Foundation of Financial Systems 2080 Board Question Paper

Financial Intermediation and Examples in Nepal

Financial intermediation is the economic process through which institutional middlemen channel surplus financial savings from household savers to deficit spending units (entrepreneurs, firms, and government) by creating secondary financial claims.

• Examples in Nepal:
  1. Depository Intermediaries: Nabil Bank Ltd. (Commercial Bank), Muktinath Bikas Bank Ltd. (Development Bank), Goodwill Finance Ltd. (Finance Company).
  2. Contractual & Investment Intermediaries: Employee Provident Fund (EPF), Citizen Investment Trust (CIT), Nepal Life Insurance Co., and Mutual Funds.

Capital Market

The capital market is that segment of the financial system dedicated to raising and trading long-term financial instruments with maturities exceeding one year (such as common stocks, preference shares, corporate debentures, and government bonds).

• It comprises both the primary market (new capital issuance) and the secondary market (liquidity and trading on the Nepal Stock Exchange - NEPSE), regulated by SEBON.

Meaning of Ancillary Financial Services

Ancillary financial services are specialized, non-deposit-taking auxiliary services that provide vital technical, informational, depository, and settlement infrastructure to ensure smooth capital market and banking operations.

• Key providers include CDS & Clearing Ltd. (electronic settlement), Credit Rating Agencies, Credit Information Bureau (CIB), and Depository Participants (DPs).

Major Roles of Risk Management Industry

The risk management industry (life, non-life, and reinsurance companies) fulfills vital economic roles:

1. Risk Transfer and Indemnification: Absorbs catastrophic property, personal, and business risks, reimbursing financial losses to sustain economic stability.
2. Contractual Savings & Capital Formation: Mobilizes long-term premium reserves and channels them into infrastructure projects, bank fixed deposits, and capital markets.

Credit Rating Agencies

A credit rating agency (CRA) is an independent, specialized financial institution that evaluates the creditworthiness and financial stability of debt issuers (corporations, banks) and assigns standardized letter-grade ratings (such as AAA, AA, A, BBB, etc.) indicating the probability of timely debt service.

• In Nepal, licensed rating agencies operating under SEBON regulations include ICRA Nepal Limited and Care Ratings Nepal Limited.

Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) is a cross-border investment in which an investor resident in one country establishes a lasting interest and significant degree of managerial control (usually 10% or more of voting equity) in an enterprise operating in another country.

• In Nepal, FDI is governed by the Foreign Investment and Technology Transfer Act (FITTA), 2075 in sectors like hydropower, tourism, and manufacturing.

Calculation of Profit Margin (PM)

Given Data:

• Asset Utilization (AU) = $1.45 \text{ times}$
• Return on Assets (ROA) = $14.5\% = 0.145$

Formula (DuPont Framework):

$$\text{ROA} = \text{Profit Margin (PM)} \times \text{Asset Utilization (AU)}$$

$$\text{Profit Margin (PM)} = \frac{\text{ROA}}{\text{AU}} = \frac{14.5\%}{1.45} = \mathbf{10.0\%}$$

The profit margin of the bank is 10.0%.

Calculation of Annual Yield on T-Bill

Given Data:

• Face Value ($F$) = Rs. 10,000
• Purchase Price ($P$) = Rs. 9,700
• Days to Maturity ($t$) = 180 days
• Discount ($D$) = $F - P = 10,000 - 9,700 = \text{Rs. } 300$

1. Bank Discount Yield ($Y_{BD}$, 360-day basis):

$$Y_{BD} = \frac{D}{F} \times \frac{360}{t} = \frac{300}{10,000} \times \frac{360}{180} = 0.03 \times 2 = \mathbf{6.00\%}$$

2. Bond Equivalent Yield / Investment Yield ($Y_{BEY}$, 365-day basis):

$$Y_{BEY} = \frac{D}{P} \times \frac{365}{t} = \frac{300}{9,700} \times \frac{365}{180} = 0.030928 \times 2.02778 = \mathbf{6.27\%}$$

Interest Rate Sensitivity of Bank A and Bank B

Given:

• Bank A Gap Ratio = 25% (0.25)
• Bank B Gap Ratio = 30% (0.30)

Evaluation:

1. Under $\frac{\text{RSA}}{\text{RSL}}$ Definition:
   • Both banks are liability-sensitive ($< 1.0$).
   • Deviation from interest rate neutrality (1.0):
     • Bank A: $|1.0 - 0.25| = 0.75$
     • Bank B: $|1.0 - 0.30| = 0.70$
   • Bank A deviates further from balance, meaning its net interest margin will experience greater percentage volatility. Hence, Bank A is more sensitive.
2. Under $\frac{\text{Gap}}{\text{Total Assets}}$ Definition:
   • Bank B has 30% gap exposure relative to assets compared to 25% for Bank A, making Bank B more sensitive in terms of absolute balance sheet exposure.

Calculation of NAV and Market Price

Given Data:

• Total Assets = Rs. 220 million
• Total Liabilities = Rs. 10 million
• Number of Shares Outstanding = 20 million
• Discount to NAV = $2\%$

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Step 1: Compute Net Asset Value (NAV)

$$\text{NAV} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Number of Shares Outstanding}}$$

$$\text{NAV} = \frac{220 - 10}{20} = \frac{210\text{ million}}{20\text{ million}} = \mathbf{Rs.\; 10.50\text{ per share}}$$

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Step 2: Compute Market Price of Fund’s Shares

$$\text{Market Price} = \text{NAV} \times (1 - \text{Discount})$$

$$\text{Market Price} = 10.50 \times (1 - 0.02) = 10.50 \times 0.98 = \mathbf{Rs.\; 10.29\text{ per share}}$$

Comprehensive Solution: Securities Dealer vs. Broker & NRB Regulation

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Part I: Securities Dealer and Distinction from Securities Broker

1. Meaning of Securities Dealer

A securities dealer is a licensed financial institution or securities firm that buys and sells securities on its own account (as a principal), taking direct inventory and market price risks. Dealers create liquidity in financial markets by standing ready to buy (bid price) and sell (ask price) at quoted prices.

2. Differences Between Securities Dealer and Securities Broker

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Part II: Need for Regulation of Depository Financial Institutions by NRB

Depository financial institutions (commercial banks, development banks, and finance companies) handle public deposits that form the lifeblood of the payments system. Regulation by Nepal Rastra Bank (NRB) is necessary for the following critical reasons:

1. Protecting Depositors’ Hard-Earned Funds:
   • Over 85% of bank funding originates from retail depositors who cannot independently audit bank solvency. NRB regulation acts as a public trust guarantee.
2. Preventing Systemic Bank Runs and Financial Panics:
   • A liquidity crisis in one bank can spark contagion across the entire financial sector. NRB provides stability through the Lender of Last Resort (LOLR) facility and liquidity reserve ratios (CRR and SLR).
3. Maintaining Monetary Stability and Credit Allocation:
   • Regulating banks ensures orderly transmission of NRB’s monetary policy interest rate corridors and directs mandatory credit toward deprived and productive sectors (agriculture, energy, tourism).
4. Enforcing Prudential Capital Discipline:
   • Enforces Basel III capital standards (minimum 11% Capital Adequacy Ratio) and CD ratio ceilings (90%) to prevent excessive credit expansion and asset bubbles.
5. Ensuring Corporate Governance and Integrity:
   • Imposes fit-and-proper criteria on bank promoters and directors, preventing insider lending, fraud, and anti-money laundering (AML/CFT) infractions.

Solution: Himal Cement Company Rights Offering

Given Parameters:

• Additional capital to raise = Rs. 50 million
• Current market price per share ($P_0$) = Rs. 220
• Subscription price per new share ($P_s$) = Rs. 100
• Rights required to buy one new share ($N$) = 2 rights (for two shares held)

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Part (a): Theoretical Value of a Right ($V_r$)

When the stock is selling rights-on:

$$V_r = \frac{P_0 - P_s}{N + 1}$$

$$V_r = \frac{220 - 100}{2 + 1} = \frac{120}{3} = \mathbf{Rs.\; 40.00}$$

The theoretical value of each right is Rs. 40.00.

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Part (b): Theoretical Ex-Rights Price ($P_e$)

Method 1: Direct Deduction

$$P_e = P_0 - V_r = 220 - 40 = \mathbf{Rs.\; 180.00}$$

Method 2: Weighted Average Formula

$$P_e = \frac{(N \times P_0) + P_s}{N + 1} = \frac{(2 \times 220) + 100}{2 + 1} = \frac{440 + 100}{3} = \frac{540}{3} = \mathbf{Rs.\; 180.00}$$

The ex-rights price of the share is Rs. 180.00.

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Part (c): Advantages of a Rights Offering

1. Protection of Shareholders’ Ownership and Voting Rights:
   • Existing shareholders are protected against dilution of their proportionate equity and control in the company.
2. Substantial Savings in Flotation Costs:
   • Directly approaching current shareholders avoids heavy underwriting fees, extensive advertising, and intermediary commissions.
3. High Probability of Successful Subscription:
   • The deep discount between the market price (Rs. 220) and subscription price (Rs. 100) provides a strong financial incentive to subscribe.
4. Fairness and Flexibility:
   • Shareholders who do not wish to invest additional cash can monetize their rights by selling them in the secondary market.

Solution: Interest Rate and Expected Inflation Determination

Given Inflation Schedule:

• Year 1 (2022): $I_1 = 5.0\%$
• Year 2 (2023): $I_2 = 6.0\%$
• Year 3 (2024): $I_3 = 7.0\%$
• Year 4 (2025): $I_4 = 8.0\%$
• Real risk-free rate ($k^*$) = $3.0\%$
• Maturity risk premium ($MRP$) = $0\%$ for maturities $\le 5$ years
• Yield on 5-year Treasury bond ($T_5$) = $10.0\%$

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Part (a): Average Expected Inflation Rate over Next 4 Years ($IP_4$)

$$IP_4 = \frac{I_1 + I_2 + I_3 + I_4}{4} = \frac{5.0\% + 6.0\% + 7.0\% + 8.0\%}{4} = \frac{26.0\%}{4} = \mathbf{6.50\%}$$

The average expected inflation rate over the next 4 years (2022–2025) is 6.50%.

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Part (b): Prevailing Interest Rate on 4-Year T-Bonds ($T_4$)

$$T_4 = k^* + IP_4 + MRP_4$$

Since $MRP_4 = 0$:

$$T_4 = 3.0\% + 6.50\% + 0 = \mathbf{9.50\%}$$

The prevailing interest rate on 4-year T-bonds is 9.50%.

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Part (c): Implied Expected Inflation Rate in 2026 (Year 5, $I_5$)

1. Expression for 5-Year Treasury Yield ($T_5$):

   $$T_5 = k^* + IP_5 + MRP_5$$
   $$10.0\% = 3.0\% + IP_5 + 0 \implies IP_5 = 10.0\% - 3.0\% = 7.0\%$$

2. Calculate $I_5$ using the Average Formula:

   $$IP_5 = \frac{I_1 + I_2 + I_3 + I_4 + I_5}{5} = 7.0\%$$
   $$\frac{26.0\% + I_5}{5} = 7.0\%$$
   $$26.0\% + I_5 = 35.0\%$$
   $$I_5 = 35.0\% - 26.0\% = \mathbf{9.00\%}$$

The implied expected inflation rate in 2026 (Year 5) is 9.00%.

Solution: Balance of Payments (BOP) Analysis (FY 2021/022)

Given Data (Rs. in Million):

• Goods: Credit = 352,154 | Debit = 1,369,317
• Services: Credit = 108,111 | Debit = 350,229
• Primary Income: Credit = 62,395 | Debit = 17,548
• Secondary Income: Credit = 829,238 | Debit = 9,735

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Part (a): Net of Goods and Services Account

1. Total Credit (Goods + Services):

   $$\text{Total Credit} = 352,154 + 108,111 = \text{Rs. } 460,265\text{ million}$$

2. Total Debit (Goods + Services):

   $$\text{Total Debit} = 1,369,317 + 350,229 = \text{Rs. } 1,719,546\text{ million}$$

3. Net of Goods and Services Account:

   $$\text{Net Balance} = 460,265 - 1,719,546 = \mathbf{-Rs.\; 1,259,281\text{ million}}$$
   (This represents a massive deficit of Rs. 1,259,281 million or Rs. 1.259 trillion).

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Part (b): Net of Primary Income and Secondary Income Accounts

1. Net Primary Income:

   $$\text{Net Primary Income} = \text{Credit} - \text{Debit} = 62,395 - 17,548 = \mathbf{+Rs.\; 44,847\text{ million}}$$
   (Surplus of Rs. 44,847 million).

2. Net Secondary Income:

   $$\text{Net Secondary Income} = \text{Credit} - \text{Debit} = 829,238 - 9,735 = \mathbf{+Rs.\; 819,503\text{ million}}$$
   (Surplus of Rs. 819,503 million, driven overwhelmingly by inward migrant worker remittances).

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Part (c): Trade Deficit / Surplus during the Fiscal Year

The trade balance includes only merchandise (goods) trade:

$$\text{Trade Balance} = \text{Goods Exports (Credit)} - \text{Goods Imports (Debit)}$$

$$\text{Trade Balance} = 352,154 - 1,369,317 = \mathbf{-Rs.\; 1,017,163\text{ million}}$$

Conclusion: Nepal incurred a Merchandise Trade Deficit of Rs. 1,017,163 million (approximately Rs. 1.017 trillion) during the fiscal year.

Short Notes: Non-Depository and Regulatory Institutions

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a. Citizen Investment Trust (CIT / Nagarik Lagani Kosh)

The Citizen Investment Trust (CIT) is a statutory autonomous non-depository contractual savings institution established under the Citizen Investment Trust Act, 2047.

• Core Objectives: Encourages voluntary and mandatory savings among civil servants, corporate employees, and the public, investing mobilized funds into industrial projects, government debt, and capital markets.
• Key Schemes: Employees’ Savings Growth Scheme, Gratuity and Pension Funds, Investors’ Account Scheme, and Unit Schemes.
• Capital Market Role: Operates as a major institutional investor and underwriter for public security offerings on the Nepal Stock Exchange.

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b. Insurance Board (Nepal Insurance Authority / Nepal Beema Pradhikaran)

The apex regulatory body overseeing the insurance sector in Nepal, originally constituted as the Insurance Board (Beema Samiti) and reconstituted under the Insurance Act, 2079.

• Key Functions:
  1. Licensing, supervising, and regulating life, non-life, and reinsurance companies.
  2. Prescribing solvency margin requirements, premium tariffs, and underwriting guidelines.
  3. Protecting the interests of policyholders and arbitrating disputes between insurers and insured clients.
  4. Expanding micro-insurance access to rural, underprivileged, and agricultural communities.

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c. Pension Fund

A pension fund is a specialized non-depository contractual financial institution that collects contributions from employers and employees during their active working years to provide monthly retirement annuities and lump-sum terminal benefits upon retirement.

• Practices in Nepal: Managed by institutions such as the Employee Provident Fund (EPF), the Pension Management Office (PMO) for civil service retirees, the Social Security Fund (SSF) under the Contribution-based Social Security Act, and private retirement trusts.
• Economic Significance: Forms long-term patient capital invested in national infrastructure, hydropower, and sovereign securities.

Analytical Exposition: Concept and Components of Nepalese Financial System

A robust financial system is the engine of modern economic growth. It acts as an institutional bridge transferring scarce capital from surplus economic units to deficit units where it can be put to productive use.

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1. Concept of Financial System

A financial system is a complex, interconnected network of financial institutions, markets, instruments, services, and regulatory bodies that interact to mobilize savings, allocate capital, facilitate payments, and manage financial risks across an economy.

Fundamental Functions:

1. Resource Mobilization & Allocation: Aggregates small, fragmented household savings and directs them into large-scale capital investments.
2. Liquidity Provision: Enables holders of financial assets to quickly convert them into purchasing power without significant loss of value.
3. Maturity & Risk Transformation: Transforms short-term, liquid deposits into long-term illiquid loans while diversifying portfolio default risk.
4. Efficient Payment and Settlement Mechanism: Provides clearing networks, electronic funds transfer (NCHL, RTGS, QR payments), and currency circulation.

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2. Major Components of Nepalese Financial System

The financial architecture of Nepal consists of five integrated components:

Components Overview: [Regulators: NRB, SEBON, Beema] ↔ [Institutions: Depository & Non-Depository] ↔ [Markets: Money & Capital] ↔ [Instruments: Debt, Equity, Hybrid] ↔ [Infrastructure: CDSC, CIB, Rating Agencies]

A. Apex Regulatory Authorities

1. Nepal Rastra Bank (NRB): The central monetary authority regulating banks and financial institutions (BFIs), foreign exchange, and payment gateways.
2. Securities Board of Nepal (SEBON): Regulates capital markets, stock exchanges, brokers, mutual funds, and public listings.
3. Nepal Insurance Authority (Nepal Beema Pradhikaran): Regulates life, non-life, and reinsurance companies.
4. Department of Cooperatives: Regulates saving and credit cooperatives.

B. Financial Institutions

• Depository Institutions (Banks and Financial Institutions - BFIs):
  • Class ‘A’ Commercial Banks (20 institutions): Full-service retail and corporate banking.
  • Class ‘B’ Development Banks: Infrastructure and regional financing.
  • Class ‘C’ Finance Companies: Hire-purchase, leasing, and personal credit.
  • Class ‘D’ Microfinance Financial Institutions: Rural collateral-free microcredit for underprivileged groups.
  • Saving and Credit Cooperatives: Community-based credit mobilization.
• Non-Depository Institutions:
  • Contractual Savings: Employee Provident Fund (EPF), Citizen Investment Trust (CIT), Social Security Fund (SSF).
  • Risk Management: 14 Life Insurance and 14 Non-Life Insurance companies, plus 2 Reinsurance firms.
  • Investment Companies: Specialized private equity, venture capital, and mutual fund management companies.

C. Financial Markets

• Money Market: Wholesale market for short-term liquidity (Treasury bills, interbank lending, repo/reverse repo, standing liquidity facility - SLF).
• Capital Market:
  • Primary Market: Flotation of new shares, debentures, and rights issues through C-ASBA and MeroShare.
  • Secondary Market: The Nepal Stock Exchange (NEPSE) with over 250 listed companies, providing trading and continuous price discovery.

D. Financial Instruments

• Short-term: Government Treasury Bills (28, 91, 182, 364 days), commercial certificates of deposit.
• Long-term: Ordinary shares, corporate debentures/bonds, Government Development Bonds (Bikash Rinpattra), citizen saving bonds, and mutual fund units.

E. Financial Infrastructure & Ancillary Services

• Central Depository Services (CDS & Clearing Ltd.), Credit Rating Agencies (ICRA Nepal, Care Ratings Nepal), Credit Information Bureau (CIB), and Deposit and Credit Guarantee Fund (DCGF).

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Conclusion

Nepal’s financial system has evolved from a state-dominated, cash-based structure into a modernized, digitized, and highly regulated institutional network. Sustained economic growth requires continued regulatory vigilance to address non-performing loans and cooperative sector stability.

Solution: Value-Weighted Index, Stock Split Mechanics, and Uses of Market Indices

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Part (a): Determine Value-Weighted Index for 2021 and 2022

Base Year = 2020 | Base Index ($I_0$) = 100

Step 1: Compute Market Capitalization for Each Year ($MC_t = \sum (P_{it} \times Q_{it})$)

1. Year 2020 (Base Year):

   • Alpha: $120 \times 1,000 = \text{Rs. } 120,000$
   • Beta: $200 \times 3,000 = \text{Rs. } 600,000$
   • Delta: $160 \times 2,000 = \text{Rs. } 320,000$
   • Base Market Cap ($MC_0$): $120,000 + 600,000 + 320,000 = \mathbf{Rs.\; 1,040,000}$

2. Year 2021:

   • Alpha: $130 \times 1,000 = \text{Rs. } 130,000$
   • Beta: $190 \times 3,000 = \text{Rs. } 570,000$
   • Delta: $180 \times 2,000 = \text{Rs. } 360,000$
   • Market Cap 2021 ($MC_{2021}$): $130,000 + 570,000 + 360,000 = \mathbf{Rs.\; 1,060,000}$

3. Year 2022: (Note: Alpha had a 2-for-1 stock split, so shares increased from 1,000 to 2,000, price is Rs. 70)

   • Alpha: $70 \times 2,000 = \text{Rs. } 140,000$
   • Beta: $210 \times 3,000 = \text{Rs. } 630,000$
   • Delta: $190 \times 2,000 = \text{Rs. } 380,000$
   • Market Cap 2022 ($MC_{2022}$): $140,000 + 630,000 + 380,000 = \mathbf{Rs.\; 1,150,000}$

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Step 2: Compute Value-Weighted Index

$$\text{Index}_t = \frac{MC_t}{MC_0} \times 100$$

1. For Year 2021:

   $$\text{Index}_{2021} = \frac{1,060,000}{1,040,000} \times 100 = \mathbf{101.92}$$

2. For Year 2022:

   $$\text{Index}_{2022} = \frac{1,150,000}{1,040,000} \times 100 = \mathbf{110.58}$$

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Part (b): Why Value-Weighted Index is Not Affected by Stock Splits

In a value-weighted index (such as NEPSE, S&P 500), each stock’s weight is determined by its total market capitalization ($P \times Q$).

1. When a company executes a stock split (e.g., a 2-for-1 split):
   • The number of shares doubles ($Q \times 2$).
   • The price per share halves ($P / 2$).
2. The product remains unchanged:
   $$\text{Market Capitalization after split} = \left(\frac{P}{2}\right) \times (2Q) = P \times Q$$
3. Because the total aggregate market capitalization of the company is theoretically identical before and after the split, the index value requires no arbitrary divisor adjustment (unlike price-weighted indices like the Dow Jones Industrial Average).

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Part (c): Uses of Stock Market Indices

1. Economic Barometer: Serves as a leading indicator of national economic health, investor sentiment, and industrial expectations.
2. Performance Benchmark: Provides a reference point against which mutual funds, portfolio managers, and institutional investors evaluate fund returns.
3. Underlying Asset for Financial Products: Serves as the basis for index mutual funds, exchange-traded funds (ETFs), and derivative contracts.
4. Measurement of Systematic Risk (Beta): Used as the proxy for the overall market return ($R_m$) in the Capital Asset Pricing Model (CAPM) to determine individual stock betas ($\beta$).
5. Academic and Economic Forecasting: Enables researchers and central banks to track wealth effects and capital formation trends.

Solution: Bank Financial Performance Comparison

Preliminary Aggregates:

1. Total Earning Assets (Loans + Investments):

   • City Bank: $21,000 + 5,000 = \text{Rs. 26,000 million}$
   • Metro Bank: $27,000 + 8,000 = \text{Rs. 35,000 million}$

2. Total Interest-Bearing Liabilities (Deposits + Debentures):

   • City Bank: $24,000 + 500 = \text{Rs. 24,500 million}$
   • Metro Bank: $26,000 + 600 = \text{Rs. 26,600 million}$

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Part (a): Non-Interest Income Ratio

$$\text{Non-Interest Income Ratio} = \frac{\text{Non-Interest Income}}{\text{Total Assets}}$$

• City Bank:

  $$\frac{350}{29,000} = 0.01207 = \mathbf{1.21\%}$$
  (Or relative to Net Operating Revenue $\frac{350}{1,900 + 350} = 15.56\%)$

• Metro Bank:

  $$\frac{650}{38,000} = 0.01711 = \mathbf{1.71\%}$$
  (Or relative to Net Operating Revenue $\frac{650}{1,600 + 650} = 28.89\%)$

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Part (b): Net Interest Margin (NIM) Ratio

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

• City Bank:

  $$\text{NIM} = \frac{1,900}{26,000} = 0.07308 = \mathbf{7.31\%}$$
  (If calculated on Total Assets: $\frac{1,900}{29,000} = 6.55\%)$

• Metro Bank:

  $$\text{NIM} = \frac{1,600}{35,000} = 0.04571 = \mathbf{4.57\%}$$
  (If calculated on Total Assets: $\frac{1,600}{38,000} = 4.21\%)$

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Part (c): Interest Spread Ratio

$$\text{Spread Ratio} = \left(\frac{\text{Interest Income}}{\text{Total Earning Assets}}\right) - \left(\frac{\text{Interest Expense}}{\text{Interest-Bearing Liabilities}}\right)$$

• City Bank:

  • Yield on Earning Assets = $\frac{4,000}{26,000} = 15.38\%$
  • Cost of Funds = $\frac{2,100}{24,500} = 8.57\%$
  • Spread Ratio: $15.38\% - 8.57\% = \mathbf{6.81\%}$

• Metro Bank:

  • Yield on Earning Assets = $\frac{4,500}{35,000} = 12.86\%$
  • Cost of Funds = $\frac{2,900}{26,600} = 10.90\%$
  • Spread Ratio: $12.86\% - 10.90\% = \mathbf{1.96\%}$

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Part (d): Evaluation of Banks’ Relative Performance

Managerial Conclusions:

1. City Bank displays exceptional core banking efficiency:
   • Its NIM of 7.31% and Spread of 6.81% demonstrate pricing power over deposits and higher yielding loan assets.
   • However, it relies heavily on traditional net interest income and should diversify fee-based services.
2. Metro Bank demonstrates superior fee-based and ancillary income diversification (Non-Interest Income Ratio of 1.71%):
   • However, its core interest spread is compressed to only 1.96%, indicating expensive deposit mobilization (cost of funds at 10.90%) or lower average asset yields.