Money, Banking & Financial Systems: Roles, Functions & Nepal’s Context

TAKEAWAYS:

• Money solves the double coincidence of wants problem in barter economies by acting as a medium of exchange, store of value, and unit of account—Nepal’s currency (NPR) fulfills these roles alongside digital wallets like Khalti.
• Commercial banks (e.g., NMB, Global IME) create money through fractional reserve banking, while the Nepal Rastra Bank (NRB) controls money supply via repo rate, CRR, and open market operations to stabilize inflation (currently ~6.5% in 2023).
• Demand deposits (savings/current accounts) and time deposits (fixed deposits) are the two types of bank deposits, with loans (e.g., home loans from Standard Chartered Nepal) funded by deposits and central bank liquidity.
• Financial inclusion in Nepal relies on mobile banking (eSewa, Khalti) and microfinance institutions (MFIs), which serve 70% of unbanked populations in rural areas.
• Monetary policy tools (e.g., NRB’s 2023 hike in repo rate to 8.5%) aim to curb inflation but risk slowing GDP growth (currently ~3.5% in FY 2023/24).
• Digital payments (e.g., Pathao’s QR codes, Daraz’s Khalti integration) reduce cash dependency but pose cybersecurity risks (e.g., 2022 Ncell data breach affecting 1M users).

1. The Nature and Functions of Money

Money is any asset that is widely accepted as payment for goods and services. It evolved from barter systems (e.g., trading rice for cloth in ancient Nepal) to commodity money (gold/silver) and finally to fiat money (Nepalese Rupee, issued by NRB).

Functions of Money

mindmap
  root((Money))
    Functions
      Medium of Exchange["Solves barter’s double coincidence problem (e.g., farmer selling wheat for NPR instead of searching for a buyer who needs wheat)"]
      Store of Value["Preserves purchasing power (e.g., saving NPR 50,000 for a future hotel management course)"]
      Unit of Account["Standardizes prices (e.g., a room in Thamel costs NPR 3,000, not ‘2 kg of rice’)"]
      Standard of Deferred Payments["Used for loans (e.g., Ncell’s installment plans for smartphones)"]

Types of Money in Nepal

2. The Banking System in Nepal

Nepal’s banking system consists of:

1. Central Bank: Nepal Rastra Bank (NRB) – monetary authority.
2. Commercial Banks: NMB, Standard Chartered, Himalayan Bank – profit-oriented.
3. Development Banks: Agricultural Development Bank (ADB), Rural Development Bank – focus on specific sectors.
4. Financial Institutions: Microfinance Institutions (MFIs), Insurance Companies.

Structure of Nepal Rastra Bank (NRB)

classDiagram
    class NRB {
        +Issues currency (NPR)
        +Regulates banks
        +Controls money supply
        +Sets repo rate (currently 8.5%)
        +Holds foreign exchange reserves (~$11B in 2023)
    }
    class CommercialBanks {
        +Accept deposits
        +Grant loans
        +Create credit
    }
    NRB --> CommercialBanks : "Regulates via CRR, SLR"
    CommercialBanks --> NRB : "Borrow via repo rate"

3. How Banks Create Money (Money Multiplier Effect)

Banks create money through fractional reserve banking. When a customer deposits NPR 10,000, the bank keeps only 5% (NPR 500) as reserves and lends out the rest (NPR 9,500). The borrower spends the loan, and the recipient deposits it in another bank, repeating the process.

Money Creation Process

flowchart TD
    A["Initial Deposit: NPR 10,000"] --> B["Bank Keeps 5% (NPR 500) as Reserve"]
    B --> C["Lends NPR 9,500 to Farmer"]
    C --> D["Farmer Buys Seeds: Deposits NPR 9,500 in Another Bank"]
    D --> E["New Bank Lends NPR 9,025"]
    E --> F["Total Money Created: NPR 19,025"]
    F --> G["Money Multiplier = 1/Reserve Ratio (1/0.05 = 20)"]

Worked Example: Money Multiplier in Nepal

• Reserve Ratio (RR): 5% (set by NRB).
• Initial Deposit: NPR 1,00,000 in Global IME.
• Money Created: $\text{Total Money}=\frac{\text{Initial Deposit}}{RR}=\frac{1,00,000}{0.05}=\text{NPR 20,00,000}$

Real-World Tie-In: When NRB reduces the reserve ratio, banks can lend more, boosting GDP but risking inflation (as seen in 2022 when NRB cut RR to 4% to stimulate post-pandemic recovery).

4. Types of Bank Deposits

5. Functions of Commercial Banks

mindmap
  root((Commercial Banks))
    Primary Functions
      Accepting Deposits["Savings, current, fixed deposits (e.g., NPR 50,000 in Himalayan Bank)"]
      Granting Loans["Personal, business, home loans (e.g., Ncell’s 0% EMI on smartphones)"]
      Agency Functions["Collecting cheques, issuing drafts (e.g., Daraz using bank drafts for large orders)"]
    Secondary Functions
      Credit Creation["Expanding money supply via loans"]
      Investment["Trading in securities (e.g., NMB investing in NEPSE stocks)"]
      Foreign Exchange["Buying/selling USD/EUR for tourists or imports"]

Real-World Example: Pathao’s Bank Partnerships Pathao uses NMB and Global IME to process NPR 500 million/month in transactions. When a user pays via Khalti, the bank:

1. Deducts the amount from the user’s Khalti wallet.
2. Credits Pathao’s merchant account.
3. Settles the amount to Pathao’s bank account (NMB) within 24 hours.

6. Central Bank and Monetary Policy Tools

NRB uses three main tools to control money supply and inflation:

7. Digital Banking and Financial Inclusion in Nepal

Nepal’s financial inclusion has grown from 38% (2018) to 65% (2023) due to:

• Mobile Banking: eSewa, Khalti, Ncell Wallet (used by 80% of urban users).
• Microfinance: MFIs like Swayamsidha lend to rural women (NPR 50,000 loans at 12% interest).
• Government Initiatives: Prakriti Sewa App for disaster relief payments via digital wallets.

Worked Example: eSewa’s Role in Tourism A hotel in Pokhara uses eSewa for:

1. Guest Payments: Foreign tourists pay via eSewa QR (converted to NPR at NPR 140/USD).
2. Supplier Payments: The hotel pays utility bills (NTC, Ncell) via eSewa.
3. Loan Repayments: The owner repays a NMB business loan via eSewa’s bank transfer.

8. Challenges in Nepal’s Banking Sector

1. High NPLs (Non-Performing Loans): 2.8% of total loans (2023), up from 2.1% in 2022.
   • Cause: Defaults in tourism/hospitality loans post-pandemic.
2. Low Digital Penetration in Rural Areas: Only 40% of rural Nepalese use digital payments.
3. Foreign Exchange Crunch: Nepal imports 80% of its fuel, leading to USD shortages.
4. Cybersecurity Risks: Ncell data breach (2022) exposed 1 million users’ data.

In the Real World

1. Khalti and eSewa (Digital Money)

   • Idea Used: Medium of Exchange + Store of Value
   • How: Khalti allows users to link bank accounts and transfer money instantly (e.g., a waiter in Thamel sends NPR 2,000 to his family in Pokhara). In 2023, 50% of all transactions in Nepal were via digital wallets.

2. NMB’s Home Loan Scheme (Fractional Reserve Banking)

   • Idea Used: Credit Creation
   • How: When you take a NPR 5,00,000 home loan from NMB, the bank:
     • Keeps NPR 25,000 (5% CRR) as reserve.
     • Lends NPR 4,75,000 to another customer (e.g., a restaurant owner in Bhaktapur).
     • The restaurant owner deposits the loan in Global IME, creating more money.

3. NRB’s Repo Rate Hike (Monetary Policy)

   • Idea Used: Controlling Inflation
   • How: In June 2023, NRB increased the repo rate from 7.5% to 8.5% to:
     • Reduce inflation (6.5% in 2023) caused by fuel price hikes.
     • Discourage banks from lending excessively (which could overheat the economy).
   • Impact: Borrowing costs rose for hotel owners taking loans for renovations, slowing investment.

Exam Tip

How This Unit is Examined (TU Pattern)

1. Short Questions (5 marks each):

   • Define fractional reserve banking, repo rate, or near money.
   • Example: "Explain how NRB controls money supply using CRR." → Draw a money multiplier diagram and mention NPR 10,000 deposit example.

2. Long Questions (15-20 marks):

   • Compare commercial banks and central banks (use a table with 4-5 points).
   • Trace the money creation process (start with NPR 50,000 deposit, show NPR 47,500 loan, and calculate total money created).
   • Analyze Nepal’s inflation problem (use 2023 inflation data, link to NRB’s repo rate hike, and suggest policy solutions).

3. Case Study (10 marks):

   • "A hotel in Pokhara takes a NPR 20,00,000 loan from Himalayan Bank. Explain how this affects the money supply."
     • Step 1: Bank keeps 5% (NPR 1,00,000) as reserve.
     • Step 2: Lends NPR 19,00,000 to another business.
     • Step 3: New business deposits the loan → money multiplier effect.
     • Final Answer: Total money created = NPR 40,00,000 (assuming 5% RR).

4. Diagram-Based Questions:

   • Draw and label:
     • Banking structure (NRB → Commercial Banks → Public).
     • Money creation flow (deposit → loan → new deposit).
     • Inflation causes (demand-pull vs. cost-push, with Nepal’s 2023 example).

Marks Boosters

✅ Use real Nepal examples (eSewa, NRB’s repo rate, NMB loans). ✅ Show calculations (money multiplier, inflation impact). ✅ Draw diagrams (money creation flow, inflation graph). ✅ Link to current events (e.g., "NRB’s 2023 decision to hike repo rate was to combat inflation at 6.5%").

Common Mistakes to Avoid

❌ Assuming 100% reserve banking (Nepal uses 5% CRR). ❌ Ignoring digital money (eSewa/Khalti are as important as cash in Nepal). ❌ Mixing fiscal and monetary policy (NRB controls money supply; government controls taxes/spending). ❌ Forgetting real-world data (e.g., Nepal’s inflation rate, forex reserves).