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INTRODUCTION TO FINANCIAL INSTITUTIONS AND CAPITAL MARKETS-The Five Parts of the Financial System

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

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INTRODUCTION TO FINANCIAL INSTITUTIONS AND CAPITAL MARKETS

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.

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RISK AND RISK MANAGEMENT IN BANKS

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 most common collateral is Treasury bills. Repos are usually made with institutional investors, such as investment and pension funds, who often have cash to invest.
The major security that banks sell is the large certificate of deposit (CD), which is highly negotiable, and can be easily sold in the money markets. Banks also sell small CDs to retail customers, but these can’t be sold in the financial markets. Other major securities sold by banks include commercial paper and bonds.
CREDIT RISK
Credit default risk occurs when a borrower cannot repay the loan. Eventually, usually after a period of 90 days of nonpayment, the loan is written off. Banks are required by law to maintain an account for loan loss reserves to cover these losses. Banks reduce credit risk by screening loan applicants, requiring collateral for a loan, credit risk
analysis, and by diversification.
Banks can substantially reduce their credit risk by lending to their customers, since they have much more information on them than on others, which helps to reduce adverse selection. Checking and savings accounts can reveal how well the customer handles money, their minimum income and monthly expenses, and the amount of their reserves to hold them over financially stressful times. Banks will also verify incomes and employment history, and get credit reports and credit scores from credit reporting agencies.
Collateral for a loan greatly reduces credit risk not only because the borrower has greater motivation to repay the loan, but also because the collateral can be sold to repay the debt in case of default. When banks make loans to others who are not customers, then the bank has to rely more on credit risk analysis to determine the credit risk of the loan applicant. Credit risk analysis is the determination of how much risk a potential borrower poses and what interest rate should be charged. The potential risk of a borrower is quantified into a credit rating that depends on information about the borrower and well as statistical models of the business or individual applicant. There are credit rating agencies e.g Moody’s, Standard & Poor etc. Most of these credit reporting agencies assign a number or other code that signifies the potential risk of the borrower.
A bank will also look at other information, such as the borrower’s income and history. A bank can also reduce credit risk by diversifying making loans to businesses in different industries or to borrowers in different locations.
However there are major challenges associated with credit risks namely reputational risks, Lack of ample liquidity and poor planning among others. When creditors are unable to pay their loans as they fall due the bank is forced to borrow to finance this position and also incur costs in forcing the customers to pay. This not only makes
business expensive but may also make the bank not to honor maturing obligations eventually straining the bank’s liquidity position. Credit risks can easily translate to huge non-performing loans.