In Collaboration with:

Access to Finance for the Poor Programme

Legal and Regulatory Review

Inception Phase Deliverable A1.1– Targeted AFP Program Legal/Regulatory Reform Support Agenda/Plan

November 10, 2014

DISCLAIMER The Access to Finance for the Poor Programme in Nepal is funded by UK aid from the UK government; however the views expressed in this report do not ecessarily reflect the UK government’s official Policies. This report, including any attachments hereto, may contain privileged and/or confidential information and is intended solely for the attention and use of the intended addressee(s). If you are not the intended addressee, you may neither use, copy, nor deliver to anyone this report or any of its attachments. In such case, you should immediately destroy this report and its attachments and kindly notify Louis Berger. Unless made by a person with actual authority. The information and statements herein do not constitute a binding commitment or warranty by Louis Berger. Louis Berger assumes no responsibility for any misperceptions, errors or misunderstandings. You are urged to verify any information that is confusing and report any errors/concerns to us in writing.

Contents A. Background ........................................................................................................................................... 1

B. Introduction to the Financial Sector ................................................................................................. 1

C. Review of Current and Proposed Acts and Regulations ................................................................ 2

C.1 Existing Acts and Proposed Amendments .................................................................................... 2

C.2 Proposed New Legislation ............................................................................................................... 4

D. Regulatory Framework Governing Financial Sector in Nepal ....................................................... 5

D.1 Nepal Rastra Bank ............................................................................................................................. 5

D.2 Department of Cooperatives .......................................................................................................... 9

D.3 Insurance Board ............................................................................................................................... 10

E. Key Issues with Legal and Regulatory Framework and Implications for AFP Programme...... 11

E.1 BAFIA 2006; Accompanying Directives/Circulars and the Proposed Amendments.............. 11

E.2 Financial Intermediation by Societies Act and Regulations/Circulars ..................................... 12

E.3 Cooperatives Act and Regulations ............................................................................................... 12

E.4 Insurance Act and Regulations/Circulars ..................................................................................... 12

E.5 Proposed MF Act (2nd Tier Regulator Act).................................................................................. 12

E.6 Proposed Draft Deposit and Credit Guarantee Law .................................................................. 12

E.7 Amended Cooperative Act ............................................................................................................ 12

E.8 Industrial Enterprise Act 1992 ........................................................................................................ 13

F. Prioritization of Legal/Regulatory Support to Help Accelerate AFP Interventions ................. 13

G. Timeline for the Implementation of Prioritized Interventions ..................................................... 14

H. Conclusion .......................................................................................................................................... 15

Acronyms AFP Access to Finance for the Poor AusAID Australian Agency for International Development BFI Bank Financial Institution CA Constituent Assembly CO Community Organisation CPDCC Constitutional Political Dialog and Consensus Committee CPNM Communist Party of Nepal Maoist DFID DCGC Deposit and Guarantee Corporation DoC Department of Cooperatives DSL Deprived Sector Lending Programme FAO Food and Agriculture Organisation FINGOs Financial Intermediary Non- Government Organisations FMDB First Micro-finance Development Bank FSAP Financial Sector Assessment Programme FSPs Financial Sector Providers GDP Gross Domestic Product GoN Government of Nepal HDI Human Development Index HLPC High-Level Political Committee IMF International Monetary Fund MF Micro finance MFDB Micro-Finance Development Bank MFI Micro-Finance Institution MWFWR Mid- and Far- Western Region NBA Nepal Banker’s Association NCF National Cooperative Federation NDBA Nepal Development Banker’s Association NEFSCUN Nepal Federation of Saving and credit Cooperatives NMBA Nepal Microfinance Banker’s Association NEPSE Nepal Stock Exchange NRB Nepal Rastra Bank PAF Poverty Alleviation Fund RMDC Rural Micro-finance Development Centre RSRF Rural Self-Reliance Fund SACCOs Savings and Credit Cooperatives SCCS Savings and Credit Cooperatives SEBON Securities Exchange Board of Nepal SCG Savings and Credit Groups SFDB Small Farmers Development Bank SMEs Small and Medium Enterprises SHGs Self-Help Groups SRGs Self-Reliance Groups UCPNM Unified Communist Party of Nepal Maoist UN United Nations UNCDF United Nations Capital Development Fund UNDP United Nations Development Fund USAID United States Agency for International Development WUPAP Western Uplands Poverty Alleviation Project

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Legal and Regulatory Review

A. Background

The inception phase deliverable # A1.1 (AFP Legal and Regulatory Support Agenda/Plan) undertakes a legal/regulatory review of the key pieces of legislation and regulations that are affecting financial inclusion in general and Micro, Small and Medium Enterprise (MSME) lending in specific. It highlights a number of issues with the existing legal and regulatory framework that have implications for the overall success of the AFP Programme. It prioritises the concerns where legal/regulatory support may be needed. Finally, the document provides a timeline for the implementation of support for the prioritized concerns during the first 12 months of the AFP Programme. The document is to be updated at the end of every year during programme life to review progress made in the past year (along with the areas where work still needs to be done) and prioritise on interventions in other pieces of legislation/regulation that will need to be worked upon. Due to the limited resources available, only those areas that can strongly impact the AFP Programme (and are not being actively addressed by other donors), shall be considered for direct support. A review of the legal/regulatory framework concerning Mobile Financial Services (MFS) and Payment Systems is provided separately under inception phase deliverable # A1.5 (Report on Integrated Approach to Mobile Financial Solutions). Once completed, priorities identified for AFP Programme involvement in the MFS and Payment Systems area will be included in the timeline for the first 12-months of our legal/regulatory reform priority agenda. An understanding on these priority legal/regulatory reform agenda items and the rollout of a timeline for the first 12-months with the relevant parties in Nepal [in particular the Microfinance Promotion & Supervision and the Regulation Departments in the Nepal Rastra Bank (NRB)] will be finalised. The AFP Programme support will also include advice on key pieces of regulations/legislation, workshops on key topics and interchange with other country regulators that have worked on similar issues. This will continue throughout the programme. Finally, while not a required deliverable under the AFP Programme, DFID has asked LBG for recommendations on the interventions needed to develop a local capital market environment that fosters an ecosystem for start-up businesses to establish a solid basis from which to grow, seek equity finance (in addition to debt only) at different stages of their growth cycle, and thereby diversify their capital base. The LBG AFP Programme team is in consultations with DFID to undertake an analysis to identify the constraints faced by actors (entrepreneurs, investors, incubators, etc.) within the private equity/SME formation ecosystem. A separate paper will draw on the discussions with the NRB, SEBON, NEPSE, Company Registrar and private sector to suggest improvements in the legal and regulatory environment for SME formation, taxation, NEPSE listings, securities market infrastructure and co-participation with venture capital players and banks to provide innovative financing options. Areas identified by a 2013 IFC report1 affecting SME formation, including starting a business; obtaining construction permits; protecting investors; enforcing contracts and resolving insolvency, will also be reviewed once the modalities for doing this work are finalised.

B. Introduction to the Financial Sector

Nepal’s financial sector comprises of variety of institutions. 198 Bank and Financial Institutions (BFIs) are classified into four categories (A, B, C and D) as per the BFI Act 2006. Figure 1 below provides a synopsis of different types of financial institutions, their governing act, respective regulatory bodies, etc.

1 Doing Business, Understanding Regulation for SMEs, 2013, IFC.

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Figure 1 –BFIs and other FIs in Nepal2 SN Types of Institutions Number Governing Act Primary Regulator

1. Class A (Commercial Banks) 30 BFI Act 2006 AD NRB 2. Class B (Development Banks) 81 BFI Act 2006 AD NRB 3. Class C (Finance Companies) 52 BFI Act 2006 AD NRB 4. Class D (Micro Finance Dev. Banks) 35 BFI Act 2006 AD NRB 5. Financial Intermediary NGOs (FINGOs) 28 Financial

Intermediation by Societies Act 1998 AD

NRB

6. Licensed Cooperatives (Limited Banking License by NRB)

15 Cooperatives Act 1991 AD

DoC and NRB

7. Insurance Companies 25 Insurance Act 1992 AD Insurance Board 8. Other NGOs involved in MF (Estimated) 15000 9. Cooperative Societies 31177 Cooperatives Act

1991 AD DoC

10. Among Cooperative Societies SACCOs & Saving Credit Cooperatives (Estimated)

18000 Cooperatives Act 1991 AD

DoC

11. Postal Saving units 117 Postal Act 1957 and By laws 1976

GoN

NRB--the central bank of Nepal--is the apex institution responsible for overseeing the Nepalese financial sector. To perform this primary function, NRB is empowered by the Nepal Rastra Bank Act 2002 (which replaced the original NRB Act 1955). The Act provides authority to NRB to license, regulate and supervise BFIs. It also allows NRB to take appropriate action against the BFIs if their activities and performance are against their fiduciary duty; and which may cause systematic risk to the sector. The BFIs are governed by BFI Act 2006 and all institutions licensed by NRB have to adhere to this act. Prior to the promulgation of the BFI Act, banks in Nepal were licensed and regulated under multiple laws. BFIs established by the Nepalese Government (such as the Nepal Bank Ltd, Rastriya Banijya Bank, NIDC and Agriculture Development Bank, Nepal) had their own separate Acts while the rest of the private commercial banks were established under Commercial Banks Act 1974. Development Banks and Finance Companies were established under Development Bank Act dated 1996 and Finance Company Act dated 1985. BFI Act 2006 was promulgated to consolidate and replace all these separate Acts.

The present Act and regulations issued by NRB are the outcome of more than two decades of financial sector strengthening support from the World Bank, IMF and other major donors. The process of reform was slow during the decade long internal conflict. However, with the end of the armed conflict, modernization of the banking system coupled with revamping of the legal and regulatory framework became a priority for the GoN. The impetus for reform was also a result of the global financial crisis in 2008, as well as serious banking malpractices and insider lending evidenced in many of the domestic BFIs. NRB has proposed further reform in the banking laws. However, the current Constituent Assembly (CA) has been pre-occupied with the constitution drafting process; and has been unable to accord the time needed to deliberate on the reform of the existing banking laws as well as other proposed legislation (discussed below). Some of these proposed changes and draft legislation was presented to the first CA over 4 years back. Draft acts have been returned back to the initiating agencies for further review and amendments necessary to accommodate the evolving political environment.

C. Review of Current and Proposed Acts and Regulations

C.1 Existing Acts and Proposed Amendments BAFIA 2006 This Act is the primary legal framework for the financial sector and provides the basis to establish and operate BFIs. It covers incorporation for the types of BFIs and their allowable mandates, governance systems, liquidation process and the regulatory authority of the NRB.

2 Banking statistics as of mid-October 2014 obtained from the NRB.

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It provides due recognition for private ownership of BFIs and is based on the principles of system safety and soundness. The act was promulgated as part of the initiation of financial sector reforms in 2006 following extensive consultations with the stakeholders. Draft revisions to this Act under consideration include a focus on corporate governance, strengthened systems safety and soundness, increased powers to the NRB for supervisory oversight, incorporation of the provisions for mergers and acquisitions into the Act, streamlining of liquidation processes for financial institutions and provisions for the establishment of an Infrastructure Bank. The proposed amendments to this Act have been returned to the NRB for further review. The amendment is intended to bring the provisions of the Act in line with recent best practices. Financial Intermediation by Societies Act 1999 This act was issued at a time when BFIs were reluctant to penetrate in the underserved areas of Nepal. Some NGOs were permitted by NRB to have limited licenses to carry out financial services and act as intermediary groups that provide financial services (usually savings and loans) for end clients through MFIs. Termed as FINGOs, these institutions began to quickly expand and broaden their reach in the underserved areas. A rapid growth in the client base, savings mobilisation and loan capital over the past few years has resulted in the FINGOs drawing added scrutiny from the NRB. The FINGOs have been mandated by the NRB to transform to MFDBs (and fall under the BFI Act) by mid July 2015 or otherwise close down their operations. Many of the FINGOs are in the process of transformation and it is expected that they will fully comply with NRB guidelines using NRB issued incentives to do so. Once the transformation process is complete, this Act will cease to exist. Cooperatives Act 1991 Formal Cooperatives have been operating in Nepal for over 60 years under the auspices of successive legislation that was last amended in 1991 and became the Cooperatives Act of 1991. This Act was the outcome of the democratic process started in Nepal in the 1990s. GoN’s liberal policy towards the establishment of cooperatives over the years has resulted in 31,000 cooperatives that have been established all over the country. Over 18,000 of them have their presence throughout the country (with concentration in urban and semi urban areas) and are involved in savings and credit activities. The sheer number of these cooperatives and the size of their business dealings have made it difficult for the Department of Cooperative to effectively regulate and supervise the sector. During the last decade, over 300 cooperative societies were reported to have been in financial trouble; with huge amount of members’ savings lost. And most of those troubled cooperatives were from big cities such as Kathmandu. Cooperatives established in small towns and semi urban areas have done well comparatively. The GoN has time and again formed task forces (the most recent being in 2013) to investigate and suggest measures for sound and safe operation of cooperatives in Nepal. These multiple deliberations have made it clear that a new law is needed and that a more robust system for monitoring and supervision is critical. A draft revision of the new Act has been drafted and is undergoing review by stakeholders. The stakeholders associated with the cooperative movement have differing views on the new draft act. NEFSCUN (National Federation of Saving and Credit Cooperatives Societies) has been advocating for a separate law for Savings and Credit Cooperative Societies (SACCOS). The National Cooperative Bank has called for a cooperative banking law. NRB has proposed that all cooperatives engaged in savings and credit activities to be regulated under the proposed Microfinance (MF) Act (discussed below). The provisions of the MF act are limited to cooperatives that perform MF activity and seek permission for such license. These differing views have created more confusion even though having a sound overarching

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Cooperatives Act would enhance financial inclusion, and enable access to finance by communities living in the rural areas of the country. The draft Act has been returned to the Department of Cooperatives for further review and amendments. Recognizing the critical role played by cooperatives in the AFP programme priority districts, it is evident that there is AFP programme support in the preparation and passage of this key piece of legislation. Insurance Act 1992 The Insurance Act provides the legal basis for life and non-life insurance companies to perform their activities. This law is also in the process of revision to accommodate better insurance practices, provision for micro insurance, improved governance, faster claim settlement and regulation of reinsurance, etc. At present many of these above-mentioned matters are being managed through directives issued by the Insurance Board. The provision for micro insurance and better crop and livestock insurance system will have a positive impact. Therefore, there is need for the AFP Programme to contribute to the development of the revised Act. Secured Transactions Act 2006 This act was promulgated to secure banking transactions through a registry for maintaining a record of collateralised movable and intangible assets. Since its enactment, the registry is yet to be established. BFIs have been lobbying strongly for the establishment of this registry to mitigate the risk associated with lending against movable assets (including automobiles, inventory, accounts receivables, etc.) that may have already been pledged to another financial institution. A weak property registration system, which inhibits the ease of collateralisation and increases the cost of borrowing, and bankruptcy dealings pose additional constraints to SME lending given slow, complicated procedures as well as the low recovery rate. The Ministry of Finance issued a letter of intent to the Credit Information Centre Limited (CICL) to house the movable registry under its auspices. Discussions with CICL have confirmed that the institution has begun the process of setting up this registry, and that it expects the same to go live by July 2015. Industrial Enterprise Act 1992 AD

This Act has classified Nepalese industries as follows: Cottage Industries: Traditional industries utilizing specific skill or local raw materials and resources, and labour intensive and related with national tradition, art and culture Small Industries: Industries with a fixed asset of up to an amount of Rs.30 million rupees are classified as small industries. Medium Industries: Industries with a fixed asset between Rs.30 million and 100 million rupees shall be named as medium industries. Large Industries: Industries with a fixed asset of more than Rs. 100 million shall be named as large industries. As the classification above is limited (based on fixed assets only), the AFP Programme will need to work with the Nepal Rastra Bank (NRB) and Ministry of Industry on the development of a uniform definition of SME.

C.2 Proposed New Legislation MF Act (Also referred to as the 2nd tier Regulator Act) This proposed act was drafted following considerable deliberation with stakeholders and first submitted in 2010 for legislative review and enactment. The act was never adopted and continued to undergo revisions, with the last significant revision made at the end of 2013.

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The draft is back with the NRB for further review. The objective of the proposed act is to build a system for better regulation of the MF sector through the creation of a 2nd tier institution/authority under NRB supervision. As per this draft act, the MFDBs, FINGOs and Cooperatives involved in savings and credit would come under the supervision of the new regulatory authority. Recognizing the implications of this proposed act for the institutions named above as well as for the overall goals of the AFP Programme, it would be important to follow developments with this draft legislation and provide support, as and when needed, to the NRB. Deposit and Credit Guarantee Act This is a new Act drafted to facilitate deposit insurance and the credit guarantee programme. Up until now, the NRB has used directives/instructions that have enabled the formation and operations of the Deposit and Credit Guarantee Corporation (DCGC). Established in 1974, the DCGC has been providing deposit insurance for BFI customers as well as loan guarantees to participating financial institutions. On the loan guarantee side, the DCGC began guaranteeing priority sector lending of commercial banks. Following the phasing out of this programme, DCGC has been extending guarantees for livestock loans, DSL mandated loans, as well as SME loans extended by Class A, B, C and D BFIs. The focus of the institution has been more on deposit insurance and less on credit guarantees. The proposed law has been drafted with the support of the NRB and technical assistance funded by DFID and the World Bank. The major focus of this new law is to provide a sound legal framework for deposit insurance; with lesser emphasis towards supporting a loan guarantee programme. This draft is under review by the Government. Recognizing the key role that loan guarantee facilities are likely to play in advancing the AFP Programme objectives, developments with this draft act will need to be closely monitored and assistance provided in the reviews, as and when appropriate.

D. Regulatory Framework Governing Financial Sector in Nepal

D.1 Nepal Rastra Bank Nepal Rastra Bank is the regulatory authority for BFIs in Nepal. Nepal Rastra Bank Act 2002 guides its activity. It also receives authority from other Acts i.e. BFI Act, FI by societies Act etc. It is a licensing, regulatory, supervisory and enforcement authority. It exercises its regulatory and supervisory oversight as follows: D.1.a Regulation of Class A – D BFIs NRB’s Bank and Financial Institutions Regulation Department (BFIRD) regulates all Class A, B, C and D BFIs. This department is responsible for issuing and revoking licenses, enforcing regulatory authority and undertaking liquidation proceedings-as and when needed. The department interprets legal provisions of the acts mentioned above, issues directives and circulars and calls on stakeholders (BFI executives) for discussions on regulatory matters, as and when, necessary. A Regulation Committee formed under the chairmanship of a deputy governor of the NRB and having representation of officials from the supervision department, legal department, foreign exchange department and research department, provides guidance to the BFIRD department. The department is headed by an Executive Director, who has under him/her various units headed by Directors. Outlined below are major regulations of relevance to the AFP Programme. D.1.a.1 Existing Major Regulations for Class D (MFDBs) Financial Institutions Nepal Rastra Bank has issued a separate set of unified directives for MFDBs. It updates these directives from time to time through the issuance of circulars. Based on the current directives,

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MFDBs can undertake MF functions as per the following requirements established by NRB: Loan Limits: - Individuals in group guarantee basis without collateral- Rs. 100,000 maximum for first time

borrowers - Individuals in group guarantee basis without collateral- Rs. 200,000 maximum for

borrowers with over two years of good performance on loans received - Individuals without group guarantee with collateral- Up to Rs. 60,000 maximum per loan

amount - Renewable energy loan (Solar home system and Bio gas) to group members- Up to Rs,

60,000 maximum per loan amount - Individuals with collateral for Micro enterprise loan- Rs. 300,000/- maximum for first time

borrowers - Individuals with collateral for Micro enterprise loan- Rs. 500,000/- maximum for borrowers

with over two years of good performance - MFDBs can lend up to Rs. 500,000/- for micro enterprises with collateral to people

(irrespective of whether they are in a group or not) living in VDC locations where there are no other BFIs,

- Women micro entrepreneurs with the project asset as collateral can be provided loan of up to Rs. 7,00,000 (thought outlined in the Monetary Policy 2014/15, guidelines from NRB have yet to be issued to MFDBs)

- Total lending exposure in the Micro Enterprise segment should not exceed 33 per cent of total outstanding loans of an MFI.

- Loan received from whole sale providers must be utilized for microfinance within 3 months

- Credit Information for borrowers seeking loans above Rs. 50,000 to be sought from all other MFIs operating in the particular area

Observations on other major directives that have an impact on the MFDB’s include: - Can be incorporated with a lesser paid up capital then other BFIs - Allowed to operate with lower capital adequacy and liquidity ratios - Easier licensing requirements - Branch expansion in the adjoining Hills and Mountain districts allowed with the same

capital base - Easier to open branches in NRB priority districts - Tendency on part of the NRB recently to not approve branch expansion in the VDCs

where there are already other MFDB branches in operation

Many of the above directives are an improvement from the past, with the NRB having favourably responded to the demands of the industry. Areas where there is still a lack of clarity, and where potential intervention/support from the AFP Programme would lead to increased financial outreach, include:

- Making clearer regulations for SME lending (Security, Project security, collateral etc.) - Clearer set of regulations for mobile banking by MFIs - Reassessment of the criteria deployed for branch opening

D.1.a.2 Deprived Sector Lending (DSL) Directives for Class A, B and C BFIs NRB regulations require Class A, B and C institutions to allocate a percentage of their credit portfolios (4.5%; 4.0%; and 3.5% respectively) to deprived sector lending. Some banks have established microfinance subsidiaries and specific programme packages to meet the requirement and deepen financial services among clients. Others have chosen to wholesale lend to MFIs who in turn, lend to deprived clients. NRB regulations have called for the following features/requirements for loans to be made under the DSL programme:

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- Individuals in group guarantee basis without collateral- Rs. 100,000/- maximum for first

time borrowers - Individuals in group guarantee basis without collateral- Rs. 200,000/- maximum for

borrowers with over two years of satisfactory loan repayment performance - Renewable energy loan to a family- Up to Rs, 100,000/- and up to Rs. 150,000/- to

borrowers with over two years of satisfactory loan repayment performance - Foreign employment loan - Up to Rs. 150,000 with or without collateral - Education loan to the students of poor families up to Rs. 200,000/- with credit guarantee

scheme - Individuals with collateral for Micro enterprise- Rs. 300,000/- maximum for the first timers - Individuals with collateral for Micro enterprise- Rs. 500,000/- maximum for borrowers with

over two year good performance - People living at VDCs where there are no other BFIs; MFDBs can lend up to Rs. 500,000/-

for micro enterprises with collateral whether they are in a group or not - Women micro entrepreneurs with the project asset as collateral and credit guarantee, can

be provided loans of up to Rs. 700,000 (Note: this was recently raised from Rs. 500,000) - Micro hydro (up to 500 KW) loan to private sector, consumer group or to cooperative

society up to an amount of Rs. 10,000,000 - If small farmers operate cold storage in groups, each farmer family to be extended up to

Rs. 300,000 per family - Rickshaw loans to rickshaw operators - Loan to rural cooperative societies to provide post-harvest services to farmers of up to Rs.

10,000,000 - Loan to backward communities like Chepang, freed forced labours homeless, freed sex

workers, etc. of up to Rs. 200,000 - Loan provided to Cooperatives other than Saving and Credit institutions who are

engaged in collective farming (livestock and poultry) of up to Rs. 10,000,000/cooperative (Per member loan of up to Rs. 90,000)

- Loan for raising cattle for wool and for weavers up to Rs. 300,000 and Rs. 400,000 for those with two years of satisfactory performance on loans undertaken

Apart from the above, the following loans and investments are also characterised as DSL for Class A, B and C BFIs: - Wholesale loan provided to MFDBs and other MFIs - Loan provided to Cooperatives engaged in MF lending activities - Loans provided to whole sale MFDBs - Equity investment in class D MFDBs - BFIs who provide loans for foreign employment of up to Rs. 150,000 per person - Loans provided to poor families on group or individual basis for construction of low cost

housing of up to Rs. 400,000 with collateral - Participation in the Youth Self Employment Fund

While meant to increase to lending to the poor, the DSL programme has largely been viewed as largely making the MFIs richer, as they are able to lend the money at a low rate and then lend it to borrowers at a much higher rate3. There have also been reports of MFIs maintaining higher spreads despite reduction in borrowing costs. There is also little to no formal tracking of the scheme to determine if the loans are actually reaching the neediest borrowers and because most FSPs are located in the urban and Terai areas, remote rural areas are not prioritised. Instead a lack of accountability and information sharing has resulted in overlaps of clients and products among banks and MFIs, contributing to client over indebtedness. Additionally, the attitude of commercial banks to avoid investment in more difficult geographical areas and less-educated, riskier clients has not significantly changed. The AFP Programme may need to work with NRB to discuss these issues, including making

3 A 2011 report found that Return on Assets (RoA) of the typical MFI is 2-3%, exceeding that of commercial banks, and an average of 32.7% return on equity (RoE). (Sanjay Sinha, Micro‐Credit Ratings International Limited, Nepal Microfinance: Rising above the turmoil – a financial and social analysis, Nepal Microfinance Review, 2011).

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the case for: • Re-examining the role and efficacy of the DSLP with a view for further improvements; and • Helping NRB establish a basis for providing banks with an entitlement to offset their

expansion in the MFWR through alternative delivery channels and e-banking service development costs against the DSL requirement, etc.

D.1.a.3 Productive Sector Lending Regulations for Class A, B and C BFIs (Agriculture, Energy, Tourism and Cottage Industries)

NRB has also mandated Class A, B and C banks to invest in the above-mentioned sector in line with the following:

- Class A BFIs must invest 20 per cent of their total loan capital (including 12 per cent in Agriculture and Energy)

- Class B and C BFIs have to invest 15 and 10 per cent respectively in the above sectors D.1.a.4 Branch Network Expansion Regulations for Class A, B and C BFIs

Branch network expansion regulations for Class A, B and C BFIs have outlined the following requirements for opening new branches:

- BFIs shall undertake viability assessments before opening a branch; - BFIs should have attained a minimum capital requirement as prescribed for the new

opening; - Shall have established a proper electronic information network; - BFIs intending to open a new branch shall not have more than 5 per cent NPL during the

previous quarter; - BFI board shall have approved the new branch opening; - Class C BFI can open a branch outside Kathmandu with an additional minimum capital of

Rs 5 million and will require an additional capital of Rs. 20 million top open a branch in the Kathmandu valley;

- Class A, B and C BFIs can be waived off the above provision of additional capital if they open branches in the municipality or VDC where there are less than two branches of BFIs or in the 14 districts referred by NRB as less financially accessed or priority districts;

- Class A and B BFIs shall be provided RS. 3 million and Rs. 10 million in interest free loans from the NRB for a period of one year if they open branches in the 14 NRB priority districts;

- BFIs shall be permitted to open one branch within Kathmandu valley if they have opened three branches outside the valley (1 within the 14 priority districts and 1 outside the district headquarters); and

- BFIs shall take permission from NRB prior to relocate, merge or close their branches.

The Branch Network Expansion regulations have been aimed at restricting unfair market share and over crowdedness, as well as enhancing presence in unserved areas. However, many argue that this regulation is restrictive and in contravention with free market policies. Also, recent occurrences of not allowing a 2nd MFDB branch to be established in a VDC is being perceived as discriminatory and a denial of competitively priced services.

D.1.a.5 Know Your Customer (KYC) Circulars/Regulations NRB has issued a circular on “Anti Money Laundering” and control of financial facility to terrorist activities in which KYC has been introduced in deposit taking, remittance, cross boarder transaction and credit extension activities. According to these directives, a BFI is supposed to undertake the following;

- Establish a system to recognize customer and manage a system of CDD (Customer Due Diligence)

- Not open account without a name, - Be able to identify account holder and beneficiary, - Take acceptable recognition information from the clients, - Verify the identity as per necessary,

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- Identify and monitor high risk clients, - Identify source of transaction amount, - Simplified KYC requirements for low risk clients with savings and current account having

less than Rs. 100,000 in annual deposits and withdrawals - Follow up, monitor and supply records of suspicious transaction to FIU (Financial

Information Unit) - Shall not provide information to unauthorized person, and - Shall continuously update client information and maintain the KYC information for up to

a 5 year time period.

D.1.b Supervision for Class A, B, C, D and other FIs D.1.b.1 Supervision of Class A, B and C Institutions NRB has created separate supervision departments for Class A, B and C BFIs; each headed by an Executive Director and with their individual divisions headed by Directors. These departments are responsible for supervising BFIs, enforcement and liquidation-if deemed necessary. NRB has created a supervision committee with representation from regulation, foreign exchange and legal departments that provides oversight and direction to these Supervision departments. D.1.b.2 Supervision for Class D FIs and other MFIs NRB’s Microfinance Promotion and Supervision Department (headed by an Executive Director) is responsible for promoting microfinance institutions as well as supervision of MFDBs; FINGOs and Cooperatives with limited banking license.4 The department also manages the Rural Self Reliance Fund (RSRF), a micro finance whole sale fund established jointly by GoN and NRB. Since the last decade, the NRB has been working to strengthen the activities of this department. As noted in a prior section, the NRB has proposed a 2nd Tier Regulator Act that calls for the establishment of a second tier institution called the Microfinance Promotion and Regulation Authority. This draft Act encompasses the operations of current MFDBs, FINGOs and Cooperatives (member deposit taking cooperatives). Cooperatives have expressed reservations with their inclusion into this draft legislation; they have been lobbying for an improved Cooperative Act. As noted earlier, there are factions also arguing for a separate law for SACCOS and Cooperative Bank. The GoN has sent back this draft act to NRB for a re-consideration in light of all the objections raised. Due to the involvement of the AFP Programme with all these above-mentioned institutions, it would be appropriate for the programme to advise the NRB Microfinance Promotion and Supervision Department on how best to restructure this proposed microfinance act.

D.2 Department of Cooperatives D.2.a Structure of the Department and Enforcement Framework The Nepalese government has accorded high importance to cooperatives. Cooperatives fall under the oversight of the Department of Cooperatives, which has been part of the Ministry of Poverty Reduction and Cooperatives since 2012. The department is headed by a Registrar. The Department has 38 division offices in the 5 geographic regions of the country. These offices oversee the cooperatives in the 75 districts as per the directives established by the Department. The Registrar has been entrusted various responsibilities by the Cooperatives Act 1991,

4 Only 15 as of July 16, 2014. NRB has cancelled the policy of providing such license to other cooperatives and also persuading these remaining to voluntarily withdraw the license.

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including the registration; oversight of cooperative societies and federations. The Registrar has the authority to discipline cooperative societies, including levying of fines and ordering their closure. The current Cooperative Act does not have enough provisions on prudential regulation and supervision. Moreover, the Department of Cooperatives lacks the resources to effectively monitor the growing number of cooperatives in the country. All stake holders have realized the need for the improvement of the Act to account for the above.

D.2.b Listing and Brief Description of Regulations/By-laws/Standards Relevant to AFP

Department of Cooperatives has issued cooperative Mapdanda (Standards- Regulations) 2011 for proper functioning of cooperatives. Major regulations as per Mapdanda are the following:

- Registration: It has taken elements like residency in the same community in a

prescribed location or same occupation or same institution as member criteria. It has also prescribed geographical limits for primary cooperative societies.

- Management: It has set the number of board of directors based on the types of cooperatives, and established the procedures for conducting meetings, etc.

- Saving mobilization: It calls for a clear set of policies for savings mobilization from the members. Total saving shall not exceed 10 times of primary capital.

- Interest rate: Cooperatives cannot charge flat and compounding interest rate and interest spread can’t exceed 3 per cent.

- Accounting basis: Cash basis. - Lending to a single member to not exceed 10 per cent of the total capital fund. - Loan classification and provisioning: Cooperatives shall classify loans as Good

(Payment not overdue), Doubtful (Payment overdue not over 1 year) and Bad (Payment overdue over 1 year) and make provision of 1%, 35% and 100% respectively.

- Liquidity: Cooperatives have to reserve 15% of total savings as liquid funds. - Dividend policy: Cooperatives can’t distribute dividend before offsetting previous

year’s expenses. They cannot distribute dividend of more than 15% as prescribed by law.

- The mapdanda prescribes the functioning of federations, provides guidance on audits, sets the requirements of the monitoring system; compliance standards and the code of conduct, etc.

- Mapdanda has instructed cooperatives to incorporate the PEARLS system for monitoring performance and disclosing the same at annual general meetings.

- Cooperatives are not allowed to engage in FOREX and off-balance sheet transactions (i.e. guarantees, Letters of Credit etc.). They shall not provide overdraft facilities.

- Cooperatives can’t open current accounts and can’t accept fixed deposits for over 3 years.

- Cooperatives can’t be involved in lottery and gift schemes.

The above guidelines are issued to ensure sound practices. However, lack of enforcement capacity due to limited resources has led to lax controls within several cooperatives. This has put several of these institutions into a difficult situation, with deposits of several members reported to have been lost. The Department of Cooperatives needs institutional strengthening support, including trained human resources and a proper budget to manage its activities.

D.3 Insurance Board

Insurance Board is the regulator as well as the supervisory body for the insurance business in Nepal. It was established under the Insurance Act 1992. It regulates life, non-life and reinsurance business. The Insurance Board registers insurers; brokers; agents and surveyors, regulates, supervises and takes corrective action if necessary. The Insurance Act has also allowed the Insurance Board for setting & reviewing insurance tariff and claim settlement procedures.

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D.3.a Structure and Operations of the Insurance Board

The Insurance Board is headed by an Executive Chairman and an Executive Director under him. There are 3 divisions (Legal & regulation, Supervision & Research and Development & Management) headed by directors. The board provides license and revokes if necessary to insurers, brokers, agents and surveyors. The board also issues regulations to all these institutions.

D.3.b Listing and Brief Description of Regulations/By-laws/Standards Relevant to AFP

The Insurance Board has issued micro insurance regulations. The law is also in the process of revision to accommodate micro insurance, reinsurance and other prudential regulation and supervision mechanisms. As the revision process is ongoing, the AFP Programme can provide critical input related to the launch of micro-insurance through MFDBs and other programme supported financial institutions.

E. Key Issues with Legal and Regulatory Framework and Implications for AFP Programme

Summarized below are the key issues with the legal and regulatory framework of relevance to the AFP Programme:

E.1 BAFIA 2006; Accompanying Directives/Circulars and the Proposed Amendments

- The Act and the proposals for revision do not specifically mention SME or MSME financing mechanisms. That has been left to regulations or self-regulation by BFIs. On the topic of security of loans, the Act mentions only “BFIs can extend loans against movable and immovable asset or other acceptable guarantee”. The provision is not enough for SME financing purposes. Most of the BFIs have interpreted these as being physical collateral (mainly land and building) with no consideration for project cash flow based lending. NRB supervisors also have little regard for project cash flow based lending.

- The Nepal Bankers Association (NBA) has proposed several changes to the proposed amendment to the BFI act, with major focus on the use of language, strengthening banks’ governance and loan recovery. As there is no mention of SME lending in the proposed draft, the comments from NBA also are not specific about MSMEs.

- In overall terms, the current regulations on branch network expansion are geared towards improving access to finance in remote locations. But in the case of MWFWR there is need to have some further improvement in the definition. Rather than just mandating the opening of 3 branches in rural areas to open a branch in KTM valley, the regulator could consider requiring opening of one or two branches in the rural areas of MWFWR if requesting a branch opening in the urban area of the same region.

- Due consideration for increasing the ceiling for transactions up to Rs 1 million using the same simplified KYC provisions currently in effect for transactions up to Rs. 100,000 account needs to be revised to Rs. 1 million5 to accommodate local SME entrepreneurs. This will enable more account openings.

- Restriction on Spread: The financial services community considers this NRB directive as regressive. Such a directive has the potential to deter banks from either accurately pricing their risk exposure or shying away from lending into priority sectors and geographical areas of interest.

- Multiple lending issues compounded due to delays in the establishment of the movable asset registry. However, we understand that the Ministry of Finance has issued letter of intent to allow CICL to act as asset registry.

5 Any transactions above Rs 1 million would fall under the provisions of the anti-money laundering act.

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- Current Directive #12 on Credit Information is not encompassing enough – does not touch on the need to bringing in cooperatives and MFIs into the CICL; covers only Class A-C institutions. There is a need for improvement in this matter.

- The role and efficacy of the DSLP: There seems to be the need for reviewing the whole system of DSLP to improve the system for better access to finance for poor as discussed under D.1.a.2 above.

- Absence of an institutionalized national payments systems framework/structure at the NRB: NRB has announced a strategy for national payment system but there is no legal/regulatory framework at present to enable the formation of a Real Time Gross Settlement (RTGS) system.

E.2 Financial Intermediation by Societies Act and Regulations/Circulars

- NRB has set out a time frame until mid-July 2015 for transformation of FINGOs to MFDB.

However, some FINGOs lack capacity to undergo the transformation process within the stipulated time.

E.3 Cooperatives Act and Regulations

- The Department of Cooperatives lacks limited institutional capacity to regulate a large

number of cooperatives, further there is a divided view whether there should be a supervisory agency for cooperatives.

- No robust performance classification and monitoring system to detect early warning signals and initiate immediate corrective measures.

E.4 Insurance Act and Regulations/Circulars

- As mentioned earlier, the Insurance Act does not cover micro insurance and agricultural insurance. Some of these activities are covered through regulations in the recent time but is not considered to be enough by the stakeholders.

E.5 Proposed MF Act (2nd Tier Regulator Act)

Possible areas for further revision could include: - Whether MFDBs, FINGOs and Cooperatives involved in savings and credit should come

under this Act - Like other wholesale MFDBs, the possibility of inclusion of the RSRF into this proposed MF

Act; further exploring the likelihood of subsuming the RSRF into one or more of the existing wholesale MFDBs

- MFDBs with presence in rural areas to be allowed to open a special lending window to local cooperatives and existing or new self-help groups to enable enhanced access and financial inclusion

E.6 Proposed Draft Deposit and Credit Guarantee Law

- Proposed draft has considered more on deposit insurance. That is obvious. But more deliberations are required to address the future of an effective and properly institutionalised loan guarantee programme.

E.7 Amended Cooperative Act

The proposed Cooperative Act revisions are in the process and have not been finalized yet. The following issues have to be addressed prior to finalizing the basis for the proposed Act:

- Should there be separate Acts for SACCOS, Cooperative bank and other form of cooperatives engaged in saving s and credit?

- Whether NRB proposal to bring SACCOS and other cooperatives under proposed MF Act is the most appropriate option?

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- Or, SACCOs and Cooperatives should be continued to be regulated under a more robust Cooperative Act

- Amended Cooperative Act to be organised under separate chapters for regulating SACCOS, cooperative banks and other cooperatives for specific purposes

- Areas where current regulations (Mapdanda) require improvement and changes that might be required in the future

E.8 Industrial Enterprise Act 1992

- The official GoN definition, as shown in Figure 2, differs from the official World Bank

definition. Further, different BFIs have their own definition on what will constitute a SME (based on annual turnover, loan size, etc.)

Figure 2: Definition of Micro, Small and Medium Enterprises

Government of Nepal6 World Bank

Micro Fixed Assets up to NPR 200,000 (USD 2,055) Up to 10 employees Total assets up to USD 10,000 or annual sales up to USD 100,000

Small Fixed assets between NPR 200,000 and not exceeding NPR 30 million (USD 308,248)

Between 10 to 50 employees Total assets or annual sales up to USD 3 million

Medium Fixed assets between NPR 30 million and NPR 100.0 M (USD 1,027,495).

Between 50 to 300 employees Total assets or annual sales up to USD 15 million

F. Prioritization of Legal/Regulatory Support to Help Accelerate AFP Interventions

Figure 3 outlines below proposed interventions/support in the legal/regulatory area based on our assessment in the preceding sections, the importance of these interventions to financial inclusion and the AFP Programme, the institutions involved, where changes need to be made and the associated priority of each.

Figure: 3: Prioritisation of Legal/Regulatory Support Proposed Intervention/Support Why Important for

Financial Inclusion and AFP Programme

Institutions Involved

Where Change Needed

Priority – High, Medium, Low

F.1 Revisiting SME Definitions To develop a consensus around a uniform definition of SME for lending purposes

Better penetration to targeted enterprises and reporting

NRB NBA NDBA NMBA

NRB Directive High

F.2 Clarity on Treatment of security / collateral for the purpose of SME lending

Encourage institutions to move away from collateral based lending to a mix of cash-flow and physical collateral

NRB NBA NDBA NMBA

Revisions to BAFIA and NRB Directives

High

F.3 Clarity on requirement of audited financials (currently all borrowers are required to submit audited financials when seeking a loan)

Make the requirement less restrictive for MSME borrowers (good point to start will be for MSME with loan size of below NPR 4 million)

NRB NBA

NRB directives High

6 The Industrial Enterprises Act 1992 (Government of Nepal)

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Proposed Intervention/Support Why Important for Financial Inclusion and AFP Programme

Institutions Involved

Where Change Needed

Priority – High, Medium, Low

F.4 Reconsideration of branch network expansion requirements Re-definition of the operating of 3 branches - Rather than just mandating the opening of 3 branches in rural areas to open a branch in KTM valley, require opening of one or two branches in the rural areas of MWFWR if requesting a branch opening in urban area of the same region.

Increase access to finance in MWFWR

NRB NRB Directive High

F.5 Reassessment of the productive lending mandate- Include into the required 12-20% into productive sector lending; a minimum threshold for investing in the priority districts to expedite development

To improve access of finance in the less accessed districts

NRB NRB Directive High

F.6 Assessment of the role and efficacy of the DSLP - Disaggregate DSL requirements

based on loan exposure across the different regions (with emphasis on priority districts)

- Call for BFIs and MFDBs maintaining some level of proportionality in lending, especially in priority districts

- Stakeholder dialogue to explore Class A-C FIs to defray part of the DSL requirement in lieu of MSME infrastructure improvements

To improve access of finance

NRB NBA NDBA NMBA

NRB Directive Medium

F.7 Draft MF Act - Review of the proposed draft bill for the establishment of the proposed MF Act, especially proposed revisions cited in Section E.5 above.

To provide appropriate legal framework and sound regulation and supervision

NRB NMBA DoC NEFSCUN NCF

Proposed draft of the Act

High

F.8 Proposed DCGC Act Re-articulation of the DCGC’s role in light of concerns over its ability to support credit guarantees (likely to grow significantly) with a limited capital base and its continued role in providing both deposit and credit guarantees

To have good system of Deposit Insurance as well as good loan guarantee system

DCGC NRB GoN

Proposed draft of the Act

Medium

F.9 Draft Cooperatives Act Allow Cooperatives to use the fund received from wholesale funds as per the agreement and waive the single borrower limit for this purpose.

Occurring in many cooperative informally. Need to make it formal. Will help increase access to poor

DOC Change in Mapdanda (Regulations) for cooperatives

High

F.10 Revisiting KYC Provisions Due consideration for increasing the ceiling for transactions up to Rs 1 million using the same simplified KYC provisions currently for Rs. 100,000

Increase SME loans and expansion

NRB

NRB Directive High

Changes to Current Directive #12 on Credit Information. Covers only Class A-C Instns.

Need to bringing in cooperatives and MFIs into the CICL

NRB NRB Directive High

G. Timeline for the Implementation of Prioritized Interventions

Figure 4 provides an indicative timeline for the AFP Programme to work on the prioritized interventions during the first year of the implementation phase.

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Figure 4: First 12 Months Legal and Regulatory Interventions S.N Interventions 1st Year- Implementation Phase

Q1 Q2 Q3 Q4 1 SME Definition articulation through NRB

directive

2 Revisit of KYC Provisions

3 Clarity on Treatment of security /collateral- through proposed revisions to BAFIA and NRB directive

4 Clarity on requirement of audited financials through NRB directive

5 Reconsideration of branch network expansion requirements through NRB directive

6 Reassessment of the productive lending mandate through NRB directive

7 Assessment of the role and efficacy of the DSL through NRB directive

8 Draft MF Act review

9 Draft Cooperatives Act review and submission of recommendations

10 Review Cooperative regulations (Mapdanda)

11. Changes to Current Directive #12 on Credit Information

H. Conclusion

This inception phase deliverable has attempted to understand the legal/regulatory areas that have a bearing in enhancing financial inclusion in the country. We have also identified issues in these areas and suggested some interventions to address them. The timeline for work on the above interventions is indicative and is subject to final discussions and reviews with the concerned institutions. Following interactions with the institutions, we will be in a better position to decide where we can prioritise our support.