Chapter 3

Financial Intermediaries

Prepared by: Junu Hada ( MBA)

 Topics to be discussed
 Depository Institutions, their functions
 Risks associated with the management of depository
institutions.
 (Liquidity risk, market or interest rate risk, credit risk,
operations risk and other risks)
 Moral hazard and adverse problems in lending and insurance
services.
 The economic regulation of financial services.
 Structure of Nepalese Financial Markets and their regulation.
 Depository Institutions
 A depository institution is a financial intermediaries that accepts
deposits from household and firms and uses the fund deposit to
make loan to other household and firm.

 They are legally allowed to accept monetary deposits from

customer.

 Depository institutions are backbone of economy as they form

capital through collection of scattering money from the public and
mobilize at to the business and other sector of the economy.
 The depository institution consist of commercial banking,
development bank, finance companies, saving and loan association,
mutual saving bank, credit union etc.
 Function of Depository Institution
 Financial Institution provide service as intermediaries of capital
and debt market.
 They are transferring funds from investor to companies in need of
those fund.
 The presence of FI facilities the flow of money through the
economy.
 To do so saving are pooled to mitigate the risk brought to provide
funds for loan.
 Such is a primary means of the depository institution to generate
revenue.
( Continued………………..)

There are other varied other functions performed by depository

institutions. Some of them are as follows:
1. Accept deposits.
2. Provide loan
3. Provide agency function
4. Provide information
5. Acts as securities underwriter or brokerage others.
 Liquidity Risk
 Liquidity risk for a bank refers to chances that a bank fails to meet
deposit outflow.
 It also refers to a quick unexpected use of credit or withdrawal of
deposits.
 A bank’s failure to meet depositors’ withdrawal demand immediately
leads to the bank into insolvency.
 Liquidity risk arises mainly because of the bank’s management’s failure
to forecast the cash flows correctly.
 Hence big and unexpected change cause liquidity risk.

 There are two sides of this risk

a) Assets side (Unexpected use of short term credit )
b) Liabilities side ( Unexpected withdrawal of fund )
Continued……
 Financial institution running liquidity risk first sell some reserve such as highly
liquid government bill.

 Second there are some liquidity management techniques that financial

institution can sell such as
 1. Repurchase agreement with central bank.
 2. Central bank typically try to forecast short term liquidity in that system and
intervene into the system using repurchase agreement with banks.
 3. Interbank market bank buys or sells assets over the day to keep their target/
requirement.
 4. Issue short term fixed income securities such as certificate of deposits.
 5. Central bank as lender of last resort.
 6. Deposit Insurance.
 Market Risk
 The uncertainty of financial institution earning resulting from
changes in all shorts of market condition is called market risk
such as:
 - Price of assets
 - Interest rate
 - Exchange rate
 - Market liquidity
 Credit Risk
 One of the major risk of financial institution like depository
institution is the credit risk.
 It is the risk that arises from the possibility of default.
 It is the risk of loss due to a debtor’s non payment of either interest
or principal on a loan or other line of credit.
 Credit risk is unavoidable business, however business can limit
such risk by establishing sound lending principles on a loan or other
line of credit.
 Operational Risk
 Operating risk is the risk resulting from a bank’s general
business operation.
 It is defined as the risk of loss resulting from poor or failed
internal process, people and system.
 Although the risk apply to any organization in business, this
particular way of framing risk management is of particular
relevance to the banking regime where regulators are
responsible for establishing safeguard to protect against
systemic failure of the banking system and economy.
Moral Hazard and Adverse Selection in
Lending and Insurance Services.
Information Asymmetric
 It is a situation where one party has more or better information
then other counter party.
 Asymmetric information in transaction appears where there are
the difference in the information available to buyers and the
information available to seller.
 It leads to the two types of problem.
 - Moral Hazard
 - Adverse selection
 These two problem exist especially in banking and insurance
industry.
 Moral Hazard
 Moral Hazard is the problem created by asymmetric information after
the transaction occurs.

In case of Insurance Company

 This is tendency of an insured to take greater risks because he is
insured.

 It is the prospect that a party insulated from risk may behave differently
from the way it would behave if it were fully exposed to the risk.

 Moral Hazard arise because an individual or institution does not bear

the full consequences of its action and therefore has a lending to act less
carefully than it otherwise would leaving another party to bear some
responsibility for the consequences of those action.
 For examples:-
- An individual with insurance against automobile. Theft may
be less vigilant about locking his or her car because the
negative consequence of automobile theft are partially/ borne
by the insurance companies.

- A shop owner may face the choice between two route- one
safe but slow, the other fast but risky. Without insurance, the
ship owner chooses the safe route with insurance, he choose the
fast route.
Continued…….
Incase of Financial Institution
 In the lending, borrowers engage in activities that are not designed by
lenders and loan investment expose to risk.

 Moral hazard in lending is the problem created by asymmetric information

after the transaction occurs.

 Moral Hazard in the financial market is the risk ( hazard) that the borrower
might engage in activities that are undesirable from the lender’s point of
view because they make it less likely that the loan will be paid back.

 Because moral hazard lowers the probability that the loan will be repaid.
Lender may decide that they would rather not make a loan.
 Moral hazard also appear in a deposit insurance because the
insured depositor can afford to be careless in placing their
deposits.
 If the insurance guarantee the deposit , the depositor give
lesser incentive to investigate the soundness of the bank
where depositor plans to place his/ her deposits.
 However, the investor in general are very concerned about the
viability of the firm in which they plan to invest.
 Deposit insurance also creates moral hazard for managers at
insured a depository institutions.
Solution for Moral Hazard Problem
 Collateral and Net worth
 Demanding sufficient collateral from counter party is one of the solution
to lessen problem of moral hazard.
 The collateral acts the security to compensate for possible losses that can
cause to the party who suffers in transaction.

Monitoring and enforcement of restrictive covenants

 Frequent monitoring of compliance of terms and conditions mentioned in
the contract also help to minimize the problem of moral hazard arise in
transaction.

 Financial intermediation
- Banks and other intermediaries have advantage on monitoring.
Adverse Selection
 Adverse selection is the problem created by asymmetric
information before the transaction occurs.

 Adverse selection in financial market occurs when the

potential borrowers who are the most likely to produce
undesirable or adverse outcome are likely to be selected.

 It can also be defined as the situation where one party has

information that the other party don’t about some aspects.
Continued……

Adverse selection in Insurance

 The insurance industry can also face problem of signaling
and screening. People who buy insurance often have a better
idea of the risks they face than do the sellers of insurance.

 Eg. People who know that they face large risks are more
likely to buy insurance than people who face the small risks.
Continued……..
Adverse selection in lending
 If the borrower knows more than lender in trading debt and
the lenders realize all the loans in a certain risk class look
much the same.
 Then the lenders fails to identify which one of the loans turn
to be the bad.
 For eg. A financial institution has loan outstanding to two
borrowers A and B.
 From lenders point of view both the borrower looks like good
risk so the lender charge them same rate 9% interest rate.
However in reality lender is known that A is good borrower
than B.
Solution for Adverse selection Problem
 Private Production and sale of information
Problem of adverse selection can be solved by collecting relevant
information about the counter party either through private production of
information or appoint some agencies.

 Government Regulation to increase information

- Role of government regulation is vital in reducing adverse selection
problem. The government sets rules such as provision of third party
insurance and both the parties involved in transaction must obey that
rules so that chance of adverse selection will be reduced.
- Similarly the financial intermediation and collateral & net worth
provision also help to reduce the adverse selection problem.
The economics of regulation of financial service

 Financial institution provide vital services to the public such as

information service, liquidity services, credit allocation, payment service
etc and any institutional failure will be costly to both the saver and user
of the fund.

 The financial services are highly regulated business. Different regulation

and regulatory institution are in place to regulate these business.

 The primary purpose of regulating financial market and institution are to

prevent from market failure and protect investor’s right.

 The regulation of the financial institution is important also to maintain

financial stability in the market.
Continued………
 The regulation of the financial institution is also important for the
following reasons
- Safety of public fund
- Promoting public confidence
- Ensuring equal opportunity and fairness
- Money creation
- Promoting Disadvantage sectors
- To ensure continue financial services.
Financial Institution Regulatory Body in Nepal

 The control and supervision of the commercial banks and financial institutions
are regulated by central bank and other specified regulatory organization.

 The financial institution are monitored and supervised by the regulating body
by making compliance with international standard and norms like capital
adequacy under Basel Accord and also Banking and Financial Institution Act
( BAFIA)

 The dominant regulatory body is the central bank in any country. Ministry of
Finance, Nepal Rastra Bank, Insurance Board, Security Board of Nepal and
Department of Co-operatives are the regulators of financial institutions in Nepal.

 The NRB Act 2058 has empowered Nepal Rastra Bank to perform regulatory
and supervisory activities for the development and sustainability of financial
system.
 Continued….
 NRB issues license and monitors their performance and enforces the
actions based on the supervision and inspection report.

 The Co-operative Act 1992 and the Co-operative regulation 1993 has
provided Co-operative Department the authority to regulate co-operative
societies and unions in Nepal.

 Insurance Board is responsible for the promotion and regulation of the

insurance business in Nepal. The board provides the licenses to insurance
companies as per Beema Act 2049 ( 1992) and issue licenses in three
categories life, nonlife and both life and non life insurance activities.
Continued…..
 Security Board of Nepal ( SEBON) which was established on June
7, 1993 act as the regulating body to regulate and develop the
securities market and protect investor’s right. It supervise and
monitors stock exchange and securities business activities and also
take the legal action against non compliance of the rules
regulations and laws.
 Structure of Nepalese Financial Market

 Money Vs Capital Market

Money Market
 Money market deals with trading of securities having maturity period of less
than one year.
 This market is designed to raise the short term fund by the business and
government organizations.
 Government issues Treasury bills, corporate organization issue commercial
papers to raise fund for short term basis in the money market.
 Other money market instrument include banker’s acceptance, certificate of
deposit, promissory note, bill of exchange having the maturity period of less
than a year.
 The money market instruments are actively traded in primary as well as
secondary market.
Continued…….
 Money market in Nepal is not well developed and in the initial phase.
 Only few institution such as Nepal Rastra Bank and commercial bank
have actively participate in money market.

 Nepalese money market is heavily dominated by Treasury bill.

 Commercial bills and short term credit provided by the commercial banks
also form another important part of money market in Nepal.
 Continued……
Capital Market
 Capital market issues the long term instruments to raise the fund for long term
purpose.
 All long term securities issued by corporations and government such as
common stock, preferred stock, corporate bonds, government bonds are capital
market instruments.
 These capital market instruments are also traded in both primary and
secondary market.
 Capital market instruments are not liquid as money market instrument.
However the existence of secondary aids to the liquidity of these instruments.
 The Nepalese stock exchange ( NEPSE) is an example of capital market
because only the securities of more than one year maturities are traded there.
 Continued……
 Primary Market Vs Secondary Market

Primary Market
 It is the market in which corporations raise new capital by issuing securities.
 Primary market can be of two types seasoned and unseasoned market.
 A seasoned market is the market that deals with offering of an additional
amount of an already existing securities. If a corporation has to make
additional amount of an already existing securities, they are traded in seasoned
primary market.

 An unseasoned that market is the market is the market for initial offering of
securities in public. It is also referred as initial public offering ( IPO).
 Merchant bankers are the specialized firm that the issuing companies
undertake the activity of sale of new issue in our context.
Continued………
Secondary Market
 Secondary Market is the market for already existing securities.

 Secondary market is classified as organized securities exchange and over-

the- counter market .

 In organized securities exchanges only the listed securities are traded

whereas in over the counter market securities which are not listed in the
organized exchange are traded.

 Nepal Stock exchange is only the secondary market in Nepal that allows
investor to trade securities.

 The secondary market is designed to provide liquidity to investors through

transferring ownership from one investor to another.