Performance appraisal of commercial banks and linkage financial indicators with economic growth in Nepal

Abstract

Banking industry, normally, occupies a bigger chunk in the financial system of a nation. Same is the case in Nepal. The growth of the banking system coupled with the rapid development in information and communication technology not only increases the banking products to the consumers but also fosters the competition and increases the complexities, risks and challenges. Although the first Nepalese commercial bank, namely Nepal Bank Limited was established in 1937, the Nepalese commercial banks have the highest growth in the period of 2000 - 2010 with the entry of a large of number of private sector banks. On one hand, the informative banking system increased people awareness and banking habit as well as made them more demanding and choosy. On the other hand, it increased the complexities and risks of failure, too. Risk management is an inevitable component of successful banking. Effective risk management has always been central to safe and sound banking activities. Hence, it is important to check bank performance whether or not banks operate prudently and hold sufficient capital to support the risks. The competitive scenery of the global economic activities needs the productivity-driven banking industry to be paying special attention for its relative level of efficacy compared to its competitors. Although bank efficiency has been a popular research area in both developed countries and less-developed nations, it has been scarce in Nepal mainly due to the lack of data, be sort of research institutes and be deficient in analytical exploring system. The objective of this study is to analyze the financial performance and efficiency of the Nepalese commercial banks and linkage of their financial indicators with economic growth. This study is considered as the first study that comprehensively investigated bank performance and efficiency using multiple methodologies of financial ratios analysis and data envelopment analysis. This study further addressed the question of whether or not commercial banking performance has significantly been affecting economic growth in Nepal. The financial performance based on CAMEL Model for different ownership structured commercial banks and selected eighteen individual banks was investigated for the period of 2005 - 2010 in order to determine their financial characteristics and identify the determinants of the performance. The results showed that public sector banks are significantly less efficient than their counterparts are; however, domestic private banks are equally efficient to foreign-owned (joint venture) banks. The econometric model (multivariate regression analysis) by formulating two regression models was used to estimate the impact of capital adequacy ratio, non-performing loan ratio, interest expenses to total loan, net interest margin ratio and credit to deposit ratio on the financial profitability, namely return on assets and return on equity of these banks. The results revealed that return on assets was significantly influenced by capital adequacy ratio, interest expenses to total loan and net interest margin, while capital adequacy ratio had considerable effect on return on equity. Data Envelopment Analysis Model has been used to investigate the efficiency of different ownership structured banks under intermediation approach and profit oriented approach. This study presents technical efficiency, pure technical efficiency and scale efficiency from 2005 - 2010. Under intermediation approach, the mean technical inefficiency of the commercial banks was 16.0% while the average pure technical and scale inefficiencies were 11.16% and 5.50%, respectively. The pure technical inefficiency of Nepalese commercial banks was higher than the scale inefficiency .This implies that pure technical inefficiency might be the main reason behind technical inefficiency in the Nepalese banking sector. Furthermore, the joint venture and domestic private banks were more efficient than public sector banks, which suffered managerial underperformance. The Tobit model to estimate the impact of risk management factors on efficiency indicated that the capital risk (capital adequacy ratio), liquidity risk (credit to deposit ratio), profitable ratios (return on assets and return on equity) have influenced the efficiencies, however credit risk (non performing loan ratio) reduced the levels of the commercial banks efficiency. Commercial bank size had consistently inverse impact on technical, pure technical and scale efficiencies. With respect to their profit-oriented approach, the public sector banks most recently in the analyzed period were observed to perform relatively more efficient than joint venture and domestic private banks due to the large scale of branch networks. In terms of the overall mean of the technical efficiency, the intermediation approach provided more efficiency scores than profit-oriented approach. Competition and new technology can all be reasons the banks are performing better as the intermediary function. Comparing the scores for different type of the commercial banks based on ownership provided mixed results. Under intermediation approach, joint venture banks were more efficient whereas public sector banks were found more efficient under profit-oriented approach. When comparing the individual banks, Nabil Bank Ltd and Standard Charted Bank Limited were more efficient under the both approaches. In addition, Agriculture Development Bank Limited, Kumari Bank Limited and Siddhartha Bank Limited were marginally efficient (more than 90%) only under intermediation approach. Thus, the bank with efficient under intermediation approach does not always mean that has better profitability performance. With linking the financial variables effect and economic growth, the regression results for the period of 1975 - 2010 indicated that deposits and assets had significant impact on the economic growth of Nepal whereas loan and advances had insignificant impact on the economic development. Furthermore, the Granger-Causality test suggests that there was no causality with deposit, loan and advances and assets with the economic acceleration. It can be concluded that not only commercial banking performance but also other variables political stability and technology play the important role in the economic advances in Nepal. This study has also empirically investigated how bank risk management factors, technical efficiency under intermediation approach and technical efficiency under profit-oriented approach have effect on economic growth using Granger causality test. It was found that the relationship between risk management factors of the bank and its efficiency was positive and statistically significant. According to these findings, the banks with capacity of managing risk had more effect on economic growth.