September 2021

FINANCIAL MARKETS Financial markets A Financial Market is an institution or arrangement that facilitates the exchange of financial assets. They are mechanisms in our society for converting public savings into investments such as buildings, machinery, infrastructure and inventories of goods and raw materials. This enables the economy to grow, new jobs to be created and living standards to rise. Financial markets therefore perform the essential economic function of channelling funds from economic units which have surplus funds (net savers) to economic units with a net deficit of funds (investors). There are several basic methods of classifying financial markets as follows: 1. A classification of the markets based on the type of instrument or service as follows: i. Debt Markets ii. Equity Markets iii. Financial services Markets 2. A broad classification that distinguishes between i. Primary & ii. Secondary Markets 3. A classification of markets based on the term to maturity and liquidity of the instrument. This method categorizes financial markets into i. Money Markets & ii. Capital Markets 4. A classification of markets according to when the financial instruments being traded will be delivered. This classification categorizes markets into: i. Spot markets ii. Futures or forward markets iii. Option markets 5. A classification of markets into open and negotiated markets. i. Auction market ii. Bourse iii. Over-the-counter market 6. Financial markets can also be classified in terms of the extent of financial intermediation involved in the sale of the financial instruments as follows: i. Direct finance markets ii. Semi-direct finance markets iii. Indirect finance markets Money markets and Capital markets  Money Markets Money markets are financial markets that are used for the trading of short-term debt instruments, generally those with original maturity of less than one year. The money market is the place where individuals and institutions with temporary surpluses of funds meet the needs of borrowers who have temporary fund shortages. Thus, the money markets enable economic units to manage their liquidity positions. For example, a security or loan with a maturity period of less than one year is considered a money market instrument. One of the principle functions of the money market is to finance the working capital needs of corporations and to provide governments with short-term funds in lieu of tax collections. The money market also supplies funds for speculative buying of securities and commodities. Capital Markets The capital market is designed to finance long-term investments by businesses, governments and households. Capital market instruments are mainly longer term debt securities (generally those with original maturities of more than one year) and equities. Examples include bonds and shares traded on the stock exchange. 2.1.3 Money market and Capital market financial instruments A financial instrument is defined as, a claim against the income or wealth of a business firm, house hold or unit of government, normally represented by a certificate, receipt or other legal document, and which is usually created by the lending of money. Financial Assets are by therefore nature intangible assets e.g i. Treasury Bills ii. Bonds iii. Shares Financial assets have played the following roles: 1. Transfer funds from surplus units to deficit units to invest in intangible assets. 2. Transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds.

Existing financial sector regulatory framework in Kenya Existing financial sector regulatory framework in Kenya The existing regulatory framework for the financial sector in Kenya consists of a number of independent regulators each charged with the supervision of their particular sub sectors. The creation of the Insurance Regulatory Authority completed the shift from having departments under the Ministry of Finance to having independent regulators for each sub-sector. The current regulatory structure is characterized by regulatory gaps, regulatory overlaps, multiplicity of regulators, inconsistency of regulations and differences in operational standards. For example, some of the regulators have at least partial exemption from the State Corporations Act while others do not, some have tax exemption, and others do not. Some regulators have powers to issue regulations while in other cases the power is retained by the Minister for Finance. This regulatory framework is clearly captured by the figure below. Regulatory gaps Some of the existing cases of regulation gaps are: The Kenya Post Office Savings Bank (KPOSB) The Kenya Post Office Savings Bank (KPOSB) was incorporated in 1978 underthe KPOSB Act(Cap 493B). The mission of the bank is to sustainably provide savings and other financial services to customers, through a countrywide branch network, by use of modern technology in delivery of efficient and effective customer service, and to the satisfaction of all stakeholders. Section 8(1) KPOSB Act that provided for the Government guarantee over the deposits placed with the savings bank was repealed via the Finance Bill 2001. The repeal of the section implies that new avenues should be found for deposit  protection. It also implies that the bank should be adequately capitalized as a first step to protect deposits against possible losses. Companies Act (CAP 486) The Companies Act, which is a holdover of pre-colonial British Law, is creating problems for private sector activities in Kenya and indeed the financial services sector. This law currently in use, is complicated, cumbersome, inconsistent and at odd with modern enabling regulation of corporations. Another layer of complexity and compliance is added to an already burdensome structure leading to multiple disclosures requirements, overlap and expensive duplication. The regulation of companies is currently under the Registrar of Companies in the Office of the Attorney General but could be brought under the financial sector regulatory framework for more responsiveness to market dynamism. Development Finance Institutions (DFIs) DFIs have always provided the impetus for economic development be it in the developed or developing countries. In Kenya, DFIs were specifically established to spearhead the development process by: Availing credit funds to those venturing into commerce, tourism and industry. Assisting those wishing to venture into small-scale manufacturing enterprises. Assisting in the initiation and expansion of small, medium and largescale industrial and tourist undertakings. Provide long-term lending (Project financing) to sustain economic development Provide Technical Assistance/Co-operation extension services  Provision of special Financing and Support services to stimulate Private Sector to live up to its potential and create jobs and wealth, develop and expand indigenous skills The existing framework has potential for disharmony as they fall under different regulators. For example ICDC/KIE are under the Ministry of Trade and Industry, IDB is under the Central Bank of Kenya and AFC the Ministry of Agriculture.  

FINANCIAL SECTOR REGULATION IN KENYA The rationale for regulation Financial systems are prone to periods of instability. In recent years, a number of financial crises around the world (South-east Asia, Latin America and Russia, Global financial crisis) have brought about a large number of bank failures. Some argue that this suggests a case for more effective regulation and supervision. Others attribute many of these crises to the failure of regulation. Advocates of the so-called ‘free banking’ argue that the financial sector would work better without regulation, supervision and central banking. In the absence of government regulation, they argue, banks would have greater incentives to prevent failures. However, the financial services industry is a politically sensitive one and largely relies on public confidence. Because of the nature of their activities (illiquid assets and short term liabilities), banks are more prone to troubles than other firms. Further, because of the interconnectedness of banks, the failure of one institution can immediately affect others. This is known as bank contagion and may lead to bank runs. Banking systems are vulnerable to systemic risk, which is the risk that problems in one bank will spread through the whole sector. Bank runs occur when a large number of depositors, fearing that their bank is unsound and about to fail, try to withdraw their savings within a short period of time. A bank run starts when the public begins to suspect that a bank may become insolvent. This creates a problem because banks want to keep only a small fraction of deposits in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets. When a bank is faced with a sudden increase in withdrawals, it needs to increase its liquidity to meet depositors’ demands. Bank reserves may not be sufficient to cover the withdrawals and banks may be forced to sell their assets. Banks assets (loans) are highly illiquid in the absence of a secondary market and if banks have financial difficulties they may be forced to sell loans at a loss (known as ‘fire-sale’ prices in the United States) in order to obtain liquidity. However, excessive losses made on such loan sales can make the bank insolvent and bring about bank failure. Bank loans are highly illiquid because of information asymmetries: it is very difficult for a potential buyer to evaluate customer-specific information on the basis of which the loan was agreed. The very nature of banks’ contracts can turn an illiquidity problem (lack of short-term cash) into insolvency (where a bank is unable to meet its obligations or to put this differently when the value of its assets is less than its liabilities). Regulation is needed to ensure consumers’ confidence in the financial sector. According to Llewellyn (1999) the main reasons for financial sector regulation are: 1. To ensure systemic stability; 2. To provide smaller, retail clients with protection; and 3. To protect consumers against monopolistic exploitation. Systemic stability is one of the main reasons for regulation, as the social costs of bank failure are greater than the private costs. The second concern is with consumer protection. In financial markets ‘caveat emptor’ (‘Let the buyer beware’) is not considered adequate, as financial contracts are often complex and opaque. The costs of acquiring information are high, particularly for small, retail customers. Consumer protection is a particularly sensitive issue if customers face the loss of their lifetime savings. Finally, regulation serves the purpose of protecting consumers against the abuse of monopoly power in product pricing. The most common objectives of financial sector regulation are: 1. Prudential: To reduce the level of risk bank creditors are exposed to (i.e. to protect depositors) 2. Systemic risk reduction: to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures 3. Avoid misuse of banks: to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime 4. To protect banking confidentiality 5. Credit allocation: to direct credit to favored sectors

FINANCIAL INSTITUTIONS AND CAPITAL MARTKETS Pensions Sub sector a) Pension: Money paid regularly to retired employees or their survivors by private businesses, federal state and local governments. They are paid inform of a guaranteed annuity to a retired or disabled employee. b) Pension schemes These are funds set up by co-operations e.g.(NSSF), labour unions, Government entity or other organization to pay the pension benefits to the retired workers. They are generally classified into two, Benefits plans and Contributions plans i) Benefits plans This scheme provides a set amount of benefits to a pensioner. The employer in this plan tends to offer large pensions to higher paid employees and also assumes that the risk associated with pension funds will not be available. Employees assume little risks because most funds are insured by the federal government to a certain limit. ii) Contributions plans Employer contributes a certain amount of money in employees name into the pension fund and makes no promises concerning the level of pension benefit that the employees will receive upon retirement. Employers contribute an amount to the fund based on the employee’s salary and as a result, higher paid employees receive higher pensions than lower paid ones. c) Retirement benefit authority (RBA) In Kenya Pension schemes are regulated by retirement benefit Authority (RBA) Objectives of RBA 1. Regulate and supervise the establishment of retirement benefit schemes. 2. Protect the investors of retirement benefit schemes. 3. Promote the development of the sector. 4. Advice the motion of finance on the national policies to be followed with regard to the retirement benefit and implement all government policies related there to d) Components of pension schemes in Kenya The pensions sub sector in Kenya consists of the following components: a) The Public Service Pension Schemes, which cover Civil Servants, Teachers, members of the Disciplined Forces, Armed Forces, the Judiciary, the National Assembly and the President, are administered by the Pensions Department of the Ministry of Finance and paid from the Consolidated Funds (CFS). b) The National Social Security Fund (NSSF) is a provident fund established in 1965 through an Act of Parliament. Its membership is mainly drawn from private sector companies, parastatals and public employees who are not under the civil service pension scheme. There are an estimated 1.1 million workers contributing to the NSSF. The required rate of contribution is capped at 10% of the wages, which is divided equally between the employer and the employee and capped at Kshs 400 per month. c) Occupational retirement benefits schemes are tax-advantaged schemes created voluntarily by employers to cater for retirement benefits for their workers. These schemes have varying contribution rates and by law are required to have an independent board of trustees, including member representatives, and independent fund managers and custodians. d) Individual retirement benefits schemes are tax-advantaged schemes created by financial institutions and whose membership is open to members

FINANCIAL INSTITUTIONS AND CAPITAL MARTKETS Stock Market (S.E) A stock exchange can be defined as the organized capital markets for securities which may be in form of shares, bonds, debentures, etc which are bought and sold through brokers who act as intermediary between the buyers and sellers of securities. Nairobi stock market came into existence as a result of Company’s Act 1948 (Cap 486) which introduced the idea of public limited companies selling their shares. The N.S.E has two subsidiary markets namely primary and secondary markets. Currently it has three markets segments (main investment markets segment, alternative investment segment, fixed income security segment) The role of Stock Exchange in economic development 1. It provides a ready capital market in which buyers and sellers of securities conclude their deals and make investment liquid. 2. The stock market through market forces of demand and supply determine price of different securities. 3. The stock market is a barometer of the economy. The stock exchange shares prices move with the general trend in the economy, mostly they follow the economic cycle. 4. They improve corporate governance. The stock market improves management standards and efficiency in order to satisfy the demand of shareholders. 5. The stock market provides a medium through which the government can absorb excess liquidity in the economy by issuing securities at favourable interest rates and hence reduce inflation. 6. The government can raise capital for development project. 7. The government and local authorities may decide to borrow money in order to finance projects such as roads construction or housing., these projects are usually funded by bonds. 8. When the government or local authority issues bonds, it may reduce the need to tax people in order to finance development. 9. The stock market index is an important indicator of economic performance. 10. Stock market is used to mobilize saving for investment i.e stock exchange is important in any economy because it acts as channel through which savings are invested to reduce income inequalities. 1.13.2 Reasons why many firms are not quoted in stock exchange market 1. Most companies operating in Kenya are owned by families who value their control such cannot go public as this dilutes their ownership. 2. Going public entails a lot of secrecy to the public because such companies are required to publish annual financial statements and also allow shareholders to inspect statutory books, list of shareholder, list of directors, creditors etc. 3. Going public is expensive as means of raising finance because of floating cost. Which include under writing, advertising, brokers commissions, legal fee for receiving banks etc 4. Some companies in Kenya are subsidiaries of multinational whose parent companies are quoted in other stock markets. 5. Going public entails a lot of formalities on the part of companies concerned. These formalities include the a. Capital market formalities b. preparing a prospector c. Arranging & paying auditors d. Compiling the companies five years audited Profit & loss accounts 6. Some firms avoid stock market because of the rigid rules and regulations 7. A highly profitable company may want to retain profits for expansion while public as shareholders may demand dividends. 8. Most companies in Kenya do not maintain proper book of accounts and as such cannot convince the public to buy their shares if their performance is questionable.

FINANCIAL INSTITUTIONS AND CAPITAL MARTKETS Microfinance sub-sector Microfinance entails the provision of financial services to low income people and enterprises. This underscores the crucial role of microfinance in empowering the Underprivileged social constituencies, and particularly women, to contribute more effectively to economic development and poverty reduction in Kenya. The Microfinance industry in Kenya has experienced major transformations over the past twenty years, growing from a fledgling concern dominated by a few donor and church-based NGOs to a vibrant industry increasingly driven by commercial sustainability. Generally, the providers of microfinance services in Kenya can be clustered into three broad categories, notably, formal, semi formal and informal institutions – with the level of formality defined by degree of regulation. Under the formal category are commercial banks and the Post Office Savings Bank. The semiformal category includes SACCO and Microfinance institutions, while ASCAS and ROSCAs dominate the informal category.  Savings and Credit Cooperative Societies (SACCOS) SACCOs form part of the semi-formal category of financial services sector in Kenya which also comprises microfinance institutions, while ROSCAs dominate the informal category. Kenya has an estimated 4,900 active SACCOs (compared with 43 commercial banks) offering savings and credit services to over 2.1 million Kenyans. SACCOs have an increasingly important rural outreach. This began to develop from 1997 when the banking sector had serious financial problems (and in some cases due to bank strategies favouring branch rationalization) that forced the closure of many rural bank branches leaving many people without any financial services. SACCOs stepped in and opened their own branches in some of these same rural areas. According to the CBK Annual Report (2004 – 2005), there are now approximately 155 SACCOs in these rural areas. Development Financial Institutions (DFIS) The Development Finance Institutions (DFI’s) were set up by the Government soon after independence to help in employment creation and to indigenize businesses. The traditional mandates of these institutions have been to help fill gaps in financing not catered for by private banks and other financial institutions and especially in the rural areas either because of Banking Act requirements, restrictions imposed by the Central Bank guidelines or because of the perceived commercial risks involved. Examples include development and seasonal loans for agriculture, small industrial investments and small businesses. Currently Kenya has five DFIs namely Agricultural Finance Cooperation Industrial and Commercial Development Cooperation Industrial Development Bank Kenya Tea Development Cooperation Kenya Industrial Estate  Insurance Sub-sector Insurance companies are financial intermediaries that collect regular relatively small payments called insurance premiums from many policy holders who actually suffer irregular losses against which they are insured e.g. death, accident, fire, theft etc Roles of Insurance Company i) Provide cover for most risks thus enabling business to undertake various ventures which could otherwise be impossible. ii) Accumulate large sums of money from premiums and this acts as long-term sources of finance both to the policy holders and other parties such as company seeking shares and debentures to insurance companies. iii) They provide technical services such as risk management service by identifying degree of risk associated with a given investment. This enables businesses to avoid high risk ventures and possible losses in capital. iv) Insurance companies insure high risk ventures and this act as a debentures to investment in high risk areas which in turn reduces the incidences of failure of businesses. v) They also provide underwriting facilitate for newly issued shares acting as a source of finances from the companies gone public. vi) They encourage savings by providing a number of polices which creates an atmosphere of good saving habits. vii) Some insurance companies provide education policies which ensure education to children in their later stages. The Kenya Insurance market consists of 44 insurance companies comprising of seven (7) Long term, twenty (20) General and seventeen (17) Composite insurers. There are two reinsurance companies. The Industry is supported by various insurance intermediaries which comprises of two hundred (200) insurance brokers, (21) medical insurance providers, and (2665) insurance agents. The other service providers in the market comprise of (213) Loss Assessors, (30) insurance surveyors, (23) loss adjusters, (1) claims settlement agent and (8) risk managers. Capital Markets Sub-sector The Capital Markets Authority (CMA) was established in 1989 through an Act of Parliament to promote, regulate and facilitate the development of an orderly, fair and efficient Capital Markets in Kenya. The capital market is part of the financial system that provides funds for long-term development. This is a market that brings together lenders (investors) of capital and borrowers (companies that sell securities to the public) of capital. The main objectives of the CMA are to: 1. Develop all aspects of the capital markets with particular emphasis on the removal of impediments to longer-term investments in productive activities. 2. Facilitate the existence of a nationwide system of stock market and brokerage services to enable wider participation of the public in stock market; 3. Create, maintain and regulate a market in which securities can be issued and traded in an orderly, fair, and efficient manner, through the implementation of a system in which the market participants regulate themselves to the maximum practicable extent 4. Protect investor interest 5. Operate a compensation fund to protect investors from financial loss arising from the failure of a licensed broker or dealer to meet his contractual obligations 6. Develop a framework to facilitate the use of electronic commerce for the development of capital markets in Kenya.

FINANCIAL INSTITUTIONS AND CAPITAL MARTKETS Banking Services through Subsidiaries a) Investment Management Services For many commercial banks, investment management is a major revenue producer. Although they are prohibited from making certain investments in corporate securities for their own accounts, banks manage billions worth of securities for wealthy individuals, corporate clients, and various kinds of retirement asset funds through their trust and investment departments or subsidiaries. They also manage assets for corporate and/or pension funds; various types of mutual funds, including money market mutual funds; and other investment companies. In each case, commercial banks exploit their investment skills and knowledge of the securities markets. b)Advisory Services Because of their expertise in financial markets and their relationships to depositors and borrowers, banks are also well situated to offer other advisory services. These advisory services include: 1) Economic analysis, 2) Investment and financial advising, 3) Asset valuation services, and 4) Bankruptcy-workout counselling. c) Brokerage Services Several bank holding companies have begun to offer securities brokerage services, including discount brokerage. Although these services are officially offered through a separate subsidiary of the bank holding company, the services may be provided within the confines of the commercial bank offices, and the separation of a commercial banking subsidiary from a stock brokerage subsidiary is not particularly apparent to the bank customer. Another area in which banks act as brokers is insurance. Credit insurance, which is often used to insure repayment of loans, is offered directly by banks. Other kinds of insurance may be offered through banks under certain restricted conditions. d) Underwriting Currently, all banking institutions are able to underwrite general obligation bonds and debentures. Some banks are major players in these markets, where they may have an advantage over investment banks when it comes to underwriting state and local bond issues. The political ties and geographical proximity that commercial banks have to the issuer are not irrelevant considerations. However, more recently, several institutions have been able to directly compete in the market for both corporate debt and equity. Over time, the corporate parent of the commercial bank, the so-called bank holding company, has been allowed to establish a separate subsidiary to engage in securities market activity. 1.7 Economic functions The economic functions of banks include: 1. Issue of money, in the form of banknotes and current accounts subject to cheque or payment at the customer’s order. These claims on banks can act as money because they are negotiable and/or repayable on demand, and hence valued at par. They are effectively transferable by mere delivery, in the case of banknotes, or by drawing a cheque that the payee may bank or cash. 2. Netting and settlement of payments – banks act as both collection and paying agents for customers, participating in inter-bank clearing and settlement systems to collect, present, be presented with, and pay payment instruments. This enables banks to economise on reserves held for settlement of payments, since inward and outward payments offset each other. It also enables the offsetting of payment flows between geographical areas, reducing the cost of settlement between them. 3. Credit intermediation – banks borrow and lend back-to-back on their own account as middle men 4. Credit quality improvement – banks lend money to ordinary commercial and personal borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes from diversification of the bank’s assets and capital which provides a buffer to absorb losses without defaulting on its obligations. However, banknotes and deposits are generally unsecured; if the bank gets into difficulty and pledges assets as security, to rise the funding it needs to continue to operate, this puts the note holders and depositors in an economically subordinated position 5. Maturity transformation – banks borrow more on demand debt and short term debt, but provide more long term loans. In other words, they borrow short and lend long. With a stronger credit quality than most other borrowers, banks can do this by aggregating issues (e.g. accepting deposits and issuing banknotes) and redemptions (e.g. withdrawals and redemptions of banknotes), maintaining reserves of cash, investing in marketable securities that can be readily converted to cash if needed, and raising replacement funding as needed from various sources (e.g. wholesale cash markets and securities markets).

 FINANCIAL INSTITUTIONS AND CAPITAL MARKETS Investment banking Investment bank is a banking institution that performs various functions not limited to the following: advising, administration, underwriting, and distribution. These services are performed as part of the basic investment banking business and are central to any firm. A detailed description of these functions is clearly outlined below. a) Advising Function In advising a corporate or government client, an investment bank will first assist its customer in making an assessment of its funding needs. Then, the investment bank will acquaint the client with the respective costs and benefits of various alternatives for raising funds. They will provide advice regarding current market conditions and the timing of any one option that may emerge as most advantageous. The process should lead to the investment bank suggesting a funding mechanism and structure that it feels will best fit the client’s needs. It may, at this point, also recommend a team of institutions that could assemble the package that would address the funding needs. b) Administrative Function Once a financial strategy has been adopted, the investment bank can perform a vital administrative function. This service involves a myriad of details associated with a new issue, such as recordkeeping, title transfer, and tax and regulatory filing on behalf of the issuing firm. Because financial covenants and regulatory structures of the securities business are routine considerations for the investment bank but obscure issues for the general business community, the investment bank can provide valuable administrative services. It aids its client in traversing waters that, to the client, are uncharted. For this service a fee is paid, while these fees may seem high, they are typically far cheaper than the disaster that could result if the client attempts to traverse the regulatory morass and financial market place on its own. Among the administrative functions that an investment bank can render is assistance in the completion of the legal documents, including the creation of a prospectus associated with any new issue. Indeed, the investment bank shares responsibility with the issuer for ensuring that everything is done in compliance with relevant securities laws. Intimate knowledge of both law and procedures is critical. The client expects its underwriter to know the in and out  of the administrative procedures associated with any offer. Certain small issues and private placements are generally exempted from registration. This is all part and parcel of the knowledge of law and process that clients expect their investment bank to employ in providing this administrative function. c) Underwriting Function The underwriting function is provided by an investment bank when it agrees to bring an issue to the market on behalf of its client. When an investment bank guarantees a fixed price to the security issuer in exchange for its securities, it is said to have “underwritten” the security offering. The underwriter is at risk if it sets the guarantee too high because it may be unable to resell the securities at a price sufficient to cover the guarantee, however, if it sets too low a guarantee, it may lose the underwriting business to a competitor. Thus, proper valuation of a security is extremely important to an underwriter. One way for the investment bank to reduce the underwriting risk is to delay, as long as possible, the price-fixing date. This allows the syndicate time to test the market for the new shares and line up purchasers at the proposed price. However, the client may not be happy with such a delay. Nonetheless most underwriters will try to wait and set the guaranteed price at the end of the registration period, which could be as little as a day or two before the actual security flotation takes place. By choosing a pricing date close to the flotation date, the underwriter has more up-to-date information on which to base a guarantee price, and it has some knowledge of the demand for the issue. While overpricing an issue can be disastrous to profitability, underpricing a security can also have bad consequences for the underwriter, even if it wins the bid to serve as the underwriter. A reputation for under-pricing a security, as evidenced by a repeated pattern of securities’ prices climbing rapidly after the commencement of the offerings, can lead prospective corporate issuers to seek alternative investment banking firms. Obviously, it is in the corporation’s interest to obtain as much cash from its securities offerings as possible while still maintaining the goodwill of its investors. The investment bank makes its profit by selling the new securities at a price higher than the net price that is guaranteed to the issuing firm. It is widely considered that a successful pricing and offering results in a rapid sale of securities, within a day or two after the offering begins, and involves a modest appreciation of the securities’ prices in the weeks immediately following the offering. This modest appreciation pleases the investors in the company and fosters goodwill. Many securities are not brought to the market in this manner. These securities are not formally purchased by the investment banker; instead they are merely distributed through either a best-efforts-basis public offering or through a private placement to a select group of investors. In these cases, the investment bank does not incur the risks of an underwriter, and it is compensated through fees for bringing buyer and seller together. This fee is lower than that associated with a price guarantee, at least on a risk adjusted basis. For some firms, only a best-efforts underwriting is possible because of the high risk or limited market recognition of the institution seeking financing. For others, private placement is a cleaner alternative and one that is easily accomplished by an investment banker with good contacts.

INTRODUCTION TO FINANCIAL INSTITUTIONS AND CAPITAL MARKETS The Five Parts of the Financial System 1. Money: Anything generally accepted as a means of payment or medium of exchange. It’s useful because you can exchange goods or services with it, either now or later (non-perishable, store of wealth. Contrast with, say, fish). 2. Financial Instruments: A written legal obligations of one party to transfer something of value to another party at some future date under certain conditions. These obligations usually transfer resources from savers to investors. Examples: Stocks, bonds, insurance policies. 3. Financial Markets: Places or networks where financial instruments are sold quickly and cheaply Examples: New York Stock Exchange, Chicago Board of Trade and Nairobi Stock exchange. 4. Financial Institutions: Firms that provide savers and borrowers with access to financial instruments and financial markets. Among other services, they allow individuals to earn a decent return on their money while at the same time avoiding risk. Exs.: banks, insurance companies, mutual funds, brokerage houses 5. Regulators: Government entity which monitors the state of the economy and conducts monetary policy. Example: central Bank of Kenya. 1.3 Flow of funds in a Financial system;- Financial system ensure flow of funds through two mechanisms;- i) Direct finance ii) Indirect finance Direct finance: – Borrowers borrow directly from lenders in financial markets by selling to them securities (financial instruments) shares, bonds, debentures Financial markets are critical for producing an efficient allocation of capital which contribute to higher production Indirect finance: – Ensures movement of funds from lenders to borrows through financial intermediaries. Financial intermediaries These are Financial institution (such as a bank, credit union, finance company, insurance company, stock exchange, brokerage company) which acts as the ‘middleman’ between those who want to lend and those who want to borrow. Importance of financial intermediaries  Reduction of transaction cost They reduce transaction cost by taking advantage of economies of scale and expertise’s (skills in financial management). They ensure flow of funds from borrows to lenders at low cost. They provide customers with services hence making it easier for customers to conduct transaction i.e. commercial bank facilities transactions in any given economy Risk sharing Uncertainly due to variation in the returns of investment Financial intermediary through a process known as risk sharing ensure return in investment and also ensure diversification of portfolio. The process of risk sharing ensures that there is low risk on investors’ assets. This process of risk sharing is sometimes known as assets transformation. This is because risky assets are transformed into safer assets for investors. Information Asymmetry Financial intermediaries in any given economy ensures that investors have information that enables them to make accurate decisions, however there can be cases of individuals and firm having more information than other. This is known as information asymmetry Lack of adequate information created by information asymmetry causes two problems in financial systems  Adverse selection Problem created by asymmetric information before a transaction occurs, which makes potential borrows not to pay back the loan hence increasing credit risk. This makes lenders avoid lending even to credit worth customers. Adverse selection makes the financial market to be inefficient 2 Moral hazard It’s the problem created by information asymmetry after the transaction has occurred. Moral hazard in financial market is the risk that the borrower may engage in activities in order to avoid paying back the loan i.e. selling the collateral. 1.4 The Financial System in Kenya The financial sector in Kenya comprises Banking, Insurance, Capital Markets and Pension Funds. It also constitutes of the Quasi-Banking sub sector which is composed of Savings and Credit Cooperative Societies (SACCOs), Microfinance institutions (MFIs), Building Societies, Development Finance Institutions (DFIs) and informal financial services such as Rotating Savings and Credit Associations (ROSCAs). The banking sector comprises of both commercial and investment banks. These two institutions play a major role in payment services and investment. Definitions as per the banking act Bank is a company which carries on, or proposes to carry on, banking business in Kenya and includes the Co-operative Bank of Kenya Limited but does not include the Central Bank Financial business means: (a) The accepting from members of the public of money on deposit repayable on demand or at the expiry of a fixed period or after notice; and (b) The employing of money held on deposit or any part of the money, by lending, investment or in any other manner for the account and at the risk of the person so employing the money; c) Financial institution means: A company, other than a bank, which carries On, or proposes to carry on, financial business and includes any other company which the Minister may, by notice in the Gazette, declare to be a financial institution for the purposes of this act. d) Institution means A bank or a financial institution or a mortgage finance company

INTRODUCTION TO FINANCIAL INSTITUTIONS AND CAPITAL MARKETS Introduction The economic development of any country depends, upon the existence of a well organized financial system. It is the financial system which supplies the necessary financial inputs for the production of goods and services which in turn promote the well being and standard of living, of the people of a country. Thus, the ‘financial system’ is a broader term which brings under its fold the financial markets and the financial institutions which support the system. The major assets traded in the financial system are money and monetary assets. The responsibility of the financial system is to mobilize the savings in the form of money and monetary assets and invest them to productive ventures. An efficient functioning financial system facilitates the free flow of funds to more productive activities and promotes investment. Thus, the financial system provides the intermediation between savers and, investors and promotes faster economic development. 1. Financial System a) Finance Finance is a branch of economics concerned with resource allocation as well as management, acquisition and investment. b) System A group of interacting, interrelated, or interdependent elements forming a complex whole. c) Financial system A financial system comprises financial institutions, financial markets, financial instruments, rules, conventions, and norms that facilitate the flow of funds and other financial services within and outside the national economy. It can be described as a whole system of all institutions, individuals, markets and regulatory authorities that exist and interact in a given economy. The institutions, government and individuals form the participants in various markets; money markets (including foreign exchange) and capital markets (including security) markets. The participant buy (borrow) and sell (lend) money to different parties at a price (interest or dividend) within the market, which is determined by the forces of demand and supply. Financial systems are crucial to the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow inter-temporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks. Since these functions take place in a market oriented environment, there is a need for an independent party to enforce rules and contracts and this is the regulator. The main regulatory authorities of the financial institutions that constitute the financial system of a given economy are the Central Bank and Capital Market Authority. 1.1 The role of financial system in the economy The financial sector provides six major functions that are crucial for the survival and efficient operation of any given economy. These functions are outlined below: 1. Providing payment services. It is inconvenient, inefficient, and risky to carry around enough cash to pay for purchased goods and services. Financial institutions provide an efficient alternative. The most obvious examples are personal and commercial checking and check-clearing and credit and debit card services; each are growing in importance, in the modern sectors at least, of even low-income countries. 2. Matching savers and investors. Although many people save, such as for retirement, and many have investment projects, such as building a factory or expanding the inventory carried by a family micro enterprise, it would be only by the wildest of coincidences that each investor saved exactly as much as needed to finance a given project. Therefore, it is important that savers and investors somehow meet and agree on terms for loans or other forms of finance. This can occur without financial institutions; even in highly developed markets, many new entrepreneurs obtain a significant fraction of their initial funds from family and friends. However, the presence of banks, and later venture capitalists or stock markets, can greatly facilitate matching in an efficient manner. Small savers simply deposit their savings and let the bank decide where to invest them. 3. Generating and distributing information. One of the most important functions of the financial system is to generate and distribute information. Stock and bond prices in the daily newspapers of developing countries are a familiar example; these prices represent the average judgment of thousands, if not millions, of investors, based on the information they have available about these and all other investments. Banks also collect information about the firms that borrow from them; the resulting information is one of the most important components of the capital of a bank although it is often unrecognized as such. In these regards, it has been said that financial markets represent the brain of the economic system. 4. Allocating credit efficiently. Channeling investment funds to uses yielding the highest rate of return allows increases in specialization and the division of labor, which have been recognized since the time of Adam Smith as a key to the wealth of nations. 5. Pricing, pooling, and trading risks. Insurance markets provide protection against risk, but so does the diversification possible in stock markets or in banks’ loan syndications. 6. Increasing asset liquidity. Some investments are very long-lived; in some cases – a hydroelectric plant, for example- such investments may last a century or more. Sooner or later, investors in such plants are likely to want to sell them. In some cases, it can be quite difficult to find a buyer at the time one wishes to sell – at retirement, for instance. Financial development increases liquidity by making it easier to sell, for example, on the stock market or to a syndicate of banks or insurance companies.

RISK AND RISK MANAGEMENT IN BANKS Introduction The increasing demand for risk management on the part of organizations, businesses and government authorities has been identified as a general societal trend emphasizing public accountability and responsibility. A bank has many risks that must be managed carefully, because it uses a large amount of leverage. Without effective management of its risks, it could very easily become insolvent. If a bank is perceived to be in a financially weak position, depositors will withdraw their funds, other banks won’t lend to it nor will the bank be able to sell debt securities in the financial markets, which will exacerbate the bank’s financial condition even more. The fear of bank failure was one of the major causes of the 2007 – 2009 credit crises and of other financial panics in the past. Although banks share many of the same risks as other businesses, the major risks that especially affect banks are liquidity risk, interest rate risks, credit default risks, and trading risks. The risks also face some major challenges.  LIQUIDITY RISK Liquidity is the ability to pay, whether it is to pay a bill, to give a depositor their money, or to lend money as part of a credit line. Liquidity risk arises when revenues and outlays are not synchronized, (Holmstrom and Tirole, 1998). A basic expectation of any bank is to provide funds on demand, such as when a depositor withdraws money from a savings account, or a business presents a cheque for payment, or borrowers may want to draw on their credit lines. Another need for liquidity is simply to pay bills as they come due. The main problem in liquidity management for a bank is that, while bills are mostly predictable, both in timing and amount, customer demands for funds are highly unpredictable, especially demand deposits. Another major liquidity risk is off-balance sheet risks, such as loan commitments, letters of credit, and derivatives. A loan commitment is a line of credit that a bank provides on demand. Letters of credit include commercial letters of credit, where the bank guarantees that an importer will pay the exporter for imports and a standby letter of credit which guarantees that an issuer of commercial paper or bonds will pay back the principal. Derivatives are a significant off-balance sheet risk, as evidenced by the collapse of American International Group (AIG) in 2008. Banks participate in 2 major types of derivatives: interest rate swaps and credit default swaps. Interest rate swaps are agreements where one party exchanges fixed interest rate payments for floating rates. Credit default swaps (CDSs) are agreements where one party guarantees the principal payment of a bond to the bondholder. It is therefore important to minimize liquidity risks by Liquidity management. This is achieved by asset and liability management. Asset management requires keeping cash and keeping liquid assets that can be sold quickly at little cost. Challenges posed by liquidity risks Without maintaining a constant pulse on their liquidity position, banks can quickly face serious reputational damage or, worse, insolvency. Liquidity for a bank means the ability to meet its financial obligations as they come due. Thus one of the main challenges to a bank is ensuring its own liquidity under all reasonable conditions. If there is any doubt about its credit, lenders can easily switch to another bank. The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of trouble. If there is serious doubt, it will be unable to borrow at any rate, and will go under. In recent years, large banks have been making increasing use of asset management in order to enhance liquidity, holding a larger part of their assets as securities as well as securitizing their loans to recycle borrowed funds. Solutions to Liquidity Risk: Asset & Liability Management Asset management requires keeping cash and keeping liquid assets that can be sold quickly at little cost. The primary key to using asset management to provide liquidity is to keep both cash and liquid assets. Liquid assets can be sold quickly for what they are worth minus a transaction cost or bid/ask spread. Hence, liquid assets can be converted into a means of payment for little cost. The primary liquidity solution for banks is to have reserves, which are also required by law. Reserves are the amount of money held either as vault cash or as cash held in the bank’s account at the Central/Reserve Bank. In Kenya, the Central Bank determines the amount of required reserves. A bank may ev en keep excess reserves at the CBK account for greater liquidity although they are non-interest bearing (the Federal Reserve started paying interest on these accounts from October, 2008) The most liquid and safest assets are government securities of which banks are major buyers in Kenya. Banks can also sell loans, especially those that are regularly securitized, such as mortgages, credit card. A bank can also increase liquidity by not renewing loans. Many loans are short-term loans that are constantly renewed, such as when a bank buys commercial paper from a business. By not renewing the loan, the bank receives the principal. However, most banks do not want to use this method because most short-term borrowers are business customers, and not renewing a loan could alienate the customer, prompting them to take their business elsewhere. A bank can increase liquidity by borrowing, either by taking out a loan or by issuing securities. Banks predominantly borrow from each other in the interbank market, where banks with excess reserves loan to banks with insufficient reserves. Banks can also borrow directly from the Central Bank, but they only do so as a last resort. Banks are big users of a debt instrument known as a repurchase agreement (REPO), which is a short-term collateralized loan where the borrower exchanges collateral for the loan with the intent of reversing the transaction at a specified time, along with the payment of interest. Most repos are overnight loans, and the

Prudential and conduct of business regulation Prudential regulation is mainly concerned with consumer protection. It relates to the monitoring and supervision of financial institutions, with particular attention paid to asset quality and capital adequacy. The case for prudential regulation is that consumers are not in a position to judge the safety and soundness of financial institutions due to imperfect consumer information and agency problems associated with the nature of the intermediation business. Conduct of business regulation focuses on how banks and other financial institutions conduct their business. This kind of regulation relates to the information disclosure, fair business practices, competence, honesty and integrity of financial institutions and their employees. Overall, it focuses on establishing rules and guidelines to reduce the likelihood that: Consumers receive bad advice (possible agency problem); Supplying institutions become insolvent before contracts mature; Contracts turn out to be different from what the customer was anticipating; Fraud and misrepresentation takes place; Employees of financial intermediaries and financial advisors act incompetently. Licensing Edwin G. West (1997), freedom of entry is the most important condition of competition. Competition brings with it market discipline. However in most countries entry into the financial sector requires specific authority from a licensing authority. The power to grant licenses or similar entry authorizations provides the possibility of exercising preventive action against the entry of institutions whose presence might be prejudicial to the interests of depositors and the soundness of the system. Specific entry requirements are designed to strengthen the authorities control on the soundness of institutions allowed to conduct banking business, this could have an indirect impact on the structure of banking sector by limiting the scope of market entry. From a regulatory viewpoint, licensing aids the adoption of the principle that a bank must be effectively managed by at least two persons of proven expertise, competence and trustworthiness. The rationale behind the adoption of this principle (the four eyes principle) is to ensure a certain depth of management and to provide for better internal control on compliance with banking laws and regulations’. In essence whereas licensing increases transaction costs, it also serves to cushion the entire economy against entry of investors whose integrity is questionable. There is a moral for licensing because deposits can be misappropriated easily; runs in one bank affects other banks and the economy. Besides since deposits are insured by government agencies there is need to keep off undesirable owners. Reserve requirements Reserve requirements force banks to hold a portion of their assets in a liquid form easily mobilised to meet sudden deposit outflows. Bernanke (1983) indicates that the bank runs of 1930-1933 in US led to large withdrawals of deposits, precautionary increases in reserve deposit ratios and an increased desire by banks for liquid or rediscount able assets. These factors plus the actual failures forced a contraction of the banking system’s role in the intermediation of credit’. Banks are in intermediation service and high reserves can harm the process. Diamond et al (1986) argue that 100% reserve requirement would restrict banks from transformation services. The effect of this would divide the bank into two. The proposal would then effectively pass the problem of runs and instability to the successors in the intermediary business. The policy would reduce the overall amount of liquidity. Reserve requirements are a back up to deposits. In case of a bank run, a bank experiencing temporary liquidity problem could use the reserves to solve the shock. Besides if the regulatory authority discovered that the bank was fatally illiquid then the reserves could be used to pay off depositors before DI is used. Capital requirements Bank capital is the equity that the bank shareholders acquire when they buy the banks stocks and since it equals the portion of the banks assets that is not owed to depositors it gives the bank an extra margin of safety in case some of its other assets go bad. Bank regulators set minimum required level of bank capital to reduce system’s vulnerability to failure.