Reforms needed to strengthen Bhutan’s financial sector: World Bank Report

Reforms needed to strengthen Bhutan’s financial sector: World Bank Report

Despite significant advancements in Bhutan’s financial sector, systemic risks and challenges persist. To address these issues, the World Bank emphasizes the urgent need for reforms aimed at enhancing financial stability, governance, and inclusion. The recently released Bhutan Country Economic Memorandum outlines several policy recommendations to bridge existing gaps and vulnerabilities.

With regard to financial stability and governance, the Royal Monetary Authority (RMA) has made strides in regulation, but further improvements are essential. A shift from compliance-focused to risk-based supervision is recommended, especially for the insurance sector, which suffers from limited regulatory capacity. Enhancing RMA’s capabilities to supervise the insurance industry is critical, along with implementing risk-based solvency requirements and revising the Financial Services Act of 2011 to facilitate composite insurance.

To reduce risks in loan origination, detailed credit underwriting guidelines must be established. The Non-Performing Loans (NPL) Management Strategy identifies high loan exposures and inadequate securities as primary causes of NPLs, underscoring the need for robust credit guidelines. While existing risk management protocols provide a foundation, uneven compliance highlights the necessity for thorough assessments.

The document mandates strengthening credit monitoring practices which is vital to prevent borrowers from defaulting. Financial institutions should adopt internal procedures and reporting mechanisms to identify potential issues early, employing Early Warning Indicators (EWIs) and Key Risk Indicators (KRIs). The RMA could issue guidelines to aid institutions in establishing early warning systems and conducting regular assessments during inspections.

In enhancing loan pricing mechanisms, adjusting the loan pricing mechanism to reflect borrower risks is essential. Financial institutions should implement risk-based pricing tailored to the credit quality of borrowers, offering differentiated loan rates based on specific circumstances. This approach would allow more flexibility in pricing for micro, small, and medium enterprises (MSMEs) and larger firms.

For improvements in the bankruptcy and insolvency framework, the existing Bankruptcy Act of 1999 needs review to expedite NPL resolution, according to the WB. Most loan defaults are currently litigated, which can be time-consuming and costly. Revising the act to strengthen creditor rights and enhance the insolvency resolution framework is essential. It states that expanding arbitration options and improving court processes for collateral seizure will further support timely resolutions.

To foster a diverse banking system and mitigate reliance on dominant public banks, enhancing competition for government deposits is crucial. Given the recent struggles of state-owned banks, a strategic approach to potential divestiture should only be considered once stability and performance metrics improve.

Strengthening corporate governance frameworks is key to fostering accountability in financial institutions. The RMA’s Corporate Governance Rules and Regulations (CGRR) introduced in 2020 set standards for governance, but limitations on board size can hinder effective committee formation. Revising these regulations to allow for optimal board composition will enhance governance practices.

While deepening financial intermediation, expanding the coverage of the Credit Information Bureau (CIB) is vital to reducing collateral-based lending. A comprehensive credit history can be developed by increasing participation from various financial service providers, helping to mitigate information asymmetry. Mandatory CIB reports during loan origination can further reduce NPL risks.

Reviewing the design of the Priority Sector Lending (PSL) scheme will address lending disincentives to the CSI sector. Identifying barriers, such as credit history issues and lending condition restrictions will improve access to credit for underserved sectors. A sustainable credit guarantee scheme is also necessary to alleviate credit constraints for MSMEs, alongside enhancing monitoring mechanisms.

Implementing a robust collateral valuation system will safeguard banks against loan losses. The RMA should develop standards aligned with international practices and provide training for lenders and supervisors.

The WB highlights that in order to bolster climate finance, a comprehensive Green Finance Roadmap with clear coordination mechanisms is required. Establishing the National Sustainable Finance Committee will facilitate collaboration among financial sector authorities and relevant government bodies. A national climate finance strategy will clarify investment priorities and encourage innovation in financing mechanisms.

Building capacity and awareness around climate risks is essential for implementing the Green Finance Roadmap. Training opportunities through initiatives like the Central Banks and Supervisors Network for Greening the Financial System (NGFS) can enhance the capabilities of both public and private sectors.

In greening financial institutions, public financial institutions should align their mandates with green objectives, promoting green lending. New blended finance instruments can help attract private capital for green projects, addressing financing gaps and risk perceptions.

Green bonds represent a viable tool for mobilizing long-term capital. Regulators should promote the development of green bond markets through guidelines and standards. The government could lead by example by issuing a green sovereign bond, signaling commitment to climate goals.

To effectively scale private finance and develop green financial instruments, a detailed operational plan is needed. Understanding the barriers to financing will aid in tailoring instruments to Bhutan’s context, particularly for adaptation financing. Through these reforms, Bhutan can enhance its financial sector resilience and support sustainable economic growth.

By Nidup Lhamo, Thimphu