CHAPTER-II

FINANCIAL INSTITUTIONS

• Introduction
• Significance of Financial Institutions in Economic Developments
• Types of Financial Institutions
• Legal Framework of Financial Institutions
Financial Institutions and Capital Markets
2.1 Introduction

2.1.1 Financial institutions are basically business organizations; act as mediators

between depositors of savings, and loan takers from the market. These organizations
also provide various financial services to the society. Their business are significantly
different from non financial (industrial and commercial) business organizations in
respect of their commercial activities, i.e., while the former deal in financial assets such
as deposits, loans, securities, and so on, the latter deal in real assets such as machinery,
equipment, stocks of goods, real estate, and so on. In other words, financial institutions
means money management companies which collect funds from the public and invest or
lend to borrowers. Financial institutions can be divided mainly into two types: those
which do not accept deposits from the public but sells a product, such as life insurance
policies or units in a unit trust or shares in mutual funds; other types which accepts
deposits from the public.

2.1.2 Financial institutions facilitate and improve the distribution of funds, money and
capital by providing services like payment mechanism, security trading, transmutation,
risk diversification and portfolio management.'Financial institutions these days actively
involve in pooling, pricing and trading risk, besides their traditional services such as
mobilizing resources and allocating credit. The different activities of financial
institutions may be either specialized or quite often overlaps. Therefore, financial
institutions can be organized on the basis of their primary activity or the degree of their
specialization with relation to savers or borrowers with whom they customarily deal or
the manner of their creation. The classification of financial institutions on the basis of
the fiinctional, geographic, sectoral scope of the business or the type of ownership are
some of the criteria, used for classifying numbers of and types of financial institutions
which exist in the economy. But, it should be kept in mind that this type of
classification may be imperfect. Therefore, the financial institutions can be classified on
the basis of activities, role of operations in the economy.

Robert O. Edmister, Financial Institutions: Market and Management, McGraw-Hill Book Company,
New York, USA, 1980, pp. 7-8
2.1.3 On the basis of activities, according to L.M.Bhole, "financial institutions are
divided into the banking and non-banking ones. The banking institutions have quite a
few things in common with the non-banking ones, but their distinguishing character lies
in the fact that, unlike other institutions, (a) they participate in the economy's payments
mechanism, i.e., they provide transactions services, (b) their deposit liabilities constitute
a major part of the national supply, and (c) they, can, as a whole, create deposit or
credit, which is money. Banks, subject to legal reserve requirements, can advance credit
by creating claims against themselves, while other institutions can lend only out of
resources put at their disposal by the savers."^ On the other hand, "the financial
institutions are also classified as intermediaries and non-intermediaries. As the term
indicates, intermediaries intermediate between savers and investors; while their assets
are from the investors or borrowers. Non-intermediary institutions do the loan business
but their resources are not directly obtained from the savers. All banking instimtions are
intermediaries. Many non-banking institutions also act as intermediaries and when they
do so they are known as non-banking financial intermediaries."^

2.1.4 Similarly, according to Peter S. Rose, "financial institutions may be grouped in a

variety of different ways. One of the most important distinctions is between depository
institutions (commercial Banks, savings and loan associations, savings banks, credit
unions); contractual institutions (insurance companies and pension funds); and
investment institutions ( investment companies, money market funds, and real estate
investment trusts). Depository institutions derive the bulk of their loanable funds from
deposit accounts sold to the public; contractual institutions attract funds by offering
legal contract the saver against risk (such as an insurance policy or retirement account).
Investment institutions sell shares to the public and invest the proceeds in stocks, bonds,
and other assets.""^

^ L. M. Bhole, Financial Institutions and Markets, 4"" ed., Tata McGraw-Hill Publishing Co. Ltd., New
Delhi, India, 2004, p. 1.4
Mbid.,p.l.5
* Peter S. Rose, Money and Capital Markets, 7"" ed., McGraw-Hill Higher Education International
Edition, USA, 2000, p. 43

25
2.1.5 In fact, financial institutions are the part of the financial market in the economy.
Therefore, financial market is the place where financial institutions play active role in
the national economic system. Financial markets are the arrangements that provide
facilities for buying and selling of financial claims and services. The companies,
financial institutions, individuals, and governments trade in financial products on these
markets either directly or through brokers and dealers on organized exchanges or off-
exchanges, The participants on the demand and supply sides of these markets are
financial institutions, agents, brokers, dealers, borrowers, lenders, savers, and others
who are inter-linked by the laws, contracts, covenants, and communication networks.^

2.1.6 "Financial markets are sometimes classified as primary (direct) and secondary
(indirect) markets. The primary markets deal in the new financial claims or new
securities and, therefore, they are known as the new issue markets. On the other hand,
secondary markets deal in securities already issued or existing or outstanding. The
primary mobiles savings and they supply fresh or additional capital to business units.
Although secondary markets do not contribute directly to the supply of additional
capital, they do so indirectly by rendering securities issued on the primary markets
liquid. Stock markets have both the primary and secondary market segments."^
Similarly, very often the financial markets are classified as money markets and capital
markets; even though there is no significant difference between the capital markets and
financial markets both do the same function of transferring resources to the
manufacturers. The real distinction is based on the differences in the period issue of
financial assets maturity in the market. The money markets deal in the short- term
claims with a period of within one year, while the capital market deals in the longer
term with a maturity period of more than one year claims.

2.1.7 On the other hand, in view of different purposes, financial markets have also been
classified into the following categories: (i) formal and informal, (ii) organized and
unorganized, (iii) official and parallel (iv) domestic and foreign. In this context, there is

' op. cit., L. M. Bhole, p. 1.5

''ibid., p. 1.5

26
no special convention with which the words informal and unorganized are used and quit
often they are used interchangeably. The financial transactions which take place without
systematic and orderly structure or outside the well-established exchanges or
arrangements constitute unorganized markets. Similarly, official and parallel financial
markets are not well defined but it depends on the nature of activities of a transaction
and also domestic market means the financial activities which are operated within the
country while foreign financial market, which deals outside boundaries of a particular
nations.

2.1.8 In spite of growing role and importance of financial institutions in international

scenario, the development and growth of financial institutions in Nepal were not
encouraging till mid-eighties. Only two commercial banks mainly Nepal Bank Limited
and Rastriya Banijya Bank were in operation. After economic liberalization, the policy
has paved the way for the establishment of private banks including the foreign joint
ventures. As a result, seventeen commercial banks are in operation. Out of seventeen
commercial banks, nine banks were established in joint venture, however, at present
there are six joint venture banks, after withdrawal of foreign investment in three banks.
Similarly, there are 32 development banks, 5 Rural Development Banks, 60 finance
companies, 20 saving and credit cooperatives with Nepal Rastra Bank (NRB) license
and 47 NGO's licensed to perform limited banking functions under the supervision of
NRB till July 15, 2005.' There are numerous other cooperatives with multipurpose
functions and characteristics registered under department of cooperatives. At the same
time, there are 18 insurance companies doing business in Nepal. However, the
Insurance companies are basically regulated by the Beema Samitee through the
Insurance Regulation Act 1992.

2.1.9 Financial system of Nepal has undergone significant change since liberalization.
Free market operation in the area of interest rate, foreign exchange rate and diversified
banking products, are latest developments in the banking sector. Though financial

^ NRB, Notice Issued by Nepal Rastra Bank, Gorkhapatra, Year 105, No. 110, Kathmandu , Nepal,
August 24, 2005, p.6

27
system in Nepal is not so multifaceted when compared to that of developed countries, it
has definitely grown to become more complex in recent years. Further, Electronic and
Internet Banking services offered by the commercial banks indicate adaptation of
advanced technologies and it has placed additional supervisory concern and challenges.
NRB has recognized and accepted these challenges. Steps are taken to strengthen
supervisory capacity by increasing efficient and professional manpower and introducing
new technologies.

2.2 Significance of Financial Institutions in Economic Developments

2.2.1 The significant role of financial Institutions in economic development has been a
much discussed topic among economists. A recent literature survey concluded that the
existing theory on this subject has not given any generally accepted model to describe
the relationship between finance and economic development.* The importance of
financial institutions in economic development depends upon the desired nature of
development. In appropriate technology-based, environment friendly, decentralized
alternative development model plays crucial for economic development. The production
function is the link between finance and economic development. It has been argued that
men, materials, and money are crucial inputs in production activities. The human capital
and physical capital can be bought and developed with money. In a sense, therefore,
money, credit, and finance are the life blood of the economic system.^ In the given real
resources and suitable attitudes, well-developed financial institutions can contribute
significantly to the acceleration of economic development.

2.2.2 In the case of Nepal, although some efforts were made to develop country's
infrastructure during the Rana regime, these were more sporadic and aimed at fulfilling
the need and the whims of the then Rana rulers. The Government's efforts to achieve
economic growth in the planned way started only in 1956 after adoption of the First
Five-Year Plan. Under different plans the Government set targets for economic growth

* Herms Niles, "Financial Development and Economic Growth: A Survey of the Literature",
InternationalJournal of Development Banking, January 1994.
' op. cit., L. M. Bhole, p. 1.10

28
and adopted various policies and programs, which were directed towards developing
infrastructure necessary for the creation of national wealth. Unfortunately, these policies
and programs have failed to take into account the need to develop the financial structure
that ought to exist side by side with the development of infrastructure necessary for the
growth of real sector. The Government policies maintained to control the financial
sector by restricting the entry of private sector into financial activities, limited the
growth of financial sector in the nation. Because of that the country had limited
financial institutions to support its developmental activities for long time.

2.2.3 During the I980's the country had only two commercial banks, two development
banks, one provident fund and few insurance companies. But, the visible impact on the
development of financial sector was observed only when the government changed its
restrictive policy and opened up hitherto closed financial sector to private sector and
foreign participation in the establishment of banks. After government's adoption of
privatization and economic liberalization policy the process got further impetus and
financial institutions in Nepal grew at a faster pace especially in quantitative terms.
Despite these progresses, financial institutions and other sectors of industry continued at
a developing stage and have to make visible impacts on the economic growth of the
country.

2.3 Types of Financial Institutions

The types of financial institutions can be divided according to their market approach,
business activities and by so many others different ways. The types of financial
institutions can also be defined according to their registration under government Acts,
rules and regulation prevailing in the country. Therefore, at present in Nepal, types of
financial institutions which are operating as follows:-

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2.3.1 Central Bank (Nepal Rastra Bank)

2.3.1.1 Nepal Rastra Bank (NRB) provides financial and banking services for the
Government of the country and acts as regulatory system as well as implements the
Government's monetary policy. It's the major task and responsibility to stabilize the
economic growth and financial system of the economy. The main functions of the
central bank are: to manage the Government's accounts, to accept deposits and grant
loans to the commercial banks and other financial institutions. It also issues and controls
bank notes circulations, to manage the public debt, to manage the exchange rate
fluctuations, to regulate the interest rate structure and control the money supply. Apart
from this, the central bank performs the functions to hold the country's gold and foreign
currency reserves, makes relation with other central banks to manage the dealings of
monetary business and act as a lenders last resort to the banking system.

2.3.1.2 The Governor of NRB, Bijaya Nath Bhattarai defined that, "The history of
Nepalese Central Bank started since Late His Majesty King Mahendra inaugurated the
Bank on April 26, 1956. The institution has gone through fundamental transformation in
its objectives, functions and other organizational and managerial features. Constantly
remaining at the centre of the Nepalese financial system, Nepal Rastra Bank (NRB) by
now has emerged as one of properly institutionalized central banks of the South Asian
region. During the early period of the Bank's establishment, its role had been focused
on increasing the circulation of the Nepalese currency throughout the Kingdom,
developing the domestic banking system and stabilizing the exchange rates of the
Nepalese currency. Since then, the domestic financial system has broadened, deepened,
diversified and witnessed qualitative changes in the product and service deliveries.
From a single banking institution then, the system has now almost 200 institutions, with
services largely diversified and, at the same time, integrating our economy with the
global one. Establishment of the banks with foreign participation, convertibility of
Nepalese currency in the current account transactions, initiation of the practice of the
formulation and dissemination of the monetary policy on an annual basis, formulation
and implementation of intensive regulatory and supervisory system and norms of the

30
international standards and Nepal's accession to the World Trade Organization are same
of the tenets of the Bank to assimilate it with the global financial fraternity. To capture
this dynamic environment and ensure domestic financial health and stability as a part of
the ongoing reform in the financial system, a new NRB Act, 2002 was enacted which
has provided more autonomy, authority and accountability to the core central banking
functions. Since then, the supervisory, oversight and regulatory functions of the Bank
have been enhanced considerably. The latest initiatives towards qualitative
improvement in the ongoing expansion of the financial system based on market oriented
healthy competition have definitely added new milestones in developing and nurturing a
financial system that would surely contribute to the sustainable growth of the economy
with overall macroeconomic stability." "^

2.3.2 Commercial Banks

2.3.2.1 Commercial banks ordinarily are simple business or commercial concerns which
provide various types of financial services to customers in return for payments in one
form or another, such as interest, discounts, fees, commission, and so on. Their
objective is to make profits. However, what distinguishes them from other business
concerns (financial and manufacturing) is the degree to which they have to balance the
principle of profit maximization with certain other principles." Its primary function is
the transfer of monetary resources from the savers to the user. Commercial banks are
institutions which issue demand liabilities used as means of payment and at the same
time make loans to business and households in a tradition from the several hundred
years ago.

2.3.2.2 The name commercial banks imply the business concerns which devoted to most
of their resources for meeting the financial needs of business firms. However, in recent
years commercial banks have significantly expanded their offerings of financial services
to consumers and units of government around the world. The result is the emergence of

'" Bijaya Nath Bhattarai, Governor, Nepal Rastra Bank in Fifty Years, Nepal Rastra Bank, Kathmandu,
Nepal, July 2005
" op. cit., L.M.Bhole, p. 8.3

31
a financial institution that has been called a financial department store because it
satisfies the broadest range of financial services needs in the global economy. The
importance of commercial banks may be measured in a number of ways. "Banks are
still the principal means of making payments, through the checking accounts (demand
deposits), credit cards, and electronic funds transfer services they offer. And banks are
important because of their ability to create money from excess reserves made available
from the public's deposits. The banking system can take a given volume of excess cash
reserves and, by making loans and investments, generate a multiple amount of credit."'^

2.3.2.3 Nepal's first commercial bank, the Nepal Bank Limited, was established in 1937.
The government owned 51 per cent of the shares in the bank and controlled its
operations to a large extent. Nepal Bank Limited was headquartered in Kathmandu and
had branches in other parts of the country. Similarly, there were other Government
banking institutions. Rastriya Banijya Bank (National Commercial Bank), a state-
owned commercial bank, was established in 1966. Since the 1960s, both commercial
and specialized banks have expanded. More businesses houses and households had
better access to the credit market although the credit market had not expanded.

2.3.2.4 Before economic liberalization policy, in the mid 1980s, only two commercial
Banks that is Nepal Bank Limited and Rastriya Banijya Bank were in operations, which
are domestic commercial banks with a wide network of branches in the country. The
Liberalization paves the way for the establishment of private banks including the
foreign joint ventures.'^ In the mid-1980s, three foreign commercial banks opened
branches in Nepal, they are The Nepal Arab Bank , Nepal Indosuez Bank (at present
management taken over by Nepalese group and name changed to Investment Banks
Limited) and Nepal Grindlays Bank (at present management taken over by Standard
Chartered Bank). Apart from this, joint venture and also under Nepalese management
other commercial banks were established after liberalization.

'^ op. cit., Peter S. Rose , p. 92

'^ NRB, Annual Report(20()2-2003), Banking Supervision , Bank Supervision Department, Nepal Rastra
Bank, Kathmandu, Nepal, 2003, p. 1

32
2.3.2.5 After restoration of multi-party democracy in 1990, the government pursued
liberal economic policy which paved the way for establishment of commercial banks by
the private sector with or without foreign investment. "As a result, seventeen
commercial banks are in operation. Out of seventeen commercial banks, nine banks
were established in joint venture. However, at present there are six joint venture banks,
after withdrawal of foreign investment in three banks." ''* Remaining ten banks are fully
owned by Nepalese investors'^. The number of commercial banks remained unchanged
at seventeen during the year under review. "Commercial banks are major players of the
financial market as they have lion's share in country's deposits (81%) and credit (72%)
till the end of fiscal year 2003/2004."'^ The open market exchange rate is determined
everyday by commercial banks themselves. The Citibank, American Express Bank and
Union European de CIC run representative offices in Kathmandu.

2.3.3 Development Banks

2.3.3.1 Development banks operate largely as commercial banks, but with lower
minimum capital requirements and intent to increase outreach to rural areas.
Development banks are tasked with making available financial resources and
technology needed for the establishment, development, expansion and increase in the
capacity and productivity of agricultural, industrial, services, trade and other
commercially viable and productive enterprises.

2.3.3.2 Commercial Banks mainly provide credit to the industrial and large scale units.
Thus, before 1959 there were two important gaps in the sector of agriculture and
industrial sector. These gaps are lack of supply of long-term funds to all industrial
units, and supply of any form of capital to small scale and agro based industrial units.
Attempts were made to bridge these gaps by setting up two specialized financial

'"ibid, p. 1
"ibid., p. 1
'^ Mr. C. B. Ramamurthy, 'Trends and Developments in Insolvency System and Risk Management:
Experience of Nepal," Insolvency System and Risk Management in Asia, The Oberoi Hotel, New Delhi,
India, 3-5 November 2004, p. 6

33
institutions. Nepal Industrial Development Corporation, a state-owned development
finance organization headquartered in Kathmandu, was established in 1959 with United
States assistance to offer financial and technical assistance to private industry. The Co-
operative Bank was renamed as became the Agricultural Development Bank, Nepal
(ADBN) in 1968 under the Agricultural Development Bank Act 1967. The ADBN is an
autonomous organization under the supervision of the Ministry of Finance.

2.3.3.3 The bank has been working as a premier rural credit institution since last three
decades contributing more than 80 per cent share in meeting institutional credit needs in
Nepal. ADBN was the main source of financing for small agribusinesses and
cooperatives. Almost 75 per cent of the bank was state-owned; 21 per cent was owned
by the Nepal Rastra Bank and 5 per cent by cooperatives and private individuals. The
Agricultural Development Bank also serves as the Government's implementing agency
for small farmers' group development projects assisted by the Asian Development Bank
and financed by the United Nations Development Program.

2.3.3.4 The Ministry of Finance reported in 1990 that the Agricultural Development
Bank, which is vested with the leading role in agricultural loan investment, had granted
loans to only 9 per cent of the total number of farming families since 1965. After
economic liberalization policy, other development banks were established and some are
in the process to establish from the private sector in the nation. "With the introduction
of Development Bank Act 1996, the number of development banks increased.
Currently, there are 17 development banks (including rural development banks) with
11% and 18% share in country's deposits and advances respectively (end of Fiscal Year
2003/04)."'^

2.3.4 Finance Companies

2.3.4.1 Finance companies are the non-banking financial institutions operating in the
overall financial system of the economy. "Finance companies are some times called

" ibid., p. 6

34
department stores of consumer and business credit. These institutions grant credit to
businesses and consumers for a wide variety of purposes, including the purchase of
business equipment, automobiles, vacations and home appliances. Most authorities
divide firms in the industry into one of three groups: consumer finance companies, sales
finance companies, and commercial finance companies."'^ Loans made by finance
companies are considered to be riskier than other loans and, therefore, generally carry
steeper finance charges than those assessed by most other lending institutions.

2.3.4.2 Though Finance Company Act was enacted in 1985, the first finance company
named Nepal Housing Development Finance Company came into operations only in
1992. By implementing the economic liberalization policy, the government has
encouraged and given space for private sector to establish and growth of finance
companies in the nation. It has been clearly mentioned that the vacuum in the present
national financial system needs to be filled by institutionally developed capital market
institutions like investment, finance, leasing & housing finance companies to create a
healthy, competitive financial sector in Eighth Plan (1992-1997). Similarly, it has been
mentioned that encouragement was given to establish finance companies in
development regions where they are not yet established in the Tenth Plan (2002-2007).

2.3.4.3 The existing financial institutions, especially commercial banks were unable to
deliver the financial needs to the consumer and industrial sector. It was fimely
encouraged for the growth and operation of finance companies to meet individual,
household, and industrial credit needs through fee based merchant banking function, by
which their scope of service delivery was expanded. To support these objectives,
currently, there are 59 finance companies in operation with 1% share in country's
deposits and 9% share in advances.

'*op. cit„ Peter S. Rose, pp. 170-171

35
2.3.5 Insurance Companies

2.3.5.1 Insurance is a kind of social device which reduces or eliminates risks of loss of
life and property. The insurance has been outlined clearly as a plan of actions by large
number of the people associate themselves and transfer the risk to the shoulder of
insurance companies to protect against risks, which are attached to individuals' life and
properties. Actually, it is social contract providing financial compensation from the
effects of misfortunes or unexpected loss, and these payments are being made from the
accumulated contribution of all those parties who participated in the scheme. Therefore,
insurance can be defined as a co-operative and protective device to spread the loss
caused by a particular damage due to unexpected events over a number of persons who
are exposed or participated to it and who agree to ensure them against that risk.

2.3.5.2 L.M. Bhole elaborated that, "the insurance industry has both economic and
social purpose and relevance. It provides social security and promotes individual
welfare. It reduces risk and helps to raise productivity in the economy. The actual
premium of insurance companies comprises the pure premium and administrative as
well as marketing cost. The pure premium is the present value of the expected cost of an
insurance claim. Since there is a lag between payment of premium and payment of
claims, there is generation of investible funds known as insurance reserves. Insurance
companies may be organized as either corporation or mutual associations. A corporation
is owned by its stock holders. In mutual association form, the customers are the owners,
and management is formally subject to their control. There are various parts of
insurance industry: life insurance, health insurance, general (property liability/ property
casualty) insurance, etc."'^

2.3.5.3 The concept of insurance is very old and not certain when the first time the
insurance scheme was started. It can only be said that origin of insurance was lost in
antiquity. Some kind of insurance found in early Rome and Romans gathered together
to purify the societies and they contributed funds from the members of society to meet

'%p.cit., L.M. Bhole, p. 11.1

36
the burial costs of dead person in the society. Therefore, the original purpose of
insurance was based on sharing the cost of loss of a few people from the many persons.
The modem insurance system was originated from the Mediterranean. One of the
earliest forms of insurance protection was marine insurance as a "BOTTOMRY
BONDS" by a group of sea- traders along the Mediterranean Coast 2000 years before
the birth of Chirst. During that period, the Babylonians, Phoenicians, Greeks, and
Romans were great traders. "Marine insurance on ships and cargos was certainly well-
known by the 14* century in Europe. Fire insurance received a big boost in England
after the great fire of London in 1666. The oil drilling operating in the rough North Sea
of the British and European coasts is insured."^" After the development of trade and
business, insurance emerged as a distinct part of commercial agreement.

2.3.5.4 Insurance history of Nepal had been developed, as a "Dharma Vakari" and
"Yogakshema" which were used for social well being since the Vedic (i.e. ancient)
period. The Bhim Sen Thapa( 1816-1847), first and most powerful Prime Minister of
Nepal was established "Guthi" a trust attached to temple. The Guthi system was taken
as the earlier stage of insurance in Nepal. There were various types of Guthi in various
regimes in different periods, e.g., "Raj Guthi", "Dharma Guthi", etc. Guthi system was
most popular in the "Shah" and "Rana" regimes. "In each and every type of Guthi the
concept of financial indemnity was easily seen. There was plenty of evidence that some
of the families were economically dependent on Guthi. Guthi also established temples
which provided employment to numerous priests and their families. There was some
system of yearly saving by people through trusts at their earning age to take care of the
old age."^'

2.3.5.5 The history of modem insurance system started when "Nepal Mai Chalani Tatha
Beema Company" a subsidiary company of Nepal Bank Limited (i.e. here after NBL),
was established in 1947 as per the then Company Act, 1936, for trade and transit the
goods safe in Nepal. In 1990, its name has been changed to Nepal Insurance Company

^^ The Insurance Institute of Canada, Introduction to General Insurance: A Text for General Insurance
Agents and Brokers, Canada: The Insurance Institute of Canada, 1990.
^' Life Insurance Business Manual for Agents, Rastriya Beema Sansthan, Nepal, 1970, p. 1

37
Limited. A large number of Indian insurance companies were conducting life and
general insurance business through their branches or local agents in Nepal till 1956.
Realizing the importance of the local insurance company, the Government had passed
the Rastriya Beema Sansthan (i.e.. National Insurance) Act, 1968. Under this Act, the
Rastriya Beema Sansthan (i.e., here after RBS) was established as a government
enterprises. This insurance company began to underwrite various types of general
insurance policies since 1968.

2.3.5.6 At the same time, to regulate and protect the insurance business in Nepal, the
government had passed the Insurance Act 1968. Under this Act the Insurance Board
was also established by empowering to regulate and control the insurance business. The
real development and growth of the insurance business has been seen after liberalized
economic policy adopted by the democratic government. To make the Insurance Board
more powerful and to give free hand to regulate and control the insurance companies,
the Government had passed new Insurance Act, 1992, and the Insurance Regulation
Act, 1993. Due to liberalized economic policy Governments efforts are under way to
remove the rigid rules and regulations and minimize the bureaucratic controls and
giving the private sector open space to participate in the insurance business to drive the
economy towards globalization. The Government new insurance business policy has
shown the positive sign and the number of insurance company increased significantly in
the private and joint venture with international companies.

2.3.6 Employees Provident Fund

2.3.6.1 A Provident Fund is a kind of little regular saving for future benefit. The
contributions of compulsory savings as per the Karmachari Sanchaya Kosh (i.e.
Employees Provident Fund) Act, 1962 was made by the employer and employees for
employees and their families to some kind of future protection of livelihood in Nepal.
Therefore, it promises to meet future obligations out of present contribution. Provident
fund to some extent protects employees and their families against loss of income after
their retirement.

38
2.3.6.2 Before 19"^ century retired people sometimes would have no money at all for
them and their families. Some of the bitter experiences are still in record regarding the
families of the army suffered when their main earning member was killed in wars or
other unexpected events. One of such sad episode inspired Maharaja Judha Shamsher,
the then Prime minister of Nepal who initiated the "Sainik Drabya Kosh" (i.e. Army
Provident Fund) in 1934^^. Slowly, the concept of the provident fund developed and
started to cover all areas of services i.e., civil, police, private sector, INGO and NGOs
etc. The Employees Provident Fund (i.e.,Karmachari Sanchaya Kosh) is the most trust
worthy organization and got confidence from different sector. Because of that, Nepal's
majority of organization from the different sector deposited their employees provident
fiind in this institutions, due to that, it has billions of rupees deposits and has been fiilly
even capable to invest in the construction of super markets, office complex, housing
and other sector of national development.

2.3.6.3 At present. Employees provident fund is one of the major financial institutions
in Nepal. It gives 9 per cent interest (earlier it was 11 per cent) to their depositors who
deposited money and gives loan up to their deposited amount free of interest or nominal
charges which is applicable as per loan regulations. It has also made the pension plan
for the retired employee to give some relief or use for some productive purposes for
themselves. It invests in fixed deposit, development bond other safe areas to minimize
the interest spread risks. It has actively engaged in the maximum utilization of
Provident Fund contribution for the ultimate benefits of the contributors. The basic
principles governing investment of funds are safety, profitability, liquidity and socio-
economic utility in the interest of its member of depositors. The Employees Provident
Fund Act, 1962 safeguards the funds in the area of investments. It prohibits investment
in the activities of speculative nature, such as purchase of shares or loans against
collateral of shares.

^^ Manohar K. Shrestha and D. B. Bhandari, Financial Institutions and Maricets, Asmita Books Publishers
and Distributors, Kathmandu, Nepal, 2004, p. 362

39
2.3.7 Co-operative Societies

2.3.7.1 Co-operative Societies are a part of the vast and powerful superstructure of co-
operative institutions which are engaged in the tasks of production, processing,
marketing, distribution, servicing for small savers, shops, small trading firms and bank
for the poor in the nation. Despite the concept of cooperative being very old in Nepal,
the only formal cooperative working under NRB regulation and supervision was
established in 1993 as per co-operative Act 1992. Nabajeeban Cooperative Society is
the first of its kind. Currently, there are 20 co-operatives working under NRB with
around 1% market share in both the deposits and advances. But in spite of these
discrepancies, cooperatives, within a short span of time, and despite certain lapses in the
Cooperative Act-1992 have become one of the pro-poor program designed as the 'bank
for the poor' and have been producers of over two million jobs by mobilizing over nine
billion rupees of lower-middle income and lower income groups. Cooperatives have
uniquely boosted the saving habit of the people, while distributing credit to the same
groups.
TK. \og^?
2.3.7.2 One of the fundamental setbacks responsible for this plight is that co-operatives
have remained a subject of 'too many affiliations with no controlling hands' in their
activities despite provisions being in place. For example, only 20 savings and credit
cooperatives out of 1575 registered with the Cooperative Department are allowed to do
banking activities by the NRB. Now the central bank's confusion is how it can monitor
these cooperatives which are not allowed to do the banking. But on the other hand,
central bank naturally claims its right to intervene in any monetary related matter
wherever in the economy. Again, Cooperative Department wants to limit itself to mere
registration and pleads for manpower deficiency to regularly monitor them. They
believe that the department should act as a registrar and a facilitator while banking
supervision is universally looked after by the central bank.

2.3.7.3 After the liberalization policy, in the nation a large number of commercial
banks, development banks, finance companies and cooperatives were established. To

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expand their business, they have aggressively expanded branch network (especially
urban areas). Numbers of banks/financial institutions and their branches have increased
at a time the country is going through a turbulent period due to the Maoist insurgency
which impacted economic growth severely. Establishment of these institutions triggered
competition in the market. As a result, customers have been able to get better and new
services at a competitive price. However, the number of professionals and size of
economy did not grow to keep up with the increase in number of banks and financial
institutions.

2.3.8 Micro Savings (Small Credit/Loan)

Financial Intermediary Societies Act 1998 in Nepal has been first amended in 2002
enables NGOs to collect savings from their group members. It is less restrictive than it
was before the amendment. In addition, NGO directors must provide a personal
guarantee for the loans taken by their NGOs from commercial banks. The Chief District
Officer at the local government level has the power to take punitive action against
NGOs. The transformation of NGOs into development banks was a protection for
NGOs staff and directors. There are 47 Non Government Organization operating
business in the villages under the NRB supervision.

2.4 Legal Framework of Financial Institutions

2.4.1 Banking system of Nepal has undergone significant changes since liberalization.
Free market operation in the area of interest rate, foreign exchange rate and diversified
banking products are latest development in the banking sector. Though banking system
in Nepal is not so multifaceted when compared to developed countries, it has definitely
grown to become more complex in recent years. Further, Electronic and Internet
banking services offered by the commercial banks indicate adaptation of advanced
technologies and it has placed additional supervisory concern and challenges.
Therefore, steps are taken to strengthen supervisory capacity by increasing efficiency
through professional manpower and by introducing new technologies. Same time it is

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essential to develop proper legal system for regulating, inspecting, supervising and
monitoring to the financial institutions. At present, following major laws relating to
Financial System are in operation.

Nepal Rastra Bank Act 2002

Bank and Financial Institutions Ordinance 2004
(The Ordinance has replaced Agricultural Development Bank Act 1967, Commercial
Bank Act 1974, Finance Company Act 1985, Nepal Industrial Development
Corporation Act 1990, Development Bank Act 1996)
Foreign Exchange Regulation Act 1962
Companies Act, 1997
Financial Intermediary Act 1998
International Financial Transactions Act 1998
Insurance Act, 1992
Debt Recovery Tribunal Act, 2001

2.4.2 NRB is the authorized institution for regulating, inspecting, supervising and
monitoring banking and financial system. "Accordingly banking legislation has been
amended over the years and currently being revised and strengthened in order to make
the power and authority of the NRB as regulator and supervisor of commercial banks
more effective. Section 84 of the NRB Act 2001 authorizes the NRB to inspect and
supervise the commercial banks. NRB's Supervision Board has framed and
implemented inspection and supervision through bye-laws 2002, are confirming to
international standard for inspection and supervision of the commercial banks. There
are also other developments in the regulatory environment that is worth mentioning
here. The Bank and Financial Institution Ordinance 2003, is being drafted under the
auspices of the Ministry of Law. This legislation, which covers all categories of banks
and financial institutions, has come into force from 4-^ February 2004."^^

^^ op. cit., NRB, Banking Supervision, Annual Report p. 3

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2.4.3 Likewise, NRB annual report describes that, 'To manage non-banking assets in
Nepal, Act in respect of establishment of Assets Management Company (AMC) is
drafted and submitted to HMG/N. Additional commitment from HMG/N, NRB and 11
commercial banks were obtained for capital investment in the company. Currently NRB
is drafting Bye-laws of the AMC. Bye-laws of Credit Information Bureau are
implemented as per NRB Act 2001, and necessary efforts are made to establish Credit
Information Bureau as independent institution under the company Act. A new extensive
directive on the credit information and blacklisting of borrowers has also been issued by
NRB. HMG/N has formed Debt Recovery Tribunal on 19th June 2003 to enforce the
Bank and Financial Institution's Debt Recovery Act 2001 effectively. The NRB, Board
of Directors has framed and implemented 'Bank Inspection and Supervision bye-law
2002' directive in respect of compulsory liquidity maintenance is amended in addition
to necessary amendment in other directives. Licensing policy of commercial banks has
also been revised. NRB discontinued appointing representative director in the
commercial banks to maintain independency in decision-making process from
regulating authority."^'*

2.5 Financial Institutions and Capital Markets

2.5.1 The relationship between financial instimtions and capital markets is inter-related
in the economy. Capital market and financial institutions are component of the financial
market, which plays the role of funds movement from saving to lending place in the
economy. Every business unit needs money to finance its activities. The money is
invested in physical resources, i.e. land and building, machines and equipment, stock of
raw materials, etc., which are used by the enterprise in production.^^ The capital market
and financial institutions provide funds for the physical production in the economy.

2.5.2 Peter Rose describes that, "The capital market designed to finance long-term
investments by business, government, and households. Trading of funds in the capital

^^ ibid., p. 3
^^ S.K.Misra and V.K.Puri, Economic Environment of Business, 3"* ed., Himalaya Publication House,
Mumbai, India, 2003, p. 670

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market makes possible the construction of factories, highways, schools, and homes.
Financial instruments in the capital market have original maturities of more than one
year and range in size from small loans to multimillion dollar credit."^^
Correspondingly, financial institutions means money management companies which
collect funds from the public and invests or lends to borrowers. Financial institutions act
as mobilizers and depositories of savings, and as purveyors of credit or finance.

2.5.3 Financial institutions are the predominant players in the capital market. They
collect scattered savings from the individual and households and transmit these funds to
the deficit sector or development sector. Financial institutions hold large amount of
short-term and long -term funds and they invest in the capital market instruments.
Moreover, various financial institutions work as a fund manager and investment
institutions in the capital market. In the capital market, some of financial institutions
assists the new share issuing company by taking under writing, market making for
selling the new issue of shares in the best possible price and make it easier to conduct
transactions. Therefore, relationship between the capital market and financial
institutions is like body and life bold of the human beings without each other they can't
survive in the economy.

^^ op. cit., Peter S. Rose, p. 10-11

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