Banking System: Structure, Operations & Risk Management

Core Concepts

What is a Banking System?

A banking system is the network of institutions that:

• Mobilizes savings (deposits from households/businesses)
• Allocates funds (loans/investments to borrowers)
• Facilitates payments (transfers, settlements)
• Manages risks (interest rate sensitivity, credit risk)

In Nepal, it is tiered:

1. Central Bank: Nepal Rastra Bank (NRB) – monetary policy, regulation
2. Commercial Banks: Nabil, Standard Chartered, Global IME – profit-driven
3. Development Banks: Agricultural Development Bank (ADB), Rural Development Bank – social goals
4. Finance Companies: Finance One, NMB Capital – specialized lending

classDiagram
    class CentralBank {
        +Regulates monetary policy
        +Issues currency
        +Supervises banks
    }
    class CommercialBank {
        +Takes deposits
        +Gives loans
        +Profit-oriented
    }
    class DevelopmentBank {
        +Focuses on agriculture/rural sectors
        +Subsidized interest rates
    }
    class FinanceCompany {
        +Specialized lending
        +Higher risk tolerance
    }
    CentralBank <|-- CommercialBank : Regulates
    CentralBank <|-- DevelopmentBank : Regulates
    CentralBank <|-- FinanceCompany : Regulates

1. Structure of Nepal’s Banking System

A. Types of Banks in Nepal

B. Key Functions of Banks

Banks perform three primary functions:

1. Deposit Function (Primary)
   • Accept deposits (savings, current, fixed) from customers.
   • Pay interest on deposits (varies by bank: Nabil ~6-8%, Standard Chartered ~3-5%).
   • Example: When you deposit Rs. 50,000 in Nabil Bank’s savings account (6% p.a.), the bank uses this money for lending while paying you interest.

2. Lending Function (Primary)

   • Provide loans (personal, business, housing, agricultural) at higher interest rates.
   • Example: A Kathmandu retailer takes a Rs. 2,000,000 loan from Global IME at 10% p.a. for inventory. The bank earns the spread (10% - 6% deposit rate = 4% net interest margin).

3. Agency Functions (Secondary)

   • Act as intermediaries for payments, investments, foreign exchange, and trust services.
   • Example: eSewa partners with Nabil Bank to process digital payments (utility bills, remittances).

2. How Banks Operate: The Accounting Cycle

A. Double-Entry Bookkeeping

Banks use T-accounts to record transactions. Every debit (Dr) has a corresponding credit (Cr).

Example: Nabil Bank receives a Rs. 100,000 deposit from a customer.

B. Journal Entries for Key Transactions

Net Interest Income (NII) = Interest Earned (15,000) – Interest Paid (2,000) = Rs. 13,000

C. Balance Sheet of a Commercial Bank

A simplified balance sheet for Nabil Bank Ltd. (as of FY 2023/24):

Key Ratios:

• Loan-to-Deposit Ratio (LDR) = Loans / Deposits = 500,000 / 350,000 = 1.43 (143%)
  • Interpretation: For every Rs. 1 deposited, Nabil lends Rs. 1.43. High LDR means aggressive lending but higher risk.
• Capital Adequacy Ratio (CAR) = Equity / Risk-Weighted Assets = 70,000 / 500,000 = 14%
  • NRB’s minimum requirement: 8%. Nabil is well-capitalized.

3. Risk Management in Banking

A. Interest Rate Risk (Gap Analysis)

Banks earn profits from the spread between lending and deposit rates. If interest rates rise:

• Deposit rates ↑ → Banks pay more interest → Lower net income.
• Loan rates ↑ → Banks earn more → Higher net income.

Gap Ratio measures sensitivity to interest rate changes:

Gap Ratio = (Rate-Sensitive Assets - Rate-Sensitive Liabilities) / Total Assets

• Positive Gap: More assets than liabilities → Benefits from rising rates.
• Negative Gap: More liabilities than assets → Hurts from rising rates.

Example: Compare Bank A and Bank B:

Past Exam Question:

"Bank ABC has a gap ratio of 18%, while Bank XYZ has 24%. Which bank is more interest rate sensitive?" Answer: Bank XYZ (higher positive gap → more exposed to rate hikes).

Real-World Tie-In:

• Nepal Rastra Bank (NRB) raises the policy rate (currently 8.5% as of 2024). Banks with a positive gap (like Nabil) benefit, while those with a negative gap (e.g., heavily reliant on fixed-rate deposits) suffer.
• Pathao’s Partner Banks: When NRB cuts rates, Pathao’s loan costs (for driver financing) drop, improving margins.

B. Credit Risk: Loan Loss Reserves

Banks set aside loan loss reserves to cover defaults. Example: Global IME has Rs. 300 million in reserves, but NRB requires a minimum of Rs. 280 million.

• If actual reserves > required: Bank is over-provisioned (safer but lower profits).
• If actual reserves < required: Bank must increase reserves or face penalties.

Past Exam Question:

"A bank has Rs. 300 million in loan loss reserves and needs Rs. 280 million. What happens if Rs. 25 million of loans default?" Solution:

1. Initial Reserves: Rs. 300 million
2. Default Loss: Rs. 25 million
3. Remaining Reserves: 300 - 25 = Rs. 275 million
4. Shortfall: 280 (required) - 275 = Rs. 5 million Action: Bank must top up reserves by Rs. 5 million or write off Rs. 5 million from profits.

C. Liquidity Risk: Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

NRB mandates:

• CRR (Cash Reserve Ratio): 3% (as of 2024) – Banks must keep 3% of deposits with NRB.
• SLR (Statutory Liquidity Ratio): 85% – Banks must hold liquid assets (govt. bonds, T-bills) equal to 85% of deposits.

Example: Nabil Bank has Rs. 500 million in deposits.

• CRR Requirement: 3% of 500 = Rs. 15 million (must be parked with NRB).
• SLR Requirement: 85% of 500 = Rs. 425 million (must be in liquid assets like T-bills).

Why This Matters:

• Low CRR/SLR: Banks have more funds for lending → Higher growth but higher risk.
• High CRR/SLR: Banks are more liquid but earn less from lending.

Real-World Example:

• When NRB raises CRR (e.g., from 2% to 3%), banks like Standard Chartered Nepal must park more cash with NRB, reducing their lending capacity. This tightens liquidity in the economy.

4. Nepal Rastra Bank (NRB): The Regulator

A. Key Functions of NRB

B. Recent NRB Policies Affecting Banks

In the Real World

1. Nabil Bank’s Loan Book: Risk vs. Return

• Scenario: Nabil Bank lends Rs. 1 billion to retailers in Kathmandu at 10% p.a.
• Risk: If inflation rises, retailers default → NPLs increase.
• NRB’s Role: Forces Nabil to maintain 3% NPL limit. If NPLs exceed 3%, NRB imposes penalties.
• Real Data (2023):
  • Nabil’s Gross NPL: 2.8% (below 3% limit).
  • Net NPL: 1.2% (after reserves).
  • Provision Coverage Ratio (PCR): 150% (reserves cover 1.5x defaults).

Why It Matters:

• If Nabil’s NPLs hit 4%, NRB may restrict its lending growth or fine it Rs. 50 million.

2. eSewa and Khalti: How Banks Earn from Digital Payments

• How It Works:
  1. You link your Nabil/Khalti account to eSewa.
  2. When you pay Rs. 2,000 for electricity, eSewa deducts from your bank account.
  3. Bank’s Cut: eSewa charges 1.5% fee → Nabil earns Rs. 30 per transaction.
• Banking Impact:
  • Lower Cash Handling: Fewer physical deposits → lower operational costs.
  • Higher Transaction Fees: Banks partner with fintechs (eSewa, Khalti) to earn non-interest income.
• NRB’s Role: Regulates interoperability (e.g., Khalti → Nabil transfers) and fraud prevention.

Real Numbers (2023):

• eSewa processed: Rs. 1.2 trillion in transactions.
• Banking Partners: Nabil, Global IME, Standard Chartered.
• Fee Income for Banks: ~Rs. 18 billion/year (from merchant commissions).

3. Ncell’s Mobile Money: How Banks Compete

• Problem: Ncell’s eSewa competes with banks for deposits.
• Bank Response:
  • Nabil Bank launched "Nabil eBanking" with higher interest (7% vs. eSewa’s 3%).
  • NRB’s Rule: Mobile wallets (eSewa) cannot pay interest on deposits → Banks retain deposit advantage.
• Impact:
  • Banks win: Customers prefer 7% savings accounts over eSewa’s 3%.
  • Fintechs lose: eSewa’s deposit growth slows.

4. Daraz’s Supplier Financing: Bank-Fintech Partnerships

• Scenario: A Kathmandu garment supplier orders Rs. 5 million worth of fabric from Daraz.
• Bank’s Role:
  1. Global IME approves a working capital loan at 9% p.a.
  2. Daraz advances payment to the fabric supplier.
  3. Supplier repays Daraz, who then settles with Global IME.
• Bank’s Gain:
  • Securitized loan: Backed by Daraz’s payment guarantee → lower risk.
  • Fee Income: Global IME charges 1% origination fee + 9% interest.
• NRB’s Oversight: Ensures no conflict of interest (banks cannot favor Daraz over local suppliers).

Worked Example: Kathmandu Retail Shop’s Loan

Business: Shree Mart, a retail shop in Thamel, Kathmandu. Owner: Mr. Bista needs Rs. 2,000,000 to expand inventory. Bank: Nabil Bank Ltd.

Step 1: Loan Application

• Loan Amount: Rs. 2,000,000
• Tenor: 3 years
• Interest Rate: 10% p.a. (floating, tied to NRB repo rate)
• Processing Fee: 1% (Rs. 20,000)

Step 2: Bank’s Underwriting

Nabil checks:

1. Collateral: Shop inventory + personal guarantee.
2. Cash Flow: Mr. Bista’s past sales (Rs. 15 million/year).
3. Debt Service Coverage Ratio (DSCR):

   DSCR = Net Operating Income / Debt Repayment
   = (Rs. 5 million profit) / (Rs. 2,000,000 * 10% + principal)
   = 5 / (0.2M + 0.67M) = **5 / 0.87M ≈ 5.75**
   

   • Interpretation: Profits cover repayments 5.75x → Low risk.

Step 3: Loan Approval & Disbursement

• Loan Terms:
  • Interest: 10% p.a. (compounded annually).
  • Repayment: Equal monthly installments (EMI) over 3 years.
• EMI Calculation:

  EMI = [P × r × (1 + r)^n] / [(1 + r)^n - 1]
  Where:
  P = Rs. 2,000,000
  r = 10%/12 = 0.833% per month
  n = 36 months
  

  EMI = [2,000,000 × 0.00833 × (1.00833)^36] / [(1.00833)^36 - 1]
      ≈ **Rs. 64,800 per month**
  

• Total Interest Paid: (64,800 × 36) - 2,000,000 = Rs. 333,200

Step 4: Accounting Impact on Nabil Bank

Step 5: Risk Management

• Interest Rate Risk: If NRB raises repo rate to 9%, Nabil’s cost of funds rises → Margin squeeze.
• Credit Risk: If Shree Mart defaults, Nabil uses:
  • Collateral (inventory) to recover funds.
  • Loan Loss Reserve to absorb losses.

Real-World Outcome:

• In 2022, Kathmandu’s retail sector saw higher defaults due to inflation.
• Nabil’s NPL ratio rose to 2.9% (from 2.5% in 2021).
• NRB’s Action: Ordered banks to increase loan loss reserves by 20%.

Exam Tip: How to Score Full Marks

1. Structure Your Answers Like This

For short questions (e.g., "Explain gap ratio"): Definition: Gap ratio measures a bank’s sensitivity to interest rate changes. Formula: (RSA - RSL) / Total Assets Interpretation:

• Positive gap: Benefits from rate hikes (more assets than liabilities).
• Negative gap: Hurts from rate hikes (more liabilities than assets). Example: Bank A (Gap = +20%) is more sensitive than Bank B (Gap = -15%).

For **long questions** (e.g., "Describe the components of Nepal’s financial system"):

1. Central Bank (NRB): Monetary policy, regulation.
2. Commercial Banks: Nabil, Global IME (deposit-taking, lending).
3. Development Banks: ADB, RDB (agriculture, housing).
4. Finance Companies: Finance One (consumer loans).
5. Payment Systems: NPCI, eSewa, Khalti.
6. Capital Markets: NEPSE, CDSC (stocks, bonds). Visual: Use a mermaid class diagram or table to compare institutions.

2. Common Mistakes to Avoid

• Ignoring NRB’s role: Always mention CRR, SLR, repo rate when discussing bank operations.
• Wrong gap ratio interpretation: A positive gap means the bank gains from rising rates, not loses.
• Forgetting real-world examples: Link theories to Nabil Bank, eSewa, or NRB policies.
• Calculation errors: Always show step-by-step (e.g., EMI formula, gap ratio).

3. High-Scoring Tips

✅ Use tables for comparisons (e.g., bank types, NRB policies). ✅ Draw T-accounts for journal entries. ✅ Relate to Nepal: Use Nabil, Global IME, or NRB data in examples. ✅ Define terms clearly: Start every answer with a one-sentence definition. ✅ Show calculations: Even if the question is theoretical, work out numbers.

4. Past Exam Patterns

Final Reminder:

• Memorize key ratios: LDR, CAR, Gap Ratio, NPL.
• Practice calculations: EMI, gap ratio, loan loss reserves.
• Connect to Nepal: Every answer should tie to Nabil, NRB, or a local business.