September 29, 2021

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).