sector is another challenge. The Nepalese banking industry has
grown and overall financial markets have become closely integrated and therefore
problems at individual banks are likely to have systemic effects. Therefore, it is
important to have effective coordination between supervisors and regulators of
the financial system; such as the Ministry of Finance (Government), Securities
Board of Nepal (SEBON) and the Insurance Board (Beema Samiti) etc. 178

11.5. Unhealthy Competition amongst the Banks

For the purpose of attracting customers toward them, distributed credit cards, visa
cards as well as medical insurance in free of cost, attempted to provide loan
comparatively in low interest rate, discounted in service charges as well as

174
Supra note 142.
175
Debt Recovery Tribunal.(2069 BS). Annual Report 2068/069. Kathmandu Nepal: Debt Recovery
Tribunal. p .17. See also Debt Recovery Tribunal.(2070 BS). Annual Report 2069/070. Kathmandu
Nepal: Debt Recovery Tribunal. p .21.
176
Supra note 153.p.46.
177
Debt Recovery Tribunal.(2069 BS). Annual Report 2068/069. Kathmandu Nepal: Debt Recovery
Tribunal. p .20. See also Debt Recovery Tribunal.(2070 BS). Annual Report 2069/070. Kathmandu
Nepal: Debt Recovery Tribunal. p .24.
178
Supra note 142. p.44.
Lending Business of Banks in Nepal: A Legal Perspective 179

disbursing loan without collateral or taking low quality property as collateral or in

personal guarantee. 179

11.6. Inventory of Credit Bureau

The credit bureau covers only loans above NRs 1 million and is slow in generating
credit reports. 180 Because the credit bureau requests information and keeps
records only for borrowers with loans above NRs 1 million, it is not useful for
small business lending. And although the bureau is supposed to generate credit
reports within three days, in practice it generally takes a week for banks to receive
them. This delay slows the growth of loan portfolios for small businesses. In
addition, the credit bureau provides limited information on borrowers-for
example, its reports do not provide historical information on borrowers, whether
they have other loans, and the number of days other outstanding loans have been
overdue. 181 Finally, because banks provide the bureau with information only on a
quarterly basis, it takes a long time for the bureau to update its records. As a result
credit bureau reports are often up to six months out of date. 182

11.7. Political Intervention

In the case of government owned banks, some borrowers acquire heavy loans by
putting political pressure from government officials on bank officers. Such
borrowers usually have more incentives to default on their loans. 183If we analyze a
couple of bank soundness indicators, we get some idea about the problems the
largest two state-owned banks are going through. From the figure, we can deduce
that ratio of NPA to total gross loan is going down, basically because a large
number of loan write-offs has been made. Also, we cannot ignore that total gross
loans have also increased. After 2005, there was a significant reduction in the ratio
because credit boom was brewing up. In the present, the ratio is far less than in
early 2000s but it is still very high by industry standards. 184

11.8. Insider Lending

Officials of most of the troubled banks are found involved in the malpractice.
Officials of different banks faced the action of NRB for insider lending. 185 Senior
Officials of Narayani Development Bank, Kabeli Development Bank, Pathibhara

179
Debt Recovery Tribunal.(2069 BS). Annual Report 2068/069. Kathmandu Nepal: Debt Recovery
Tribunal. p .19. See also Debt Recovery Tribunal.(2070 BS). Annual Report 2069/070. Kathmandu
Nepal: Debt Recovery Tribunal. p .23.
180
Nepal Rastra Bank.( 16 July 2005). Unified Directive 12. kathmandu, Nepal: Nepal Rastra Bank.
181
Such data are reported if the borrower has a loan larger than NRs 2.5 million or has been
blacklisted—that is, the borrower has loans overdue for more than six months, is bankrupt or has
disappeared, and the like.
182
Supra note 148.p. 35.
183
Supra note 172.36.
184
Ibid.
185
Prithivi Man Shrestha.(June 18,2013).Insider Lending Taking Its Toll on Banking.
[Link](as of Jun. 19, 2013).
180 NJA Law Journal 2014

Development Bank, Infrastructure Development Bank, Uddyam Development Bank,

Excel Development Bank and Khadbari Development Bank were taken action after
finding their involvement in insider lending, according to the NRB’s Development
Bank Supervision Report. 186

The report also showed that 11 financial institutions that were declared crisis-
ridden were the victims of insider lending. This reflects how insider lending is
taking its toll on the banking sector. In the latest incident at Siddhartha
Development Bank, insider lending led to the arrest of former Kist Bank Managing
Director Kamal Gyawali’s wife Gauri Khanal, while Gyawali himself had to resign
from his post. 187

In Gorkha Development Bank, Nepal Development bank and Samjhana Finance

Company, directors were involved in insider trading. In Samjhana’s case,
promoters were involved in collecting deposits and providing loans by maintaining
hidden accounts even though the central bank barred it to collect deposits and
provide loans. Such loans used to go for their kin which they never repaid. The
central bank directive bars insider trading. 188

11.9. Lack of Competent Human Resources

The rapid growth of banks has increased demands for competent human
resources. However, the supply of skilled human resources seems to be inadequate
and this has led to high mobility of few experienced staff from one bank to other.
There is a need to develop human resources capable of meeting the growing
demand in the financial sector while there are very few institutional mechanisms
for providing the capacity-building service. This has restrained the overall
competency of the banking industry. Low levels of understanding, weak analytical
and communicating skills as well as lack of competencies to be proactive and
innovative are being the barriers not only for the development of industry but also
for the supervision functions. 189

11.10. Controlling Ever-greening of Loans

The growing number of banks and financial institutions has resulted in pressures
for competing in unhealthy ways. As other sectors of the economy have not been
performing well, the number of good borrowers is limited. The overall macro-
economic indicators are not very conducive to support the rapid growth of the
banking sector. But statements suggest that Non Performing Assets (NPAs) are
also declining, indicating that some banks could be „ever-greening‟ loans to bring
NPAs at minimum levels. They have used high volumes of revolving loans,
overdrafts and working capital loans to ever-green loans and understate the level

186
Ibid.
187
Ibid.
188
Supra note 167.
189
Supra note 153.p.47.
Lending Business of Banks in Nepal: A Legal Perspective 181

of NPAs. It is a challenge to control the practice of loan ever greening, and to

address the issue of understatement of NPAs and overstatement of capital. 190

11.11. Institutional Set Up and Arrangements

Lending business of Bank can be stronger when there is a support and
coordination among supporting institutions in the financial system. Credit
Information Bureau (CIB) and Debt Recovery Tribunal (DRT) are two such
institutions. Similarly, the Credit Rating Agency (CRA) and Assets Management
Company (AMC) can also be helpful in validating the findings of supervision and
enhance market monitoring. The establishment and strengthening of such
institutions help in enhancing the level of supervisory capacity. Absence of these
institutions has added challenges to the banking supervision. 191

12. Conclusion
Lending inherently requires that the lender “trust” the borrower to repay the loan
at a later date. For the lender to be able to trust the borrower, the lender must
have means of screening out incompetent and untrustworthy borrowers. However
one chooses to put it, the bank’s problem is to distinguish between good and bad
firms (or projects), and good and bad character. By good and bad firms (or
projects) we mean expected return and risk. By good and bad character we mean
the borrower’s honesty. 192

Non-performing loan to total gross loan decreased to 2.6 percent in mid-July

2013. The same ratio was 3.2 percent in mid-January 2013 and 2.6 percent in mid-
July 2012. Average NPL ratio of three state owned commercial banks was 6.7
percent, whereas such ratio for private commercial banks was 2.4 percent in mid-
January 2013. The respective ratios were 6.5 percent and 1.7 percent in mid-July
2012. Similarly, non-performing loan net of provisions to capital stood at 4.1
percent in the review period. Such a decline in NPL reflects the improvement in
assets quality of commercial banks in the review period. 193

The banking system of Nepal may be characterized by low volume of turnover,

high interest rate on lending, wide interest rate spread, inefficient management,
lack of project financing practice, problem of inadequate working fund, and
unhealthy competition among banks.

Basel III has some micro-prudential elements so that risk is managed in each
individual institution and macro-prudential elements will take care of issues
relating to the systemic risk. The micro-prudential element of Basel III

190
Id.p.48.
191
Id.p.47.
192
Kenneth Koford & Adrian E. Tschoegl.(1997).Problems of Bank Lending in Bulgaria: Information
Asymmetry and Institutional Learning. USA: The Wharton Financial Institutions Center. p.1.
193
Supra note 153.p.50.
182 NJA Law Journal 2014

incorporates definition of capital, better risk coverage, leverage ratio, and

international liquidity framework, among others. Similarly, the macro-prudential
elements of Basel III are leverage ratio, capital conservation buffer, counter cyclical
capital buffer, forward looking and dynamic provisioning, addressing systemic risk
and interconnectedness, loan to value ratio, debt to income ratio and credit to
GDP ratio, and macroeconomic policy reform (including monetary and fiscal
reform, institutional and structural reform), among others. 194

Banks has to take property (moveable or immovable) or project, as a security or

collateral of loan. However, the property or project pre-valuation, valuation and
re-valuation procedure could not be made scientific and transparent. The existing
problems facing by the banking are due to the subjective and obscure collateral
valuation system. To make the collateral evaluation system more credible, the
valuator as well as concerned staffs of the banks must be made responsible. Where
disbursing loan exceeding certain amount, there shall be separate collateral
valuation process. There shall be separate legal provisions regarding valuators as a
distinct professional and such valuators shall be licensed or authorized from the
concerned authority for collateral valuation or a separate entity shall be
established for the purpose of collateral valuation. The other bad aspect of
collateral valuation system is that there are different standards of government for
collateral valuation. There is no doubt that collateral valuation is made for the
contentment of the lenders. How much the lender is willing to take risk and which
standard is to be followed, is the subject determined by the lender. However, tax
shall not be evaded or bank shall not bear any loss due to the collateral
valuation. 195

The experience shows that generally the principal debtor provides immovable
property as collateral for the loan while lending. In most of the case such
properties are found insufficient to cover the principal and interest of the loan.
Due to the insufficient to cover the loan, no one is ready to accept or buy the
property in auction and finally, the bank is compelled to accept the property in
auction. Such property could no cover the total loan if it is sold, however it could
not be sold immediately. If the foreign (Korean, Chinese, Thai etc.) practices are
observed, such properties are managed through asset management company. The
AMC may improve, renovate or revitalize and sell in high price. It is the experience
of maximum utilization of property by selling the same. The AMC may be
established by the government or in private public partnership. 196

Secured Transaction Act, 2063 has been enacted with the purpose of to secure
obligations with movable and intangible property by making consolidated legal

194
Supra note 153.p. 111.
195
Madhab Poudel. (2069).Implementation of Debt Recovery Legal Provisions and their Effectiveness.
A Report of Seminar on Debt Recovery Tribunal and Disputes on Corporate Lending. Kathmandu, Nepal:
ADB and [Link]. 7-24.
196
Ibid.
Lending Business of Banks in Nepal: A Legal Perspective 183

provisions in relation to secured transactions for the maximum promotion of

economic activities for the economic development of the country. 197 It is based on
US Commercial Code (UCC) and sufficient in Nepalese context. 198 So the Act shall
be implemented effectively.

The NRB has introduced stress testing system 199 of the banks since 2011/12. It has
already issued guidelines consisting of simple methods of stress testing process.
All the commercial banks have been advised to carry out stress testing on a
quarterly basis. They need to assess their soundness in the key risk areas such as
credit risk. 200 In the field of lending business of banks the NRB stress testing
system shall be effectively implemented.

NRB has already formulated and enforced some of the macro-prudential

regulations relating to strengthening of the capital of BFIs, expanding access of
general people to financial services, implementing risk based supervision,
establishing coordination among the various regulators of financial sector,
enhancing corporate good governance in BFIs, and updating the banking rules and
regulations in timely manner, among others etc. Similarly, policies regarding
differentiation between bankers and entrepreneurs/businessmen, strengthening
financial intelligence, enhancing financial discipline, formulating financial literacy
policy, making necessary arrangement against multiple banking practices for
maintaining financial stability in Nepal are underway. 201 Such measures shall be
effectively implemented.

Banks and Financial Institutions have been given extra-ordinary powers to recover
the loans from the delinquent clients. But as the saying goes with great power
comes great responsibility as well. Power has a tendency to be misused and the
Banks must be alert and not be attracted by such temptations for misuse. Banks in
Nepal need to remain purely financial institution and must concentrate on
increasing its profit through banking services and not from real estate
speculation. 202

197
Secured Transaction Act, [Link].
198
Supra note 195.
199
Stress testing is a forward looking risk management tool adopted by NRB, which has been applied
to "A" class financial institutions for the first time. NRB has taken the policy of extending stress
testing practice gradually in both the "B" and "C" class financial institutions. Stress testing practice
is used to evaluate the potential impact of specific events on a bank and the impact of such events
on a set of financial variables.
200
Nepal Rastra Bank.(July 2013). Financial Stability Report. Kathmandu, Nepal: Nepal Rastra Bank. p.
51.
201
Id.p. 111.
202
Purna Man Shakya.(2069). Rights and Duties of Financial Institutions in Loan Management. A
Report of Seminar on Debt Recovery Tribunal and Disputes on Corporate Lending. Kathmandu, Nepal:
ADB and [Link]. 24-36.
184 NJA Law Journal 2014

In short, to overcome the problems as mentioned above, there shall be good

corporate governance, 203 scientific collateral valuation system, 204 reform of
regulations according to the international instruments and best practices,
effective credit risk management mechanism, 205 skilled human resources, effective
and appropriate supervision and inspection, effective debt contract enforcement
mechanism, effective co-ordination and cooperation between or among the
regulators, effective implementation of related law, policy and directives of NRB,
effective execution of provisions regarding reward and punishment, control on the
ever greening of loans etc. 206

203
Supra note 200.
204
Ibid.
205
Ibid.
206
Ibid.