( This article is a winner essay in the Nation wide essay competition organized by Nepal Rastra Bank in 2015)
Importance of Banking for the Economic Development
Bank: The word “Bank” derived from French word “benqua” which came from the Italian word “banca” which means bench. It is because long ago moneychangers (today often called as bankers) used to do their business at a bench out in the open air.
Banks, the institutions authorized by the government to accept deposits, pay interests, clear checks, make loans, act as an intermediary in financial transactions and provide other financial services. In general word, banks are the financial institutions licensed as the receiver of the deposits and provider of loans. Similarly, the business engaged in by banks is called banking. The types of banks depend upon the specialization in their own field. Each bank has its own and unique principles, policies and interest rate. The several types of banks include commercial/retail bank, saving banks, investment bank, Industrial development bank, land development bank, Indigenous banks, mortgage banks, exchange bank, consumer bank and so forth. In almost all of the nations there is an institutionalized and guiding system called central bank under which banks hold liquid assets equal to only a portion of their current liabilities.
Global History: A sound banking system is vital for smooth development which can play vital role in economy. Financial and banking success underpins the economic prosperity of any nation and its economy. Therefore, people searched best way for the safety and easy transactions of their belongings and property since very long. In ancient time, people wouldn’t have secured and concretized buildings as of today and there was invariably threat to their property. Therefore, most rich people held accounts at the nearby temples or church because it was the place which was supposed to be always surrounded by honest people adding sense of faith and security. In such cases, property was safe and temple would have loan facilities as well. Such traditions have been documented in the ancient history of many countries such as Greece, Rome, Egypt, and Babylon etc.
Nepalese History: It is difficult to trace the history of banking system in Nepal with correct chronological order due to the lack of well documented history and data. However, Nepal started the era of modern and formal banking after the establishment of Nepal Bank Limited in 1937 which was established as a semi government bank with the authorized capital of Rs. 10 million and paid-up capital of Rs. 892 thousands. Until then all monitory transactions were carried out by private dealers and trading centers. Until mid – 1940s, the only medium of exchange was metallic coins. Therefore, contemporary government felt the acute need of a separate and central institution to issue national currencies and promote financial organization of the nation.
Therefore, later in 1956 Nepal Rastra bank was established as the central bank of Nepal under the Nepal Rastra bank Act, 1955 with the objective of maintaining macro-economic stability through sound and effective monetary, foreign exchange and financial sector policies. At the very initial days of NRB, the development of monetary market in Nepal was far poor. Most of the transactions were carried out in Indian Currency including the salary provided by the government. Therefore, to overcome the existing difficulties of development and monetary market, NRB was established. NRB gathers saving from all over the country and provides liquidity for industry and trade. Later, 1957 AD stood as a corner stone when industrial development bank was firstly established to promote industrialization in Nepal, which in 1959 AD was converted into Nepal Industrial Development Corporation. NRB is the apex regulatory authority to manage and supervise the banking sector activities. Due to the dominant presence of banking sector in the capital market, the policies and regulatory approaches undertaken by the NRB heavily affect the capital market activities and hence there is a sequential complementarily between the capital market and the banking sector development in Nepal. Rastriya Banijya Bank was established later in 1965 AD as the second commercial bank of Nepal. Both the commercial banks were able to impact best in the contemporary financial and economic sphere.
Agriculture has been the backbone of Nepalese economy. Therefore, Nepalese economy can’t be boosted without boosting agricultural sectors. Hence, realizing this reality, separate Agriculture Development Bank was established in 1968 AD which is the first and still largest institution to finance on agriculture sectors. For more than decades, no more banks had been established in the country and the contemporarily those banks were highly regulated by the NRB. After declaring free economy and privatization policies, the government encouraged foreign banks for joint venture in Nepal.
Role of banks in economy:
The role of financial institutions like banks for the economic development of any economy is a widely discussed topic among economists and bankers since the early 1990s. Banks are essential for each country’s economy, since no growth can be achieved unless savings are efficiently channeled into investment
Researchers believe that financial systems play a crucial role in easing market frictions and hence influencing saving rates, investment decisions, technical innovation and therefore, long run growth rate. In addition, stable banking system fosters the proper and widely accepted distribution of income. In particular, the crucial need for a stable banking system has highlighted in the wake of the Asian Crisis of late 1990s. The rapid influx of short-term, speculative capital flows to Asian Economies was a major contributing factor to the crisis. States with stronger domestic financial sectors and particularly, robust banks, however, better absorbed the ripple effects of the external shocks.
Bank based approach helps to mobilize resources in identifying and implementing good projects and monitoring of those projects and investments. In addition, they help to mobilize and pool savings, provide payments and services that facilitate the exchange of goods and services, produce and process information about investors and investment projects to enable efficient allocation of funds and exert corporate governance after these funds are allocated, and help diversify, transform and manage risks.
Any modern financial system contributes to economic development and the improvement in living standards by providing various services to all the sectors of the economy. These include clearing and settlement systems to facilitate trade, channeling financial resources between savers and borrowers, and various products to deal with risk and uncertainty. In principle, these various functions can be provided by banks or other financial institutions or directly through capital markets. Banks and other financial intermediaries stay alive because they are an efficient response to the fact that information is costly. Banks specialize in assessing the credit worthiness of borrowers and providing an ongoing monitoring function to make sure borrowers meet their obligations. They are rewarded for these services by the spread between the rates they offer to the accumulated pool of savers, and the rates they offer to potential borrowers. This process is known as ‘maturity transformation’ and is at the heart of modern banking. Banks offer a repository for savings, and then transform them into long-lived (illiquid) assets – housing loans and lending to businesses. In addition, banks play a role in providing payment and settlement services which are necessary for households, business and other financial institutions to settle day-to-day transactions.
As a country becomes more developed, one typically sees the capital markets playing a greater role in supplying financial products and services relative to that supplied by the banks. In many advanced economies, for example, raising business debt through securities rivals or exceeds that provided though the banking system.
- Banks and financial (in)stability – making the system safer
Transforming short term deposits into longer term lending is one of the most important functions that banks perform for the economy. It is also what makes financial systems prone to fragility. This process exposes banks to illiquidity or possibly insolvency given the possibility of bank runs from depositors and creditors, or deterioration in lending quality. Banks’ own practices and financial regulation have an important bearing in reducing or amplifying this risk. For example, banks have choices around how much debt they use to fund their lending (leverage), while the quality of that lending is influenced by a number of governance-related factors. These include the control that creditors and shareholder put forth over bank managers, as well as the internal risk management systems of the bank. Regulations also set boundaries on what banks are able to do.
Given the interconnections between a bank and the overall sectors of the economy, the effects of a bank in stress or failure can potentially spill over to the wider financial and economic system. When financial savings cannot be accessed, the credit intermediation process is disrupted or the transactional role via the payments and settlement systems is undermined, economy is affected. Governments are naturally reluctant to see such important institutions fail since economic crises that are accompanied by major banking crises are typically far worse than usual business cycle slowdowns.
However, as we have seen from the experience of Ireland and Iceland, supporting stressed banks can create major fiscal problems, particularly if the banking system is very large relative to the size of the economy. A banking crisis can evolve into a sovereign debt crisis, which itself can have cross-border contagion effects.
- Making the financial system more efficient – the role of banks
The banks’ role as financial intermediaries has a major bearing on how efficiently the economy allocates its resources between competing uses. In considering efficiency, we are interested in whether lending activity helps resources flow to their ‘best use’ or whether some sectors get too little or too much credit relative to what is needed for the economy to perform at its best. We are also interested in whether lending and other financial activities are provided in a cost effective manner from the point of view of consumers and the degree to which the banks improve and innovate their financial products and services over time.
All else equal, a well-managed bank acting carefully and operating in a reasonably competitive market will be making credit available at an appropriate price to creditworthy borrowers. However, in intensed banking systems dominated by a handful of large banks, competition may be lacking. Households and firms may end up paying more to access credit (and other bank services) than in a more competitive system.
Financial sector efficiency can also be compromised by boom-bust cycles, which is why there has been a resurgence of interest in how we might avoid or reduce these. During booms, lending standards may fall significantly and lenders may under price hazard with too much credit being allocated to any one sector (such as the rural sector or property development
International evidence suggests what might be more important for competition and efficiency is how ‘contestable’ the banking system (or individual banking product markets) is, rather than simply how many banks operate (i.e. market structure). Contestability is influenced by both the actions of incumbent banks, and by various formal and informal barriers to entry and exit.
With the beginning of economic liberation in the mid – 1980s and increasing private sector investment in the financial sector from 1990s, the number of banks and financial institutions including commercial banks, development banks and other financial companies mushroomed from 38 in 1994 to 1997 in 2011. Consequently, the ratio of total banking assets to GDP went up to 78% from 35% during the period. Similarly, the ratio of private sector credit went to GDP from 20% in 1994 to 64% in 2011
Importance of Banks in Nepalese context
It has been known from prior research that there is a significant and strong relationship between country’s financial sector and overall country’s economic growth. The country can develop its
Economy quickly if the country has well financial system. Likewise, the regulatory bodies regularly monitor the banking sector for economic growth. In Nepal, Nepal Rastra Bank i.e. central bank reforms regulatory financial sectors, which indicate to the banking, sector. These sectors contribute to the economy in two fold. First they play a primary role in the economy through development activities and second they provide capital to general public and development organizations for improving through funded and non-funded credit facilities.
In Nepal, the common resource of supplies fund and the main source of financing to support national
Economic performances are commercial banks, development banks, finance companies and micro-development banks. However, other savings and cooperative institutions and non-government organizations are also providing limited banking facilities. Over the past decade, substantial interest focused on the link between the financial sector and economic growth. Endogenous growth theory emerged in the late 1980s and paved the way for new theories exploring the link.
Till the July end 2011, the number of banks and financial institutions are: 31 commercial banks, 87
Development banks, 79 finance companies and 21 micro-credit development banks, and all these institutes are licensed by central bank. Similarly, other non-banking institutes such as 16 saving and credit co-operative and 38 non-government organizations (NGOs) that are also providing limited banking facilities allowed by central bank. Till 1956, there was only one commercial bank, Nepal Bank Limited, with the number of all other financial institution being zero. At the end of the 1984 three more commercial banks and one development bank were established. By the end of 2002, there were altogether 140 banks and financial institutions (18 commercial banks, 9 development banks, and 51 finance companies with the establishment of saving and credit cooperatives and NGOs). The growth scenario in terms of number has reached 272 banks and financial institutions with 31 commercial banks and 87 development banks and 79 finance companies with the establishment of savings and credit cooperatives and NGOs as shown in as end of July 2011. As the result of greater financial reform by (the) Government of Nepal, such as ease of licensing policies, statutory requirements, foreign exchange exposure, and cash reserve ratios; liberalization of the interest rates; full convertibility of current account and other prudential rules and regulatory reforms have accelerated the growth of banking industry in Nepal.
Some specific sectors benefitted from financial institute, especially bank for development are:
- Infrastructure Development
Investment in infrastructural development by the banks and ease of finance in local development have shown positive effects in the development of infrastructural facilities in global scenario. Citing the examples of such cases, Nepalese banking sector can play a major role in imparting and facilitating the development process.
- Agriculture and Livelihood
As Nepal is an agrarian economy yet relying on traditional approach in agricultural production, the financial approach such as effective policies and strategies for the enhancement of livelihood in rural areas as well as professional farming practices in urban, by any financial institute will be beneficiary not only for overall GDP contribution of agriculture sector but also the livelihood enhancement of the people. Only a single industry in birgunj operates producing modern machineries and agricultural tools, investment in agrarian industry will also undoubtedly benefit the dependent, with the major roles for economy.
- Green Energy
The new concept of green economy and green energy are at a good pace globally these days as along with the development, nature is given high importance. Clean energy development bank, as one of the example for finance in the energy sector.
- Sustainable Cities
The investments in the sustainable development through the effective mobilization of the financial resources and knowledge through the financial sectors, better manages the development with the major responsibilities in it.
- Education and so on
ASEAN invest in education and human capital building whereas SAARC doesn’t which is also one of the major cause of south asean countries, lagging in development as human capital is the best form for the overall efficient and effective management of other resources. Banks can provide educational loans and other forms like entrepreneurship, human capital building trainings and so on.
Before the remittance through banking, hundi and other measures existed resulting in low revenue from remittance sector. Banking has regulated black money somehow and can encourage more access to banking through the free and legalize flow of remittance.
Recommendations: Nepal is a Least Developed Country (LDC) having GDP less than US $ 500. Therefore, banking sectors of Nepal has a great responsibility to lead Nepal toward more advanced and modern era. Therefore, following things have been recommended for the betterment of the National economy.
- Studies shows that increase in security in market development actually tends to increase the use of bank finance in developing countries. Therefore, both systems are complement to each other during development process. Therefore, financial and related other sorts of securities should be made reliable to the general people.
- Higher stock market liquidity or greater bank development leads to higher growth, irrespective of development of the other. Therefore, development of banks should be promoted up to carrying capacity.
- Quality of financial institutions and their services needs to be fostered to robust economic growth of nation.
- Many literatures suggest that countries with better developed financial systems experience faster economic growth and enjoy lower level of poverty and income inequality. Therefore, concerned authorities should be focused on making financial environment more healthy, productive and advanced.
- The government plays an important role in building effective and inclusive financial systems and discusses policies to make effective financial activities for development. Therefore, the government needs to do whatever it should do.
- Evidence suggests that human capital development contributes heavily to the stability of financial institutions and banks. In underdeveloped and developing countries, both pre-and pro-liberalization, often suffer from an inadequate supply of capable professionals. Therefore, policies should be put forwarded to enhance the academic as well as other professional skills of the professionals.
- Public-private partnership should be massively implemented to boost banking sectors which is the most efficient and effective approach of development. This approach has been widely adopted by recent government of India and can be fruitful in Nepal also. Financial liberalization boosts economic growth by improving allocation of resources and the investment rate.
- Better feasibility study of the investments relating to human and allround development should be undertaken for the effective result of investment by the banks and also promote rural banking in case of Nepal.
- Nepalese market as dominated by commercial banks, developmental investment opportunities can be fostered.
Therefore, ample opportunities lie in the banking sector, especially in Nepal as the market is yet to be penetrated and the better the effective ratio of saving and spending occur in any economy, the more well-organized economy maintains.
The Financial Sector and Economic Development: Banking on the Role of Human Capital ,Manuela W. Armenta
Relationship between Financial Development and Economy: A Case of Nepal, OanhThiVuong
The role of banks in the economy – improving the performance of the New Zealand banking system after the global financial crisis, Dr Alan Bollard, Chris Hunt and Bernard Hodgetts
The banking industry in the emerging market economies: competition, consolidation and systemic stability – an overview, John Hawkins and Dubravko Mihaljek
Contributions of banking sector in economic growth: A Case of Pakistan , Dr. Aurangzeb