Dean's Office Official Model Question Paper

Commercial Bank

A commercial bank is a licensed financial intermediary that accepts deposits from surplus economic units and extends credit/loans to deficit units, facilitating payment settlement and capital allocation.

Classification of BFIs in Nepal (BAFIA 2073)

• Class ‘A’: Commercial Banks (Full-service corporate and retail banking, foreign exchange, LCs).
• Class ‘B’: Development Banks (National and regional industrial/infrastructure financing).
• Class ‘C’: Finance Companies (Hire-purchase, leasing, housing finance).
• Class ‘D’: Microfinance Financial Institutions (Poverty alleviation, collateral-free group micro-credit).

Cash Reserve Ratio (CRR)

CRR is the mandatory percentage of total deposit liabilities that commercial banks must maintain as non-interest-bearing cash reserves with the central bank (Nepal Rastra Bank mandates 4% CRR). Its purpose is controlling systemic money supply and ensuring basic liquidity solvency.

Multiple Credit Creation

Multiple credit creation is the process whereby initial primary deposits deposited in the banking system generate secondary loan deposits multiple times larger than the original cash injection, driven by the reciprocal of the reserve ratio.

Stale Cheque vs. Post-Dated Cheque

• Stale Cheque: A cheque presented for payment after its legal validity period has expired (more than 6 months from the date of issue in Nepal).
• Post-Dated Cheque (PDC): A cheque bearing a future date that cannot be cashed or honored by the bank prior to that specified date.

Multiple Credit Creation Process in Banking

Commercial banks create credit by lending out surplus funds from initial primary cash deposits.

1. Theoretical Mechanism & Money Multiplier

• If a commercial bank receives an initial primary deposit of $\text{Rs. } 100,000$ and the central bank’s Cash Reserve Ratio (CRR) is $10\%$, the bank reserves $\text{Rs. } 10,000$ and lends out $\text{Rs. } 90,000$.
• The borrower spends $\text{Rs. } 90,000$, which is deposited into another bank. That bank reserves $10\%$ ($\text{Rs. } 9,000$) and lends $\text{Rs. } 81,000$. This multiplier chain continues:

$$\text{Total Deposit Expansion} = \text{Initial Deposit} \times \left(\frac{1}{\text{CRR}}\right) = 100,000 \times \left(\frac{1}{0.10}\right) = \mathbf{\text{Rs. } 1,000,000}$$

$$\text{New Credit Created} = 1,000,000 - 100,000 = \mathbf{\text{Rs. } 900,000}$$

2. Practical Leakages and Constraints

In real economies, credit expansion is constrained by two major leakages:

1. Currency Drain / Cash Leakage ($c$): When borrowers withdraw a portion of loan proceeds as physical paper currency rather than redepositing in banks.
2. Excess Reserves ($e$): When banks voluntarily hold precautionary reserves above statutory requirements due to economic uncertainty.

$$\text{Effective Money Multiplier } (m) = \frac{1 + c}{\text{CRR} + e + c}$$

As cash drain ($c$) or excess reserves ($e$) increase, the banking system’s capacity to create credit contracts proportionally.

Regulatory and Monetary Policy Instruments of Nepal Rastra Bank

Under the Nepal Rastra Bank Act (2058 BS), NRB uses quantitative and qualitative policy tools to manage macroeconomic liquidity and ensure banking stability:

+----------------------------------------------------------------------+
|                    NEPAL RASTRA BANK MONETARY TOOLS                  |
+-----------------------------------+----------------------------------+
| 1. QUANTITATIVE (DIRECT/INDIRECT) | 2. QUALITATIVE / MACROPRUDENTIAL |
|  - Cash Reserve Ratio (CRR - 4%)  |  - Credit-Deposit (CD) Ratio (90%)|
|  - Statutory Liquidity Ratio (SLR)|  - Single Obligor Limits (SOL)   |
|  - Bank Rate & Policy Repo Rates  |  - Loan-to-Value (LTV) Caps      |
|  - Standing Liquidity Facility    |  - Deprived Sector Lending (DSL) |
|  - Open Market Operations (OMO)   |  - Sectoral Credit Ceilings      |
+-----------------------------------+----------------------------------+

1. Quantitative Instruments

• Cash Reserve Ratio (CRR): Currently 4% for Class A, B, and C institutions. Adjusting CRR directly expands or contracts the banking system’s monetary base.
• Statutory Liquidity Ratio (SLR): Mandatory holding of unencumbered liquid assets (government treasury bills and bonds) equal to 12% of total deposits for commercial banks.
• Interest Rate Corridor (IRC): Sets the bounds for short-term interbank interest rates:
  • Ceiling: Standing Liquidity Facility (SLF) / Bank Rate.
  • Policy Target: Overnight Repo Rate.
  • Floor: Standing Deposit Facility (SDF).
• Open Market Operations (OMO): Outright purchase/sale of government securities and reverse repos to manage seasonal liquidity spikes.

2. Qualitative & Macroprudential Directives

• Credit-Deposit (CD) Ratio: Mandates that a bank’s total local currency loans cannot exceed 90% of total deposits plus core capital.
• Loan-to-Value (LTV) Limits: Caps mortgages at 50% within Kathmandu Valley to prevent real estate speculative bubbles.
• Targeted Sector Lending: Enforces mandatory credit quotas in Agriculture (minimum 15%), Energy/Hydropower (minimum 10%), and MSMEs (minimum 15%).

Financial Statements of Commercial Banks & NIM

A commercial bank’s financial architecture is distinct from non-financial manufacturing firms:

1. Bank Balance Sheet Architecture

2. Bank Income Statement & Net Interest Margin (NIM)

• Interest Income: Earned from loan portfolios and treasury securities.
• Interest Expense: Paid to depositors and interbank lenders.
• Net Interest Income (NII):
  $$\text{NII} = \text{Interest Income} - \text{Interest Expense}$$

3. Net Interest Margin (NIM) Formula & Significance

$$\text{NIM} = \frac{\text{Net Interest Income (NII)}}{\text{Average Total Earning Assets}}$$

• Strategic Benchmark: NIM measures the efficiency of a bank’s core intermediation spread. In Nepal, banks strive for a NIM between 3.5% and 4.2% to comfortably absorb loan provisioning and generate healthy Return on Equity (ROE).

Basel III Capital Adequacy Framework in Nepal

Nepal Rastra Bank enforces the Basel III Capital Accord to ensure commercial banks hold sufficient capital reserves to absorb unexpected credit, market, and operational losses.

+----------------------------------------------------------------------+
|                     BASEL III REGULATORY CAPITAL                     |
+-----------------------------------+----------------------------------+
| TIER 1 CAPITAL (GOING-CONCERN)    | TIER 2 CAPITAL (GONE-CONCERN)    |
| - Common Equity Tier 1 (CET1):    | - Subordinated Term Debt (> 5y)  |
|   Paid-up Equity, General Reserve,| - General Loan Loss Provisions   |
|   Retained Earnings, Share Premium|   (Pass loans up to 1.25% of RWA)|
| - Additional Tier 1 (AT1):        | - Exchange Equalization Reserves |
|   Perpetual Non-Cumulative Prefs | - Investment Adjustment Reserves |
+-----------------------------------+----------------------------------+

1. Minimum Capital Ratios Mandated by NRB

• Minimum CET1 Ratio: 6.0% of Total Risk-Weighted Assets (RWA).
• Capital Conservation Buffer (CCB): 2.5% in common equity.
• Total Tier 1 Capital Ratio: Minimum 8.5% of RWA.
• Total Capital Adequacy Ratio (CAR): Minimum 11.0% (8.5% Tier 1 + up to 2.5% Tier 2).

2. Structural Tiers of Capital

1. Common Equity Tier 1 (CET1): The highest-quality, permanent loss-absorbing capital. Includes paid-up ordinary share capital, statutory general reserves, share premium, and retained earnings, net of regulatory deductions (goodwill, deferred tax assets).
2. Additional Tier 1 (AT1): Qualifying perpetual non-cumulative preference shares without fixed maturity dates.
3. Tier 2 (Supplementary) Capital: Secondary loss-absorbing reserves available in liquidation. Includes subordinated bonds with remaining maturity over 5 years and general loan loss provisions on performing loans (capped at 1.25% of credit RWA).

Case Study: Apex Commercial Bank Limited

(a) Mandatory Loan Loss Provisioning & NPL Ratio Calculation (7 Marks)

1. Loan Loss Provisioning Table:

• General Provisions (Pass Loans): Rs. 1,625 Million.
• Specific Provisions (Substandard + Doubtful + Loss): $1,000 + 1,750 + 2,500 = \mathbf{\text{Rs. } 5,250\text{ Million}}$.
• Total Required Provision = Rs. 6,875 Million.

2. Gross and Net Non-Performing Loan (NPL) Ratio:

• Total Non-Performing Loans (NPL) = $\text{Substandard} + \text{Doubtful} + \text{Bad} = 4,000 + 3,500 + 2,500 = \mathbf{\text{Rs. } 10,000\text{ Million}}$
• Gross NPL Ratio:
  $$\text{Gross NPL Ratio} = \left(\frac{10,000}{140,000}\right) \times 100 = \mathbf{7.14\%}$$
• Net Non-Performing Loans: $\text{Gross NPL} - \text{Specific Provisions} = 10,000 - 5,250 = \text{Rs. } 4,750\text{ Million}$
• Net NPL Ratio:
  $$\text{Net NPL Ratio} = \left(\frac{4,750}{140,000 - 5,250}\right) \times 100 = \left(\frac{4,750}{134,750}\right) \times 100 = \mathbf{3.53\%}$$

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(b) Capital Adequacy Ratio (CAR) Computation & Compliance Evaluation (7 Marks)

1. Tier 1 (Core) Capital:

• Paid-up Ordinary Share Capital: Rs. 12,000 M
• Statutory General Reserves: Rs. 4,000 M
• Retained Earnings: Rs. 1,500 M
• Total Tier 1 Capital = Rs. 17,500 Million

2. Tier 2 (Supplementary) Capital:

• Subordinated Term Debt (Eligible portion): Rs. 3,000 M
• General Loan Loss Provision eligible for Tier 2: Pass loan provision up to max 1.25% of credit RWA. (Here, Pass provision = Rs. 1,625 M is eligible).
• Total Tier 2 Capital = $3,000 + 1,625 = \mathbf{\text{Rs. } 4,625\text{ Million}}$
• (Note: Tier 2 is capped at 100% of Tier 1; Rs. 4,625M < Rs. 17,500M, so fully admissible).

3. Total Eligible Capital Base:

$$\text{Total Capital} = \text{Tier 1} + \text{Tier 2} = 17,500 + 4,625 = \mathbf{Rs.\ 22,125\ Million}$$

4. Regulatory Ratios (on RWA of Rs. 160,000 M):

• Tier 1 Ratio:
  $$\text{Tier 1 CAR} = \left(\frac{17,500}{160,000}\right) \times 100 = \mathbf{10.94\%} \quad (\text{NRB Minimum: } 8.50\% \implies \mathbf{Compliant})$$
• Total Capital Adequacy Ratio (CAR):
  $$\text{Total CAR} = \left(\frac{22,125}{160,000}\right) \times 100 = \mathbf{13.83\%} \quad (\text{NRB Minimum: } 11.00\% \implies \mathbf{Compliant})$$

Compliance Evaluation: Apex Bank comfortably complies with NRB’s Basel III minimum CAR thresholds (13.83% vs. 11.00% minimum). However, its Gross NPL of 7.14% exceeds the regulatory 5.0% ceiling, which triggers prompt corrective action (PCA) warnings and dividend distribution restrictions from NRB.

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(c) Strategic Loan Recovery and Capital Action Plan (6 Marks)

Special Recovery Unit -> CIB Blacklisting -> Collateral Auction -> Capital Preservation

1. Establishment of a Dedicated Special Recovery Unit (SRU):
   • Remove bad loan files from regular branch managers and assign them to an elite, centralized Special Assets Management Group headed by legal and recovery specialists.
2. Aggressive Legal Enforcement and Collateral Foreclosure:
   • Issue formal 35-day legal public notices in national dailies under the Banking Offence and Punishment Act and BAFIA 2073.
   • Proceed with public collateral land auctions. If auctions lack bidders, acquire the physical properties as Non-Banking Assets (NBA) or initiate cases before the Debt Recovery Tribunal (DRT).
3. CIB Blacklisting & Cross-Default Pressures:
   • Submit default records to the Credit Information Bureau (CIB) Nepal to blacklist corporate promoters, freezing their access to credit across all 54 commercial banks and financial institutions.
4. Prudent Dividend Policy and Capital Preservation:
   • Suspend cash dividends for the fiscal year; retain 100% of distributable profits as retained earnings to cushion further loan-loss provisioning hits without breaching Tier 1 buffers.