THE KENYAN

FINANCIAL SYSTEM

The financial system facilitates the

transformation of savings into investment
& consumption. are systematically
interrelated.
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The financial system consists of:

 Financial assets
 Financial intermediaries and
 Financial markets

The primary function of the system is

to allocate the capital resources in an
economy.

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 FINANCIAL ASSETS
 If ‘A’ transfers funds to ‘B’, ‘A’ receives a
financial asset, which represents a claim
against the income and assets of ‘B’. From the
point of view of ‘B’, such a claim represents a
financial liability.

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 Note:
For every financial asset, there is a
corresponding financial liability. Financial
assets are the basic products of the financial
system. There are three broad types of
financial assets: money, debt and stock.

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 Money (notes and coins) is issued by the
Central bank of Kenya and by Commercial
banks as demand deposits and debt is issued by
a variety of organizations, including the
government of Kenya and its agencies.

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 Equity and preference is issued by business
organizations.

 Debt capital entails a fixed interest and

principal repayment burden.

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 Examples of financial assets (securities) are:

 Equity (Ordinary) Shares

 Preference Shares

 Debentures

 Treasury bills and Bonds

 Commercial Papers

 Company Deposits

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 FINANCIAL
INTERMEDIARIES

 Financial Intermediaries are institutions or

firms that mediate or stand between ultimate
lenders and ultimate borrowers or between
those with budget surplus and those who run
budget deficits.

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Below are examples of financial intermediaries:

 Commercial banks
 Building Societies

 Merchant Banks

 Development Banks

 Post Office Savings Bank

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 Savings and Credit Co-operative
Societies (SACCOS)
 Insurance companies
 Unit trusts (mutual funds)
 Investment Trusts
 Investment companies
 Pension funds e.g. N.S.S.F

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 Finance Houses
 Capital Markets and Nairobi Stock Exchange
Market
 Foreign Exchange Bureaux
 The Government
 Acceptance Houses
 Stock Exchange Market

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 The central function of all financial
intermediaries is to collect surpluses (savings)
of other economic units and to lend them to
the deficit spenders. If these intermediaries did
not perform this function, it would be
necessary for individual depositors to agree
terms directly with individual borrowers.
Although, this is a bit inconveniencing, there
are some instances where it becomes necessary
to do so - for example a company raising funds
directly from the public.
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BENEFITS OR FUNCTIONS
OF
FINANCIAL
INTERMEDIARIES

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 Maturity transformation

 Majority of deposits is for very short-term

(Bank deposits), whereas most loans are
required for longer periods (mortgages are for
20 to 25 years). Financial intermediaries are
able to overcome this maturity mismatch by
offering a wide range of deposit accounts, thus
helping to ensure that not all the depositors’
funds are withdrawn at the same time.
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 Financial Intermediaries also have access to
wholesale money markets such as the inter-
bank market, where they can raise short-term
finance should they encounter some shortage.

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 Risk Transformation
 Individual depositors are generally reluctant to
lend all their savings to other individuals or
companies, principally because of the risk of
default or fraud. Intermediaries effectively
enable lenders to spread this risk over a wide
variety of borrowers. Intermediaries also have
the experience and the skills needed to improve
credit management. Transformation of risk can
also be referred to as Risk reduction.

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 Aggregation

 The majority of retail deposits are relatively

small, averaging under sh. 20,000.00, while
loans are typically larger, with mortgages
being for sh. 500,000.00 and above. Financial
intermediaries can overcome this size
mismatch by aggregating small deposits, and,
if necessary, by accessing the wholesale
money markets for funding.

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 Geographic Location

 A further difficulty that individual depositors and

individual borrowers might experience is the simple
problem of locating one another within their own area or
their own circle of contacts. A depositor, for example, in
Nairobi is unlikely to know of the existence of a likely
borrower in Eldorate. Intermediaries overcome these
search and location problems through their national
branch network, and more recently by the introduction of
telephone banking.

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 Induce Savings

 Savers require store of value to hold their

savings in. Financial intermediaries, assisted by
the financial markets, promote savings by
providing a wide range of financial assets as
store of value. For savers (wealth holders), this
offers ample choice of portfolios with attractive
combinations of income, safety, yield, etc.

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 Law of Large Numbers
 The economic basis of financial institutions lies in the
economy of large scale in portfolio management and in
the law of large numbers. Banks, insurance companies,
unit trusts and other financial institutions operate on
the assumption, supported by statistical law of large
numbers that not all creditors (depositors) will
withdraw their deposits at the same time, and that while
others are withdrawing, others (new or old) are
depositing or paying in cash. These intermediaries are
therefore able to make liabilities that are more liquid.

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 Professional Management
 The large size of assets portfolios that financial
intermediaries have allows them to employ
professional managers, who are well-versed in the
complexities of modern finance, in appraising loan
proposals, evaluating investment opportunities,
monitoring loans and investments, analysis the market
and other developments etc. this is important as
individual owners (savers) cannot afford the cost of
professional management and other support staff. They
do not in general also have the knowledge, time or
desire to manage on their own.

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 FINANCE HOUSES
 These are basically lending organizations.
They are known for smaller-scale lending on
consumer goods, but many also offer corporate
loan packages. Their activities are sometimes
referred to as the secondary banking sector.

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 Wholesale Finance

 Finance houses fund their operations mainly

through the wholesale finance market rather
than their attracting deposits from the general
public. Funds are placed with Finance houses
on unsecured basis for periods from three to
six months.

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 Finance houses offer more or less the same
services offered by other financial institutions like
commercial banks, building societies, etc. The
services of Finance houses are:

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 Unsecured Loans

 These are usually fixed-rate loans for terms of

one to five years, which can be used for any
purpose – holiday, building or buying a house,
business, agriculture, etc. These services are
provided through agencies with sales outlets.

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 Secured Loans

Finance houses also provide secured loans for

home improvement & other purposes.

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 Hire Purchase
 A hire purchase company (hiree) gives goods on hire
to a user (hirer) who pays periodic hire purchase
installments. On payment of final hire purchase
installment, the ownership of the goods is transferred
to the hirer from the hiree. Typically, in a hire
purchase transaction, the hiree charges interest on a
flat rate basis. This means that interest is charged on
the amount financed in the beginning and not on the
diminishing balances. Under this system of purchase,
the goods belong to the lending institution until they
are fully paid for.
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 Leasing
 This is a method of acquiring a physical asset
for a fixed period and is commonly used by
businesses for acquiring company vehicles and
expensive items of equipment such as
photocopiers. The lending organization retains
the ownership of the item, receives payments
over a specified period (say 3 years) and then
takes back the item to sell to recoup
outstanding cost, sometimes to the person who
has been leasing it.
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 Factoring
 Some Finance houses provide factoring
services to businesses. So they manage a
company’s invoices and debtors and collect
(and retain) the money owed to the company.
The factor (Finance house) buys trade debts
from its clients at a discount and makes profit
when the debts are realized.

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 MERCHANT BANKS

 Merchant Banks are also known as wholesale

banks or investment banks. They are
specialized banks concern with the
arrangement of finance and in investment
management, for large corporate clients in a
big way.

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 They are often involved in advising companies
on the issuing of new share or loan capital, and
many Merchant banks are also active in the
field of pension fund management.

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 Origins of Merchant Banking
 The origins of Merchant Banking lie – as the
name suggests – in the financing of
international trade. Their earliest business was
acceptance, which started when early merchant
bankers accepted bills of exchange (basically
promising to pay internationally traded goods
and services).

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 Services offered by Merchant
Banks
 They accept, discount and purchase genuine
trade bills with emphasis on the international
trade i.e. they give acceptance credit.
 They provide import/export advice to business
engaged in international trade.
 Merchant banks give short term and medium
term loans to companies.

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 They arrange lease and hire purchase finance to their
customers.
 They finance property development (mortgages).
 They manage investment funds, with their main
clients being pension funds and insurance companies.
 Merchant banks act as underwriters for businesses
going public or floating such shares.

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 Difference between Merchant Banks
and Commercial Banks
Merchant Banks
Undertake wholesale banking
Usually do not provide personal
accounts to small depositors
Their customers are usually big
companies
Merchant banks offer leasing & hire
purchase facilities for heavy
equipments and machinery
Merchant banks lend on long-term
basis because they also borrow long
Commercial Banks
Banking Undertake retail
Usually offer different accounts even to
small depositors
Their customers are usually small savers
& a few big companies
Commercial Banks do not usually offer
leasing and hire purchase facilities
except under special circumstances
Commercial Banks usually lend short-
term because they mostly accept demand
deposits
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 DEVELOPMENT BANKS
 These are specialized financial institutions,
which perform the twin functions of providing
medium and long-term finance to private
entrepreneurs and of performing various
promotional roles conducive to economic
development.

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 As the name suggests, they are development-
oriented banks and therefore as banks they
provide finance. They are different from
commercial banks in the following ways:

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Development Banks Commercial Banks

Do not seek or accept deposits of Accept deposits of money from the

money from the general public general public

Specialize in providing medium and Specialize in providing short-term

long-term finance finance

Main objective is to promote Main objective is to accept deposits

economic development by of money from the general public
promoting investment and enterprise for lending & investment

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The development promotional roles
may take the following forms:

 Provision of risk capital

 Underwriting of new issues
 Arranging for foreign exchange loans
 Identification of investment projects and
opportunities

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 Provision of technical advice
 Provision of both local and foreign market

information
 Evaluation of project reports

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THE FINANCIAL MARKETS IN
KENYA
 The financial market can be defined as the sum
total of all capital, money and security market
institutions operating in an economy. This also
include individuals, companies, institutions
and government, who buy (borrow) and sell
(lend) money to different parties at a price
(interest or dividend) determined by the
market forces of demand and supply of money.
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 THE MONEY MARKET
 This is a market for short-term funds
(instruments), i.e. finance for business for
about 2 years. Examples are:

 Bank Overdrafts
 Short Term Loans

 Promissory Notes

 Bills Of Exchange

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 Trade Credit
 Guilt Edged Securities (Govt. Securities)

 Bankers’ Certificate Of Deposits

 Commercial Papers

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Financial Institutions or Intermediaries
that sell short-term funds are:

 The Government
 Commercial Banks

 Acceptance Houses

 Discounting Houses

 Merchant Banks

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Buyers of such finances are:

 Individuals
 Companies

 Government

 Financial Institutions

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 Characteristics of the Money Market

 The market provides short-term finance only

 The securities bought and sold in this market are highly
negotiable as they can be bought and sold easily
 The finance in this market is usually not secured and
depends on the goodwill of the borrower or buyer
 This finance is used to solve liquidity problems of the
concerned parties

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 This finance is very expensive as compared to
other sources
 It is not a perfect market because the demand
for such finance far exceeds its supply
 This market brings together the buyers and
sellers of the short-term securities

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 THE CAPITAL MARKETS

 The markets are for long-term funds i.e. finances that

are available over 2 years. This market is not well
developed in Kenya. This market is divided into two.
 The security market is a market for long term
securities like equity shares, preference shares,
debentures and govt. stocks.
 The long-term loan market is a market for long-term
loans, mortgage finance, lease finance and higher
purchase finance.

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Financial institutions (intermediaries) that sell
Long-term funds (Participants in the Capital
Market) are:

 The Government of Kenya

 The Stock Exchange

 Investment Banks

 Investment Companies

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 Insurance Companies
 Pension Funds

 Commercial Banks

 Hire Purchase Companies

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 Services Rendered by the Capital
Market
 They offer long-term finance to the
businesses, which is used to acquire fixed
assets.
 They encourage foreign investments in the
securities of the quoted companies.
 They facilitate the purchase and sale of
shares and other securities.

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 The market provides permanent finance
necessary for a strong financial base of going
concerns, e.g., equity share capital,
irredeemable preference shares, convertible
debentures and convertible preference shares.

 The market provides useful information and

advice to investors.
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 The market enables individuals and companies
to obtain long-term finance, which they can
sell in the money market in form of short-term
loans.
 The market is responsible for an orderly
secondary market, which facilitates the
liquidation of long-term investments.

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 It promotes the culture of thrift or savings. The fact
that institutions exist and that there is some returns
expected from investments, encourages savings.

 The stock exchange assists in the transfer of savings

to investment in productive enterprises as an
alternative to keeping the savings idle.
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 It assists in the rational and efficient allocation
of capital, which is a scarce resource.

 The stock market promote higher standards of

accounting, resource management and
transparency in the management of business

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 Difference between the Money
Market and the Capital Market
Money Market Capital Market
1 Goodwill of borrower Goodwill of the borrower is not
qualifies him for the important, but his ability to
finance raise securities is what matters
2 Finance is usually Finance is usually obtained in
obtained in cash kind, e.g. in form of assets
3 Finance is expensive Finance is usually cheap
4 This market does not deal It is a channel through which
with the foreign exchange foreign investments come into
for investment reasons the country

5 Finance here is usually Finance here is usually secured56

 THE STOCK EXCHANGE
MARKET
 The Stock Exchange Market is a place where
securities are bought and sold

 It is usually a building or part of the same where

members of the exchange, acting as brokers or
dealers buy or sell securities.

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 This is an organized capital market for securities
inform of shares, preference shares, debentures etc.

 The stock exchange deals primarily in the

secondary issues (second hand securities)

 Not all companies or businesses can have their

securities traded in the stock exchange market,
unless they are members i.e. listed or quoted in the
market

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 Unlike other markets, one is not permitted to buy
and sell shares directly in the stock exchange
market. According to the rules, you can only do
your buying and selling through a licensed
member of the stock exchange market called a
‘stockbroker’ or a ‘share broker’.

 Stockbrokers are the only ones authorized to buy

and sell securities on behalf of others for some
commission. This commission is a fee called
brokerage and is fixed by the Stock exchange
market.

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THE ROLE OF THE STOCK
EXCHANGE

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 Raising Capital for Businesses

 The Stock Exchange provides companies

with the facility to raise capital for expansion
through selling shares to the investing public.

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Mobilizing Savings for Investment

 When people draw their savings and invest in shares,

it leads to a more rational allocation of resources
because funds, which could have been consumed, or
kept in idle deposits with banks, are mobilized and
redirected to promote business activity with benefits
for several economic sectors such as agriculture,
commerce and industry, resulting in a stronger
economic growth and higher productivity levels.

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 Facilitate Company Growth
 Companies view acquisitions as an
opportunity to expand product lines, increase
distribution channels, hedge against volatility,
increase its market share, or acquire other
necessary business assets. A takeover bid or a
merger agreement through the stock market is
one of the simplest and most common ways to
company growing by acquisition or fusion.

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 Redistribution of Wealth
 By giving a wide spectrum of people a chance
to buy shares and therefore become part-
owners (shareholders) of profitable enterprises
, the stock market helps to reduce large income
inequalities. Both casual and professional
stock investors through stock price rise and
dividends get a chance to share in the profits
of promising business that were set up by other
people.
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 Corporate Governance
 By having a wide and varied scope of owners, companies generally tend to
improve on their management standards and efficiency in order to satisfy
the demands of these shareholders and the more stringent rules for public
corporations by public stock exchanges and the government.
Consequently, it is alleged that public companies (companies that are
owned by shareholders who are members of the general public and trade
shares on public exchanges) tend to have better management records than
privately-held companies (those companies where shares are not publicly
traded, often owned by the company founders and/or their families and
heirs, or otherwise by a small group of investors). However, some well-
documented cases are known where it is alleged that there has been
considerable slippage in corporate governance on the part of some public
companies (e.g. Enron Corporation, MCI WorldCom, Pets.com, Uchumi).

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 Creates Investment Opportunities for
Small Investors

 As opposed to other businesses that require

huge capital outlay, investing in shares is open
to both the large and small stock investors
because a person buys the number of shares
they can afford. Therefore the Stock Exchange
provides an extra source of income to small
savers.

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 Government Raises Capital for
Development Projects
 The Government and even local authorities like
municipalities may decide to borrow money in order
to finance huge infrastructure projects such as
sewerage and water treatment works or housing
estates by selling another category of securities
known as bonds. These bonds can be raised through
the Stock Exchange whereby members of the public
buy them. When the Government or Municipal
Council gets this alternative source of funds, it no
longer has the need to overtax the people in order to
finance development.
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 Barometer of the economy
 At the stock exchange, share prices rise and
fall depending, largely, on market forces.
Share prices tend to rise or remain stable when
companies and the economy in general show
signs of stability and growth. An economic
recession, depression, or financial crisis could
eventually lead to a stock market crash.
Therefore the movement of share prices and in
general of the stock indexes can be an
indicator of the general trend in the economy.
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 Listing Requirements

 The listing requirements are the set of

conditions imposed by a given stock exchange
upon companies that want to be listed on that
exchange. Such conditions sometimes include
minimum number of shares outstanding,
minimum market capitalization, and minimum
annual income.
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 Requirements by stock exchange

 Companies have to meet the requirements of

the exchange in order to have their stocks and
shares listed and traded there, but requirements
vary by stock exchange:

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Requirements for Listing (Quoting) on
the Nairobi Stock Exchange Market
 The company in requiring quotation must
register with the Registrar of companies as a
limited company.

 The company must have a fully paid capital

of not less than Ksh. 2,000,000.00 with a
nominal value of between Ksh. 5.00 and
Ksh. 10.00.
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 The company must supply the Stock Exchange
authority with details of its directors, legal
advisers, and company secretary and company
auditors.

 The company must inform the stock exchange

authorities of its current distribution of shares.

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 The company must supply the stock exchange
authority with the following:

 Audited financial statements

 Articles and memorandum of association

 Chairman’s report

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 The company must be ready to offer 20% of
its share capital to the public.

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The Capital Market Authority
(CMA)

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 The Capital market authority was established
in 1990 to stimulate the development of long-
term debt and equity markets. The main
objectives are:

 To protect the investors

 To provide enough incentives for long term

investments

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 To advice the government on matters
concerning the development of Capital market

 To license brokers, dealers, Unit Trusts,

Investment bankers, and other participants

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 To protect and compensate any investor who
may suffer loss resulting from brokers or
dealers

 To regulate and oversee the issue and

subsequent trading both in primary and
secondary markets instruments

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 The capital market Authority has established a
trading floor in the Nairobi stock Market and a
training of staff to increase their technical
expertise. It also has powers to control the
activities of the Market.

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 BENEFITS
OF
INVESTING

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 Income:
 This is in form of dividend equities or interest
on bonds.

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 Capital gains: This is in form of long-term
price appreciation, shot-term price gains, and
bonus and rights issues.

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 Tax advantages
 Withholding tax is usually low as compared to
other investments.

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 Collateral
 Securities can be used as collateral to secure
financing (loan).

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 Confidentiality

 Financial securities are intangible and

therefore guarantee confidentiality in
management of wealth.

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 Flexibility
 Shares are traded in units and lots that are
affordable by investors of different income
levels. Bonds are also fairly affordable as
compared to other forms of investments like
real estate.

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 Liquidity
 Securities are easily transferable at a low
transaction cost as compared to other assets
such as real estate. An investor can therefore
get in and out at his convenience.

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 Hedge Against Inflation

 Share prices over a long term tend to out

perform inflation. Therefore, investment in
securities

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Spreading of Risk & Maximization of
Returns
 The range and variety of securities listed in the
stock exchanges provide investors an
opportunity to minimize their exposure to
specific company risk by spreading their
investments across a wide selection of stocks.

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 Operating Convenience
 Since investing in securities represents the
separation of ownership from management, it
therefore does not require personal
commitment of the investor for it to give
return. Investors are therefore saved the
occupational hazards of careers, as opposed to
other businesses that need the personal
presence and involvement of the entrepreneur.

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