Financial Systems: Components, Institutions & Nepal’s Landscape

Core Concepts: What is a Financial System?

A financial system is the network of institutions, markets, instruments, and regulations that facilitate the flow of money between savers (households, businesses with surplus funds) and borrowers (businesses, governments, individuals needing funds). It ensures efficient allocation of resources and economic stability.

Why Does Nepal Need a Financial System?

1. Channel funds from those with excess money (e.g., salary earners) to those needing capital (e.g., small businesses).
2. Reduce transaction costs (e.g., borrowing directly from a neighbor vs. a bank).
3. Manage risk (e.g., insurance, hedging against inflation).
4. Promote economic growth by funding infrastructure, agriculture, and industries.
5. Provide financial services like payments (e.g., eSewa, Khalti), savings, and investments.

Components of a Financial System

The financial system consists of four key components, visualized below:

graph TD
    A["Financial System"] --> B["Financial Institutions"]
    A --> C["Financial Markets"]
    A --> D["Financial Instruments"]
    A --> E["Regulatory Bodies"]
    B --> B1["Depository (Banks, NBFCs)"]
    B --> B2["Non-Depository (Insurance, Pension Funds)"]
    C --> C1["Primary Market (IPOs, Bonds)"]
    C --> C2["Secondary Market (NEPSE, Forex)"]
    D --> D1["Debt Instruments (Loans, Bonds)"]
    D --> D2["Equity Instruments (Shares)"]
    E --> E1["NRB (Nepal)"]
    E --> E2["SEBI (India)"]
    E --> E3["SEC (USA)"]

1. Financial Institutions

These are intermediaries that connect savers and borrowers. They are classified into:

• Depository Institutions: Accept deposits and lend funds (e.g., banks, NBFCs).
• Non-Depository Institutions: Provide financial services without accepting deposits (e.g., insurance companies, mutual funds).

Comparison Table: Depository vs. Non-Depository Institutions

## In the Real World

1. eSewa & Khalti (Digital Payments)

   • Idea Used: Financial Intermediation
   • How? These apps act as intermediaries between users (savers) and merchants/businesses (borrowers or service providers). When you pay for a Daraz order via Khalti, the app holds your money temporarily (like a bank) before transferring it to the seller. The system also provides liquidity services (instant transfers) and risk management (fraud detection).

2. Nabil Bank’s Loan for a Kathmandu Retail Shop

   • Idea Used: Depository Institution + Credit Creation
   • How? If a small shop owner takes a loan from Nabil Bank to expand, the bank uses deposits from savers (e.g., your fixed deposit) to lend to the shop. The bank earns interest on the loan while paying you interest on your deposit. This is fractional reserve banking—the bank lends out most of your deposit while keeping a fraction as reserve.

3. NEPSE (Nepal Stock Exchange)

   • Idea Used: Secondary Financial Market
   • How? When you buy shares of NTC or Ncell on NEPSE, you’re participating in the secondary market. The exchange provides liquidity (easy buying/selling) and price discovery (fair valuation of shares). Without NEPSE, investors couldn’t easily trade shares, reducing market efficiency.

2. Financial Markets

Markets where financial instruments (shares, bonds, derivatives) are bought/sold. Divided into:

• Primary Market: New issues (IPOs, government bonds).
• Secondary Market: Trading existing instruments (NEPSE, forex markets).

Worked Example: NEPSE Share Purchase Suppose you buy 100 shares of Ncell at Rs. 1,000 each on NEPSE:

• Primary Market Role: If Ncell issues new shares, you’d buy them here (new capital for the company).
• Secondary Market Role: You buy existing shares from another investor. NEPSE earns a transaction fee, and the company gets no new money—but liquidity improves.

3. Financial Instruments

Tools used to raise or invest funds:

• Debt Instruments: Loans, bonds (e.g., government securities).
• Equity Instruments: Shares (e.g., NEPSE-listed companies like Himalayan Bank).
• Derivatives: Futures, options (used for hedging).

Example: Government of Nepal’s Bond Issuance

• The government borrows from the public by issuing 10-year bonds at 8% interest.
• Why? To fund infrastructure (e.g., roads, hospitals) without raising taxes.
• Who benefits? Investors (e.g., pension funds) earn fixed returns; the government gets long-term funds.

4. Regulatory Bodies

Ensure stability, transparency, and consumer protection. In Nepal:

• Nepal Rastra Bank (NRB): Regulates banks, NBFCs, and payment systems (e.g., eSewa).
• Securities Board of Nepal (SEBON): Oversees NEPSE and mutual funds.
• Insurance Board: Regulates insurance companies.

Why Regulate Depository Institutions?

1. Prevent Bank Runs: Ensure depositors’ money is safe (e.g., NRB’s deposit insurance scheme).
2. Control Risk: Limit exposure to bad loans (e.g., NRB’s loan classification rules).
3. Maintain Liquidity: Banks must hold reserves (e.g., 8% CRR for commercial banks).
4. Combat Money Laundering: KYC (Know Your Customer) rules.

NRB’s Supervisory Tools

## Visual: The Accounting Cycle of a Nepali Bank

Let’s trace how a Kathmandu-based retail shop interacts with Global IME Bank for a Rs. 500,000 loan. We’ll use T-accounts (ledger entries) and a journal entry table to show the flow.

Step 1: Shop Takes a Loan

The shop borrows Rs. 500,000 from Global IME at 10% annual interest, repayable in 3 years.

Journal Entry in Global IME’s Books:

Step 2: Interest Accrual (After 1 Year)

Global IME earns Rs. 50,000 in interest (10% of Rs. 500,000).

Journal Entry:

Step 3: Shop Repays Principal + Interest

After 3 years, the shop repays Rs. 500,000 + Rs. 150,000 (total interest).

Journal Entry:

## The Financial System in Nepal: Current Status

Nepal’s financial system has evolved with:

1. Growth of Digital Payments: eSewa, Khalti, and IME Pay handle ~50% of transactions.
2. Expansion of NBFCs: Non-bank financial companies (e.g., NMB Bank, Siddhartha Bank) now compete with traditional banks.
3. Capital Market Development: NEPSE’s market cap grew from Rs. 500 billion (2010) to Rs. 3 trillion (2023).
4. Regulatory Challenges:
   • High non-performing loans (NPLs) in some banks (~5% in 2023, but rising).
   • Liquidity crunch during COVID-19 (NRB injected Rs. 100 billion).
   • Financial inclusion gaps: Only 50% of Nepalis have bank accounts (vs. 70% in India).

## Exam Tip: How to Score Full Marks

This unit is conceptual + applied. Follow this structure for 9+ marks:

1. Define Clearly: Start with a one-line definition (e.g., “A financial system is a network of institutions, markets, and instruments that facilitate the transfer of funds from savers to borrowers.”).
2. Use Visuals: Draw a flowchart (like the mermaid diagram above) or a table (like the depository vs. non-depository comparison) to explain components.
3. Nepal Focus: Always relate to NRB, NEPSE, or local examples (e.g., “NRB regulates banks to prevent bank runs, as seen during the 2001 financial crisis”).
4. Worked Examples: Solve numerical problems using T-accounts or journal entries (like the Kathmandu shop loan above).
5. Regulation: For questions on NRB, mention:
   • Onsite tools: Audits, inspections.
   • Offsite tools: Financial ratios (e.g., NPL ratio, capital adequacy).
   • Purpose: Stability, transparency, consumer protection.

Common Mistakes to Avoid:

• ❌ Listing components without explaining their role (e.g., just saying “banks” without how they intermediate).
• ❌ Ignoring Nepal-specific examples (e.g., using US SEC instead of NRB).
• ❌ Skipping diagrams/tables—examiners love visual clarity!

## Past Exam Questions Solved

Q: “Explain the concept of financial system. What are the major components of Nepalese financial system?”

Answer: A financial system is a structured network that enables the efficient transfer of funds from surplus units (savers) to deficit units (borrowers) via intermediaries, markets, and instruments. It promotes economic growth, risk sharing, and price discovery.

Major Components in Nepal:

1. Financial Institutions:
   • Depository: Nabil Bank, Global IME, NBFCs (e.g., NMB Capital).
   • Non-Depository: Life Insurance Corporation, Siddhartha Mutual Fund.
2. Financial Markets:
   • Primary: NEPSE IPOs, government bond auctions.
   • Secondary: NEPSE trading, forex markets (e.g., buying USD from Nepal SBI Bank).
3. Financial Instruments:
   • Debt: Bank loans, government securities (e.g., 10-year Nepal Treasury Bonds).
   • Equity: Shares of NTC, Ncell on NEPSE.
4. Regulatory Bodies:
   • NRB: Regulates banks, NBFCs, and payment systems.
   • SEBON: Oversees NEPSE and mutual funds.

Visual:

graph LR
    A["Nepal's Financial System"] --> B["Institutions"]
    A --> C["Markets"]
    A --> D["Instruments"]
    A --> E["Regulators"]
    B --> B1["Nabil Bank\n(Depository)"]
    B --> B2["Life Insurance\n(Non-Depository)"]
    C --> C1["NEPSE\n(Secondary)"]
    C --> C2["Bond Auctions\n(Primary)"]
    D --> D1["Ncell Shares"]
    D --> D2["Government Bonds"]
    E --> E1["NRB"]
    E --> E2["SEBON"]

Q: “Why do banks need regulation by NRB?”

Answer: Banks require regulation by the Nepal Rastra Bank (NRB) to ensure:

1. Financial Stability:
   • Prevent bank runs (e.g., if depositors panic and withdraw all funds, as in the 2001 financial crisis).
   • Maintain liquidity via Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
2. Consumer Protection:
   • Deposit insurance (up to Rs. 100,000 per depositor) protects savers.
   • Fair lending practices (e.g., NRB caps loan interest rates).
3. Risk Management:
   • Loan classification: NRB forces banks to classify loans as standard, sub-standard, or doubtful to disclose true NPL levels.
   • Capital adequacy: Banks must hold 8% of risk-weighted assets as capital (Basel III norms).
4. Prevent Money Laundering:
   • KYC (Know Your Customer) rules (e.g., banks verify identities before opening accounts).
   • Anti-Money Laundering (AML) reporting for suspicious transactions.

Example: In 2020, NRB fined Machhapuchchhre Bank Rs. 50 million for violating KYC norms, highlighting the need for compliance.

## Summary Checklist

Before the exam, ensure you can: ✅ Define financial system, depository/non-depository institutions, and primary/secondary markets. ✅ Draw a flowchart of Nepal’s financial system components. ✅ Explain NRB’s role with examples (e.g., CRR, NPL monitoring). ✅ Solve a journal entry problem (like the Kathmandu shop loan). ✅ Relate concepts to real-world apps (eSewa, NEPSE, Ncell loans).