CHAPTER I

INTRODUCTION

1.1 Background of the Study

Banking is the fastest growing sector in the economy. Banking sector plays the vital role in the
development of the economy. In a general view bank is an institution which collect the money
from people and also give loan if anyone need the fund. But in the broad sense, bank is that
institution which polls the scatter fund and utilizes it into the productive sector that may
contribute in the development of the economy. It do not only deal with the money also it deals
with credit and remittance and expanding business and perform the agent between the two party.

Bank is an institution which performs the intermediary between the surplus and deficit in the
financial resources. Every economic activity is directly or indirectly channeled through the bank.
Bank is the only one perfect institution which can perfectly mobilize the ideal fund of the people
and also that institution which make easier the investment. So that we can say the bank plays a
crucial role in the process of economic development and its importance is as a means of
achieving economic growth and prosperity within the country. In the process of providing
financial services, they assume various kinds of risk.

Risk is defined as “a condition in which exists an exposure to adversity.” In addition, there is an

expectation of what the outcome should look like. Therefore, risk is defined here as a condition
in which there exist a possibility of deviation from a desired outcome that is expected or hoped
for. Other definitions include the restriction that risk is based on real world events, including a
combination of circumstances in the external environment. We do not agree with this limitation.
Potential risks that might occur in the future are excluded. In addition, we do not limit the range
of risk to circumstances in the external environment.

The term risk is linked to the possibility of deviation. This means that the possibility of risk can
be expressed as a probability, ranging from 0 to 100 percent. Therefore, the probability is neither
impossible nor definite. This definition does not require that the probability be quantified, only
that it must exist. The degree of risk may not be measurable, for whatever reason, but the

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probability of the adverse outcome must be between 0 and 100 percent. Another key element of
the definition is the “deviation from a desired outcome that is expected or hoped for.” The
definition does not say how such an undesirable deviation is defined. There are many ways of
building expectations. By projecting historical data into the future, we build expectations. This
pattern of behavior can be observed in our everyday lives. Another way of building expectations
is to forecast by using information directed toward the future, not by looking back. The definition
of expectations is absolutely keys in the concept of risk. Any misconception of the expectations
will distort the measurement of risk substantially.

Many definitions of risk include the term adverse deviation to express the negative dimension of
the expected or hoped-for outcome. We do not agree with this limitation, which implies that risk
exists only with adverse deviations, which must be negative and thus are linked to losses. Such a
restriction would implicitly exclude any positive connotations from the concept of risk. We
believe that risk has two sides, which both have to be included in the definition, and that risk
itself has no dimension, negative or for the purposes of this discussion, risk is defined as “a
condition in which there exists an exposure to adversity.” In addition, there is an expectation of
what the outcome should look like. Therefore, risk is defined here as: risk a condition in which
there exists a possibility of deviation from a desired outcome that is expected or hoped for.

Banks and other regulated financial institutions have been forced by government regulations and
industry self-regulating bodies to develop the culture, infrastructure, and organizational processes
and structures for adequate risk management. Risk management has become a non delegable part
of top management’s function and thus a non delegable responsibility and liability. Driven by
law, the financial sector has developed over the past years strategies, culture, and considerable
technical and management know-how relating to risk management, which represents a
competitive advantage against the manufacturing and insurance sectors.

Risk management is an integrated part of upper management’s responsibilities or an independent

control and oversight function. Risk management is not a new function or gadget in the financial
industry. However, based on recent events, regulators and the media have increasingly
scrutinized risk management practices and techniques. A closer look at some of the accidents

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makes it apparent that managers, regulators, and investors have partially lost control of risk
management, overestimated their own capabilities and capacities, and brought companies and
entire markets to the edge of the abyss. Therefore, Risk management is the good topic for the
researcher. Commercial bank have to assume different kind of risk; market risk ,operational risk,
credit risk and other risk of them credit risk cover the significant risk of the total risk.

Though the banking sector has been facing different types of risks, major banking problems have
been either explicitly or indirectly caused by the weaknesses in credit risk management. So, in
this study, the researcher has focused mainly on the credit risk management of the commercial
banks in Nepal. However, the brief introduction of other risks like liquidity risk, interest risk,
operation risk and foreign exchange risk is also included. In addition to the credit risk the bank
faces other risks. According to the Nepal Rastra Bank Unified Directives 2005, the major source
of risk is credit risk, liquidity risk, foreign exchange risk, and interest rate risk etc

Brief Introduction of Miteri Development Bank Limited

Miteri Development Bank Limited (MDBL) commenced its operation on April 03, 2001 as the
15th commercial bank in the country. The bank was established with an objective to provide state
of the art financial services tailored to meet customer’s individual requirements. The bank is
promoted by a group of highly reputed Nepalese businessmen and professionals, and is managed
by experienced and dynamic professionals. In short period of time, the bank has been able to win
the trust and confidence of all stakeholders by offering innovative need centered products and
services, maintaining high standard of corporate governance and shouldering on social and
humanitarian issues. The main focus of bank is long term win-win relationship, excellence on
business, managing change and innovative sights. The bank has 16 branches including head
office of Putalisadak and now its corporate office is in Darbarmarg.

Miteri development bank limited with diversification and risk based lending strategy has been
able to increase the loan portfolio in fiscal year 2007/08. The total loans and advance recorded
for the year 2007/08 was RS.11335.09 million with a growth of 26.08% .The bank has properly
balanced its lending portfolio on retail and corporate sector, where credit concentration is of 13%
and 87% respectively.

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The bank has adopted computerized system in banking. The main software of the bank is called
Globus and the bank has the Any Branch Banking System (ABBS). The bank also provides
different services such as ATM and electronic banking etc. The bank has been providing loans
and advances in various sectors such as agriculture, manufacturing, deprived sector, industry and
consumer financing etc.

Based on the personal interview with key personal, it is found that risk is considered as the major
threatening factor in miteri development bank limited, which is given high priority by the top
management for its proper management. The bank has developed well defined polices and
procedure with structured organizational layers for management of risks. Accordingly, the bank
has categorized the overall risk into credit risk, interest risk, liquidity risk, foreign exchange risk,
operation risk etc. The main risk management committee includes Asset Liability Management
Committee, Audit Committee and Human Resource Commit.

1.2 Statement of the Problem

Miteri development bank limited is fairly young in terms of its operation; the bank has been
pursuing an integrated, multi-channel strategy in order to address customer’s needs. Branch
network expansion is one of the continuous strategies of the bank to serve the customers, having
unfulfilled banking needs, located in various geographical areas of the country. Similarly, the
bank is also adopting various technologies such as Debit card, internet banking, SMS banking in
order to serve their needs without forcing them in come on to the bank premises. Further, the
strategic alliance made by the bank with various business partners has also increased the choices
for the customers to get the services of Miteri Developmmet Bank Limited.

To sustain further growth of asset, income and risk absorbing capacity, the bank has
continuously enhanced its capital base. The bank now has total capital fund of Rs.1880 million,
comprising core and supplementary of Rs1,360 million and Rs.52.38 million respectively in
fiscal year 2007/[Link] current paid up capital of the bank is Rs.1078.2 million, which will be
increased to Rs. 328.2 million by the end F/Y 2007/08. In order to strengthen and leverage the
capital base through internal and external sources. Similarly, the bank has maintained the capital
adequacy ratio at 14.4% in F/Y 2007/08, which is well above the statutory requirement of

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11%. The bank has contributed NPR 103 million to the Government of Nepal in form of
corporate tax during the fiscal year 2007/08.

The essence of financial soundness of company lies in balancing its goals, commercial strategy,
product market choice and resultant financial and statically tools such as financial ratios income
and expenditure statement analysis etc. Many questions relating to company overall profitability,
liquidity position and long term solvency, operating effectively inter firm comparison assets
utilization should be assumed will answered financial condition of the company and risk
minimizing policy.

The major issue of the banking sector in Nepal is the Credit Risk. Poor lending practices, which
are indicated by poor financial analysis of borrowers, inadequate or substandard collateral and
improper portfolio analysis, poor tracking of credit and intention of borrowers to default have
resulted in the high amount of Non Performing Loan of major commercial banks such as Nepal
Bank Ltd (NBL) and Rastriya Banijya Bank (RBB).

Various issue of miteri development bank limited is to deal for the purpose of this study. Some
among the various issues but the important are as follows;
 What are the risk dealt by miteri development bank limited in the market and with in the
organization ?
 What are the sources of credit risk ?
 What are the strength and weakness of the miteri development bank limited ? Whether
the earning
power and operation efficiency is satisfactory ?
 What are the efforts generated by NRB directive for the management of credit risk of
Miteri Development Bank Limited ?
 What are the strategies followed by miteri development bank limited and what should be
it in future for better management of credit risk ?

Similarly, there is the problem of high credit concentration risk. The recovery of loan is also the
major challenge for Nepalese Commercial banks. The willful defaulter, that is the client who
defaults the loan intentionally, is also one of the major problem of Nepalese commercial banks

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especially for NBL and RBB.

Further, the issuance of new 16 unified directives by the NRB in 2005 has also provided the
commercial banks different measures related to credit risk, interest rate risk, foreign exchange
risk, liquidity risk and operation risk coupled with maintaining adequate capital to safeguard the
interest of investors, depositors and shareholders. The commercial banks need to comply with
many Prudential's, which have also provided the challenges to the commercial banks of Nepal.
Among these, the loan loss provisioning and capital adequacy measures have been providing the
major challenges to Nepalese commercial banks. That is why, the researcher has mainly focused
on the credit risk of miteri development bank limited among the commercial banks.

1.3 Objectives of the Study

This study is intended to find out different types of risk faced by miteri development bank
limited among them through out study of credit risk and it’s management strategies followed by
miteri development bank limited is primary objective.

Main objective of this study can be listed as followed.

 To study the sources of credit risk.
 To analyze NRB directive and measure on the risk management of commercial
bank.
 To analyze the risk management system of miteri development bank limited focused on
credit risk
 To generate a conclusive management idea to minimize the credit risk faced by
institution.

1.4 Significance of the study

Banking sector is vital sector for economic growth in a country. For the growth and development
of this sector proper management of risk by considering the return is required. In today’s
competitive scenario, several macro economic factors such as political, economical, social and
technological factors have increased the challenges to the banking sector. The success of any
organization is largely dependent on how properly the organization can manage the risk.

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Banking sector also involves several risks, which need to be handled promptly for the survival
and growth. As this research is made mainly to introduce the various risks among them the
management of credit risk in reference to NRB directives is taken as major objective. It will
provide valuable insight to different stakeholders about the major problems of banks and bank’s
action for its management. The key stakeholders who will be largely facilitated by this research
includes, Miteri Development Bank Limited under will highly be benefited by this research. This
research identifies major risks of this bank, its current risk management styles, NRB guidelines
on risk management and organization of basic compliance of such guidelines etc. Further, the
bank will know not only the current performance but also the idea about its strength and
weaknesses.

Individuals, who have keen interest in Nepalese economy and banking sector, will be benefited.
This research provides an insight into the organizational risk management patterns within the
standards set by NRB.

Policymakers will also be benefited as this paper provides the exact problems in risk
management and identifies the need for formulation of new policies or amendment of old
policies.

1.5 LITERATURE REVIEW

The first chapter highlighted the problem and objective of this study. This chapter provides the
concept inputs and bases for this study. This chapter includes the conceptual review and review
of different studies.

1.5.1 Conceptual Review

Risk is defined as “A condition in which there exists an exposure to adversity.” In addition, there
is an expectation of what the outcome should look like. Many definitions of risk include the term
adverse deviation to express the negative dimension of the expected or hoped-for outcome.
Therefore, risk is defined here as: risk a condition in which there exists a possibility of deviation
from a desired outcome that is expected or hoped for. Other definitions include the restriction
that risk is based on real world events, including a combination of circumstances in the external
environment.

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Risk management is the process of measuring are assessing risk and then developing strategies
the risk. In ideal risk management, a prioritization process is followed whereby the risks with the
greatest loss and the greatest probability of occurring are handled first, and risks with lower
probability of occurrence and lower loss are handled later. In practice , the process can be very
difficult and balancing risks with a high probability of occurrence but lower loss vs a risk with
high loss but lower probability of occurrence can after be mishandled.

Risk refers to uncertainty on the investment faced by the investors. It is the possibility that actual
outcomes may be different from those expected. Risk can be defined as the possibility of
deviation of the actual return from the expected return. Kupper (2000) defines risk as the
volatility of corporation’s market value. Risk management, on the other hand, is the process of
measuring or assessing risk and then developing strategies to manage the risk. In general, the
strategies employed include transferring the risk to another party, avoiding the risk, reducing the
negative affect of the risk, and accepting some or all of the consequences of a particular risk.

1.5.2 Research Gap

The purpose of research is to develop some expertise in one’s area, to see what new contribution
can be made and to receive some ideas, knowledge and suggestions in relation to risk
management of Meteri Development Bank Limited. Thus previous studies can’t be ignored
because they provide the foundation to the present study. In other word, there should be
continuity in research. This continuity in research is ensured by linking the present study with
past research study and try to fulfill the gap of the research. From the review of various
literatures, it has been found many research work have been done on the study of NRB Directives
and its compliance and analysis of credit management through loan loss provision, non-
performing loans and capital adequacy; however, very few thesis have been found on the credit
risk management which is the most important aspect of the banking sector. So, the researcher can
make further research on capital adequacy, concentration risk, collateral risk, and the actual
practices followed by the management of Nepalese commercial banks from its own side besides
the NRB directives to manage and control the credit risks etc. Hence, the researcher had
attempted to fill this gap by measuring the credit risk of KBL by studying its credit risk
management system. This study also aims to find out the organizational structure of MDBL for
the proper implementation.

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1.6 Research Methodology
Research is an original contribution to the existing stock of knowledge for its advancement and it
is also essentially an intellectual and creative activity. IT is the pursuit of truth with the help of
study, observation, comparison, experiment and may help the creative problem solver to reach
his/her objectives more efficiently. Similarly, methodology refers the various steps that are
generally adopted by a researcher in studying his/her research problem along with the logic
behind it.

Research methodology is a systematic way to solve the research problem. In other words,
research methodology describes the methods and process applied in the entire aspect of the study.
Kothari (1994) defines Research methodology as the various sequential steps (along with a
rational of each steps) to be adopted by a researcher in studying a problem with certain
objectives in view. Thus, research methodology is a way to systematically research the problem.
The main objective of this research is to measure the credit risk of the meteri development bank
and to study the various management techniques and principles used by the Nepalese
commercial banks to manage the credit risk. Thus, this chapter consists of the research
methodology applied in the study for the fulfillment of the stated objectives. Thus the overall
approach to the research is presented in this chapter. This chapter consists of research design,
sample size and selection process, data collection procedure and data processing and presentation
techniques and tools.

1.6.1 Research Design

Research design is a plan, structure and strategy of investigation conceived so as to obtain
answers to research questions and to control variance. It provides only a guideline for the
researcher to enable him to keep track of his/her actions and to know that s/he is moving in the
right direction in order to achieve his goal. The design may be a specific presentation of the
various steps such as selection of a research problem. The formulation of the hypothesis,
conceptual clarity, methodology, survey of literature Bibliography, data collection,
Interpretation, presentation and report writing in the process of research.

This study is the combination of descriptive and a expiratory type of research. Historical data are
used to identify and analyze the credit risk of a bank in the past period. Similarly, management

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system, organizational structure and policies for mitigating the credit risk and the credit risk
management procedures have been presented in descriptive form so as to identify the current
status from which pitfalls can be identified. From collection of past data and information from
key informants, the credit risk management system has been analyzed and recommendations
have been made for improving the credit risk management of bank. Since only one bank has
been selected for the study, this study is a individual case study of single bank in credit risk and
their management system.

1.6.2 Population and Sampling

The principle object of sampling is to get maximum information about the population with
minimum effort or with limited resources such as time, money and personnel. The small group
that is chosen for study is called a sample and the whole group which it is believed to represent is
called population. The number of observation in the sample is termed the sample size. Sampling
refers to the choosing of a sample from a population.

The population for the study comprises all the Nepalese commercial banks and among the total
population only one commercial bank under the study constitutes the sample for the study. The
sample is chosen with an objective to find out the credit risk management system of new
commercial bank, which has completed 8 years. MDBL is taken for the study this bank has
appropriate information about many respects such as capital base, profit, deposit, lending and
date of establishment etc.

1.7 Limitations of the Study

The outcome of the study is an individual effort. Therefore management, resource mobilization
and time constraints limit the in-depth study of all commercial banks operating except
commercial banks under study.

The study is also based on primary data especially through personal interview and questionnaire.
Therefore, the accuracy of results and conclusions highly depends on the reliability of these
facts.

The evaluation is made through the analysis of financial statement published and presented by

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the banks. Therefore generalization of the whole banking industry cannot be made.

Resource, time, money constraints and inaccessibility of sufficient information also limit the
conclusion drawn from study.

The study has covered only the six years data from fiscal year 2002/2003 to 2007/08.

1.6 Organization of the Study

The study is organized into the following five chapters:
Chapter I – Introduction.
Chapter II – Review of Literature.
Chapter III – Research Methodology.
Chapter IV – Data Presentation and Analysis.
Chapter V – Summary, Conclusion & Recommendations.

Chapter I is the introductory part of the study. This chapter describes the background of
the study, focus of the study, statement of the problem, objectives of the study, rationale of the
study and limitations of the study.

Chapter II includes a discussion on the conceptual framework and review of the related and
pertinent literature available. The conceptual considerations and review of related literature
conducted in this chapter provides a framework with the help of which the study has been
accomplished.

Chapter III describes the research methodology employed in the study. In this chapter, research
design, nature and sources of data, methods of data collection and tools and techniques of data
analysis are discussed.

Chapter IV consists of presentation and analysis of data, which deals with the empirical analysis
of the study and the major findings of the study.

Chapter V is the summary, conclusion and recommendations of the study.

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