Financial Institutions & Markets: Types, Roles & Functions

TAKEAWAYS:

• Financial institutions (FIs) act as intermediaries between savers and borrowers, enabling economic growth by channeling funds efficiently.
• Depository FIs (banks, NBFCs) accept deposits and lend, while non-depository FIs (insurance, mutual funds) manage risks or investments.
• Primary markets (IPOs, bonds) create new securities, while secondary markets (NEPSE) facilitate trading; brokers and dealers bridge buyers and sellers.
• Risk management is critical for FIs—credit risk (Ncell’s loan defaults), liquidity risk (NTC’s cash flow gaps), and operational risk (eSewa’s cyberattacks) must be mitigated.
• Microfinance (e.g., Siddhartha Foundation) and pension funds (NEPSE’s retirement plans) address financial inclusion and long-term savings.
• Sustainability in FIs hinges on ethical lending (e.g., Daraz’s supplier credit policies) and regulatory compliance (Nepal Rastra Bank’s oversight).

1. What Are Financial Institutions?

Financial institutions (FIs) are organizations that facilitate the transfer of funds from savers (surplus units) to borrowers (deficit units). They include banks, insurance companies, mutual funds, and microfinance institutions. Their primary role is to mobilize savings, allocate capital efficiently, and manage financial risks.

Key Functions of Financial Institutions

flowchart TD
    A["Financial Institutions"] --> B["Mobilize Savings"]
    A --> C["Allocate Capital"]
    A --> D["Manage Risks"]
    A --> E["Provide Payment Services"]
    A --> F["Facilitate Economic Growth"]

Why They Matter in Nepal:

• Ncell (mobile banking) mobilizes savings via mobile wallets and lends to SMEs.
• NEPSE (stock exchange) allocates capital by trading shares of companies like Nepal Bank Limited.
• Siddhartha Foundation (microfinance) manages risks for rural borrowers with small loans.

2. Classification of Financial Institutions

FIs are broadly classified into depository and non-depository institutions.

A. Depository Institutions

Accept deposits and lend money. Examples in Nepal:

• Commercial Banks (NMB, Global IME)
• Development Banks (Agribank, Finance Bank)
• Microfinance Institutions (Siddhartha, KIST)

B. Non-Depository Institutions

Do not accept deposits but provide financial services:

• Insurance Companies (NIC Asia, Standard Chartered Nepal)
• Mutual Funds (Nepal Investment Trust, NIBL Mutual Fund)
• Pension Funds (NEPSE-managed retirement funds)

Comparison Table

3. Role of Financial Institutions in the Economy

FIs play a pivotal role in economic development by:

1. Channeling Savings to Productive Use: Households deposit money in banks, which lend to businesses (e.g., Daraz expanding logistics).
2. Risk Sharing: Insurance companies (e.g., NIC Asia) spread risk across policyholders.
3. Payment Systems: Banks and NTC enable digital transactions (eSewa, Khalti).
4. Financial Inclusion: Microfinance (e.g., Siddhartha) serves unbanked rural populations.

Example: Ncell’s Role Ncell accepts deposits via mobile wallets and lends to SMEs, reducing reliance on traditional banks. This reduces liquidity risk for borrowers and increases financial inclusion.

4. Types of Financial Markets

Financial markets are where assets are traded. There are two main types:

A. Primary Market

• New securities (stocks, bonds) are issued.
• Example: NEPSE IPOs for companies like Nepal Bank Limited.
• Participants: Issuers (companies), underwriters (banks), investors.

B. Secondary Market

• Existing securities are traded.
• Example: NEPSE trading floor where shares of Nepal Life Insurance are bought/sold.
• Participants: Brokers, dealers, investors.

Visual: Primary vs. Secondary Market Flow

flowchart TD
    A["Issuer (Company)"] --> B["Primary Market (IPO)"]
    B --> C["Investors (Public)"]
    C --> D["Secondary Market (NEPSE)"]
    D --> E["Traders (Brokers/Dealers)"]
    E --> F["Investors (Retail/Institutional)"]

5. Role of Brokers and Dealers

A. Brokers

• Agents who facilitate trades between buyers and sellers.
• Example in Nepal: Stockbrokers at NEPSE execute trades for clients.
• Services:
  • Match buyers/sellers.
  • Charge commissions (e.g., 0.25% on trades).
  • Provide research and advice.

B. Dealers

• Principals who trade for their own accounts.
• Example: NMB Capital acts as a dealer in government securities.
• Services:
  • Buy/sell securities at quoted prices.
  • Provide liquidity to the market.

Comparison Table

6. Problems of Nepalese Stock Market

Despite growth, Nepal’s stock market faces challenges:

1. Low Liquidity: Few traders → volatile prices (e.g., NEPSE index swings).
2. High Risk: Lack of regulatory oversight → fraud (e.g., 2019 Ponzi schemes).
3. Limited Investors: Mostly institutional investors (banks, mutual funds).
4. Infrastructure Gaps: Slow settlement, poor digital access.

Worked Example: NEPSE’s Liquidity Crisis (2020)

• Issue: Low trading volume → wide bid-ask spreads.
• Impact: Investors hesitate to buy/sell, reducing market efficiency.
• Solution: NEPSE introduced T+2 settlement to improve liquidity.

7. Risk Management in Financial Institutions

FIs face multiple risks that must be managed:

A. Credit Risk

• Borrower defaults (e.g., Ncell’s loan defaults in 2021).
• Mitigation:
  • Credit scoring (e.g., NMB’s loan approval models).
  • Collateral requirements (e.g., mortgages for home loans).

B. Liquidity Risk

• Inability to meet withdrawal demands (e.g., NTC’s cash flow issues).
• Mitigation:
  • Maintain cash reserves (e.g., Nepal Rastra Bank’s liquidity ratios).
  • Short-term investments (T-bills, repos).

C. Operational Risk

• Fraud, cyberattacks (e.g., eSewa’s 2022 data breach).
• Mitigation:
  • Cybersecurity measures (encryption, firewalls).
  • Internal audits.

Visual: Risk Management Framework

flowchart TD
    A["Financial Institution"] --> B["Identify Risks"]
    B --> C["Assess Risks"]
    C --> D["Mitigate Risks"]
    D --> E["Monitor Risks"]
    E --> F["Report Risks"]

8. Microfinance and Financial Inclusion

Microfinance provides small loans to low-income groups, promoting financial inclusion.

Example: Siddhartha Foundation

• Service: Small loans (Rs. 5,000–Rs. 50,000) to rural women.
• Impact:
  • Reduces poverty (e.g., Kathmandu Valley farmers).
  • Encourages entrepreneurship (e.g., homestay businesses).

Sustainability Challenges

1. Default Risk: Borrowers may default if income drops.
2. High Costs: Branch operations in remote areas are expensive.
3. Regulatory Hurdles: Nepal Rastra Bank’s strict lending rules.

Solution: Group lending (e.g., KIST’s joint liability model) reduces default risk.

9. Term Structure of Interest Rates

Interest rates vary by maturity:

• Short-term rates (e.g., Nepal Rastra Bank’s repo rate) are lower.
• Long-term rates (e.g., 10-year government bonds) are higher.

Example: NEPSE Bond Yields (2023)

Why? Longer-term bonds compensate for inflation risk and reinvestment risk.

10. Non-Depository Financial Institutions

These FIs do not accept deposits but provide financial services:

1. Insurance Companies (e.g., NIC Asia) → Risk transfer.
2. Mutual Funds (e.g., NIBL Mutual Fund) → Investment pooling.
3. Pension Funds (e.g., NEPSE-managed funds) → Retirement savings.

Example: NEPSE’s Role in Pension Funds

• Manages Employee Provident Fund (EPF) for retirees.
• Invests in government securities and stocks to ensure growth.

11. Financial Instruments

FIs use instruments to manage risks and generate returns:

1. Bonds: Fixed-income securities (e.g., Nepal Government Securities).
2. Stocks: Equity shares (e.g., Nepal Bank Limited).
3. Derivatives: Options, futures (e.g., NEPSE’s index futures).

Worked Example: Bond Valuation

• Given: A bond pays Rs. 75 yearly, callable in 2 years at Rs. 1,050.
• Assumption: Market interest rate = 6%.
• Calculation:
  • Year 1: Rs. 75 (coupon) + Rs. 75/(1.06) = Rs. 147.17
  • Year 2: Rs. 1,050/(1.06)^2 = Rs. 962.26
  • Present Value = Rs. 147.17 + Rs. 962.26 = Rs. 1,109.43

12. Exam Tips for Unit 1

1. Memorize Definitions: Know the difference between brokers (agents) and dealers (principals).
2. Compare Markets: Always contrast primary vs. secondary markets with Nepalese examples (NEPSE, IPOs).
3. Risk Management: Link credit risk to Ncell’s loans and liquidity risk to NTC’s cash flow.
4. Microfinance Focus: Highlight Siddhartha’s group lending and sustainability challenges.
5. Term Structure: Explain why long-term bonds have higher yields using inflation risk.
6. Real-World Links: Always tie answers to NEPSE, Daraz, or Ncell—examiners love this!

flowchart TD
    A["Customer"] --> B["Deposit Funds"]
    B --> C["Ncell Wallet"]
    C --> D["Loan Request"]
    D --> E["Ncell Approval"]
    E --> F["Business (SME)"]
    F --> G["Repayment"]
    G --> H["Customer"]

Final Note: This unit is highly practical. Always use Nepalese examples (NEPSE, Ncell, Siddhartha) to score full marks. For numericals, show calculations step-by-step like the bond valuation example above. Good luck!