A healthy financial sector is essential to facilitate sustainable economic growth. Theoretically, the channel by which financial development supports economic growth is via enhancing financial intermediation, for example, moving funds from savers to investors in a cost-effective manner which motivates individuals towards more efficient resource allocation decisions.[Greenwood and Jovanovic (1989), Levine and Zervos (1998)]. In the literature, there are four channels by which financial development affects economic growth: 



(1) by improving the screening of funds-seeking investors and their subsequent monitoring, and thereby channeling the allocation of resources for its most profitable investments;
(2) by encouraging the mobilization of savings by means of providing diverse instruments that match the differing preferences of savers;
(3) by lowering the transaction, screening, and monitoring costs through economies of scale; and
(4) by enhancing various options of risk and liquidity management.


Each of these four financial functions influences savings and investment decisions of economic agents and ultimately results in higher economic growth. 

Does this theoretically important relationship between the financial sector and economic growth hold true for Nepal? There is no clear cut answer. Recent publications by Bhetuwal (2007) and Poudel (2006) find that financial development (FD) contributes positively to domestic economic growth. On the other hand, Shrestha (2005) did not find any significant relationship between economic growth and FD. A recent study by Nepal Rastra Bank suggests that domestic economic growth is found to be somewhat supported by FD; but, the effect is noticeable with a one-year lag, but not at a contemporaneous level (NRB, 2009). 


In this context of mixed results, the appropriate development of Nepalese financial sector is essential so that it can play a critical and positive role in the economic growth of the nation. The goal of this paper is to provide both an overview of the developments in the domestic financial system and a recommendation for reaping the maximum benefit from domestic FD. In this regard, the paper assesses the Nepalese FD system, provides some observation and analysis leading to recommendations on the next steps to be taken by policy makers. The paper is structured into five sections. In the next section, stylized facts are provided on the Nepalese financial system. This will be followed by some performance measurements of the domestic financial system. The fourth section provides some discussion and observation highlighting three issues, which is followed by a recommendation for initiating the formulation of a Financial Sector Master Plan (FSMP) with the last section providing a summary and a concluding remark.