Commercial Banking & Risk Management: Core Functions, Risks & Controls

TAKEAWAYS:

• Commercial banks create money via fractional reserve banking and facilitate payments through clearinghouses like the Nepal Clearing House (NCH).
• Risk-weighted assets (RWA) determine capital requirements under Basel III, with loans (100%) and government securities (0%) having different weights.
• Credit risk is mitigated by collateral, loan-to-value ratios, and diversification, while liquidity risk is managed via liquidity coverage ratios (LCR) and stress tests.
• Market risk arises from interest rate fluctuations and is hedged using derivatives (e.g., swaps) or matching asset/liability maturities.
• Operational risk (e.g., fraud, cyberattacks) is controlled via internal audits, KYC policies, and technology like eSewa’s transaction monitoring.
• Nepal Rastra Bank (NRB) enforces reserve requirements (e.g., 4% for transaction deposits) and capital adequacy ratios (CAR ≥ 10%) to ensure bank stability.

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1. Core Functions of Commercial Banks

Commercial banks are the backbone of Nepal’s financial system, linking savers (depositors) with borrowers (businesses, households). Their primary roles include:

1.1 Deposit-Taking and Lending

Banks accept deposits (savings, current, fixed) and lend them to earn interest. The fractional reserve system ensures banks don’t lend out 100% of deposits, maintaining liquidity.

How banks create money by lending multiples of reserves (Image: Erik Streb, CC BY-SA 3.0, via Wikimedia Commons)

```mermaid
flowchart TD
    A["Depositor: Rs 100"] -->|deposits| B["Bank: Rs 100"]
    B -->|keeps 10% reserve| C["Reserve: Rs 10"]
    B -->|lends 90%| D["Borrower: Rs 90"]
    D -->|spends| E["New Depositor: Rs 90"]
    E -->|deposits| B
    B -->|lends 81%| F["Next Borrower: Rs 81"]

Key Idea: A single deposit of Rs 100 can generate Rs 1,000+ in loans via the money multiplier effect (1/reserve ratio). In Nepal, NRB sets reserve requirements (e.g., 4% for transaction deposits).

1.2 Payment Systems and Clearing

Banks facilitate transactions via:

• Cheques: Cleared through the Nepal Clearing House (NCH).
• Digital Payments: eSewa, Khalti, and Rupaiya (Ncell’s mobile wallet) use real-time gross settlement (RTGS).
• Bank Drafts: Guaranteed by issuing banks.

```mermaid
flowchart TD
    A["Bank A: Rs 50,000"] -->|"cheque"| B["NCH Clearing"]
    B -->|"settles"| C["Bank B: Rs 50,000"]
    B -->|"settles"| D["NRB: Net Settlement"]
    B -->|"RTGS"| E["eSewa/Khalti: Rs 10,000"]
    E -->|"settled"| F["Merchant: Rs 10,000"]
    G["Bank Draft: Rs 20,000"] -->|"guaranteed"| H["Issuing Bank: NRB"]

Nepal's payment systems: cheques, digital payments, and bank drafts Worked Example (NRB’s Role): If Bank A has a net debit of Rs 200 million in NCH, NRB adjusts its reserve account accordingly to maintain liquidity.

1.3 Investment and Trust Services

Banks invest in government securities (G-secs), corporate bonds, and mutual funds. They also act as trustees for pension funds (e.g., Nepal Insurance Corporation’s life insurance policies).

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2. Risks in Commercial Banking

Banks face four major risks: credit, market, liquidity, and operational. Each is managed differently.

2.1 Credit Risk

Definition: Default by borrowers (e.g., a business failing to repay a loan). Sources:

• Loan defaults (e.g., Sirjana Finance’s past NPAs).
• Counterparty risk (e.g., a corporate borrower defaulting on a trade finance letter of credit).

Mitigation Strategies:

Worked Example (Loan Portfolio): Suppose Global IME Bank has:

• Rs 500M in loans to SMEs (risk weight = 100%)
• Rs 300M in government securities (risk weight = 0%)
• Rs 200M in corporate bonds (risk weight = 50%)

Risk-Weighted Assets (RWA) = (500 × 100% + 300 × 0% + 200 × 50%) = Rs 650M.

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2.2 Market Risk

Definition: Losses from interest rate changes or currency fluctuations. Sources:

• Interest rate risk: Fixed-rate loans vs. floating-rate deposits.
• Foreign exchange risk: Banks with USD/Rs exposures (e.g., Nepal Rastra Bank’s forex reserves).

Mitigation Tools:

```figure
{"type":"t-account","title":"Interest Rate Swap Example","dr":[["To Counterparty: Fixed Rate Payments","Rs 5,000/year"],["To Floating Rate Loan Interest","Variable"]],"cr":[["By Counterparty: Floating Rate Payments","Variable"],["By Fixed Rate Deposit Interest","Rs 5,000/year"]],"caption":"How Global IME Bank hedges floating-rate loans using an interest rate swap"}

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2.3 Liquidity Risk

Definition: Inability to meet short-term obligations (e.g., Sirjana Finance’s 2020 liquidity crisis). Sources:

• Deposit withdrawals (e.g., Kathmandu Bank’s 2015 run on deposits).
• Asset illiquidity (e.g., holding long-term loans when cash is needed).

Mitigation Tools:

Worked Example (LCR Calculation): Suppose NMB Bank has:

• HQLA (cash, G-secs): Rs 150M
• 30-day net cash outflow: Rs 120M

LCR = (150 / 120) × 100 = 125% (complies with NRB’s 100% requirement).

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2.4 Operational Risk

Definition: Losses from fraud, cyberattacks, or human error. Sources:

• Cybercrime: eSewa’s 2021 phishing scams.
• Regulatory violations: Global IME Bank’s 2022 fine for KYC lapses.

Mitigation Tools:

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3. Risk Management Frameworks

Banks use Basel III and NRB’s guidelines to manage risks.

3.1 Basel III: Capital Adequacy

Key Ratios:

1. Capital Adequacy Ratio (CAR) ≥ 10%:

   • Tier 1 Capital (core capital: paid-up capital, retained earnings) ≥ 6%.
   • Tier 2 Capital (subordinated debt, revaluation reserves) adds to CAR.

   Example (ABC Bank Ltd.):

   Item	Amount (Rs M)	Risk Weight	RWA Contribution
   Paid-up Capital	2,400	0%	0
   General Reserve	400	0%	0
   Loans (SMEs)	1,500	100%	1,500
   Government Securities	300	0%	0
   Total RWA			1,500
   CAR = (Tier 1 Capital / RWA) × 100 = (2,400 / 1,500) × 100 = 160% (complies).

2. Leverage Ratio ≥ 5%:

   • Total capital / total assets ≥ 5%.

3.2 Stress Testing

Banks simulate economic downturns (e.g., 10% unemployment, 20% GDP contraction) to assess resilience.

```mermaid
flowchart TD
    A["Baseline Scenario"] --> B["Stress Scenario: 20% GDP Drop"]
    B --> C["Simulate Loan Defaults: +15% NPA"]
    C --> D["Check Capital Buffer: CAR ≥ 8%?"]
    D -->|Yes| E["Passes"]
    D -->|No| F["Raise Capital or Reduce Risk"]

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4. Nepal-Specific Context

4.1 NRB’s Role in Risk Management

• Reserve Requirements: 4% for transaction deposits (reduced from 6% in 2020).
• Liquidity Support: Repos (e.g., Rs 20M to Sirjana Finance in 2020).
• Capital Controls: Limits on foreign currency loans.

4.2 Case Study: Global IME Bank’s Risk Management

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## In the Real World

1. eSewa’s Fraud Prevention (Operational Risk)

   • Idea: Uses machine learning to flag suspicious transactions (e.g., multiple small transfers in a row).
   • How: Analyzes velocity of transactions and user behavior patterns to detect fraud in real time.
   • Example: Blocked Rs 50M in fraudulent transactions in 2022.

2. NMB Bank’s Loan Portfolio Diversification (Credit Risk)

   • Idea: Allocates loans across agriculture (30%), SMEs (40%), real estate (20%) to avoid sector-specific shocks.
   • How: Limits single-borrower exposure to 10% of capital.
   • Example: During the COVID-19 lockdown, agriculture loans (subsidized by NRB) kept NMB’s NPA ratio below 2%.

3. NRB’s Liquidity Support via Repos (Liquidity Risk)

   • Idea: Acts as a lender of last resort by lending cash against collateral (e.g., government securities).
   • How: Sirjana Finance borrowed Rs 20M in 2020 under a 7-day repo to meet reserve requirements.
   • Worked Example:
     • Repo Rate: 5%
     • Amount Borrowed: Rs 20M
     • Cost: Rs 20M × 5% × (7/365) = Rs 194 (daily interest).

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## Exam Tip

1. Risk-Weighted Assets (RWA) Calculation:

   • Always multiply each asset class by its risk weight and sum them.
   • Formula: RWA = Σ (Asset × Risk Weight).
   • Common Weights:
     • Loans to SMEs: 100%
     • Government securities: 0%
     • Corporate bonds: 50–100%

2. Basel III Ratios:

   • CAR = (Tier 1 Capital / RWA) × 100 ≥ 10%.
   • Leverage Ratio = (Total Capital / Total Assets) × 100 ≥ 5%.

3. NRB’s Tools:

   • Reserve Requirements: 4% for transaction deposits (adjusts via monetary policy).
   • Liquidity Support: Repos, Discount Window Facility.

4. Risk Management Strategies:

   • Credit Risk: Collateral, LTV ratios, stress testing.
   • Liquidity Risk: LCR, NSFR, HQLA.
   • Market Risk: Swaps, asset-liability matching.
   • Operational Risk: KYC, internal audits, tech (e.g., eSewa’s AI).

5. Nepal-Specific Focus:

   • Always tie answers to NRB’s policies (e.g., Basel III adoption in 2019, LCR implementation in 2020).
   • Use real banks (NMB, Global IME, NMB) in examples.

6. Numerical Problems:

   • For T-bill pricing, use: $$\text{Price}=\text{Face Value}\times (1-\text{Discount Rate}\times \text{Time})$$
     • Example: 90-day T-bill, face value Rs 1M, discount rate 8%: $$\text{Price}=1,000,000\times (1-0.08\times 0.25)=\text{Rs }980,000$$

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Final Note: Always label your tables (e.g., "Risk-Weighted Assets Calculation for X Bank") and show workings for numerical problems. NRB’s policies are high-weight topics—expect 2–3 questions on them.