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Chapter I


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Background of the Study

A strong financial system is very
important for a country to flourish. The economic progress of a nation and
development of banking is invariably interrelated. The banking sector is an
indispensable financial service sector supporting development plans through
channelizing funds for productive purpose, intermediating flow of funds from
surplus to deficit units and supporting financial and economic policies of
government. The importance of bank’s stability in a developing economy is
noteworthy as any distress affects the development plans (Rajaraman
& Vasishtha, 2002) thereby the economic progress (Thiagarajan,
Ayyappan, & Ramachandran, 2011). The stability of banking hence is a
pre-requisite for economic development and resilience against financial crisis.
Like any other business, success of banking is assessed based on financial
performance / profitability and quality of asset it possesses (Ombaba,

The role of financial system in any
country is to aggregate capital from surplus source and allocates the resources
to deficit units through formal and informal channels. The financial system
comprises of numerous banks, a range of insurance companies, and stock exchanges
Hvidkjaer, & O’Hara, 2002). Banking system plays a pivotal role
in the economic development of a country and focus core of the money market in
an advance country.  Investment portfolio
is one of the major function of the bank which helps to generate the income and
diversify the risk. Diversification is a portfolio strategy designed to cut
back risk by combining various investments (Rop,
Bokongo, & Yusufkibet, 2016).

Asset quality also
referred to as loan quality has been defined as the overall risk attached to
the various assets held by an individual or institution. It is most commonly
used by banks to determine how many of their assets are at financial risk and
how much allowance for potential losses they must make. The most common assets
requiring a strict determination of asset quality are loans, which can be
non-performing assets if borrowers default on repayment obligations. Risk
managers often assess the quality of assets by assigning a numerical ranking to
each asset depending upon how much risk is involved (Ombaba, 2013).

Poor bank performance may lead to
banking failure and crisis, which have negative consequences on the economic growth
2011). This has necessitated continuous
research in this field to fill the gaps and establish the critical determinants
of commercial banks financial performance. Investment is the current commitment
of resources for a period of time to desire future payments that will
compensate the investor for the time the funds are committed, the expected rate
of inflation, and the uncertainty of the future payments. The investment return
is a measure of the growth in wealth resulting from the investment done.  For greater profit with minimum risk,
investment portfolio is created. The portfolio choice problem and the optimum
allocation of resources under multiple investment options is not a new topic in
the economic literature. (Gruber,
1996), for example, already pointed out
the substitutability of real and financial assets in portfolio balances.
Depending on respective rates of returns, investors decide how to allocate
their portfolios between real investments and financial investments.

Performance measurement begins with
portfolio valuations and transactions translated into a rate of return. For
large companies, connecting market products to contribution margin in order to
achieve portfolio excellence can be elusive. Balancing performance expectations
and resource allocation across multiple business units requires clearly defined
portfolio management processes within business units at the corporate level.
Maximum profitability requires portfolio executives to prioritize and execute
innovation strategically (Karimi,

The banking sector is one of the most
regulated ones today and bank capital regulation is of utmost importance. The
commercial banks in Nepal face capital requirements based on the Basel Core
Banking Principles. The government of Nepal is still in the implementation
phase of Basel III guidelines and for the same, lending plays an important role
for banks in order to comply with those guidelines.

Commercial Banks Commercial Bank Act, 2031 B.S. of Nepal has defined it as a commercial
bank is one which exchanges money, deposits money, accepts deposits, grants
loans and performs commercial banking functions and which is not a bank meant
for co-operative agriculture, industries or for such specific purpose. The
Commercial Bank Act 2031 also pointed the functions of commercial banks
commercial banks provide short term debts necessary for trade and commerce.
They take deposits from the public and grants loans in different forms. They purchase
and discount bills of exchange, promissory note, and exchange foreign currency.
They discharge various functions on behalf of their customers provided that
they are paid for their services. The main objective of commercial
banks is to collect the idle fund, mobilize them into productive activities,
grant loans, exchange foreign currency, agency function and other services. The
main source of profit for commercial banks are the mobilization of their
resources. Henceforth, it cannot be denied that commercial banks play a vital
role in the growth and development of the economy.

Generally, commercial banks attract
return nearly about 60-70% of its revenue by mobilizing the deposits through
the medium of loans and advances where risk along with some cost is involved. There
is always a risk factor associated along with advancing loans such as market
risk, liquidity risk, interest rate risk etc. The risk that the bank faces
mostly is the borrowers risk, risk of non-payment of advanced loans. The
balance sheet of commercial banks shows that the huge investment of banks is on
loan and advances. The banks are expected to support their legal communities
along with adequate supply of credit for the business by pricing them
reasonably and determining the interest rates.

Commercial banks are an important
part of economy development and therefore, government and central banks try
their best to protect the banks from various issues and also, protect the
depositors and shareholders money. Government and central banks have issued
directives and guidelines which are modified and amended as per the requirement
for the sound performance of banking system. All the banks have to follow these
rules and regulations for their successful performance and be one of the major
body to take part in the growth and development of the country’s economy.

Statement of Problems

For the development of the country’s
economy, banking sector plays the vital role. The main objective of the bank is
to collect deposits from the customer and to mobilize into the most profitable
and preferable sector. Most of the government banks in Nepal is in loss though
the private sector banks are running in profit. NRB is operating under the
government rules and regulations but still most government banks are running in
loss and private sectors banks are running in profit.

In the Nepalese economy, commercial
banks have enlarged and opened many branches over the previous few years. This
has resulted in extremely tremendous increase in deposit liabilities and in
turn, a rise in volumes of investment portfolios. Correct investment portfolio
management ensures effectiveness, liquidity and safety within the use of
resources among different objectives. At every decision purpose, the portfolio
manager has a list of investment opportunities at hand and may decide wherever
to require a foothold supported market conditions and additionally the
assessment of determinants (Morris
& Hough, 2010). Diversification
made it cheaper for establishments to win quality in their role as screeners or monitors of borrowers (Diamonds & Wortmann, 1986). On the other
hand, corporate finance theory suggests that corporation sought to focus so as
to get the best attainable pleasure from
management’s experience and to scale back the agency issues activities for
investors to diversify on their own. Therefore,
there was lack of empirical proof on the effects of diversification on banks
financial performance. Many banks mostly still focus on constant common
portfolios inside the markets.

In Nepal, the profitability rate,
operating expenses and dividend distribution rate among the shareholders has
been found different in the financial performance of various banks in different
period of time. None of the banks can earn smoothly without well-managed
portfolio of investment. The problem of the study will ultimately find out the
relation between investment portfolio and financial performance of various
banks. At present we have twenty-eight commercial banks (Class A). In spite of
rapid growth, some indicators show performance is not much encouraging towards
the service coverage. In such a situation, the study tries to analyze the
present performance of commercial banks.

Rationale of the Study

Commercial Bank Act,
2031 B.S. of Nepal has defined it as a commercial bank is one which exchanges
money, deposits money, accepts deposits, grants loans and performs commercial
banking functions and which is not a bank meant for co-operative agriculture, industries
or for such specific purpose. The Commercial Bank Act 2031 also pointed the
functions of commercial banks commercial banks provide short term debts
necessary for trade and commerce. They take deposits from the public and grants
loans in different forms. They purchase and discount bills of exchange,
promissory note, and exchange foreign currency. They discharge various
functions on behalf of their customers provided that they are paid for their

Research Questions

initial step that a researcher has to take while conducting a research is to
formulate the research questions. This will help to researcher to identify the
correct direction of carrying out the study as well as helps in selecting the
appropriate methodology for carrying out the study. On the basis of the
background of study and problem statement, the study focuses on getting the
answers to the under listed questions:

RQ1: Is there any significant
relationship between cash balance maintained by banks and their performance?

RQ2: How has loan and advances
impacted performance of Nepalese commercial banks?

RQ3: To what extent does investment
of banks effects their performance?

RQ4: Does provision for possible
loans influence the performance of Nepalese commercial banks?

Objectives of the

Undoubtedly, the role of the banks in
mobilizing and utilizing scare and scattered resources of nation is
praiseworthy one. The main objective of the study is to have true insight into
banking and non-banking investment aspects of banks and their impact on the
financial performance of the banks. The specific objectives of this study are
listed below:

To assess the
relationship between cash balance and performance of commercial banks.

To investigate the impact
of loan and advances on performance of commercial banks.

To examine the effects
of investment on performance of commercial banks.

To study the influence
of provision for possible loans on performance of commercial banks.

Conceptual Framework

conceptual framework refers to the design of analyzing those factors which may
impact the financial performance of the commercial banks. There are lot of
researches done where different factors have been identified which directly or
indirectly impacts the performance of the commercial banks. As
per the
hypotheses formulated based on the literature review of the study the dependent
and the independent variables of the research are presented below.

Independent Variables: Investments,
INV; Loan and Advances, LA; Cash Balance, CB; and Provision for Possible Loans,

Dependent Variable: Performance of
the Commercial Banks measured by Tobin’s Q, TQ.

On the basis of the factors
identified, the following conceptual framework has been developed:

Variables                                                 Dependent Variable

Investments (I)

Loans and Advances(LA)

Cash Balance (B)

of banks

Provision for possible
loans (P)










Figure 1: Conceptual Framework of the

Hypothesis and

on the review of Literature and the research objective the following Hypotheses
are proposed to be explored in the current research:

There is no significant relationship between cash balance and performance of

There is significant positive relationship between investments and performance
of banks.

There is significant positive relationship between loan and advances and performance
of banks.

There is significant positive relationship between provision for possible loans
and performance of banks.

Significance of the

research will be significant to the Nepalese commercial banks, their employers
and employees and other market participants as this study will provide them
with valuable information related to the banking and non-banking investments
that the banks perform along with their performance. The study will help the clients
of banks to have a clear vision of how banks invest in certain assets either
banking or non-banking and also, about the performance of the banks.

the study will help in understanding the impact of investments on financial
performance of banks in relation to the case of developing countries like Nepal
and contribute to the existing literature in this field. Specifically, the
study will contribute to assessing the impact of loan and advances on the performance
of banks as previous studies relating the relation of loan and advances are
relatively scarce.

Limitations of the

Each and every study has its own
limitations. We cannot write freely where we want. No study can be free from
constraints such as economic resources, number of objects for study, resources,
time etc. All the necessary data may not be available due to business secrecy.
This study too is no exception and is characterized by the following

The research is
limited to the study of 15 banks out of 28 banks.

The study is based on
secondary data.

This study has
analyzed and evaluated the data for the period of 10 years only.

In this study, only
selected financial and statistical tools and techniques are used.

1.10     Definition
of Terms

In this section, both dependent and interdependent
variables which has been considered for the study has been defined.

1.8.1 Tobin’s Q Tobin (1977) Tobin’s q is the ratio between a physical
asset’s market value and its replacement value. It was first introduced
by Nicholas Kaldor in 1966 in his article
“Marginal Productivity and the Macro-Economic Theories of Distribution:
Comment on Samuelson and Modigliani”.  It is calculated using the formula:

Tobin’s Q =

Investments Avram, et al., (2009) define the universal
investment as expenditure made now to make gains in future. A company has to
invest in order to develop and stay in the competitive market.

Loan and Advances Loan may be regarded as credit granted where the money is
disbursed and its recovery is made on a later date. It is provided for definite
purpose for which is interest is charged. Advance on the other hand is a credit
facility which is granted largely for short-term purposes.

Cash Balance Total amount of money in a financial account, calculated by
adding all deposits to the initial deposit and deducting all disbursements or
payments made. Net cash balance can be positive, if money is available; or
negative if the account has been overdrawn.

1.8.5 Provision for possible loans Loan loss provision is an expense set aside as an allowance
for uncollected loans and loan payments. This provision is used to cover a
number of factors associated with potential loan losses including bad loans,
customer defaults and renegotiated terms of a loan that incur lower than
previously estimated payments. Loan loss provisions are an adjustment to loan
loss reserves and can also be known as valuation allowances.

Organization of the
Research Chapters

thesis report has been divided into five chapter and their brief discussion is
projected below:

the first chapter, the introduction and background of the study has been
included along with the problem statement, significance of the study, research
objectives, scope, conceptual framework and hypothesis.

second chapter presents the review of relevant literatures along with the
findings of various scholars in their research.

The third chapter includes the research
design along with the population and sample of the study and the analytical
tools and techniques used in this study.

The forth chapter presents the findings
and discussions by analyzing the data collected. The practical use of tools and
techniques prescribed in chapter three will be seen in this chapter.

chapter five highlights the conclusion and recommendations of the study. The
practical and theoretical contributions emanating from the study are discussed
in this chapter.


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