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ABSTRACT

Financial Institutions have been regarded to be the core area of economic development. However, Nepal could not achieve satisfactory level of economic development and growth due to Maoists war (1996-2006) and the political instability. The increase in size and number of commercial banks are limited only in the urban areas so that banking services are not accessible to the general public.
This paper examines interaction between financial development and economic growth in Nepal employing correlation analysis, regression analysis, financial ratios and other related theories.
As we found that financial institutions have grown rapidly which has implication in overall economy of the nation. The economic indicators such as GDP, GDP per capita, loan assets of commercial banks, investment, deposit, number of commercial banks, and inflation rate from fiscal year 2001 to 2007 are used for the analysis of this study.
The relevant ratios of commercial banks such as deposit, investment, and profitability are found to be in increasing trend. The growth rate of GDP/capita is however volatile in the study period, the regression result of Deposit/GDP is weakly significant under the study period {(0,06)*}. The investment growth rate is not significant at all possibly due to the time lag of the effect of investment on the economic development.
Furthermore, correlation between Growth rate of GDP and deposit/GDP (?=0.49). The Growth rate of GDP and investment over GDP is positive related with a correlation coefficient of 0.82. This has confirmed our beliefs in the set out of the thesis.

1 INTRODUCTION
1.1 Motivation of the study and background
Economic growth for developing countries has important indications for poverty elimination and world economic development. This has been the goals of world financial institutions such as World Bank and IMF. To study economic development of Nepal can provide a real world example of a politically complicated and poverty stricken country’s development process, the importance of economic freedom of the country to its development and indications to the future path of the development. Developing countries have welcomed the multinational banking in order to attract more foreign investments and facilitate the industrial development. There are a number of countries which changed their economic status after the multinational banking intervention such as Korea, Thailand, and Mexico etc. All of these countries opened the door for the foreign investment through MNBs when they were in deep financial trouble.
Now MNBs’ banking concept is adopted by all countries as a tool to meet the need of capital and funding needs to boost the industrial sector (Manandar, 2008).
Over the past few years, service sector has been growing rapidly and accounted for about 20 percent of total international trade. The rate of increase of the service sector is higher than the goods sector. The main importer and exporter of commercial services are developing countries. The Asian economy has grown tremendously because of the increment in the trade of commercial services, construction services, computer software, data processing and tourism. Thus the role of commercial banks is remarkably enhanced in all the countries to support the increasing need of the service sector and the economy in general (Economic survey, 2008).
As Bhaskar Sharma (2000) in Business Age pointed out “one of the most important achievements as a result of the growth in the number of commercial banks in the post liberalization period is in the area of domestic banking savings.” “Deposit-GDP ratio, one of the most important economic parameters is widely employed to analyze the efficiency of the banking system. More savings from the economy would make more funds available for investment.” This has become our motivation of the study.
1.2 Objectives of the study
The objectives of the study are:
To offer a detailed and realistic study of Nepal over the recent decades;
To review partially the literature concerning growth theory, economic growth and financial institutions;
To investigate the contribution of Financial Institutions to the economic growth using Deposit/GDP ratio, etc., in a developing country setting in Nepal; and
To study the development of the commercial banks in Nepal in recent decades.
1.3 The problem statement of the study
Is investment growth of the financial institutions significantly related to the GDP per capita? And is the percentage of deposit over GDP significantly contributing to GDP per capita growth? We use Nepal as the study object.
1.4 Limitation of the study
There are various types of financial institutions operating under various sector of economy but this study concentrates on the commercial banks of Nepal due to obvious reasons stated in part.Furthermore this study limits its coverage on the growth and development of commercial banks during the past seven years, that is, from 2001 to 2007.
The research data is based on secondary data. Certain important areas of study are omitted, e.g. corporate governance, political stability, remittance, and technological advancement to the development of Nepalese economy due to the scope of the study.
1.5 Structure of the study
The whole thesis is divided into six chapters. The second chapter gives a detailed background study and overview of the financial sector. The third chapter is the theory which describes the growth theory and the models related to both growth theory and the banking sector. The fourth chapter is the methodology and data which presents different statistical tools used and data presentation. The Summary and Conclusions constitutes the last chapter of this thesis.

2 Background study of Nepalese economy
Nepal is one of the poorest countries in the world. It is landlocked and covered by mountains as well as hills. The main profession of Nepalese people is agriculture. More than 70 percent of the people are found to be engaged in agriculture sector and rest is employed in service and industry. Unemployment is approximately 40 percent and country severely lacks skilled manpower. However, the productivity of agriculture is falling down and the population of the country is at an increasing trend. Therefore, the
traditional occupation is not enough to meet the growing needs of Nepalese people. Now Nepalese people have started to think about the alternative sources of income where financial institutions have been regarded to be the core alternative ways to solve this problem. Press trust of India reported on economic data released by Nepal Central Bureau of Statistics on July 9, 2008 that Nepal’s economic is in recovery path with 5.56 percent growth in current fiscal year, most impressive performance in last 7 years, per capita income now stands $470, increase of 11 percent growth shown by number become less obvious when the steep rise inflation rate is considered. Nepal inflation rate now stands at 9 percent so gains made by 11 percent rise in per capita income will not make much difference in the common man’s daily life (Ghimire, 2008).
Nepal is also the least developed country in the world in terms of GDP per capita. About one third of the total population is living below the poverty line. The contribution of agriculture sector to the GDP constitutes 38 percent. The GDP rate is slowly accelerating. The GDP increased 2.7 percent in the year 2007 (Statistical pocket book- 2007).
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Industrial activities in the country involve processing of agricultural products including jute, sugarcane, tobacco, and grain. The Maoist war has led to the decrease of tourism which is the key source of foreign exchange income. Nepal has good prospects of expanding tourism and hydropower for the economic development. Low economic growth and persistent deficits in financial and trade balances in recent years have left Nepal with very limited resources for development funds needed for nation building. At present the major part of development expenditure comes from other countries as loans and donations. Nepal has adopted mixed economic policy . Many financial institutions were established within the country to achieve social economic development of the country (Economic survey 2007).
The Nepalese monarch ended the century old system in 1951. Reforms in 1990 established a multiparty democracy with constitutional monarchy in the country. Nepal communist party Maoist started insurgency in 1996. The Nepal Communist Party Maoist had previously started civil war (1996-2006) which they termed `` people’s war`` with an aim of establishing a ``People’s republic of Nepal``. A comprehensive peace agreement signed in November 2006 had ended the decade long armed conflict in which thousand of civilians, Maoist guerrilla fighters and the then royal Nepalese army personnel were killed and displaced. This insurgency adversely affected the economic development of the country in the study period. Ten members of the royal family, including the King Birendra Bir Bickram Saha Dev and Queen Aishwarya Rajya Laxmi Devi Saha were killed in 2001 allegedly by the then crown prince Dipendra. After the royal massacre, Gyanendra Shah (Gyanendra's brother, Birendra) succeeded to the throne upon the death of his nephew Dipendra who was King for only three days while in a coma.
In February 2005, the new king Gyanendra dismissed the prime minister and his cabinet after they dissolved the parliament. The king declared a state of emergency, imprisoned party leaders, and assumed power and took complete control of the government. The king allowed parliament to reconvene due to mass protests organized by the seven parties and the Maoists in 2006. The election of constitutional assembly is held in 2008 and the nation is declared as republic by the first meeting of constituent assembly(Khadaka,2007). Due to such political instability the country failed to achieve satisfactory level of social and economic development and growth. A mixed economy is an economic system that incorporates aspects of more than one economic system.This usually means an economy that contains both privately owned and state owned enterprises. Or that combines elements of capitalism and socialism or mixed of market economy and planned economy characteristic.
Nepal has a reasonably diversified financial sector as evidenced by the number and variety of institutions that play an active role in the society, relative to Nepal’s small and underdeveloped economic base over the past 20 years, Nepal’s financial sector has become deeper, and the number and type of financial intermediation has grown rapidly with in this period. The Nepalese financial sector has grown significantly both in terms of business volume and size of assets and market capitalization (Nepal Development Forum march 2000).
The financial sector was not opened up for private sector until the early 1980s in Nepal. At the beginning of the 1980s when financial sector was not liberalized there were only two governments controlled commercial banks; Rastriya Banajya Bank and Nepal Bank Limited and two development banks performing banking activities in Nepal. The economic reforms initiated by the government more than one and half decade ago have changed the landscape of several sectors of the Nepalese economy. As a result of this policy, large number of banks and financial institutions mushroomed across the country. The Nepalese financial market is comprised of regulated and non regulated sector. The Nepalese organized financial sector is composed of banking and non banking sector. Besides commercial bank, micro credit institution, cooperatives and NGOs; there are other institutions that perform near bank services like postal saving, employee provident fund, mutual fund and citizen investment trust, insurance companies and Nepal stock exchange etc. Similarly brokers, security dealers, market makers and money exchangers are other players of financial market. However,2 Nepal Rastra Bank’s regulatory and supervisory regime is limited to the commercial bank, development banks, finance companies, micro credit development banks, saving and credit cooperatives and non government organizations of which license for operation is provided by Nepal Rastra Bank . The following table depicts the types and number of financial institution licensed
Nepal Rastra bank (NRB), the central bank of Nepal, established in April 26, 1956, under the NRB act 2012 is the sole authority for licensing and supervising banks and financial institutions in Nepal. Replacing NRB act 2012, the NRB act 2018 has empowered Nepal Rastra Bank to conduct the supervision of financial institutions and has provided more autonomy, authority and accountability to the core central banking function, which undoubtedly includes the supervision function as well.
by NRB by mid July 2007 (N.R.B Bulletin, 2007) and the financial institutions are classified into ABCD according to capital size. The higher the capital required to register the financial institution, is ranked as A and lower B, C, D and none classified respectively.

Table-1 Number of Financial Institutions






SN

1

2

3

4

5

6

Types of Financial institutions

Commercial Banks

Development Banks

Finance Companies

Micro Credit Development bank

Saving and Credit Cooperative

Non Government Organization

Class

A

B

C

D

NonClassified

Non Classified

Number

20

29

70

11

19

47

Sources: Banking and Financial Statistics (mid July 2007, No. 47)

Nepal Rastra Bank has been given various rights and powers including rights of granting license to banks and financial institutions, their monitoring, inspection and supervision and also taking over the management if it appears that transactions of the bank are detrimental to the interest of the depositors. It has authority even to cancel license in case of material non-compliance of various prudential norms and relevant laws and regulations. The following table depicts total assets of licensed institutions and the share of various types of financial institutions.
Table-2
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2.1 Overview of Commercial Banks in Nepal
There is no doubt that the banking sector is important for both developed and developing economies. Developed economies already have a highly sophisticated financial market in place where as developing economies have no or only rudimentary institutions in place.
Financial markets play a key role in the development of a country. They are the intermediary link in facilitating the flow of fund from domestic savings into productive investment which ultimately help to lower the cost of capital to investors and accelerate economic growth of the country. Financial intermediation between borrowers and savers is done by commercial banks and other non bank entities. Now a day, the crucial importance of financial intermediation in economic development has come under the increasing scrutiny by both economists and policy makers in developing countries. However, financial development in many developing economies is still faced by a number of obstacles such as macroeconomic instability, the fragility of stock markets, the limitation of capital markets, and the inefficiency of development and specialized banks. Despite some of these limitations, banking systems in underdeveloped countries remain integral components of the general economic systems. And they can be seen as a key element in any development effort (Zeinab2006)
Though Nepalese financial sector is reasonably diversified with financial institutions having institutional arrangement of varied nature, commercial banks are the major player in this system and they occupy substantial share in the structure of financial sector (See table 2). The commercial banks are supervised by the bank supervision department of NRB while the rest of these institutions are supervised by Financial Institution Supervision. Safe and sound banking is of crucial importance to the financial stability and sustainable development of the country.
The first conventional bank in Nepal was the Nepal Bank Limited, established in 1937 followed by Rastriya Banijya Bank in 1966. These banks have the largest networks and they have their operations even in the remote areas of the country. Rastriya Banijya bank is fully owned by the government while the government has controlling stake in Nepal Bank Limited. As the financial market was barred for private investor up until the mid 1980s these two banks were the only players in the banking industry3 . Table 3 provides the detailed information about the date of incorporation of the commercial banks in Nepal.
The economic liberalization policy adopted in the mid of 1980s brought about a surge in the banking industry. The large numbers of banks were established and the numbers continue to grow to the present day.


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