The Role of Financial

Institutions and Markets

Unit 1
 Chapter outline
• Meaning of financial markets and institutions
• Functions of financial markets
• Classification and diversity of financial markets
• Types of financial institutions and their functions
• Classification of financial institutions in Nepal.
 Financial System
• Financial system intermediates between the flow of funds belonging to those
who save a part of their income and those who invest in productive assets.
• It mobilizes and usefully allocates scarce resources of a country.
• A financial system is a complex , well integrated set of sub systems of
financial institutions, markets, instruments & services which facilitates the
transfer and allocation of funds efficiently & effectively.
Financial System Overview
 Meaning of Financial Markets
• Market in which financial securities (assets) can be traded
• Financial markets facilitate transfer of funds from person or businesses
without investment opportunities (i.e. lenders and savers or surplus unit) to
those who don’t have them (i.e. borrowers and spenders or deficit unit)
 Functions of Financial Market
• Liquidity on tradable assets: facilitates the exchange of securities by making it accessible to the investor
who can easily sell the securities he holds and thus helping the conversion of the assets to cash.
• Price Determination of financial instruments: determined by the demand and supply forces i.e.,
frequent interaction between the investors helps in deciding the price of the securities.
• Efficiency: provides the platform to the probable seller and the buyer easily where they trade with each
other, which helps them in saving their time, efforts and money in finding other required parties.
• Borrowing and lending: investors having the savings are linked with the industries which require the
funds, thereby mobilizing the savings and inserting them into most productive uses.
• Information aggregation and coordination: provides many types of different information to the traders
who can get easy access to that information without the requirement of investing their time and
money.
• Enhancing income: Financial markets allow lenders to earn interest or
dividend on their surplus invisible funds, thus contributing to the
enhancement of the individual and the national income.
• Productive usage: Financial markets allow for the productive use of the
funds borrowed. Thus enhancing the income and the gross national
production.
• Capital formation: Financial markets provide a channel through which new
savings flow to aid capital formation of a country.
 Importance of financial market
• Helps savers to become investors
• Helps businesses to raise money to expand their business
• Helps in economic growth
 Segments of Financial markets

• Direct Financing:
• Funds are transferred directly from ultimate savers to ultimate borrowers

• Indirect Financing:
• A financial intermediary transforms financial claims with one set of
characteristics into financial claims of other charateristics.
Transfer of funds on Financial market
 Types of Financial Markets
• Stock market Commodity market
Nature of Assets • Bond market Derivative market

• Equity market
Nature of Claim • Debt market

• Money market
Maturity of Claim • Capital market

• Cash market
Delivery Timing • Future market

• Exchange traded market

Organizational Structure • Over the counter market
 By Nature of Assets
• Stock market: This is the market where shares of the company are listed and
traded after their IPO.
• Bond market: This market allows companies and the government to raise money
for a project or investment. Investors buy bonds from a company, which later
returns the amount of bond with agreed interest.
• Commodities market: In this market, investors buy and sell natural resources or
commodities, like corn, oil, meat, and gold.
• Derivatives market: This market deals in derivatives or contracts, whose value is
based on the underlying asset being traded.
 By Nature of Claim
• Equity Market: It is a market where investors deal in stocks or other equity
instruments. It is basically the market for residual claims.
• Debt Market: In this market, investors buy and sell fixed claims or debt
instruments, like debentures or bonds.
 By Maturity of Claim
• Money Market: The markets where investors buy and sell securities that mature
within a year are the money market. Assets that investors buy and sell in this
market are commercial paper, certificate of deposits, treasury bills, and more.
• Capital Market: Markets, where investors buy and sell medium and long term
financial assets, is a capital market. There are two types of capital market: Primary
Market (where a company issues its shares for the first time (IPO), or already
listed company issues fresh shares) and Secondary Market or Stock Market (where
buyers and sellers trade already issued securities in the primary market).
 By Timing of Delivery
• Cash Market: It is the market where transactions are settled in real time.
• Futures Market: In this market, settlement and delivery take place at a
future specified date.
 By Organization Structure
• Exchange Traded Market: A market with centralized authority and set
regulations are Exchange Traded Market, like NYSE, NASDAQ.
• Over-the-Counter Market (OTC): Markets with customized procedures
and decentralized organization is an OTC market. It is a type of secondary
market. Smaller organizations prefer this market as it has fewer regulations
and is less expensive.
 Private and Public market
• In Private markets, transactions are negotiated directly between two parties
• In public markets, standardized contracts are traded on organized exchanges.
• Bank loans and private debt placements with insurance companies are examples of private market
transactions. Because these transactions are private, they may be structured in any manner that
appeals to the two parties.
• Securities that are issued in public markets (for example, common stock and corporate bonds) are
ultimately held by a large number of individuals. Public securities must have fairly standardized
contractual features, both to appeal to a broad range of investors and also because public investors
do not generally have the time and expertise to study unique, non-standardized contracts.
• Private market securities are more tailor-made but less liquid, whereas publicly traded securities are
more liquid but subject to greater standardization.
 Financial Institutions
• Financial markets are imperfect, securities buyers and sellers do not have full access to the
information
• Individual with excess funds do not have the expertise to assess the creditworthiness of potential
borrowers
• Financial institutions are required to resolve the limitations caused by market imperfections
• They accept funds from surplus units and channel the funds to deficit units
• Without financial institutions, the information and transaction costs of financial market transactions
would be expensive
• Financial institutions are organizations that process monetary transactions, including business and
private loans, customer deposits, and investments. They're key to the financial intermediation process
 Function of Financial Institutions
• Lower transaction costs
• Economies of scale
• Liquidity services: Since transaction costs are reduced, financial institutions are able to provide customers
with additional liquidity services , such as checking accounts which can be used as methods of payment or
deposits which can be liquidated any time while still bearing some interest .
• Reduce Risk
• Risk Sharing (Asset Transformation) : Through the process of asset transformation not only maturities,
but also the risk of an asset can change : A financial institution uses funds it acquires (e.g. through
deposits) and often turns them into a more risky asset (e.g. a larger loan). The risk then is spread out
between various borrowers and the financial institutions itself.
• Diversification: The process of risk sharing is further augmented through diversification of assets
(portfolio-choice ), which involves spreading out funds over a portfolio of assets with different types of
risk
• Reduce Asymmetric Information:
• Asymmetric Information in financial markets - one party often does not know enough about
the other party to make accurate decisions.
• Adverse Selection (before the transaction)—more likely to select risky borrower
• Moral Hazard (after the transaction)—less likely borrower will repay loan
Financial institutions are important in the production of information. They help reduce
informational asymmetries about some unobservable quality of the borrower for example
through screening , monitoring or rating of borrowers, Net worth and collateral
• Finally , some financial institutions specialize on services such as
management of payments for their customers or insurance contracts against
loss of supplied funds.
• Through all of these channels financial institutions increase market
efficiency from an economic point of view.
 Types of financial institutions
Financial institutions can be classified as:
1. Depository
2. Non-depository institutions
 Depository Institutions
• Accepts deposits from surplus units and provide credit to deficit units through loans
and purchase of securities
• Offer deposit accounts that can accommodate the amount and liquidity characteristic
• Repackage funds from deposits to provide loan of the size and maturity as desired by
the borrower side
• Accept risks on loans provided
• More expertise to evaluate the creditworthiness of the borrowers
• Diversified funding
 Role of depository institutions
• Depository institutions accept deposits from surplus units and provide credit
to deficit units
• Depository institutions are popular because:
• Deposits are liquid
• They customize loans
• They accept the risk of loans
• They have expertise in evaluating creditworthiness
• They diversify their loans
 Types of Depository Institutions
Commercial banks:
• Serve surplus units by offering a wide variety of deposit accounts, and transfer
those funds to deficit units by providing direct loans or purchasing debt securities
• Their operations are exposed to risk because their loans and many of their other
investments in debt securities are subject to the risk of default by the borrowers
• Banks are required to maintain a minimum level of capital, relative to their size
 Savings Institutions
• Savings institutions, sometimes called thrift institutions, are banks that
serve a local community.
• They take the deposits of local residents and lend the money back in the
form of consumer loans, mortgages, and small business loans.
• Savings institutions include savings and loan institutions and savings banks
• Concentrate on residential mortgage loans
 Credit unions
• Are non-profit and restrict their business to the credit union members, who
share a common bond i.e common employer or union
• Much smaller than other depository unions
• Use most of their funds to provide loans to their members
• They charge lower loan rates and pay higher interest rates on savings, and
they offer a wide variety of financial services for their owners.
 Non-depository Instituions
• Generate funds from sources other than deposits but also play a major role
in financial intermediation
• They make contractual arrangement and investment in securities to satisfy
the needs and preferences of investors.
 Finance Companies
• Obtains funds by selling commercial paper (a short term debt instrument)
and issuing securities and bonds and then lend the funds to individuals and
small businesses
• Do not accept deposits
• Tend to meet various kinds of consumer credit needs.
• They involve in leasing, project financing, housing and other kind of real
estate financing.
 Mutual funds
• Open-end investment companies.
• Mutual funds are basically a large public portfolio that accepts funds from members
and then use these funds to buy common stocks, preferred stocks, bonds and other
short-term debt instruments issued by government and corporation.
• Sell shares to surplus units and use the funds received to purchase a portfolio of
securities
• By purchasing the shares of mutual funds and money market mutual funds, small
savers are able to invest in a diversified portfolio of securities with a relatively small
amount of funds
 Insurance Companies

• They provide insurance policies that reduce the financial burden associated with
death, illness and damage to property.
• They charge premium in exchange for the insurance that they provide
• These funds received are commonly invested in stocks or bonds issued by
corporations or bonds issued by government
• They pool the small premiums of the insured to pay the larger claims to those who
have losses. The premium payments are regular while the losses are irregular, both
in timing and amount.
 Pension Funds
• Many corporations offer pension plans to their employees
• Employees and their employers periodically contribute funds to the plan
• It is an effective way to save for the retirement
• These funds contributed in pension funds are invested in stocks or bonds
 Securities firms
• Broker, executes securities transactions between two parties
• Dealers, makes a market in specific securities by maintaining an inventory of securities.
• Income of broker is mainly based on the markup, the dealer’s income is influenced by the
performance of the security portfolio maintained
• Underwriting and advising service providers/Investment bankers place newly issued
securities for corporations and government agencies
• This service includes primary market, where the firms may sell securities for a client at a
guaranteed price or may simply sell the securities at the best price they can get for their
client
 Classification of Financial institutions in Nepal
• Class A: Commercial Banks - 20
• Class B: Development Banks - 17
• Class C: Finance Companies - 17
• Class D: Micro Finance Companies - 52
• Infrastructure Development Bank -1 (Nepal Infrastructure Bank Ltd)
 Commercial Banks in Nepal
Nepal Bank Laxmi Sunrise Bank Ltd Prabhu Bank Ltd
Agricultural Development Bank Ltd Citizen Bank International Ltd Siddhartha Bank Ltd
Nabil Bank Ltd Prime Commercial Bank Ltd Bank of Kathmandu Ltd
Nepal Investment Mega Bank Ltd Century Commercial Bank Ltd Civil Bank Ltd
Standard Chartered Bank Ltd Rastriya Banijya Bank Ltd
Himalayan Bank Ltd Sanima Bank Ltd
Nepal SBI Bank Ltd Macchapuchhre Bank Ltd
NCC Bank Ltd NIC Asia Bank Ltd
Everest Bank Ltd Global IME Bank Ltd
Kumari Bank Ltd NMB Bank Ltd
 Development Banks in Nepal
Shine Resunga Development Bank Ltd Green Development Bank Ltd
Jyoti Bikash Bank Ltd Kamana Sewa Bikas Bank Ltd
Mahalaxmi Bikas Bank Ltd Lumbini Bikash Bank Ltd
Corporate Development Bank Ltd Miteri Development Bank Ltd
Garima Bikas Bank Ltd Muktinath Bikash Bank Ltd
Jyoti Bikash Bank Ltd Narayan Development Bank Ltd
Karnali Development Bank Ltd Sahara Bikash Bank Ltd
Excel Development Bank Ltd Salapa Bikash Bank Ltd
Shangri-la Development Bank Ltd Sindhu Bikash Bank Ltd
 Finance Companies
Best Finance Company Ltd Nepal Finance Ltd
Capital Merchant Banking & Finance Ltd Nepal Share Market & Finance Ltd
Central Finance Ltd Manjushree Finance Ltd
Goodwill Finance Ltd Multipurpose Finance Company Ltd
Guheshwori Merchant Banking and Finance Ltd Pokhara Finance Ltd
Gurkhas Finance Ltd Progressive Finance Ltd
ICFC Finance Ltd Reliance Finance Ltd
Janaki Finance Company Ltd Samridhi Finance Ltd
Lalitpur Finance Ltd Shree Investment & Finance Company Ltd
Srijana Finance
CHAPTER ENDS