Chapter 1: Introduction | Fundamentals of Financial System (BBS 3rd Year) | TU

FINANCIAL SYSTEM IN NEPAL

Complete Exam Notes – Fundamentals of Financial System (BBS 3rd Year)

Chapter 1: Introduction

Based on NRB statistics (Mid-July 2026), BAFIA 2073, NRB Act 2058, Securities Act 2063 and Insurance Act 2079

Prepared by Santosh Tharu | www.tharusantosh.com.np

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1Concept of Financial System

DefinitionThe financial system of a country is the set of institutional arrangements (institutions, instruments, markets, laws and regulators) that mobilize resources from surplus units to deficit units in the economy.

Some people and organizations earn more than they spend, while others need more money than they have. The financial system links the two groups so that idle savings become productive investment.

SURPLUS UNITSSavers / Lenders

Savings→

FINANCIAL SYSTEMInstitutions, Assets, Markets, Laws

Funds→

DEFICIT UNITSBorrowers / Spenders

Surplus Units and Deficit Units

	Surplus Units (Savers)	Deficit Units (Borrowers)
Position	Income is greater than spending	Spending / investment needs exceed income
Examples	Households, retired persons, remittance-receiving families, profitable firms	Businesses, government, farmers, students, home buyers
Role	Lend / invest and earn interest, dividend or capital gain	Borrow / issue securities and pay interest or dividend

Key Features

• Mobilizes savings and channels them into productive investment.
• Facilitates payments and exchange of goods and services.
• Allocates resources efficiently across sectors (agriculture, hydropower, industry, services).
• Manages risk through insurance, diversification and hedging.
• Supports monetary policy and economic stability through the central bank.
• Promotes economic growth, capital formation and employment.

2Components of Financial System

A well-functioning financial system has five inter-related components:

FINANCIAL SYSTEM OF A COUNTRY

Financial Institutions

Financial Assets

Financial Markets

Acts and Regulations

Regulatory Authorities

Component	Meaning	Nepalese Examples
Financial Institutions	Organizations that collect funds and provide financial services	Commercial banks, insurance companies, EPF, CIT
Financial Assets	Claims (instruments) created and traded in financial markets	Shares, bonds, treasury bills, deposits, insurance policies
Financial Markets	Markets that channel funds from surplus to deficit units	NEPSE, T-bill market, inter-bank market
Acts and Regulations	Laws, rules and directives governing financial activities	NRB Act 2058, BAFIA 2073, Securities Act 2063
Regulatory Authorities	Bodies that license, supervise and monitor participants	NRB, SEBON, Nepal Insurance Authority

3Financial Institutions

Financial institutions collect funds from savers and provide funds or financial services to users. They are divided by whether they accept deposits from the general public.

Basis	Depository Institutions	Non-Depository Institutions
Meaning	Financial institutions that accept deposits from the general public	Financial institutions that do not accept deposits from the general public
Source of funds	Savings, current, fixed and other deposits	Premiums, contributions, share capital, units sold, fees
Examples in Nepal	Commercial banks, development banks, finance companies, microfinance institutions, savings and credit cooperatives, Postal Savings Bank	Insurance companies, EPF, Citizen Investment Trust (CIT), Social Security Fund (SSF), merchant banks, mutual funds, securities companies, stock brokers, NEPSE, CDSC
Main function	Accept deposits, grant loans, offer payment services	Contractual savings, insurance, investment management, capital market support
Regulator	Mainly Nepal Rastra Bank (cooperatives: cooperative regulator)	SEBON, Nepal Insurance Authority, respective Acts

Classification of BFIs by Nepal Rastra Bank

Class	Type of Institution	Governing Act	Notes
A	Commercial Banks	BAFIA 2073	Full banking services; national level
B	Development Banks	BAFIA 2073	National or provincial / district level
C	Finance Companies	BAFIA 2073	Limited banking services
D	Microfinance Financial Institutions	BAFIA 2073	Small loans to low-income and rural groups

4Financial Assets

DefinitionFinancial assets are assets (claims on future income or wealth) that are traded in financial markets. They have value because of the contractual right they represent, not physical substance.

Types of Financial Assets

Category	Examples	Features
Money market instruments	Treasury bills, call money, certificates of deposit, commercial paper, repo	Maturity up to one year; low risk; high liquidity
Capital market instruments	Ordinary shares, preference shares, debentures, development / citizen bonds, mutual fund units	Long term; higher return and risk
Deposits and savings	Savings, current, fixed deposits	Safe, liquid; issued by depository institutions
Insurance and pension	Life and non-life policies, EPF / SSF contributions	Contractual, long-term protection and retirement saving
Derivatives	Forwards, futures, options, swaps	Value derived from underlying asset; limited use in Nepal

Real Assets vs Financial Assets

Basis	Real Assets	Financial Assets
Nature	Tangible, physical (land, building, gold, machinery)	Intangible claims (shares, bonds, deposits)
Value source	Utility and physical use	Right to future cash flow
Liquidity	Generally low	Generally high
Transaction cost	High	Lower

Characteristics of Financial Assets

• Liquidity – ease of converting into cash without loss.
• Return – interest, dividend or capital gain.
• Risk – uncertainty of getting the expected return.
• Maturity – time until the claim is repaid.
• Marketability and divisibility – can be traded easily in small units.

5Financial Market

DefinitionA financial market is the market that channels funds from surplus units to deficit units by providing a place or mechanism to buy and sell financial assets.

Functions of Financial Markets

• Mobilization of savings and their allocation to productive uses.
• Price discovery – buyers and sellers set interest rates and share prices.
• Liquidity – investors can sell assets quickly.
• Reduces transaction and information cost.
• Risk sharing and diversification across many assets.

Classification of Financial Markets

Basis	Types	Explanation
Maturity of asset	Money market and Capital market	Short-term (up to 1 year) vs long-term funds
Stage of issue	Primary and Secondary market	New issue (IPO, FPO, bond issue) vs trading of existing securities
Asset traded	Equity, debt, foreign exchange, derivative market	Shares; bonds and loans; currencies; futures and options
Structure	Organized (exchange) and Over-the-counter	NEPSE trading vs direct bank-to-bank dealing

Money Market vs Capital Market

Basis	Money Market	Capital Market
Maturity	Up to one year	More than one year
Instruments	T-bills, call money, CDs, commercial paper	Shares, debentures, long-term bonds
Purpose	Working capital and liquidity management	Fixed capital, expansion, projects
Risk and return	Low	Higher
Nepalese institutions	NRB, commercial banks (inter-bank market)	NEPSE, CDSC, SEBON, merchant banks

6Acts and Regulations

Acts and regulations create the legal framework that defines who can operate, what they can do, and how consumers and the system are protected. (Years are in Bikram Sambat.)

Act	Main Purpose
Nepal Rastra Bank Act, 2058 (2002)	Establishes NRB as central bank; monetary policy, currency issue, supervision of BFIs
Bank and Financial Institutions Act (BAFIA), 2073 (2017)	Licensing, operation, capital, supervision and winding up of Class A, B, C and D institutions
Companies Act, 2063 (2006)	Incorporation, management and winding up of companies; share issue
Securities Act, 2063 (2007)	Regulates issue and trading of securities; establishes SEBON, stock exchange and brokers
Insurance Act, 2079 (2022)	Regulates insurance business; establishes the Nepal Insurance Authority
Deposit and Credit Guarantee Act, 2073 (2017)	Protects small depositors through deposit insurance and credit guarantee
Foreign Exchange (Regulation) Act, 2019 (1962)	Controls foreign exchange transactions and reserves
Negotiable Instruments Act, 2034 (1977)	Law on cheques, bills of exchange and promissory notes
Assets (Money) Laundering Prevention Act, 2064 (2008)	Prevents money laundering and terrorist financing
Banking Offence and Punishment Act, 2064 (2008)	Defines and punishes banking offences
Banks and FIs Debt Recovery Act, 2058 (2002)	Debt recovery for BFIs through the Debt Recovery Tribunal
Cooperatives Act, 2074 (2017)	Registration, operation and regulation of cooperatives
Employees Provident Fund Act, 2019 (1962)	Establishes EPF; retirement savings of employees
Citizen Investment Trust Act, 2047 (1991)	Establishes CIT for mobilizing small savings and retirement schemes
Contribution-Based Social Security Act, 2074 (2017)	Social Security Fund (SSF) contributory benefits

NoteBesides Acts, NRB Unified Directives, SEBON Rules / Guidelines and Insurance Authority Directives regulate day-to-day operations (capital adequacy, CRR / SLR, single obligor limit, KYC and others).

7Regulatory Authorities

Regulatory authorities license, supervise and monitor financial participants to protect depositors and investors and keep the system stable.

Ministry of Finance (Government of Nepal)

Nepal Rastra BankBanks, FIs, forex, monetary policy

SEBONCapital market, NEPSE, CDSC

Nepal Insurance AuthorityLife, non-life, re-insurance

Cooperative RegulatorsSavings and credit cooperatives

Authority	Area Regulated	Key Role
Nepal Rastra Bank (est. 2013 BS / 1956)	Banks and financial institutions, money market, foreign exchange	Central bank; monetary policy; issues currency; banker to government and banker's bank; licenses and supervises BFIs; manages foreign reserves
Ministry of Finance	Overall financial and fiscal policy	Government policy, budget, public debt, state-owned financial institutions
Securities Board of Nepal (SEBON, est. 2050 BS / 1993)	Capital market	Approves securities issues; regulates NEPSE, CDSC, brokers, merchant bankers, mutual funds; investor protection
Nepal Insurance Authority (under Insurance Act 2079)	Insurance sector (earlier Beema Samiti)	Licenses and supervises life, non-life and re-insurance companies, agents and surveyors
Cooperative regulators (Dept. of Cooperatives / National Cooperative Regulatory Authority)	Savings and credit cooperatives	Registration, monitoring and supervision of cooperatives
Office of the Company Registrar	Companies	Registers companies and enforces Companies Act
Deposit and Credit Guarantee Fund	Deposit insurance	Guarantees small deposits of BFIs

8Size and Structure of Nepalese Financial System

Number of Financial Institutions

Licensed banks and financial institutions (BFIs) as per Nepal Rastra Bank, Mid-July 2026 (Asar End 2083):

S.N.	Type of Institution	Class	Number
1	Commercial Banks	A	20
2	Development Banks	B	17
3	Finance Companies	C	16
4	Microfinance Financial Institutions	D	51
5	Infrastructure Development Bank	-	1
	Total NRB-licensed BFIs		105

Number of BFIs by type (Mid-July 2026)

20

17

16

51

1

Commercial Banks (A)Development Banks (B)Finance Cos. (C)Microfinance (D)Infra. Dev. Bank

Other (non-BFI) financial institutions

• Insurance companies – life, non-life and re-insurance, regulated by Nepal Insurance Authority.
• Contractual / provident funds – EPF, CIT, Social Security Fund.
• Capital market institutions – NEPSE (stock exchange), CDSC (depository), merchant banks, mutual funds, stock brokers.
• Cooperatives – a very large number of savings and credit cooperatives across the country.
• Postal Savings Bank and other specialized institutions.

Assets Held by Financial Sectors

The Nepalese financial system is bank-dominated: commercial banks hold the largest portion of total financial sector assets.

Sector	Relative Share of Assets	Remark
Commercial banks	Largest (dominant)	Main source of credit; wide branch network
Development banks	Small	Mostly regional / sectoral lending
Finance companies	Very small	Declining due to mergers
Microfinance institutions	Small	Rural and priority-sector reach
Insurance companies	Growing	Life insurance has the larger share
EPF, CIT, SSF	Large long-term funds	Retirement and contractual savings
Cooperatives	Significant	Semi-formal; large membership

Figures change every month. For exams, quote the latest numbers from NRB's Banking and Financial Statistics / Financial Stability Report.

Structure of the Nepalese Financial System

NEPALESE FINANCIAL SYSTEM

FORMAL SECTORNepal Rastra BankCommercial / Development banksFinance companies, MicrofinanceInsurance companiesEPF, CIT, SSFNEPSE, CDSC, SEBON

SEMI-FORMAL SECTORSavings and credit cooperativesNGOs doing microfinancePostal savings

INFORMAL SECTORMoneylendersDhukuti (ROSCA)Friends / relativesLandlords, traders

• The system has gone through liberalization (since the 1980s), mergers and acquisitions, leading to fewer but stronger BFIs.
• Mergers reduced the number of commercial banks, development banks and finance companies in recent years.
• The capital market is still small and developing; one stock exchange (NEPSE) and one depository (CDSC).

9Process of Funds Transfer from Surplus Units to Deficit Units

Funds move from savers to borrowers in two ways:

Direct Transfer	Indirect Transfer
Surplus units lend directly to deficit units, who issue claims (shares, bonds) to them.	Surplus units lend through a financial intermediary, which then lends to deficit units.

10Direct Transfer of Fund

MeaningDirect transfer is the process in which surplus units directly provide funds to deficit units without an intermediary creating a new claim. The deficit unit issues a direct (primary) security to the lender.

SURPLUS UNITSSavers / Investors

Money / Funds→

DEFICIT UNITSIssuers / Borrowers

Direct claims (shares, bonds, IOU) flow back to the saver. Brokers or underwriters only assist.

Examples

• Buying shares in an IPO or rights issue.
• Buying government development bonds or treasury bills directly.
• Lending to a friend or relative against a promissory note.
• Buying debentures issued by a company.

Advantages	Disadvantages
Lender may earn higher return; no intermediary margin	High search and information cost to find a counterparty
Borrower gets funds at lower cost (no spread)	Higher risk because there is no diversification
Direct relationship / control (shareholder rights)	Mismatch of amount, maturity and risk preferences
Flexible terms by mutual agreement	Lower liquidity and weak protection if default occurs

11Indirect Transfer of Fund

MeaningIndirect transfer is the process in which funds move from surplus to deficit units through a financial intermediary. The intermediary issues indirect (secondary) securities (deposit receipts, policies) to savers and acquires primary securities (loan agreements) from borrowers.

SURPLUS UNITSDepositors

Deposits / premium→

FINANCIAL INTERMEDIARYBank, Insurer, Fund

Loans→

DEFICIT UNITSBorrowers

Examples

• Depositing in a bank that lends to businesses and households.
• Paying insurance premium; the insurer invests in bonds, shares and loans.
• Contributing to EPF / SSF / CIT; funds are invested in the economy.
• Buying mutual fund units that invest in a portfolio of shares.

Advantages	Disadvantages
Lower search and transaction cost	Intermediary charges a margin (interest spread, fees)
Risk reduced through diversification and expertise	Savers have less control over use of funds
Flexible amount and maturity; high liquidity for savers	Risk of intermediary failure (needs regulation and deposit guarantee)
Professional appraisal and monitoring of borrowers	Savers earn lower return than direct lending

Direct vs Indirect Transfer of Funds

Basis	Direct Transfer	Indirect Transfer
Intermediary	Not involved	Involved (bank, insurer, fund)
Claim received by saver	Primary (direct) security	Secondary (indirect) security
Risk	High, concentrated	Low, diversified
Liquidity	Usually low	Usually high
Cost of search	High	Low
Return to saver	Higher (no spread)	Lower (after spread)
Examples	Shares, bonds, personal loans	Bank deposits, insurance, mutual funds

12Financial Intermediaries and Financial Intermediation

Financial IntermediariesFinancial intermediaries are institutions that stand between savers and borrowers, collecting funds from surplus units and lending them to deficit units (commercial banks, finance companies, insurance companies, pension and provident funds, mutual funds).

Financial IntermediationFinancial intermediation is the process by which intermediaries collect funds from savers by issuing their own liabilities (deposits, policies) and use them to acquire financial assets (loans, securities) of deficit units.

Types of Financial Intermediaries

• Depository intermediaries – banks, finance companies, microfinance, cooperatives.
• Contractual savings intermediaries – insurance companies, EPF, SSF, CIT.
• Investment intermediaries – mutual funds, merchant banks, securities companies.

13Functions and Roles of Financial Intermediaries

Intermediaries exist because direct lending is costly and risky. Their main functions are:

1. Reducing Transaction Cost

• Transaction cost includes search cost, verification cost (checking creditworthiness), monitoring cost and enforcement cost.
• Intermediaries have economies of scale and specialized expertise, so cost per transaction is low.
• Example: A depositor does not need to search for a borrower; the bank does appraisal and recovery.

2. Reducing Risk through Diversification

• Intermediaries pool funds of many savers and lend to many borrowers in different sectors, so loss on one loan is offset by others.
• Small savers who cannot diversify gain a lower-risk pooled portfolio.
• Example: A mutual fund holds shares of many companies; a bank lends to agriculture, hydropower, trade and services.

3. Transforming the Financial Assets

• Intermediaries buy primary securities (loans, bonds) that savers may not want and issue secondary / indirect securities (deposits, policies) that savers prefer.
• They transform size (small deposits into large loans), risk (risky loans into safe deposits), liquidity (illiquid loans into liquid deposits) and maturity.
• Example: Small deposits of Rs. 1,000 each become a Rs. 50 million project loan.

4. Alleviation of Adverse Selection and Moral Hazard

Problem	Meaning	How Intermediaries Reduce It
Adverse selection	Before the transaction: risky borrowers are most eager to borrow, so the lender may select bad borrowers (information asymmetry)	Screening and credit appraisal, credit information bureau, collateral, collecting borrower information
Moral hazard	After the transaction: borrower may misuse funds or take excess risk because someone else bears the loss	Monitoring, loan covenants, collateral and guarantees, staged disbursement, penalties

5. Maturity Intermediation

• Savers prefer short-term, liquid deposits whereas borrowers need long-term funds (home, project loans).
• Intermediaries bridge this gap by converting short-term deposits into long-term loans.
• By the law of large numbers only a small portion of depositors withdraw at once, so banks can lend long term but must hold reserves (CRR / SLR) to manage liquidity risk.

SAVERSwant short-term, liquid assets

Short-term deposits→

BANKMaturity transformer

Long-term loans→

BORROWERSwant long-term funds

6. Providing Payment Mechanism

• Intermediaries provide an efficient system of payments that reduces the need to carry cash and speeds up settlement.
• Instruments and channels: cheques, drafts, ATM / debit and credit cards, mobile and internet banking, QR payments, ConnectIPS, RTGS and remittance.
• This lowers cost of trade, improves safety and supports e-commerce and digital finance in Nepal.

14Chapter Summary at a Glance

Topic	Key Points to Remember
Financial system	Institutional arrangement to mobilize resources from surplus to deficit units
Components	Institutions, Assets, Markets, Acts and Regulations, Regulatory authorities
Institutions	Depository (accept public deposits) and Non-depository (do not)
Financial assets	Assets traded in financial markets: money market and capital market instruments
Financial market	Channels funds from surplus to deficit units; primary / secondary, money / capital
Regulators	NRB, SEBON, Nepal Insurance Authority, cooperative regulators, Ministry of Finance
Size (Mid-July 2026)	20 commercial banks, 17 development banks, 16 finance companies, 51 microfinance, 1 infrastructure bank = 105 BFIs
Fund transfer	Direct (no intermediary) and Indirect (through intermediary)
Intermediary functions	Transaction cost, diversification, asset transformation, adverse selection / moral hazard, maturity, payment mechanism

15Short Answers

Q1. What is a financial system?Ans: A set of institutional arrangements (institutions, assets, markets, laws and regulators) that mobilizes funds from surplus units to deficit units.

Q2. Differentiate depository and non-depository institutions.Ans: Depository institutions accept deposits from the public (banks, finance companies, microfinance); non-depository institutions do not (insurance, EPF, CIT, mutual funds).

Q3. What are financial assets?Ans: Assets or claims traded in the financial market, e.g. shares, bonds, treasury bills, deposits.

Q4. What is a financial market?Ans: A market that channels funds from surplus units to deficit units by trading financial assets.

Q5. What is financial intermediation?Ans: The process of collecting funds from savers by issuing deposits or policies and lending / investing them to deficit units.

Q6. Define adverse selection and moral hazard.Ans: Adverse selection is selecting risky borrowers before the deal because of information asymmetry; moral hazard is misuse or excess risk-taking by borrowers after receiving funds.

Q7. What is maturity intermediation?Ans: Converting short-term deposits into long-term loans so both savers and borrowers get their preferred maturity.

Q8. Name the regulators of the Nepalese financial system.Ans: Nepal Rastra Bank, Securities Board of Nepal, Nepal Insurance Authority, cooperative regulators and Ministry of Finance.

16Exam Tips

• Always start with a definition in the exact words of the syllabus, then explain with Nepalese examples.
• Draw the flow diagram of direct and indirect fund transfer; diagrams earn extra marks.
• Use tables for differences (depository vs non-depository, direct vs indirect, money vs capital market).
• For size and structure, quote the latest NRB figures with the date and mention BFI classes A, B, C and D.
• For the six functions of intermediaries, remember T-R-T-A-M-P (Transaction cost, Risk, Transform assets, Adverse selection / moral hazard, Maturity, Payment).
• Link every point to the Nepalese context: NRB, NEPSE, SEBON, BAFIA 2073, EPF, CIT, cooperatives.

Frequently Asked Exam Questions

• Explain the concept and components of the financial system. (Long, 10 marks)
• Describe the size and structure of the Nepalese financial system. (Long)
• Explain the process of fund transfer from surplus to deficit units. (Long)
• Discuss the functions and roles of financial intermediaries. (Long)
• Write short notes: depository institutions, financial assets, financial market, adverse selection and moral hazard. (Short)

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Prepared by Santosh Tharu · Learn . Grow . Succeed