Financial Markets & System: Roles, Functions & Structure

TAKEAWAYS:

• Financial markets are platforms where buyers and sellers trade assets, enabling liquidity and price discovery.
• The financial system includes markets, intermediaries, and regulatory bodies that channel funds from savers to investors.
• Money markets (short-term) and capital markets (long-term) serve distinct needs, with instruments like T-bills and stocks.
• Financial intermediaries (banks, NBFIs) reduce transaction costs and mitigate risks for individuals and businesses.
• Central banks (e.g., NBR) stabilize economies via monetary policy and liquidity management.
• Efficient financial systems drive economic growth by allocating capital to productive uses.

1. Definition and Purpose of Financial Markets

Financial markets are organized systems where buyers and sellers trade financial assets (e.g., stocks, bonds, loans). Their primary functions:

• Liquidity: Convert assets into cash quickly.
• Price discovery: Determine fair market values.
• Risk sharing: Spread risk via diversification (e.g., mutual funds).

Visual: Market Structure

flowchart TD
    A["Financial Markets"] --> B["Money Market\n(Short-term: <1 year)"]
    A --> C["Capital Market\n(Long-term: >1 year)"]
    B --> D["T-bills, Commercial Paper"]
    C --> E["Stocks, Bonds, IPOs"]

Real-World Example:

• eSewa/Khalti: These platforms enable peer-to-peer transactions (a form of financial market interaction) by facilitating instant fund transfers between users, reducing reliance on physical cash. The liquidity function is critical here—users can convert digital credits into cash or spend them immediately.

2. Components of the Financial System

The financial system comprises:

1. Financial Markets (primary/secondary)
2. Financial Intermediaries (banks, NBFIs)
3. Regulatory Bodies (NBR, SEBON)
4. Central Bank (Nepal Rastra Bank)

Comparison Table:

3. Types of Financial Markets

A. Money Market

• Short-term (<1 year) instruments.
• Instruments in Nepal:
  • Treasury Bills (T-bills): Issued by NBR to raise short-term funds.
  • Commercial Paper: Unsecured promissory notes (e.g., issued by NBFIs).
  • Call Money: Overnight loans between banks.

Visual: T-bill Issuance Process

flowchart TD
    A["NBR"] --> B["Issues T-bills\n(Rs 10M, 91-day term)"]
    B --> C["Primary Market\n(Banks, NBFIs bid)"]
    C --> D["Secondary Market\n(Trading among investors)"]

Worked Example: NRB auctions Rs 10 million in 91-day T-bills at 8% yield. A bank bids Rs 5 million. Calculate its cost.

• Calculation:
  • Face value = Rs 10M
  • Yield = 8% → Discount = 8% × 91/365 = 1.99%
  • Bid price = Rs 10M × (1 − 0.0199) = Rs 9.801M
  • Cost to bank: (Rs 10M − Rs 9.801M) / Rs 9.801M × 100 = 1.99% effective yield.

B. Capital Market

• Long-term (>1 year) instruments.
• Primary Market: New securities (IPOs, bonds).
• Secondary Market: Trading existing securities (NEPSE).

Real-World Example:

• Daraz IPO (2021): Listed on NEPSE, raising capital for expansion. Investors bought shares in the secondary market after the IPO, demonstrating how capital markets fuel business growth.

4. Financial Intermediaries

Definition: Institutions that channel funds from savers to borrowers (e.g., banks, NBFIs, insurance companies).

Advantages:

• Reduce transaction costs (e.g., pooling small deposits).
• Mitigate risk via diversification (e.g., mutual funds).
• Provide liquidity (e.g., banks offer loans).

Disadvantages:

• Regulatory burden (e.g., NBR’s capital adequacy rules).
• Moral hazard (e.g., risky lending by NBFIs).

Visual: Intermediary Flow

flowchart TD
    A["Savers"] --> B["Deposit in Bank"]
    B --> C["Bank Lends to Borrowers"]
    C --> D["Businesses/Govt. Spend"]

Example in Nepal:

• NMB (Nepal Mandala Bank): Accepts deposits (intermediary function) and lends to businesses (e.g., Pathao drivers for loans).

5. Role of Central Banks

Functions:

1. Monetary Policy: Control money supply (e.g., NBR’s repo rate).
2. Lender of Last Resort: Provide liquidity to banks (e.g., during crises).
3. Regulator: Supervise financial stability (e.g., NBR’s stress tests).

Worked Example: NBR purchases Rs 20M government securities. Required reserve ratio = 8%. Calculate demand deposit creation.

• Step 1: Initial injection = Rs 20M.
• Step 2: Banks deposit Rs 20M; excess reserves = Rs 20M × (1 − 0.08) = Rs 18.4M.
• Step 3: New loans = Rs 18.4M; repeat until no excess reserves.
• Total creation = Rs 20M / 0.08 = Rs 250M.

Formula: $$\text{Total Deposit Creation}=\frac{\text{Initial Injection}}{1-\text{Reserve Ratio}}$$

6. Financial System in Nepal

Key Players:

• NBR: Central bank (monetary policy, regulation).
• SEBON: Securities regulator (NEPSE oversight).
• NBFIs: Non-bank financial institutions (e.g., finance companies).

Challenges:

• Limited access to formal markets (e.g., rural areas).
• High transaction costs for small investors.

Visual: Nepal’s Financial System

flowchart TD
    A["Households"] --> B["Deposits\n(Banks, NBFIs)"]
    B --> C["Loans\n(Businesses, Govt.)"]
    C --> D["Investments\n(NEPSE, Bonds)"]
    E["NBR"] -->|"Regulation"| C
    E -->|"Liquidity"| B

In the Real World

1. Ncell’s Debt Issuance:

   • Ncell raised capital via corporate bonds (capital market instrument) to fund 5G expansion. Investors bought these bonds, providing long-term funds while Ncell paid periodic interest.

2. Pathao’s Working Capital Loans:

   • Pathao partners with finance companies (intermediaries) to offer short-term loans to drivers. These loans are funded by deposits from individuals, demonstrating how intermediaries bridge the gap between savers and borrowers.

3. NEPSE’s Stock Trading:

   • When you buy Ncell shares on NEPSE, you’re participating in the secondary capital market. The price reflects supply/demand, and liquidity ensures you can sell quickly if needed.

Exam Tip

• Definitions: Always link examples (e.g., "NBR is a central bank because...").
• Calculations: Master money multiplier and bond valuation formulas.
• Comparisons: Contrast money vs. capital markets (tenor, instruments).
• Nepal Focus: Use local examples (NMB, NEPSE, NBR) to score higher.
• Diagrams: Draw flows for intermediaries/central bank operations—examiners love visuals.

Common Pitfalls:

• Confusing primary (new issues) vs. secondary markets.
• Forgetting to state who benefits from intermediaries (savers/borrowers).
• Misapplying reserve ratio calculations (use the formula above).

Final Note: Financial markets are the "circulatory system" of the economy. Without them, capital wouldn’t flow efficiently, and businesses (like Daraz or Pathao) couldn’t grow. Memorize the key players and their roles—this unit is 30% of your exam!