Key Banking Concepts

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Banking Concepts

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Core Banking Concepts

Understanding fundamental banking concepts is crucial for comprehending how financial systems operate and for preparing for banking exams.

Simple Interest: Calculated only on the principal amount. $$ \text{Simple Interest} = \frac{P \times R \times T}{100} $$ where $P$ = Principal, $R$ = Rate of Interest, $T$ = Time.
Compound Interest: Calculated on the principal amount and also on the accumulated interest of previous periods. $$ \text{Compound Interest} = P\left(1 + \frac{R}{100}\right)^T - P $$

Base Rate: The minimum interest rate set by commercial banks, determined by their cost of funds. Banks cannot lend below this rate, except for certain priority sector loans as prescribed by the central bank.
Prime Lending Rate: The interest rate offered by banks to their most creditworthy customers, typically lower than rates offered to other borrowers.
Spread Rate: The difference between a bank's weighted average lending rate and its weighted average deposit rate. It indicates the bank's profitability from core operations.

These are crucial tools used by the central bank (NRB) to manage liquidity and regulate the banking sector:

CRR (Cash Reserve Ratio): The percentage of a commercial bank's total deposits that it must hold as reserves with the central bank. For example, if CRR is 4%, banks must deposit 4% of their net demand and time liabilities with NRB.
SLR (Statutory Liquidity Ratio): The percentage of a commercial bank's total deposits that it must maintain in liquid assets, such as gold, unencumbered approved securities (government bonds), or excess reserves with the central bank. For example, if SLR is 12%, banks must hold 12% of their liabilities in these liquid forms.

These are open market operations used by the central bank to manage liquidity in the financial system:

Repo Rate (Repurchase Agreement): The rate at which the central bank buys government securities from commercial banks with an agreement to sell them back at a later date. This injects liquidity into the banking system.
Reverse Repo Rate: The rate at which the central bank sells government securities to commercial banks with an agreement to buy them back. This absorbs liquidity from the banking system.

Definition: Loans where the borrower has failed to make scheduled interest or principal payments for a specified period, typically 90 days or more.
Significance: A high NPL ratio indicates potential financial distress for banks and the overall economy. Nepal's banking sector NPLs generally hover around 3–4%, which is considered manageable compared to an OECD ideal of less than 5%.

Purpose: A mandatory identification and verification process that banks and financial institutions must undertake when opening accounts or establishing business relationships with customers.
Objective: Primarily to prevent money laundering, terrorist financing, and identity theft, ensuring compliance with Anti-Money Laundering (AML) regulations.