Saugat Dangal

Roll No. 18722

Banking Management Assignment

Liquidity Crunch & Credit Crunch in Nepalese Context

LIQUIDITY CRUNCH
In the context of banking, liquidity crunch refers to a financial situation in which the banking
system is short of cash and cash-equivalents required for immediate spending/outflow.

Although individual banks on a day-to-day operation basis face disbalance of cash inflow &
outflow leading to short-term cash shortage, this is not regarded as liquidity crunch. For it to
be a liquidity crunch, there should be more sustained shortage of liquid funds throughout the
entire banking/economic system.

One of the most obvious indicator of liquidity crunch in Nepal is the CD ratio getting tighter,
and the gap between deposit and credit in the banking system getting narrower. We have been
hearing that there is currently a liquidity crunch in Nepal. This is supported by the fact that the
CD ratio is completely tight at 90.36 (April 2022) compared to the ceiling of 90 that must
currently be maintained. Also, the deposit-credit gap has been getting narrower as seen in the
data of the last 12 months below:
In simple terms, the reason for this liquidity crunch is that the increase in credit disbursement
is relatively more than the increase in deposits/resources. Thus, currently the banks are in short
of loanable funds due to the following reasons:

• The government enacted an expansionary fiscal/monetary policy to kickstart & revive

the slowing down economy after the COVID crisis and lockdown. As the result, the
volume of credit increased rapidly in the financial system of Nepal. There was a huge
outflow of funds from the banks. Refinancing facilities to COVID-hit businesses added
more to this increase in credit.

• Due to uncertainty caused by COVID, and the slowing down economy, the rate of
deposit increment had slowed down as people preferred to hold cash. Similarly, the
rescheduling of loan repayments for COVID-hit business also delayed the inflow of
cash into the banks. Loan recovery slowed down as well which again delayed the
inflow of funds.

• As the economy began reviving post-COVID, imports in Nepal began to rise. This led
to money flowing out of the economy. Similarly, although the rate of foreign
employment rose, Nepal’s remittance inflow declined because the remittance began
channeling through informal means. As the result, the inflow of money into the
economy also declined.

• The provision of CCD ratio being replaced by CD ratio in the latest monetary policy
automatically absorbed & reduced some volume of the loanable funds in the banking
system by default.

• The government was also unable to spend its budget as planned due to which money
supply did not increase by much in the banking system/economy. (Sluggish CAPEX)

All-in-all, the increase in outflow of funds from the banks, and decrease in inflow of funds into
the banks has left the banks in a position such that they have become short of resources to
disburse more loans (i.e., shortage of loanable funds). This current situation of liquidity crunch
has in turn led to the increase in interest rates as well in Nepal.
Apart from the current liquidity crunch, Nepal has faced liquidity crunches several times in the
past too. Nepal usually faces liquidity crunch after following the period of aggressive credit
disbursement:

• In 2016/17: Extensive loans was disbursed to revive the economy post-earthquake,

which then eventually lead to liquidity crunch.

• In 2010: Banks heavily financed real estate in greed of profits such that they almost
emptied their accounts. There was liquidity crunch after the bubble burst.

Where there is liquidity crunch, the interest rate rises, which decreases the demand for credit,
and increases the supply of deposit. As the result, the liquidity position gets eased but the banks
again lend aggressively for higher profits hence leading to liquidity crunch again. Thus, some
sort of cyclical effect can be seen in the liquidity position/crunch situation in Nepal.

Seasonal effects also cause short-term liquidity crunches in Nepal:

• Bank Deposits usually shrink during Dashain/Tihar festive season (Oct-Dec) as people
tend to hold cash (new notes). Also, during festive season, people make purchases of
imported goods leading to outflow of funds from the Nepalese banks.

• As a new Fiscal Year starts (July), individuals and business are due to settle their taxes
for the previous FY by 6 months’ time (January). In this period, funds from the banking
system flows to the government leading to a decline in liquidity in the banking system.
CREDIT CRUNCH
Credit crunch is a situation in which there is a sustained decline in the level of lending in the
economy. During a credit crunch, the level of credit disbursed by BFIs decreases. Even if the
absolute volume of credit extended does not decline, the decrease in the rate of credit growth
can also be said to be credit crunch.

There may be multiple reasons for credit crunch in the banking system:
• When there is liquidity crunch such that the BFIs do not have enough loanable funds
available to lend;
• When the interest rate rises following a liquidity crunch, and the demand for loans is
low due to high cost of borrowing;
• When the demand for loan is low by itself independent of the interest rate, usually
during the period of calamities (e.g., earthquake, COVID) and during recession;
• When the BFIs themselves are unwilling to extend more credit because of the high risk
they perceive in the economy/sector (e.g., during real estate bubble).

In Nepal, banks are highly profit driven so they are unlikely that they themselves will be
unwilling to extend more credit even if there is risk. Banks in Nepal are always aggressive in
terms of lending. Hence, the cause of credit crunch in Nepal is mostly the first 3 reasons.

During crisis like earthquake, and COVID, economic activities slowed down. The demand for
loan for investment purpose declined due to fear and uncertainty. As the result, short-term
credit crunch was observed in 2016 and 2020. However, this soon led to excessive liquidity in
the market and the banks began lending aggressively leading to credit expansion. However
again, aggressive credit led to liquidity crunch in the market (current situation), and the banks
were tight in resources to grant more loan – thus, the level credit disbursement fell, and credit
crunch was observed once again (current situation).

From this we can understand that credit crunch comes hand-in-hand with liquidity crunch. As
there is shortage of loanable funds during liquidity crunch, it will automatically lead to credit
crunch. Following this trend, we can observe that credit crunch interconnected with liquidity
crunch in Nepal, and both follow a cyclical pattern:
 Liquidity Crunch

Shoratge of
Agrressive
Loanable Funds,
Lending by BFIs
High Interest
such that all
Rates & Low
resources are
Credit
exhausted
Disbursement

Covid &
Earthquake
as Catalyst
Surplus Funds:
Excess Liquidity
Credit Crunch
& Lower
Interest Rates

Overtime
increase in
deposit /
resources but
low credit
extension

Here, crisis such as COVID acted as the catalyst to run this cycle.

Due to this reason, ‘credit crunch’ and ‘liquidity crunch’ are synonymously used in the context
of Nepal and have the similar underlying causes: primarily due to assets-liability mismatch
(growth in credit not matched with growth in deposit), and improper liquidity management by
the BFIs. Credit crunch has also occurred in more or less the same period of the liquidity crunch
(2010, 2016, 2022) in Nepal.