BBM 415 Updated Notes - Jan - 2024

SCHOOL OF BUSINESS AND ECONOMICS
Department of Account’0-p0p-0ing and Finance
2020/2021 Academic Year
Course lecturer: Dr. BITOK
;
COURSE OUTLINE
BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS
Purpose of the course
The course seeks to expose the students to the operational, country, and management risks in
financial institutions, the measurement of these risks, and their management through various
methods.
Course Objectives
1. To describe the nature of financial institutions and their operations
2. To identify skills on how to evaluate, measure and manage the risks facing financial
institutions
3. To describe the regulatory context of financial institutions
Expected learning outcomes

At the end of the course, the student should be able to:
1. Explain the special nature of financial institutions and their operations
2. Evaluate, measure, and manage the risks facing financial institutions
3. Discuss the regulatory context of financial institutions
Course Content
1. Financial intermediaries and why they are special
▪ Financial services industry
2. Depository institutions
▪ Insurance companies
▪ Securities firms and investment banks
▪ Mutual funds and hedge funds
▪ Finance companies
3. Risks of financial intermediation

▪ Interest rate risk
▪ Market risk
▪ Credit risk
▪ Off-Balance-Sheet Risk
▪ Country or sovereign risk
BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

▪ Technology and operational risk
▪ Liquidity risk
▪ Insolvency risk
▪ Measuring risks
▪ Managing risks
4. Liability and liquidity management

▪ Deposit insurance and other liability guarantees
▪ Capital adequacy
5. Product diversification
▪ Futures and forwards
▪ Swaps
▪ Options
▪ Caps
▪ Floors and collars
▪ Loan sales
▪ Securitization
6. Regulatory framework of financial institutions.

Learning and Teaching Methodologies
Lectures, group discussions, and assignments
Instructional Materials and Equipment’s
Lecture rooms, whiteboards, and whiteboard markers
Assessment:
Type Weighting
Continuous Assessment Tests 30 %
Examination 70 %
Total 100 %
Core Text
1. Anthony Saunders and Marcia Cornett (2003). Financial Institutions Management, a Risk
Management Approach, 4th (international) Edition, McGraw-Hill.
2. S.J. Geenbaum and A.V. Thakor (1995). Contemporary Financial Intermediation, Dryden
Press.
3. W. Hogan et al (2001). Management of Financial Institutions, John Wiley and Sons
Australia.

TOPIC ONE
The History of the Banking Sector in Kenya: An Evolution in History
The banking sector in Kenya is ever-evolving despite the numerous economic challenges that have
been witnessed within the sector. The industry remains strong and vibrant. At the moment, three
banks have been placed under receivership with only one having recovered and back to operations.
Kenya currently has 44 banks. 31 of the banks are locally owned while the remaining 13 are
foreign-owned. Among the 31 locally owned banks, the government of Kenya has a shareholding
in three of them, 27 of them are commercial banks and one is a mortgage finance institution, known
as Housing Finance.
Definition of terms
Finance
Finance is a branch of economics concerned with resource allocation as well as management,
acquisition, and investment.
In other words, finance involves managing or multiplying funds to the best interest while
tackling the risks and uncertainties.
There are three main types of finance
Personal Finance
Personal Finance involves managing the funds of an individual and helping them achieve the
desired goals in terms of savings and investments. Personal finance is specific to individuals and
the strategies depend on the individuals earning potential, requirements, goals, time frame, etc.
Personal finance includes investment in education, assets like real estate, cars, and life insurance
policies, medical and other insurance, saving, and expense management.
Personal Finance includes:
• Protection against unforeseen and uncertain personal events

• Transfer of wealth across generations of the family
• Managing taxes and complying with tax policies (tax subsidies or penalties)
• Preparing for retirement
• Preparing for long term expenses or purchases involving a huge amount
• Paying for a loan or debt obligations
• Investment and wealth accumulation goals

Corporate Finance
Corporate finance is about funding the company expenses and building the capital structure of the
company. It deals with the source of funds and the channelization of those funds like the allocation
of funds for resources and increasing the value of the company by improving the financial position.
Corporate finance focuses on maintaining a balance between risk and opportunities and increasing
the asset value.
Corporate Finance Includes:
• Capital budgeting
• Employing standard business valuation techniques or real options valuation
• Identifying the source of funding in the form of equity, shareholders’ funds, creditors,
debts
• Determining the utility of unappropriated profits for future investment, operational
utilization, or distribution to the shareholders
• Acquisition and investment in stock or other assets
• Identifying relevant objectives, opportunities, and constraints
• Risk management and tax considerations
• Stock issuance while going public and listing on the Stock exchange
Public Finance
This type of finance is related to states, municipalities, and provinces in short government required
finances. It includes long term investment decisions related to public entities. Public finance takes
factors like distribution of income, resource allocation, and economic stability into consideration.
Funds are obtained majorly from taxes, borrowing from banks or insurance companies.
Public Finance includes:
• Identifying the expenditure required by the public entity

• The sources of revenue for the public entity
• Determining the budgeting process and source of funds
• Issuing debts for public projects
• Tax management
b) System
A group of interacting, interrelated, or interdependent elements or parts forming a
Complex whole.

Again, a system can be defined as an organized collection of parts that are highly integrated to
accomplish an overall goal or outcome in an organization.
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.
Again, a financial system can be defined as a system that enables the transfer of money between
investors and borrowers. A Financial System indicates a group of complex and closely linked
institutions, agents, procedures, markets, transactions, claims, and liabilities within an economy.
The financial system bridges the gap between deficit spenders and surplus spenders.
The financial system provides channels to transfer funds from individuals and groups who have
saved money to individuals and groups who want to borrow money.
The primary task of a financial system is to move or channel funds savers to borrowers either for
consumption or investment. In the financial system, the costs, availability of funds, and the price
are determined. The financial institutions include insurance companies, finance companies,
investment banks, etc.
Components of Financial System
1. Financial Institutions
A financial institution (FI) is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange.
Financial institutions facilitate the smooth working of the financial system by making investors
and borrowers meet. They mobilize the savings of investors either directly or indirectly via
financial markets, by making use of different financial instruments as well using the services of
numerous financial services providers.
Examples of financial institutions include banks, trust companies, insurance companies,

brokerage firms, and investment dealers.
2. Financial Markets
A financial market is a place (environment) where financial assets are traded (created or
transferred). It can be broadly categorized into money markets and capital markets. The money

market handles short-term financial assets (less than a year) whereas capital markets take care of
those financial assets that have a maturity period of more than a year.
The key functions are:

• Assist in the creation and allocation of credit and liquidity.
• Serve as intermediaries for mobilization of savings.
• Help achieve balanced economic growth.
• Offer financial convenience.
Note:
Financial markets catch the attention of investors and make it possible for companies to finance
their operations and attain growth. Money markets make it possible for businesses to gain access
to funds on a short term basis, while capital markets allow businesses to gain long-term funding to
aid expansion. Without financial markets, borrowers would have problems finding lenders.
Intermediaries like banks assist in this procedure. Banks take deposits from investors and lend
money from this pool of deposited money to people who need a loan. Banks commonly provide
money in the form of loans.
3. Financial Instruments
Refers to the assets that can be traded in the market environment. This asset can be cash, equity
shares, debentures, bonds, etc.
A financial instrument is a real or virtual document representing a legal agreement involving any
kind of monetary value.
Financial instruments may be divided into two types: cash instruments and derivative
instruments.
4. Financial Services
Financial services consist of services provided by Asset Management and Liability Management
Companies. They help to get the necessary funds and also make sure that they are efficiently
deployed. They assist to determine the financing combination and extend their professional
services up to the stage of servicing of lenders. They help with borrowing, selling and purchasing
securities, lending and investing, making and allowing payments and settlements, and taking care
of risk exposures in financial markets. These range from the leasing companies, mutual fund
houses, merchant bankers, portfolio managers, and bill discounting and acceptance houses.
5. Money
Money is understood to be anything that is accepted for payment of products and services or the
repayment of debt. It is a medium of exchange and acts as a store of value. However, money may
not be a good store of value since it loses value with inflation.

TOPIC TWO
DEPOSITORY INSTITUTIONS/ FINANCIAL INTERMEDIARY
A financial intermediary is an entity that performs intermediation between two or more parties in
a financial context. It is a typical institution that facilitates the channeling of funds between lenders
and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such
as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form
of loans or mortgages.
A financial intermediary is an entity that acts as the middleman between two parties in a financial
transaction, such as a commercial bank, investment bank, mutual fund, or pension fund.
They are individual that serves as a middleman among diverse parties to facilitate financial
transactions.
Examples of financial intermediaries
• Banks
• Mutual savings banks
• Savings banks
• Building societies
• Credit unions
• Financial advisers or brokers
• Insurance companies
• Collective investment schemes
• Pension funds
• cooperative societies
• Stock exchanges
TYPES OF FINANCIAL INTERMEDIARIES
1. Investment Bankers. These are institutions that buy the new issue of securities for resale to
other investors.
An investment banker is an individual who often works as part of a financial institution and is
primarily concerned with raising capital for corporations, governments, or other entities.
Examples of an investment banker in Kenya
• Equity Investment Bank

• Standard Investment Bank
• Old Mutual Securities
• ABC Capital

• African Alliance Kenya Investment Bank
• Afrika Investment Bank
• Faida Investment Bank
• NIC Securities
• Renaissance Capital (Kenya)
2. Insurance Companies
These are companies that provide protections to financial companies against risks or unforeseen
future. If you have a risky investment you might wish to insure, against the risk of default. Rather
than trying to find a particular individual to ensure you, it is easier to go to an insurance company
that can offer insurance and helps spread the risk of default. On the other hand, life insurance
companies take savings in form of annual premiums from individuals and they invest these funds
in securities such as shares, bonds, or real assets. Savers will receive annuities in the future.
3. Financial Advisers
A financial adviser doesn’t directly lend or borrow for a client. Financial advisers offer specialist
advice to the client. They enable clients to understand all the intricacies of the financial markets
and spending time looking for the best investment.
4. Credit Union
A credit union is a non-profit financial institution that’s owned by the people who use its financial
products. Credit union members can access the same kinds of products and services as offered by
a traditional bank, such as credit cards, checking and savings accounts, and loans. Members elect
a board of directors to manage the credit union to ensure that their best interests are represented.
Credit unions aim to serve members by offering competitive products with better rates and fees
than you see with a for-profit bank. Like a bank, credit unions charge interest and account fees,
but they reinvest those profits back into the products it offers, whereas banks give these profits to
its shareholders.
Credit unions are informal types of banks that provide facilities for lending and depositing within
a particular community. They are cooperative associations whose members have common bonds
e.g. employees of the same company. The savings of the member are loaned only to the members
at a very low-interest rate e.g. SACCOS charges p.m. interest on the outstanding balance of the
loan.

5. Mutual funds/Investment trusts
These are mutual investment schemes. These pool the small savings of individual investors and
enable a bigger investment fund. Therefore, small investors can benefit from being part of a larger
investment trust. This enables small investors to benefit from smaller commission rates available
to big purchases.
6. Pension Funds.
These are retirement schemes or plans funded by firms or government agencies for their workers.
They are administered mainly by the trust department of commercial banks or life insurance
companies. Examples of pension funds are NSSF, NHIF, and other registered pension funds of
individual firms.
7. Savings and Credit Associations.
These are firms that take the funds of many savers and then give the money as a loan in form of a
mortgage and to other types of borrowers. They provide credit analysis services.
FUNCTION OF FINANCIAL INTERMEDIARIES
1. Banking services
This includes handing deposits into checking and savings accounts, as well as lending money to
customers. Granting loans and advances to the public as and when they require.
2. Advisory services
Intermediaries provide financial services to people and organizations with a variety of tasks.
Financial advisors can help with due diligence on investments, provide valuation services for
businesses, aid in real estate endeavors, and more. Financial advisors help to guide people in the
right direction when making financial decisions.
3. Insurance/protection
These are intermediaries that offer protection against uncertainty and encourages risk-sharing
purposely to minimize the impact of the loss.
4. Saving mobilization
The channel /move funds from savers to borrowers without financial Intermediaries it is too
difficult to transfer funds from those who have and have investment opportunities to those who
have investment opportunities to promote development. Financial intermediaries provide an
avenue for public saving. Financial assets provide a profitable and relatively low-risk outlet for
public saving.
5. Reduction of transaction cost
Reduction of transaction cost for example time and money spent in carrying out a financial
transaction for example the cost of hiring a lawyer to write the loan contract. Financial
intermediaries can substantially reduce transaction costs because their large size allows taking

advantage of economies of scale. A simple loan contract can be used over again in life. Financial
intermediaries loan transactions thus lowering legal cost per transaction.
6. Risk management
➢ Liquidity risk
Capital savers, on the other hand, prefer to have the option to draw their savings or move them
into another investment opportunity when the need to do so arises i.e. savers like to have their
savings in liquid. Banks enable the borrowers and lenders to meet their objectives
➢ Risk diversification
Investing in an individual project is riskier than investing in a wide range of projects whose
expected returns are unrelated. Banks or intermediaries allow risk diversification.
7. Acquisition of information
It is not possible for savers to have the time or capacity or financial muscle to collect process and
compare information in many different enterprises before choosing where to invest. Intermediaries
intermediate and collect information about demanders of funds on behalf of savers.
8. Monitoring borrowers and exerting corporate control.
It is evident that the ability and financial intermediaries to monitor the performance of enterprises
on behalf of many investors help to ensure that investors receive returns that promptly reflect the
enterprises’ performance (i.e. ensure that they are not being defrauded by the firm managers as a
result of lack of information) and create the right incentives for managers of the borrowing
enterprises to perform well. This helps to enhance growth and capital accumulation.
9. They help reduce the exposure of investors to risk.
Risk is the uncertainty of relieving an investor will earn from assets. Financial intermediaries get
this through the process of “risk-sharing”. Financial intermediaries create and sell assets with risk
characteristics that people are comfortable with and use the funds they acquire by selling these
assets to purchase other assets that may have more risk.
10. The financial market provides an excellent way to store wealth or value
Financial assets sold in the financial market provide an excellent way to store wealth or value for
example share. Financial assets do not depreciate over time. Besides they also generate income
and their risk of loss is much safer than any other assets.
11. Financial intermediaries provide credit to finance consumption and investment.
They help large borrowers since in the process of financial intermediation more funds are made
available to borrowers in the financial markets
12. Conversion of wealth stored in financial assets into cash with little risk of loss.
They provide liquidity for savers who own financial instruments but need money. Money is the
only asset that is possessed in perfect liquidity. However, it has the lowest rate of return of all
assets traded in fin intermediaries. Its purchasing power is seriously eroded by inflation. Savers,

therefore, minimize their holding on money and hold higher-yielding financial assets in the fin
intermediaries when they so wish.
13. Provision of interest on deposits
They improve the lives of small savers by providing them with interest on their deposits and help
more borrowers who can get loans they otherwise could not have obtained.
14. Financial intermediaries provide denomination intermediation.
Since some securities are sold in an amount beyond the reach of an average investor (commercial
paper) by investing in money markets such investors become accessible to the average investor.
The financial institution can afford to buy them to individuals in small amounts in the money
markets
15. They provide a mechanism for making payments for goods and services.
This is done through specific financial assets traded in financial intermediaries for example current
accounts. They provide maturity intermediation most deposits want to make short term deposits
while borrowers want long term deposits financial institution borrow short term deposit and lend
long term. Without financial institutions bearing the risk of maturity, mismatch might not be long
term mortgage markets.
16. Transmission of monetary policy
Financial intermediaries play an important role in the transmission of monetary policy from the
central bank to the rest of the economy. Depository institutions are the conduit through which
monetary policy actions affect the rest of the financial sector and the economy in general. Monetary
policy actions include open market operations, setting the discount rate, and setting reserve
requirements
17. Help in reducing any asymmetric information
Financial intermediaries also help in reducing any asymmetric information where one party in a
financial market does not know enough about the other party to make an accurate decision for
example a borrower has better information about the potential lender and risk associated with
investment projects for which the funds are borrowed than the lender.
Challenges Facing Financial Intermediaries (2017 Surveyed)
1. Corporate Governance and the Culture of Compliance.
A less prescriptive, but still challenging, area of compliance for financial institutions is governance
and culture. Much has been discussed in the last year about corporate governance considerations
and an institution’s culture of compliance, not only in light of enforcement actions on incentive
compensation and sales practices but also in light of specific guidance on establishing a culture of
compliance. These considerations begin with the board of directors and senior management and
trickle down through the institution. Tone at the top, communication, and incentives are key to
navigating the labyrinth of inspirational guidance from federal and state regulators.

2. Compliance with Consumer Laws.
Compliance with consumer laws is a traditional challenge for any financial institution offering or
providing products or services directly or indirectly to consumers. Mortgage origination and
servicing, loan officer compensation, fair lending, and unfair and deceptive acts or practices plague
consumer finance industry participants due to difficult and even conflicting obligations. One
particular highlight this year will be the ongoing implementation of new rules under the Home
Mortgage Disclosure Act (HMDA). More data fields mean greater scrutiny for those subject to the
HMDA reporting requirements.
3. Securities Compliance (for publicly traded and privately held banks).
Now is the time of year when publicly traded institutions are preparing for their annual meetings
and finalizing the related SEC filings. 2017 brings some new requirements for publicly traded
institutions, while other requirements that publicly traded institutions used to focus on are back in
the spotlight. Although privately held institutions are not impacted by most of these requirements,
securities law matters should nevertheless be a focus for privately held institutions. Whether trying
to raise capital or to refinance existing debt, various securities law requirements need to be
complied with by privately held institutions.
4. Mergers & Acquisitions.
Higher valuations, improving multiples, more capital, and the potential for regulatory relief this
year are all contributing to increased consolidation in the financial institutions market in 2017.
Potential sellers continue to be motivated by several factors, including the continued burden of
regulation, competition, unclear succession plans, and the expectation of higher multiples. The
time appears ripe for making deals or at least raising capital to prepare for potential future deals.
5. BSA/AML and OFAC Compliance.
The more things change, the more they stay the same. This is the case with the challenge of
complying with the Bank Secrecy Act, anti-money laundering, and economic sanctions rules for
financial institutions. Even as new technologies, markets, and participants emerge in gray areas of
regulation, BSA/AML compliance challenges are remarkably consistent across industries. New
rules and guidance issued throughout 2016, along with the debilitating nature of any hiccup in
compliance with these rules, means that BSA/AML and economic sanctions compliance remain
atop the list of risks for financial institutions. Financial institutions should also be mindful of
compliance obligations with respect to economic sanctions regulations administered by the Office
of Foreign Assets Control (OFAC). OFAC enforces economic and trade sanctions against
countries and individuals deemed to be threats to the national security or foreign policy of the
United States.

6. Cybersecurity.
One of the more dangerous risk areas for financial institutions for some time will be a cybersecurity
risk. As federal and state regulators continue to pepper financial institutions with new regulations,
tools, and guidance, many institutions are struggling to keep up with even the basic tenets of a
cyber-security risk management policy or program. Navigating cybersecurity risk begins with
awareness and preparedness, which is what we are focusing on from the outset with our clients. A
necessary first step is to conduct a risk assessment that can inform the second step, a response plan
to guide a financial institution through the aftermath of a cyber-security incident.
7. Data Security and Privacy.
In addition to cybersecurity concerns, the risk of a data breach incident affecting customer financial
or personally identifiable information calls for specific actions on the part of financial institutions.
Similarly, compliance with traditional and emerging privacy regulations requires strict standards
for housing sensitive data, as well as adherence to traditional federal and state privacy statutes
focused on privacy notices and sharing information for marketing purposes.
8. FinTech.
Financial technology, or FinTech, describes a multitude of firms’ activities, and capabilities for
financial services. From the automated teller machines (ATMs) of the 1960s through today’s
online lending platforms with unique algorithms for underwriting, FinTech has represented and
continues to represent, great challenges and opportunities for financial institutions. Indeed, as more
FinTech companies emerge and new partnerships are established with traditional financial
institutions, federal and state regulators are taking notice—and even getting in on the innovation
game themselves. However, using and/or partnering with FinTech presents traditional risks and
compliance challenges that financial institutions need to review.
9. Third-Party (Vendor) Risk Management.
Third-party risk management continues to receive a heightened degree of attention from the
regulatory community, especially the enforcement apparatus. It seems that almost every one of
these relationships is subject to increased examiner scrutiny and liability concerns, which is
unlikely to abate in 2017. Financial institutions will continue to be liable for the actions of their
vendors and cannot risk a bare-bones third-party risk management program.

10. Capital Planning.
As the economy continues to improve, and valuations and capital increases, result, assessing and
preparing for capital needs are at the forefront of many institutions’ minds. Whether an institution
is thinking about raising capital, using its stock as currency in an acquisition, and/or considering a
pay down or refinancing of outstanding debt, careful consideration should be undertaken not only
with regard to the capital opportunities of today but also with regard to planning for future market
changes.
Financial Services Institutions

If you want to work in this industry, you need to research and understand not only the different
kinds of financial services but also the different kinds of financial services institutions. Below
are just a few kinds of institutions that offer the aforementioned services.
• Commercial Banks (Banking)

• Investment Banks (Wealth management)
• Insurance Companies (Insurance)
• Brokerage Firms (Advisory)
• Planning Firms (Wealth management, Advisory)
CPA Firms (Wealth management, Advisory)
Key Factors which Drives Growth in Kenya’s Financial Services Sector
Kenya’s financial services sector is increasingly sophisticated and diversified. The key prospects
for growth are as follows;
1. ICT Enabled Financial services
The adoption of technology at a high rate creates room for the development of compatible ICT
enabled services.
Financial institutions are increasingly utilizing mobile application platforms and internet banking,
hence there is increased efficiency in distribution, leading to increased uptake of services in the
mass market
The expansion of the service channels in the sector provides opportunities in the client
management solutions realm.
2. Risk Management
The current state of information sharing opens up opportunities for investment both in terms of
databases and reliable financial records.

The growth of the sector across various channels increases the need for solutions like
cybersecurity, monitoring, and record-keeping.
3. Financing
More than 70% of SMEs lack access to medium and long-term finance, which creates a need for
innovative debt and equity instruments for SMEs.
Increased financial inclusion in Kenya has driven financial institutions to seek into less
penetrated markets in the region to open up new revenue channels in other EAC countries
Partnerships with local financial institutions provide opportunities for consultancy in product
development.
4. Regulatory Environment
The regulatory environment has been strengthened with the emphasis being placed on
transparency, governance, and capitalization, hence ensuring stability
5. Regional Integration
Treasury seeks to set up the Nairobi International finance center (NIFC) to be the regional hub
for regional financial operations.
The local business environment is relatively stable and as such Kenya’s capital market is a
stimulant for investments in the region.
6. The emergence of alternative channels of distribution
The agency model of distribution has reduced the operating costs and improved efficiency,
thereby making it a key driver for diversification and wider reach

TOPIC THREE
RISK OF FINANCIAL INTERMEDIATION
Introduction
A financial intermediary is an establishment or an institution which acts as a third party between
investors and firms in trying to obtain funding.
A typical example of a financial intermediary is a bank, but there are more such as life insurance
companies and building societies. It is important to note that financial intermediaries do not use
their own money instead they use the money of its depositors.
Financial intermediaries should be concerned with risk because it can make its capital volatile and
in most cases when financial intermediaries are faced with these types of problems the most probable
outcome is that they can go into severe financial distress or this could lead to bankruptcy.
The risks arises when the financial intermediaries do not correctly regulate their own techniques
and staff. There are many examples where financial intermediaries such as Baring’s bank and
BCCI (Bank of Credit & Commerce International) were forced to declare bankruptcy due the
inappropriate actions as they themselves played as financial intermediaries.
Major objective of management of financial institution
1. To increase the financial institutions returns for its owners or stakeholders/shareholders

2. To reduce the risk to occur
Definition of Risk
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will
differ from an expected outcome or return. Risk includes the possibility of losing some or all of an
original investment. In finance, risk is the probability that actual results will differ from expected
results.
Risks can be termed as the uncertainties resulting in an outcome that is adverse in relation to the
planned objectives or expectations. Financial risks are uncertainties resulting in adverse variation

of profitability or outright losses. In so far as profit or loss of a business depends upon the net result
of all cash inflows and outflows, uncertainties in cash flows will create uncertainties in profits. A
business with large variation in net cash flow will be considered to be one with higher risk while
one with low variation will be considered as less risky.
Note: Effective management of risks determines the success or failure of a modern financial
institution. The main risks faced by financial institutions include;
Types of Financial Risks Faced by Financial Institutions
1. Interest rate risk

Interest rate risk is the probability of a decline in the value of an asset resulting from unexpected
fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g.,
bonds). Interest rate risk incurred by a financial institution when the maturities of its assets and
liabilities are mismatched.
Interest rate risk is the current or prospective risk to earnings and capital arising from adverse
movements in interest rates. Excessive interest rate risk can pose a significant threat to a financial
institution’s earnings and capital base. Interest rate risk refers to potential impact on Net interest
income or Net interest margin or Market value of Equity caused by unexpected changes in market
interest rates. This risk can be subdivided further into;
Types of interest rate risks
i. Reinvestment risk- This is uncertainty with regard to interest rate at which the future cash flows could
be reinvested. Any mismatches in cash flows would expose the financial institutions to variations in
net interest income as the market interest rates move in different directions.
Again, they are risk that arises when assets have been long-funded. The need to reinvest maturing assets
arises as liabilities have yet to mature. Loss occurs when market interest rates on reinvestment's drop.
ii. Net interest position risk – Where financial institutions have more earning assets than paying
liabilities interest rates adjust downwards. Such institutions will experience a reduction in net interest
income as the market interest declines and increases when interest rates rise.

iii. Gap / Mismatch risk- This arises from holding assets and liabilities with different principal amounts,
maturity dates or reprising dates thereby creating exposure to unexpected changes in the level of market
interest rates. For instance an asset maturing in two years at a fixed interest rate of interest has been
funded by a liability maturing in six months. The interest margin would undergo a change after six
months as liability would be reprised up on maturity causing variation in net interest income.
iv. Yield curve risk- This arises from the pricing of assets and liabilities based on different benchmarks.
For instance a financial institution may raise a liability that is linked to the 91 day Treasury bill and the
amount used to fund an asset that is linked to the 364 days Treasury bill. In a rising interest rate scenario
both the 91days and 364 days Treasury bill rates may increase but not identically due to non- parallel
movement of the yield curve thus creating a variation in net interest earned.
v. Refinancing Risk - Risk that arises when assets have been short funded. The need to seek additional
funds arises to pay of maturing liabilities mature, hence the refinancing need. Loss occurs when market
interest rates increase and it costs more to borrow funds
Measuring Interest Rate Risk
Financial institutions use various techniques to measure the exposure of earnings and of economic
value to changes in interest rates. The variety of techniques ranges from calculations that rely on
simple maturity and reprising tables to static simulations based on current on and off balance sheet
positions to highly sophisticated dynamic modelling techniques that incorporate assumptions
about the behavior of the FI and its customers in response to changes in the interest rate
environment.
The main methods include;
Repricing schedules
The simplest techniques for measuring a FI’s interest rate risk exposure begin with a
maturity/Repricing schedule that distributes interest-sensitive assets, liabilities and off-balance
sheet positions into a certain number of predefined time bands according to their maturity ( if fixed-
rate) or time remaining to their next repricing (if floating-rate). Those assets and liabilities lacking
definitive repricing intervals e.g sight deposits or savings accounts or actual maturities that could
vary from contractual maturities are assigned to repricing time bands according to the

judgement and past experience of the FI. The difference between those assets whose interest rates
will be repriced or changed over some future period (RSAs) and liabilities whose interest rates will
be repriced or changed over some future period (RSLs) is referred to as the repricing or funding
gap.
Static simulation
In static simulations, the cash flows arising solely from the FI’s current on and off-balance sheet
positions are assessed. For assessing the exposure of earnings, simulations estimating the cash
flows and resulting earnings streams over a specific period are conducted based on one or more
assumed interest rate scenarios.
Dynamic simulation
In a dynamic simulation approach, the simulation builds in more detailed assumptions about the
future course of interest rates and the expected changes in a FI’s business activity over that time.
For instance the simulation could involve assumptions about a bank’s strategy for changing
administered interest rates, about the behavior of the customers and/or about the future stream of
business that the bank will encounter. Such simulations use these assumptions about future
activities and reinvestment strategies to project expected cash flows and estimate dynamic earnings
and economic value outcomes.
How to Mitigate Interest Rate Risk?
Interest rate risk can be mitigated using the following methods
1. Diversification
If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he
can diversify his existing portfolio by adding securities whose value is less prone to the interest
rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the
portfolio by including a mix of short-term and long-term bonds.
2. Hedging

The interest rate risk can also be mitigated through various hedging strategies. These strategies
generally include the purchase of different types of derivatives. The most common examples
include interest rate swaps, options, futures, and forward rate agreements (FRAs).
2. Market risk/trading risk/systematic
Market risk is the possibility of an investor experiencing losses due to factors that affect the overall
performance of the financial markets in which he or she is involved. Market risk is also known as
systematic risk because it relates to factors, such as a recession, that impact the entire market and
cannot be eliminated through diversification.
Again, market risk is the risk of losses on financial investments caused by adverse price
movements. Examples of market risk are: changes in equity prices or commodity prices, interest
rate moves or foreign exchange fluctuations.
Note:
Market risk, is the risk that a financial institution may experience loss due to unfavorable
movements in market prices. It arises from the volatility of positions taken in the four fundamental
economic markets: interest sensitive debt securities, equities, currencies and commodities. The
volatility of each of these markets exposes financial institutions to fluctuations in the price or value
of on- and off- balance sheet marketable financial instruments.
Market risk can further be classified into;
i. Foreign exchange rate risk- This is the current or prospective risk to earnings and capital arising
from adverse movements in currency exchange rates. The potential for loss arises from the process
of revaluing foreign currency positions on both on- and off- balance sheet items, in shilling terms.
ii. Price risk- This results from changes in the prices of equity instruments, commodities and other
instruments. The potential for loss arises from the process of revaluing equity or investment
positions in shilling terms.
iii. Currency risk: The risk that exchange rates will go up or possibly down
iv. Equity risk: The risk that share prices will go up or down

v. Inflation risk: the potential for inflation to increase the price of all goods and services such that it
undermines the value of money
vi. Commodity risk: the possibility of commodity prices such as metals change value dramatically
vii. Interest rate risk: the risk that comes from an increase or decrease in interest rates
Market Risk Measurement
Market risk management framework is heavily dependent upon quantitative measures of risk. The
market risk measures seek to capture variations in market value arising out of uncertainties
associated with various risk elements. They provide an objective measure of market risk in a
transaction or of a portfolio. Market risk is measured using the Value at Risk (VAR) method.
A. Value at Risk Method (VAR)

VAR is defined as the predicted worst-case loss at a specific confidence level over a certain period
of time assuming normal trading conditions. It measures the potential loss in market value under
normal circumstances of a portfolio using estimated volatility (price move) for a given horizon.
There are three main approaches to determining the VAR;
• Correlation
• Historical simulation
• Monte Carlo simulation
B. Stress testing
Market value of a portfolio varies due to movement of market parameters such as interest rate,
market liquidity, inflation, exchange rate, stock prices etc. Movement in market parameters on a
day-to-day basis causes the changes in the market value of the portfolio. This represents the normal
risk that is associated with normal day to day movements. There remains the risk of large non
normal movement in market parameters that signifies abnormal market conditions but that could
potentially occur.
Stress testing essentially seeks to determine possible changes in the market value of a portfolio
that could arise due to non-normal movement in one or more market parameters. The process
involves identifying market parameters to stress the quantum of stress and determine the time

frame. Once these are determined it is applied on the portfolio to assess the impact on it. Stress
testing can be carried out using any of the following techniques;
i. Simple Sensitivity Test

This technique isolates the short term impact on a portfolio’s value of a series of predefined moves
in a particular market risk factor. For instance, if the risk factor was the exchange rate, the shocks
might be exchange rate changes of +/- 2%, 8%, 10% etc.
ii. Scenario Analysis

This specifies the shocks that might plausibly affect a number of market risk factors
simultaneously if an extreme but possible event occurs. It seeks to assess the potential
consequences for a firm of an extreme but possible state of the world. A scenario analysis can be
based on an historical event or a hypothetical event. Historical scenarios employ shocks that
occurred in specific historical episodes. Hypothetical scenarios use a structure of shocks thought
to be plausible in some foreseeable but unlikely circumstances for which there is no exact parallel
in recent history.
iii. Maximum Loss

This assesses the risks of a portfolio by identifying the most potentially damaging combination of
moves of market risk factors. Risk managers who use this technique find the output of such
exercises to be instructive.
iv. Extreme value Theory

This is a means to better capture the risk of loss in extreme but possible circumstances. It is the
statistical theory on the behavior of the very high and low potential values of probability
distributions
2. Credit risk
Credit risk is the current or prospective risk to earnings and capital arising from an obligor’s failure
to meet the terms of any contract with the bank or if an obligor otherwise fails to perform as agreed.
The largest source of credit risk is loans. However, credit risk exists throughout the other activities
of the bank both on and off the balance sheet.

Credit risk is a measure of the creditworthiness of a borrower. In calculating credit risk, lenders
are gauging the likelihood they will recover all of their principal and interest when making a loan.
Borrowers considered to be a low credit risk are charged lower interest rates. Lenders, investors,
and other counterparties consult ratings agencies to asses the credit risk of doing business with
companies.
Types of Credit Risk
• Credit Default Risk - The risk of loss when the financial institution considers that the obligor is
unlikely to pay its credit obligations in full or the obligor is more than 90 days past due on any material
credit obligation. Default risk may impact all credit-sensitive transactions, including loans, securities
and derivatives.
• Concentration Risk - The risk associated with any single exposure or group of exposures with the
potential to produce large enough losses to threaten a financial institution's core operations. It may arise
in the form of single name concentration or industry concentration.
• Country Risk - The risk of loss arising when a sovereign state freezes foreign currency payments
(transfer/conversion risk) or when it defaults on its obligations (sovereign risk).
• Credit spread risk/ Down grade risk
Even if a borrower does not default there is still risk due to worsening in credit quality. This may
arise from a rating change i.e either an upgrade or downgrade.
Credit Risk Measurement
An institution should have procedures for measuring its overall exposure to credit risk as well as
exposure to connected groups, products, customers, market segments and industries for
appropriate risk management decisions to be made. Internationally, the direction has been for
institutions to put in place stringent internal systems and models, which allow them to effectively
measure credit risk.
This risk measurement system assists institutions to make provisions for credit risk and assign
adequate capital. The effectiveness of the institution’s credit risk measurement process is
dependent on the quality of management information systems and the underlying assumptions
supporting the models. The quality, detail and timeliness of the information are of paramount
importance in determining the effectiveness of the credit risk management. The measurement of

the risk should take into account the nature of the credit, maturity, and exposure profile, existence
of collateral or guarantees and potential for default.
The institution should also undertake an analysis of the whole economy or in particular sectors to
ensure contingency plans are taken on higher than expected levels of delinquencies and defaults.
Credit risk measurement involves the process of credit rating/scoring.
Credit rating/scoring
Credit rating of an account is done with primary objective being to determine whether the account after the
expiry of a given period of time would remain a performing asset i.e it will continue to meet its obligations
as and when they arise. The credit rating exercise seeks to predict whether the borrower will have the
capability to honour his/her financial commitments in future. In reality there are no mathematical or
empirical models that can predict accurately the future capability of a borrower to meet his/her financial
obligations. Nevertheless financial institutions all over the world rely on some form of in house developed
model that seeks to predict the future capability of a borrower to meet his/her obligations. Credit
rating/scoring involves two major activities;
i. Developing a Credit Rating Model

A CRM essentially differentiates borrowers based on degree of stability in terms of revenue generation.
Uncertainty in revenue generation has a profound impact on the ability of a borrower to adequately maintain
any financial commitments. Where revenue generation is stable over a given period of time uncertainty or
risk associated is considerably low. For instance cash generation from an investment in government
securities is absolutely stable and hence risk associated with such investment is almost zero. It may also be
clarified that rating has nothing to do with profitability. A highly profitable company may have higher level
of uncertainties in revenue generation and therefore may be rated lower than a borrower with a relatively
lower profitability but having more stable revenue generation.
In developing a rating model factors that have an impact on revenue generation are relied upon. For
corporate and commercial borrowers, these models generally have qualitative and quantitative sections
outlining various aspects of the risk including, but not limited to, operating experience, management
expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully
reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and
conditions presented within the contract. For individual borrowers, most lenders employ their own

models (credit scorecards) to rank potential and existing customers according to risk, and then apply
appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a
higher price for higher risk customers and vice versa. With revolving products such as credit cards and
overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most
commonly in the form of property.
Credit score cards
They are mathematical models which attempt to provide a quantitative estimate of the probability
that a customer will display a defined behavior (e.g. loan default, bankruptcy or a lower level of
delinquency) with respect to their current or proposed credit position with a lender. Scorecards are
built and optimized to evaluate the credit file of a homogeneous population (e.g. files with
delinquencies, files that are very young, files that have very little information). Most empirically
derived credit scoring systems have between 10 and 20 variables. Credit scoring typically uses
observations or data from clients who defaulted on their loans plus observations on a large number
of clients who have not defaulted. Statistically, estimation techniques such as logistic regression
or probit are used to create estimates of the probability of default for observations based on this
historical data. This model can be used to predict probability of default for new clients using the
same observation characteristics (e.g. age, income, house owner). The default probabilities are
then scaled to a "credit score." This score ranks clients by riskiness without explicitly identifying
their probability of default.
ii. Maintaining data on rating migration patterns

Rating migration refers to change in the rating status of a borrower over a period of time when
rated using the same model. For instance a borrower who may have been rated highly
(A status) may be rated lowly (B) one year down the line based on the same model. Rating
migration of a single account may not convey much information. Hence the migration will mostly
focus on a large number of accounts that have similar rating. Such analysis ensures that the rating
migration maps fairly well with market standards i.e. rating migration patterns published by
recognized rating agencies.

iii. Use External credit rating agencies
Financial institutions may also employ the services of internationally recognised credit rating
agencies such as Standard and Poor and Fitch Group both based in the United States.
iv. Use of credit reference bureaus

A credit bureau or consumer reporting agency or credit reference agency is a company that collects
information from various sources and provides consumer credit information on individual
consumers for a variety of uses. It is an organization providing information on individuals'
borrowing and bill-paying habits. This helps lenders assess credit worthiness, the ability to pay
back a loan, and can affect the interest rate and other terms of a loan. Interest rates are not the same
for everyone, but instead can be based on risk-based pricing, a form of price discrimination based
on the different expected risks of different borrowers, as set out in their credit rating. Consumers
with poor credit repayment histories or court adjudicated debt obligations like tax liens or
bankruptcies will pay a higher annual interest rate than consumers who don't have these factors.
Additionally, decision-makers in areas unrelated to consumer credit, including employment
screening and underwriting of property and casualty insurance, increasingly depend on credit
records, as studies have shown that such records have predictive value.
Credit bureaus collect and aggregate personal information, financial data, and alternative data on
individuals from a variety of sources called data furnishers with which the bureaus have a
relationship. Data furnishers are typically creditors, lenders, utilities, debt collection agencies and
the courts (i.e. public records) that a consumer has had a relationship or experience with. Data
furnishers report their payment experience with the consumer to the credit bureaus. The data
provided by the furnishers as well as collected by the bureaus are then aggregated into the credit
bureau's data repository or files.
The resulting information is made available on request to customers of the credit bureau for the
purposes of credit risk assessment, credit scoring or for other purposes such as employment
consideration or leasing an apartment. Given the large number of consumer borrowers, these credit
scores tend to be mechanistic. To simplify the analytical process for their customers, the different
credit bureaus can apply a mathematical algorithm to provide a score the customer can

use to more rapidly assess the likelihood that an individual will repay a given debt given the
frequency that other individuals in similar situations have defaulted. Most consumer welfare
advocates advise individuals to review their credit reports at least once per year to ensure that the
reports are accurate
3. Off-Balance-Sheet Risk
Off balance sheet refers to the assets, debts or financing activities that are not presented on the
balance sheet of an entity.
It is the risk posed by factors not appearing on an insurer's or reinsurer's balance sheet. Excessive
(imprudent) growth and legal precedents affecting defense cost coverage are examples of off-
balance-sheet risk.
Off balance sheet financing allows an entity to borrow being without affecting calculations of
measures of indebtedness such as debt to equity (D/E) and leverage ratios low. Such financing is
usually used when the borrowing of additional debt may break a debt covenant. The benefit of off
balance sheet items is that they do not adversely affect the liquidity position of an entity.
Most commonly known examples of off-balance-sheet items include research and development
partnerships, joint ventures, and operating leases.
Country or sovereign risk
The sovereign is the State, representing its citizens. Sovereign risk, or country risk, is the risk that
a government could default on its debt (sovereign debt) or other obligations. It is also, the risk
generally associated with investing in a particular country, or providing funds to its government.
Sovereign risk, in the context of disasters, is the economic impact a government would face in the
case of a disaster which affects its citizens.
Sovereign risk is the chance that a national government's treasury or central bank will default on
their sovereign debt, or else implement foreign exchange rules or restrictions that will significantly
reduce or negate the worth of its forex contracts.

Technology risk, or information technology risk
Refers to the potential for any technology failure to disrupt a company or a business enterprise.
Every type of technology risk has the potential to cause financial, reputational, regulatory, and/or
strategic risk. As such, it’s critical to have an effective technology risk management strategy in
place to anticipate potential problems.
Technological risk management
Risk management includes the strategies, processes, systems, and people aimed at effectively
managing potential technology risks.
Essentially, the goal of cyber security risk management is to identify potential technology risks
before they occur and have a plan to address those technology risks. Risk management looks at the
internal and external technology risks that could have a negative effect on a company. Risk
management teams define their technology risk management plans by identifying and analyzing
technology risks, managing the technology risks by implementing their strategies, and forming
contingency plans.
Mitigating technology risks
Before risk management teams can decide how to best manage the technology risks, they have to
identify the causes of the technology risks that they’ve identified. At this point, the risk
management team discusses how each technology risk will impact the business.
As risk management teams learn about the causes of the technology risks, the impacts of the
technology risk that they’ve identified, and the probability that the risks will occur, teams can start
to determine possible solutions to manage or prevent technology risks.
Risk management teams should also write the technology risk responses into their risk
management plans to prepare for the next part of the process, which is implementation.

Working from the top priorities down, the risk management team will then break down the risk
responses for each technology risk into action steps, which become part of the risk management
plan.
The risk management team should immediately implement whatever action steps they can to
proactively prevent the technology risks from occurring. If a technology risk occurs, the risk
management team can retrieve the plan and put the appropriate steps into action.
Operational Risk
This is defined as the risk of loss resulting from day-to-day business activities within a given field
or industry due to failed internal processes, people and systems or from external events. It is the
risk of loss arising from the potential that inadequate information system; technology failures,
breaches in internal controls, fraud, unforeseen catastrophes, or other operational problems may
result in unexpected losses.
Types of Operational Risks
This risks are classified according to;
i. Course based risk

ii. Effect based risk
A. Cause based classification
i. People oriented causes such as negligence, incompetence, insufficient training and integrity
ii. Process oriented/Transaction based causes such as business volume fluctuation, organizational
complexity, product complexity and major changes
iii. Process oriented/ Operational control based causes such as inadequate segregation of duties, lack
of management supervision and inadequate procedures
iv. Technology oriented causes such as poor technology and telecom, obsolete applications, lack of
automation, information system complexity, poor design, development and testing
v. External causes such as natural disasters, operational failures of a third party, deteriorating
social/political environment.
B. Effect Based Causes
• Legal liability

• Regulatory, compliance and taxation penalties
• Loss or damage to assets
• Restitution
• Loss of recourse
• Write downs
Other classifications of operational risk includes;
i. Internal fraud
These are acts of a type intended to defraud, misappropriate property or circumvent regulations,
the law, or company policy (excluding diversity or discrimination events) which involve at least
one internal party. Examples include intentional misreporting of positions, employee theft and
insider trading on an employee’s own account.
ii. External fraud

These are acts by third party of a type intended to defraud, misappropriate property or circumvent
the law. Examples include robbery, forgery and damage from computer hacking.
iii. Employment practices and workplace safety

These are acts inconsistent with employment, health or safety laws or agreements or which result
in payment of personal injury claims or claims relating to diversity or discrimination issues.
Examples include workers compensation claims, violation of employee health and safety rules,
organized labour activities, discrimination claims and general liabilities e.g. customer slipping and
falling at a branch office.
iv. Clients, products and business practices

This is the unintentional or negligent failure to meet a professional obligation to specific clients
including fiduciary and suitability requirements or from the nature or design of a product.
Examples include fiduciary breaches, misuse of confidential customer information, and improper
trading activities on the bank’s account, money laundering and sale of unauthorized products.
v. Damage to physical assets

Loss or damage to physical assets from natural disasters or other events. Examples include
terrorism, vandalism, earthquakes, fires and floods.

vi. Business disruption and system failure
Losses arising from disruption of business or system failures such as hardware and software
failures, telecommunication problems and utility outages.
vii. Execution, delivery and process management

Losses from failed transaction processing or process management and relations with trade counter
parties and vendors. Examples include data entry errors, collateral management failures,
incomplete legal documentation, unapproved access given to clients’ accounts, non-client
counterparty mis-perfromance and vendor disputes.
Measurement Approaches to Operational Risks
These includes;
a) The Basic Indicator Approach

Under this approach, operational risk capital is set to equal 15% of annual gross income over the
previous three years. Gross income is defined as net interest income plus non-interest income. Net
interest income is the excess of income earned on loans over interest paid on deposits and other
instruments that are used to fund the loans.
Operational risk capital = 15%*Gross income over the previous 3 years.
b) Standardized Approach
Under this method an institution’s activities are divided into eight business lines; corporate finance,
trading and sales, retail banking, commercial banking, payment and settlement, agency services,
asset management and retail brokerage. The average gross income over the last three years for
each business line is multiplied by a “Beta Factor” for that business line and the result summed to
determine the total capital.
c) Advanced Measurement Approach (AMA)

Under this method the operational risk regulatory capital requirement is calculated by the
institution internally using qualitative and quantitative criteria. To use the AMA, the institution
must satisfy additional requirements to those of the standardized approach. These are;

• It must be able to estimate unexpected losses based on an analysis of relevant internal and external data
and scenario analysis.
• The institution’s system must be capable of allocating economic capital for operational risk across
business lines in a way that creates incentives for the business lines to improve operational risk
management.
Liquidity Risk
Liquidity is a term used to refer to how easily an asset or security can be bought or sold in the
market. It basically describes how quickly something can be converted to cash. There are two
different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is
market liquidity risk, also referred to as asset/product risk.
Again, liquidity risk is the current or prospective risk to earnings and capital arising from a
financial institution’s inability to meet its liabilities when they fall due without incurring
unacceptable losses. It arises when the cushion provided by the liquid assets are not sufficient to
meet its obligations.
Types of Liquidity Risk
i. Funding risk- This arises from the need to replace net outflows due to unanticipated withdrawal
of funds or non-renewal of deposits
ii. Time risk- This arises from the need to compensate for no receipt of expected inflows of funds
i.e. performing assets turning into non-performing assets
iii. Call risk- This arises due to crystallization of contingent liabilities. This may also arise when a
financial institution may not be able to undertake profitable business opportunities when it arises.
iv. Market Liquidity Risk - Market or asset liquidity risk is asset illiquidity. This is the inability to
easily exit a position. For example, we may own real estate but, owing to bad market conditions, it
can only be sold imminently at a fire sale price. The asset surely has value, but as buyers have
temporarily evaporated, the value cannot be realized.
Measuring Liquidity Risk

Liquidity represents the ability to accommodate decreases in liability and to fund increases in
assets. A financial institution has adequate liquidity when it can obtain sufficient funds either by

increasing liabilities or by converting assets promptly and at reasonable cost. In measuring a
bank’s liquidity exposure the following methods can be used;
a. Net liquidity statement

This statement lists sources and uses of liquidity thus providing a measure of the net liquidity
position. A manager must be able to measure liquidity position on a daily basis if possible.
b. Peer Group Ratio comparisons

This involves comparing some of the institution’s key ratios and balance sheet features-such as
loans to deposits, borrowed funds to total assets and commitments to lend to asset ratios-with those
of institutions of similar size and geographic location.
c. Liquidity index
This index measures the potential losses a FI could suffer from a sudden or fire sale disposal of
assets compared to the amount it would receive at a fair market value established under normal
market conditions. The larger the differences between immediate fire sale asset prices and fair
market prices the less liquid is the portfolio of assets.
Strategic Risk
This is the current and prospective impact on earnings or capital arising from adverse business
decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This
risk is a function of the compatibility of an organization’s strategic goals, the business strategies
developed to achieve those goals, the resources deployed against these goals, and the quality of
implementation. The resources needed to carry out business strategies are both tangible and
intangible. They include communication channels, operating systems, delivery networks, and
managerial capacities and capabilities. In strategic management, the organization’s internal
characteristics must be evaluated against the impact of economic, technological, competitive,
regulatory, and other environmental changes.
Reputational Risk
This is the potential that negative publicity regarding an institution’s business practices, whether
true or not, will cause a decline in the customer base, costly litigation, or revenue reductions. This

risk may result from a financial institution’s failure to effectively manage any or all of the other risk
types. Reputational risk also involves external perception. Thus reputational risk is where the actions
of a business damage its reputation, to the extent that it may lose sales or customers, or where the
actions of a financial institution damage its reputation to the extent that they lose business or offer
to bear or share losses suffered by their customers. Many management teams have been criticized
for the way they handled a crisis – not because their strategy was ill conceived or clumsily
implemented, but because they failed to tell the outside world what the strategy was.
Bankruptcy Risk/ Insolvency risk
Bankruptcy risk, or insolvency risk, is the likelihood that a company will be unable to meet its debt
obligations. It is the probability of a firm becoming insolvent due to its inability to service its debt.
Many investors consider a firm's bankruptcy risk before making equity or bond investment
decisions. Firms with a high risk of bankruptcy may find it difficult to raise capital from investors
or creditors.
A firm can fail financially because of cash flow problems resulting from inadequate sales and high
operating expenses. To address the cash flow problems, the firm might increase its short-term
borrowings. If the situation does not improve, the firm is at risk of insolvency or bankruptcy.
In essence, insolvency occurs when a firm cannot meet its contractual financial obligations as they
come due. Obligations might include interest and principal payments on debt, payments on
accounts payable, and income taxes.
More specifically, a firm is technically insolvent if it cannot meet its current obligations as they come
due, even though the value of its assets exceeds the value of its liabilities. A firm becomes legally
insolvent if the value of its assets is less than the value of its liabilities. A firm is finally considered
to be bankrupt if it is unable to pay its debts and files a bankruptcy petition.
How to Determine Bankruptcy Risk
Solvency is often measured with a liquidity ratio called the current ratio, which compares current
assets (including cash on hand and any assets that could be converted into cash within 12 months,

such as inventory, receivables, and supplies) and current liabilities (debts that are due within the
next 12 months, such as interest and principal payments on debt serviced, payroll, and payroll
taxes).
There are many ways to interpret the current ratio. Some, for example, consider a 2:1 current ratio
as solvent, showing that the firm's current assets are twice its current liabilities. In other words, the
firm's assets would cover its current liabilities about two times.
How do you know if a company is at risk of going bankrupt?
The following are often signs of trouble:
i. Dwindling cash and/or losses, especially if they represent a trend

ii. Abrupt dismissal of the company auditor
iii. Dividend cuts or the elimination of dividends
iv. Departure of senior management
v. Insider selling, especially large or frequent transactions following negative news
vi. Selling off a product line to raise cash
vii. Cuts in perks like health benefits or pensions
How Companies mitigate Insolvency Risk
No company becomes insolvent overnight. If it looks like your business is headed in that direction,
take steps to protect it.
Focus on cash flow. Among other actions, this may involve invoicing promptly, recovering debts,
renegotiating credit limits, renegotiating contracts with suppliers, selling assets (if necessary), and
reducing the amount of cash tied up in stock.
Reduce business expenses. Possibilities include cutting advertising and/or research and
development, paying off debts earlier to lower interest on debt, reducing staff overtime, delaying
the purchase of new or leased equipment.

Keep your creditors in the loop. Discuss any problems you are having with payments and be
ready to negotiate and compromise.
Get good financial and legal advice. Consult the company's accountant and lawyer, who should
already be familiar with your business.
Bankruptcy Protection
When a public company is unable to meet its debt obligations and files for protection under
bankruptcy, it can reorganize its business in an attempt to become profitable, or it can close its
operations, sell off its assets, and use the proceeds to pay off its debts (a process called liquidation).
In a bankruptcy, the ownership of the firm's assets transfers from the stockholders to the bondholders.
Because bondholders have lent the firm money, they will be paid before stockholders, who have an
ownership stake.

CHAPTER FOUR
LIABILITY AND LIQUIDITY MANAGEMENT
Liquidity
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash
without affecting its market price. In other words, liquidity describes the degree to which an asset
can be quickly bought or sold in the market at a price reflecting its intrinsic value. Cash is
universally considered the most liquid asset because it can most quickly and easily be converted
into other assets. Tangible assets, such as real estate, fine art, and collectibles, are all relatively
illiquid. Other financial assets, ranging from equities to partnership units, fall at various places on
the liquidity spectrum. Therefore a liquid asset is an asset that can easily be converted into cash
within a short period of time.
In accounting, liquidity is a measure of the ability of a debtor to pay their debts as and when they
fall due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity is the
ability to pay short-term obligations. Liquidity refers to the ability of an institution to meet
demands for funds.
There are two major determinants of a company's liquidity position. The first is its ability to
convert assets to cash to pay its current liabilities (short-term liquidity).
Methods measures of liquidity
1. Market liquidity
2. Accounting liquidity.
Market Liquidity
Market liquidity refers to the extent to which a market, such as a country's stock market or
a city's real estate market, allows assets to be bought and sold at stable, transparent prices.
The stock market is characterized by higher market liquidity. If an exchange has a high
volume of trade that is not dominated by selling, the price a buyer offers per share (the bid
price) and the price the seller is willing to accept (the ask price) will be fairly close to each
other.
Investors, then, will not have to give up unrealized gains for a quick sale. When the
spread between the bid and ask prices grows, the market becomes more illiquid. Markets
for real estate are usually far less liquid than stock markets. The liquidity of markets for
other assets, such as derivatives, contracts, currencies, or commodities, often depends on
their size, and how many open exchanges exist for them to be traded on.

Accounting Liquidity
Accounting liquidity measures the ease with which an individual or company can meet their
financial obligations with the liquid assets available to them the ability to pay off debts as they
come due. In investment terms, assessing accounting liquidity means comparing liquid assets to
current liabilities, or financial obligations that come due within one year.
There are a number of ratios that measure accounting liquidity, which differ in how strictly they
define "liquid assets." Analysts and investors use these to identify companies with strong liquidity.
It is also considered a measure of depth.
Measuring Liquidity
Note: Generally, in using these formulas, a ratio greater than one is desirable.
Current Ratio
The current ratio is the simplest and least strict. It measures current assets (those that can
reasonably be converted to cash in one year) against current liabilities. Its formula would be:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio (Acid-test ratio)

The quick ratio, or acid-test ratio, is slightly stricter. It excludes inventories and other current
assets, which are not as liquid as cash and cash equivalents, accounts receivable, and short-term
investments. The formula is:
Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) /
Current Liabilities
Acid-Test Ratio (Var)

A variation of the quick/acid-test ratio simply subtracts inventory from current assets, making it a
bit more generous:
Acid-Test Ratio (Var) = (Current Assets - Inventories - Prepaid Costs) / Current Liabilities
Cash Ratio
The cash ratio is the most exacting of the liquidity ratios. Excluding accounts receivable, as well
as inventories and other current assets, it defines liquid assets strictly as cash or cash equivalents.
More than the current ratio or acid-test ratio, the cash ratio assesses an entity's ability to stay solvent
in the case of an emergency. The worst-case scenario on the grounds that even highly profitable
companies can run into trouble if they do not have the liquidity to react to unforeseen events. Its
formula is:

Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities
Liability
A liability is something a person or company owes, usually a sum of money. Liabilities are settled
over time through the transfer of economic benefits including money, goods, or services. Recorded
on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages,
deferred revenues, bonds, warranties, and accrued expenses.
In general, a liability is an obligation between one party and another not yet completed or paid for.
In the world of accounting, a financial liability is also an obligation but is more defined by previous
business transactions, events, sales, exchange of assets or services, or anything that would provide
economic benefit at a later date. Liabilities are usually considered short term (expected to
be concluded in 12 months or less) or long term (12 months or greater).
Liabilities are also known as current or non-current depending on the context. They can include a
future service owed to others; short- or long-term borrowing from banks, individuals, or other
entities; or a previous transaction that has created an unsettled obligation. The most common
liabilities are usually the largest like accounts payable and bonds payable. Most companies will
have these two line items on their balance sheet, as they are part of ongoing current and long- term
operations.
The Relationship between Liabilities and Assets
Assets are the things a company owns or things owed to the company and they include tangible
items such as buildings, machinery, and equipment as well as intangible items such as accounts
receivable, interest owed, patents or intellectual property. While liabilities refers to the obligation
between one party and another not yet completed or paid for. They includes loans, accounts
payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses.
Liquidity and Asset-liability Management
Asset-liability Management (ALM) is the process of planning, organizing, and controlling asset
and liability volumes, maturities, rates, and yields in order to minimize interest rate risk and
maintain an acceptable profitability level. Simply stated, ALM is another form of planning. It
allows managers to be proactive and anticipate change, rather than reactive to unanticipated
change. An institution’s liquidity is directly affected by ALM decisions. Managers must always
analyze the impact that any ALM decision will have on the liquidity position of the institution.
Liquidity is affected by ALM decisions in several ways:

▪ Any changes in the maturity structure of the assets and liabilities can change the cash
requirements and flows.
▪ Savings or credit promotions to better serve clients or change the ALM mix could have a
detrimental effect on liquidity, if not monitored closely.
▪ Changes in interest rates could impact liquidity.
Liquidity Management
Liquidity management is a set of ongoing strategies and processes that ensure your business is able
to access cash as needed to pay for goods and services, make payroll and invest in new
opportunities that arise.
Liquidity management means ensuring that the institution maintains sufficient cash and liquid
assets purposely to;
1. To satisfy client demand for loans and savings withdrawals

2. To pay the institution’s expenses.
Therefore, liquidity management involves a daily analysis and detailed estimation of the size and
timing of cash inflows and outflows over the coming days and weeks to minimize the risk that
savers will be unable to access their deposits in the moments they demand them. In order to manage
liquidity, an institution must have a management information system in place manual or
computerized that is sufficient to generate the information needed to make realistic growth and
liquidity projections. The information needed includes:
❖ The actual deposit liabilities of the MFI as of a certain date according to client name,
maturity, amount, and type of account.
❖ A history of deposit and loan inflows and outflows.
❖ A history of overall daily cash demands to determine the amount of cash that needs to be
kept on-site and in demand deposit type accounts
Liquidity Management Policy
A financial institution should have a formal liquidity policy that is developed and written by the
officials with the assistance of management. The policy should be reviewed and revised as needed,
no less than annually. The policy should be flexible, so that managers may react quickly to any
unforeseen events. A liquidity policy should specifically state:
❖ Who is responsible for liquidity management?

❖ What is the general methodology of liquidity management?
❖ How will liquidity be monitored or, in other words,
❖ What liquidity management tools will be used?

❖ What are the time frames to be used in cash flow analysis, the level of detail, and the intervals at which
the cash flow tools used are to be updated.
❖ The level of risk that the institution is prepared to take in minimizing cash to enhance profitability.
Specifically, the policy should establish minimums and maximums for total cash assets and for the
amount to be kept on-site.
❖ How often decisions about liquidity should be reviewed, including: assumptions used to develop the
cash flow budget, the minimum cash requirement as described in daily cash forecasting, and any of the
established ratio targets.
❖ Which assets are considered to be liquid?
❖ Established limits for the maximum amount to be invested in any one bank, to limit exposure to a
bank failure.
❖ Who may access or establish a line of credit for short-term liquidity needs.
❖ What are acceptable reasons or scenarios for accessing the line of credit?
Monitoring the ALM Position
In order to successfully monitor the ALM position of a savings institution:
• Managers must have effective liquidity management plans in place.

• Managers must be able to identify the core or stable deposit base in the institution and match that against
longer-term assets to reduce the interest rate risk. Stable deposits include: equity, certificates of deposit
with penalties for early withdrawal, retirement savings, savings with a stated purpose, and regular
savings accounts with small balances. Within each savings account type managers must determine the
amount or percentage of funds that can be used to fund longer-term loans.
• Managers must be able to identify the minimum net margin (gross income – cost of funds) necessary
to fund financial costs, operating expenses, and contributions to capital.
The objective of liquidity management
1. To ensure that banks are able to meet in full all their financial obligations as they fall due
2. Is not to eradicate or eliminate risk, but to manage it in a way that the volatility of net interest
income is minimized in the short run and economic value of the bank is protected in the long run.
3. To maximize earnings and return on assets within acceptable levels of risk
4. Stable or increasing net interest margin
5. Adequate earnings in both ordinary and shocked interest rate environments
6. Adequate liquidity
7. Acceptable level of net worth

Deposit insurance and other liability guarantees
Deposit insurance is a measure implemented in many countries to protect bank depositors, in full
or in part, from losses caused by a bank's inability to pay its debts when due. Deposit insurance
systems are one component of a financial system safety net that promotes financial stability.
Like any other insurance policy, it is a protection cover against losses accruing to bank deposits if
a bank fails financially and has no money to pay its depositors and has to go in for liquidation.
This create what is known as Bank run
Refers to contagious run is an unjustified panic condition in which liability holders withdraw funds
from a deposit-taking institution without first determining whether the institution is at risk. This
action usually occurs at a time that a similar run is occurring at a different institution that is at risk.
The contagious run may have an adverse effect on the level of savings that may affect wealth
transfers, the supply of credit, and control of the money supply. Deposit-taking institutions and
insurance companies face the most serious risk of contagious runs.
Bank runs are costly to society since they create liquidity problems and can have a contagion effect.
Because of the first-come, first-serve nature of deposit liabilities, bank depositors have incentives
to run on the bank if they are concerned about the bank's solvency. As a result of the external cost
of bank runs on the safety and soundness of the entire banking system, a safety net to remove the
incentives to undertake bank runs was put into place in 1967. The primary pieces of this safety net
are deposit insurance and other guaranty programs that provide assurance that funds are safe even
in cases when the FI is in financial distress.
Other elements of the safety net are access to the lender of last resort (borrowing from the Bank
of Canada) and minimum capital guidelines.
Moral hazard
Moral hazard occurs in the financial institution industry when the provision of deposit insurance
or other liability guarantees encourages the institution to accept asset risks that are greater than the
risks that would have been accepted without such liability insurance
How does a risk-based insurance program solve the moral hazard problem of excessive risk
taking by FIs?
A risk-based insurance program should deter banks from engaging in excessive risk-taking as long
as it is priced in an actuarially fair manner. However, since the failure of banks can have significant
social costs, regulators have a special responsibility towards maintaining their solvency, even
providing them with some form of subsidies. In a completely free market system, it is possible that
deposit-taking institutions located in sparsely populated areas may have to pay

extremely high premiums to compensate for a lack of diversification or investment opportunities.
Such DTIs may have to close down unless subsidized by the regulators. Thus, a strictly risk- based
insurance system may not be compatible with a truly competitive banking system.
Capital forbearance refers to regulators’ permitting an FI with depleted capital to continue

operations. The primary advantage occurs in the short run through the savings of liquidation costs.
In the longer run, the likely cost is that the poorly managed FI will become larger, more risky, but
no more solvent. Eventually even larger liquidation costs must be incurred.
Banks are allowed (and usually encouraged) to lend or invest most of the money deposited with
them instead of safe-keeping the full amounts (see fractional-reserve banking). If many of a bank's
borrowers fail to repay their loans when due, the bank's creditors, including its depositors, risk
loss. Because they rely on customer deposits that can be withdrawn on little or no notice, banks in
financial trouble are prone to bank runs, where depositors seek to withdraw funds quickly ahead
of a possible bank insolvency. Because banking institution failures have the potential to trigger a
broad spectrum of harmful events, including economic recessions, policy makers maintain deposit
insurance schemes to protect depositors and to give them comfort that their funds are not at risk.
Deposit insurance institutions are for the most part government run or established, and may or
may not be a part of a country's central bank, while some are private entities with government
backing or completely private entities. There are a number of countries with more than one deposit
insurance system in operation, including Austria, Canada (Ontario & Quebec), Germany, Italy,
and the United States
Federal Deposit Insurance Corporation (FDIC)
The Federal Deposit Insurance Corporation (FDIC) is a US government institution that provides
deposit insurance against bank failure.
The body was created during the Great Depression when the public had lost trust in the
banking system. Prior to its formation, a third of US banks had collapsed, leading to the loss of
many depositors’ funds. There was no guarantee on bank deposits other than the bank’s stability,
and only depositors who were quick enough to withdraw their money were lucky enough to retain
it.
The FDIC was established with the aim of maintaining public confidence in the financial system
and promoting sound banking practices.

History of the FDIC
The Federal Deposit Insurance Corporation was formed in 1933, following the stock market
crash of 1929 that led to the failure of thousands of banks. Investors who were worried about losing
their bank deposits started withdrawing their savings, and this resulted in the collapse of even more
banks. Following the crisis, then US President, Franklin Roosevelt, ordered a four-day bank
holiday to allow for the inspection of the banks. Later that year, he signed the Banking Act of 1933
that led to the formation of FDIC to restore public confidence in the financial system.
The Banking Act gave the FDIC authority to provide deposit insurance to commercial banks, as
well as to supervise and regulate state non-member banks.
Functions of the FDIC
The Federal Deposit Insurance Corporation directly supervises more than 4,000 banks to ensure
they operate within the law and that investors’ funds are secured. The agency also acts as the
primary federal regulator of banks chartered by state governments that do not join the Federal
Reserve System. It ensures that banks comply with consumer protection laws such as the Fair
Credit Billing Law, the Truth-in-Lending Law, Fair Debt Collection Practices Law, and the Fair
Credit Reporting Law. Savings, checking, retirement, and other deposit accounts are insured for
up to $250,000 per ownership category. However, the FDIC does not insure mutual funds,
securities, money market accounts, or bonds.
The FDIC executes its mandate with the help of two components, the Advisory Committee on
Economic Inclusion and the Office of International Affairs. The Advisory Committee on
Economic Inclusion advises the FDIC on banking policies and initiatives and makes corresponding
recommendations. The banking policies include reviewing basic retail financial services such as
money orders, remittances, check cashing, stored value cards, and short-term loans. The Office of
International Affairs helps the FDIC address global financial challenges that affect the deposit
insurance system. It also provides technical assistance and training to foreign deposit insurers and
bank supervisors
The two most common ways for the FDIC to resolve a closed institution and fulfill its role as
a receiver are;
Purchase and Assumption Agreement (P&A), in which deposits (liabilities) are assumed by an
open bank, which also purchases some or all of the failed bank's loans (assets). The bank's assets
that convey to the FDIC as receiver are sold and auctioned through various methods, including
online, and using contractors.

Deposit Payoff, as soon as the appropriate chartering authority closes the bank or thrift, the FDIC
is appointed receiver. The FDIC as insurer pays all of the failed institution's depositors [36] with
insured funds the full amount of their insured deposits. Depositors with uninsured funds and other
general creditors (such as suppliers and service providers) of the failed institution do not receive
either immediate or full reimbursement; instead, the FDIC as receiver issues them receivership
certificates. A receivership certificate entitles its holder to a portion of the receiver's collections on
the failed institution's assets.
In Kenyan context
In 1989, the government of Kenya established the Deposit Insurance System (DIS), dubbed
“Deposit Protection Fund Board,” which has since transited to the Kenya Deposit Insurance
Corporation (KDIC). KDIC is mandated to protect depositors against the loss of their insured
deposits in the unlikely event of failure of a member bank.
Our members include: commercial banks, mortgage finance institutions and Microfinance banks
licensed by the Central Bank of Kenya and as such, membership to KDIC is mandatory. The
current membership comprises 42 Commercial banks, one Mortgage Finance Institution, and 14
Deposit Taking Microfinance banks.
In Kenya, the DIS is an integral component of an effective financial safety net that protects small,
vulnerable, and unsophisticated depositors. This consequently enhances consumer protection.
When a bank fails, the protected depositors are notified through mainstream media, social media
or any other relevant channel, on the process of lodging a claim to their protected deposits.
The Kenya Deposit Insurance Corporation (KDIC) is a Kenya government corporation providing
deposit insurance to depositors in Kenyan banks and deposit-taking microfinance institutions. The
KDIC was created by act of parliament in May 2012.
History
At the time KDIC was established in 2012, it was an integral part of the Central Bank of Kenya,
the country's central bank and banking regulator. The law also established the Deposit Insurance
Fund (the Fund), replacing the Deposit Protection Fund. KDIC, by law is mandated to administer
the Fund, by collecting contributions for the Fund from member institutions; and holding,
managing, and applying the Fund.
The KDIC also is mandated to receive, liquidate, and wind up institutions for which it is the
designated receiver or liquidator, a function previously overseen by the Central Bank of Kenya.
The KDIC Act mandates the Central Bank to appoint the KDIC as the sole and exclusive receiver
of a member institution when (a) the institution's obligations to creditors exceed its

assets (b) deliberately violates a regulatory or supervisory order (c) fails to provide necessary
access to inspectors or lacks general transparency (d) is unable to meet any of its financial
obligations, either now or in the near future (e) engages in activities that violate any of the country's
laws.
In 2014, the law was amended and KDIC became separated from the Central Bank. KDIC collects
a flat rate fee of 0.15 percent of all deposits from each member institution, adjustable at the
discretion of KDIC. It also collects an additional fee based on the risk-adjusted percentage of their
total deposit liabilities during the previous twelve months as calculated by KDIC
Role and Functions
The Deposit Insurance Corporation (DIC) was established by the Central Bank and Financial
Institutions (Non-Banking) (Amendment) Act, 1986 which amended the Central Bank Act Chapter
79:02.
The DIC insures depositors in all institutions licensed to operate under the Financial Institutions
Act 2008. Depositors in all licensed financial institutions are insured up to a maximum of TT
$125,000. Only deposits held in Trinidad and Tobago and payable in Trinidad and Tobago dollars
are insured.
The DIC is financed mainly by contributions and annual premiums levied on licensed member
institutions. The DIC is empowered to borrow and special premiums may be levied on all member
institutions should the demand on the Fund exceed its resources.
The Deposit Insurance Corporation manages and invests the Fund and is thus able to provide
insurance coverage for deposits.
Deposit insurance is payable only when a bank or other such institution licensed to operate by the
Central Bank has been “closed by or with the approval of the Central Bank as a result of financial
difficulties.” It must, however, be noted that this payment is made only when a depositor has made
a claim supported by proof.
The depositor must submit a claim to the DIC within one year from the date of closure and
the payment of the insurance must commence not later than three (3) months after closure.
Claims are processed by the Deposit Insurance Corporation, and payments depending on volume,
may be effected through agent banks or by the Deposit Insurance Corporation itself.
In addition to this insurance function the DIC is empowered to act as the Liquidator or Receiver
of failed member institutions. This role complements that of insurer and administrator of the Fund,
as the efficient realization of assets permits the Fund to recoup the Insurance monies paid out,
which by statute enjoy a preferential status.

Depository institutions provide 4 important services to the economy:
i. They provide safekeeping services and liquidity

ii. They provide a payment system consisting of checks and electronic funds transfers;
iii. They pool the money of many savers and lend it out to people and businesses; and.
iv. They invest in securities.
CAPITAL ADEQUACY
Capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital
a bank or other financial institution has to hold as required by its financial regulator. This is usually
expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted
assets. These requirements are put into place to ensure that these institutions do not take on excess
leverage and become insolvent. Capital requirements govern the ratio of equity to debt, recorded
on the assets side of a firm's balance sheet. They should not be confused with reserve requirements,
which govern the liabilities side of a bank's balance sheet in particular, the proportion of its assets
it must hold in cash or highly-liquid assets.
What is the Capital Adequacy Ratio (CAR)?
The Capital Adequacy Ratio set standards for banks by looking at a bank’s ability to pay liabilities,
and respond to credit risks and operational risks. A bank that has a good CAR has enough capital
to absorb potential losses. Thus, it has less risk of becoming insolvent and losing depositors’
money. After the financial crisis in 2008, the Bank of International Settlements (BIS) began setting
stricter CAR requirements to protect depositors.
Adequacy Ratio (CAR) also known as capital to risk-weighted assets ratio, measures a bank's
financial strength by using its capital and assets. It is used to protect depositors and promote the
stability and efficiency of financial systems around the world.
Calculating CAR
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets.
The capital used to calculate the capital adequacy ratio is divided into two tiers.
As shown below, the CAR formula is:

Tier-1 Capital
Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets
and audited revenue reserves. Tier-1 capital is used to absorb losses and does not require a bank
to cease operations. Tier-1 capital is the capital that is permanently and easily available to cushion
losses suffered by a bank without it being required to stop operating. A good example of a bank’s
tier one capital is its ordinary share capital.
Tier-2 Capital
Tier-2 capital comprises unaudited retained earnings, unaudited reserves and general loss reserves.
This capital absorbs losses in the event of a company winding up or liquidating. Tier-2 capital is
the one that cushions losses in case the bank is winding up, so it provides a lesser degree of
protection to depositors and creditors. It is used to absorb losses if a bank loses all its Tier-1 capital.
The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's
capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans, evaluating
the risk and then assigning a weight. When measuring credit exposures, adjustments are made to
the value of assets listed on a lender’s balance sheet.
All of the loans the bank has issued are weighted based on their degree of credit risk. For example,
loans issued to the government are weighted at 0.0%, while those given to individuals are assigned
a weighted score of 100.0%.
Risk-Weighted Assets
Risk-weighted assets are used to determine the minimum amount of capital that must be held by
banks and other institutions to reduce the risk of insolvency. The capital requirement is based on
a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of
credit is considered to be riskier and requires more capital than a mortgage loan that is secured
with collateral.
Note;
❖ The purpose is to establish that banks have enough capital on reserve to handle a certain amount
of losses, before being at risk for becoming insolvent.
❖ Capital is broken down as Tier-1, core capital, such as equity and disclosed reserves, and Tier-2,
supplemental capital held as part of a bank's required reserves.
❖ A bank with a high capital adequacy ratio is considered to be above the minimum requirements
needed to suggest solvency.
❖ Therefore, the higher a bank's CAR, the more likely it is to be able to withstand a financial
downturn or other unforeseen losses.

Note: Additional notes on Capital adequacy
IMPORTANCE OF CAPITAL ADEQUACY IN INTERNATIONAL RISK

MANAGMENT
Introduction
Capital adequacy base specifically made to sustain a banking business from insolvency. Banks are
regularly advice to maintain a capital level unimpaired of loss. This implies that the capital to be
maintained by banks should be able to cover losses of credit defaults and other losses that could
be incurred by banks. According to the Capital Adequacy Standard set by Bank for International
Settlements (BIS), banks must have a primary capital base equal at least to eight percent of their
assets a bank that lends 12 dollars for every dollar of its capital is within the prescribed limits.
Based on the economy of a country, the highest policy making body of a country has the power to
set the capital adequacy of her country.
According to Okea for (2011) Capital adequacy is measured by the ratio of a bank unimpaired
capital funds to total funds committed to credit operations and/or risk asset investments. The
capital adequacy ratio (CAR) was introduced in Nigeria in 1976
when banks were required to maintain a minimum ration of 10% between their adjustedcap ital
funds and their loans and advances before paying dividends.
The role of the Central banks in any economy lies in the effective regulation and supervision of
the banking sector, as well as critical developmental initiatives of the Bank. The CBN ensures that
the DMBs have adequate levels of capital that is 15% for banks that have international subsidiaries
and 10% for banks without international subsidiaries, which is one of the first levels of defense,
which a central bank has against banking system crisis. But if a bank does get into trouble, the
central bank has to make judgment about how
much support it should give to such institution and balance the benefit s of providing support
against the risks of moral hazard. Making such judgments what Alan Greenspan has called the
“essence of central banking”. The central bank therefore, plays an important part, directly and
indirectly, in deciding the division of risk in the financial system as a whole between the public
sector and private sector. Recently, The Central Bank of Nigeria (CBN) has disclosed that the
Capital Adequacy Ratio (CAR) of commercial banks has improved from the 10.79 per cent as at
August 2018, to 15.26 per cent as of December 2018.
MEASURES OF CAPITAL ADEQUACY IN BANKS
The capital adequacy of banks is tightly regulated worldwide in order to better ensure the stability
of the financial system and the global economy. It also provides additional protection for
depositors. In the United States, banks are regulated at the federal level by the Federal Deposit
Insurance Corporation (FDIC), the Federal Reserve Board and the Office of the

Comptroller of the Currency (OCC). Additionally, state
chartered banks are subject to state regulatory authorities. Regulation and solvency of banks isco
nsidered to be critical because of the unique importance of the banking industry to the
functioning of the economy as a whole. Monitoring the financial condition of banks is also
important because banks have to deal with a mismatch in liquidity between their assets and
liabilities. On the liabilities side of a bank's balance sheet are very liquid accounts, such as
demand deposits. However, a bank's assets primarily consist of rather illiquid loans. While loans
can be (and frequently are) sold by banks, they can only quickly be converted to cash by selling
them at a substantial discount.
Assessing Capital Adequacy
The most commonly used assessment of a bank's capital adequacy is thecapitaladequacy ratio.
However, many analysts and banking industry professionals prefer the economic capital measure.
Additionally, analysts or investors may look at the Tier 1 leverage ratio or basic liquidity ratios
when examining a bank's financial health.
Capital Adequacy Ratio
Commercial banks are required to maintain a minimum capital adequacy ratio. The capital
adequacy ratio represents the risk-weighted credit exposure of a bank. The ratio measures two
kinds of capital:
1. Tier 1 capital is ordinary share capital that can absorb losses without requiring the bank
to cease operations.
2. Tier 2 capital is subordinated debt, which can absorb losses in the event of a winding up of a
bank
Some analysts are critical of the risk-weighting aspect of the capital adequacy ratio and have
pointed out that the majority of loan defaults that occurred during the financial crisis of 2008 were
on loans assigned a very low-risk weighting, while many loans carrying the heaviest weighting for
risk did not default.
Tier 1 Leverage Ratio
A related capital adequacy ratio sometimes considered is the Tier 1 leverage ratio. The Tier 1
leverage ratio is the relationship between a bank's core capital and its total assets. It is calculated
by dividing Tier 1 capital by a bank's average total consolidated assets and certain off-balance
sheet exposures. The higher the Tier 1 leverage ratio is, the more likely a bank can withstand
negative shocks to its balance sheet.

Economic Capital Measure
Many analysts and bank executives consider the economic capital measure to be a more accurate
and reliable assessment of a bank's financial soundness and risk exposure than the capital adequacy
ratio.
The calculation of economic capital, which estimates the amount of capital a bank needs to have
on hand to ensure its ability to handle its current outstanding risk, is based on the bank's financial
health, credit rating, expected losses and confidence level of solvency. By including such economic
realities as expected losses, this measure is considered to represent a more realistic appraisal of a
bank's actual financial health and risk level.
Liquidity Ratios
Investors or market analysts can also examine banks by using standard equityevaluations that ass
ess the financial health of companies in any industry. Thesealternative evaluation metrics include
liquidity ratios such as the current ratio, the cash ratio or the quick ratio.
BANK RISK MANAGEMENT
Risk is defined as a probability of unspecified future events, a foregone or a missed opportunity,

or a positive or a negative deviation from the projected outcome, the probability of damage or
profit (Jasevičienė, 2013, Garbanov, 2010). It is for this reason that the solvency and the liquidity
risk in banking is an object to be managed in order to ensure a successful performance of the
banking system. A successful solution of
risk management problems becomes a guarantor of the success of the activity beingsurveyed.
Risk management issues in Nigeria, as well as worldwide, are receiving exceptional attention
and importance both in terms of expanding the variety of the risks being surveyed and
of developing a set of risk management instruments. Solvency
andliquidity risk management is a process that enables shareholders of the bank tomaximise their
profit without exceeding an acceptable risk. One of the most important objectives in banking
operations is to choose the most appropriate ratio between the risk level and the profit rate
(Jasienė, 2012). In the banking sector, risk ordinarily means a threat that a bank may lose part of
its resources, revenues, or suffer higher costs
when performing certain financial operations. Assumption of a risk in the banking businessdoes
not, however, always mean loss. Efficient management of capital adequacy and liquidity risks at
the bank may build a solid basis for a successful business. G. Garbanov (2010) describes
efficient risk management as one of the methods enhancing a bank’s competitiveness, decreasing
its financial costs and increasing the worth of 62 the bank. In the banking business, risk
management does not mean the full elimination of risk from the operations of the bank; complete
elimination of risk not being feasible does not mean that banks can do nothing and reconcile to
the damage caused by risk as if

itwere inevitable. Therefore, the objective that any bank defines is a proper risk management.
This puts banks on a level playing field to compete among themselves while properly managing
the risk.
IMPORTANCE OF CAPITAL ADEQUACY IN INTERNATIONAL RISK

MANAGEMENT
Banks in the modern world face an inherent risk of insolvency. Since the banks are so highly
leveraged, there could be a run on the bank any moment if their reserves are considered to be
inadequate by the market. Hence, banks must maintain adequate capital in their vaults if they want
to survive. However, what constitutes “adequate” is subjective. This is generally measured in the
form of a “capital adequacy ratio” and central banking institutions all over the world
prescribe the level of capital that needs to be maintained. The following are some key role of capital
adequacy in risk management:
Ensuring Solvency of Banks
The capital adequacy ratio is important from the point of view of solvency of the banks and their
protection from untoward events which arise as a result of liquidity risk as well as the credit risk
that banks are exposed to in the normal course of their business. The solvency of banks is not a
matter that can be left alone to the banking industry. This is because banks have the savings of the
entire economy in their accounts. Hence, if the banking system were to go bankrupt, the entire
economy would collapse within no time. Also, if the savings of the common people are lost, the
government will have to step in and pay the deposit insurance. Hence, since the government has a
direct stake in the issue, regulatory bodies are involved in the creation and enforcement of capital
ratios. In addition to that capital ratios are also influenced by international banking institutions.
Limits the Amount of Credit Creation
Theoretically, reserve requirements are supposed to limit the amount of money that can
be created by banking institutions. However, in some countries, like the United Kingdom and
Canada, there is no reserve requirement at all. However, here too banks cannot go on creating
unlimited money. This is because the capital adequacy ratio also impacts the amount of credit that
can be created by the banks.
Capital adequacy ratios mandate that a certain amount of the deposits be kept aside whenever a
loan is being made.
These deposits are kept aside as provisions to cover up the losses in case the loan goes bad. These
provisions therefore limit the amount of deposits that can be loaned out and hence limit

creation of credit. Changes to the capital adequacy ratio therefore can have a significant impact
on the inflation in the economy.
Credit Exposure
The capital adequacy ratios are laid based on the credit exposure that a particular bank has.
Credit exposure is different from the amount loaned out. This is because banks
canhave credit exposure if they hold derivative products, even though they have notactually
loaned out any money to anybody. Therefore, the concept of credit exposure and how to measure
it in a standardized way across various banks in different regions of the world is an important
issue in formulating capital adequacy ratios. There are two major types of credit exposures that
banks have to deal with.
Balance Sheet Exposure:
Balance sheet exposure is the amount of risk that a bank is exposed to on account of the activities
that are listed on its balance sheet. This would include the credit exposure that result from the loans
that have been sanctioned. It would also result from the credit exposure that is the result of the
securities that have been purchased by the bank. Hence an analyst can simply look at the balance
sheet and come to an exact estimate of the credit exposure of any bank.
Off Balance Sheet Exposure:
On the other hand, there are some risky activities that a bank takes that are not listed on the balance
sheet. For instance, bank
mayissue guarantees to some parties on behalf of some other parties. Theseguarantees are not
financial transactions that can be listed on the balance sheet. However, they do create credit risk
in the process. Similarly the bank may purchase derivative products which do not have any effect
on the balance sheet today. However, they may expose the bank to significant amounts of risks.
The amounts of catastrophic risks that can be caused by derivatives have been witnessed by the
banks during the subprime mortgage crisis. An analyst therefore needs to measure the credit risk
that has been generated by off balance sheet activities. In order to accurately calculate
the credit exposure that arises due to such risks, the analyst requires additional information from
the banks.
Multi-Tiered Capital
For the purpose of calculating the capital adequacy ratio, not all the bank’s capital is considered to
be at an equal footing. The capital is considered to have a multi-tiered structure. Therefore, some
part of the capital is considered to be more at risk than other parts. These tiers represent the
order in which the banks would write off this capital if the situation to do so arises.

Risk Weighting
Also, all credit exposures of the banks are not considered at an equal footing either. Some of the
liabilities of the bank i.e. demand liabilities and the loans that have been financed by them are far
more dangerous than other liabilities. Hence, they need to be assigned appropriate risk weights.
Using the system of weighted risks, banks can be more prepared regarding the probability of an
adverse outcome and to meet the effects that such an outcome would have on the profitability and
solvency of the bank.
CONCLUSION
Banks occupy an important position in the financial system of every economy, therefore a little
mishap in its management will definitely have an effect on the economy and base on the
globalization in the financial system of the world in this recent times, contagious effect of financial
crises may tend to spread out to other countries if not well managed.
However, unfavorable financial situation is a risky phenomenon that can never be completely
eradicated in any economy, various researches has shown that no matter how the economy is
careful over financial crisis, it is bound to occur over time, but what is expedient is how to reduce
its regular occurrence. Risk management becomes a prerequisite for the finance sector
managers of every economy to reduce the reoccurrence of unfavorable financial situation.
Therefore,
capital adequacy as an important risks management measure in banks becomes a very important f
actor to ensure that banks do not go into distress that willadversely affect the global economic
system.

TOPIC FIVE
PRODUCT DIVERSIFICATION
Product diversification
Product diversification is a strategy employed by a company to increase profitability and achieve

higher sales volume from new products. Diversification can occur at the business level or at
the corporate level.
Business-level product diversification

Expanding into a new segment of an industry that the company is already operating in.
Corporate-level product diversification

Expanding into a new industry that is beyond the scope of the company’s current business unit
Why Companies Diversify?
In addition to achieving higher profitability, there are several reasons for a company to diversify.
For example:
• Diversification mitigates risks in the event of an industry downturn.

• Diversification allows for more variety and options for products and services. If done
correctly, diversification provides a tremendous boost to brand image and company
profitability.
• Diversification can be used as a defense. By diversifying products or services, a company
can protect itself from competing companies.
• In the case of a cash cow in a slow-growing market, diversification allows the company to
make use of surplus cash flows.
Objectives of diversification
• To make profit or maximize the returns.
• To make stability in the earning and growth of an organization.
• If the market undergoes the process of saturation, product diversification helps in
undergoing and reducing the risk of the business.
• It creates competition in the market and further helps in surviving this competition with
ease.
• It helps in reducing overhead expenditure and thus amounts to the reduction of indirect
expenses overall.
• To meet the demand of diversified retailers and curtail market expenditure
Why financial institutions diversify their portfolios
a) Diversified bank portfolios can help avoid excessive risk concentration.

A widely accepted theory among financial experts is that lending risks must be managed at both
the borrower and portfolio levels. Since different types of loans react differently to certain
market conditions, the performance of some loan products will be balanced by other loans that
perform better during that same period of time. This basically means that well diversified bank
portfolios can remain strong even when certain loan programs start to perform badly, keeping the
probability of failure at a tolerably low level.
b) Diversified portfolios respond better to changing market conditions.
Portfolio diversification means more than just having different loan products. To achieve superior
diversification, a bank should opt for loan products that respond positively to various economic
events.
For example, diversified bank portfolios that include asset classes with various risk and return
characteristics, such as small business loans, personal loans, home equity loans, home equity lines
of credit, auto loans, conventional mortgages and manufactured home loans, are less susceptible
to market volatility and less likely to experience a significant loss due to adverse market conditions.
c) Diversified bank portfolios can deliver significant returns.
A higher rate of return is among the benefits a diversified portfolio can deliver. A portfolio
diversification strategy that allocates resources across a broad spectrum of asset classes—
including less traditional loan products, like manufactured home loans—will ultimately create
long-term wealth for a bank or credit union
Diversified bank portfolios enable banks to meet their financial objectives.
Using diversification, banks can customize their investment strategies and match their portfolios
to specific risk tolerances. To limit exposure to market volatility, for instance, a bank with a low
risk tolerance can opt for low-risk, high-yield and high-performing loan products like
manufactured home loans provided by an experienced and reputable loan origination and servicing
company.
d) Pursuing diversification can lead to successful partnerships.
Some investors may not feel comfortable investing in a new asset class because they lack
experience in that particular area. As a result, they continue to invest in loan products they’re most
comfortable with, ending up with concentrated loan portfolios.
Although a financial institution which intends to expand into the manufacture home lending market
might consider that certain risks could lead to lower profitability, opting for loan programs
provided by a reputable and reliable indirect lender with plenty of experience in this sector allows
a bank or credit union to indirectly benefit from extensive expertise in applicant screening, loan
underwriting, customer communication, payment collection, portfolio performance and
compliance monitoring.
As it can be seen, diversification is a useful tool for reducing portfolio volatility and managing
risks without sacrificing returns. However, a significant percentage of portfolio performance is
driven by asset allocation decisions. To minimize the “ups and downs” associated with loan
portfolios, loan products must be strategically combined in varying proportions within

customized, diversified bank portfolios, while considering the long-term investment objectives of
each financial institution.
1. FORWARD AND FUTURE CONTRACTS
Forward contract
An agreement between two parties where the contract price is agreed today and is to be exercised
in the future date.
Not standardized
Contracts are written and goes through clearing house
Futures contracts
Is the same as forward contracts except that they are standardized and sold at the Nairobi stock
exchange
Is an agreement between two parties where the standardized contract price is agreed today and is
to be exercised in the future date but within the Nairobi Stock Exchange.
They are standardized
Contracts does not go through clearing houses
NB: In future contract, both the seller and buyer has a right and obligation
Difference between forward contracts and future contracts
Basis for Forward Contract Future Contract

comparison
An agreement between two parties An agreement between two parties where
Meaning where the contract price is agreed the contract price is agreed today and is to
today and is to be exercised in the be exercised in the future date
future date
What is it? Are not standardized contract – Are standardized contract
Tailor made
Traded on Over the counter, i.e. there is no Organized stock exchange i.e. NSE
secondary market
Settlement On maturity date On daily basis
Risk High Low
Default As they are private agreement, the No such probability
chances of default are relatively
high
Contract Depends on the contract terms. Fixed
size
Collateral Not required Initial margin required
Maturity As per the terms of contract Predetermined date
Regulation Self-regulated By stock exchange
Liquidity Low High

2. SWAP
Swaps are derivatives in which two parties agree to swap or exchange one asset for another at a
given future date.
A swap is an agreement between two parties to exchange sequences of cash flows for a set period
of time.
Types of Swaps
1. Interest Rate Swaps

This type of swap allow two parties to exchange fixed and floating cash flows on an interest-
bearing investment or loan.
Businesses or individuals attempt to secure cost-effective loans but their selected markets may not
offer preferred loan solutions. For instance, an investor may get a cheaper loan in a floating rate
market, but he prefers a fixed rate. Interest rate swaps enable the investor to switch the cash flows,
as desired.
Deals with interest rate forecasting i.e. investor’s belief when interest rates fall will swap with
securities of shorter periods and vice versa
2. Currency Swaps
The transactional value of capital that changes hands in currency markets surpasses that of all other
markets. Currency swaps offer efficient ways to hedge forex risk.
3. Zero Coupon Swaps

Similar to the interest rate swap, the zero coupon swap offers flexibility to one of the parties in the
swap transaction. In a fixed-to-floating zero coupon swap, the fixed rate cash flows are not paid
periodically, but just once at the end of the maturity of the swap contract. The other party who
pays floating rate keeps making regular periodic payments following the standard swap payment
schedule.
4. Total Return Swaps

A total return swap gives an investor the benefits of owning securities, without actual ownership.
A TRS is a contract between a total return payer and total return receiver. The payer usually pays
the total return of agreed security to the receiver and receives a fixed/floating rate payment in
exchange. The agreed (or referenced) security can be a bond, index, equity, loan, or commodity.
The total return will include all generated income and capital appreciation.
5. The Bottom Line

Swap contracts can be easily customized to meet the needs of all parties. They offer win-win
agreements for participants, including intermediaries like banks that facilitate the transactions.
Even so, participants should be aware of potential pitfalls because these contracts are executed
over the counter without regulations.

3. OPTION
Refers to the right but not obligation to buy or sell an underlying asset on or before the expiry
date (specified date)
Types of options
a. Call option – Refers to the right but not an obligation to buy an underlying primary asset
at a specified price on or before the expiry date.
b. Put option – Refers to the right but not obligation to sell and underlying primary asset at
a specified price on or before the expiry date.
c. In - the Market option – Refers to an option where the exercise price is less than the
market price. They are profitable options hence investors should exercise (E<ST).
d. Out – of market option - Refers to an option where the exercise price is higher than the
market price. They are not profitable options hence investors should not exercise (E>ST).
e. At – the Market option - Refers to an option where the exercise price is the same as the
market price. They are not profitable options hence investors should not exercise (E=ST).
f. Covered options – Are options issued by investors holding the asset
g. Naked option – Are options created by the investor who may not be holding the asset
Style which options can be exercised

European option – An option that can be exercised (Executed) only on the expiry date
American option – An option that can be exercised (Executed) on or before expiry date
4. CAPS
What is a cap?
A cap, also referred to as an interest rate cap.
It is a risk management tool that provides protection against increasing interest rates while
maintaining the ability to participate in favorable rate movements.
It is an agreement between a buyer and a financial institution such as a bank to receive

compensation if the reference rate moves beyond an agreed level, known as the strike rate. One
major type of loan that uses interest rate caps is an adjustable rate mortgage, or ARM.
A cap is a consumer protection that limits the amount that an interest rate can change in an
adjustment interval or over the term of the loan.
For instance, if the per-period cap is 1 percent and the current rate is 7 percent, the newly adjusted
interest rate cannot go below 6 percent or higher than 8 percent.
One popular loan instrument that carries a cap is an ARM.

An ARM is a type of mortgage that doesn’t come with a fixed interest rate. The rate changes
throughout the duration of the loan based on movements in an index rate, such as the cost of funds
index or the interest rate on certain Treasury securities.
ARMs typically include several types of caps that control how the interest rate can adjust. There
are three types of caps:
• The initial adjustment cap determines how much the rate can increase the first time it moves
after the fixed-rate expires. This type of cap typically ranges from 2 percent to 5 percent.
This means that the first time it changes, the new rate cannot be two to five percentage
points (depending on the actual cap) greater than the initial rate during the fixed-rate period.
• Subsequent adjustment caps refer to how much the interest rate can increase in the periods
of adjustment that follow. This cap is commonly 2 percent, so the new rate cannot be more
than two percentage points higher than the previous rate.
• The lifetime adjustment cap refers to how much the rate can increase in total, throughout
the life of the loan. It is most commonly 5 percent, so the rate cannot be five percentage
points higher compared to the initial rate. However, some lending institutions may have
higher caps.
Practical example of a Cap
A borrower who is paying the Libor rate on a loan can protect himself against a rise in rates by
buying a cap at 2.5 percent. If the interest rate exceeds 2.5 percent in a given payment period, the
payment won’t move higher that the 2.5 percent cap.
Benefits of a Cap
1. Flexibility.
It allows buyers to tailor their caps based on their interest rate views, hedging and cash-flow
requirements.
2. Certainty
Buyers can manage their interest rate exposure when they lock in a strike rate as a hedge against
the unsettled balance up to the pre-agreed strike rate.
5. LOAN SALES/ SECONDARY LOAN PARTICIPATIONS
Occurs when a bank makes a loan and then sells the cash stream from the loan without explicit
contractual recourse, guarantee, insurance, or other credit enhancement, to a third party.
A loan sale is a sale, often by a bank, under contract of all or part of the cash stream from a specific
loan, thereby removing the loan from the bank's balance sheet.

Often subprime loans from failed banks in the United States are sold by the Federal Deposit
Insurance Corporation (FDIC) in an online auction format through companies. Performing loans
are also sold between financial institutions.
Banks have become very active in recent months selling off loans in large portfolio sales. For
example, it has been widely publicized that RBS and its subsidiary Ulster Bank are currently
offering for sale many loans in large portfolio sales as part of RBS’s “Capital Resolution” project
to work out its non-performing loan book. Lloyds Banking Group have also been particularly
active in selling off loans over the past few years.
Risks of loan sales to borrowers

Borrowers often (with justification) have the following concerns:
1. Their loan will be sold to a third party with whom they have no existing commercial
relationship, and with whom they would not have chosen to have a lender/borrower
relationship.
2. The interests/strategy of the purchaser in dealing with the loan may be very different from
that of the original lender. The objectives of funds investing in distressed debt vary;
sometimes they are interested in investing in loans for the long term but often their
objective is to make a profit by taking enforcement action and possession of the property
that is providing security for the loan and selling it on (or holding the property rather than
the loan as an investment). The purchaser may not be in the business of lending money at
all, but in acquiring assets.
3. Some borrowers may be able to agree a restructuring at a profit for the purchaser which in
fact provides a better outcome than they had been able to negotiate with their initial lender.
Whether the purchaser is open to such an offer will depend on its commercial objective in
purchasing the loans and if the borrower has the means/funding to agree terms that provide
an acceptable return to the purchaser compared to other prospects for profit from the deal,
either in the short term or long term.
4. Where the loan being sold is in default (whether by way of missed payments, breach of
covenants or other facility terms) or becomes in default after the sale, the purchaser will
usually have the same rights as the selling bank under the terms of the loan facility.
Typically this will include the ability to demand repayment of the loan, put the borrower
into administration, send receivers in to sell off property, increase interest payments and
fees and generally insist on renegotiating less favorable terms with the borrower.
5. Loans are usually purchased with the benefit of all the security available to the lending
bank, which will include any cross company or personal guarantees as well as debentures
or charges over shareholdings in associated companies. In groups of companies,
enforcement action or insolvency proceedings taken against one company by a new lender
may have serious knock on implications for other group entities due to common provisions
allowing other lenders to the group to treat this as an event of default triggering rights to
call their own loans and/or apply increased rates of interest/fees

Solutions to the risk of loan sales to borrowers
So what can concerned borrowers do to protect their position in circumstances where they are
notified (or suspect) that their bank is intending to sell their loan to a third party?
a) Know your rights. Check your loan agreement/facility letter– can the bank sell the
loan to whomever and howsoever it wants? Or are there restrictions/conditions the
bank must comply with?
b) Borrowers should check the terms of all security documents and associated contracts, such
as interest rate hedging products, to see whether these can be sold on with the loan without
the borrowers’ consent or if there are any restrictions on them
c) Make sure that any ongoing disputes or agreements reached with the bank about
amendments to terms on your facility, or waivers of the bank’s rights are recorded in
writing.
d) It is strongly advisable to take legal advice on any proposed changes to facility terms, even
if they appear straightforward or if you think you know what they are intended to do,
because there may be implications or consequences not apparent to non-lawyers which
could be important in the context of your rights in the event the bank decides to sell your
loan.
e) Apply to court for an order restraining the bank from selling your loan. If having
considered the points above, you believe that the bank is selling your loan in breach of the
provisions in your loan agreement or there is a risk of disclosure of confidential information
in the process that could damage your business, then consider applying to Court for an
order restraining the bank from either selling your loan without complying with the
required procedure or from wrongfully disclosing your confidential information. This
usually takes the form of making an urgent application for an injunction.
6. SECURITIZATION
Securitization is the procedure where an issuer designs a marketable financial instrument by

merging or pooling various financial assets into one group. The issuer then sells this group of
repackaged assets to investors. Securitization offers opportunities for investors and frees up capital
for originators, both of which promote liquidity in the marketplace
Also Securitization is the process of taking an illiquid asset or group of assets and, through
financial engineering, transforming it (or them) into a security.
However, securitization most often occurs with loans and other assets that generate
receivables such as different types of consumer or commercial debt. It can involve the pooling of
contractual debts such as auto loans and credit card debt obligations.
Benefits of Securitization
The process of securitization creates liquidity by letting retail investors purchase shares in
instruments that would normally be unavailable to them. For example, with an MBS an investor
can buy portions of mortgages and receive regular returns as interest and principal payments.
Without the securitization of mortgages, small investors may not be able to afford to buy into a
large pool of mortgages.

Unlike some other investment vehicles, many loan-based securities are backed by tangible goods.
Should a debtor cease the loan repayments on, say, his car or his house, it can be seized and
liquidated to compensate those holding an interest in the debt.
Also, as the originator moves debt into the securitized portfolio it reduces the amount of liability
held on their balance sheet. With reduced liability, they are then able to underwrite additional
loans.
Merits of securitization
a) Turns illiquid assets into liquid ones
b) Frees up capital for the originator
c) Provides income for investors
d) Let’s small investor play
Demerits of securitization
a) Investor assumes creditor role
b) Risk of default on underlying loans
c) Lack of transparency regarding assets
d) Early repayment damages investor's returns
7. FLOORS AND COLLARS
Floors (Interest rate floor)
Are similar to cap except that it is structured to hedge against decreasing interest rates (or down-side
risk). An interest rate floor closely resembles a portfolio of put option contracts.
A floor sets a base level of interest that a borrower must pay and also sets a base level of interest that
a lender or investor can expect to earn.
Collars
It is the combination of a cap and a floor.
It consist of buying a cap and selling a floor or vice versa. Zero cost collars exist when the premium
of the floors exactly matches that of the cap.
Advantages of Collars
a) Provides protection against interest rate increase and gain from interest rate decrease.
b) It can be used as a form of short-term interest rate protection in times of uncertainty.
c) It can be structured so that there is no up-front premium payable (Zero-cost Collar).
d) It can be cancelled, however there may be a cost in doing so.

Disadvantages of Collars
a) It provides you with some ability to participate in interest rate decreases with the Floor rate as
a boundary.
b) To provide a zero cost structure or a reasonable reduction in premium payable under the Cap,
the Floor Rate may need to be set at a high level. This negates the potential to take advantage
of favorable market rate movements.

TOPIC SIX
FINANCIAL INSTITUTIONS REGULATORY ENVIRONMENT
Introduction
Over the years, there have been many arguments and debates over the necessity for financial
regulation. Those who believe in the efficacy of markets argue that regulation is not necessary, as
market forces will operate to best serve society and optimize the allocation of resources. However,
there are many who point out that markets do not always operate in the best interests of societies
so some form of intervention in the form of regulation is necessary.
Meaning of financial regulation

Regulations are rules made by a government or other authority in order to control the way
something is done or the way people behave. Regulation is the controlling of an activity or process,
usually by means of rules.
Financial regulation is a form of regulation or supervision, which subjects financial institutions to

certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial
system. This may be handled by either a government or non-government organization. Financial
regulation has also influenced the structure of banking sectors by increasing the variety of financial
products available.
Financial regulation is the supervision of financial markets and institutions. Financial regulations
necessitate financial institutions to certain requirements, restrictions and guidelines. The primary
purpose of a financial regulation is to maintain the integrity of the financial system. Financial
regulation protects investors, maintain orderly markets and promote financial stability.
Financial institutions are one of the most heavily regulated of all businesses internationally.
Financial service firms face strict government rules limiting:
✓ The services they can offer – the size
✓ The territory they can enter or not enter
✓ The constitution of their portfolio assets, liabilities and capital
✓ How to price and deliver their service to the public
The objectives of financial regulators are usually:

• Market confidence – to maintain confidence in the financial system
• Financial stability – contributing to the protection and enhancement of stability of the
financial system
• Consumer protection – securing the appropriate degree of protection for consumers.
Financial regulations aim to:

• Enforce applicable laws;
• Prosecute cases of market misconduct;
• License providers of financial services;
• Protect clients;

• Investigate complaints;
• Maintain confidence in the financial system.
Reasons for Regulation

There are a number of reasons for regulation they include:
1. To avoid the emergence of monopolies and foster healthy competition among market
players.
2. To correct externalities. Externalities are costs and benefits that accrue to third parties
because of production or consumption of a good. For instance, due to some unforeseen
event, a surge in demand of a particular good may make dealers to attempt to charge above
normal prices and thus make abnormal profits.
3. Information asymmetry – this refers to a situation where one party to a transaction has more
information than the other does. Regulations aim at compelling parties to disclose facts and
information that are pertinent to the transaction. Alternatively, restrict parties from taking
advantage of insider information.
4. Regulation is sometimes necessary to ensure that “profit skimming” does not occur. This
is when a supplier will only supply the customers that lead to the greatest profit returns and
ignore supply to others.
5. To stave off moral hazard. This refers to a scenario where some people not paying for a
service or product over-consume without regard to the costs being borne by others. For
instance, in the insurance industry it is often claimed that some people make excessive
claims against their policies whilst others make few or no claims. Insurance is based on the
idea of pooling the costs of bearing risk such that all participants benefit so when some
make excessive claims they may be benefiting more than others may.
6. Regulation is also necessary in the rationalization and coordination of economic activity to
organize behavior or industries in an efficient manner. For instance, the central bank
regulates banks to ensure that the monetary policy is executed effectively.
7. To promote confidence in the financial system. Unless the public is confident in the safety
and security of their funds they will withdraw their savings hence reduce the volume of
funds available for productive investment. This will slow economic growth and over time
the public standards of living will decline. Some of worst economic conditions are trigged
by a financial panic where financial institution and markets cease to function.
8. Control inflation- some financial institutions have the ability to create money in form of
credit cards, checkable deposits, which can be used to make payments for purchasing of
goods and services. If uncontrolled money growth may lead to increase in the general price
levels or inflation. This will adversely affect consumers especially those of fixed income
since inflation reduces the purchasing power of money. Therefore, the ability of financial
institutions to create money needs monitoring.

9. To help the disadvantaged sectors in the economy- To help those groups that appear to
need special help in the competition for scarce resources/funds e.g. farmers, small scale
businesses, low income families. The government places high social value on subsidizing
or guaranteeing loans made to those sectors. However, it is more efficient to pay direct
money subsidies to these groups of people rather than indirectly reach them by regulating
financial institutions hence interfering with the free operations of the financial service
markets.
10. Safety of public funds particularly the deposits owned by individual and families. While
savers have the responsibility to evaluate the quality and stability of financial institution
before committing their saving to it, the government is concerned with small savers who
may lack the financial expertise and access to quality information necessary to judge the
true condition of a financial institution. However, while safety is vital for savers, no
government can completely remove risk for savers.
11. To ensure equal opportunity and fairness in public access to financial service. Scholar
believes that the powerful force of competition generated by both foreign and domestic
supplies can eventually wipe out the sign of discrimination.
Theories of regulation
Initially the main advantage claimed for regulation was the protection of the public interest. This
applied in both modes of regulation – statutory regulation or public ownership. Regulation was
believed to protect against market failure. Markets “failed” when they were not economically
efficient.
a. Public Interest Theories

Advocates of the public interest theories of regulation see its purpose as achieving certain publicly
desired results which, if left to the market, would not be obtained. The regulation is provided in
response to the demand from the public for corrections to inefficient and inequitable markets. Thus,
regulation is pursued for public, as opposed to private, interest related objectives. This was the
dominant view of regulation until the 1960s and still retains many adherents. It is generally felt
that determining what is the public interest is a normative question and advocates of positive
theorizing would, therefore, object to this approach on the basis that they believe it is not possible
to determine objective aims for regulation; there is no basis for objectively identifying the public
interest.
b. Interest Group Theories

An extension of the public interest theory is the interest group theory approach. Thus, regulation
is viewed as the products of relationships between different groups and between such groups and
the state. Advocates differ from public interest theorists in that they believe regulation is more
competition for power rather than solely for the public interest. There are a range of interest group
theories from open minded pluralism to corporatism. The former sees competing groups struggling
for political power with the winners using their power to shape the form of regulation. On the
other hand, corporatists emphasize the extent to which successful groups enter into

partnership with the state to produce “regulatory regimes that exclude non-participating interests”.
c. Public choice theory
Stresses the extent to which governmental behavior is understood by envisioning all actors as
rational individual maximizer’s of their own welfare. Analysis is directed to the competing
preferences of the individuals involved – how they get around regulatory goals in order to further
their own goals. Consequently, private interests are served rather than the public interest. Public
choice theory reconciles political and economic questions. It relies on the neo-classical economic
assumption of rational choice (self-interest) to predict the behavior of politicians (the regulators)
– politicians only enact those policies that ensure their re-election which, as described above, will
direct them to those with the resources to further this aim.
d. Capture theory
Regulatory agencies are captured by producers. As a positive theory it assumes that regulators
(political actors) are utility maximizer’s. Although the utility is not specified it would seem to
mean securing and maintaining political power. In order to do this, they need votes and money,
resources able to be provided by groups positively affected by regulatory decisions. Thus, the
regulators have been “captured” by such (special) interest groups who “seek to expropriate wealth
or income.
Regulatory Strategies
The right choice of regulatory strategies by regulators will avoid debates over the need for the
regulation if the relevant objectives could be achieved in ways other than the particular regulation.
a. Command and control

This is where regulators take a clear stand as to what activities are considered acceptable and what
not with strictly enforced and severe penalties imposed on the latter. Examples would include work
and safety regulations with which businesses must comply – strict standards are imposed. There
are some issues with this regulatory strategy. First, it has been shown that because a close relation
between the regulator and the regulated develops the regulators may be captured by the regulated.
Secondly, this strategy often leads to overly strict and inflexible and even a proliferation of rules.
Thirdly, it is often extremely difficult to decide on what standards are appropriate. In these
situations, the standard setting should be balanced against the potential for anti-competitive
behavior – that is, insisting on such uniform standards that it is difficult to distinguish providers.
Finally, there are issues over enforcement. For example, enforcement might involve the
appointment of many inspectors of bodies charged with enforcing the many rules: how can equity
be maintained and complaints avoided?
b. Self-regulation
This is a less severe regulatory strategy then command and control. It is usually employed in
relation to professional bodies or associations. Such organizations develop systems of rules that
they monitor and enforce against their members. This is what the accounting profession fought
hard to maintain. Generally acceptable accounting principles and later accounting standards were
developed by professional accounting bodies to avoid government control of accounting practice.

Some people are not convinced about the effectiveness of self-regulation, such as the ability of a
body to enforce regulation directed against some behavior of its members. There are questions of
openness, transparency, accountability and acceptability of the process. In addition, the rules
written by self-regulators may be self-serving and difficult to be shown to have been contravened.
c. Incentive-based regulation
Although it is usual to think of taxes being used as a penalty to discourage certain activities, taxes
can be used as a positive incentive. The advantage of such an approach to regulation is ease in
enforcement (the regulated have to make claims for the incentive) but the disadvantages include
the difficulty in predicting the effectiveness of the incentive schemes.
d. Disclosure regulation
Advocates of the disclosure of information mode of regulation claim it is not heavily
interventionist. It usually refers to the requirements of product information, such as the food value
of a pre-packaged food, whether the product is organically produced, environmentally friendly,
and the country of manufacture/origin and so on. Arguments could be made that this could also
relate to the disclosure of financial information although this is not the usual connotation.
Types of Regulations
By preventing banks runs which may occur if consumers get concerned about the safety of their
deposit, regulations ensure a safer banking environment. The regulators also attempt to enhance
the safety of the banking system by overseeing individual banks, regulators impose some discipline
so that banks assuming more risks are forced to create their own form of protection against the
possibility that they would default.
1. Capital regulation
Banks are subject to capital requirements which force them to maintain a minimum amount of
capital or equity as a percentage of total assets. In general, banks would prefer to maintain a low
amount of capital to boost their returns on equity whereas regulators have argued that banks need
sufficient amount of capital to absorb potential operating losses. These may reduce bank failures
enhancing depositor’s confidence in the banking system. In the Ask Accord (Switzerland, 1998).
The central banks of 12 major countries agreed to uniform capital requirements. The bank accord
introduces capital requirements based on the risk level of the bank. It forced banks with greater
risks to maintain a higher level of capital and thereby discouraging such banks from excessive
lending.
2. The government safety Net/Deposits Insurances

Recall the issue of moral hazard- incentives of one party to a transacting to engage in activities
detrimental to the other party. Regulators require banks to contribute to a deposit insurance fund
so that in case they fail, depositors can at least be assured of losing everything they had deposited
within the bank.

The problem with safety nets is that the depositors will not impose the discipline of the market
place on banks by withholding deposits when they suspect that the bank is taking on too much
risk. Consequently, banks with a government safety net have an incentive to take a greater risk
than the other would.
3. Too Big to Fail

Regulators are naturally reluctant to allow a big bank to fail and cause losses to depositors. Such
banks when they show signs of failing. They are usually closed and merged with other strong banks
or they are given a large infusion of capital by the government. This increases the moral hazard
incentive for pay bulk.
Lack of information about bank assets can lead to bank panics where depositors lack information
on whether their bank is good or bad, they rush to withdraw. If nothing is done to restore the public
confidence, a bank panic can result. Government safety net can short circuit runs on bank and bank
panic. By providing production for depositors it can overcome reluctance to put funds in the
banking sector.
4. Chartering and Examination

It involves overseeing those who operate bank (bank supervision or prudential supervision. This
can reduce moral hazard and adversely affect selection in the banking business.
It also involves screening proposals for new banks to prevent undesirable people from controlling
the bank.
Regular onset bank regulations which allow regulators to monitor whether the banks are complying
with the capital requirements and restrictions on asset holding also limit moral hazard. Bank
examiners give banks a so called CAMELS which is an acronym based on capital adequacy, asset
quality management earnings and sensitivity to market risk.
If the CAMEL’S rating is low, the banks can be issued with ceased or desist orders. Banks
examinations are conducted by bank examiners who sometimes make unannounced visit to the
bank so that nothing can be swept under the rug in anticipation of their examination.
FISCAL POLICIES
These are policies upon which the government uses its expenditure and revenue programs in order
to achieve desirable effects and avoid undesirable effect in the economy.
Objectives/Aims of Fiscal Policies

✓ Maintain economic stability
✓ Facilitate economic growth
✓ Fair distribution of income
✓ Create employment
✓ Create desirable consumption level

✓ Attain desirable price level
Instruments of Fiscal Policies

✓ Public revenue
✓ Public expenditure
✓ Public borrowing
Monetary policies
✓ Monetary policies are a deliberate use of the monetary system by the government
through the BNR to regulate economic performance of a country.
Objectives of Monetary Policies
✓ To maintain price stability
✓ Promote exchange rate stability
✓ Create employment
✓ Creation of sound banking and financial institution to mobilize savings and capital
REGULATION OF FINANCIAL INSTITUTIONS

Financial institutions are one of the most heavily regulated of all businesses internationally.
Financial service firms face strict government rules limiting:
• The services they can offer – the size
• The territory they can enter or not enter
• The constitution of their portfolio assets, liabilities and capital
• How to price and deliver their service to the public
Reasons for regulating of Financial Institutions

1) Safety public funds particularly the deposits owned by individual and families.
While savers have the responsibility to evaluate the quality and stability of financial institution
before committing their saving to it, the government is concerned with small savers who may
lack the financial expertise and access to quality information necessary to judge the true
condition of a financial institution. However, while safety is vital for savers, no government can
completely remove risk for savers. In the long run it may be more efficient and less costly for the
government to promote full disclosure of the financial conditions of the individual institution and
let competition be in a free market place to discipline the poorly managed and excessively risk
financial institution into order.
2) To promote confidence in the financial system.

Unless the public is confident in the safety and security of their funds they will withdraw their
savings hence reduce the volume of funds available for productive investment. This will slow
economic growth and over time the public standards of living will decline. Some of worst
economic conditions are trigged by a financial panic where financial institution and markets cease
to function.

3) To ensure equal opportunity and fairness in public access to financial service.
Scholar believes that the powerful force of competition generated by both foreign and domestic
supplies can eventually wipe out the sign of discrimination. Other observers argue that such an
event might take a very long time particularly in those markets where financial firms can collide
with each other and other agree not to compete.
4) Lowering regulatory barriers

While discrimination is unpleasant, it can be more effectively eliminated by lowering regulatory
barriers to competition and making it easier for customers offended by discrimination to recover
the damages in court than by struggling to enforce complicated rules and by requiring endless
compliance reports
5) Control inflation
Some financial institutions have the ability to create money in form of credit cards, checkable
deposits, which can be used to make payments for purchasing of goods and services. If
uncontrolled money growth may lead to increase in the general price levels or inflation. This will
adversely affect consumers especially those of fixed income since inflation reduces the purchasing
power of money. Therefore, the ability of financial institutions to create money needs monitoring.
6) Help the disadvantaged sectors in the economy

Regulations help those groups that appear to need special help in the competition for scarce
resources/funds e.g. farmers, small scale businesses, low income families. The government places
high social value on subsidizing or guaranteeing loans made to those sectors. However, it is more
efficient to pay direct money subsidies to these groups of people rather than indirectly reach them
by regulating financial institutions hence interfering with the free operations of the financial
service markets.
7) Ensure the government continuous to receive vital services.

Government borrows money and depends upon financial institutions to buy T-bills. Financial
institutions help the government in collecting tax revenues and in pursuit of economic policy
through the manipulation of interest rates and money supply. However, profit motivated financial
institutions would still provide these services if they were profitable to do so without necessarily
having to be controlled.
8) There is no absolute refutable argument satisfying the regulation of financial institutions.

Much depends on personal, political and philosophy regarding the society’s objectives and
whether the objectives were still likely to be achieved by free forces or by collective action
through government laws and regulations.

REGULATION OF COMMERCIAL BANKS
Financial regulations are a form of government regulation which subject banks to certain
requirements, restrictions and guidelines. This regulatory structure creates transparency between
banking institutions and the individuals and corporations with whom they conduct business, among
other things. Given the interconnectedness of the banking industry and the reliance that the national
(and global) economy hold on banks, it is important for regulatory agencies to maintain control
over the standardized practices of these institutions.
Forms of regulation
The regulatory norms in the banking sector can be divided into two parts;
1. Monetary regulation
Monetary policy refers to the combination of measures designed to regulate the value, supply and
cost of money in an economy. It can be described as the art of controlling the direction and
movement of credit facilities in pursuance of stable price and economy growth in an economy.
Monetary policy comprises the formulation and execution of policies by the central bank to achieve
the desired objective or set of objectives; the policies and decisions are aimed at guiding bank
lending rates to levels where credit demand and money growth are at a level consistent with
aggregate supply elasticity. The effectiveness of monetary policy and its relative importance as a
tool of economic stabilization varies from one economy to another, due to differences among
economic structures, divergence in degrees of development in money and capital markets resulting
in differing degree of economic progress, and differences in prevailing economic conditions. To
achieve the desired stabilization in an economy, central banks use various monetary policy
instruments which may differ from one country to another according to differences in political
systems, economic structures, statutory and institutional procedures, development of money and
capital markets and other considerations.
2. Prudential regulation
The prudential regulation is regulation of deposit-taking institutions and supervision of the conduct
of these institutions and set down requirements that limit their risk-taking. The aim of prudential
regulation is to ensure the safety of depositors' funds and keep the stability of the financial system.
Prudential regulation in financial institutions enables transparency and protection of stakeholders
of the institutions. A major weakness of some financial systems is the fact that the absence of
prudential regulations in some key areas can lead to bank failures and systemic instability.
Establishing sound, clear and easily monitored rules for financial activities both encourage
managers to run their institution better and facilitates the work of supervisors. A major weakness
of the financial system is the fact that various financial institutions, especially cooperatives and
intermediaries in rural areas, operate completely outside prudential regulations. The main
indicators of prudential regulations are capital adequacy, liquidity and risk profile.

Objectives of bank regulation
• Prudential—to reduce the level of risk to which bank creditors are exposed (i.e. to protect
depositors). Banks are mobilisers of public deposits. Placing your hard earned money in some
ones else’s hand is matter of tremendous faith. This faith, once broken, can have contagious
effect. It can quickly spread to loss of faith in the entire banking system and collapse of
economy.
• Systemic risk reduction—to reduce the risk of disruption resulting from adverse trading
conditions for banks causing multiple or major bank failures
• Avoid misuse of banks—to reduce the risk of banks being used for criminal purposes, e.g.
laundering the proceeds of crime
• To protect banking confidentiality
• Avoid concentration of financial resources in hands of a few individuals – Large amount of
liquid cash in hands of private individuals can lead to market manipulation to the detriment of
general public.
• Credit Creation Capacity of Banks – Financial Regulations also affect credit creation capacity
of banks.
• Impact on Money Supply – Banks are primary tool of controlling money supply in the market
and controlling inflation and interest rates.
• Provide Finance for Certain Special Sectors – Through regulations, government ensures credit
flow for priority sectors like agriculture, exports, housing, Small Scale Industries, etc.
Types of Financial Regulation

1. Restrictions on asset holdings,
The moral hazard associated with a government safety net encourages too much risk taking on the
part of financial institutions. Bank regulations that restrict asset holdings are directed at minimizing
this moral hazard, which can cost the taxpayers dearly. Even in the absence of a government safety
net, financial institutions still have the incentive to take on too much risk. Risky assets may provide
the financial institution with higher earnings when they pay off, but if they do not pay off and the
institution fails, depositors and creditors are left holding the bag. If depositors and creditors were
able to monitor the bank easily by acquiring information on its risk taking activities, they would
immediately withdraw their funds if the institution was taking on too much risk. To prevent such
a loss of funds, the institution would be more likely to reduce its risk-taking activities.
2. Capital requirements,
Capital requirements are another way of minimizing moral hazard at financial institutions. When
a financial institution is forced to hold a large amount of equity capital, the institution has more to
lose if it fails and is thus more likely to pursue less risky activities.

3. Prompt corrective action,
If the amount of a financial institution’s capital falls to low levels, two serious problems result.
First, the bank is more likely to fail because it has a smaller capital cushion if it suffers loan losses
or other asset write-downs. Second, with less capital, a financial institution has less “skin in the
game” and is therefore more likely to take on excessive risks. In other words, the moral hazard
problem becomes more severe, making it more likely that the institution will fail and the taxpayer
will be left holding the bag.
4. Chartering and examination,
Overseeing who operates financial institutions and how they are operated, referred to as financial
supervision or prudential supervision, is an important method for reducing adverse selection and
moral hazard in the financial industry. Because financial institutions can be used by crooks or
overambitious entrepreneurs to engage in highly speculative activities, such undesirable people
would be eager to run a financial institution. Chartering financial institutions is one method for
preventing this adverse selection problem; through chartering, proposals for new institutions are
screened to prevent undesirable people from controlling them.
5. Assessment of risk management,
The guidelines by regulatory authorities require the bank’s board of directors to establish interest-
rate risk limits, appoint officials of the bank to manage this risk, and monitor the bank’s risk
exposure. The guidelines also require that senior management of a bank develop formal risk
management policies and procedures to ensure that the board of directors’ risk limits are not
violated and to implement internal controls to monitor interest- rate risk and compliance with the
board’s directives.
6. Disclosure requirements,
To ensure that better information is available in the marketplace, regulators can require that
financial institutions adhere to certain standard accounting principles and disclose a wide range of
information that helps the market assess the quality of an institution’s portfolio and the amount of
its exposure to risk. Regulation is needed to increase disclosure to limit incentives to take on
excessive risk and to upgrade the quality of information in the marketplace so that investors can
make informed decisions, thereby improving the ability of financial markets to allocate capital to
its most productive uses. The efficiency of markets is assisted by the RSE disclosure requirements
mentioned above, as well as its regulation of brokerage firms, mutual funds, exchanges, and credit-
rating agencies to ensure that they produce reliable information and protect investors.
7. Consumer protection,
The existence of asymmetric information also suggests that consumers may not have enough
information to protect themselves fully in financial dealings. The global financial crisis has
illustrated the need for greater consumer protection because so many borrowers took out loans
with terms they did not understand and that were well beyond their means to repay.

8. Restrictions on competition,
Increased competition can also increase moral hazard incentives for financial institutions to take
on more risk. Declining profitability as a result of increased competition could tip the incentives
of financial institutions toward assuming greater risk in an effort to maintain former profit levels.
Thus governments in many countries have instituted regulations to protect financial institutions
from competition.
Reasons for regulating of Financial Institutions

9) Safety public funds particularly the deposits owned by individual and families.
While savers have the responsibility to evaluate the quality and stability of financial institution
before committing their saving to it, the government is concerned with small savers who may
lack the financial expertise and access to quality information necessary to judge the true
condition of a financial institution. However, while safety is vital for savers, no government can
completely remove risk for savers. In the long run it may be more efficient and less costly for the
government to promote full disclosure of the financial conditions of the individual institution and
let competition be in a free market place to discipline the poorly managed and excessively risk
financial institution into order.
10) To promote confidence in the financial system.

Unless the public is confident in the safety and security of their funds they will withdraw their
savings hence reduce the volume of funds available for productive investment. This will slow
economic growth and over time the public standards of living will decline. Some of worst
economic conditions are trigged by a financial panic where financial institution and markets cease
to function.
11) To ensure equal opportunity and fairness in public access to financial service.
Scholar believes that the powerful force of competition generated by both foreign and domestic
supplies can eventually wipe out the sign of discrimination. Other observers argue that such an
event might take a very long time particularly in those markets where financial firms can collide
with each other and other agree not to compete.
12) Lowering regulatory barriers

While discrimination is unpleasant, it can be more effectively eliminated by lowering regulatory
barriers to competition and making it easier for customers offended by discrimination to recover
the damages in court than by struggling to enforce complicated rules and by requiring endless
compliance reports
13) Control inflation

Some financial institutions have the ability to create money in form of credit cards, checkable
deposits, which can be used to make payments for purchasing of goods and services. If
uncontrolled money growth may lead to increase in the general price levels or inflation. This will

adversely affect consumers especially those of fixed income since inflation reduces the purchasing
power of money. Therefore, the ability of financial institutions to create money needs monitoring.
14) Help the disadvantaged sectors in the economy

Regulations help those groups that appear to need special help in the competition for scarce
resources/funds e.g. farmers, small scale businesses, low income families. The government places
high social value on subsidizing or guaranteeing loans made to those sectors. However, it is more
efficient to pay direct money subsidies to these groups of people rather than indirectly reach them
by regulating financial institutions hence interfering with the free operations of the financial
service markets.
15) Ensure the government continuous to receive vital services.

Government borrows money and depends upon financial institutions to buy T-bills. Financial
institutions help the government in collecting tax revenues and in pursuit of economic policy
through the manipulation of interest rates and money supply. However, profit motivated financial
institutions would still provide these services if they were profitable to do so without necessarily
having to be controlled.

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SCHOOL OF BUSINESS AND ECONOMICS

Department of Account’0-p0p-0ing and Finance

2020/2021 Academic Year

Course lecturer: Dr. BITOK

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS

Purpose of the course

Expected learning outcomes

3. Risks of financial intermediation

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

4. Liability and liquidity management

6. Regulatory framework of financial institutions.

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

The History of the Banking Sector in Kenya: An Evolution in History

There are three main types of finance

Personal Finance includes:

• Protection against unforeseen and uncertain personal events

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

Corporate Finance Includes:

Public Finance includes:

• Identifying the expenditure required by the public entity

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

Components of Financial System

Examples of financial institutions include banks, trust companies, insurance companies,

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

The key functions are:

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

Examples of financial intermediaries

Examples of an investment banker in Kenya

• Equity Investment Bank

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

7. Savings and Credit Associations.

FUNCTION OF FINANCIAL INTERMEDIARIES

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

Challenges Facing Financial Intermediaries (2017 Surveyed)

1. Corporate Governance and the Culture of Compliance.

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

3. Securities Compliance (for publicly traded and privately held banks).

4. Mergers & Acquisitions.

5. BSA/AML and OFAC Compliance.

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

7. Data Security and Privacy.

9. Third-Party (Vendor) Risk Management.

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

Financial Services Institutions

• Commercial Banks (Banking)

Key Factors which Drives Growth in Kenya’s Financial Services Sector

1. ICT Enabled Financial services

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

6. The emergence of alternative channels of distribution

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

Major objective of management of financial institution

1. To increase the financial institutions returns for its owners or stakeholders/shareholders

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK

Types of Financial Risks Faced by Financial Institutions

1. Interest rate risk

Types of interest rate risks

BBM 415: MANAGEMENT OF FINANCIAL INSTITUTIONS BY DR. BITOK