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    Chapter 9



    By Guru Prasad Paudel*

    1. Introduction

    The rapid growth in household debt in mortgage and consumer credit offers both opportunities and challenges. Debt is a two-edged sword. When used wisely and appropriately, it improves society’s welfare. Various types of loans give different advantages to the bank and financial institutions as well as to the whole economy. Similarly, different types of credits provide portfolio diversification for the banking sector. Credit facilities provide employment, production and consumption. In the longer term, a healthy and vibrant household finance sector also facilitates a shift towards domestic demand that will help rebalance the export-oriented growth model. However, high levels of household debt may heighten an economy’s vulnerability to instability and crises. Excess use of debt can be a disaster. Like in individual households and firms, over-borrowing leads a country to economic wreck and it weakens the government’s ability to deliver essential services to its citizens (S. G. Cecchetti, et al., 2011). Such problems have been seen in boom-bust cycles in some credit card markets, rapid house price increases in several economies and the recent global financial turmoil. To make a stable financial system, there should be balanced credit system.

    The financial system plays a vital role in the economy. Being a caretaker of a financial system, the central bank’s concern has been heightened in the aftermath of the global financial crisis. In a stable financial system, financial institutions, markets and infrastructures should be able to perform their functions smoothly and be capable of withstanding various shocks without any disruption in the operation of the financial system (NRB, 2013). Excess loans towards any sector can be a serious concern for the central banks.

    Mortgage and consumer credit differ significantly across countries along a number of dimensions, including product diversity, type of lender, mortgage funding, purpose of loan and the degree of government participation. In this study, different classifications of mortgage finance have been employed. The Nepalese Banking

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    and Financial Institutions (NBFIs) are categorised into four types, namely: Commercial bank (Class A), Development Bank (Class B), Finance Companies (Class C) and Microfinance Development Bank (Class D). The development banks and finance companies do not provide the hypothecation loan. Almost all loans which they provide are mortgages. However, due to the unavailability of longer and reliable data, loans from development banks and finance companies are ignored. Loans from the development banks and finance companies occupy around 20% of total loan. So, in this report, mortgage finance is defined as commercial bank loans that use land and building as collateral.

    The data sources are mostly secondary including the Nepal Rastra Bank’s (NRB) annual reports and quarterly economic bulletins and various issues of Economic Survey of Ministry of Finance, Nepal (MOFN).

    It is the intent of this paper to look into the recent trends and development in mortgage finance/ fixed collateralised loans and consumer credit in Nepal and to identify the driving forces for the observed trends. Moreover, the paper reviews the directives, rules and regulations implemented by the NRB pertaining to real estate loans and their impact on ensuring financial stability.

    The overall paper consists seven sections. Section 2 discusses the development and trends of mortgage finance and consumer credit; basically, this section explains how the Nepalese economy has affected by the development of mortgage finance and consumer credit along with the some macro-economic indicator, such as economic growth, interest rates, demographic factors, financial innovations, etc.; Section 3 provides a survey of the related literature; Section 4 presents the results from a stress testing exercise; Section 5 discusses the policy measures or actions that have been taken central banks and national governments in mitigating the potential adverse impact of mortgage finance and consumer credit. In Section 6 the policy gaps that need to be addressed are identified to ensure that the growth of mortgage finance and consumer credit do not negatively affect financial stability; the last section concludes.

    2. Mortgage Finance and Consumer Credit: Developments and Trends

    2.1 Background

    In Nepal, there is very low volume of project and hypothecation loans compared to collateral-based credits. In another words, most of the Bank and Financial Institutions (BFIs) grant the loans where fixed assets or properties are pledged as collateral. Banks accept the land and building as collateral not only

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    for housing loans, sometimes they prefer fixed assets as collateral in business loans also. According to the quarterly economic bulletin (2013) around 56% of the total loan and advances were secured by fixed property as collateral. The bulletin incorporates the total collateral outstanding credit of Commercial Banks (CBs) which classifies the collateral in 18 categories. Such types of securities include gold and silver, government securities, machinery, export bills, domestic bills, overdraft, and house and land, etc.

    Consumer credit (CC) is basically the amount of credit which is used by the ultimate consumers to purchase non-investment goods or services that are consumed. This heading includes loans to purchase different gadgets, automobiles, and education, but excludes debts taken out to purchase real estate or margin on investment accounts. Here, in this study a mortgage for purchasing a house is excluded from consumer credit. In Nepal, credit card loan is not significant. Loans against gold and silver are considered consumer credit. This type of loan occupies around 3%. Due to the unavailability of actual data, the loans which are used for consumable goods and services are excluded. As mentioned above, most BFIs grant loans and advances to the ultimate consumer against fixed asset pledged as collateral.

    In case of project financing the probability of loan default depends upon the project’s success or failure, but in the case of mortgage financing, the recovery of credit and advances rely upon the quality of collateral. If the fair market value of the fixed collateral falls, the loan may converted into Non-performing Loan (NPL). When the credit risk arises and converts into higher level of NPL, it may lead to the financial instability. In this way, safeguarding financial stability may require the BFIs to identify the main sources of banking risks and vulnerabilities.

    Like the developed economies, Nepal also experienced the some escalation in real estate prices in 2008/9. Most of Nepalese aspire to own their own homes. Due to the massive increase of foreign remittances, Nepalese BFIs have excess liquidity but there was lack of investment in the productive areas due to the domestic violence. At that right time, the real estate market was in the boom phase whereby the prices of the real estate properties were soaring significantly. The prices of real estate properties soared nearly 2-3 folds within a year. However, when the real estate boom reached near saturation, the price of the real estate did not move further. In 2009, to save from the real estate crisis the NRB issued a directive to stop further investment towards the real estate and commercial housing. As per the directives, real estate and commercial housing loans have to be restricted to 30% of the total portfolio by the end of that year

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    and to 25% by the end of the next fiscal year. Since then the real estate and commercial housing business have been declining. In this situation, these BFIs are unable to extend further credit because most of BFIs had already exceeded the NRB ceiling. Moreover, the hiked interest rates had put a squeeze on the extension of fresh credit, but it also affected the existing borrowers.

    2.2 Driving Forces of Real Estate and Consumer Credit Booming in Nepal

    Foremost, the financing of the BFIs is the driving force behind the real estate and housing price boom. According to Kent C., et al. (2007), households demand credit for a number of reasons. Perhaps chief among these is the desire to purchase residential property. In Nepal also, people’s per capita income is very low. In this situation, the majority of the people cannot afford individual homes by self-financing, so bank financing has become a convenient tool for constructing or buying a house. Real estate entrepreneurs also depend on bank financing to smoothen and expand their business.

    The literature explains the number of developments which have fueled to increase both the demand and supply of mortgage and consumer credit over the past few decades. The demand-side factors are the increasing need for housing units, growing urbanisation, expansion of economic growth, emerging middle class, and migration towards the urban or semi-urban area. In spite of moderate economic growth, Nepal has gained in poverty reduction. This was mainly driven by soaring remittances. Besides the demand-side factors, the role of supply-side factors such as deregulation in banking rules and regulation, easy access to BFIs, moderate interest rate are also key factors that have contributed to a significant rise in real estate in Nepal. Broadly, these factors can be categorised in terms of demand- and supply-side factors (Figure 1).

    Figure 1 Driving Forces of Real Estate Boom

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    2.2.1 Remittances Inflows