Financial Markets & Institutions: Types, Roles & Nepal’s System

TAKEAWAYS:

• Financial markets channel funds from surplus units (savers) to deficit units (borrowers) via instruments like stocks, bonds, and loans.
• Depository institutions (banks, NBFIs) create liquidity by issuing deposits, while non-depository (insurance, pension funds) pool long-term funds.
• Nepal’s money market (short-term) and capital market (long-term) are regulated by the Central Bank of Nepal (CBN) and Nepal Rastra Bank (NRB).
• NEPSE (Nepal Stock Exchange) and Ncell’s mobile banking use similar principles: trading securities (stocks vs. mobile credits) to allocate capital efficiently.
• Foreign exchange markets (e.g., NTC’s forex deals) manage currency risk for exporters/importers like Daraz.
• Financial intermediation (e.g., eSewa’s digital wallets) reduces transaction costs and asymmetric information compared to direct lending.

1. Introduction to Financial Markets

Financial markets are organized systems where buyers and sellers trade financial assets (stocks, bonds, loans, forex). They ensure liquidity, price discovery, and risk sharing. Nepal’s key markets include:

• Money Market: Short-term (≤1 year) instruments (T-bills, commercial paper).
• Capital Market: Long-term (stocks, bonds, IPOs).
• Foreign Exchange Market: Currency trading (NPR/USD, NPR/INR).

Why they matter:

• Connect savers (households, pension funds) with borrowers (businesses, governments).
• Enable economic growth by allocating capital to high-return projects (e.g., Daraz’s expansion).
• Provide price signals (e.g., NEPSE’s index reflects investor sentiment).

1.1 Types of Financial Markets

1.2 Functions of Financial Markets

1. Liquidity Provision: Assets can be bought/sold easily (e.g., Ncell’s mobile credits traded via eSewa).
2. Price Discovery: Market-clearing prices (e.g., NEPSE’s closing index reflects investor confidence).
3. Risk Sharing: Diversification via stocks/bonds (e.g., a pension fund investing in NEPSE’s diversified portfolio).
4. Economic Efficiency: Allocates capital to productive uses (e.g., loans to Daraz for warehouse expansion).

2. Financial Institutions

Institutions intermediate between savers and borrowers, reducing transaction costs and asymmetric information.

2.1 Classification of Financial Institutions

flowchart TD
    A["Financial Institutions"] --> B["Depository Institutions"]
    A --> C["Non-Depository Institutions"]
    B --> D["Commercial Banks\n(e.g., NMB, Global IME")]
    B --> E["Development Banks\n(e.g., Agribank, NMB Development Bank)"]
    B --> F["Non-Banking Financial Institutions\n(e.g., eSewa, Khalti)"]
    C --> G["Insurance Companies\n(e.g., Nepal Insurance, Standard Chartered)"]
    C --> H["Pension Funds\n(e.g., Social Security Fund)"]
    C --> I["Investment Banks\n(e.g., Global IME Capital)"]

2.2 Depository Institutions

Definition: Hold deposits and lend to businesses/individuals. Key Players in Nepal:

• Commercial Banks: NMB, Global IME, Standard Chartered (issue loans, accept deposits).
• Development Banks: Agribank (focus on agriculture), NMB Development Bank (SMEs).
• NBFIs: eSewa, Khalti (digital wallets, microloans).

How they work:

• Liability Side: Accept deposits (e.g., NMB’s savings accounts).
• Asset Side: Lend to borrowers (e.g., NMB’s business loans).
• Spread: Earn profit from interest spread = Lending rate – Deposit rate.

Example: eSewa’s Role eSewa acts as an NBFI by:

1. Accepting deposits (digital wallets).
2. Lending to merchants (e.g., Kathmandu’s cafés) via instant loans.
3. Reducing transaction costs for Pathao drivers (who use eSewa for payouts).

2.3 Non-Depository Institutions

Definition: Pool funds but do not issue deposits. Key Players:

• Insurance Companies: Nepal Insurance (life/non-life insurance).
• Pension Funds: Social Security Fund (retirement savings).
• Investment Banks: Global IME Capital (IPOs, mergers).

Example: Ncell’s Mobile Banking Ncell partners with banks (e.g., NMB) to offer mobile banking, but the funds are held by banks, not Ncell. This is a non-depository relationship because Ncell does not issue its own deposits.

3. Financial Markets in Nepal

sequenceDiagram
    participant Savers as Households/Pension Funds
    participant NEPSE as Nepal Stock Exchange
    participant Borrowers as Companies (e.g., Ncell)
    Savers->>NEPSE: Buy Ncell Shares (NPR 100/share)
    NEPSE->>Borrowers: Funds (NPR 100M)
    Borrowers->>NEPSE: Pay Dividends (NPR 5/share)
    NEPSE->>Savers: Return on Investment
    Note right of NEPSE: Primary Market: IPO
    Note right of Borrowers: Secondary Market: Trading
    Note right of Savers: Capital Gains: NPR 150/share

3.1 Money Market

• Instruments:
  • Treasury Bills (T-bills): Short-term government debt (e.g., NRB issues 91-day T-bills).
  • Commercial Paper: Unsecured short-term loans (e.g., banks issue CP to raise funds).
• Participants:
  • Borrowers: Government, banks, corporations.
  • Lenders: Commercial banks, NBFIs, foreign investors.

Worked Example: NRB’s T-bill Auction NRB auctions 91-day T-bills at 6% interest. If you invest NPR 100,000, you receive NPR 106,000 after 91 days. Calculation: $$\text{Face Value}=\text{Investment}\times \left(1+\frac{\text{Interest Rate}\times \text{Days}}{365}\right)$$ $$=100,000\times \left(1+\frac{0.06\times 91}{365}\right)=\text{NPR }101,500$$

3.2 Capital Market

• Primary Market: New securities issued (e.g., IPO of Ncell in 2018).
• Secondary Market: Trading existing securities (e.g., NEPSE’s trading floor).

NEPSE’s Role:

• Lists 100+ companies (Ncell, Siddhartha Hospital, Himalayan Bank).
• Index: NEPSE-50 tracks top 50 stocks (e.g., Ncell, Global IME).

Example: Ncell’s IPO (2018)

• Issue Price: NPR 100 per share.
• Post-IPO Price: NPR 150 (traded on NEPSE).
• Investors: Retail (via brokers), institutional (pension funds).

3.3 Foreign Exchange Market

• Participants: Banks (NMB, Global IME), exporters (Daraz), importers (NTC).
• Functions:
  • Convert currencies (e.g., NPR to USD for Daraz’s imports).
  • Manage exchange rate risk (e.g., NTC hedges forex for international calls).

Example: Daraz’s Forex Needs Daraz imports goods from China (USD). To hedge, it:

1. Locks in USD/NPR rate at NRB’s forex market.
2. Avoids losses if NPR depreciates.

4. Role of Central Bank (NRB)

The Nepal Rastra Bank (NRB) regulates financial markets:

• Monetary Policy: Controls interest rates (e.g., repo rate to curb inflation).
• Bank Supervision: Ensures banks follow Basel III norms.
• Foreign Exchange Management: Manages NPR’s value vs. USD.

Example: NRB’s Repo Rate Hike (2023)

• Action: Raised repo rate from 6% to 7% to curb inflation.
• Impact:
  • Banks pay higher interest on loans → higher borrowing costs for businesses (e.g., Daraz’s warehouse expansion).
  • Savings accounts yield more → increased deposits in banks.

5. Financial Environment

The financial environment includes:

1. Economic Factors: GDP growth, inflation (affects NEPSE’s performance).
2. Political Factors: Stability (e.g., NRB’s policies post-earthquake).
3. Technological Factors: Digital banking (eSewa, Khalti).
4. Regulatory Factors: NRB’s rules on forex, interest rates.

Example: Kathmandu Traffic and Financial Environment

• Problem: Traffic congestion (like Kathmandu’s Ring Road) increases opportunity cost of time.
• Financial Impact:
  • Banks: Higher loan defaults if unemployment rises (due to traffic delays).
  • NEPSE: Investors may pull out if economic uncertainty grows.

6. Real-World Applications

## In the real world

1. eSewa’s Digital Wallets

   • Idea Used: Financial intermediation (like banks but digital).
   • How: Accepts deposits (wallet credits), lends to merchants (instant loans), and processes payments (Pathao drivers).
   • Example: A Kathmandu café owner uses eSewa to:
     • Deposit NPR 50,000 (liability).
     • Borrow NPR 20,000 for inventory (asset).
     • Process NPR 10,000 customer payments daily.

2. Ncell’s Mobile Banking

   • Idea Used: Capital market principles (trading financial assets).
   • How: Ncell partners with banks to offer mobile wallets, but the funds are held by banks (non-depository).
   • Example: A Ncell user adds NPR 1,000 to their wallet (deposit with the bank), then uses it to pay for Pathao rides (like trading a security).

3. Daraz’s Supply Chain Finance

   • Idea Used: Money market instruments (commercial paper).
   • How: Daraz issues commercial paper to raise short-term funds for inventory.
   • Example: Daraz needs NPR 50 million for Diwali sales. Instead of bank loans, it issues 90-day commercial paper at 8% interest, reducing costs.

7. Exam Tip

• Focus on Nepal’s Context: Always relate to NEPSE, NRB, eSewa, Ncell, Daraz.
• Compare Markets: Money vs. capital vs. forex (use the table above).
• Worked Examples: Practice T-bill calculations, NEPSE valuation, and NRB’s repo rate impact.
• Institutions: Know depository vs. non-depository (eSewa vs. insurance companies).
• Real-World Tie-Ups:
  • eSewa = Digital NBFI.
  • Ncell’s IPO = Capital market.
  • Daraz’s forex = Foreign exchange market.

Common Pitfalls:

• ❌ Confusing money market (short-term) with capital market (long-term).
• ❌ Forgetting NRB’s role in regulating forex and interest rates.
• ❌ Not linking financial institutions to real Nepalese examples (eSewa, Ncell).

8.1 Worked Example: Ncell’s Loan Valuation

Scenario: Ncell wants to borrow NPR 1 billion for 5 years. Banks offer 12% interest. How much will Ncell pay annually?

Solution: Use the annuity formula for loan payments: $$PMT=\frac{P\times r\times (1+r{)}^n}{(1+r{)}^n-1}$$ Where:

• $P=1,000,000,000$ (loan amount),
• $r=0.12$ (annual interest rate),
• $n=5$ (years).

Calculation: $$PMT=\frac{1,000,000,000\times 0.12\times (1.12{)}^5}{(1.12{)}^5-1}=\text{NPR }277,410,000\text{ per year}$$

Total Repayment: $$277,410,000\times 5=\text{NPR }1,387,050,000$$

Why this matters:

• Ncell must ensure cash flows (from mobile subscriptions) cover this payment.
• If Ncell’s cost of capital (12%) > expected returns, the loan is risky.

8.2 Trace: How a Bank’s Loan is Processed

sequenceDiagram
    participant Customer
    participant Bank
    participant NRB

    Customer->>Bank: Applies for loan (NPR 500,000)
    Bank->>NRB: Checks credit score (Basel III norms)
    NRB-->>Bank: Approves if risk < threshold
    Bank->>Customer: Disburses loan (NPR 500,000)
    Customer->>Bank: Repays with interest (NPR 560,000)
    Bank->>NRB: Reports loan performance

8.3 Comparison: Depository vs. Non-Depository Institutions

8.4 Financial Statements of a Nepalese Business

Example: Kathmandu Retail Shop (Pvt. Ltd.) Balance Sheet (Simplified):

Income Statement (Year Ending 2023):

How Financial Markets Help:

• The shop takes a bank loan (NPR 200,000) from NMB (depository institution).
• Uses NEPSE’s stock market to raise equity if expanding.
• Manages forex risk if importing goods (e.g., from China).

8.5 Graph: Interest Rates vs. Loan Demand

Explanation:

• If NRB lowers repo rate, banks reduce loan interest → more demand (e.g., Daraz expands).
• If NRB raises rate, loans become expensive → less demand (e.g., small shops delay expansion).

8.6 Table: Nepal’s Key Financial Institutions

8.7 Exam Question Practice

Question: "Explain the application of cost of capital in financial decision making. Use a Nepalese example."

Answer: The cost of capital is the minimum return a firm must earn to justify its investments. It guides decisions like:

1. Project Selection: Only approve projects with IRR > cost of capital.
2. Financing Choices: Compare debt (cheaper) vs. equity (riskier).

Nepali Example: Daraz’s Warehouse Expansion

• Cost of Capital: 15% (mix of debt/equity).
• Project: Build a new warehouse in Pokhara (cost: NPR 500 million).
• Decision:
  • If warehouse generates >15% ROI, proceed (financed via NEPSE’s capital market).
  • If ROI < 15%, reject or seek cheaper debt (e.g., NRB’s low-interest loans).

Why it matters:

• Daraz avoids financial distress (like Ncell’s past debt crises).
• Investors (e.g., Ncell shareholders) expect returns > cost of capital.

8.8 Common Exam Mistakes to Avoid

1. Mixing Markets:

   • ❌ "Money market deals with long-term loans." (Incorrect: money market = short-term).
   • ✅ "Money market includes T-bills (91 days), while capital market includes Ncell’s IPO."

2. Ignoring NRB’s Role:

   • ❌ "Banks regulate forex rates." (Incorrect: NRB does).
   • ✅ "NRB manages forex reserves and sets repo rates to control inflation."

3. Overlooking Real Examples:

   • ❌ "Explain financial institutions." (Vague).
   • ✅ "eSewa is an NBFI that offers digital wallets and microloans, reducing transaction costs for Pathao drivers."

4. Calculation Errors:

   • ❌ Forgetting to convert annual interest to daily for T-bills.
   • ✅ Use the formula: $\text{Interest}=\text{Principal}\times \frac{r\times t}{365}$.

8.9 Key Formulas to Memorize

1. Simple Interest: $$I=P\times r\times t$$ Where:

   • $I$ = Interest,
   • $P$ = Principal,
   • $r$ = Annual rate,
   • $t$ = Time (in years).

2. Compound Interest: $$A=P{\left(1+\frac{r}{n}\right)}^{nt}$$ Where:

   • $A$ = Amount,
   • $n$ = Compounding periods/year.

3. Loan Payment (Annuity): $$PMT=\frac{P\times r\times (1+r{)}^n}{(1+r{)}^n-1}$$

8.10 Final Checklist Before Exam

• Can you define money, capital, and foreign exchange markets?
• Can you list 3 Nepalese examples for each market type?
• Do you know the difference between depository and non-depository institutions?
• Can you calculate T-bill returns or loan payments?
• Can you explain NRB’s role in regulating banks and forex?
• Can you link financial markets to real Nepalese businesses (eSewa, Daraz, Ncell)?

In the real world

• eSewa’s microloans: Uses financial intermediation to lend NPR 5,000–50,000 to small merchants (e.g., Kathmandu’s tea shops) at 1.5% daily interest, reducing transaction costs vs. traditional banks.
• Ncell’s IPO (2018): Demonstrates capital market efficiency—NPR 100/share IPO rose to NPR 150 on NEPSE, allocating capital to Nepal’s largest telecom for expansion.
• Daraz’s forex deals: Relies on foreign exchange markets to convert USD (supplier payments) to NPR (local operations), hedging risk via NTC’s forex services.