INTRODUCTION TO FINANCIAL INSTITUTIONS AND CAPITAL MARKETS

Introduction

The economic development of any country depends, upon the existence of a well organised 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 mobilise 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

Finance
Finance is a branch of economics concerned with resource allocation as well as management, acquisition and investment.

System
A group of interacting, interrelated, or interdependent elements forming a complex whole.

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. Itcan 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.
Channelling investment funds to uses yielding the highest rate of return allows increases in specialization and the division of labour, 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.

1.2 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;-

1. Direct finance

2. 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.

1.3.1 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.

1.3.2 Importance of financial intermediaries

1. 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

2. 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.

3. 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

1. 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.

1.4.1 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:

• 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
• 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;

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.

Institution means
A bank or a financial institution or a mortgage finance company

1.4.2 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.

1. 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.

2.  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.

3. 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.

4. Distribution Function
The distribution function involves the placement of newly issued securities into the hands of investors. This is an essential part of the underwriting process, and it distinguishes some investment bankers from other members of the financial community who do not have the ability to access large pools of funds for their clients. The distribution function represents the essential value of the underwriting function to the corporate client, as it places the firm’s securities into the hands of final investors.

A good investment bank is able to quickly reduce its risk through the way it structures its distribution network for the new issue.
There are two groups that the underwriter depends upon to accomplish this risk reduction during the crucial, albeit short, period of price vulnerability.

First, through the formation of an underwriting syndicate, the lead underwriter is able to share in the price risk of the issue. Each member of the syndicate absorbs a share of the risk that the ultimate selling price will be inadequate to cover its portion of the costs of the guarantee. Syndicate members are also expected to bear the risk associated with the price stabilization function. It is common for underwriters to agree to stabilize the price of a newly issued security for up to a month or more beyond the issue date. If the market price begins to sink below some predetermined level, the underwriters will step in and buy shares. This serves to stabilize prices, or at
least ensure that they stay above some threshold level deemed acceptable. The risk arises if, after the period of stabilization, the underwriters carry a large inventory of securities that cannot be sold at prices sufficient to recover their costs.

The second group established by the underwriter to reduce risk is the selling group. The underwriter is able to sell the issue more widely and rapidly through such an arrangement than if it were to undertake all sales alone. While other firms of the group are not liable for their inability to sell the issue, a firm’s inclusion in the group is predicated on the presumption that it has the ability to enhance the distribution network and that it also has a financial incentive to do so. While an underwriting syndicate can include anywhere from four to a hundred or more members, a sales group usually includes not only the syndicate members but also additional brokerage houses.

1.5. Commercial banking

A commercial bank is a middleman of sorts, although we use the elegant name of a depository financial intermediary. It produces or manufactures nothing of its own, and unlike most middlemen, a commercial bank buys and sells very little. Instead, it has one commodity- money– which it “rents” from one party and then “rents out” to others. The rent a commercial bank pays for money is in the form of interest, in the case of savings and time deposits, and in the form of the cost of providing convenient transfer and payment services, in the case of checking deposits. The rent it charges for use of the money is in the form of fees and interest on loans and investments.

Commercial banks obtain their funds from several sources. Perhaps the most visible sources are checking deposits and savings accounts of various forms. However, these institutions also raise funds from the issuance of various types of non deposit securities. In addition, commercial banks issue equity capital of various forms both to sustain operations and to satisfy the regulators.

1. Deposits at Commercial Banks
Banks attract funds through the administration of various depository accounts that, combined, represent the majority of their funding base. There are two main types of depository accounts: transaction accounts and non transaction accounts.

Transaction Accounts. The term transaction accounts often referred to as sight deposits. Certain transaction accounts are primarily used by businesses and pay no interest. These are commonly called demand deposits. Other checkable deposits are held primarily by consumers and can pay interest. Negotiable orders of withdrawal (NOW) account is the term given to what is perhaps the most visible interest-bearing checking account in the USA. Some of these accounts require very little by way of balances to pay interest, while others offer more favourable interest rates but require a high minimum balance. In many cases, these deposit accounts charge transaction fees or monthly maintenance charges to cover these services, but in any case, they serve as the basic transaction account for both households and firms.

A recent innovation in these transaction accounts is the issuance of debit cards. Debit cards can be used to withdraw or deposit funds in checking and savings accounts via an automated teller machine (ATM). In addition, these plastic cards may also be used to make purchases, much in the same way as checks and cash, in what is referred to as a point of sale (POS) transaction. The purchaser simply presents the plastic card to the vendor and enters a password; the vendor then enters the amount of the transaction. In this way, funds are transferred from the buyer’s checking account to the vendor’s account, without the need of paper checks and the accompanying
processing costs.

The main purpose of holding balances in a transaction account is to facilitate monetary exchange, that is, to permit payments to be made in exchange for a purchase. The costs to the bank for the funds deposited is the rather substantial administrative and check processing costs and, for some of these checkable accounts, the interest cost associated with average balances.

2. Savings and Time Accounts.
Sometimes referred to as non transaction deposits or time deposits, these accounts are a major source of bank funds. This category includes various types of deposits that earn interest but are generally not used to pay bills. These types of accounts include retail savings accounts, money market accounts, and various kinds of certificates of deposit. Money market accounts are same as savings accounts only that they pay higher interest rates, require a higher minimum balance and allow 3-6 withdrawals per month and
have a cheque facility. The first of these accounts is the standard retail savings account, in the past referred to as a passbook savings account. This account derives its name from the passbook that used to track the deposits and withdrawals and was presented for each transaction. In any case, the passbook savings account is the most flexible of the savings vehicles. Deposits and withdrawals can be made at any time, as often as desired, and in any amount without invoking a penalty, unlike with time deposits and some money market accounts.

Money market accounts are the second form of savings account. These deposits may offer a somewhat higher yield to depositors, who are generally required to hold higher balances in the accounts. An outgrowth of the banks’ attempt to compete directly with the money market instruments and mutual funds for the consumers’ investment, the money market account’s name reflects its aspiration. In fact, yields are often below open market rates and are frequently slow to change. In these kinds of accounts, the investor may have
the ability to draw checks to pay bills. However, there is usually a low limit on the number of checks that can be written against each account in any given month – such as two drafts per month.

The rates of interest paid on savings accounts and money market deposits are typically somewhat lower than returns that can be obtained through direct capital market security purchases. Nonetheless, these accounts have remained competitive. Depositors willingly accept these lower rates due to the increased convenience of these accounts, which provide easy access at any time, and the
existence of deposit insurance up to $100,000 in USA. Certificates of deposit, while also covered by deposit insurance up to the same $100,000 limit, impose somewhat more restrictive conditions upon the investor. They are designed to be held until maturity and bear a fixed interest rate stated on a printed certificate. If redeemed prior to maturity, certificates of deposit may carry a substantial interest penalty, amounting to several months of lost interest. They are held for investment purposes, mostly by individuals, and
carry maturities generally ranging from three months to five years.

3. Non-depository Liabilities
In addition to depository accounts, banks issue a variety of debt obligations to attract funds. These securities, unlike the deposit liabilities are not covered by deposit insurance, but they can be used to raise large amounts of cash quickly and to provide funds of a particular desired maturity. At times, it is cheaper to raise funds in this way than through deposit taking because these instruments escape levies for deposit insurance and come with no expectation of services to be provided by the bank. Banks also obtain funds by borrowing from their holding companies, which in turn, issue their own debt. This issuance may be in the domestic capital market, as in the case of commercial paper issued by the bank’s holding company.

4. Equity Capital
A bank will attract equity capital through the issuance of both common and preferred stock. In addition, the banking industry has a large amount of retained earnings, which, over time, can increase the bank capital account. For instance, if a bank or bank examiner determines that a particular loan is unlikely to ever be repaid, the loan is removed as an asset on the bank’s balance sheet and a corresponding reduction is made in the bank’s loan loss allowance account. If this proves insufficient to cover the loss, funds are
transferred from the bank’s capital account. While equity constitutes a relatively small portion of the funds raised by a typical bank it is nonetheless a very important source of funds because it provides the cushion against losses and adverse economic events. It is for this reason that regulators around the world have paid increasing attention to this area of bank balance sheets. The cost of this bank capital is equal to the dividend stream that investors expect.

Investors in Commercial banks are the same as investors in any other equity issue. They measure their return, by looking at current dividends paid plus whatever capital gains they expect to receive. This expected total return must be sufficient to entice them to hold the equity. The other securities are referred to as hybrids because their behaviour falls somewhere between debt
and equity in terms of their claim on bank earnings, their seniority, or their maturity. The simplest of these securities is perpetual non-cumulative, variable-rate preferred stock. Their return is tied to current market interest levels, as well as the bank’s profitability for the period; they are therefore similar to floating-rate debt instruments.

At the other extreme, the bank may issue subordinated debt with either a fixed or variable rate of return. This is an obligation that is independent of the bank’s ability to pay. Indeed, if the bank cannot cover the interest on its debt, it may well be forced into bankruptcy or liquidation. The differentiating feature of this instrument from other non-deposit liabilities, however, is that its covenants place its claim on assets below others hence, the use of subordination in the title. Such debt generally has a maturity beyond seven years at issue. These two features, subordination and long maturity, have led regulators to define it as secondary capital and to allow banks to include it with common and preferred stock of various kinds in the definition of total capital for regulatory purposes.

5. Uses of Funds
The commercial bank seeks to deploy all of the funds it raises in a manner that generates income above and beyond the expense incurred by the institution to obtain funds. In this regard, the commercial bank is actually no different from any other profit-seeking firm. What distinguishes a bank is the manner in which it raises funds and the ways in which it deploys them. There are several
categories of assets in which a commercial bank deploys its funds: cash and cash equivalents, deposits, investment securities, loans, and physical capital.

1. Cash and Cash Equivalents
Banks cannot deploy all of their funds. Because there is always a demand for ongoing transactions that require cash and because of regulatory concern over liquidity, banks maintain some of their resources in highly liquid form. Accordingly, a bank maintains vault cash for day-to-day contingencies, and it also maintains deposits in a clearing account at the Central Bank. Both of these types of balances pay no interest. However, bank regulators require that a certain amount of funds be maintained both in vault cash and in the clearing account. This required amount is referred to as required reserves. The size of required reserves is based upon the structure of the bank’s liabilities.

Beyond the required minimum level of reserves, a bank may wish to maintain excess reserves in order to have sufficient liquidity to conduct its daily business efficiently and to handle any unforeseen contingencies that may arise. However, because reserves are not earning assets, it is generally desirable, from a profitability perspective, to keep these balances as low as is practicable.

At any moment in time, a commercial bank is likely to be in possession of numerous checks and drafts issued by other banks and their customers. These are treated as cash in the process of collection, and they are usually considered to be liquid assets. Beyond this, most banks have deposits at other banks. A small bank will deposit some funds with a large one in return for help in executing its transactions. Large banks may have clearing balances with one another, particularly internationally. These deposits may be interest bearing, but they are intended to compensate the recipient bank for its correspondent banking services. On the other hand, banks may be holding deposits for the earnings they offer. Like other investors, they see CDs of other institutions and Eurodollar CDs as viable investment vehicles that offer both return and certain degree of liquidity in the secondary market. Additionally, these assets offer a maturity choice that may fit nicely into the bank’s goals to limit the mismatch between the duration of assets and liabilities.

2. Investment Securities
A bank raises funds in part by issuing securities, it may seem curious that a bank also invests in securities. The conundrum becomes more curious when one observes the kinds of securities predominantly held in bank portfolios. How is a bank going to earn a profit on these securities unless it is able to issue its own securities at lower rates of interest than the government’s securities? Rarely is a bank safer than a government, which can always resort to printing money to repay its debt. Thus, the bank should not be able to issue
securities that pay a lower rate of interest than that paid by the government securities. Yet banks do hold these assets, and in substantial volume. Why?

There are six different but reasonably valid explanations for this phenomenon.

1) A bank will often invest in securities of a different maturity than those it issues. For example, it may raise money in the funds market, which is typically an overnight market, and reinvest in securities with a longer maturity. If the term structure of interest is positively sloped, the bank may be able to earn more on its securities investments than it is paying for funds, even though its
own credit worthiness is less than that of the governments that issue the securities in which it invests.

2) Second, the purchase of governmental securities may induce the government to conduct other, more profitable business with the bank and to maintain profit-making accounts there. Thus, the government securities themselves may appear to be unprofitable, but considered as a package, the business becomes profitable.

3) Government securities are often quite liquid, and holding them can serve as a secondary source of reserves, if needed. Accordingly, some are held for this reason even if the bank has no other relationship to the governmental unit.

4) Some Government and Quasi Government securities offer attractive yields that can yield more to a bank than it costs to raise funds. This is due to one of two reasons:- Some Quasi Government bodies e.g. municipalities have more credit risk than certain banks and can therefore carry higher yields than bank paper, – The tax-exempt status of the issue offers an after-tax effective yield sufficiently high to warrant investment.

5) Government securities can serve as a convenient vehicle to invest funds temporarily until some more profitable lending opportunity comes along or can be negotiated.

6) Security purchases and sales can be used to quickly alter the duration of an asset portfolio to some desired level. In addition to government securities, commercial banks are also able to hold the securities of other financial institutions beyond those formally designated as deposits. Mutual funds: Professionally managed collective investment which pools funds from investors and then invests in equity, debt instruments etc

3. Loans
The major category of investments for many commercial banks has been loans. While the bank’s position in its local market may permit it to raise funds somewhat less expensively than open market borrowers, its total profit must not depend on this source alone. In focusing on specialized liabilities and assets, both of which require a substantial amount of local information, a bank is able to earn larger spreads between their cost of funds and the return on their investments than a simple money manager who tries to make the best picks among assets at prices set in the open market. The advent of the information age, however, is reducing the bank’s ability to keep this information advantage. This trend notwithstanding, banks still depend upon lending for a substantial portion of their profit and activity. Many of the loans a bank makes to individuals and firms are secured by real estate. This area of banking is referred to as mortgage lending. In addition, consumers borrow for durable goods, such as automobiles, and to finance current consumer
spending. Some of this lending is secured; some is not. In the latter category is the burgeoning market for unsecured consumer debt.

This is a natural service for banks to offer since they can take advantage of the information they already have about the credit worthiness and financial condition of their depositors. The other category of unsecured consumer debt is credit cards. When a consumer makes a purchase using a Visa or MasterCard issued by a bank, the bank makes immediate payment to the vendor, but at a discount of 1 to 6 percent. The funds with which the bank makes payment to the vendor come from the bank initially, as the customer has done nothing but sign the slip. The bank then collects the full value of the funds from the consumer on his regular billing cycle due date, thereby profiting from the spread.

Another profitable opportunity is presented to the bank if the consumer is unable to make full payment on the due date. In this case, a loan is automatically extended to him, at an amount not to exceed his prearranged credit limits and at a preset interest rate. Periodic payments are expected thereafter until the debt is settled. Most credit card issuers charge a steep interest rate on credit granted under these terms. However, there are costs that must be subtracted from this wide margin. The difference between the full value charged to the consumer and the discounted amount paid to the vendor represents only the gross profit to the bank issuer. From this gross profit must be subtracted the costs of funds, the cost of bad consumer credit, and the administrative costs of processing the bills. These costs are quite substantial and reduce the profitability of this product line from excessive to only attractive. In addition to consumer lending activity, the commercial bank has a large and important commercial and industrial loan portfolio.

Indeed, the industry’s name rests upon the assumption that its primary role is to provide the funds needed for the commercial sector. Such business loans are often a large and important part of the bank’s balance sheet. The challenge is to find projects that are both worthy of investment and can pay an interest rate sufficient to cover the bank’s transactions costs and cost of funds. Yields
on these loans are generally lower than on consumer lending, yet commitments are large. With a small capital base, relative to total assets, the bank must be exceedingly conservative in its lending. Losses can quickly erode capital and cause failure.

4. Tangible Property
One final category of assets that a commercial bank typically holds is real property, such as buildings, furniture, equipment, computers, and the like. These are included in the “other assets” category. These assets are usually not very liquid and constitute a small part of a bank’s asset portfolio. By accounting tradition, these assets are kept at original purchase price less depreciation, and they account for only a fairly small fraction of total assets.

5. Activities beyond the Bank Balance Sheet
A bank holding company is a corporate entity that owns the commercial bank and may also own a set of other firms that are engaged in various kinds of financial activities including mortgage banking, consumer lending, and a whole host of other related businesses. These firms expand the reach of the bank, while frequently bearing the brand name of the so- called lead bank of the holding company. The second way a banking institution may increase its activity is to engage in businesses and provide products and services that do not show up on its balance sheet directly. In the everchanging financial markets, there are many opportunities to offer services or sell products that do not directly involve the bank’s balance sheet. The reason bankers have increasingly looked for these activities can be summed up in one word: competition. There has been tremendous competition facing the modern bank, forcing the spreads between the cost of funds and the return on investments to narrow and causing its market share to decline even in those areas where it has traditionally concentrated. Exacerbating this situation is the increased economic volatility of recent decades and the accompanying
uncertainty regarding the ability to maintain any given spread over time.

Hence, many commercial banks today derive a sizable portion of their revenues from off-balance sheet activities. Rather than retain assets and liabilities on the bank’s balance sheet for long periods of time, these firms generate much of their income from fees charged for various services performed beyond any part of the banking firm’s balance sheet.

1.6 Banking Services through Subsidiaries

1. 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.

2. 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.

3. 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.

4. 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).

1.8 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 povertyreduction in Kenya. The Microfinance industry in Kenya has experience  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.

1.9 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.

1.10 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

1.11 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

• Provide cover for most risks thus enabling business to undertake various ventures which could otherwise be impossible.
• 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.
• 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.
• 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.
• They also provide underwriting facilitate for newly issued shares acting as a source of finances from the companies gone public.
• They encourage savings by providing a number of polices which creates an atmosphere of good saving habits.
•  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.

1.12 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.

1.12.1The 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.

1.13 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)

1.13.1 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

• Capital market formalities
• preparing a prospector
• Arranging & paying auditors
• 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.

1.14 Pensions Sub sector

1. 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.
2.  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

• 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.
• 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.

3. 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

4.  Components of pension schemes in Kenya
The pensions sub sector in Kenya consists of the following components:

• 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).
• 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.
• 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.
•  Individual retirement benefits schemes are tax-advantaged schemes created by financial institutions and whose membership is open to members of the public interested in saving for retirement. These schemes provide a savings vehicle for those whose employers have not started occupational schemes, those who want to top up occupational savings, those in small firms including professionals and the self-employed and those who opt to transfer preserved benefits from other schemes.

1.15 Central Bank

This is a large financial institution that handles the government’s finances, regulates the supply of money and credit in the economy, and serves as the bank to commercial banks. Commercial banks deposit some of their reserves at the central bank, and the central bank is the “lender of last resort” to commercial banks in times of crisis.

Exs.: Central Bank of Kenya, the Federal Reserve System of the U.S, the European Central Bank (ECB; for countries using the Euro). CBK is responsible for financial soundness of an economy. It identifies gaps in the financial market and looks for solutions to these gaps.

1.15.1 Role of CBK

The roles are outlined in the CBK Act of 1966 and the banking Act of 1968 The Act give CBK the powers to ensure financial soundness of the economy this is through issuing of currency, and Control of money supply in the economy. The banking Art allows CBK to operate on commercial basis and offers such services as currency notes to commercial banks, and discounting securities.

1. Issuing of currency and control of money supply
This is the most important role of CBK and calls for a high degree of efficiency and trust. CBK is allowed to print money to match the resources accumulated by different sectors of the economy. This means that there is a strong correlation between the money supply in the economy and the resources in the economy. It is always kept as top secret in order to avoid speculation. CBK maintains some resources to back the Kenyan currency. They are referred to as reserves and they are in form of Gold, silver, and other strong foreign
currencies.

2.  Adviser to the Government

• On economic policies necessary at any one point in time to stimulate economic development of various sectors
• Ways of raising finance e.g. best sources of finance and best cost of the interest to be paid on such finances
• Best means of managing the private sector from the financial management point of view. In particular it advices on which projects the public sector and which the Government is to finance
• Gives advice on ways and means of controlling inflation
• Means and ways of boosting purchasing power of the people in order to uplift their standards of living

3. Banker to the Government

• Undertakes all government transactions e.g. different government ministries will draw chaque on it for payment for different services and goods the ministry has purchased
• Receives various payments on behalf of Government e.g. tax payments are deposited in the consolidated account maintained by CBK, foreign aid and other funds received by Government
• It also pays foreign loans on behalf of the Government thus it keeps foreign exchange reserves for this purpose
• It advances loans to the Government both short term and long term to finance Government projects

4. Management of public debt
Public debt is that finance which Government borrows from its citizens and foreigners through Government securities such as treasury bonds and stocks. Finances from these securities are received by CBK on behalf of the Government to finance deferent economic activates. CBK will receive the finance from the securities and also undertakes to pay interest and principle to the public or foreigner when they fall due. Advice the Government the rate of interest the securities will carry. Advice the Government to what conditions will be ideal to sell Treasury bill or Government stocks

5.  Banker to commercial banks

• Acts as the clearing house where it acts as a middle man in settlement of debt by or to any commercial bank in Kenya
• It is the sole custodian of reserve deposits which by law commercial banks are required to maintain with CBK
• Acts as a source of short term finance to commercial banks e.g. when commercial banks are faced with short term liquidity problems they borrow from CBK
• It acts as an arbitrator in disputes between commercial banks e.g. financial expansion disputes
• It is authorised by commercial banks to sell or discount promissory notes, bill of exchange or any other documentary instalment maturing within 180 days

6. Financial controller of all commercial banks
Commercial banks are required to be guided in their activities by CBK in the following areas:-

• Areas in which investments are a priority to Government investment plans
• Submit periodic reports from which important statistics used to gauge the financial soundness of the economy are prepared e.g. savings accumulated over a period of time or investments made over a period of time
• Advice commercial banks in matters of financial planning
• Advice commercial banks in their process of credit creation

7. Lender of last resort
If circumstances warrant or dictate CBK may act as lender of last resort in the following circumstances
Under high inflationary circumstances where the general public looses confidence in money and prefers to invest in real estates
A commercial bank may fail to raise the finance necessary to undertake a given investment, either due to high capital investment or due to liquidity constraints thus forcing it to turn to CBK for financing

8. Foreign exchange administration
The county earns through sale of goods and services to the foreign countries. This finance is usually in form of money such as dollars, euro, Japanese yen, sterling pound, douche mark etc. These currencies make up the special exchange rate in the international trade. The process of management of international trade is aimed at ensuring that there is a balance between inflows from abroad and outflows out of the country. For this reason CBK will allow as little money as possible to live the economy but to allow as march as possible to enter the economy. In its control of forex, CBK is the sole seller of foreign currency in Kenya. Commercial banks can do this with approval from CBK