Some Lessons from the US financial crisis for Nepal

	Article Published in myrepublica.com (2009-1-10) The world economy is now in recession, triggered by the sub-prime mortgage crisis that began in the US housing market since the mid-2007. Tsunami of this financial crisis has swept various big banks and dragged the economies of advanced countries into recession. The so-called big banks, "too big to fail", like Lehman Brothers and Bear Stearns have disappeared, and stock markets all over the world have historically plunged in 2008. The current crisis looks like a serious crisis after the 1930´s great depression. This event is, in fact, a blow to the flourishing free market concept after the 1970s in the name of neo-liberalism. What happened in the high tech and advanced financial system of developed countries? Main reasons for the current financial crisis can be succinctly categorized as: first, false conception of people that real estate prices grow forever and heavy credit flow to this sector by the financial institutions; second, highly complex financial derivative markets promoted by securitization, not backed up by real sector activities in the name of risk diversification and financial engineering, motivated by speculative purpose, which people hardly understand; third, highly integrated financial market and homogenous behavior, adopting same sort of model for evaluating risks, thereby exhibiting "animal spirit"; fourth, high leverage ratio by borrowing short-term and buying long-term mortgage- based securities; and the last but not least is the relaxation of regulatory measures on the ground that market can regulate itself through self-discipline. Many economists and intellectuals have already analyzed, in detail, the reasons behind the current financial crisis, which has the epicenter in the US. Moreover, many people have also discussed the possible implications from the current financial crisis in the different sectors of economy in Nepal as well. However, the matter of what should we learn from this crisis for Nepalese financial system is greatly lacking in our discussion. Actually, one should get some lessons from this crisis to avoid similar crisis in future in any country. Nepal´s financial sector is still nascent and is not so complex so that we have not witnessed any systemic financial crisis to date. However, our financial system is not far from such a crisis if we look at the current development of this sector. Amidst the weak performance of real sector, the financial sector has been expanding rapidly in recent years. Thanks to the remittance inflows so far. Having observed the profit of some banks and financial institutions, many new investors are more and more interested to enter this sector. However, with the ever expanding market, the financial regulator may not able to regulate the system efficiently and opportunity of profit will wither away. The long run fate of the financial system is, indeed, based on the performance of the productive sector. Given the weak real sector in Nepalese economy, it is time to think twice before entering into this sector. The second lesson is that haphazard and risky credit lending, for sake of fast profit, may invite crisis sooner or later. Banks and financial institutions in Nepal have recently been extending credit heavily to real estate sector. For example, private sector credit from commercial banks increased by 26.9 per cent in 2007/08 compared to a rise by 17.1 per cent in 2006/07. As a result, the real estate prices have been rising in the major cities of the country. In 2007/08, commercial banks alone extended Rs. 8.2 billion credit to real estates and Rs. 10.0 billion to residential construction. If we include development banks and finance companies, this amount can go up further. People generally believe that real estate prices do not fall, but, this is not true. A burst in the price of real estate is seen to be one of the major causes that has been triggering financial crisis in the world. For example, Japan´s financial crisis in the 1990s, East Asian financial crisis in 1997 and the recent US financial crisis are a few to name. Thirdly, financial institutions are running their business on public deposit; they should be regulated properly by the regulators, in most cases the central bank. Excessive credit flows to unproductive sector should be checked as it can trigger a crisis sooner or later. The main job of financial system is to facilitate payment system in the economy and act as financial intermediary linking depositors and lenders. Undesired risk taking for making hefty profit should be checked. In this context, tightening monetary policy stance and the recent introduction of risk-based supervision by Nepal Rastra Bank can be taken as a step in the right direction. The fourth lesson is that players in the financial market should be heterogeneous because herd and homogenous behavior would trigger and aggravate financial crisis. However, the current policies taken by Nepal Rastra Bank has been promoting the homogeneity in the financial sector, and narrowing the gap among the commercial banks, development banks and finance companies. From the current fiscal year 2008/09, commercial banks, development banks and finance companies are the counterparties for the monetary policy and all of them can mobilize current deposit: prior to this, commercial banks only mobilized current deposits. As a result, 25 commercial banks, 58 development banks and 70 finance companies are competing in the same kind of market and performing almost the same sort of jobs. Their growing inter-linkage and circular relation could make financial system vulnerable. The fifth lesson is that market is powerful, but it can fail sometimes. Hence, there should be effective and efficient public institution to regulate the financial market. The right combination of the government and the market is therefore necessary for a healthy development of the economy. To conclude, it can be said that financial sector is a very important, but sensitive market. It can facilitate real economic activities, but it is very prone to crisis by nature; and when it fails, it drags the economy into crisis by obstructing payment system and credit market. Hence, all stakeholders from general public to the operators of financial institutions and the central bank should constantly monitor the development of this sector. Most importantly, banks and financial institutions should not lend heavily to unproductive sector. A proper and a reasonable diversification of the portfolio are necessary to mitigate likely default risk. It is to be noted that a long run sustainability of the financial sector finally depends on the equal development of the productive sector. (Shrestha is a PhD student at New School for Social Research, New York, USA.)