Niraj Adhikari and Sundar Panthee

A well-functioning financial system acquires and uses information to allocate resources to the most productive investment projects and manages and distributes risk to those most willing to bear it. It adds to social welfare and economic growth as it improves the allocation of resources and reduces the volatility of consumption and investment. A well-functioning financial system is also able to better absorb adverse shocks, making the real economy less sensitive to them. As a consequence, economic growth is less volatile. Informational asymmetries in both financial markets and institutions can develop because borrowers have more information than lenders about the potential value and risk associated with the investment projects. These asymmetries are exacerbated by factors such as poor quality of financial information and poor corporate governance.

The Nepali financial system comprises financial markets, financial institutions, and unorganised sector. Currently, the Nepali economy is passing through tremendous crises. Due to security condition, economic activities are concentrated in urban areas, which has created inefficiencies in the financial sector. Liquidity with the financial sector is high due to lack of investment opportunities. But contradictory profit figures of financial institutions indicate sound financial activities, which are quite unbelievable. Neither the recovery of bad loans is possible in adverse conditions, nor are there any new investment activities. Most of the innovative development projects are terminated in the initial planning phase. Tourism, production and commercial activities have gone down; only the remittances have been providing some fuel to the economy. The financial system is not functioning well. The recent news of tax evasion from banking sector and cheating from co-operatives and finance companies reflect bad corporate governance and bad regulatory control.

Frictions in the financial system can cause inefficiencies, which impair the efficient allocation of resources and make the economy sensitive to adverse disturbances with significant welfare consequences. There is empirical evidence that these frictions are important from a macroeconomic point of view, since countries with fewer financial frictions tend to have stronger economic growth and lower output volatility. Reducing financial inefficiencies can, in principle, lead to a better allocation of resources, as well as helping the economy and the financial system to better absorb shocks. Policy measures to increase the quality of financial information, as well as the enforceability of rules, regulations, and contracts governing the financial system can promote both financial system efficiency and stability. Evaluating the ultimate net benefit of any given financial system policy, however, requires careful monitoring and analysis.

Since financial system is a sub-system of the national economical system, it is affected by the country’s political as well as economical situations. On the top of it, the financial system in itself is in a a problematic situation with poor accounting and auditing practices, operational inefficiencies, poor risk assessment system, poor information system, etc. Problems caused by outer environments are quite impossible to overcome. However, solving internal problems of the system and promoting financial system efficiency are only possible through implementing good corporate governance, mainly transparency in activities of the actors and good regulatory supervision and control.