Kathmandu-Nepal's banking system is currently facing an unusual contradiction. Banks and financial institutions are flush with lendable funds. Lending rates have fallen to their lowest level on record. Deposit rates have also continued to decline.

Despite the availability of such cheap credit, businesses have been reluctant to borrow. As a result, banks are sitting on excess cash, forcing Nepal Rastra Bank (NRB) to absorb massive amounts of liquidity from the financial system.

The challenge now goes beyond interest rates. Weak market demand, subdued private sector investment confidence, sluggish government capital spending, and a lack of new productive projects have prevented low cost credit from stimulating economic activity. Economists describe this situation as a 'liquidity trap,' where banks have ample funds and interest rates remain low, yet lending and economic expansion fail to gain momentum.

The key question is no longer whether interest rates will fall further. Instead, the real test for the new monetary policy is whether it can raise private sector credit growth to its target of 11 percent despite borrowing costs already being at historic lows. More than Rs 1.2 trillion in excess liquidity parked in the banking system has become the sector's biggest challenge.

According to NRB's Current Macroeconomic and Financial Situation Report for the first 11 months of fiscal year 2025.26, lending rates have continued to decline across the banking sector, but cheaper credit has not translated into stronger loan expansion.

By mid June, the weighted average lending rate of commercial banks had dropped to 6.64 percent from 7.99 percent a year earlier. Lending rates at development banks declined to 7.71 percent from 9.40 percent, while those of finance companies fell to 8.90 percent from 10.22 percent.

Commercial banks have further reduced deposit rates for the month of Shrawan. The average maximum rate on individual fixed deposits has fallen to 4.167 percent from 4.258 percent in the previous month, indicating that lending rates are likely to decline further.

Just three years ago, in fiscal year 2022.23, the average lending rate had reached 13.03 percent. Since then, lending costs have steadily declined to the lowest level recorded since NRB began publishing weighted average interest rate data.

Deposit rates have also fallen to historic lows. The weighted average deposit rate of commercial banks dropped to 3.29 percent from 4.29 percent a year earlier. Development banks saw their average deposit rate decline to 3.62 percent from 5.02 percent, while finance companies recorded a fall to 4.46 percent from 6.09 percent.

The decline in deposit rates has created another problem for savers. Inflation reached 5.22 percent in mid June, exceeding the average deposit return offered by banks. This means depositors are now earning a negative real return. With an average deposit rate of 3.29 percent against inflation of 5.22 percent, the real return on savings has fallen to negative 1.93 percent, meaning interest income is no longer sufficient to preserve purchasing power.

Ordinarily, such a sharp decline in borrowing costs would be expected to boost loan demand. However, NRB data show the opposite trend. Private sector credit expanded by only 6.2 percent during the review period, compared with 8 percent growth in the corresponding period last year. Although banks are willing to lend at lower rates, businesses remain hesitant to invest, making weak credit demand one of the economy's biggest concerns.

To manage the large volume of idle funds, NRB absorbed a net Rs 39.17 trillion in liquidity through various monetary instruments during the first 11 months of the current fiscal year. In the same period last year, the central bank had absorbed Rs 21.34 trillion. The near doubling of liquidity absorption within a year reflects unprecedented excess liquidity in the banking system.

In response, NRB's Monetary Policy for fiscal year 2026.27 has placed structural reforms in the banking sector at the centre of its agenda.

Governor Biswo Poudel has announced plans to reclassify banks and financial institutions by developing a more specialised banking system based on the size and nature of their businesses. The policy also seeks to reduce operating costs, lower the cost of capital mobilisation, and ultimately pass those benefits on to borrowers and customers.

The monetary policy has also set an ambitious target of increasing private sector credit growth to 11 percent during the current fiscal year.

It also aims to keep inflation within 5.5 percent, actively use monetary instruments to maintain adequate liquidity, encourage remittance inflows through formal channels, improve the management of individual blacklisting provisions, and strengthen institutional efficiency across the banking sector.