Clarity Connect

Nepal’s financial sector reform program, initiated in 2002, has made notable progress in modernizing the legal and regulatory framework, developing key financial institutions, and increasing private sector participation. The dominance of state-owned banks has declined, and the Nepal Rastra Bank (NRB) has enhanced its supervisory and regulatory capacity. Key financial legislations and infrastructure were also established, fostering improved governance across the sector.

As of 2023, Nepal had 22 commercial banks (Class A), 17 development banks (Class B), 17 finance companies (Class C), and 64 microfinance institutions (Class D). Commercial banks dominate the financial landscape, holding nearly 89% of total banking sector assets. NRB mandates that banks allocate 25% of their lending to priority sectors such as agriculture, MSMEs, and hydro energy—set to increase to 40% by FY2025, with 15% specifically for SMEs.

Macroeconomic Context and Regional Disparities

Nepal’s economy is gradually recovering, with GDP growth projected at 4.5–5.0% in FY2025, following a slowdown in FY2023–24. Inflation eased from 7% in FY2022 to 6.5% in FY2024 due to improved agricultural output and increased public investment. Agriculture, including forestry and fisheries, employ around 80% of the population and contributing 24.1% to GDP in the current fiscal year. However, the economy remains heavily reliant on remittances, and private sector growth remains subdued.

Regional disparities persist. Bagmati Province leads in per capita income and financial inclusion, driven by urbanization, infrastructure, and digital adoption. Provinces like Madhesh, Karnali, Sudurpaschim and Koshi provinces lag behind in terms of financial services, urbanization, literacy, and infrastructure.

Deepening Financial Inclusion – Microfinance Sector (Class D Financial Institutions)

Microfinance institutions in Nepal are regulated by NRB as Class D Financial Institutions. The Nepal Rastra Bank (NRB) licensed and authorized NGOs that were engaged in community-based financial operations, resulting in the formation of Financial Intermediary NGOs (FINGOs).  MFIs are supported by the broader financial sector with major commercial institutions being shareholders and also lenders to MFIs. In addition, MFIs in Nepal are permitted to accept deposits from their members which provides 40% of funding, while also cheaper than accessing external borrowings. Investments from foreign investors and lenders is not a common practice in the MFI ecosystem, however there are steps being taken to facilitate more direct investment. At the same time, all MFIs are listed on the Nepali Stock exchange and are actively mobilizing public investments in addition to domestic institutional capital.

Microfinance institutions have spread their services throughout the country, covering 77 districts and 6 million households in Nepal. Data shows the highest number of MFIs in Lumbini province, 1162; the second one is in Madhesh province, 1061; the least existing position is in Karnali province, with only 236 branches. Apart from credit and operational risk, geographical difficulties limit expansion, with limited financial awareness and literacy among micro-borrowers.

An analysis of the 52 class ‘D’ financial institutions as of Oct 2024 reveals that there is significant variation in the financial performance with profitability, asset quality and capital adequacy improvement expected in FY2025. On an average, retail MFIs had a negative RoA of -0.4% (annualised), capital adequacy at 11.5% and gross NPL of 7.9%. The largest MFI contributes 8% of the overall market and the top 5 MFIs together make up 33% of the total market.

MFIs face rising non-performing loans (NPLs), averaging 7.9% as of October 2024. The anti-microfinance movement in Nepal led to tightening regulatory oversight in 2023 and also impacted disbursements leading to a slowdown in industry growth in FY2023. In response to the anti-microfinance movement in 2023, NRB limited the number of lenders per borrower and capped total MFI loans. The protests led to a six-point government agreement in July 2024, reinforcing regulatory oversight.

Profitability remains under pressure due to a 15% interest rate cap, with only 9% of MFIs having a RoA above 2%. As per the central bank of Nepal (NRB) directive, MFIs cannot charge an interest rate of more than 15%. With the 15% interest rate cap, profitability of MFIs is impacted with industry average RoA of 1.05% and RoE of 9.02% in FY2024. While 25 MFIs (64% of portfolio) are profitable, 12 MFIs (30% of portfolio) have less than 1% RoA and 22 MFIs (54.5% of portfolio) have less than 2% RoA. Only 3 MFIs (representing 9% of portfolio) have a RoA >2%. This indicates not just a stress on overall profitability, but also the ability of MFIs to absorb the rising NPLs. With the current capping on interest rates, and rising NPLs, growth and expansion opportunities for majority of the MFIs will be limited.

Greater need for capital to fulfil credit demand: Minimum capital adequacy threshold is 8% but given the average NPL in the sector is 7.9%, the minimum threshold is insufficient to meet the provisioning requirements for bad loans. 15 MFIs have a capital adequacy >12% and 7 MFIs have a capital adequacy > 15%.  37 MFIs have less than 12% capital adequacy, falling short of provisioning needs.

Recommendations for MFIs

Despite their wide reach and strong presence in rural areas, Nepal’s MFIs face mounting pressure from rising non-performing loans (NPLs), limited profitability, and growing public scrutiny. To address these challenges and enhance their sustainability and impact, MFIs require better financial management, diversified lending (including collateral-based products), and strengthened risk assessment to ensure sustainability and expansion:

• Enhance risk management systems: Develop robust internal audit and early warning systems to detect repayment issues before they escalate. This includes loan portfolio analysis, stress testing, and delinquency management tools.
• Introduce collateral-based and individual lending: In addition to traditional joint liability group (JLG) models, MFIs should offer secured and semi-secured loans for micro-enterprises, home improvement, agri-value chains, and renewable energy solutions.
• Use credit scoring and household-level financial assessments: MFIs should develop basic credit scoring models and digitize borrower profiling using alternative data.
• Use MIS for portfolio monitoring: Strong management information systems (MIS) enable real-time visibility of loan performance and staff productivity.
• Leverage capital markets: With all MFIs listed on NEPSE, improving governance and reporting standards can help attract long-term institutional investors.
• Build capital adequacy buffers: MFIs must proactively raise equity capital—whether through retained earnings, new investor participation, or concessional funds—to meet regulatory thresholds and absorb future shocks.

The microfinance sector in Nepal has played a vital role in expanding financial access to underserved populations across all provinces. However, it now faces a pivotal moment, marked by increasing non-performing loans, constrained profitability due to interest rate caps, and heightened public scrutiny.

While regulatory reforms and recent policy actions have sought to stabilize the sector, long-term resilience will depend on how effectively MFIs adapt their business models. This includes improving governance and financial management, diversifying loan products, embracing digital innovation, and enhancing client protection. Equally critical is the need for new capital inflows and risk-sharing mechanisms to support growth without compromising prudential standards.