On a recent trip to Chennai, I met an American lady seated next to me. It was a flight of about two hours and hence a fairly long time to converse. She introduced herself as Gene Turnbull, a senior research scholar at Stanford University; currently working on the financial sectors of emerging markets, mainly focusing on South Asia. What a coincidence?

I asked her, What is your opinion of the financial markets in this subcontinent? She looked at me for a while and then said, I may need to start from a few not too old past events that plagued the entire global financial system.That's fine with me, I quipped.

She started.

We need to look back at the global financial crisis which erupted in 2007 and severely damaged the western, mainly the advanced economies; the US was worst affected. That point in time, Asian economies, which are mostly emerging market economies, viz China, India, Indonesia etc were doing fine. They did not immediately feel the heat of the virtual collapse in the western markets, mainly the US and advanced West European Countries. China's dependence on exports was quite substantial and hence some fears loomed large about the sustainability of high rate of growth of the Chinese economy and the valuation of the currency. India was marginally better placed in the sense that the domestic demand continued to be firm and that supported the Indian growth. She further explained that the Asian economies were far more prepared in managing themselves. The governments and regulators also remained alert post Asian crisis of the late nineties.

I asked her, What do you feel about the financial markets particularly in South Asia? I'm interested to know about Nepal. She continued . Perhaps this is not a good time for the banks, mainly in the west. They are besieged with low growth and erosion in capital stemming from sovereign debt exposures and stricter regulatory pressure. As a result, they are suffering from low return on capital. It looks like that would continue to be the case thanks to enhanced capital requirement under BASEL III. She, however, maintained that the banks in India, China and other emerging markets are more likely to sustain their returns on capital despite increased capital requirements under BASEL III. This will probably create a catalytic effect in attracting more capital in the emerging markets that are experiencing a broader economic landscape.

As a sequel to the financial crisis of 2007, BASEL III did set forth revised rules for capital requirements for the banks. The minimum equity requirement, that is, Tier I capital will now be 7 per cent; a sharp increase from the present level of 2 per cent. Total capital requirement ( inclusive of Tier II) will increase from 8 per cent to 10.5 per cent. In addition, there will be a counter- cyclical buffer. To be precise, the banks may be required to operate with a capital in the range of 15-17 per cent in the years to come. You may know that the leading banks in Europe and the US already have capital adequacy of more than 14-15 per cent as mentioned.

The additional requirements under Basel III would necessitate capital injection of significant amount for the large banks in the west. The estimated amount of capital to be raised for meeting Basel III would be to the tune of 475 billion euros. The western banks would have to encounter at least three main challenges in the process of implementation of BASEL III viz firstly, the enormity of Euro Zone crisis, secondly, the slowdown in lending and contraction of balance sheets, and thirdly, stricter regulatory requirements emanating from the respective central banks.

To tell you honestly, I was enjoying the analysis. She continued. You may well guess that the investors would think twice before putting their money in the western banks as the ROI would shrink, though the safety around their investments might be better than before. So, there would be an inclination for the investors to look towards the east. I asked her, What is your opinion about the banks in India?

She replied that although the Indian Banks are passing through a stressful period resulting from falling net margin in interest, higher incidence of nonperforming loans and more restrictions imposed by the central bank in respect of sectoral lending, these banks are better positioned to maintain a good return on equity in the long term. The growing domestic demand in the EME's (emerging market economies) and their conducive macroeconomic policies would help boost bottom lines of the banks in these countries including India. I then categorically asked her a question about the smaller economies in South Asia viz Nepal. I explained my interest in knowing about Nepal. She remained quiet for some time as if she was drowned in deep thought and then quipped, What is your specific question?

I replied, What do you think about the banking system in this country? She was of the opinion that the country was in the early stage of development and the accompanying financial system needed higher level of governance and stronger foundation in the form of stricter implementation of regulations and transparency. She felt that the supervision system of the central bank needed further strengthening and more professional approach in the sense that they should not see wood for the tree.

I could not agree more that her observations were interesting. Against the back drop of a looming financial crisis in the Euro Zone and the very slow recovery in the US, it is quite likely that contagion effect can hit the emerging market economies including Nepal and this may lead to the crisis of confidence. Banks will experience falling returns, lesser ability to support credit off take and higher incidents of NPA. Considering all this, I asked her my final question on Nepali financial system, Do you think Nepali Banks require further injection of capital in order to maintain capital adequacy and create a cushion against possible erosion? She thought for a while and responded mildly, Yes, but it needs a lot of debate and political consideration . She was absolutely right. I think this is a serious subject for discussion and the sooner it is done, it's better for the country.

(Mundul is a Director with Standard Chartered Bank Nepal Ltd)