Financial Markets & Services: Definitions, Roles, and Nepal’s System

TAKEAWAYS:

• Financial markets are intermediaries that connect savers (investors) with borrowers (businesses/government) via instruments like stocks, bonds, and derivatives.
• Nepal’s financial system has four pillars: markets, institutions (banks, insurance), assets (shares, loans), and regulators (Nepal Rastra Bank, SEBON).
• Money markets trade short-term instruments (T-bills, commercial paper) while capital markets handle long-term (shares, bonds).
• Financial services facilitate payments, risk transfer (insurance), and investment—critical for economic growth.
• Regulation (e.g., capital adequacy ratios) ensures stability by preventing fraud and market crashes.
• Efficiency in markets (liquidity, transparency) reduces costs for businesses and investors alike.

Core Concepts: What Are Financial Markets?

Financial markets are organized platforms where buyers and sellers trade financial assets (e.g., stocks, bonds, derivatives). Their primary role is to allocate capital efficiently from surplus units (savers) to deficit units (borrowers).

1.1 Definition and Importance

• Definition:

  "A financial market is a marketplace where individuals and institutions trade financial securities, commodities, and other fungible items at low transaction costs and price transparency."

• Why They Matter:

  • Capital Allocation: Directs funds to productive sectors (e.g., infrastructure, startups).
  • Price Discovery: Stock prices reflect a company’s true value (e.g., NEPSE’s share prices).
  • Risk Management: Investors diversify risk via instruments like futures (used by Nepali farmers hedging crop prices).
  • Liquidity: Assets can be bought/sold quickly (e.g., trading shares on NEPSE).

1.2 Key Components of Financial Markets

classDiagram
    class FinancialSystem {
        +Markets
        +Institutions
        +Assets
        +Regulators
    }
    class Markets {
        +Money Market
        +Capital Market
        +Derivatives Market
    }
    class Institutions {
        +Banks
        +Insurance
        +Investment Firms
    }
    class Assets {
        +Stocks
        +Bonds
        +Derivatives
    }
    class Regulators {
        +Nepal Rastra Bank (NRB)
        +Securities Board of Nepal (SEBON)
    }
    FinancialSystem --> Markets
    FinancialSystem --> Institutions
    FinancialSystem --> Assets
    FinancialSystem --> Regulators

In the Real World

1. eSewa (Digital Payments):

   • Uses financial intermediation to connect users (savers) with merchants (borrowers) via mobile wallets. When you pay for a bus ticket via eSewa, the platform acts as a marketplace for liquidity, ensuring transactions settle instantly.

2. NEPSE (Nepal Stock Exchange):

   • Capital market in action: When a company like Nabil Bank issues shares, retail investors (e.g., your uncle in Pokhara) buy them via NEPSE. The exchange provides price transparency (e.g., Nabil Bank’s P/E ratio of 12x) and liquidity (shares can be sold anytime).

3. Ncell’s Microfinance Loans:

   • Money market instrument: Ncell offers short-term loans (e.g., 6-month installments) to small businesses. These loans are negotiable instruments (like commercial paper) traded between banks and financial institutions.

1.3 Types of Financial Markets

A. Money Market vs. Capital Market

Worked Example: Nabil Bank’s T-Bill vs. Share Purchase

• Money Market: Nabil Bank issues a 91-day T-bill at 8% interest. A bank buys it for ₹1,000,000. After 91 days, they get ₹1,080,000 (₹80,000 profit). This is a short-term, low-risk investment.
• Capital Market: You buy 100 shares of Nabil Bank at ₹250/share (₹25,000 total). After 1 year, the share price rises to ₹300 (₹5,000 profit) plus you receive a ₹10/share dividend. Here, you bear market risk (price could drop).

1.4 Nepal’s Financial System: Structure and Components

Nepal’s financial system is built on four pillars, as regulated by the Nepal Rastra Bank (NRB) and Securities Board of Nepal (SEBON).

1.4.1 The Four Pillars

flowchart TD
    A["Financial System of Nepal"] --> B["Financial Markets"]
    A --> C["Financial Institutions"]
    A --> D["Financial Assets"]
    A --> E["Regulators"]
    B --> B1["Money Market"]
    B --> B2["Capital Market"]
    C --> C1["Commercial Banks"]
    C --> C2["Development Banks"]
    C --> C3["Microfinance Institutions"]
    D --> D1["Stocks"]
    D --> D2["Bonds"]
    D --> D3["Derivatives"]
    E --> E1["NRB"]
    E --> E2["SEBON"]
    E --> E3["Insurance Board"]

1.4.2 Components Explained

1. Financial Markets:

   • Money Market: NRB’s T-bills, commercial paper (used by banks for liquidity).
   • Capital Market: NEPSE (primary: IPOs; secondary: trading shares).
   • Derivatives Market: Futures (e.g., wheat futures for Nepali farmers).

2. Financial Institutions:

   • Banks: Nabil, Standard Chartered (offer loans, deposits).
   • Microfinance: Siddhartha Microfinance (provides small loans to rural entrepreneurs).
   • Insurance: NIC Asia (protects against risks like health or property loss).

3. Financial Assets:

   • Stocks: Shares of Himalayan Bank (traded on NEPSE).
   • Bonds: Government securities (e.g., 10-year bonds at 7%).
   • Derivatives: Currency futures (used by exporters to hedge against USD fluctuations).

4. Regulators:

   • NRB: Controls monetary policy (e.g., repo rate adjustments).
   • SEBON: Regulates NEPSE and protects investor interests.
   • Insurance Board: Oversees insurance companies like SBI Nepal.

1.5 Functions of Financial Markets

Financial markets perform six critical functions:

1.6 Why Regulate Financial Markets?

Regulation ensures stability, transparency, and investor protection. Key reasons:

1. Prevent Market Abuse: Insider trading (e.g., a banker trading on non-public info).
2. Ensure Solvency: Banks must maintain capital adequacy ratios (e.g., 8% of risk-weighted assets).
3. Protect Investors: SEBON mandates disclosure rules for listed companies.
4. Maintain Confidence: NRB’s interventions (e.g., lowering repo rates) stabilize the economy.

Example: SEBON’s Role in NEPSE

• Requires companies to disclose audited financials before listing.
• Bans short-selling (selling borrowed shares) to prevent crashes.
• Result: NEPSE’s market capitalization grew from ₹1.2 trillion (2010) to ₹3.5 trillion (2024).

1.7 Financial Services and Their Roles in the Economy

Financial services include banking, insurance, investment, and payments. Their roles:

Worked Example: Kathmandu Retail Shop’s Financial Needs Imagine Mr. Gurung, who runs a ₹5mn/year retail shop in Thamel. He needs financial services for:

1. Working Capital: Takes a ₹2mn loan from Nabil Bank (money market instrument).
2. Risk Protection: Buys ₹50,000 insurance from NIC Asia to cover shop damage.
3. Investment: Deposits ₹1mn in a fixed deposit (6% interest) for emergencies.
4. Payments: Uses eSewa for customer transactions (reduces cash handling).

Exam Tip

1. Definitions First: Always define terms precisely (e.g., "Financial markets are platforms where buyers/sellers trade assets at low transaction costs").
2. Compare Money vs. Capital Markets: Use the table above—examiners love this!
3. Nepal-Specific Examples: Link answers to NEPSE, NRB, or eSewa (e.g., "Like NEPSE’s share trading, capital markets facilitate long-term funding").
4. Regulation is Key: Mention NRB/SEBON when discussing stability or investor protection.
5. Numerical Questions: For stock quotes (like the Mega Company example), calculate:
   • Dividend Yield = (Annual Dividend/Share Price) × 100 Example: Mega’s 10% dividend yield on ₹150 share = ₹15/₹150 × 100 = 10%.
   • P/E Ratio = Share Price/Earnings per Share Example: Mega’s P/E = ₹150/₹15 = 10x (means investors pay ₹10 for ₹1 of earnings).

Past Exam Question Solved

Question: "Briefly explain the importance of financial services in the financial system." Answer: Financial services are the backbone of the financial system because they:

1. Facilitate Transactions: Enable payments (e.g., Khalti for Daraz orders) and settlements.
2. Mobilize Savings: Banks and insurance companies pool funds from savers (e.g., your FD in NMB).
3. Manage Risk: Insurance (e.g., NIC Asia) protects against uncertainties like accidents or crop failures.
4. Provide Liquidity: Financial markets (e.g., NEPSE) allow assets to be converted to cash quickly.
5. Support Economic Growth: By funding businesses (e.g., Ncell’s expansion via bank loans) and infrastructure.
6. Enhance Efficiency: Digital platforms (e.g., eSewa) reduce transaction costs and time.

Visual:

flowchart TD
    A["Financial Services"] --> B["Payments<br/>(eSewa, Khalti)"]
    A --> C["Savings<br/>(FDs, Mutual Funds)"]
    A --> D["Risk Management<br/>(Insurance)"]
    A --> E["Investments<br/>(NEPSE, Bonds)"]
    A --> F["Liquidity<br/>(Money Market)"]
    A --> G["Economic Growth<br/>(Bank Loans)"]

Summary Table: Key Differences

Final Checklist for Exams

✅ Define financial markets, money market, capital market. ✅ Compare money vs. capital markets (table or bullet points). ✅ List Nepal’s financial system components (4 pillars). ✅ Explain functions of financial markets (6 points). ✅ Give examples from NEPSE, NRB, eSewa, or banks. ✅ Calculate dividend yield, P/E ratio for stock quotes. ✅ Discuss regulation (NRB, SEBON, capital adequacy).