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RATIONALE

One important way in which the standard of living of society can be raised is by replacing the subsistence economy with one
based on specialisation and exchange. But to be effective, this system must be organized efficiently on a community basis.
There must be some means of co-coordinating the preferences and decisions of all the individual procedures as to the types
and quantities of their output, with the preferences and decisions of all the individual workers as to the types of employment
for which they train and offer their service, and with the preferences and decisions of all the individual consumers as to the
nature and quantity of the goods and services they consume. There must be some way in which the innumerable exchanges
involved in such a system can be efficiently settled; and it must be possible for exchanges to be effected in a manner capable
of reconciling the widely different timing preferences of individuals. The role of money is to provide these means.

As students of business administration, it would be difficult to find a subject for study that is of greater importance for the
welfare of business and individuals than the financial systems and its markets. The money and capital markets are the
mechanism for converting the public savings into investments in buildings, machinery and equipment, public facilities, and
inventories of goods and services that make it possible for the economy to grow, for new jobs to be created, and for the living
standards to rise. It is the financial system that handles most of the payments made for purchase of food, clothing, shelter,
automobiles, and tens of thousands of other goods and services.

That system also generates credit to sustain the public’s spending and standard of living and stores future purchasing power
in the form of stocks, bonds, and other securities. And the money and capital markets make possible the liquidation of those
securities whenever cash is needed for immediate use. Therefore, the central theme of this handout has been to highlight these
essential contributions of the financial system to the economy, hopefully leaving the student with a clear picture of how
money and the financial system operates to fulfill these varies functions and roles.

COURSE OBJECTIVES

1) To present a comprehensive yet interesting analysis of the financial system in a developing country.
2) To provide a clear view of all major types of financial institutions that operates within the financial system.
3) Finally, to identify and understand the current and future trends – economic, demographic and financial – that are
reshaping the financial system in order to respond to tomorrow’s financial service needs and pressures.

COURSE OUTLINE

1.0 Money
1.1 The barter system
1.2 Evolution and development of money
1.3 Nature and function of money
1.4 Definition of money
1.5 Attributes of good money (characteristics)
1.6 Classification of money
1.7 Demand for money
1.8 Role of money in a modern economy

2.0 Monetary Board (Commercial Banks)


2.1 Financial intermediation
2.2 Typical structure of financial markets
2.3 Types of banks
2.4 Development of commercial banking in E. Africa
2.5 Organization and structure
2.6 Role of commercial banks (functions of commercial banks)
2.7 Credit creation process
2.8 Role played by banks in developing countries.

3.0 The Central Bank


3.1 Evolution of Central Banking
3.2 Functions of a Central Bank
3.3 General instruments of monetary policy
3.4 A note on central bank of Kenya
3.5 Note on bank supervision in Kenya
3.6 Recent changes in banking laws and regulations in Kenya
3.7 Problems faced by the central bank in developing countries.
4.0 Other financial Institutions
4.1 Money markets
4.2 Capital markets
4.3 The Nairobi stock exchange
4.4 Specialised banks

5.0 Financial Assets


5.1 Characteristics of financial assets
5.2 Loanable funds theory of investment determination
5.3 The rational expectations theory
5.4 Different kinds of financial assets
5.5 A note on international money
5.6 Exchange rates.

Teaching and Learning Approaches


In class discussion, assignments, CATs, Lectures and study material.

Assessment
The course will be determined as follows:
REGULARS DLM
CAT 15% -
Assignment 1 7.5% 15%
Assignment 2 7.5% 15%
Final Exam 70% 70%
100% 100%

REFERENCES
No single textbook can be comprehensive enough for the course. The following readings will however be quite useful.
1. Newlyn W. T. (1967). Money in an African context (1990).
2. Chandler L. V. –The Economics of Money and Banking
3. Basu S. K. (1987) –Central banking in the Emerging Countries
4. Rose S. P. (1989) –Money and Capital Markets -3rd Edition
5. Smith Garry (1991) –Money, Banking and Financial Intermediation.

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1.1 THE BARTER SYSTEM
Before the evolution of money, exchange was done on the basis of direct exchange of goods and
services. This is known as barter. Barter involves the direct exchange of one good for some quantity
of another good. For example, a horse may be exchanged for a cow, or 3 sheep or 4 goats. For a
transaction to take place, there must be a double coincidence of wants. For instance, if the horse-owner
wants a cow, he has to find out a person who not only possesses the cow but wants to exchange it with
the horse. In other cases, goods are exchanged for services. A doctor may be paid in kind as payment
for his services. For example, he may be paid a cock, or some wheat or rice or fruit. Thus a barter
economy is a moneyless economy. It is also a simple economy where people produce goods either for
self-consumption or for exchange with other goods which they want. Bartering was found in primitive
societies. But it is still practiced at places where the use of money has not spread much. Such
monetized areas are to be found in many rural areas of underdeveloped countries.

Barter system was prevalent in the earliest stages of man as a commercial animal. Even today, in some
of the interior parts of African countries barter exchange in some degree is in operation.

The barter system is not as simple and smooths a system of exchange as its meaning shows. Many
difficulties and inconveniences are inherent in a simple barter. As society becomes more civilized and
the complexities of economic organization begin to multiply, exchange through barter tends to become
more difficult and complicated

Difficulties of Barter System


A few major difficulties of the barter system may be traced below:-

1. Want of Coincidence
The first difficulty in the barter system of exchange is that there has to be a double coincidence of
wants. Two persons can have barter exchange only if their disposable possessions mutually suit each
other’s needs. In barter trading, thus two parties must agree on their mutual exchange, which is
possible only if there exists a double coincidence of wants. That is, one party must be wanting a
commodity which the other party wants to dispose of and the former must have disposable
possession of the commodity that is desired in exchange by the latter. In a barter, therefore, a person
who wants to exchange his goods for some other goods has not only to find another person who
possesses what he needs but who, at the same time, has a desire for what he has to offer. In practice,
it is difficult always to have such double coincidence of wants and, therefore, there are delays in
transactions, and a considerable amount of time and effort is wasted in effectuating the exchanges.
Clearly, trade and business cannot develop rapidly in a barter economy for want of coincidence.
Barter as such is a high barrier to economic progress.

2. Lack of a Common Measure of Value


Another serious difficulty of the barter is that it lacks any common measures of value or unit of
account. In the absence of a well-defined unit of account, in a barter, the values of goods are
measured in a relative sense; hence there is no absolute measurement of value. Since the value of
each commodity can be expressed in terms of every other commodity one has to remember a large
number of cross relations of values in exchange for different goods which is physically impossible to
do when there are an infinite number of commodities. Under such conditions, no meaningful
accounting system can be evolved.

3. Want to Means of Sub-division


Barter exchange also suffers from a severe inconvenience on account of indivisibility of many kinds
of goods. One can easily portion out a bag of food grains, a basket of fruits, etc. which are divisible
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goods and can give more or less in exchange for what is wanted. But the real difficulty arise in the
process of exchange between indivisible and divisible goods. For instance, a horse is not divisible
and cannot be exchanged in parts against different divisible goods like rice, sugar, potatoes, etc. thus,
barter trade between divisible good like rice, sugar, potatoes, etc. thus, barter trade between divisible
and indivisible goods in small values cannot be carried on without a loss of value.

In a barter system, smooth exchange operations are impossible for want of a means of sub-dividing
and distributing values according to people’s varying requirements.

4. Lack of Standard of Deferred Payments.


Another drawback of barter is that it lacks a standard of deferred payments, so that contracts
involving future payments or loan transactions cannot take place with ease in such a system. Credit
transactions cannot be promoted smoothly under barter trading. Chance of controversy about the
quality of goods or services to be repaid can arise. There will be no easy agreement on the mode of
repayment. Credit transactions would also involve high risks to both parties as the real value of a
commodity to be repaid may drastically increase in future.

5. Lack of Efficient Store of Value


Perhaps, a major inconvenience of the barter is the lack of facility to store value or lack of existence
of a generalised purchasing power. Under barter, people can store value for future use by storing
wealth, but the difficulty arises when wealth consists of perishable goods. Moreover, the store of
value in terms of real wealth involves cost and further, the problem of storing the goods arises. In
addition, bulky goods cannot be easily exchanged for other goods as and when required. A quick
exchange sometimes involves a heavy loss, too.

1. Lack of specialization
Another difficulty of the barter system is that it is associated with production system where each
person is a jack-of-all trade. In other words, a high degree of specialization is difficult to achieve
under barter system. Specialisation and interdependence in production is only possible in an
expanded market system based on money economy. It is next to impossible that all wishes of
bartering individuals should coincide on the kind, quantity and value of the things which are
mutually desired in a modern economy in which on a single day millions of persons may exchange
millions of commodities and services.

2. EVOLUTION OF MONEY
Growing inconvenience of barter in the complex economic societies necessitated the invention of
money. Writers like Spalding, however, opines that money seems to have been discovered rather than
invented in the progress of economic civilization of mankind. According to Crowther, money was
undoubtedly an invention; “It needed the conscious reasoning power of man to make the step from
simple barter to money accounting”. Whatever it may be, the fact remains that with the increased
volume of trade and growing process of division of labour and specialization, barter became more and
more difficult in its direct exchange phenomenon. Hence, to overcome the basic difficulties of barter
such as want of double coincidence, want of means of subdivision, etc., it was thought that exchange of
goods should be made indirect by using some medium in between. Thus, money came into the picture as
a medium of exchange.

Crowther observes that, in the beginning, in a simple exchange of goods for goods, the terms of
exchange were fixed with reference to one standard commodity. Values of different goods being
measured in terms of this standard commodity, in the exchange process, it came to be accepted as a
medium of exchange. This standard commodity used as a medium of exchange was known as money.

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Etymologically, term “money” is derived from the Latin word Moneta, the name of the Roman goddess
Juno, in whose temple coins were being minted. Use of money as a medium of exchange and a unit of
account is, however, much older than coinage. Numerous things like shells and sheep, grains and stones,
tea and tobacco, ivory and iron, gold and silver have been used as money at different times and different
places before the invention of modern day’s metallic and paper money. The origin of money as such is
difficult to trace for want of record. Lord Keynes puts that the origin of money is deep-rooted in
antiquity, and it is a far more ancient institution. “Its origins are lost in the mists when the ice was
melting, and may as well stretch back into the paradisiacal intervals in human history of the inter-glacial
periods, when the weather was delightful and the mind free to be fertile of new ideas in the Island of the
Hesperides or Atlantis or some Eden of Central Asia”. Indeed, money is the epitome of the history of
human civilization.

No doubt, the evolution of money has been as secular process. Like several other economic institutions,
money, in its present form, has passed through several phases and developed through the centuries.

Development of Money in Different Stages


The development of money ahs passed through various stages in accordance with time, place and
circumstances with the progress of economic civilization of mankind. Economists have recognized five
such stages in the evolution of money:-

i. Animal/Commodity Money.
ii. Metallic Money.
iii. Coinage.
iv. Paper Money.
v. Credit Money/Fiat Money.

i) ANIMAL/COMMODITY MONEY
Animals were being used as a common medium of exchange in the primitive hunting stage. History
records that cattle occupied a place of pride as money in the earliest period of human civilization. In
temperate regions of Europe, Asia and Africa cattle was regarded as the most standard unit of barter for
quite a long time in the primitive era. In the fourth century B.C., the Roman State had officially
recognized cows and sheep as money to collect fines and taxes.

In the early pastoral societies everything was valued in terms of cattle, which were a symbol of wealth
and prestige. It was only after their use as a standard unit of account that they also came to serve as a
medium of exchange and a store of value.

The use of cattle as money had inherent weaknesses.


 There was, for instance no standard cow, bull, or ox.
 Moreover, because cattle are not divisible, small transactions could not be made.
 On the other hand, for large payments, a herd of oxen constituted a difficult method of settlement if
payment were to be made some distance away.
 As a store of value, cattle were only as good as their life expectancy.

To overcome all these weaknesses cattle were first supplemented and later replaced by articles of
common use such as cloth, axes, hoes, and fishhooks. The virtual disappearance of the use of cattle as
money did not occur without leaving a lasting reminder. The word “precuniary” is derived from pecus,
the Latin word for cattle, and “fee” comes from the Old English foeh (cognate of the German vieh), also
meaning cattle. Today cattle and goats are still used as a measure of value by the Dinka people of the
Southern Sudan.

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COMMODITY MONEY
In certain communities, early primitive money, in its crudest sense, also took the form of commodity
money. A large number of commodities from ranging from axes to yarn have been adopted as money.
The particular commodity chosen to serve as money depended upon various factors like location of the
community, climate, environment of the region, cultural and economic standard of society, etc. For
example, people living by the seashore adopted shells and dried fish as money. People of the cold
regions in Alaska and Sibera preferred skins and furs as a medium of exchange. African people used
ivory and tiger jaws as money. Besides, commodities such as precious stones, rice, tea, tobacco, etc. also
served as money during the primitive days of human civilization. Professor Paul Einzig has recorded
some 172 commodities in the list of primitive money.

Hence, various types of commodities have been used as money from the beginning of human
civilization. Stones, spears, skins, bows and arrows and axes were used as money in the hunting society.
The pastoral society used cattle as money. The agricultural society used grains as money. The Romans
used cattle and salt as money at different times. The Mongolians used squirrel skins as money. Precious
stones, tobacco, tea, shells, fishhooks, and many other commodities served as money depending upon
time, place and economic standard of the society

The use of commodities as money had the following effects:


 All commodities were not uniform in quality, such as cattle, grains etc. Thus lack of standardization
made
pricing
difficult.
 Difficult to store and prevent loss of value in the case of perishable commodities.
 Supplies of such commodities were uncertain.
 They lacked in portability and hence were difficult to transfer from one place to another.
 There was the problem of indivisibility in the case of such commodities as cattle.

ii) METALLIC MONEY


Such articles, as mentioned above, were used as money in small societies and they could not be used for
trading purposes by larger ones which were having trade relations with other nations both by land
and sea even in ancient times. All sorts of commodities have been used as money at one time or
another, but gold, silver and copper proved to have great advantages. They were precious because
their supplies were relatively limited, and they were in constant demand by the wealthy for
ornament and decoration. Thus, these metals tended to have a high and stable price. Further, they
were easily recognized, they were divisible into extremely small units, and they did not easily wear
out.

The transition from cattle to metals was slow. The use of copper, iron, silver and gold can be traced
back as far as 5000 B.C. Metals became preferred over other commodities because of certain essential
characteristics; they were relatively homogeneous, easily recognizable, highly durable, easily portable,
and divisible into any size. Metals had the additional advantage that a high intrinsic value could be
placed on them. A few ounces of gold or silver could be exchanged for large units of other goods.

At first metals took the form of ordinary implements and adornment and served the dual purpose of
being both usable commodities and money. Only later did their function as money supersede their
function as useful commodities. But even at this stage of the development of money, its value was
related to the shape of objects in common use. For example, the Chinese hoe cast in bronze was first
used as an implement and later also as a token of value. In time it was made smaller and thinner and
circulated as a “tool coin”. The final break in the association between monetary metals and metals in
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the form of goods came when the value of a metal was determined by its weight. By 2000 B.C.
Babylonia had developed a monetary system based on silver. Silver passed by weights known as
shekels and talents, which were used as units of account. These were measures of weight which
originated with grain. The British pound, the German mark, and the Italian lira all date from the time
when monetary metals passed by weight.

(iii) COINAGE STAGE


Metals as a medium of exchange had disadvantages as to both their quality and their quantity. Only
people familiar with the technique of assay using acids could determine the fineness or purity of metals.
Moreover, each transaction involved the inconvenience of weighing the metal. For merchants who had
to deal in metals continually, determining the purity and weight was cumbersome.

It is believed that in the seventh century B.C. a merchant in Lydia started to punch an identifying mark
on each metal ingot after he had assayed it. If the metal again passed through his hands, how would
recognize his symbol and escape the task of doing another assay. This marked the beginning of
rudimentary coinage. This innovation is attributed to King Midas of Lydia in the eighth century B.C. But
gold coins were in use in India many centuries earlier than in Lydia. Thus coins came to be accepted as
convenient method of exchange.

The history of coinage is long and interesting. Coinage originated spontaneously and in many places.
At first, as was the case in Lydia, irregular pieces of metal punchmarked to guarantee their purity but nit
their weight passed from hand to hand. Later, the metal pieces were formed into special identifiable
shapes. This was the beginning of the process of minting. Metal was formed into distinctive pieces with
distinctive markings recognizable as to both purity and weight and therefore value. It was then as easy
step from measure by weight to measure by tale – by count. The essential requirement for this transition
was the acceptability of coin for its face value, which is the amount stamped on its face.

Early coin, particularly silver and gold, allowed cheating. The weight of the coins was reduced by
clipping, which involved removing a thin layer of metal from around the edge of the coin. This was
prevented in the seventeenth century with the milling of the coin. A milled coin has a serrated edge
which makes clipping easily noticeable. Milled coins also put a stop to the more difficult and therefore
less usual practice of hollowing coin. Once clipping and hollowing were prevented, sweating started.
Sweating was the practice of putting coins in a leather bag and shaking them vigorously to collect small
amounts of metallic dust in the bag. The only apparent effect this had on the coins was that of normal
wear.

Not to be outdone by the cunning of their subjects, some rulers were quick to seize the chance of getting
something for nothing. The power to mint placed rulers in a position to work a really profitable a
fraud. They often used some suitable occasion – a marriage, an anniversary, an alliance – to remit
the coinage.
Subjects would be ordered to bring their coins into the mint to be melted down and coined afresh with a
new stamp. Between the melting down and the recoining, however, the rulers had only to toss some
further inexpensive base metal in with the molten gold. This debasing of the coinage allowed the ruler to
earn a handsome profit by minting more new coins that the number of old ones collected, and putting the
extras in the royal vault. To this day, the revenue generated from the power to create currency is known
as seigniorage3.

As the price of gold began to rise, gold coins were melted in order to earn more selling them as metal.
This led governments to mix copper or silver in gold coins so that their intrinsic value might be more
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than their face value. As gold became dearer and scarce, silver coins were used, first in their pure form
and later on mixed with alloy or some other metal.

As soon as coinage came to play an important role in the economy of the ancient world, the prerogative
of minting was assumed by political sovereigns, who viewed it as a source of revenue. The avowed
intention was to protect the public interest by providing a uniform readily recognizable and honest
system of coins. But because the state frequently used its monopoly on minting to make a profit by
debasing the coinage, the intention of providing honest coinage was often thwarted. Where the state did
not take over the minting of coins completely, private merchants were allowed to mint their own coin:
or alternatively the state would mint money and allow a few merchants the exclusive right to distribute
it.

Coins are of two types:


i. Standard or full-bodied coins and
ii. Token Coins

A coin is regarded as a Standard Coin or Full bodied coin of its “face Value” (i.e. the exchange value
fixed by the issuing authority and embossed on it) is equal to its “intrinsic value” i.e. the worth of the
metallic content of the coin. In the past, coins made from precious metals like gold and silver were
regarded as standard coins and the monetary systems adopting them were referred to as “gold and silver
standards”.

On the other hand, a token coin refers to a coin having the face value of more than tits intrinsic value.
Token coins are usually made of cheap metals like nickel, copper or bronze. They are generally of lower
denominations. Token coins are issued primarily as a form of subsidiary money which is to be used for
small change only. They are useful as a convenient means for the payment of small sums.

Since all types of coins are issued by the state authorities, either the Treasury or the Central Bank of the
country; they are regarded as legal tender. Legal tender money’s acceptability is sanctioned or backed up
by law; hence, a refusal to accept it is a punishable offence. Standard coins are, however, unlimited legal
tender in the sense that the are acceptable as a means of payment of up to any amount, while token coins
are limited legal tender as payments can be made up to a small sum only.

Before the invention of coins, it was necessary to carry the metals in bulk. When a purchase was made,
the requisite quantity of the metal was carefully weighted on a scale.

Again, metal proved to be an inconvenient thing to accept, weigh, divide and access in quality.
Accordingly, metal was made into coins of predetermined weight. Therefore coins came to be accepted
as a convenient method of exchange.

Gresham’s law. The early experience of currency debasement led to the observation known as
Gresham’s law, after Sir Thomas Gresham, an advisor to Queen Elizabeth 1, who stated that “ad
money drives out goods”. He noted that the value of the metallic content in coins should not be
above their face value.

When Queen Elizabeth 1 came to the throne of England in the middle of the sixteenth century, the
coinage had been severely debased. Seeking to help trade, Elizabeth minted new coins that contained
their full value in gold. However, as fast as she fed these new coins into circulation, they disappeared.
The reason being that people hoarded the full-bodied coins with the result that debased coins were found
in circulation.
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Greham’s insights have proven helpful in explaining the experience of a number of modern high
inflation economies.

For example, in the 1970s, inflation in Chile raised the value of the metallic content in coins above their
face value. Coins quickly disappeared from circulation as private citizens sold them to entrepreneurs
who melted them down for their metal. Only paper currency remained in circulation and was used for
tiny transactions such as purchasing a box of matches. Greshman’s Law is one reason why modern
coins, unlike their historical counterparts, are merely tokens that contain a metallic value that is only a
minute fraction of their face value.
3
Seigniorage was not normally revenue generated by debasement, but originally was an explicit duty, or
tax, levied on the mint. In the modern context, the possibility of debasement does not enter, so the term
applies to the revenue that accrues from the power to print bank notes (which have very low production
costs relative to their face value) and from the fact that many central banks force banks to place non-
interest bearing deposits at the central bank (which finances the holding of interest bearing securities.

ii) PAPER MONEY


The use of metallic coins that run into some difficulties. It was not only inconvenient but also risky to
carry gold or silver coins from one place to another by merchants. Therefore, coins had the disadvantage
of being stolen and inconvenient to carry over long distances.

The next important step in the history of money was the evolution of paper currency

One source was goldsmiths who required secure safes, and the public began to deposit their gold with
such goldsmiths for safe-keeping. Goldsmiths would give their depositors receipts promising to
hand over the gold on demand. When any depositor wished to make a large purchase, she/he could go
to her/his goldsmith, reclaim some of her/his gold, and hand it over to the seller of the goods. If the
seller had no immediate need for the gold, he/she would carry it back to the goldsmith for safe-keeping
on his behalf.

If people knew the goldsmith to be reliable, there was no need to go through the cumbersome and risky
business of physically transferring the gold. The buyer needed only to transfer the goldsmith’s receipt to
the seller, who would accept it as ling as he was confident that the goldsmith would pay over the gold
whenever it was needed. If the seller wished to buy a good from a third party, who also knew the
goldsmith to be reliable; this transaction too could be effected by passing the goldsmith’s receipt from
the buyer to the seller. The deposit receipt was ‘as good as gold’. The convenience of using pieces of
paper instead of gold is obvious.

When it came into being in this way, paper money represented a promise to pay so much gold on
demand. In this case, the promise was made first by goldsmiths and later by banks4.

Such paper money, which became banknotes, was backed by previous metal and was convertible on
demand into this metal.

Fractionally backed paper money. Early on, many goldsmiths and banks discovered that it was not
necessary to keep a full ounce of gold in the vaults for every claim to an ounce of circulating as paper
money. ‘At any one time, some of the bank’s customers would be withdrawing gold, others would
be depositing it, and most would be trading in bank’s paper notes without indicating any need or
desire to convert them into gold’.

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4
Banks grew out of at least two other trades in addition to that of the goldsmiths. There were scriveners,
who had writing skills and sold their services managing other people’s financial affairs; there were also
merchant bankers, who started trading in commodities but ended up specializing in trade finance.

As a result, the bank was able to issue more money redeemable in gold than the amount of gold that it
held in its vaults. This was good business, because the money could be invested profitably in interesting
earning loans (often called advances) to individuals and firms. The demand for loans arose because
some customers wanted credit to help them over hard times or to buy equipment for their businesses. To
this day, banks have many more claims outstanding against them than they actually have in reserves
available to pay those claims. We say that the currency issued in such a situation is fractionally backed
by the reserves.

The major problem with a fractionally backed, convertible currency was maintaining its convertibility
into the precious metal by which it was backed. The imprudent bank that issued too much paper money
would find itself unable to redeem its currency in gold when the demand for gold was even slightly
higher than usual. It would then have to suspend payments, and all holders of its notes would suddenly
find that the notes were worthless. However, the prudent bank that kept a reasonable relationship
between its note issue and its gold reserve would find that it could meet a normal range of demand for
gold without any trouble.

If the public lost confidence and demand redemption of its currency en masse, however, the banks
would be unable to honour their pledges. The history of (19 th and early (20th banking around the world is
full of examples of banks that were ruined by ‘panics’ or sudden runs on their gold reserves. When this
happened, the banks’ depositors and the holders of their notes would find themselves with worthless
pieces of paper5.

Paper Money consists of currency notes issued by the State Treasury or the Central Bank of the country.
In Kenya, all notes are issued by the Central Bank of Kenya (CBK)

In modern era, the use of paper money is widespread owing to its following advantages:-
1. Paper money is economical. Obviously, paper is much cheaper than any metal.
2. Paper money economizes the use of precious and scarce metals by serving as representative money.
3. It is very convenient to carry paper money from place to place.
4. It is also easy to store paper notes. Currency notes of lakhs of rupees can be stored in a small vault.
5. It is easier to count paper notes than metallic coins.
6. Supply of paper money is easily adjustable as per the need of the economy. Thus, paper money is of
great monetary and fiscal advantages to the government.
However, paper money has also some disadvantages such as:-
1. There is the danger of over issue of notes as they can be easily printed and their supply depends
upon the whim of the government. An excessive money supply may lead to rising prices or inflation
thereby reducing the value (purchasing power) of money.
2. Paper money lacks general acceptability if the people lose confidence in the government for one
reason or the other.
3. Durability of paper money is much less than metallic money.
4. Paper money can circulate3 within the domestic economy only. For making foreign exchange
payments, paper money is not acceptable unless is a key currency lie dollar.

But these disadvantages are surmountable by a proper check. Therefore, paper money is in wide
circulation

FIAT MONEY/ CREDIT MONEY


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This was an important step in the history of money. As time went on, note issue by private banks became
less common, and central banks took control of the currency. In time, only central banks were permitted
to issue notes. Originally, the central banks issue paper currency that was fully convertible into gold. In
those days gold would be brought to the central bank, which would issue currency in the form of ‘gold
certificate’ that asserted that the gold was available on demand. The gold supply thus set some upper
limit on the amount of currency.

In modern economic societies, with the development of a banking activity along with paper money,
another form of convertible money has developed in the form of credit money or bank money. Bank
demand deposits, withdraw able by issuing cheques, have started functioning as money, and cheques are
now conventionally accepted as a mode of payment by the business community in genera. It must be
noted that a cheque by itself is just a credit instrument. Actually it is the bank deposit behind the cheque
that serves as money.

Bank money today constitute a major part of money supply in advanced counties. In many counties such
as America, it amounts to nearly 90 percent of the total money supply. In poor counties, the proportion
of currency money widely exceeds that of bank money.

Indeed, in a modern economy, currency money and bank money together constitute the total stock of
money or money supply. Currency money is a legal tender and has general acceptability, whereas bank
deposits are conventional money and lack general acceptability.

Another stage in the evolution of money in the modern world is the use of the cheques as money which
is simply a form of bank note. It is a means of transferring money or obligations from one person to
another. But a cheque is different form a bank note. A cheque is not money; it is simply a written order
to transfer money; only the deposit itself is money.

The final stage in the evolution of money has been the use of bills of exchange, treasury bills, bonds,
debentures, savings certificates for money and is liquid assets. These are known as ‘near money’. They
are close substitutes for money and are liquid assets. Thus in the final stage of its evolution money has
become intangible. Its ownership is now transferable simply by book entry.

Thus the origin of money has been through various stages:-


 From animal/commodity money to
 Metallic money,
 From coinage to
 Paper money and
 From credit money (cheques) to
 Near money

Prof. Shackle opines ‘the history of the evolution of money is a strand in the history of growth of
civilization second in importance only to that of language.

Money began as a commodity, and has ended as a system of recording transactions and bring every act
of purchase and sale, of borrowing and lending, o0f working and producing and consuming, that takes
place anywhere in the whole world at any time, into some degree of relation with every other such act.

1.3 FUNCTIONS AND SIGNIFICANCE OF MONEY


Money is an important and indispensable element of modern civilization. In ordinary usage, what we use
to pay for things is referred to as money. To a layman, thus in Kenya, the Shilling is the money, in
England the Pound is the money while in America the Dollar is the money. But, to an economist, the
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shilling pound or dollar are merely different units of money. Hence, the question still remains, what is
money? How will you define it in scientific terms?

1. DEFINITION OF MONEY
The definition of money is still an unresolved issue of monetary economics. Though we are all quite
familiar with the tem “money”, it is a concept which still lacks absolute clarity in scientific terms. In
fact, to define money in an exact sense is a difficult task. This is because there are various categories of
assets which possess the attributes of money. No wonder then, that we find economists holding different
opinions on the most appropriate definition of money. Money is any item that serves as a medium of
exchange and store of value.

Among the traditionalists, however, some economists have laid emphasis on general acceptability, while
others stress on its functions, in providing a definition of money.

Seligman, for instance, defines money as anything that possesses general acceptance ability. On the
other hand, economists such as Walker says that money is what money does. Even professor Hicks, in
his Critical Essays in Monetary Theory, says that “money is defined by its functions”. Professor R. G.
Hawtrey observes that, “money is defined by one of those concepts which, like a teaspoon or umbrella,
but unlike an earthquake or a buttercup, are definable primarily by the use or purpose which they serve”.
Professor W. T. Newlyn is, however, more precise when he says:- “Anything is money which functions
generally as a medium of exchange”. Newlyn, thus, reconciles both the aspects –general acceptability
and functions of money. Indeed, general acceptability is a necessary condition for anything to be
considered as money. In fact, general acceptability as a means of payment, by all the members of society
is the sinc qua non of any type of money. 2 Money, thus, thus, becomes a social phenomenon on account
of its general acceptability.

Crowther, however, aptly provides an analytical and illuminating description of many, when he defines
it as “anything that is generally acceptable as a means of exchange (that, as a means of settling debts)
and which, at the same time, acts as a store of value.” 3. His definition implies that money is that thing
which performs the following three functions:-
i. Serves as a medium of exchange or as a means of payment,
ii. Serves as a common measure of value and
iii. Serves as a store of value.

To modern economists, however, the crucial function of money is that it serves as a store of value.
Anything can be money provided it is generally acceptable as money. Truly money, in its present form
(of currency and demand deposits of banks), has evolved gradually, through trial and error, over a long
time since the dawn of civilization. Many things from clay and coir to cattle and coins have been used as
money, from time to time, in the various stages of human civilization. In fact, modern money – coins
and currency – is a social phenomenon, with a political orientation.

Empiricists’ Approach
The empiricist group of monetary economists, however, hold that money is a complex phenomenon. It
does not define itself to currencies and demand deposits of banks, but also includes a host of financial
assets such as bonds, government securities, time deposits with banks, and equity shares, which serve as
a store of value. Some economists categories these financial assets as near-money, distinct from pure
money which they refer to as cash and chequeable deposits with commercial banks. Though the
distinction between money and near-money is not very sharp, one can analyses the difference between
the two in the following manner.

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1. Money (cash and current account bank deposits) is the most liquid asset of all. Money possesses
hundred per cent liquidity in the sense that it is readily and immediately acceptable in general as a
means of payment and in the settlement of debts.
2. Money (currency unit) serves as a common denominator of value. The value of other financial assets
are expressed in terms of money. Thus, money as a unit of account is an important aspect of money.
3. Other financial assets are income-yielding assets, while cash balances earn no interest. This
fundamental distinction is very significant in determining the liquidity preference of the community.
Indeed, as a store of value, money has good substitutes in other assets because these assets give
returns, while money by itself does not do anything except that it confers on it the convenience of
liquidity.

The traditionalists include near-money from the workable definition of money, whereas the empiricists
include it. The latter seek the empirical investigation of financial assets. According to them, money is
conceived as cluster of those assets which possess attributes of satisfying one or more criteria of
identical behaviour in performing the functions of money. To them, money is what money does. While
clustering financial assets into one set (as money), they have laid down certain criteria:-
i. Stability of the demand function,
ii. High degree of substitutability and
iii. Feasibility of measuring statistical variations in real economic factors influenced by the monetary
policy and this is to be explained through the given cluster of financial assets in the economy.

On this account, it would be appropriate to quote Fredman and Schwartz:- “The definition of money is
to be sought for not on grounds of principle but on grounds of usefulness in organizing our knowledge
of economic relationship.”4

Indeed, in a modern money economy, money is a lubricant which keeps the wheels of the economy
moving smoothly. However, money does not remain merely a technical device of exchange. It functions
in such a manner as to influence the operative forces of the real economy.

For analytical and practical reasons, money must be statistically definable. Money is not just a
philosophy or an abstract idea like utility in economics. Money, being a social phenomenon – a creation
of the economic community – is a concrete thing, a commodity and an asset ( though in various forms).
Hence, it must be conceived and measured very precisely so as to visualize the overall dynamic effects
of money or the functioning of the modern economic system.

Money in modern economy plays several roles. Paul Einzing classifies the functions of money into two
broad categories – static and dynamic. In its static function, money is used as s passive technical
instrument of exchange devised to overcome the difficulties of barter so as to ensure a better operation
of the economic system. By its dynamic function, money works as a determining force in moulding
system. By its dynamic function, money works as a determining force in moulding the functioning of the
economic system and setting a particular economic trend.

2. STATIC FUNCTIONS OF MONEY


Money as a Medium of Exchange
The fundamental role of money in an economic system is to serve as a medium of exchange or as a
means of payment. On account of its general acceptability, as a medium of payment, money has ready
purchasing power and becomes a circulating medium. Being a generally acceptable medium of
exchange, money facilitates the multiple exchange of goods and services with minimum effort and time.
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In fact, the essential function of money is to obviate the difficulties of the barter system by serving as a
medium of exchange. In doing so, it breaks up barter into sales and purchases. Commodities, instead of
being exchanged directly for other commodities, are exchanged for money, which is again exchanged for
other goods. Thus, money, as a medium of exchange, permits an exchange of goods and services that
need not be simultaneous. This is, perhaps, the most significant property of money in a modern complex
economy. Being a generally acceptable medium of exchange, money obviates the main difficulty of the
barter system – the need for a double coincidence of wants, and quickens the process of exchange
transactions.

Though its physical substance does not have much relevance to the ability to perform its task as a
medium of exchange, nevertheless, in order that it becomes a good circulating medium, money should
possess certain attributes such as uniformity, cognisability, durability, portability, divisibility and
general acceptability. Universal acceptability as a means of payment; its durability confers on money
its role of purchasing power; its portability is desired for the convenience of making transactions; its
divisibility facilitates the smooth operation of small and big transactions and its general acceptability
generates public confidence in money.

Money as a Unit of Account


Money conventionally as well as technically acts as a unit of account or enumerative. In a monetised
economy, where money is the medium of exchange, money can be treated as a common measure or
common denominator of value. The value in exchange of all goods and services can be expressed in
terms of money. Such an expression gives rise to the price system. Money is, in fact, acts as a means of
calculating the relative prices of goods and services. In this sense, it has been regarded as a unit of
account. For instance, the rupee is the unit of account in India; the dollar is the unit of account in the
U.S.A., and so on.

The use of money as a unit of account in a monetized economy is a great technological improvement
over the barter system. It is enough for people to know the relative prices of different goods and there is
no need for them to remember multiple cross-relationships of the exchange values of these goods.
Again, in a monetized market, the real cost (measured in terms of time and efforts) of exchanging good
is low, since a minimum amount of information is required to conclude a transaction. This has far
reaching effects on the development of trade and economy.

Money is, thus regarded as man’s most useful and revolutionary invention. It has provided a language of
economic communication, and since it is a common measure of value, money makes possible a smooth
operation of the price system or market mechanism in a modern economic society. It automatically
provides the basis for keeping accounts, calculating profit and loss, and costing. Money being a uniform
and easily comprehensive unit of account, the aggregate real output of the economy of nation can be
measured as national income in monetary terms.

There is a marked distinction between money as a medium of exchange and money as a unit of account.
As a medium of exchange, money functions as something real – a coin, a currency not, a credit entry in
a bank account, but as a unit of account, money functions as an abstract measure of value – the rupee,
the dollar the yen etc. Thus, money as a unit of account is only a mode of expression and does not
necessarily have physical substance. In other words, the unit of account is something abstract, while the
medium of exchange is concrete. The rupee, as a notion, has no physical existence but the rupee not is a
physical entity.

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In short, as a pure unit of account, money is just a measure, like the metre or the kilogramme. It is
viewed in an abstract sense. As a medium of exchange, however, money is viewed with some physical
attributes.

Money as Standard of Deferred Payments


Money is a unit in terms of which debts and future transactions can be settled. In Kenya for instance, the
shilling or unit of account is the standard of deferred payments or future payments. Since a barter
economy lacks a standard of deferred payments or future payments, its progress is dull and slow. In a
modern economy, however, money acts as a means of settling indebtedness, or measuring deferred
payments or future payments. Loans are made and future contracts are, thus, settled in terms of money.

The existence of money in modern economic society has enabled people to effectuate wide scale credit
transactions. In fact, the effectiveness of modern commerce and trade is built on the citadel of credit,
which rests on the foundation of money as a unit of account and a standard of deferred payments. In the
process, money credit has brought dynamism to modern economic life.

Money as Store of Value


Money acts as an efficient store of value. The function of money as a medium of exchange makes it a
convenient asset to hold. Holding of money enables a person to avoid the time and effort which would
otherwise have to be involved in synchronizing market exchanges (as in the barter system). Money
being a permanent abode of purchasing power holds command over goods and services all the times
present as well as future. To hold money or to keep cash balances, in fact, becomes a form of holding
wealth. The function of money here is in the form of an asset or a form of wealth, because it confers
power on its holder to claim real goods and services. It is a convenient means of keeping any income
which is surplus to immediate spending needs and it can be exchanged for the required goods and
services at any time. Rather than keeping their wealth in non-liquid assets such as houses, or less liquid
assets such as shares, many people in modern societies prefer to keep their wealth in the form of money.
The function of money as an asset is the direct result of one of the most important properties of money,
namely, its liquidity.

People tend to keep money balances as a representative part of their real income (the value stored) in
anticipation of future monetary transactions. Money, in fact, is held to bridge over the period between
receipt of income and its expenditure. As such, money is a link between the present and the future. It
serves as a store of value because it has purchasing power and its exchange utility can be used at any
time. The holder of money is empowered to spend it at his will.

As a matter of fact, the two functions of money as a store of value and as a means of payment, both
current and deferred, are inseparable. To serve as a good medium of exchange and to be a good standard
of deferred payment and to serve as an efficient store of value, the value or purchasing power of money
must be stable. Since the purchasing power of money depends on the price level, it is essential to
maintain the stable value of money. If money shrinks in its purchasing power or its exchange value over
a period of time, as happens during inflationary periods, people may lose confidence in cash balances as
an efficient store of value.

However, the use of money as a store of value is not without draw backs. Value of money never remains
stable, so that the hoarder of money suffers a loss when its value deteriorates and gains when it
appreciates. Moreover, the variation in the use of money as a store of value is liable to be disturbing to
the functioning of the economic system.
We may summaries these functions of money with the following couplet:-
“Money is a matter of functions four”
“A medium, a measure, a standard and a store”.
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It follows, thus that all the functions of money are due to money being a medium of exchange; - the
middle term in the exchange of goods and services for each other. Goods are exchanged for money, and
then money is exchanged for goods. Hence, in a money economy, wants are satisfied through indirect
exchange.

Further, the price system on account of the use of money becomes the fundamental characteristics of
money economy. In a free capitalist system, economic choices are facilitated through the price system.
Moreover, in a money economy, since most transactions are settled in money, it is obvious that most
incomes are received in the form of money, because the receipt of an income is itself a transaction. It is
also an important feature of a money economy that incomes are received and measured in terms of
money.

Introduction of money, thus, changes the characteristics of barter economy altogether.

3. DYNAMIC ROLE OF MONEY


On account of its static or technical functions, money tends to play a dynamic role in determining
economic trends and highly important part in the economic system by influencing the general level of
process. Its volume and velocity whether the motivation comes from the state itself or from the general
public, can lead to a rise or fall in the general price level. Since rising prices generally stimulate
production, and falling prices check it, a general rise or fall in the price level is liable to affect, for better
or for worse, the welfare of most sections of the community. Monetary conditions are inclined to
stimulate or discourage consumption as well as production. Money, thus, is a potent factor that is liable
to stimulate or hinder economic progress.

The changes in the flow of money have a definite influence in determining the course of a free-change
economy. The laws of nature do not provide the means of ensuring that there should be just enough
money, neither too much not too little, under an “automatic” operation of the system. Money, therefore,
plays an important and active part in influencing economic trends through either an inadequate or excess
of its supply compared with the amount required for maintaining the stability of its value and the volume
economic activities@.

Money directs idle resources into productive channels, and thereby affects output, income,
employment, consumption and consequently, the economic welfare of the community at large.

Money makes it possible to have financial economic planning as a workable proportion of physical
planning at the micro-level and micro-level.

Being an essential part of the modern exchange mechanism and the market economy, money is surely
productive, in the sense that it is an aid to specialization and production I a capitalist economic system.

Money Encourages the Division of Labour


Use of money makes exchange process efficient and quick. It eliminates enormous costs and delay
involved in searching for the double coincidences of wants. Due to the smooth exchange system and
market mechanism created by the use of money, the need to produce all goods which one may require is
eliminated. In a money economy, one may specialize in the production of that good only in which he is
very proficient and has a greater interest and aptitude. And, she would tend to produce more in excess of
self-consumption requirement in order to create a marketable surplus. By selling his marketable surplus
of the commodity, he earns money. Money, thus, is the abode of purchasing power. Through this money
he can buy different goods to satisfy his varied wants.

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In short, in a money economy, different persons tend to specialize in different goods and through the
marketing process; these goods are bought and sold for the satisfaction of multiple wants. In this way,
occupational specialization and division of labour is encouraged by the use of money.

Modern civilization owes its growth to the economic efficiency of the people. The improvement in
economic efficiency is, by and large, the product of the degrees and complexities of specialization and
division of labour in the economic society. The progress of specialization is, however, determined by the
efficient system of exchange. The system of exchange in a modern economy has become efficient
basically because of the institution of money.

Money Smoothens Transformation of Savings into Investments


In a modern economy, savings and investments are effected by two distinct sets of people: Households
and Firms. Households save. Firms invest. In real terms, there is no direct link between the savers and
the investors. Economy, thus, needs transformation of savings into investments. In real terms,
investments means using of the surplus of real income (in excess of consumption) as resources saved
from consumption in producing goods meant for further production.

The household can lend savings (money saved from income) to firms. The mobilization of savings can
be effectuated through the working of various financial institutions: banks and non-bank financial
institutions. Money capital so borrowed by the investors when used for buying raw materials, labour,
factory plant etc. becomes investment. Investment, in real terms, thus, leads to the generation of
employment, income and output.

In this way, money smoothens the transformation of savings into investment in a modern economy.

Use of money as a means of deferred payment has given birth to credit transactions – lending and
borrowing – as a consequence of which money market and capital market have developed in a modern
economy. The main function of money and capital market is to mobilize savings for investment. Thus,
money is the basis of transforming savings into investment.

Indeed, money and the consequent development of monetary and financial institutions is an important
factor in the process of economic development of a country.

Furthermore, with the aid of the modern monetary system, a government is in a position to spend much
in excess of the amounts it can raise by taxation, because it can borrow any amount from the public and
from the banking system. The money economy, thus enables the government to embark upon costly
economic social, and political policies which would be out of its reach financially were it not for the
dynamic functions of money.
Moreover, money may also play an important part in the social sense by redistributing income and
wealth by means of taxation and expenditure.

The institution of money is an extremely valuable social instrument, which makes a large contribution to
economic welfare. In the absence of money, many of the transactions of a modern economy and in
particular, credit transactions, would not would be worth making and as a consequence, division of
labour would be hampered and lesser amount of goods and services would be produced. Real income
would, therefore not only be allocated less satisfactorily from the standpoint of economic welfare, but it
would also contain a smaller amount of money, if not all sorts of goods. Obviously, then, money is not
merely a veil or a garment. It is a key and a means by which the productive energies which would
otherwise be latent, can be released. Though money by itself creates nothing, it strongly influences the
creation of utilities. “Money is sterile in that by itself it can produce nothing useful, but it has a very
high indirect productivity owing to its ability to facilitate exchange and specialization”6.
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4. MONEY AS A LIQUID ASSET: A LINK WITH FUTURE
In the assets portfolio of an individual, money occupies an important place because money is the most
liquid of all assets. It possesses the unique attribute of perfect liquidity. No other form of wealth is
perfectly liquid.

Liquidity may mean ready exchangeability or expendability of an asset. In other words, it refers to
moneyness of the asset. In general, liquidity implies simply the ability of an asset to be converted into a
spendable from without any risk or loss to its holder. There are, therefore, two basic determinants of
liquidity of an asset:-
i. Capital certainty or the stability in value, and
ii. Shiftability or transferability.

The attribute of capital certainty of an asset implies that it can be converted into other assets without any
loss of value. The shiftability characteristic of the asset implies that it is a readily exchangeable
commodity. Thus, transferability is a necessary condition for liquidity.

Compared to all other assets, money is easily marketable or transferable, because it actually functions as
a medium of exchange. In fact, money is a directly expendable and universally acceptable commodity in
the settlement of obligations. Again, money possesses relative stability of value, also. Hence, there is
capital certainty in money. For instance, assets such as common stock in stock exchanges are a store of
value because they are marketable and can be sold promptly. But they are not stable in terms of value.

Their price stability is considerably less than that of money. Therefore, such assets do not posses the
liquidity of money, which does not involve the risk of loss to the holder. A shilling is still a shilling.

In fact, all assets such as savings accounts, bonds and government securities, treasury bills, common
stock and inventories, and real estate, do serve as stores of value, but they differ in degree of liquidity.
For instance, for the withdrawal of assets held in fixed deposit accounts of the commercial banks, there
is need to serve notice well in advance to encash the deposits. Equity shares, bonds, etc. have to be sold
in the stock exchange market first, in order to obtain money, which is expendable. In the selling process,
there is not only some delay, but there are also chances of loss; and it also involves costs, such as
broker’s commission, etc. If assets are in terms of real goods, there is storage cost and there are
possibilities of depreciation of the stocks of goods held. It also involves a high time element in the
selling process.

In short, money is readily expendable; while in the case of other assets (financial or real), one has to first
exchange a given asset for cash, which involves a time lag cost, and even capital uncertainty. There is,
therefore a demand for money to hold cash balances: cash plus demand deposits of commercial banks.
As a store of value, people’s preference for money over other assets flows essentially from the
characteristic liquidity of money and the uncertainty about the future value of non-money assets.
Kenyans, in this context, states that “the importance of money essentially flows from its being a link
between the present and the future by acting as a store of value.” Money is, thus, not a neutral element.
The holding of money and changes in its demand exert a significant influence on the aggregate
economic system of any country.

Chart 1
ASSET PORTFOLIO : THE LIQUIDITY BANKING OF CLAIMS

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1.4 MONEY AND NEAR MONEY

Money consists of currency and bank deposit. Coins and currency notes issued by the Central Bank of a
country and cheques of Commercial Banks of a country are liquid assets. Infact, cheques and bank drafts
are almost perfect substitutes for money. This is because they perform the medium of exchange function
of money.

But cheques and drafts can be issued at short notice only in the case of demand deposits. This is not the
case with time deposits which can be withdrawn either at the end of the fixed period or by giving a prior
notice to the bank. Thus near money assets serve the store of value function of money temporarily and
are convertible into medium of exchange in a short time without loss in their face value.

Besides time deposits, other near money assets are bonds, securities, debentures, bills of exchange,
treasury bills, insurance policies, etc. All these types of assets have a market and are negotiable so that
they can be converted into real money within a short time. These negotiable instruments are near money
instruments.

Bonds, securities and debentures fall in the same category. Bonds and securities are issued by the
Government (and at times by companies – i.e. bonds) while debentures are issued by companies. They
are the means to borrow funds for short, medium or long periods and carry a fixed rate of interest. They
are near money assets because they are convertible into cash at a short notice in the money market.

A bill of exchange is another form of money. It is an IOU (I Owe You). It is drawn by an individual (or
firm) demanding to be paid a stated sum of money on a specified date which is never more than 90 days.
A bill of exchange is not money by itself but is certainly money on the due date. For the bill to be
acceptable, it must be accepted by the bank of the debtor or the debtor him/herself (i.e. by endorsing it).
The bill of exchange is, however, near money if its owner wishes to turn it into cash. It can be easily
converted into money at a discount or by receiving less money than its face value.

It is usually important to differentiate the bill of exchange from the promissory note. The promissory
note is the earliest type of bill. It is a written promise on the part of a businessman to pay another a
certain sum of money at an agreed future date. Again, as the bill of exchange, a promissory note usually
falls due to payment after 90 days with three days of grace. A promissory note is drawn by the debtor
and has to be accepted by the bank in which the debtor has his/her account, to be valid. The bill of
exchange is similar to the promissory note, except in that it is drawn by the creditor and is accepted by
the bank of the debtor. Also, the promissory not is a near money instrument as the creditor can get it
discounted from his/her bank till the date of recovery.
Treasury bill issued by the Government also fall in the category of near money. A treasury bills is a
promise by the Government to pay a stated sum in the near future usually 30, 60 or 90 days. A treasury
bill is also like a bill of exchange which is a convertible into money at a discount within a short period.

Life insurance policy is another example of near money. The holder of a life insurance policy can obtain
cash in the form of a loan on his/her policy at a short notice. Thus a life insurance policy is a form of
liquid asset which can be regarded as near money.

Besides these recognized instruments of near money, some intermediaries (non-bank financial
intermediaries) have come into existence to provide a market for certain assets. Such intermediaries
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provide funds on the security of some assets, and brokers who buy and sell property, bonds, debentures,
shares etc. they help in increasing the liquidity of such assets thereby converting them into near money.

Money and near money can now be distinguished


▪ Near money is anything that fulfills the stores of value functions, and is readily convertible into a
medium of exchange, but is not itself a medium of exchange.
▪ Money is a legal-tender and gives the possessor liquidity in hand. It performs the medium of
exchange function.
▪ On the other hand, near money assets do not have any legal status. They possess money ness or
liquidity but not ready liquidity like money. They are almost perfect substitutes for money as a store
of value.
▪ Money, however, is a liquid asset which does not need to be converted into a form in which it is
generally accepted as payment. It is therefore, the most liquid asset.
▪ Despite the fact that near money assets do not possess ready liquidity they are mostly preferred by
individuals. They are preferred to cash by individuals because they serve as a margin of safety
motive. The yield from these instruments is higher than that from demand deposits and they are safer
than cash.

1.5 THE CHARACTERISTICS OF MONEY


The earliest and simplest form of money was some commodity which could also be used in
consumption, including its use as an ornament or religious sacrifice. But our study of the evolution of
money can be improved. It is therefore necessary to examine those characteristics which are thought to
be desirable but not absolutely necessary in money.

These include:-
(i) Portability
Money must be easy to carry to and from the place where payment is made. Paper money is more
portable than coins.

(ii) Acceptability
Money should be acceptable to an individual as a means of exchange. One will accept money if
he/she is convinced that the other person will agree to accept the same money in exchange for
commodities.

(iii) Durability
Money has to be physically hard wearing and can be used in many transactions. It costs money to
print money, thus money should be durable to avoid excessive manufacturing costs.

(iv) Scarcity
Money should be scarce, i.e. in proportional to the goods available. If it is in abundance, it will
result in inflation. Also, printing of money should be controlled in order to avoid the devaluation of
the currency.

(v) Homogeneity (Identical)


Money of the same denomination should be identical. Any piece of money should be
indistinguishable from any other piece, so that individuals will be indifferent between units of the
same type of money. For example, a not of Khs.100 should be worth 5 Kshs.20 coins, not 6!
(vi) Recognisability

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People should be able to recognize and distinguish different currencies. For example, a Kenyan note
of any denomination from a Ugandan one. Bank notes and coins are recognized by shape, size,
colour and design and the content indicating the value.

(vii) Divisibility
The money used is capable of being divided into very small units so that the same type of money
can be used for a very wide range of transactions.

1.6 CLASSIFICATION OF MONEY

On the basis of the materials used, money can be classified in to metallic money and paper money.
1) Metallic Money:- Money made of any metal such as gold, silver, nicked, copper, etc. is called
metallic money. Metallic money is further classified into standard money, and token money.

a) Standard Money
Standard money is money whose value as a commodity for non-monetary purposes is as great as
its value as money. Such money is made of coins whose face value equals their intrinsic or
metallic value. The holder of such coins may use them as metal by melting them or as money ,
because the value of the metal in the coins is the same as their monetary value. Standard money
is, therefore, known as full-bodied money.

b) Token Money
Token Money is representative money whose intrinsic value of the metal is less than its face
value (i.e. such money is made of coins whose face value does not equal their metallic value).

2) Paper money:-Paper money refers to notes of different denominations made of paper and issued by
the Central Bank.

a) Convertible paper money


Convertible paper money is that which does not have 100 percent backing in the form of
standard coins or bullion). But the holder of the paper money can get it converted in bullion or
coins or demand (examples of the receipts that were issued by the goldsmiths).

b) Inconvertible paper money


Paper money is which does not have any backing of standard coins or bullion and is also not
convertible into them. Notes issued by Central Banks of all countries represent inconvertible
paper money. They are also known as fiduciary money

c) Fiat Money
Paper money which circulates on the authority of the government. It is money which is created
and issued by the state, but is not convertible by law into anything other than itself, and has no
fixed value in terms of an objective standard. Presently, all inconvertible paper money is fiat
money and there is practically no difference between the two.

3) Legal-Tender money and Non-Legal-Tender Money:- Legal Tender money is that which the state
and people accept as the means of payment and is discharge of debts. It is legalized commodity that is
recognized in a country as money and it can be used for exchange or for the payment of debts. Since
it has the authority of the Government, such money is accepted compulsory by the people. All notes
and coins issued by the Government and the Central Bank of a country are compulsory legal-tender
in that country.

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Non-Legal-Tender Money:-is money which does not possess any legal authority of the state or the
Central Bank. It is also known as ‘optional money’. Bank money in the form of cheques and bills of
exchange, promissory notes, etc is non-legal tender money. People are not bound to accept such
money because there is no legal sanction behind their issue.

1.7 THE DEMAND FOR MONEY


The amount of wealth that everyone in the economy wishes to hold is in the form of money balances
called the demand for money. Because people are choosing how to divide their given stock of wealth
between money and bonds (investment), it follows that, if we know the demand for money, we also
know the demand for bonds.

With a given level of wealth, a rise in the demand for money necessarily implies a full in the demand
bonds; if people with to hold Kshs1 billion more of money, they must wish to hold Kshs.1 billion less
of bonds. Therefore, the opportunity cost of holding any money balance is the extra interest that could
have been earned if the money had been used instead of purchase bonds.

Clearly, money will be held only when it provides services that are valued at least as highly as the
opportunity cost of holding it. Three important services that are provided by money balances give rise
to three different motives for holding money.
▪ The transactions motive.
▪ The precautionary motive.
▪ The speculative motive.

(i) The Transactions Motive


Most transactions require money. Money passes from consumers to firms to pay for the goods and
services produced by firms, money passes from firms to employees to pay for the factor services
supplied by workers to firms. Money balances that are held to finance such flows are called
transactions balances.

But what determines the size of the transactions balances to be held? The key factor here is
income. If for example income of an individual doubles, for any reason, the transactions balances
held by firms and households for this purpose will also double, on average. We can thus say that,
generally, there will b a stable, positive relationship between transactions and national income. A
rise in national income also leads to a rise in the total value of all transactions and hence to an
associated rise in the demand for transactions balances.

(ii) The precautionary motive


Much expenditure arise unexpectedly, such as when your car breaks down, a relative falls sick, etc.
As precaution against cash crises, when receipts are abnormally low or disbursements are
abnormally high, firms and individuals carry money balances. Precautionary balances provide a
cushion against uncertainty about the timing of cash flows. The larger such balances are, the
greater is the protection against running out of money because of temporary fluctuations in cash
flows.

The seriousness of the risk of a cash crisis depends on the penalties that are inflicted for being
caught without sufficient money balances. A firm is unlikely to be pushed into insolvency, but it
may incur considerable costs if it is forced to borrow money at high interest rates in order to meet a
temporary cash crisis. Indeed, most firms have an overdraft facility with their bank precisely for
this reason; it gives them the right to borrow money quickly when they are short of cash (of course,
they still have to pay interest on what they borrow.
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The precautionary motive, like the transactions motive, causes the demand for money to vary
positively with the money value of national income. For most purposes, the transactions and
precautionary motives can be merged, as they both involve desired money holdings being
positively related to income. Indeed, they both involve money being held in relation to planned or
potential transactions.

Institutional arrangements affect precautionary demands. In the past, for example, a traveler would
have carried a substantial precautionary balance in cash, but today a credit card covers most
unforeseen expenses that may arise during traveling.

(iii) The speculative motive


Money can be held for its characteristics or as asset. Firms and individuals may hold some money
in order to provide a hedge against the uncertainty inherent in fluctuating prices of other financial
assets. Money balances held for this purpose are called speculative balances. This motive was first
analysed by Keynes, and the classic modern analysis was developed by Professor James Tobin,
the 1981 Nobel Laureate in Economics.

Any holder of money balances forgoes the extra interest income that could be earned if bonds were
held instead. However, market interest rates fluctuate, and so do the market prices of existing
bonds. Their present values depend on the interest rate). Because their prices fluctuate, bonds are a
risky asset. Many individuals and firms do not like risk; they are said to be risk-averse.

In choosing between holding money or holding bonds, wealth holders must balance the extra
interest income that they could earn by holding bonds against the risk that bonds carry. At one
extreme, if individuals hold all their wealth in the form of bonds, they earn extra interest on their
entire wealth, but they also expose their entire wealth to the risk of changes in the price of bonds.
At the other extreme, if people hold all their wealth in the form money, they earn less interest
income, but they do not face the risk of unexpected changes in the price of bonds wealth – holders
usually do not take either extreme position. They hold part of their wealth as money and part of it
on bonds; that is, they diversify their holdings. The fact that some proportion of wealth is held in
money and some in bonds suggest that, as wealth rises, so will desired money for speculative
purposes.

1.8 ROLE OF MONEY IN A MODERN ECONOMY

Money is of vital importance to the operation of the national and international economy. Money plays an
important role in the daily life of a person whether he/she is a consumer, a producer, a businessman, an
academician, a politician or an administrator. An individual need not be an economist to be actually
aware that money plays an important role in modern life; he/she need think only of his/her own
experience.

Removes the Difficulties of Barter


The importance of money lies in that it removes the difficulties of barter. There is no necessarity of
double coincidence of wants and possessions in the modern monetary economy. It also overcomes the
difficulty created by the indivisibility of commodities. There are no problems of storage and transfer of
values. Money removes these difficulties of barter by acting as a standard of value, as a store of value, as
a medium of exchange, and as a standard of deferred payments. Herein lies the importance of money in
a modern economy.

To the Consumer
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Money possesses significance for the consumer. The consumer receives his income in the form of
money rather than in goods and services. With money in hands, he can get any commodity and services
she/he likes, in whatever quantities to generalize his/her purchasing power, and to make claims on
society in the form which suits him/her best.

To the Producer
Money is easily important to the producer. He/she keeps his/her account of the value of inputs and
output in money. The raw materials purchased, the wages paid to workers, the capital borrowed, the rent
paid, the expenses on advertisements, etc. are all expenses of production which are entered the books of
account. The sale of products in money terms are his/her save proceeds. The difference between the two
gives him/her profit. Thus a producer easily calculates not only his/her costs of production and receipts
but also profit with the help of money.

Further, money helps in the general flow of goods and services from agricultural, industrial and tertiary
sections of the economy because all these activities are performed in terms of money. Money enables
man as a producer to concentrate his attention on his own job, and so to add more effectively to the
general flow of goods and services which constitutes the income of the society.

In specialization and division of labour


Money plays an important role in large scale specialization and division of labour in modern production.
The specialization and division of labour on which our economic structure is founded would be
impossible if every man had to spend a large part of his time and energies in bartering his products for
the materials of his industry and the goods which he requires for his own consumption. Money helps the
capitalists to pay wages to a large number of workers engaged in specialized hobs on the basis of
division of labour. Each worker is paid money/wages in accordance with the nature of work done by
him/her.

Therefore, since money facilitates specialization and division of labour, it helps in the growth of
industries.

It is in-fact through money that production on a large scale is possible. All inputs like raw-materials,
labour, machinery, etc. are purchased with money and all output is sold in exchange for money.

As the Basis of Credit


The entire modern business is based on credit and credit is based on money. All monetary transactions
consist of cheques, drafts, bills of exchange etc. these are credit instruments which are not money. It is
bank deposits that are money. Banks issue such credit instruments and create credit. Credit creation, in
turn, plays a major role in transferring funds from depositors to investors. Thus credit expands
investment on the basis of public savings laying in bank deposits and help in maintaining a circular flow
of income within the economy.

As a means of capital formation


As a corollary to the above, money acts as a means of capital formation. Money is a liquid asset which
can be stored and storing of money implies savings, and saving are kept in bank deposits, to earn interest
on them. Banks, in turn lend these savings to businesses for investment in capital equipment, buying of
raw materials, etc. from different sources and places. This makes capital mobile and leads to capital
formation and economic growth.

As a means of capital formation

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As a matter of fact, money is not only a means of capital formation, but is also an index of economic
growth. The various indications of growth are national income, per capita income and economic welfare.
These are calculated and measured in money terms. Changes in the value of money of prices also reflect
the growth of an economy. A fall in the value of money (or rise in prices) means that the economy is not
progressing well in real terms. On the other hand, a continuous rise in the value of money (or a fall in
prices) reflects retardation of the economy. Somewhat stable prices imply a growing economy. Thus
money is an index of economic growth.

In National and International Trade


Money facilitates both national and international trade. The use of money as a medium of exchange, as a
store of value and as a transfer of value has made it possible to sell commodities not only within a
country but also internationally. To facilitate trade, money has helped in establishing money and capital
markets. There are banks, financial institutions, stock exchanges, international financial institutions etc.
Which operates on the basis of the money economy and they help in both national and international
trade.

Further, trade relations among different countries have led to international co-operation. As a result, the
developed countries have been helping the growth of underdeveloped countries by giving them loans
and technical assistance. This has been made possible because the value of foreign aid received and its
repayment by the developing countries is measured in money.

To the Government
Money is of immense importance to the government. Money facilitates the levying and collection taxes,
fines, fees and prices of services rendered by the government to the people. It simplifies the floating and
management of public debt and government expenditure in development and non-development
activities. It would be impossible for modern governments to carry on their functions without the use of
money.

To the society
Money confers many social advantages. It is on the basis of money that the superstructure of credit is
built in the society which simplifies consumption, production, exchange and distribution. It acts as a
lubricant for the social life of the people, and oils the wheels of material progress. Money is at the back
of social prestige and political power.

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LECTURE 2

THE BANKING SYSTEM (COMMERCIAL BANKS)

2.1 FINANCIAL INTERMEDIATION


The principal function of banks’ are to take deposits and make loans. In this they fulfill the role of financial intermediaries.
The financial intermediary borrows from those with surplus funds and lends them to those with a shortage of funds. This role
is a vital one because the needs of lenders and borrowers cannot always be matched through direct contract for several
reasons:-

(i) The lender may wish to lend short while the borrower may wish to borrow long
(ii) The lender may be willing to lend only a small sum while the borrower wants to borrow a large amount
(iii) Lender and borrower may be unable to communicate directly due to distance or other factors.
(iv) The lender may be unwilling to take the risk inherent in the borrower’s project.

The financial intermediaries solve these problems by entering into two distinct and very different contracts, one with
the lender and the other with the borrower. This enables the needs of both parties to be met. Thus the financial
intermediary:

- Borrows short and lends long ; i.e. may borrow on a few days notice and lend to mortgage (i.e. longer term)
- Borrows small amounts and aggregates them to provide large loans.
- Transforms risks. Lenders are spared the high risk of direct lending. Instead they enjoy the benefits of the risk-spreading
activities of the financial intermediary, whereby losses are absorbed by the large number of loans undertaken.
1
A bank can be defined as an institution which collects funds from the general public, safeguards them and makes them
available to the true owners when they require them, but also loans out sums not immediately required by their true owners to
those who are in a position to provide sufficient security.

TYPES OF FINANCIAL INSTITUTIONS

a) Central Bank
This is a government-owned Bank whole principle function is to carry out the monetary policy of a country. This
function requires the Central Bank to work closely with the government and have some means of controlling the
commercial banks.

b) Commercial Bank
After the Central Bank, the Commercial Banks are the most important institutions in the financial system of any
country. They generally deal, either as borrowers or lenders, with a wide cross-session of the public than any other
financial institution. These are banks which undertake all kinds of ordinary banking business. Unlike the other financial
institutions (except the Central Bank) they create the stuff they lend – money.

c) Non-Bank Financial Intermediaries (NBFI)


The NBFIs are so called because they are not really banks in the strict sense of the word. They include: hire purchase or
finance companies, savings banks, insurance companies, merchant banks, building societies, common trust funds,
pension funds and government lending agencies.

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These intermediaries pod funds from net savers and lend them to finance expenditures of business firms and local
bodies. To obtain funds from net savers, the intermediaries issue and sell indirect securities such as time deposits,
common fund stocks, saving and loan shares, and insurance policies. They purchase primary securities to lend funds to
ultimate borrowers. Primary securities include government securities, mortgages, common and preferred stock, and
consumer and other short-term debts. Thus NBFI are financial firms that buy one kind of financial asset and sell
another. For instance, saving and loan associations and mutual savings banks mainly buy mortgages and sell saving
deposits, insurance companies buy mainly bonds and sell insurance policies; and finance companies buy installments
loans and sell commercial papers.

As a group, the NBIFs have much in common with commercial banks;

Firstly; both are financial intermediaries; both act as middlemen between those who have funds to lend and those who need
funds to borrow. Therefore, both borrow from the public through deposits and lend to the public through loans and other
credit facilities.

Secondly; because the working capital of both is money, they are competitors in the markets for deposits and for loans.
They compete by offering various types of incentives in order to attract customers. In addition, both are influence in their
operations by the size and maturity structure of their deposits.

Thirdly; as financial institutions, commercial banks and NBIFs and both creators of financial assets and both generate
income for themselves and for the public through their operations, which consequently affect the production and distribution
of goods and services in the economy.

Finally, because of their influence on the economic situation, the two types of financial institutions have come to be subject to
varying degrees of restraint and controls imposed by the monetary authorities 2. (i.e. commercial banks in Kenya were
subjected to lower loan, ceilings, higher liquidity requirements and limits on private sector credit expansion).
2
For the difference in supervision see Ngugi and Kabubo, (p.p8 on Central Bank Regulations).

These are substantial differences between commercial banks and NBFIs:-

Firstly, all the deposits of the commercial banks are payable on demand that very short notice, while nearly all the deposits
of the NBFIs are fixed for specific periods.

Secondly, the commercial banks obtain a big percentage of their loans interest free on current accounts, while nearly all
the deposits of the NBFIs are interest bearing.

Thirdly, because all their deposits are payable on demand or at very short notice, the commercial banks do not generally
make long-term loans. They rather concentrate on short-term self-liquidating loans. They therefore observe what has come
to be called the liquidity principle in lending, because they are influenced in making their loans by the liquidity nature of
their deposits. The NBFIs, while also influenced by the liquidity of their deposits, observe what is called matching
principle. By this principle, loans are matched with the duration of deposits or vice versa. Because their deposit are generally
fixed for specific periods, the NBFIs can in general grant longer-term loans than the commercial banks.

Fourthly, although both are lenders, the commercial banks are lenders to anybody for almost any purpose, while the NBFIs
are specialist lenders. For instance, building societies specialize in hose or mortgage financing, insurance companies and
pension funds on stocks and shares, and finance houses specialize in installment or consumer credit.

Fifthly, commercial banks operate through a wide spread branch network, while NBFIs generally have an office or fewer
offices.

Finally, and perhaps the most important difference is that commercial banks deposits are generally regarded by the public as
pure money which can be used for making pay month in the form in which they are, by transfers through credit instruments
such as cheques, and can be withdrawn on demand or at very short notice. On the other hand, deposits with NBFIs are
generally regarded as quasi- or near money, which has to be purified, i.e. converted into bank deposits or currency, before
being used as a means of payment. This derives from the fact that the NBFIs do not usually offer current account and cheques
facilities.

2.3 Origin of Commercial Banking in East Africa

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The origin of commercial banking in Kenya lays in the commercial connections between India and the East Africa regions
which existed towards the close of the nineteenth century. The National Bank of India was the first bank in Kenya in 1896.
Later the Standard Bank of South Africa came in 1910 and the National Bank of South Africa in 1916.

The establishment of these banks was in line with the practice of the British bank to follow the development of trade in their
colonies and promote international trade. The National Bank of India which later became known as the National and
Grindlays Bank, operated mainly in India while the Standard Bank of South Africa now the Standard Bank concentrated in
South Africa. These banks thus developed links with Britain, India and South Africa and offered new opportunities to the
settlers and traders who come to Kenya. This growing community provided initial sources of deposits for the banks either
from the money they brought with them or from that which they got from the sale of primary commodities. These banks then
started collecting deposits locally which they used in Kenya and the surplus of it was used in investing in places like London
because of the lack of investment opportunities in the economy of this country.

As we have noted, for the most part, banks established in East Africa (and colonial Africa) were the branches of private
commercial banks of the colonial powers. These banks primarily loaned funds directly to foreign firms, to white settlers
owing plantations and mines, or to Asian traders. Africans obtained cash for the most part only in the form of low wages
earned by working on the plantations and farms. If they required additional funds in emergencies, they usually found it
necessary to turn to money-lenders charging very high interest rates.

It was not surprising that Africans complained frequently that the colonial commercial banks hindered rather than helped
African business interests. The banks loaned funds primarily to foreigners rather than to Africans arguing that Africans could
not provide adequate security for loans. In effect, these policies tended to reinforce the oligopolistic position of the foreign
firms in the economy by restricting the efforts of Africans to obtain the necessary funds to compete.

The foreign-owned commercial banks generally kept a substantial share of their reserves abroad including profits
accumulated from their business in Africa. This was a further drain of funds which might have been invested in economic
development in the colonies. It can be thus noticed that for a long period, these banks were involved in a process of exporting
capital from Kenya an underdeveloped country to a developed country. As the economy of Kenya expanded it attracted many
new banks after half a century of banking monopolized by the three banks. These new banks included the Bank of India and
Bank of Baroda in 1953, Habib Bank Ltd in 1956, Ottman Bank and the Commercial Bank of Africa in 1958 who
concentrated mostly in the urban areas. In 1960, the Co-operative Bank of Kenya also opened and provided specialized
banking services for the members of the growing co-operative movement.

At independence, Kenya inherited a financial system composed of the Currency Board of East Africa, a commercial bank
sector dominated by foreign banks, and a small number of specialized financial institutions. The currency board, however,
lack monetary and financial independence. The government thus found it necessary to establish national monetary controls
aimed at efficiency operation of the monetary system. In May 1966, the Central Bank of Kenya was established by an Act of
parliament with only 10 (mainly foreign owned) commercial banks. The set goal for the financial sector was to ensure its
growth and stability so that it could stimulate growth in other sectors of the economy thus achieving a high economic growth
rate.

The inherited financial system expanded and became for diversified in the 1970’s and 1980’s especially with the government
policy to encourage local participation in the financial system and setting up of specialized institutions to collect savings and
finance investment through issuing new bank and NBFI’s licenses. The number of commercial banks increased from 9 to 15
in 1980, and by 1985 there were 23 commercial banks. Commercial banks currently stand at over 50.

2.4 Organisation and structure of Commercial Banks

Commercial banks differ in their organization and structure from country to country. The structure of banking in Africa,
particularly the influential position held in it by expatriate banks, has largely determined the official policy towards banking
adopted by African Governments since independence. Within the general structure, certain striking characteristics may be
seen. An outstanding one is that in each country, a branch – banking system operates. This means that each country is
served by a network of banks which are branches of a few large, well-established banking organizations. This contracts with
the system which exists in some continents (especially the U.S.A) where each individual banking house is a separate
independent company. The principal banking system in Kenya is the branch baking and will be contrasted with the
unit banking system.

Unit banking
Unit banks are independent, one office banks. Their operations are confined in general to a single office. The existence of unit
banking in USA is due to legal restrictions that prevent the growth of monopoly in banking. The Unit bank usually operates

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in small towns and in commercial centers. A few examples in Kenya include Bank of Tokyo Mitsubishi Ltd. Euro Bank Ltd
and Fidelity Commercial Bank Ltd among others.

Branch Banking
Branch banking is the most prevalent banking system in the majority of the countries in Africa. Under this system, a big bank
has a number of branches in different parts of the country and even many branches within a cosmopolitan city.

Merits of branch banking


The branch banking system has many advantages, which has it a more superior (and preferred) system to the unit banking
one.
(i) The branch banking system has the advantage of spending risks geographically and industrially. If branches in a
particular area suffer loses due to recession in industries located there, these losses can be offset by profits from prospers
areas. In other words, the branch banking system has a greater capacity to move funds geographically from the areas
where they are less needed to areas with larger demand.

(ii) As a corollary to the above, a big bank with a large network of branches is able to utilize its funds most profitably. It can
carry out its banking operations with lower cash reserves in each branch and lend the remaining amount to its customers.
Incase the need for excess cash in one arises, it can be met by transferring funds from some other branch. Thus the
commercial bank earns larger profits under branch banking system than under unit banking.

(iii) The branch banking system has the advantage of large scale organization because bank is able to recruit efficient and
trained staff and pay better than the unit banks. It can thus realize the advantage of intensive specialization and division
of labour by carrying out separate banking operations under different staff.

(iv) Big banks, apart from providing banking facilities to trade, industry, business and the usual customer at cheaper rates,
they can provide banking facilities throughout the length and breath of the country , whether it is a small village or a big
city, it is this way that branch baking also helps in the equitable distribution of fund within the country

(v) Under the branch banking system a big bank with the large financial resources is in a better position to choose securities
and make large investments in keeping with the principles of safety and liquidity.

(vi) Finally, the Central Bank of the country can control the banks more effectively under the branch banking system then
under the unit banking system. It is easier to control the credit policies of a few large banks than those in numerous unit
banks.

Demerits of branch Banking


The branch banking system has its critics who point towards a number of disadvantages of this system.

(i) Under the branch banking system, there is bureaucratization and the management of all the branches is under the control
of the head office. This leads to delay in taking prompt decisions by the branch managers. They have to refer all cases for
advances to the head office.

(ii) As a corollary to the above, the branch managers are not able to meet the borrowing needs of the local business
community as efficiently and sympathetically as the unit banks. This is because the branch managers have to operate
under rules set by the head office.

(iii) The branch banking system leads to the establishment of monopoly banking in the country. When a few big banks open
branches in all parts of the country, they limit competition in banking and ultimately lead to the establishment of
monopoly in the banking industry. Funds tend to concentrate in a few banks. It may further lead to the concentration of
economic power in industry and even to political power by such financially powerful banks.

(iv) As the big banks have a network of branches spread throughout the country, it becomes, at times difficult to manage and
supervise them efficiently and control becomes lax, the banking services suffer and the clients are hit hard.

(v) Another disadvantage of branch banking is that deposits of one area may be used for financing business and industry in
other areas where the banks expect to earn more by lending. This may adversely affect the former area if it is already
backward.

(vi) Branch banking leads to competition among different banks in establishing branches at various places. The tendency
leads to unnecessary increase in expenses. The usual practice is for the locality in big towns. This leads to concentration
of branches, thereby resulting in unhealthy competition and rivalry. Sometimes the banks give inducements in the form
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of gifts and provide free outstation services to attract customers. Such devices increase bank expenses and lead to
wastage of essential resources.

Despite the elements, the branch banking system is preferred to the unit banking in developing countries. In underdeveloped
economics, the unit banking system cannot be successful. There is need to develop agriculture, industry and trade which is
only possible through the branch banking system with its large financial resources. Further, for a balanced regional
development, it is through branch banking that funds can be utilized from branches in developed regions to backward
regions. However, the disadvantages of the branch banking system can be avoided through proper regulation by the Central
Bank of the country.

FUNCTIONS OF COMMERCIAL BANKS


1. Storing Money
One of the principal functions of a bank is to accept and safeguard its customers’ money. There are three principal types
of account which a customer may open with a bank.

The most common is a Current Account. Money in a current account may be withdrawn on demand, or it may be
transferred to another person in whole or in part y means of a cheque or other document. Subject to the agreement of the
bank manager, it may be possible to overdraw a current account – i.e. to transfer or withdraw more money than has been
deposited. Because a bank may be called upon to repay the whole o a deposit at any time, there is little that it can do with
money in a current account. It is therefore customary to charge the customer a small commission for the responsibility of
holding his/her money for him/her. Interest is also charged, of course, if the account is overdrawn.

Current accounts are quite different from deposit accounts. This account (s) is suitable for those who are prepared to
forgo their right to withdraw or transfer the money in demand; therefore, deposit account holders do not have cheques
books. Banks normally state that they require seven days notice of any withdrawal, but usually this is not insisted upon.
Banks normally state that they require seven days notice of any withdrawal, but usually this is not insisted upon. Banks
are able to use money placed on deposit to a greater extent than they are able to use money in current accounts, and
therefore interest is paid by the bank to the customer.

It is often possible to open a savings account, which is a special type of deposit account suitable for small savers. Many
banks also offer home safes free of charge. These are small boxes especially suitable for encouraging children to save
and from time to time the safe can be taken to the bank and the contents paid into a savings account.

2. Transferring Money
This is usually done in three main ways:-

(i) Paying Cheques – drawn by its customer and made payable to other people. Money in a current can be
withdrawn or transferred in a variety of ways. One of the most common is by cheques. This is a written instruction
by the customer telling the bank to pay out, or to transfer to another person’s account, a stated sum of money.
Normally, cheques can only be exchanged for cash over the counter at the branch of the bank at which the account
is held, though it is usually possible to arrange for limited sums to be drawn at other branches if this is desired.

(ii) Credit Traders – This is a system under which a person with a number of payments to make can present his/her
bank with a list of the names of the payees, the addresses of the banks concerned and the individual amounts to be
paid, one cheque, payable to the bank, is then drawn to cover the full amount, and the bank arranges the rest.
Under this system, the customer instructs the bank to credit the account of a specified person with a specified sum
of money. This system is very useful in paying salaries.

A large employer will issue only one cheques covering the total amount payable in salaries to his/her employees.
The cheques together with the list of employees’ names, their respective salaries, and account numbers is
forwarded to the bank. The bank then debits the account of the employer and credit the accounts of each one of
the employees with the respective amounts of their salaries. This reduces the degree of risk inherent in carrying
the large sums of money for payment of salaries.

(iii) An extremely useful facility offered by banks to those who have regular periodic payments to make, such as rent
payments, mortgage payment, hire-purchase installments club subscriptions and insurance premiums, is the
standing order system. A simple form is completed telling the bank what sum to pay, to whom it should be paid
and when, and the bank arranges payment accordingly until the order expires or is countermanded (cancelled) The
bank will only execute a standing order if there is sufficient funds in the account of the person wishing to have the
money transferred. Banks charge a fee commission every time the standing order is executed.
3. Collecting Money
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Banks collect money on the customer’s behalf mainly in the following ways:-

(i) Accepting money from third parties for a customer’s account. Customers who own securities such as shares in
companies, often arrange for the dividends to be collected by their banks and credited directly to the accounts.
(ii) Presenting cheques deposited by customers to other banks for payment.
(iii) Collecting the proceeds of bills of exchange drawn by the customers. Bills of exchange are documents held by a
creditor under which the debtor has promised to pay a certain sum of money at a given date, which may be several
months away. The creditor’s banks will not only present the bill for payment when it becomes due, but will often
‘discount’ it for slight commission immediately, and hold it until the date when it becomes due.
(iv) Accepting credit transfers, i.e. bringing money from other banks (branches) to the customer or account.

4. Lending Money
Lending money is perhaps the most important of all banking activities. It is important to the banks, for the interest charge
on loans is how they earn their living. A bank lends a certain percentage of the cash lying in deposit on a higher interest
rate than it pays on such deposits. This is how it how it earns profit and carries on its business. It is important to the
community, for bank loans are essential to the smooth functioning of the economy.

All manner of people need to borrow money from time to time; some need small loans, some need large; some need the
money for short periods, some for long. Different types of banks cater for different needs. Commercial banks specialize
in meeting the needs of borrowers requiring reasonably small amounts for short periods. For all their customers, banks
are there ready to help-subject, of course, to their responsibilities to their depositors, and to government controls. The
bank advances loans in the following ways:-

i. By Overdraft:- When a customer is allowed to draw more money from his account then he/she has in it. His/her
account is said to be allowed to run into the red’. This is done by providing the overdraft facility up to a specific
amount. The customer is charged interest only on the amount by which his/her current account is actually
overdrawn and not by the full amount of the overdraft sanctioned to him/her by the bank. The overdraft procedure
tend to be favored by borrowers, but, for several technical reason, bankers often prefer to make loans.

ii. By a Bank Loan:- In this case a stated sum is made available to the customer (borrower) in a special loan account
and he/she pays interest on that amount whether he/she withdraws it from the bank or not. The amount of the loan
is usually put on to the customer’s account as if he/she had deposited money into the account. Loans are more
formal. They require completing of loan forms, agreement on the loan amount, rate of interest and the due date.
The provision of loans is governed by the banking policy of the bank and the Banking Act, Section 10 of the
Kenya Banking Act prohibits a bank or any other financial institution for lending a person a sum of money in
excess of 5% of the total deposit liabilities of that bank. It also makes it illegal to lend anyone person or institution
a loan in excess of 100% of the person’s or institution’s paid up capital.

Besides, good banking practices do not allow a bank to loan out such sums of money that it will be unable to meet its
customer withdrawal demand on request. The size of the loans to be granted depends on the personal position of the
customer and the security provided. In general, the size of a loan depends on the prevailing government policy, the
individual bank policy, its liquidity position, and the degree of risk inherent in lending him/her money. The bank will
want to know the credit worthiness of the customer and his/her financial integrity.

All this information will be made available to the bank manager when he/she interviews the customer. If the bank
manager is satisfied with their talk, the manager will ask the customer to sign a loan agreement together with a
repayment standing order. The amount of the loan is then credited to the customer’s current account and a separate loan
account is opened. As periodical repayments are made, they are credited to the loan account and the balance declines
until full payment is made.

iii. Discounting Bills of Exchange:- If a customer holding a bill of exchange needs money, the bank provides
him/her the money by discounting the bill of exchange. The bank deposits the amount of the bill in the current
account of the bill-holder after deducting its rate of interest for the period of the loan. The bank then holds the bill
until it matures and then presents for payment from the banker of the debtor who accepted the bill in its own
name.

iv. Call Loans:- These are very short-term loans advanced to the bill brokers for not more than fifteen days. These
are advanced against first class bills or securities. Such loans can be recalled at a very short notice. In normal
times they can also be renewed. The first two methods are the most frequent used methods. The loan account has
the following advantages over the overdraft facility.

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 The loan account has the advantage of a fixed period of operation. The bank cannot cancel the loan account
until this period has expired, so the businessman can be sure that the money will be available to him for the
whole period. The overdraft, however, can be cancelled by the bank at any time.
 The interests charged on overdraft are usually higher than that charged loan accounts

But the overdraft has advantages too.


 An overdraft is a more convenient method of borrowing. It requires less formality and is more easily
negotiable, especially when small amounts are involved. Loan accounts, on the other hand, require more
documentation.
 Payments into the account reduce the overdraft and therefore reduce the interest burden.
 Also interest is only charged on the part of the loan that is used; i.e. on the amount that has been overdrawn.
An overdraft may therefore be cheaper than a loan amount; because, in the case of the loan account, interest is
charged on the full amount, regardless of whether the customer (borrower) has money in his/her account or
not. In other words, interests is payable on the full amount of the loan, once the customer’s account has been
credited and his/her loan account debited, and whether the money is utilized or not.

To illustrate this:-
Suppose that A borrows Kshs.10,000 through a loan accou8nt while B borrowsKshs.10,000 on overdraft. At the end
of three months, each months, each has used only Kshs.5,000 of their loan. A will have used only Kshs.5,000 in
his/her current account while B’s current account will show Kshs.5,000 in the red. A will pay interest on the full
Kshs.10,000 outstanding on hi/her loan account, while B will pay interest only on the Kshs.5,000 for which he/she
is in the red. He will therefore pay less interest than A. who borrowed on loan account.

5. Acting as a guarantor, trustee, or executor for a customer.


 A commercial bank may guarantee a customer to another party that is willing to either lend money to the customer,
or sell him/her goods or services on credit.
 A trustee is an individual who acts for another person in his/her absence. Commercial banks do this for their
customers by making payments or receiving money, on their behalf.
 Executors are people or organizations who are asked to distribute the assets of a person who is either dead or
bankrupt. Commercial banks at times are asked to do this.

6. Facilitating the buying or goods and services on credit by its customers.


Commercial banks usually do this in four main ways:-
i. Issuing traveler’s cheques to customers,
ii. Issuing letters of credit to customers,
iii. Issuing documentary acceptance credit,
iv. Issuing bank credit cards to customers.

i. Traveler’s Cheques
A traveler’s Cheque is a bank draft (that is, a cheque drawn by a bank on a bank) for a fixed sum of money
payable to a person to whom it has been issued. Traveler’s cheques are issued by banks to individuals who must
pay an equivalent amount of cash plus the bank’s commission. They are issued in denominations preferred by the
individual. A traveler’s cheques may be in local currency (and therefore payable within the country of issue) or in
foreign currency (and therefore payable in the foreign countries specified on the back)

Traveler’s cheques are mostly useful to travelers, enabling them to make small payments for hotel bills, small
purchases e.t.c. The person to whom traveler’s cheques are being issued signs the cheques in front of the bank
official issuing them. The person will sign them again in front of the official at the bank at which he/she wants
them cashed. Many banks also require that the holders of traveler’s cheques provide satisfactory proof of identity
as a condition for cashing their cheques.

The need to countersign the cheques in the presence of an officer of the paying bank and the identity requirements
are two safety measures that make traveler’s cheques very attractive. These measures ensure that anybody who
steals the traveler’s cheques will not be able to cash them. They are also convenient because they can be presented
for payment any bank.

ii. Letters of Credit


A letter of credit is issued to a person traveling overseas to buy goods. It merely states that the issuing bank will
pay any bill presented to it, provided that the conditions outlined in the document have been satisfied. The letter of
credit will specify the sum that must not be exceeded, the nature of goods to be bought, and the date at which the
goods must be shipped out of the country of the seller. One might say that a letter of credit is a guarantee for
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payment issued by a bank. When a seller abroad is presented with a letter of credit, he/she will dispatch the goods,
and then draw a Bill of Exchange on the bank that issued the letter of credit. A letter of credit may be either an
ordinary letter or credit or a circular letter of credit. The former is issued for one transaction only, while the latter
is issued for much transaction, so that each seller draws a bill of exchange on the one letter of credit. Each seller
marks off the value of his/her sale on the back of the letter.

iii. Documentary Acceptance credit,


Sometimes, sellers in foreign countries want to ensure that the money for the purchase is paid in their own country
before they dispatch the goods. In such a case, an overseas buyer will ask his/her bank to establish a documentary
acceptance credit what this means in that the buyer’s bank will ask a correspondent bank in the seller’s country to
pay the seller the sum of money specified in the document. The conditions laid down in the document must have
been fulfilled, and all the documents concerning the transaction must be handed over by the seller, to the
correspondent bank.

Like the letter of credit, a documentary acceptance credit will specify the nature of the goods to be bought, the
date by which the goods have to be shipped out of the seller’s country, and the documents that must be handed to
the correspondent bank before payment can be made. In the case of a letter of credit, the seller draws a foreign bill
of exchange. In the case of a documentary acceptance credit, the seller will draw a local bill of exchange. In the
case of a documentary acceptance credit, the seller will draw a local bill of exchange on the correspondent bank.

iv. Bank Credit cards


A service that is becoming very popular and one that the banks have found profitable to provide, is the bank credit
card service. This card is issued to a customer with a sound credit rating (i.e. a trusted customer). The card enables
the holder to buy goods and services on credit from specified suppliers (i.e. business houses that accept the credit
cards) including travels, meals and hotel accommodation. Each credit card bears a specimen signature of its holder
and is embossed by the issuing bank with the holder’s name and number. When goods or services are supplied, the
card holder hands, the card to the supplier who has agreed to join the scheme. The supplier places the card in a
special in printer machine, which records the holder’s name and number on a sales voucher, to which are added the
particulars of the transaction. The holder signs the voucher, and the supplier compares the signature with that on the
card. He then sends the voucher to the issuing bank which pays the amount claimed less a service charge. At the end
of the month, the bank sends a fully itemized statement to its card holder, who must remit his/her cheque for the
total amount. The card holder is not required to pay any interest upon the sum due, provided that he/she makes
payment within a specified time, usually about three weeks. Alternatively, the card-holder is expected to make
monthly payments, covering all expenses incurred using the card, to the issuing bank.

Credit cards may also be used for the purpose of obtaining cash from branches of the issuing bank or branches of
certain other banks with whom arrangements have been made. Credit cards can be used to obtain credit only up to
the holder’s limit set by the issuing bank. The banks issuing credit cards cover their administrative costs and profit
from the interest they charge on the credit facilities they offer. The interest is normally charged on unpaid monthly
balances.

Some credit cards have international status, in the sense that they are accepted for business transactions in most
countries despite the fact that they are issued by a bank based in a specific county. The main advantage of credit
cards is that they minimize the use of cash. It is more convenient to carry one or a few cards than a large number of
banknote. Therefore, there can be no doubt that credit cards save trouble to traveling businessmen. Credit cards are
also widely used by shoppers, who need not carry large amounts of cash or be concerned about the reluctance of
suppliers to accept personal cheques.

Another advantage is that a cardholder enjoys a period of ‘free credit’ which lants for something between three and
seven weeks, depending on the terms of the issuing bank. Credit cards also do bring benefits to suppliers of goods
and services. The principle benefit to them is that a credit card ensures certainty of payment. Suppliers no longer
have to send out numerous reminders of outstanding debts. Losses through bad debts are reduced, and additional
liquidity is achieved.

7. Offering Safe-custody for Customers


One very important service which a bank offers to its customers is that of keeping safe custody valuables of various
kinds, including jewellery, share certificates, life policies and title deeds. As a general rule, property which is thus left
with a bank for safe custody is deposited in a locked box, the key which is retained by the customer. Alternatively, items
such as deeds, share certificates and life policies may be enclosed in an envelope which is sealed with sealing wax.

8. Giving Confidential Financial Reports to its Customers


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With the consent of the customer, a commercial bank will furnish an inquirer with a financial report on the customer, to
make it possible for that customer to get some financial benefit. For example, by the banker’s reference system, a
person can request his/her banker to forward a statement of his/her financial reliability to the bank manager of another
person with whom, perhaps, trade is contemplated.

9. Cash Dispensers
Some commercial banks (especially the major ones) are offering what is becoming a very popular facility – automation
machines or cash dispensers. Customers who use cash dispensers may obtain limited amounts of cash at any time of the
day and night. Most dispensers are build into walls of existing bank offices, though a few have been placed specifically
(i.e. strategically) for the benefit of customers who are unable to visit their banks in normal working hours. For example,
a few have been installed in hospitals for the use of doctors and nurses, others at factories, shopping centres etc.
10. Other Services Commonly Offered by Commercial Banks
Besides the above noted services, the commercial banks have a number of other function, which are perhaps, most
notable by their range and diversity. Account banks offer investment services to their customers interested in buying or
selling stocks and shares; they are also able to render valuable services to companies who wish to issue shares. Dividend
payments on existing shares are often made through banks.

Advice upon taxation matters is another way in which banks are often able to help, and many undertake a wide range
of trustee work. This involves acting as administrators in handling of other peoples’ affairs, and requires the undertaking
of considerable legal and accounting responsibility.

Hire purchase and Insurance Services are often made available through subsidiary companies. All banks issue books
and pamphlets explaining, in simple terms, banking practice, and many issue learned journals on current economic
trends.

A Bankers’ Draft is a cheque drawn on a bank. It is more readily acceptable for setting bills or debts than personal
cheques. A request to issue a banker’s draft is usually made by a customer who has to pay money to someone who is not
prepared to accept his/her cheques. The customer who requires a draft will be asked to complete an application form
stating the amount of the draft, the name of the payee and the place of payment. The bank guarantees payment as the
person to whom it is issued will have paid the bank an equivalent amount plus commission. Unlike personal cheques,
bank drafts do not have to be cleared with the issuing bank before payment is effected.

ii. Negotiable Instruments


The collection, discounting and payment of negotiable instruments form a substantial part of a commercial bank. The
expression – negotiable instrument – means that if a person receives an instrument from another person, honestly
believing everything is in order, she obtains a full right to that instrument and can enforce it against the drawer, even if it
subsequently turns out to have been stolen. The essential characteristics of a negotiable instrument are:-

i. The instrument and the rights which it embodies are capable of being transferred by deliver, either with or without
endorsement as to whether the instrument is in favour of order or bearer (i.e. mere delivery transfers a legal title to
the transferee),

ii. The person to whom the instrument is negotiated can sue on it in his/her name;
iii. The person to whom a current and apparently regular negotiable instrument has been negotiated, who takes it in
good faith and for value, obtains a good title to it, even though her/her transferor had a defective title or notice at all.
Unless an instrument possesses these three characteristics, it is not a negotiable instrument. Some of the negotiable
instruments handled by commercial banks include:- Bill of exchange (which include cheques), promissory notes,
Traveler’s cheques, among others. The aim of this section is to take a closer look at the most commonly used instrument
the cheques.

The Cheque
One of the most common ways of settling debts in the modern commercial world is by means of cheques drawn upon
bank current accounts. A cheque is an important instrument for effecting payment. It must be stressed that a cheques is
not money. It is merely evidence of money.

If for example, a person writes a cheques but does not have sufficient funds in his/her account to cover the cheque, the
person to whom it has been paid will not receive the money it is supposed to transfer to him/her. Thus cheques are not
legal tender, a creditor is not legally bound to accept a cheque in settlement of a debt. A person who is owed money
must accept any legal tender offered to him/her in payment. Should he/she refuse such money, then the debtor is released
off the obligation to pay.
A Cheque as a Bill of Exchange
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A cheque is then merely evidence of money but it is a very important instrument nevertheless. An ordinary bill of
exchange may be defined as ‘a demand for payment drawn by a creditor and addressed to a debtor, demanding a
fixed sum of money payable to the creditor, or to his order, on a certain date’. This definition also applies to a
cheque. A cheque is also a bill of exchange, but it is of a special type. Firstly, an ordinary bill of exchange involves only
two parties. These are the drawer (i.e. the person who is owed the money) and the drawee (i.e. the person who owes the
money and is being called upon to pay the debt). A cheque, on the other hand, involves three parties; the drawer (i.e. the
person who makes it out, in this case the debtor who is paying the debt), the drawee (the bank which has to pay it and
the drawer has a current account with it) and the payee, who is the creditor to whom the money is to be paid.

The second difference between a cheque as an ordinary bill of exchange is that in the case of a cheque the drawee is
always a bank, whereas in the case of an ordinary bill of exchange the drawee need not be a bank and rarely is so.

A cheque can be defined as a bill of exchange that always uses a bank as the drawee. The importance of this is that
banks are subject to special laws and enjoy a certain legal protection which is not available to other debtors.

Types of Cheques
Cheques may be open or crossed. A cheque is said to be open if it can be cashed across the counter of the particular
branch of the commercial bank on which it was drawn. Alternatively, it can be paid into any bank for credit to an account
held there. There are two kinds of open cheques: Order cheques and bearer cheques.

A cheque like a bill of exchange is a negotiable instrument, which means that the funds evidenced by these instruments
can be transferred from the person originally intended to receive them to another person. Thus, an order cheque is
payable to the payee (i.e. the person whose name appears on its face). It is also payable to any other person to whom the
payee endorses. A cheque is endorsed by the payee if he/she signs the back of it and writes doen the name of the new
payee. An open cheque that does not contain the name of the payee is called a bearer cheque. This kind of cheque can
be cashed by anybody who presents it across the counter. Therefore the difference between an order cheque and a bearer
cheque is that the transfer of funds of an order cheque can only be made when the payee signs on the back of the cheque.
The transfer of funds on a bearer cheque can be made by ‘delivery’ meaning that a payee of a bearer cheque can transfer
his/her right to receive money by merely handing over the cheque to the person whom he/she now wants to receive
payment. Because of the risk of losing a cheque, bearer cheques are now very rare, as anybody picking up such a cheque
can have it cashed.

Safeguarding Cheques from Misappropriation


One way in which a drawer of a cheque can safeguard his/her cheque money is by crossing the cheque. Crossing a
cheque means that parallel lines are drawn across the face of the cheque. A crossed of a cheque also means that such a
cheque cannot be cashed at the counter of the drawee’s bank (i.e. the paying bank). Since a crossing on a cheque means
that it must be paid into a bank account, the bank should make sure that the person who presents such a cheque in the
rightful owner of the money that the cheque is transferring. Should the collecting bank accept a crossed cheque and pay
to the wrong person, then it will be obliged to pay the full value to the rightful owner when he/she claims. When a
collecting bank collects money on a crossed cheque for the wrong person, it is said to have committed a crime of
conversion, meaning that it has given the money away to the wrong person.

Banks will issue cheque books which have the crossing already printed on the cheques. If the drawer wishes to canal the
crossing so that the cheque can be exchanged for cash he/she must write pay cash within the crossing, and add his/her
signature.
A crossing on a cheque may either be a general crossing or a special crossing. A special crossing has the name of the bank
and branch between the parallel lines and can only be honoured for payment at the named branch of the bank. Its effect is to
prevent the cheque, should it go astray, being paid into an account of another bank. The crossing may also include the words
‘Account payee only’; not negotiable; ‘Not transferable’. This amounts to a direction to bank to credit the cheque to the
account of the payee, and not someone else’s account.

A general crossing does not have the name of the bank or branch and thus can be deposited at any branch where the payee
holds an account. Therefore the difference between a general crossing and a special crossing is that a cheque that has been
crossed generally, remains negotiable, that is, the funds it evidences can be transferred to another person legally. It is
therefore, merely an instruction that paying bank not to pay it at its counter, and to the collecting bank to be careful about
who it collects the funds for. A special crossing, on the other hand, cancels the negotiability of cheque. The special crossing
is an instruction to the collecting bank to collect the cheque money only for the account of the ‘payee’. Thus a payee of a
cheque that has been specially crossed cannot transfer it to anyone else.

Clearing Bank Cheques

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Hundreds of cheques are written annually by individuals and organizations to effect payments of one kind or another.
Commercial banks will accept from its customers (for their accounts) not only cheques drawn on it but also cheques drawn
on other banks. The system that transfers these cheques from the collecting banks to the paying banks, and the settlement of
the indebtedness between banks that results, is called the clearing house system.

A clearing house is a place where different banks settle payments that are due to each other as a result of their customer’s
transactions conducted using cheques. The representative of different banks meet at the clearing house and effect the
necessary transfer of funds. Actually what happens is that a bank will subtract what other banks owe it from what it owes
other banks and only pay the difference. The following example illustration have a clearing house works:-

Suppose Mr. Juma who has an account with the Standard Bank issues a cheque worth Kshs.8,000 to Sungura wholesale
Traders who operate an account with the Kenya Commercial Bank; Suppose further that Mr. Juani who operates an
account with the Kenya Commercial Bank issues a cheque worth Kshs.5,000 to Mr. Kalima who holds an account with the
Standard Chartered Bank (SCB). The following are the chain of events that will result from these transactions:-

i. Sungura wholesale Traders will deposit a cheque for Kshs.8,000 with the Kenya Commercial Bank. Kenya
Commercial Bank, in turn will send the cheque to the Standard chartered Bank for clearance. In effect, Kenya
Commercial Bank is owed Kshs.8,000 by the Standard Chartered Bank.

ii. Mr. Kalima will deposit a cheque for Kshs.5,000 with the Standard Chartered Bank. This bank will in turn send
the cheque to Kenya Commercial Bank (KCB) for clearance. In this case, the SCB is owned Kshs.5,000 for
clearance. In this case, the SCB is owed Kshs.5,000 by the KCB.

iii. The representation of both banks will meet at the clearing house to verify the signatures of Mr. Juma and Mr. Juani
and their respective account balances.

iv. The cheques will be exchanged, and the differences of Kshs.3,000 will be paid to the KCB by the SCB. Since both
banks have accounts with the Central Banks of Kenya, the SCB will simply mistrust it to transfer the money to the
account of the KCB.

v. The successful completion of the clearance exercise results in:

▪ Mr. juma’s account will be debited (i.e. reduced) with Kshs.8,000,


▪ Sungura Wholesale Traders’ account will be credited (i.e. increased) with Kshs.8,000,
▪ Mr. Juani’s account will be debited with Kshs.5,000.

Payment by Cheque
When payment is made by cheque, it is considered to be conditional i.e. payment is not received until the cheque is cashed.
Where cheques are posted, if any of them gets lost, the sender assumes the resulting loss, except where payment by post was
requested. A cheque, once endorse d and paid, serves as an evidence of receipt by payee of the amount of the cheque.

Dishonored Cheques
Quite after cheque and cheque-books are lost, or there arise a dispute between drawer and payee after issue of the cheque. In
such cases it is possible to instruct the bank to refuse payments. This is known as stopping a cheque. Unless, however, a
cheque has been marked not negotiable stopping a cheque does not relieve the drawer of any liability to an innocent person
to whom it may have been. Transferred.

As was previously noted, a cheque is a bill of exchange, drawn on a bank and payable on demand. It is an order to a named
bank to pay a specified sum of money to a specified person or bearer on demand. Cheques are, however, not legal tender,
meaning that a creditor cannot be forced to accept one in payment of a debt. If he/she does accept it, it is assumed in law that
he/she does so on condition that is honoured when presented for payment. Banks may refuse payment on cheques they are
returned to the person who paid them in, either with a full explanation or, as is common, with the simple statement ‘refer to
drawer’, who is left to make his/her peace as best he/she can with his/her creditors.

i. A cheque can be dishonoured when the drawer has insufficient funds to meet the cheque. The paying bank will
return the cheque with the words, ‘Refer to Drawer’, written on the face of the cheque.

ii. When a cheque has been improperly drawn, it will also be returned to the party presenting the cheque. There are 3
main ways in which a cheque may be improperly drawn,

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a. When the signature of the drawer differs from the specimen held by the bank. The cheque will be returned with
the words ‘Signature Differs’.

b. When the amounts in words and figures differ. The cheque will be returned with the words ‘Amounts in words
and Figure Differ’.

c.When there is an alteration in the payee’s name or the date or the amounts whether in words or figures. The bank
will return the cheque unless the alteration has been signed by the drawer. When returning the cheque, the bank
will write the words, ‘Alteration needs Confirmation’ on the face of the cheque.

iii. When a cheque has been in circulation for too long a time, the bank will return such a cheque with the words ‘stale
cheque’. A cheque is considered to be stale if it has been in circulation for six or more months without being
presented for payment. It must be noted, however, that the extent to which a cheque can be considered to be stale
will depend on the circumstances surrounding the transaction. In most cases the drawer remains liable on a cheque
for six years from the date of issue except where loss has been incurred due to delay to present it for payment. This
would occur, for example, where a bank is unable to pay cheques drawn on it in full due to insolvency. Endorsers
are, however, fully discharged from the liability of a cheque if there is an unreasonable delay in presentation
for payment.

iv. If a cheque is presented before the date that it bears (matures) it will be returned with the words, ‘Post-Dated’.
Where a cheque is post-dated, it is implied that the customer’s instructions to the bank are to pay the cheque only on
such date as indicated. Where the bank pays the cheque before the indicated date, the customer has a right to stop
his/her account from being debited by the amount of the cheque. He/she may also seek damages. The bank is held
responsible for paying a post-dated cheque pre-maturely because there are many possible things that can happen and
make payment of the cheque not possible even when such cheque becomes due. The customer may, for example die
before the cheque due in which case payment cannot be effected. Where bank had made a pre-mature payment, it
becomes entirely responsible for the payment and the trustee of the deceased will not accept responsibility for
payment, besides, even if the customer does not die, he/she may wish to stop payment before the due date or he/she
may not have enough money on the account to cover the amount of the cheque before a specified date. In all such
cases, the bank will be cover the amount of the cheque before a specified date. In all such cases, the bank will be
considered to have neglected the instructions from the customer if it pays a post-dated cheque before the due date.

v. The drawer no longer has an account with the drawer bank.

vi. The drawer has been declared bankrupt or mentally ill. When a person is insolvent or unable to pay his/her debts as
they fall due, he/she can petition the court to take over the running of his/her estate and distribution of his/her assets
among creditors. If he/she fails to do so, the creditors will do so. The objects of bankruptcy are:-

a. To secure a fair distribution of assets to creditors;


b. To free the debtor from his/her debts so that he/she can enter new business ventures as soon as the court
discharges him/her.
c. To find out the reasons for his/her bankruptcy.
For a person to be declared bankrupt he/she will have defaulted in paying or meeting his/her financial obligations as they fall
due. Once it has been established that a person cannot or is not able to pay his/her creditors on due date, a petition based on
the existing act (law) of bankruptcy is filed either by him or by his/her creditors. After this, the third step is to draw up a
statement of affairs. This statement shows the current financial position of the debtor. The creditors will then meet and
discuss the statement in order to see whether the debtor has made any proposals regarding the way he/she intends to pay
his/her creditors or revive the state of his/her finances.

If the creditors reject the proposals, a receiving order is discharged to him/her. The debtor is then summoned to court and a
public examination of his/her financial affairs is carried out. After examination in court, adjudication is made declaring
him/her bankrupt, such order is also gazetted in the official government gazette. The last step is to appoint a trustee to
administer the estater (usually a bank). It is worth nothing that a person is not considered to be bankrupt until the notice
of adjudication has been made. After the appointment of a trustee or an official receiver, the debtor can apply for his/her
discharge.

Where a person is mentally incapacitated, the bank must receive a notice of mental incapacitated, the bank must
receive a notice of mental incapacity before it can take steps. When such notice is received, the bank will not pay any
cheques drawn by the customer and its mandate to act on his/her instructions is terminated. Here there is great controversy as

Prepared by Mr. Johnbosco Kisimbii

37
to what degree of mental sickness constitutes mental incapacity. However, for a person to be mentally incapacitated he/she
must be so mentally disordered that he/she is not able to understand the nature of the transaction that he/she enters.

Here, the bank must be very careful. Where a state of mental disorder is wrongful assumed, the bank will bear the liability of
wrongful dishonour of cheques drawn by the customer. On the other hand, if mental disorder is not assumed, when it should
have been assumed, the bank will incur liability for paying out the customer’s funds after his/her incapacity.

The course of action on the part of the bank depends on the kind of account that the customer operates and whether the
customer has guaranteed any of the bank’s accounts. For sole or joint accounts, a notice of mental incapacity leads to a
complete stoppage of the account (freeze) whether it is in credit or debit. Account cheques to the account are returned unpaid
and marked ‘Drawer’s mandate terminated’, or ‘Insufficient mandate’.

For a partnership account, there is usually no need to stop the account, The mandate may be terminated, but the incapacity of
a partner does not bring about the dissolution of the partnership, though it may form a basis for dissolving it. Where such a
patient had guaranteed any of the bank’s accounts, the guarantee should be recalled and the account stopped until the
principal debtor makes new arrangements.

It is very difficult to establish that a particular patient is mentally incapacitated. Here, a notice will be considered to be
effective it has been established that the patient has been voluntarily or compulsory admitted into a mental hospital. It is
usually wise to obtain the report of a medical practitioner attending him/her before action is taken. Also, it is very important
that the bank receive a written confirmation from the hospital or authority concerned whether the person is able to attend to
and run his own financial affairs.

EXAMPLES OF CHEQUES

i. The Open Cheque


Cheque 1. An example of an open and bearer cheque

No. 1344086 Date: 10th April, 1999

KENYA COMMERCIAL BANK LTD,


MOI AVENUE, MOMBASA
_________________________________________

PAY: Bearer __________________________ =Kshs.4,000/=


Sum of four thousand shillings only

Simiyu
W. K. Simiyu

Cheque 2. An example of an open cheque which ahs specified the person to whom payment should be made

No. 1344086 Date: 10th April, 2000

KENYA COMMERCIAL BANK LTD,


MOI AVENUE, MOMBASA
_________________________________________
OR ORDER
PAY: Mr. E. W. Kamau
Sum of four thousand shillings only______________________________
______________________________

Simiyu =
W. K. Simiyu

The difference between the open bearer cheque and an open cheque carrying a person’s name is that the bearer cheque
carrying a person’s name is that the bearer cheque can be cashed by anybody and it does not require endorsement.

Prepared by Mr. Johnbosco Kisimbii

38
Therefore, cheque 2 can only be cashed by a different person if Mr. E. W. Kamau endorses it (i.e. by signing at the bank)
to the order of that person whom he/she wants the bank to pay.

ii. Crossed Cheques


The main reason for crossing a cheque is to make it hard for fraudulent activities to taken place. Normally, a crossed
cheque should never be cashed over the counter. This has many advantages:-

a. It reduces the possibility of a fraudulent party receiving payment.


b. It gives both the bank and the issues of the cheque enough time to discover any fraudulent activity.
c. If a fraud has been committed it is easier to trace the fraudulent person and his/her accomplice to the collecting
bank.
d. It gives the drawer enough time to stop the payment of the cheque if he/she wishes

Cheque 3. Simple Crossing

No. 134869 Date: 10th April, 1999

KENYA COMMERCIAL BANK LTD,


MOI AVENUE, MOMBASA
_________________________________________

PAY: Jane Simuli OR ORDER___


Four thousand shillings only ___________

& Co. =
Simiyu
W. K. Simiyu

Cheque 4. Not Negotiable Crossing

No. 134869 Date: 10th April, 2000

KENYA COMMERCIAL BANK LTD,


MOI AVENUE, MOMBASA
_________________________________________

PAY: Jane Simuli OR ORDER


Sum of four thousand shillings only________ Simiyu
W. K. Simiyu =Kshs.4,000/=

A cheque which has been properly endorsed to another person, the person obtains title to the cheque immediately but where
the cheque is marked not negotiable he/she does not obtain any title at all.

Credit Creation by Commercial Banks

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39
Credit touches the lives of may people and in different ways. It is very important part of business. An understanding of credit
is, therefore, essential for personal use as well for business activities. Credit performs key functions in the economy. Some of
these include:-

i. Credit makes money available that would otherwise be idle. That is, in exchange for payment of interest, people
entrust their personal savings to banks and other financial institutions. The banks, in turn, lend these savings to
individual and business.
ii. Like money, credit also serves as a medium of exchange. Through it else’s, transactions can be completed quickly,
with a minimum of work, and without the exchange of money.
iii. Credit facilities the pace of economic activity. It is a tool that helps a business to match its capital to its varying needs.
That is, by borrowing additional capital, a business an increase production during peak business activity, and by
extending credit, a business can induce customers to buy, thus gaining a competitive advantage over firms that do not
give credit.

The creation of credit or deposits is one of the most important functions of commercial banks. Like other
corporations, banks aim at earning profits. For this purpose, they accept cash in demand deposits and time deposits and
advance loans on credit to customer. When a bank advances a loan, it occasionally does not pay the amount in cash. But
it opens a current account in the customer’s name and allow him/her to withdraw the required sum by cheques. In
this way, the bank creates credit or deposits.

Demand deposits arise in two ways:


One is when customers deposit currency with commercial banks. Two, when banks advance loans, discount bills, provide
overdraft facilities and make investments through bonds and securities. The first type of demand deposits are called ‘
primary deposits’. Banks play a passive role in opening them. The second type of demand deposits are called ‘derivative
deposits’ Banks actively create such deposits.

The process of Credit Creation


The ability of banks to create credit depends on the fact that banks need only a small percentage of cash to deposits. If banks
kept 100 percent cash deposits, there would be no credit creation. Modern banks do not keep 100 percent cash reserves. They
are legally required to keep a fixed percentage of their deposits in cash, say 10, 15 or 20 percent. They lend and or invest the
remaining amount. Thus it is the required reserve ratio that becomes the basis of credit creation. Symbolically, the
required reserve ratio is:-

RRr =RR …(1)


D

Or RR =RR x D ….(2)

OR D =RR ….(3)
RRr

Or _D_ =_I_ ….(4)


RR RRr

Where: D is the deposits of the bank;


RR it is required cash reserves and
RRr the required reserve ratio

In the last equation, I/RRr is called the deposit multiplier. It is the one that determines the limit to deposit expansion by a
bank. If a bank has K£ 1000 deposits and its legal minimum requirements ratio, RRr is 20 percent, it can create credit to the
extent of K£5000.

i.e._I_ x D = _I_ x K£1000 = K£5000


RRr 0.2

The bank is ‘loaned up’ to the limit of K£ 5000 and it cannot create deposits till its reserves increase further.

To explain the process of credit creation, we start with a monopoly bank which has branches through the country. It has K£
1000 in deposit and is required to keep 20 percent as the legal reserve ratio (RRr). Further, all those who get loans from it,
deposit their cheques in its branches and do not keep any amount in cash. It is initial balance sheet is shown in Table 1 and
the final balance sheet in Table 2.
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40
Table 1. Initial balance sheet of the monopoly bank.
___________________________________________________________________________________________

Assets Liabilities

Reserve s K£1000 Deposits K£1000


Total K£1000 Total K£1000

Given that initially the monopoly bank has K£1000 as deposits, and the required reserve ratio is 20 percent, it is liable to
create additional credit to the tune of K£4000. Consequently, its deposits increase to K£5000.

i.e. _I_ x D = _I x 1000 = K£5000


RRr 0.2

Also RRr x D = 0.2 x 5000 = 1000

Table 2. Final balance sheet of the monopoly bank


Assets Liabilities

Reserves K£1000 Deposits K£5000


Loans K£4000
Total K£5000 K£1000

There is no monopoly bank these days, but there are may banks that operate in a country. To explain the process of credit
creation, we make the following assumptions.

1. There are many banks, i.e. A,B,C, etc in the banking system.
2. Each bank has to keep 20 percent of its deposits in reserves. In other words, 20 percent is the required reserve ratio
fixed by law.
3. The first bank, (a) has an initial K£1000 as deposits.
4. The loan amount drawn by the customer of one bank is deposited in full in the second bank, and that of the second bank
(i.e. B) into the third bank (i.e. C), and so on. The money does not leak outside the commercial banks.
5. Each bank starts with the initial deposit which is deposited by the debtor of the other bank.

Given these five assumptions, the initial and the final balance sheets of bank A are shown in table 3 and 4 respectively.

Table 3. Initial balance sheet of bank A.


___________________________________________________________________________________________

Assets Liabilities

Reserve s K£1000 Deposits K£1000


Total K£1000 Total K£1000

Table 4. Final balance sheet of bank A.


___________________________________________________________________________________________

Assets Liabilities

Reserve s K£200 Deposits K£1000


Loans K£800

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41
Total K£1000 Total K£1000

Table 4 reveals that Bank A advances K£800 which are 4/5th (80 percent) of its deposits as loans, and keeps K£200 i.e. 20
percent (1/5th) in reserves.

This loan of K£800 is deposited by the customer in bank B whose initial and final balance sheets are shown in tables 5 and 6
respectively. Bank B therefore starts with a deposit of K£800, keeps 20 percent of it or K£160 as cash in reserves and lends
the remaining 80 percent or K£640.

Table 5. Initial balance sheet of bank A.


___________________________________________________________________________________________

Assets Liabilities

Reserve s K£800 Deposits K£800

Total K£800 Total K£800

Table 6. Final balance sheet of bank B.


___________________________________________________________________________________________

Assets Liabilities

Reserve s K£160 Deposits K£800


Loans K£640

Total K£800 Total K£800

This loan of K£640 is deposited by the customer of Bank B into Bank C. The initial and final balance sheets of Bank C are:-

Table 7. Final balance sheet of bank C.


___________________________________________________________________________________________

Assets Liabilities

Reserve s K£640 Deposits K£640

Total K£640 Total K£640

Table 8. Final balance sheet of bank C.


___________________________________________________________________________________________

Assets Liabilities

Reserve s K£128 Deposits K£640


Loans K£512

Total K£640 Total K£640

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42
Bank C keeps K£128 or 20 percent of K£640 in cash reserves and advances the balances of K£512 as loan. This process will
go on to Bank D,E,F and so on, until finally to the sixtieth bank when the last deposit is too small to generate any fresh loans,
and all banks are ‘loaned up’. Ultimately, new deposits are created to the tune of K£5000 in the banking system.

Table 9. Multiple Credit Creation


___________________________________________________________________________________________

Bank New Deposits Required reserves New Loans__________


(1) (2) (3) (4)

A K£1000 K£200 K£800


B 800 160 640
C 640 128 512
Other Banks 2560 512 2048

Total for the _______ ______ ______


Banking system 5000 1000 4000

Table 10 shows multiple credit creation for 30 banks.

Table 10. Multiple Credit Creation (for 30 banks)

Bank New Deposits Required Reserves New Loans


(1) (2) (3) (4)
1 K£1000.00 K£200.00 K£800.00
2 800 .00 160.00 640.00
3 640.00 128.00 512.00
4 512 .00 102.40 409.00
5 409.00 81.90 327.70
6 327 .70 65.50 262.20
7 262.20 52.40 209.80
8 209 .80 42.00 167.80
9 167.80 33.60 133.60
10 133 .60 26.70 106.90
11 106.90 21.00 85.50
12 85 .50 17.10 68.40
13 68.40 13.70 54.70
14 54.70 10.90 43.80
15 43.80 8.80 35.00
16 35.00 7.00 28.00
17 28.00 5.60 22.00
18 22.40 4.00 17.00
19 17.90 3.60 14.30
20 14.30 2.90 11.40
21 11.40 2.30 9.10
22 9.10 1.90 7.20
23 7.20 1.40 5.80
24 5.80 1.20 4.60
25 4.60 0.90 3.70
26 3.70 0.70 3.00
27 3.00 0.60 2.40
28 2.40 0.50 1.90
29 1.90 0.40 1.50
30 1.80 0.30 1.20
OTHER BANKS 9.80 1.80 8.60
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43
TOTAL FOR THE
SYSTEM 5,000.00 1,000.00 4,000.00

LIMITATION ON THE POWER OF COMMERCIAL BANKS TO CREATE CREDIT


Banks do not have unlimited posers to create credit, given that they have to function under certain restrictions.

1. Amount of Cash
The credit creation of power by banks depends upon the amount of cash they possess. The longer the cash, the larger the
amount of credit that can be created by banks. The amount of cash that a bank has in its vaults cannot be determined by
it. It depends upon the primary deposits with the bank. Thus, the bank’s power of creating credit is limited by the cash it
possesses.

2. Proper Securities
An important factor that limits the power of a bank to create credit is the availability of adequate securities. A bank
advance loans to its customers on the basis of a security, or a stock or a building, or some other types of asset. It turns
illiquid from wealth into liquid wealth and thus creates credit.

3. Banking Habits of the people


The banking habits of the people also govern the power of credit creation on the part of banks. If people are not in the
habit of using cheques, the grant of loans will lead to the withdrawal of cash from the credit creation stream of the
banking system. This reduces the power of banks to create credit to the desired level.

4. Minimum Legal Reserves Ratio


The minimum legal reserve ratio of cash to deposits fixed by the central bank is an important factor which determines
the power of banks to create credit. The higher this ratio (RRr), the lower the power of banks to create credit; and the
lower the ratio, the higher the power of banks to create credit.

5. Excess Reserves
The process of credit creation is based on the assumption that banks stick to the required reserve ratio fixed by the
central bank. If banks keep more cash reserves that the legal reserve requirements, their power to create credit is limited
to that extent. If Bank A of our example decides to keep 25 percent of K£1000 instead of 20 percent, it will lend K£750
instead of K£800. Consequently, the amount of credit creation will be reduced even if the other banks in the system
stick to the legal reserve ratio of 20 percent.

6. Leakages
If there are leakages in the credit creation stream of the banking system, credit expansion will not reach the required
level, given the legal reserve ratio. It is possible that some person who receive cheques do not deposit them in their
bank accounts, but withdraw the money in cash for spending or for hoarding at home. The extent to which the amount
of cash is withdrawn from the chain of credit expansion is the power by which the banking system to create credit is
limited.

7. Bahaviour of Other Banks


The power of credit creation is further limited by the bahaviour of other banks. If some of the banks do not advance
loans to the extent required of the banking system, the chain of credit expansion will be broken. Consequently, the
banking system will not be ‘loaned up’.

8. Cheque Clearance
The process of credit expansion is based on the assumption that cheques drawn by commercial banks are cleared
immediately and reserves of commercial banks expand and contract uniformly by cheque transaction. But, it is not
possible for banks to receive and draw cheques of exactly equal amounts. Often some banks have their reserves
increased and others reduced through cheque clearance. This expands and contracts credit creation on the part of
commercial banks. Accordingly, the credit creation stream is disturbed.

9. Economic Climate
Banks cannot continue to create credit limitlessly. Their power to create credit depends upon the economic climate in
the country. If there is a boom, there is optimism, investment opportunities increase and businesses take more loans
from banks, so credit expands. But in depressed times when the business activity is at a low level, banks cannot force
the business community to take loans from them. Thus the economic climate in a country determines the power of
banks to create credit.

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44
10. Credit Control Policy of the Central Bank
The power of commercial banks to create credit is also limited by the credit control policy of the central bank. The
central bank influences the amount of cash reserves with banks by open market operations, discount rate policy,
variable reserve ratio and varying margin requirements. Accordingly, it affects the credit expansion or contraction by
commercial banks.

LECTURE 3

3.0 CENTRAL BANK

3.1 Evolution of Central Banking


Some people claim that banking originated in China and others claim that it originated from the activities of Venetian
Merchants in the middle ages. We shall not bother ourselves with this type of detailed history. Our purpose will be well
served if we simply note that what may be called modern banking developed as a result of people’s desire for a place to keep
their money and other valuables safely. In this period, money consisted only of very precious metals, such as gold or silver. In
those days, many people kept their valuables with the King of the country. There were many reasons for this:- The King was
the only person in whom many people had confidence and therefore trusted, and nobody is likely to leave his/her money or
valuables with a person they don’t trust. The king had private carriers and could be relied upon to defend his palace
successfully in case of attack. Money left with the King was therefore considered to be much sager than it had been deposited
anywhere else.

But on the other hand, the King was constantly in need of money, particularly to undertake the wars which were frequent at
that time. It happened, therefore, that he used up the money deposited with him and counld not repay it easily. Besides, he
borrowed all the time and often defaulted.

People therefore became very reluctant to leave their valuables with the King for safe keeping because they were no longer
considered safe. They also refused to lend him since he often defaulted. They began to look for other places to keep their
money or valuables for safety and this led to the developed of banking. The King too had to device an alternative way of
borrowing from the public, which led to the establishment of the Bank of England in England. This was set up in 1694 as a
private commercial institution, mainly in order to borrow from the public and lend to the Government.

Unlike the King, the bank could be sued. People therefore felt confident of lending to the bank, knowing that, if the bank
defaulted, they could take it to court to recover their money or valuables.

But banking had developed many years before the establishment of the bank of England. As we have shown above, the inputs
for the development of banking arose from people’s search for safe custody of their money and other valuables. These
included accountants, solicitor (at the time called scriveners) and goldsmiths. The goldsmiths were found most suitable, not
necessarily because they dealt in gold, but because they had safes and had won the confidence of the community as highly
respectable members of the society, who could be trusted.

These goldsmiths received valuables from the public in exchange for receipts, which they issued. They undertook to repay
the valuables on presentation of the receipts. Rather than going in person to tender the receipts to the goldsmith for payment,
the depositor could simply send somebody to the goldsmith with the receipt for payment. In this way the receipts issued by
the goldsmith came to be used as a means of payment. This was the first stage in the development of banking.

In the second stage: as the receipts issued by the goldsmith came to be used as a means of payment, it encouraged the
goldsmith to undertake a second function, that of issuing his own notes, which encouraged the goldsmith to undertake a
second function, that of issuing his own notes, which were similarly used as a means of payments. This is why all early banks

Prepared by Mr. Johnbosco Kisimbii

45
were banks of issue. They found this practice very profitable, for once they had earned the confidence of the commercial
community, fewer and fewer people wished to change their notes for actual money.

These led to the third stage in the development of banking. The goldsmiths noticed that fewer and fewer people changed their
notes for actual money and realized that they could safely lend out some of the money deposited with them, provided they
kept enough to enable them to pay those who wanted actual money. In time they found that only very small proportion of
total deposits were necessary for this purpose, so they lent what was left after putting this proportion aside. In this way, the
early bankers undertook the action of lending money. The goldsmiths made a charge for lending money.

The profitability of this business led to the fourth stage in the evolution of banking. Rather than waiting in their ivory to
whereas for the public to deposit valuables with them, the goldsmiths set out to attract deposits, by offering to pay interest.
They did this because the more deposits they acquired, the more lending they could undertake and the more profits they
made.

The fifth stage came with the development of the cheque. As we noted earlier, the early banker issued receipts in return for
the valuable which he received. At first he could repay these deposits only to the person or persons who had actually
deposited the valuables with him. In time, however, a practice developed whereby the depositor made out an order to his
banker to pay to some named person or bearer of the receipt the stated amount out of the sum standing to his credit. This is
how the cheque originated, and its development helped to bring about lending by means of overdrafts.

Finally, as legal restriction to note issue were introduced, banks found it more profitable and convenient to concentrate on
attracting deposits than on issuing notes. Accordingly, banks of deposits eventually replaced bank of issue, and note issue
became the prerogative of central banks.

These therefore were the various stages in the evolution of banking. With this in mind, we can attempt a definition of a bank
or banking. We must start by making it clear that banking has eluded any precise or ‘correct’ definition over the centuries.
Also, given that there are different types of banks; i.e. Central Banks, Commercial Banks, Saving Banks, Merchant Banks,
Industrial Banks, Development Banks etc. It would be difficult, or at least cumbersome to formulate a definition of banking,
which would be wide enough to embrace the diverse activities carried on by all types of banks.

One could, of course give the word ‘bank’ or ‘banking’ a narrow meaning and call that a definition, or one could give it a
much wider meaning, and still call it a definition. The Oxford Dictionary defines a bank as ‘an establishment for the custody
of money which it pays out on a customer’s order. This is a narrow definition. Others have also defined banking to be ‘a
system whereby individuals put in money into an institution (in this case a bank ) either for safety in the form of current
accounts or for interest purposes.

Others observe that a modern banker can be defined as a ‘dealer in debts; and modern banking as ‘dealing in debts’.
Technically, the money that the banker deals in is simply the debt he/she creates against him/herself, and he/she makes a
living by buying and selling this money.

Thus, a bank may be defined as ‘an institution which collects funds from the general public, safeguards them and makes
them available to the true owners when they require them, but also loans out sums not immediately required by their
true owners to those who are in a position to provide sufficient security’. Research findings in the form of pamphlets,
books, journals and periodicals.

Still in pursuit of improvements in the welfare of the insurance industry the institute, in conjunction with the Government and
other players in the industry, helped establish the College of Insurance which, bedsides preparing student for insurance
exams, facilitates seminars and workshops for employees from around the region. Also with conjunction with the Insurance
Training and Education Trust, the instate has seen the need to introduce a local insurance diploma, which is suited to the
local insurance needs. The institute has undertaken this challenge after seeing the decline in the number of students, sitting
for foreign insurance examinations. For instance, there has been a general outcry that the exams are too expensive. This is
partly to blame for the declining enrolment.

The institute is not all about insurance. It also plays a social role, facilitating get-togethers such as lunch time discussion
forums which are addressed by prominent persons from both in and out of the insurance industry. Issues relevant to the
Kenyan economy are discussed at the forums.

The Association of Kenya Insurers (AKI), another major body in the Kenyan insurance industry, aims at ensuring that
insurance companies are able to provide the insuring public with accurate data on the types of products they offer. It also
plays an active role in the promotion of insurance education, and it is fully involved in the running of the college of
insurance. The aim of the association is to provide courses and training that are unequalled in the region. The association is
Prepared by Mr. Johnbosco Kisimbii

46
also establishing ways of getting closer to the insuring public. It is therefore taking care of the interests of the insuring public
as well as the insurance companies.

3.3 FUNCTIONS OF CENTRAL BANK


A central bank performs the following functions as given by De Kock and accepted by the majority of economists

1. Regulator of Currency
The central bank is the bank of issue. It has the monopoly of not issue. Notes issued by it circulate as legal tender
money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the
government mint but they are put into circulation through the central bank.

Central banks have been following different methods of note issue in different countries. The central bank is required
by law to keep a certain amount of gold and foreign securities against the issue of notes. In some countries, the amount
of gold and foreign securities bears a fixed proportion between 25 to 40 percent of the total notes issued. In other
countries a minimum fixed amount of gold and foreign currencies is required to be kept against note issue by the
central bank. The system is operative in India whereby the Reserve Bank of India is required to keep Rs 115 crores in
gold and Rs 85 crores in foreign securities. There is no limit to the issue of notes after keeping this minimum amount
of Rs200 crores in gold and foreign securities.

The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued which helps in
facilitating exchange and trade within the country. It brings stability in the monetary system and creates confidence
among the public. The central bank can restrict or expand the supply of cash according to the requirements of the
economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also
controls the banking system by being the ultimate source of cash. Last but not least, by entrusting the monopoly of
note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as
compared with their face value.

2. Banker, Fiscal Agent and Adviser to the Government


Central banks everywhere act as bankers, fiscal agents and advisers to their respective governments. As banker to the
government, the central bank keeps of government. But it does not pay interest on government deposits. It buys and
sells foreign currencies on behalf of the government. It keeps the stock of gold of the government. Thus it is the
custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the
government for a period not exceeding 90days. It floats loans, pays interest on them, and finally repays them on behalf
of the government. Thus it manages the entire public debt. The central bank also advises the government on such
economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit
financing, balance of payments, etc. As pointed out by De Kock, “Central Banks everywhere operate as bankers to the
state not only because it may by or convenient and economical to the state, but also because of the intimate connection
between public finance and monetary affairs”.

3. Custodian of Cash Reserves of Commercial Banks


Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand deposits
liabilities with the central banks. It is on the basis of these reserves that the central bank transfers funds from one bank
to another to facilitate the clearing of cheques. Thus the central bank acts as the custodian of the cash reserves of
commercial banks and helps in facilitating their transactions. There are many advantages of keeping the cash reserves
of the commercial banks with the central bank, according to De Kock. In the first place, the centralization of cash
reserves in the central bank is a source of great strength to the banking system of a country. Secondly, centralized cash
reserves can serve as the basis of a large and more elastic credit structure than if the same amount were scattered
among the individual banks. Thirdly, centralized cash reserves can be utilized fully and most effectively during periods
of seasonal strains and in financial crisis or emergencies. Fourthly, by varying these cash reserves the central bank can
control the credit creation by commercial banks. Lastly, the central bank can provide additional funds on a temporary
and short term basis to commercial banks to overcome their financial difficulties.

4. Custody and Management of Foreign Exchange Reserves


The central bank keeps and manages the foreign exchange reserves of the country. It is an official reservoir of fold and
foreign currencies. It sells gold at fixed prices to the monetary authorities of other countries. It also buys and sells
foreign currencies at international prices. Further, it fixes the exchange rates of the domestic currency in terms of
foreign currencies. It holds these rates within narrow limits in keeping with its obligations as a member of the
International Monetary Fund and tries to bring stability in foreign exchange rates. Further, it manages exchange
control operations by supplying foreign currencies to importers and persons visiting foreign countries on business,
studies etc, in keeping with the rules laid down by the government.
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5. Lender of the last Resort
De Knock regards this function as a sine qua no of central banking. By granting accommodation in the form of re-
discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions, the
central bank acts as the lender of the last resort. The central bank lends to such institutions in order to help them in
times of stress so as to save the financial structure of the country for collapse. It acts as a lender of the last resort
through discount house on the basis of treasury bills, government securities and bonds at “the front door”. The other
methods is to give temporary accommodation to the commercial banks or discount houses directly through the “back
door”. The difference between the two methods is that lending at the front door is at the bank rate and in the second
case at the market rate. Thus the central banks as lender of the last resort is a big source of cash and also influences
prices and markets rates.

6. Clearing House for Transfer and Settlement


A bankers’ bank, the central bank acts as a clearing house for transfer and settlement of mutual claims of commercial
banks. Since the central bank holds reserves of commercial banks, it transfers funds from one bank to other banks to
facilitate clearing of cheques. This is done by making transfer entries in their accounts on the principle of book-
keeping. To transfer and settle claims of one bank upon others, the central bank operates a separate department in big
cities and trade centres. This department known as the “clearing house”. And it renders the service free to commercial
banks.

When the central bank acts as a clearing agency, it is time-saving and convenient for the commercial banks to settle
their claims at one place. It also economizes the use of money. “It is not only a means of economizing cash and capital
but is also a means of testing at any time the degree of liquidity which the community is maintaining”.

7. Controller of Credit
The most important function of the central bank is to control the credit creation power of commercial bank in order to
control inflationary and deflationary pressures within this economy. For this purpose, it adopts quantitative methods
and qualitative methods. Quantitative methods aim at controlling the cost and quantity of credit by adopting bank rate
policy, open market operations, and by variations in reserve ratios of commercial banks. Qualitative methods control
the use and direction of credit. These involves selective credit controls and direct action. By adopting such methods,
the central bank tries to influence and control credit creation by commercial banks in order to stabilize economic
activity in the country.

Besides the above note functions, the central banks in a number of developing countries have been entrusted with the
responsibility of developing a strong banking system to meet the expanding requirements of agriculture, industry, trade
and commerce. Accordingly, the central banks possesses some additional powers of supervision and control over the
commercial banks. They are the issuing of licenses; the regulation of branch expansion; to see that every bank
maintains the minimum paid up capital and reserves as provided by law; inspecting or auditing the accounts of banks;
to approve the appointment of chairmen and directors of such banks in accordance with the rules and qualifications; to
control and recommend merger of weak banks in order to avoid their failures and to protect the interest of depositors;
to recommend nationalization of certain banks to the government in public interest; to publish periodical reports
relating to different aspects of monetary and economic policies for the benefit of banks and the public; and to engage
in research and rain banking personnel e.t.c. for the benefit of banks and the public; and to engage in research and train
banking personnel e.t.c.

3.4 CENTRAL BANK AS THE CONTROLLER OF CREDIT

Objectives of Credit Control


Credit control is the means to control the lending policy of commercial banks by the central bank.
The central bank control credit to achieve the following objectives:-

1. To Stabilize the Internal Price Level –One of the objective of controlling credit is to stabilize the price level in the
country. Frequent changes in prices adversely affect the economy. Inflationary or deflationary trends need to be
prevented. This can be achieved by adopting a judicious policy of credit control.

2. To Stabilize the Rate of Foreign Exchange – With the change in the internal prices level, exports and imports of the
country are affected. When prices fall, exports increase and imports decline. Consequently, the demand for domestic
currency increased in the foreign market and its exchange rate rises. On the contrary, a rise in domestic prices leads to
a decline in exports and an increase in imports. As a result, the demand for foreign currency increases and that of
domestic currency falls, thereby lowering the exchange rate of the domestic currency. Since it is the volume of credit
money that affects prices, the central bank can stabilize the rate of foreign exchange by controlling bank credit.
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3. To protect the outflow of gold – The Central bank holds the gold reserves of the country in its vaults. Expansion of
bank credit leads to rise in prices which reduce exports and increase imports, thereby creating an unfavorable balance
of payments. This necessitates the export of gold to other countries. The central bank has to control credit in order to
prevent such outflows of gold to other countries.

3.4 GENERAL INSTRUMENTS OF MONETARY POLICY

1. Bank Rate Policy


The bank rate or the discount rate is the rate fixed by the central bank at which it rediscounts first class bills of exchange and
government securities held by the commercial banks. The central bank control credit by making variation in the bank rate.
The bank rate enables the central bank operate directly on the level and structure of interest rates.

When commercial banks find themselves short of cash, instead of contracting bank deposits, they may go to the central bank,
which can make additional cash available in its capacity as ‘lender of the last resort’ to help the banks out of their difficulties.
The central bank can make cash available for a short period of time in either two ways:-
i. By lending cash directly, and charging a rate of interest known as the ‘Discount Rate’ or
ii. By buying approved short-term securities from the commercial banks.

The Central Bank exercises regulatory powers by making this help both more expensive to get, and also more difficult to
get.

The central bank can do the former by charging a very high ‘penal’ rate of interest, well above the other short-term rates
ruling in the money market. This makes borrowing from it costly. So the commercial banks borrow less. They, in turn, raise
their lending rates to customers. The market rate of interest also rises because of the tight money market. This discourages
fresh loans and also dampens business activity.

The central bank effects the latter policy by requiring banks to give only very safe treasury bill or ‘penal’ rate of interest, well
above the other short-term rates ruling in the money market. This make borrowing from it costly. So the commercial banks
borrow less. They, in turn, raise their lending rates to customers. The market rate of interest also rises because of the tight
money market. This discourages fresh loans and also dampens business activity.

The central bank effects the latter policy by requiring banks to give only very safe treasury bills or ‘first class’
trade bills (those guaranteed by the very reputable institutions) as collateral to guarantee the loan incase of failure to repay.
Likewise, if the central bank makes cash available by buying approved short-term securities, it can charge a high effective
rate of interest by buying them at a low price and can declare itself willing to buying only a limited category of the safest
bills. This high effective rate of interest charged when the central bank buys securities is in fact a re-discount rate, since the
central bank is buying securities which are already in the market but at a discount.

The opposite happens when credit is to be expanded in the economy. If the need of the economy is to expand credit, the
central bank lowers the bank rate. Borrowing from the bank becomes cheap and easy. So the commercial banks are able to
borrow more and in turn are able to advance loans to customers at a lower rate. The market rate of interest is reduced. This
encourages business activity, leading to the expansion of more credit. Thus the lowering of the bank rate offsets deflationary
tendencies while raising the bank rate controls inflation.

2. Open Market Operation (OMO)


OMO are another method of quantitative credit control used by the central banks. This method refers to the sale and
purchase of securities, bills and bonds of government by the central bank. There are two principal motive of OMO:-

i. To influence the reserves of commercial banks in order to control their power of credit creation.
ii. To affect the market rates of interest so as to control the commercial bank credit.

OMO is by far most frequently used policy tool of the central bank because of its flexibility and effectiveness. OMO impact
directly on reserves; reserves increase when the central bank buys securites and decrease when the central bank sells
securities.

The central bank employs so-called dynamic open-market operations in its pursuit of longer-run objectives. When inflation is
the foremost economic problem, the bank is likely to be pursuing a policy of monetary stringency-slowing money supply
growth all allowing interest rates to rise. In this case the central bank’s dynamic open-market operations would amount to net
sales of securities and the corresponding reduction in reserves.

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On the other hand, depressed economic activity is likely to result in open-market operations that inject reserves into the
financial system in order to permit monetary expansion and an easing of interest rates.

Another aspect of the open-market operations is that; most of the uses of this technique are defensive in nature-designed to
offset undersired temporary changes in reserves due to currency flows and other factors over which the central bank has no
control. For example, currency in circulation outside depository financial institutions tend s to greatly increase during the
period immediately prior to Christmas. This occurrence drains reserves and, if reserves were not injected into the financial
system by the central bank to offset it, would result in a multiple contraction of demand deposits. Such injection is
accomplished by central bank purchases of Treasury securities in OMOs. When the holiday is over and currency flows back,
the central bank reserves its field, selling securities to avoid an undersired expansion of reserves. One must note that when
the supply of money changes as a result of OMOs, the market rates of interest also change. A decrease in the supply of bank
money through the sale of securities will have the effect of raising the market interest rates. On the other hand, an increase in
the supply of bank money through the purchase of securities will reduce the market interest rates. Thus upon-market
operations have a direct influ8ence on the market rate of interest.

Open Market Operations –Vs- Bank Rate Policy


The question arises whether the bank rate is more effective as an instrument of credit control or OMOs.

The bank rate policy influences the cost and supply of commercial bank credit; while Open-market operations affects the
cash reserves of the commercial banks.

The significance of the bank rate policy is that, when the rate goes up, the commercial banks have to raise their rate of
interest on their lending to borrowers since their cost of borrowing from the central bank has increased. But changes in the
bank rate affect the credit creation power of the commercial bank if only they re-discount their bill with the central bank. If
the banks do not feel the necessity of availing re-discounting facilities of the central bank, arise in the bank rate will have no
effect on the commercials banks.

On the other had, the lending power of the commercial banks is directly related to their cash reserves, and open-market
operations influence their cash reserves directly and immediately, thereby affecting their credit creation power.

Further, from the standpoint of their strategic value to the central bank, OMO’s possess a degree of superiority over the bank
rate policy because of the fact that initiative is in the hand of the monetary authority in the case of the former, whereas bank
rate policy is passive in the sense that its effectiveness depends on the responses of commercial banks and their customers to
changes in bank rate. But the experience of developed economies tells us that these two policies are not competitive but
complementary to each other. If they are supplemented, they can control credit more effectively than individually.

If the central bank raises the discount rate for the purpose of contracting credit, it will not be effective when the commercial
banks have large excess reserves with them they will continue to expand credit irrespective of the rise in the bank rate. But if
the central bank first draws away to itself the excess reserves of the commercial banks by the sale of securities and then rises
the bank rate, it will have the effect of contracting credit, similarly, the sale of securities alone will not be so effective in
contracting credit unless the bank rate is also raised. The sale of securities by the central will reduce the cash reserves of
commercial banks but if the discount rate is low, the commercial banks will get funds from the ‘discount window’ of the
central bank.

Thus, the commercial banks will always know that if the bank rate is raised, it means that the central bank is anxious to see a
restriction of credit. If commercial banks do not in turn raise their own rate of interest (i.e. have excess reserves), they know
that the central bank will step up its open-market operations and ‘squeeze’ their cash still further. Hence OMOs and change in
the bank rate are often used together.

These controls are at times of limited effectiveness. In inflationary periods, they may restrict credit somewhat, although today
more and more large firms (especially in developed economies) obtain a large share of their funds for investment out of
profits, so that they are not limited to borrowing form bans. As a result, credit, credit restrictions and increased interest rates
tend to limit the borrowing of smaller firms, given rise to the criticism that it contributes to the growth of monopolies.
Furthermore, central and controls may have little influence in encouraging borrowing during a depression. Business will not
borrow if there is no market for their increased output, no matter how cheaply the loans may be obtained.

3. Variable Reserve Ratio


This is also known as required reserve ratio or legal minimum requirements. Every commercial bank is required by law to
maintain a minimum percentage of its deposits with the central bank. The minimum amount of reserves with the central bank
may be either a percentage of its time and demand deposits separately of total deposits. Whatever the amount of money
remains with the commercial banks over and above these minimum reserves is known as the excess reserve. It is on the basis
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of these excess reserves that the commer5cial bank is able to create credit. The larger size of the excess reserves, the greater
is the power of a bank to create credit, and vice versa. It can also be said that the larger the required reserve ratio, the lower
the power of a bank to create credit and vice versa.

When the central bank raises the reserve ratio of the commercial banks, it means that the banks are required to keep more
money with the central bank. Consequently, the excess reserves with the commercial banks are reduced and they can lend less
than before. This can be explained more clearly with the help of the deposit multiplier formula:-

If a bank has K£1000 in deposit its legal minimum ratio or the required reserve ratio, RRr is 20 percent, it can create credit to
the extent of K£5000.

i.e. 1 x D = 1 x 1000 = 5000


RRr 0.20

This bank is said to be ‘loaned up’ to the limit of K£5000 and it cannot create more deposits its reserves increase further. If
the RRr is now reduced from 20 percent to 10 percent the banks can create credit to the extent of K£10,000

1 x D = 1 x 1000 = 10,000
RRr 0.10

Therefore, the bank is ‘loaned up’ to the limit of K£10,000. If the RRr is now increased to 25 percent from 20 percent;

1 x D = 1 x 1000 = 4,000
RRr 0.25

The bank will be ‘loaned up’ to the limit of only K£4,000

Variable Reserve Ratio Vs Open Market Operations


There are divergent views about the superiority of variable reserve ratio over open market operation. To those who consider
the former as superior instrument of credit control, it is ‘a battery of the most improved type that a central bank can add to its
armoury’. They give the following arguments.

 The variable reserve ratio affects the power of credit creation of the commercial banks more directly, immediately, and
simultaneously than open market operations. The central bank has imply to make a declaration for changing the reserves
requirements of the banks and they have to implement it immediately. But open market operation require sale or
purchase of securities which is a time consuming process.
 The effectiveness of open market operations depends upon the existence of a broad and well organized market for
securities. Thus this instrument of credit control cannot be operative in counties which lack such a market (especially the
bills market). On the other hand, the method of variable reserve ratio does not require any such market for its operation
and is applicable equally in developed and underdeveloped markets, and is thus superior to open market operations.
 Further, since open market operations involve the sale and purchase of securities on a day-to-day and week-to-week
basis, the commercial banks and the central bank which deal in terms are likely to incur losses. But variations in the
reserve ratio do not involve any losses.

Despite the superiority of variable, reserve ratio over open market operations, supporters of open market operations have
argued that they are more effective as a tool in controlling credit than variable reserve ratio because of the following reasons:-

 When the central bank sells securities to the banks to control inflation, they are forced to buy them. They are, therefore
prevented from given more loans to private credit market. On the other hand, if the ratio is raised, the banks will be
required to keep larger balances with the central bank. They will also be faced with reduced earnings. They will
therefore, be induced to sell government securities and give more loans to the private credit market. Thus open market
operations are more effective for controlling inflation than the change in reserve ratio.
 In another sense, open market operations are more effective as an instrument of credit control than variations in the
reserve ratio. In every country there are non-banking financial intermediaries which deal in securities, bonds, etc and also
advance loans and accept deposits from the public. But they are outside the legal control of the central bank (in terms of
reserves). Since they also deal in government securities, open market sale and purchase of such securities by the central
bank also affect their liquidity position. But they are not required to keep any reserves with the central bank, unlike the
commercial banks.

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 Again, variations in the reserve ratio are meant for making major and long-run adjustments in the liquidity position of the
commercial banks. They are, therefore, not suited for making short-run adjustments in the volume of available bank
reserve, as are done under open market operations.
 Further, as a technique, reserve ratio can only influence the volume of reserves of the commercial banks. On the other
hand, open market operations can influence not only the reserves of the commercial banks but also the pattern of the
interest rate structure. Thus open market operations are more effective in influencing the reserves and credit creation
power of the banks than variations in reserve ratio.
 Last but not least, the technique of variations in reserve ratio is clumsy, inflexible, and discriminatory (i.e. hurting
smaller banks more than the larger ones) where as that of open market operatins is simple, flexible and non-
discriminatory in its effects.

It can be concluded from the above discussion of the relative merits and demerits of the two techniques that in order to have
the best of the two techniques that in order to have the best of the two, they should be used jointly rather than independently.
If the central bank raises the reserve ratio, it should simultaneously start purchasing and not selling, securities in those areas
of the country where there is monetary stringency. On the contrary, when the central bank lowers the reserve requirements of
the banks, it should also sell securities to those banks which already have excess reserves with them, and have been engaged
in excessive lending. The joint application of the two policies will not be contradictory but complementary.

Credit Control Techniques in Developing Economies


The central bank should aim at controlling credit in order to influence the patterns of investment and production in a
developing economy. Its main objective is to control inflationary pressures arising in the process of development. This
requires the use of both quantitative and qualitative methods of credit control.

Open Market Operations are not successful in controlling inflation in underdeveloped economies because the bill market is
small and undeveloped. Commercial banks keep an elastic cash ratio because the central banks’s control over them is not
complete. They are also reluctant to invest in government securities due to their relatively low interest rates. Moreover,
instead of investing in government , they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash.
Only the last condition is operative because commercial banks are not in the habit of rediscounting or borrowing from the
central bank.

In underdeveloped economies, the bank rate policy is also not so effective due to the lack of bills of discount and the habit of
the commercial banks to keep large cash reserves. Where the central bank is more powerful, is able to influence the market
rates by appropriate changes in the bank rate.

The use of the variable reserve ratio as a method of credit control is more effective than the open market operation and the
bank rate policy, Commercial banks are able to create more credit in underdeveloped countries as they keep large cash
reserves. The central bank can check this expansion by raising the compulsory reserve ratio.

The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the
allocation of credit, and thereby the pattern of investment. In underdeveloped countries, there is a strong tendency to invest in
gold, jewelry, inventories, real estate, etc instead of in alternative productive channels available in agriculture, mining
plantations and industry. The selective credit controls are more appropriate for controlling and limiting credit facilities for
such unproductive purposes. They are beneficial in controlling speculative activities in food grains and raw materials. They
prove more useful in controlling ‘sectional inflation’s’ in the economy. They curtail the demand for imports by making it
obligatory on importers to deposit in advance an amount equal to the value of foreign currency. This has also the effect of
reducing the reserves of the banks in so far as their deposits are transferred to the central bank in the process. The selective
credit control measures may take the form of changing the margin requirements against certain types of collateral, the
regulation of consumer credit and the rationing of credit etc.

4. Selective Credit Controls


Selective or qualitative methods of credit control are meant to regulate and control the supply of credit among its possible
uses. Unlike the general instruments, selective instruments do not affect the total amount of credit but the amount that is put
to use in a particular sector of the economy. The aim of selective credit control is to channelise the flow of bank credit from
speculative and other undesirable proposes to socially desirable and economically useful uses. Prof. Chandler defines
selective credit controls as ‘those measures that would influence the allocation of credit, at least to the point of decreasing the
volume of credit used for selected purposes without the necessity of decreasing the supply and raising the cost of credit for all
purposes’.

A. Regulation of Margin Requirements


This method is employed to prevent excessive use of credit to purchase or carry securities by speculators. The central bank
fixes minimum margin requirements on loans for purchasing or carrying securities, they are, in fact, the percentage of the
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value of the security that cannot be borrowed or lend or lent. In other words, it is the maximum value of loan which a
borrower can have from the banks on the basis of the security.

For example, if the central bank fixes a 10 percent margin on the value of a security worth K£1000, then the commercial
bank can lend only K£900 to the holder of the security and keep K£100 with it. If the central bank raises the margin to 25
percent, the commercial banks can lend only K£750 against a security of K£1000. If the central bank wants to curb
speculative activities, it will raise the margin requirements. On the other hand, if it wants to expand credit, it reduces the
margin requirements.

B. Regulation of Consumer Credit


This is another method of selective credit control which aims at the regulation of consumer installment credit or hire-
purchase finance. The main objective of this instrument is to regulates the use of bank credit by consumers in order to buy
durable consumer goods on installment and hire-purchase. For this purpose, the central bank employees’ two devices:-
 Minimum down payments; and
 Maximum periods of repayment

Suppose a bicycle costs K£500 and credit is available from the commercial banks for its purchase.

The central bank may fix the minimum down payment to 50 percent of the price, and the maximum period of repayment to
10 months. So K£250 will be the minimum which the consumer will have to pay to bank at the time of purchase of the
bicycle and the remaining amount is ten equal installments of K£25 each. This facility will create demand for bicycles.

Thus, the bicycle industry would expand along with the related industries such as tyres, tubes, spare parts, etc. and this may
lead to inflationary situation (rise in prices) in this and other sectors of the economy. To control this, the central bank raises
the minimum down payment to 70 percent and the maximum period of repayment to three installments. So the buyer of a
bicycles will have to pay K£350 each.

Therefore, if the central bank find slump in particular industries of the economy, it reduces the amount of down payments and
increases the maximum periods of repayments. Reducing the down payments tend to increase the demand for credit for
particular durable consumer goods on which the central bank regulation is applied. Increasing the maximum period of
repayment, which reduces monthly payments, tends to increase the demand for loans, thereby encouraging consumer credit.
On the other hand, the central bank raises the amount of down payments and reduces the maximum periods of repayment in
boom(s) inflationary situations).

This instrument has its drawbacks. It is cumbersome, technically defective and difficult to administer because it has a narrow
base. It is applicable to a particular class of borrowers whose demand for credit forms an insignificant part of the total credit
requirements.

If therefore, discriminates between different types of borrowers. This method affects only persons with limited incomes and
leaves out higher income groups. Finally, it tends to misallocate resources by shifting them away from industries which are
covered by credit regulations and lead to the expansion of other industries which do not have any credit restrictions.

C. Rationing of Credit
The wide use of credit rationing as a method of controlling credit was made use of only in recent times, particularly after the
first world war to control the exceptionally difficult conditions resulting from war and post –war inflation. At times when the
demand for credit exceeds the total available resources, it is the obligation of the central bank to divide the available funds in
some definite way among the competing needs. The setting of credit quotas (i.e. 25 percent of all credit must go to
agriculture) is the only decisive method which the central has in order to prevent excessive credit demands on the part of
business.

D. Direct Action
Central bank in all countries frequently resort to direct action against commercial banks. Direct action is in the form of
‘directives’ issues from time to time to the comer banks to follow a particular policy, which the central banks want to enforce
immediately. This policy may not be used against all banks against erring banks. For example, the central bank may refuse
rediscount facilities to certain banks which may be granting too much credit for speculative purposes, or in excess of their
capital and reserves or restraint them from granting advances against the collateral of certain commodities, etc. It may also
charge a penal rate of interest from those banks which want to borrow from it beyond the prescribed limit. The central bank
may even threaten a commercial bank to be taken over by it in case it fails to follow its policies and instructions.

E. Moral Suasion

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Moral suasion is the method of persuasion, of request, of informed suggestion, and of advice to the commercial bank usually
adopted by the central bank. The executive head of the central bank calls a meeting of the heads of the commercial banks
wherein he/she explain to them the need for the adoption of a particular monetary policy in the context of the current
economic situation, another appeals to them to follow it.

In England, France, Sweden and the Holland, where the central bank exercises great moral influence in the financial circles
and is accepted as the financial leader by the banking community. Here, the central bank successfully exerts its sobering
influence on the member banks through moral suasion. However, in USA, moral suasion has not been much successful
because there are over 15,000 commercial banks with most banks commanding large cash reserves and not subject to the
restrictions of the Federal Reserve System as there are not members of the system. As already noted, moral suasion can only
be successful if the commercial banks are prepared to follow the lead of the central bank. This depend on the strength of the
central bank and the prestige it commands among the member banks in the country’s economy.

F. Publicity
The central bank also uses publicity as an instrument of credit control. It publishes weekly or monthly statements of the
assets and liabilities of the commercial banks for information of the public. It also publishes data relating to money supply,
prices, production and employment, and of capital and money markets, etc. This is another way of exerting moral pressure on
the commercial banks. The aim is to make the public aware of the policies being adopted by the commercial banks vise versa
the central bank in the light of the prevailing economic conditions in the country.

It cannot be said with definiteness about the success of this method. It pre-supposes the existence of an educated and
knowledgeable public about the monetary phenomena. But even in advance countries, the percentage of such person in
negligible. It is, therefore, highly doubtful if they can exert any moral pressure on the banks to strictly follow the policies of
the central bank. Hence, publicity as an instrument of selective credit control is only of academic interest.

3.5 CENTRAL BANK OF KENYA AT A GLANCE

1. Establishment of the Bank


The central bank of Kenya was established in 1996 through an Act of Parliament – the Central Bank of Kenya Act of 1966.
The establishment of the Bank was a direct result of the desire among the three East African countries to have independent
monetary and financial policies. This led to the collapse of the East Africa Currency Board (EACB) in mid 1960s.

2. Structure of the Bank


Responsibility for determining the policy of the Central Bank is given by the Central Bank of Kenya Act to the Board of
Directors. The Board consists of seven members:-
 The Governor, who is also its chairman
 The Deputy Governor, who is deputy chairman
 The Permanent Secretary to the Treasury who is a non-voting member
 Five other non-executive directors.

All members appointed by the president to hold office for a term of four years and are eligible for reappointment. In the case
of the Governor, appointment is for a maximum of two terms of four years each and can only be terminated by a tribunal
appointed by the president to investigate his conduct.

The executive management team comprises the Governor, the Deputy Governor and nine heads of department who report to
the Governor. The bank operates from its head office in Nairobi and has branch offices in Mombasa, Kisumu and Eldoret.

3. The central Bank Act and it’s Relations with the Government
The Central Bank of Kenya Act of 1966 set out objectives and functions and gave the Central Bank Limited autonomy. Since
the amendment of the Central Bank of Kenya Act with effect from April, 1997, the Central Bank operation have been brought
into line with the changed situation in Kenya caused by economic reforms. There is now greater monetary autonomy.

Though required to support the general economic policy of the Government, the Central Bank of Kenya is not Subject to any
directive from the Government in exercising the powers conferred on it by the Central Bank of Kenya (Amendment) Act,
1966. However, both the Government and the Central Bank make mutual consultations on important policy matters. The
Central Bank, for example, is required to advise the Government on monetary policy matters of major importance and to
provide information at the Government’s request. The Government in turn invites the Governor of the Central Bank to advise
on fiscal issues that may have important ramifications on the Bank’s monetary policy.

4. Mission of the Bank

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The Central Bank plays a unique role in the economy and performs various functions not normally carried out by commercial
banks. The functions of the Bank have changed over time depending on the changing economic conditions. Currently, its
main task, as stipulated in the Central Bank of Kenya (Amendment Act), 1996 is that of “maintaining price stability and
fostering liquidity, solvency and proper functioning of a stable market – based financial system”. As such it is responsible for
formulating and executing monetary policy, supervising and regulating depository institutions, assisting the Kenya
Government’s financing operations and serving as Kenya Government banker. This is very much in line with contemporary
central banking practice the world over.

5. Importance of Maintaining Price Stability


Maintaining price stability is crucial for a proper functioning market-based economy. Low and stable inflation reduces the
continuous rise in the general price level that it no longer adversely influences the decisions of consumers and producers.
While, high rate of inflation inevitably give rise to a decline in the efficient working of a market economy and in the medium
to longer term to a lower rate of growth of the economy as a whole.

6. How the Bank Ensures Price Stability


As movements in the general price level are influenced by the amount of money in circulation, the Central Bank of Kenya
operates in a way that restricts the growth of the total money stock available in the economy to predetermined growth target
(see Monetary Policy Statement). There are three major tools that Bank uses to implement monetary policy.

Open Market Operations:-through open market operations, the Bank buys or sells Kenya Government Treasury Bills both
in the primary and secondary in order to produce a desired level of Bank reserves. These securities are held in the Bank,
which currently has a value of roughly Kshs.120 billion. The bank therefore, injects money to the economy when it buys
Treasury Bills and drains money when it sells it. As the law of supply and demand take over in the money market, the cost of
loanable funds (interest rates) adjust itself to the desired level.

Discount Window Operations:- The bank, as lender of the last resort, may provide secured short-term loans to commercial
banks temporarily in need of funds, but only after they have exhausted their market sources of funds. The discount rate is set
by the Central Bank to reflect the monetary policy objectives.

Reserve Requirement:-The central bank is empowered by the Act to demand a certain proportion of commercial banks’
deposits to be held as non-interest bearing reserves at the Central Bank. An increase in reserve requirements would be
regarded as an attempt to restrict bank credit. A reduction in the reserve ratio would be viewed as an expansion of credit as it
increases the credit creation power of the banks.

7. Other Functions of the Bank


In addition to these primary task, the Central Bank performs other specific functions which have evolved with the changing
economic environment since its inception in 1966:

Issue of notes and coin:- The Central Bank of Kenya is entrusted with the making, issuing and destroying notes and coins in
Kenya Shillings. The monopoly of issuing notes and coins enables it to exercise control over the money in circulation and
thereby fulfill its primary tasks of safeguarding the domestic value of the Kenya Shillings. At present, the Central Bank issues
five denominations of notes: Kshs.20, Kshs.50, Kshs.100, Kshs200, Kshs.500 and Kshs.1,000. While, new generation coins
are in denominations of:-10 cents, 50 cents, Kshs.1, Kshs.5, Kshs.10.

Provision of Banking Services to Banks:-The central bank provides commercial banks clearing facilities of other cashless
payments a task laid down in the CBK AMENDMENT Act of promoting the smooth operation of payments, clearing and
settlement systems. The Bank is also entrusted with the supervision of commercial banks in order to ensure efficient and
sound financial system in the interest of depositors and the economy as a whole.

Provisions of Banking Services to Government:- As banker and fiscal agent of Government, the bank accepts deposits and
effects payments on behalf of Government. It also maintains and operates specials accounts for the Government on behalf of
Government. It also maintains and operates specials accounts for the Government. This function has, however, been
circumscribed in the recent Central Bank (Amendment) Act of 1997 to prevent any erosion of the Bank credit, as this has
been the major cause of monetary expansion in the economy (see the Monetary Policy Statement). The central bank also
administers the public debt, i.e. effecting issuance, payment of interest on, and redeeming of bonds and other securities of the
Government.

Foreign Exchange Operations:-The central bank hold official foreign exchange reserves of the country for the purposes of
repaying and serving the country, public external debt; and intervening in the interbank foreign exchange market largely to
smooth out erratic exchange rate fluctuations, thus helping to maintain orderly market conditions crucial for the shilling
exchange rate stability.
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8. Functions of Branches
To provide an efficient service to the banks and satisfy their requirements for bank notes, the central Bank has opened
branches in various regions of the country. The branch responsibility is to ensure that there is an adequate supply of new
notes available to meet the demand, and to replace unfit notes.

3.6 A NOTE ON BANK SUPERVISION IN KENYA

1. International Accounting Standards


The institute of Certified Public Accountants of Kenya (ICPAK) adopted the International Accounting Standards (IAS) in
1998 and many companies started its implementation in 1999. With respect to the banking institutions, the applicable
accounting standards is IAS and except for a re-issue in interpretation relating to provisioning for bad and doubtful debts,
there has not been any problem in the implementation of the standards and most of the banking institutions have implemented
them.

The adoption of IAS in Kenya is commendable since it is in line with the recommendations of the Base Committee for
effective banking supervision and which the regional grouping of supervisors, i.e. East and Southern Africa Supervisors
Forum (ESAF), has resolved to implement across the sixteen countries in the sub-region.

2. Implementation of Core Principles for Effective Banking Supervision


The core principles for effective banking supervision are practices which all supervisory authorities should strive to achieve.
To assist in objective determination of level of implementation, the Basel Committee has formulated detailed methodology to
be utilized in the assessments. While the IMF and World Bank are carrying out the assessments as part of their wider
Financial Sector Assessments Programmes (FSAP), the regional grouping like ESAF can formulate ways for organizing peer
assessments. In the meantime, each country is expected to carry out objectives self-assessment of the extent of
implementation.

A review of how well various countries in the East and Southern Africa region have implemented the core principles shows
that the following particular core principles have generally posed problems in implementation:-

a. Autonomy of the Supervisory Authorities (Core Principles 1,2)


In some countries, the Central Banks still do not have full independence in regulatory matters especially in licensing and
revocation of licenses.

b. Assessment of Country and Market Risks as well as Derivatives (Core Principles Nos 11, 12, 13)
In some countries in the area, the examiners are not well exposed in evaluation market risks and derivatives.

c. Money Laundering (Core Principle No. 15)


Although it is well acknowledged that money laundering is becoming a problem in the region, many countries do not
have anti-money laundering legislation. This makes effective prudential supervision difficult.

d. Consolidated Supervision (Core Principle No. 20)


Several of the economics in the region do not have complex banking groups and hence have not implemented
consolidated supervision.

e. Prompt Corrective Actions (Core Principle No. 22)


For a variety of reasons, sometimes beyond the Supervisory Authority, prompt corrective action is not taken thus
worsening the problems of institutions with problems.

3. Non-Performing Loans
The high level of non-performing loans continues to be an issue of major supervisory concern in Kenya. The level of non-
performing loans has been increasing steadily from Kshs.56 billion in 1997 to Kshs.83 billion in 1998 and to Kshs.97 billion
in 1999.

There are tow main reasons for the increase in non-performing loans. First, the depressed performance in the economy and
secondly, the Central Bank of Kenya in co-operation with the external auditors has strictly enforced the classification
guidelines and hence a sizeable portion of the increase is attributed to better identification. It would be important to note that
while the non-performing advances are high, the banks were holding Kshs.54 billion in provisions against the debts and could
write-off the debts to clean up the balance sheets.

A variety of solutions have been floated to assist in reducing the level of non-performing loans including:-
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a. Formation of a Credit Reference Agency: Where banks can exchange information on the bad borrowers. While a
private sector credit reference bureau is in operation, its full operation has been hampered by lack of legislation to allow
banks to exchange information but enactment of the necessary legislation is in process.

b. Improvement in the Court System: While formation of Credit Reference Bureaus and improvement in the credit risk
assessment may prevent future loans becoming delinquent, the current stock of the non-performing loans needs to be
quickly resolved. The success of this would be possible if the judicial and court systems are operating efficiently. A
number of initiatives have been taken to improve the judicial and court systems are operating efficiently. A number of
initiatives have been taken to improve the judicial system through appointment of more judges, provision of physical
facilities and amendment of the relevant laws.

c. Non-performing Assets Recovery Trust (NPART): Proposals have been made on forming a body to take over the non-
performing assets from the banking system. Such bodies have worked relatively well in several countries where the
government has issued bonds to fund the non-performing loans from government owned banks. In Kenya, a similar
move could be adopted to resolve the Government owned banks saddled by non-performing loans. However, it would be
difficult to adopt in the case of private sector banks.

2.4 High Lending Interest


Compared to the developing countries, the lending rates in Kenya are relatively high. The management of interest rates falls
in the realm of monetary and fiscal policies. However, banks are perceived to have some contribution to make in the current
high rates of interest which makes it a supervisory concern as well.

The main causes of the relatively high interest rates in Kenya can be attributed to the following:
 High domestic debt
 Effect of the cash ratio
 Inefficiency in the Banking sector
 High levels of non-performing loans
 Perceived risk by the investors
 Lack of competition in the banking sector

From the above list, it is obvious that some of the causes of the relatively high lending interest rates are in the domain of
Government rather than the banks. There are however some causes that banks would need to address. Compared to the other
countries, the banks in Kenya operate on a very wide interest rate margin of up to 10%. This is largely due to lack of
effective competition, use of outdated systems and procedures, poor risk assessment and weak corporate governance. The
banks must therefore seriously address these issues in order to contribute to the reduction of the lending interest rates in the
country.

2.5 Operational Risk


Banks in Kenya have in the normal course of business been assessing the operational risks focusing largely on the
conventional internal controls. There is however need to strengthen operational risk management because of the insecurity as
well as technological advancement.

There has been escalation of armed bank robberies in banks leading to considerable losses. While I is the Government’s
responsibility to improve the general security, banking institutions are required to play their part by strengthening or
modifying their internal controls. Some of the measures they could consider undertaking include: preventing vital
information falling into wrong hands, enhancing physical security of premises to control and limit entry; adopting methods to
make stolen cash unusable. As the banks acquire modern technology in their daily operations new risks emerge and they
must evolve techniques of addressing them which involve retraining their staff.

2.6 Micro Finance


Despite the relatively considerable development of the formal banking sector in Kenya, a large section of population has been
left out and their access to credit is mainly through micro-finance institutions. Micro-finance institutions have been funded
by donors and for them to sustain their operations, local funding through deposit taking would be necessary.

The Central Bank of Kenya has in the past focused on the regulation of the formal banking sector. However, the Bank now
appreciates the need to extend is mandate to regulation of micro-finance in order to play a more direct role in poverty
alleviation.

3.3 Monetary Penalties

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In 1998, the Banking Act was amended to give the Minister for Finance powers to prescribe penalties. The relevant gazette
notice was issued in June 1999. The notice specifies the range of violations which would subject to monetary penalties and
the method which would be followed in levying the penalties. It is expected that the enforcement of the Banking Act will be
enhanced considerably arising form the ability to levy penalties. However, the imposing of penalties will be used as a last
resort after the other less punitive options have been exhausted. A transparent and objective system will be utilized in
implementing the penalties.

3.4. Proposed changes in Legislation


The review of legislation will be continued until all the core principles are implemented. The following other
proposals have been submitted to Parliament and if passed, they will be law by January, 2001:
 Power to share information with other Supervisory Authorities.
 Reporting of change of ownership in banks to Central Bank.
 Procedures to facilitate merging of institutions.
 Making issuance of bouncing cheques and cheque kiting a criminal offence.

5.0 FINANCIAL ASSETS


What is a Financial Asset?
It is a claim against the income or wealth of a business firm, household, or unit of government, represented usually by a
certificate, receipt, or legal document, and usually created by the lending of money. Familiar examples include: stocks,
bonds, insurance policies and deposits held in a Commercial Bank, or Savings Bank.

5.1 Characteristics of Financial assets

1. Financial Assets do not provide a continuing stream of services to their owner as does a home. These assts are
sought after because the promise future returns to their owners and serve as a store of value (purchasing power).

2. These assets cannot be depreciated because they do not wear out like physical goods. Moreover, their physical
condition or form is generally not relevant in determining their market value (price).

3. Because financial assets are generally represented by a piece of paper (certificate or contract) or by information
stored in a computer file, they have little or no value as a commodity, and their cost of transport and storage is low.

4. Finally, financial assets are fungible – they can be easily changed in form and interchanged with or substituted for
other assets. Thus, a bond or stock usually can be quickly converted into cash at low cost and the subsequently
converted into any other asset the holder desires.

5.2 The Loanable funds theory


We saw that only when the economy, the money market, the loanable funds market and the foreign currency markets re
simultaneously in equilibrium interest rate will be characterized by:
1. Planned saving = planned investment – across the whole economic system.
2. Money supply = money demand – (equilibrium in the money market).
3. Quantity of loanable funds supplied = quantity of loanable funds demanded (i.e. equilibrium in the loanable funds
market).

The simple demand – supply framework is useful for analyzing movements in interest rates.
For example; if the total supply of loanable funds from savings and other sources is increasing
and the total demand for loanable funds remains unchanged or rises slowly, the volume of credit
extended in the financial market must increase, and interest rates will fall as illustrated above.

The figures shows the supply curve sliding downward and to the right when SLF’, increases to
SLF’, resulting in a decline in the equilibrium rate of interest from i1 to 12. The equilibrium quantity of loanable funds traded
in the financial system increases from c1 to c2.

What happens when the demand for loanable funds increases with no change in the total supply of funds available?

In this instance, the volume of credit extended will increase, but loans will be made at higher rates. The loanable funds
demand curves rises from DLF to D’LF, driving the interest rate upward from 2i to i2.

5.3 THE RATIONAL EXPECTATIONS THEORY

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In recent years a fourth major theory about the forces determining interest rates that appears to be gaining supporters is the
rational expectations theory of interest rates. It builds upon a growing body or research evidence that the money and capital
markets are high efficient institutions in digesting and reacting to new information affecting interest rates and security prices

For example, when new data appear about business investment, household saving, or growth in the nation’s money supply,
investors begin immediately to translate that new information into decisions to buy or sell securities, borrow or lend funds. In
a short space of time perhaps in minutes or seconds – security prices and interest rates change to reflect the new information.
So rapid is this process of the market digesting and using new information that security prices and interest rates presumably
already impound the new data from virtually the moment the data appears. In a perfectly efficient market it is impossible to
share excess profits by trading on publicly available information. Interestingly enough, this concept of the rapid response of
interest rates and security prices to new information runs counter to much of the traditional interest rate literature and counter
the many interest – rate forecasting modern which assume that weeks or months must pass before a new development
affecting rates and prices will exert its full effect on the financial market place.

Thus the national expectations view suggest that interest rates do not stray permanently from their current equilibrium levels
unless new information appears. Old news will not affect today’s interest rates because those rates already have impounded
that information. Rates will only change to entirely new and unexpected information appears.

For example, if the government announced in its budget that it was going to borrow heavily in the next few months, interest
rates would probably increase, as investors would view the government’s additional need for credit as adding to other
demands for credit in the economy and, with the supply of credit unchanged, interest rates would be expected to move higher.

Imagine a new scenario, however, the government suddenly reveals that, contrary to expectations, tax revenues are now being
collected in greater amounts than first forecast and therefore no new borrowing will, in fact, be needed. Interest rates
probably will full immediately as market participants are forced to revise their borrowing and lending plans to deal with the
new situation.

Clearly, the pat rates will take depending on what market participants expected to begin with. Thus, if market participants
were expecting increased demand for credit (with supply unchanged) in unexpected announcement of reduced credit demand
implies lower interest rates in future. Similarly, a market expectation of less credit demand in the future (again, supply
unchanged when confronted with an unexpected announcement of higher credit demand, implies that interest rates will rise.

5.4 DIFFERENT KINDS OF FINANCIAL ASSETS


While there are thousand of different financial assets outstanding at any one time, they generally fall into one of three
categories;
i. Money,
ii. Equities,
iii. Debt securities.

Any financial asset that is generally accepted in payment for purchases of goods and services is money. Equities (more
commonly known as stock) represent ownership in a business firm and as such are claims against the firms profits and
against proceeds from the sale if any of its assets. We usually further subdivide equities into common stock, which entitles its
holders to vote for the members of a firm’s board of directors and therefore determine company policy, and preferred stock,
which normally carries no voting privilege but, does entitle its holder to a fixed share of the firm’s net earnings ahead of the
common stockholders.

Debt securities include such familiar financial claims as bonds, notes and accounts payable. Legally these financial assets
entitle their holder to a priority claim over the holder of equities to the assets and income of an individuals, business firm, or
unit of government.

Financial analysts usually divide debts securities into two broad classes:
1. Negotiable, which can easily be transferred from holder to holder as a marketable security and
2. Non-negotiable, which cannot legally be transferred to another party. Passbook saving accounts are good examples of
non-negotiable debt securities. e.g. Money & Capital Markets – 3rd Edition by Peter S. Rose.

 Buying and selling of shares – Read on their own!

5.5 A NOTE ON INTERNATIONAL MONEY


Many financial transactions crisis cross national border investors from Europe, America etc by Kenyan bonds and stocks.
Countries with large trade surpluses, such as Japan and the oil exporting nations, recycle their excess revenues by investing in
other countries across the world. Consortia of international banks lend tens of billions of dollars to multinational companies
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and to governments. Everyday, hundreds of billions of dollars’ worth of foreign currencies are traded worldwide by
individuals, business, banks and governments. The twin centres of this international foreign-exchange market are New York
and London. These centres are electronically linked to each other and to other trading areas, and are also interconnected
through the international branches of large banks.

Currency prices have real economic effects. A British company that plants coffee, expecting to export the coffee to the U.K
may find that by the time the coffee matures, the value of the Kenyan shilling has risen so much relative to the U.K pound
that the coffee cannot be exported profitably. Multinational companies that produce and market products in many countries
are continually buffeted by currency revaluations.

Another consequence of the linkage of world financial markets in that economic events in one nation have worldwide
repercussions. For example, when credit is scarce and interests rates are high in the United States, U.S. banks borrow in
Europe, thereby raising interest rates abroad. A stock market panic in one country can have ripple effects on the stock markets
in all countries.

5.6 EXCHANGE RATES


Almost every nation has a domestic currency that is used for transactions within its borders – the Kenya shillings, U.S dollar,
Japanese Yen, British Pound and so forth. When transactions cross national boundaries, a currency conversion is usually
necessary. For example, consumers in U.K have pounds to spend on coffee, but Kenyan farmers (who produce the coffee)
want shillings to spend at their local supermarkets. Thus, when U.K citizens buy Kenyan coffee, their pounds will at some
point be exchanged for Kenya Shillings.

As is true of tomatoes, haircuts and other goods and services, each foreign currency has a price at which it is bought and sold.
The exchange rate is the price of one currency in terms of another – for example, the price of a Kenya shillings in U.S dollars
(79) or U.K Pound (110).

A nation’s currency undergoes depreciation when foreign currency becomes more expensive, meaning that currency has been
devalued, i.e. when then Kenyan shilling falls from 79 to 100 against the dollar, we say that it has depreciated, meaning it
now costs more to purchase the dollar. On the other hand, a currency appreciates as foreign currency becomes less expensive,
i.e when the Kenyan shilling raises in value from Kshs.78 to the dollar to Kshs.50 to the dollar.

Purchasing power parity e = pd


Where pd = overall level of domestic prices,


Pƒ = overall level of foreign prices
E = exchange rate, domestic currency / foreign currency.

According to this theory, the percentage change in the exchange rate between two countries is approximately equal to the
differences in their rates of inflation.

% e = % pd - % Pƒ

If or example, U.S prices increase faster than Kenyan prices, then the dollar must depreciate relative to the shilling for U.S.
products to remain competitive. Specifically, a 10% increase in U.S prices and a 3 percent increase in Kenyan prices implies
a 7 percent depreciation of the dollar relative to the shilling. (a 7% increase in the no. of dollars needed to buy a shilling).

EFFECTS OF EXCHANGE RATES ON ECONOMIC ACTIVITY


The primary advantage of floating exchange rates is that they break the impasse created by in consistent to domestic
economic policies. If there are different rates of inflation in two countries, these can be offset by a simple devaluation of the
currency of the nation with the most rapid inflation (as was shown above).

Note that purchasing power parity may be approximately in the long run, it does not hold in the short run. Exchange rates rise
and fall daily, not to equate international commodity prices but because speculators think that one currency is a more
attractive investment than another.

For now, we observe that changes in exchange rates have economic effects: the depreciation of a country’s currency reduces
the price of its exports and raises the price of its imports; currency appreciation has the opposite effects.

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CHAPTER FOUR

OTHER FINANCIAL INSTITUTIONS


Financial institutions are normally divided into those, which comprise the capital market, and those which comprise the
money; market; the former, are primarily concerned with long- term loans and the latter with short-term loans. The capital
market consists of stock exchanges, investment corporations, ad development banks (a term which covers a variety of
institutions concerned with long-term loans aimed at financing projects considered to be of national importance. Most
African countries have capital markets of some. Standing. A money market usually consists of discount and acceptance
houses, whose main function is receiving and lending money for such short periods and sometime, overnight. The two
markets also differ in terms of instruments they deal in. The money market deal in highly marketable liquid debt instruments
such as the promissory note, the bill of exchange, the treasury bill, commercial paper, etc. On the other hand, the capital
market deals in common stocks, share, debentures and bonds.

THE MONEY MARKET


In the detail, the money market refers to a network of markets that are grouped together because they deal in financial
instruments that have a similar function in the economy and are to some degree substitute from the point of view of holders.
The instruments of the money market are liquid assets; interest-bearing debts that mature within a short period of time and
are callable on demand. Therefore, the money market is collective name given to various forms and institutions that deal with
the various grades of near money instruments. Therefore, the money market is collective name given to various forms and
institutions that deal with the various grades of near-money instruments. Thus, the money; markets deals not in money proper
but in near money assets ‘in which short term debt obligations are traded. Usually, the central and commercial banks are
connected with both the money and capital market. In developing countries where specialist discount houses have yet to
develop, the banks tend to take a more active part in the market than other wise would. It has become a common practice in
Africa for central Banks to issue, on their Government’s instructions treasury bills: these bills are recognition of a short-term
loan, usually on three months, to the Government. In the absence of true money market facilities, treasury. Bills have done
much to provide for the short-term outlet for surplus funds in African countries.

INSTITUTIONS OF MONEY MARKET


1. Central Bank: It is the pivot around which the entire money market revolves. It acts as the guardian of the money,
market and increases or decreases the supply of money and credit in the interest of stability of the economy.
2. Commercial Banks: These also deal in short-term loans, which they lend to business and trade. They discount bills of
exchange and treasury bills and lend against promissory notes and through advance sad overdrafts.
3. No-Bank Financial Institutions: These also lend short-term funds to borrower in the money market. Such financial
institutions include savings banks, investment houses, insurance companies and other financial corporations.
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4. Discount Houses And Bill Brokers: In developed money markets, rite companies operate discount houses. The
primary function of discount houses is to discount bills on behalf of others. They borrow money for very short periods
(or ‘at call: which means that it can be called back immediately) from banks, companies, and other financial
institutions. The money they borrow is invested in the buying of commercial ills or treasury bills. It is the fact that they
buy and sell bills at a discount to their face value that earned them their liable.

Along with discount houses, there are bill broker in the money market who act as intermediaries between borrowers
and lenders by discounting bills of exchange at a nominal commission. In underdeveloped money markets, only bill
brokers operate.

5. Acceptance houses: This act as agents between exporters and importers and between lender and borrower traders. The
accepted bills drawn on merchants so as to make these bills negotiable in the money markets. By accepting a trade bill
they guarantee the payment of the ill at maturity. However, their importance has declined because the commercial
banks have undertaken the acceptance business.
All these institutions which compromise the money market do not work in isolation but are interdependent and interrelated
with each other.

WORK OF THE MONEY MARKET


The money market consisting of commercial banks, bill brokers, acceptance houses, no-bank financial houses and the central
bank operates through the bills, securities, treasury bills, and government securities and call loans of various types.

First, the money market operates through the call loan market. It has been defined as ‘a market for marginal funds’,
temporarily unemployed or unemployable funds. In this market, the commercial banks use their unused funds to lend for very
short periods to bill brokers and dealers in stock exchange. Such loans are mostly for a week, even for a day or a night and
can be recalled at a very short notice. Bill brokers and stock brokers who borrow such fund use them to discount or purchase
bills or stocks. Such fund are borrowed at the ‘call date’ which is generally lower than the prevailing bank rate.

Second, the money market operates through the bill market in this market; funds are made available to businessmen and the
government by the commercial banks and brokers. The instruments of credit are promissory note, internal bills of exchange
and treasury bills. For example, the government borrows through the treasury bill from the commercial bank and no-bank
financial institutions.

Third, the money market operates through the collateral loan market for a short period. The commercial bank allied to
brokers and discount house again collateral bonds; stock, secreted, etc in case of need, commercial bank themselves borrow
from the large banks and the central bank on the basis of collateral security.

FUNCTIONS OF A MONEY MARKET


1. It provides short-term funs to the public and private institutions needing such financing for their working capital
requirements. Thus the money market helps the development of commerce, industry and trade within and outside the
country.
2. It provides an opportunity to banks and other institutions to use their surplus funds profitable for a short period.
3. The money market helps the government in borrowing short-term funds at low interest rate on the basis of treasury bills.
On the other hand, if the government were to issue paper money or borrow from the central bank, it would lead to
inflationary pressures in the economy.
4. A well developed money market helps in the successful implementation of the monetary policies of the Central Bank. It
is through the money market that the central bank is in a position to control the banking system and thereby influence
commerce and industry.
5. By facilitating the transfer of funds from one sector (surplus sector) to another (deficit sector), the money market helps
in financial mobility, which is essential for the development of commerce and industry in an economy.
6. Also, as the money market deals in near-money assets and not money proper, it helps in economizing the use of cash. It
thus provides a convenient advantage way of transforming funds from one place to another, thereby immensely helping
commerce and industry.
7. The existence of a money market ensures that funds raised within the economy are used within the country.

Without such markets, those who have funds surplus to their immediate requirements will either hold them idle in the
economy, which is unproductive, or invest them in foreign markets.

8. Money markets provide a fund of specialized knowledge and skill through constant continuous dealing in the market.
This specialized bill and knowledge tend to enhance the reputation of the country. In time the market may develop into
an international financial centre (i.e. London, Tokyo and New York). If this happens the increased activity in the market
will bring many obvious advantages to the economy. These include more employment opportunities and earnings from
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payments made by users of the market, particularly foreigners. This is how New York, Zurich, London and Tokyo
developed as international financial centres.
9. The existence of a developed money market removes the necessity of borrowing the commercial bank from the central
Bank. To the commercial banks, the money market provides the means by which a lower cash reserve can help without
risking a loss of liquidity. This is because it provides them with a first line of defense against cash shortage, through the
call market. For instance, if the banks are threatened with a cash shortage, through the call market. For instance, if the
banks are threatened with a cash shortage, they form first to call money at call, which can realize on demand, at times
within minutes. In the absence of call money, the banks world probably holds more cash in their reserves. Also banks
prefer to recall their loans rather than borrow from the Central Bank at a higher rate of interest.

A second line of defense against cash shortage is the financial instrument created in a money market such as treasury
bills. For instance, even after realizing call money, and the commercial banks are still short of cash, they turn to bills
discounted, which they can realize for additional cash. By offering these two facilities, the money market enables the
commercial banks are still sort of cash; they turn to bills discounted, which they can realize for additional cash. By
offering these two facilities, the money market enables the commercial banks to maintain stable cash and liquid assets
than would otherwise have been possible.

10. As a corollary to (number 3) the money market gives the central bank a channel for the injection of cash into the system
and for the performance of its functions of lender of the last resort. The money market is the traditional channel by which
the central Bank makes the bank rate or rediscount rate effective. Through their credit control. Techniques (expecially
open-market operations) and special deposits they can ease or tighten the money market, which will be reflected in the
structure of interest rates in the market.

CHARACTERISTICS OF A DEVELOPED MONEY MARKET


The developed money market is a well-organised market, which has the following main features:-
1. A Central Bank: A developed money market has a central bank at the top, which is the most powerful authority in
monetary and banking matters. It controls, regulates and guides the entire money market. It provides liquidity in the
money market as it is the lender of the last resort to the various constituents of the money market.
2. Organised Banking System: An organised and integrated banking system is the pivot around which the whole money
market revolves. It is the commercial banks, which supply short-term loans, and discount bills of exchange. They form
an important link between the brokers, borrowers, and the central bank in the money market.
3. Specialised sub-markets: A developed money market consists of a number of specialized sub-markets dealing in
various types of credit instruments. There is the call loan market, the bill market, the collateral, loan market, and the
foreign exchange market. The larger the number of sub-markets, the more developed is the money market but the mere
number of sub-markets isn’t enough. What is required is the various sub-markets should be properly integrated with each
other.
4. Existence of large Near-Money – assets. The larger the number of near money assets i.e. Bills of exchange, promissory
notes, treasury bills, securities bonds, etc. the more developed are the money market.
5. Integrated interest-rate structure: Another important characteristic of a developed money market is that it has
integrated interest-rate structures. The interest rate prevailing in there various markets are integrated to each other. A
change in the bank rate leads to proportional changes in the interest rate prevailing in the sub-markets.
6. Adequate financial resources: A development money market has easy access to financial sources from both within and
outside the country.
7. Remittance facilities: A developed money market provides easy and cheap remittance facilities of transferring funds
from one market to the other. The London Money market provides such remittance facilities throughout the world.
8. Miscellaneous Factors: Besides the above noted features, a developed money market is highly influenced by factors
such as restriction on international transactions, crisis boom, depression, war, political instability, etc.

CAPITAL MARKETS
The money and discount markets play a very crucial role in liquidity adjustment between deficit and surplus units in that
market.

The capital market serves the medium –term and long term funds.

LINKAGES BETWEEN MONEY AND CAPITAL MARKETS


▪ Many lenders and borrows of funds use both markets
▪ The degree of participation in either market shifting over time and their situated and financial conditions change.
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▪ A firm may borrow from the money market for temporally funding of long-term capital needs while waiting for more
favourable capital market conditions.
▪ Many financial intermediaries operate in both markets e.g. commercial banks, brokers, and dealer.
▪ Funds are constantly being moved from one market to another e.g. collections of long-term obligations may be ploughed
into short-term ones vice-versa.
▪ A borrower may pay short-term obligation while at the same time issuing a long-term one and vice-versa.
▪ Many institutions lendi9ng in the money market depend frothier borrowing in the capital market and vice versa.

PRIMARY AND SECONDARY FINANCE MARKETS


Finance markets are sometimes divided into primary and secondary markets
▪ Primary markets are those concerned with the raising of new financial claims e.g. –a company raising new equity on the
stock exchanges new issues market participates in a primary finance market.
▪ A company borrowing from its bank
▪ Is in the primary market.
▪ Secondary finance markets are those concerned with the buying and selling of (second hand) existing financial claims.
e.g. the stock exchange trading market.
▪ The recognition of a promissory note to a third party is a deal taking place in the secondary market.
▪ The over the counter (OTC)
▪ Over the telephone trading.
ORGANISED AND UNORGANISED FINANCE MARKETS
▪ An organised market is one with a systematic apparatus of brokers, dealers, jobbers, etc acting as intermediary’s buyers
and sellers e.g. commodity exchanges. The stock exchange.
▪ Trading in securities takes place at a particular physical sight i.e. the ‘floor’ of the exchange.
i. Dictate the manner in which trade is to be carried out. Y exchange members,
ii. Govern the conduct of members,
iii. Forbid practices relating to manipulation of security prices.

▪ Operation of banks and other financial intermediaries would be included only to the extent that brokers are employed to
find the best terms on the availability of fund.
▪ But borrowers and lenders usually approach banks and financial institutions directly.

BASIC CHARACTERISTICS OF CAPITAL MARKETS


i. Encompass markets for medium term and long term funds,
ii. Have both primary and secondary components,
iii. Encompass markets for equity instruments and market for debt instruments.

OTHER CHARACTERISTICS
▪ Finance (Instruments) not highly negotiable requires secondary market.
▪ Lending usually secured debt market,
▪ Funds usually serve the needs of large companies,
▪ Presence of intermediaries e.g. brokers e.g. organised markets
▪ Markets facilities facilitate foreign portfolio investments e.g. foreign bond market,
▪ Finance is mainly obtained in form of assets e.g. lese finance, hire purchase etc.
▪ Finance usually cheaper than in the money market.
INSTRUMENTS USED IN CAPITAL MARKETS
Debt Instruments
▪ Term depends on the nature of participants (7 years)
▪ Bonds/government stocks
▪ Instruments used for borrowing by governments, local authorities and financial institutions e.g. government fight –
edged securities.

Consider
▪ Term bonds – issued with a sing maturity,
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▪ Serial bonds – issued with variable maturities,
▪ Corporate bond – by PLC’s,
▪ Foreign bonds.

Debenture
▪ Issued by companies to raise loan capital
▪ Can be redeemable or irredeemable
Classes include
▪ Mortgage debenture
▪ Issued on security of company assets
Secured debenture
-Form a fixed change on specified assets of a company
-Mortgage finance – by financial institutions
-Borrowing and lending is done against immovable securities e.g. building societies
-Lease and hire – purchase finance.

Equity instruments
▪ Ordinary shares
▪ Preference shares
▪ Consider various classes
The above instruments are traded in both the primary and secondary markets.

Primary markets – New financial claims


Securities traded for the first time. Institutions involved include:-
▪ Venture capitalists
▪ Mortgage financial institutions e.g. HFCK
▪ Development Financial Institutions e.g. ICDC,
▪ Leasing, a hire purchase companies e.g. Diamond Trust (K) Ltd.
▪ Investment banks e.g. Kenya Industrial Development Bank,
▪ Brokers and dealers. Other participants include
-Individuals
-Business
-The government, etc.
▪ New issue market of the stock exchange e.g. shares.
Secondary markets
Constitute mechanisms, within the finance markets, that facilitate trading in existing financial claim.

The most adamant institution in any developed capital market is the stock exchange, also known as the security market.
Within this mechanism are stockbrokers’ investor, dealers and jobbers.

The Exchange’s (Secondary market)


A stock exchange is a highly organised market for dealings in stocks. e.g. shares bonds, and debentures and other securities
(through the medium of brokers, dealers, jobbers, etc)
▪ It allows convenient transfer of financial claims or investments from the owner to another,
▪ The S.E does not contribute any funds to the financing process,
▪ It is organised in such a way that only members (brokers, jobbers, etc.) are allowed to transact business in this market
subject to a prescribed set of rules.

Thus
▪ An investor wishing to buy or sell securities must act through a broker,
▪ The existence of stock exchanges means that it is generally possible to buy or sell securities at any time and at the market
price.

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Stock brokers, Jobbers and dealer.
For the stock exchange, brokers act as agents and agree to bring all their business to the market i.e. to the jobbers, who deal
on their own account and agree to trade only with members of the stock exchange.
 Brokers thus act as middlemen between the investing public and the stock exchange Dealers buy and sell securities on
there own account and do not commit themselves to deal exclusively with only part.

Over-the-counter market (over-the-telephone)


Part of secondary market where securities not listed of the organised exchanges are traded.
▪ Consists (OTC) of a network of dealers who are ready to buy any reasonable, quantity of a security or securities in which
they deal at the ‘bid’ price and sell at the ‘asked’ price.
▪ OTC trading in securities listed in the stock exchange is known as the ‘third market’, while direct exchange of securities
by institutions without involving brokers or dealers referred to as the ‘fourth market’.
▪ Prominent among other participant in the secondary market include:- Commercial banks in their clearing and acceptance
and functions.
▪ Other financial intermediaries including institutional investors e.g. savings banks, building societies, insurance
companies, pension funds, investment trusts, unit trusts etc.
▪ Individual investors business. Companies government departments etc.
The function of the secondary trading capital market is correct the mismatch of the demand and supply requirements of
surplus and deficit units. But an effective secondary market is dependent on the primary finance market just as a growing
primary market would depend on the extent of development in the secondary market.

▪ An investor buying securities in the primary market must be assured of the possibility of Liquidating vestment at will.
▪ The two markets are therefore inter-dependent. This organised primary and secondary markets are controlled by the
stock exchange (NSE).
The New Issue Market (Organised)
Provides an organization, which can be used deficit units to raise funds from surplus units. Surplus units release money to
deficit units when they know that financial claims document received in exchange can be sold in secondary market.

Getting Listed on the Stock Exchange


To make issues on the stock exchange public limited companies must apply a listing/obtain a quotation.
▪ Company’s name appears on the stock exchange list.
▪ Shares said to be listed.
▪ This makes it possible for the company share to be dealt in.
▪ Shares bought and sold on the stock exchange.
Thus
The general rule in the stock exchange is that new issues must carry with them a ‘listing’ on the trading market. And a
minimum of 35% of company’s market capitalization must be offered to the market by the first issue of shares

A company seeking a listing must be represented by a stock broking member of the stock exchange appointed by the
company or its merchant bank to act as the sponsor to the new issue. The timing of an issue has to be cleared with the CMDA
issue committee to ensure orderly new issue market e.g. ensure
▪ That announcement of new issues do not coincide
▪ That the liabilities of underwriters to be issued is not excessive,
▪ The closing date of the issue and the date of the first dealing on the trading market are reasonably spread.
After underwriting has been arranged the sponsoring brokers applies the quotations committee of the sto0ck exchange for a
listing, dealing security holders have received their allotment of securities (if listing requirements have been net).

The Capital Market Development Authority (CMA)

Established by an act of parliament CMA (Act) 1979.

Objectives:
1. To support and encourage the development of a more active capital market,
2. Institute regulatory framework for the improvement and effective proper functioning of fair and orderly markets.

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Thus
▪ Ensure adequate disclosure of corporate and market information both in public offering, prospectuses and one continuing
basis.
▪ Promote effective organization and self-regulatory duties of the stock exchange.
▪ Establish and manage reading rules in the capital market,
▪ Carry the responsibility of the registration of securities professionals e.g. brokers, dealers, etc.
▪ Ensure protection of investors both local and foreign.
▪ Create conditions necessary to promote investor confidence.
▪ Enhance mobilization and allocation of financial resources.
1. Encourage growth of an active secondary market to enhance liquidity in long-term investments
in securities.
2. Lay down the necessary framework for the growth of a second-tear. Market securities exchange
for venture capital to be invested in new companies with good growth prospects (but no track record to qualify them to
be listed in the main stock exchange) OTC – Trade.
3. Facilitate the creation of unit trusts vehicles for small investors.
4. Encourage establishment of specialized institutions as full security firms of underwriters and
discount houses.

▪ Lias with stock exchange brokers to advice on prices of shares to be floated to ensure that floatation is successful,
▪ In conjunction with the Stock Exchange create awareness of investment opportunities in corporate securities.
▪ Advertising & promotion to stimulate demand
▪ Remove all bureaucratic red tape in financial markets
▪ Facilitate wider participation by local & foreign investors
▪ Encourage institutional investors e.g. incurrence companies to invest in securities to provide a stable finance market.

The capital market authority facilitates the above functions by enforcing rules and regulations affecting:-
1. Compliance by securities exchange with the admission procedure for its members
2. The conditions of eligibility for grant of license to brokers dealers
3. Procedure for admission of a license holder to any securities exchange
4. Broker/dealer conduct e.g.
▪ Requirements for broker or dealer independence i.e
i. Act without entering into formal or informal agreements with members of the same securities exchange, in relation to
trading activities.
ii. Execute client orders on first come, first served basis
iii. Maintain daily record of solders received from clients
iv. Exercise diligence and care so as not to misinform or misdirect customers.

▪ Desisting from prohibited dealings e.g.


i. Creating a false market in any listed security
ii. Establishing a ‘corner’ or trade where a ‘corner’ has developed in a listed security
iii. Being party to any manipulative scheme or device with respect to any listed security

5. Capitalisation and Rights Issues


▪ Approval of capitalization and rights issues. CMA’S authority for issues to maintain order and fairness in the market.
▪ Relevant information to be included in the application of capitalization and rights issues.

6. ‘Take-over offers’
▪ Are schemes involving the making of offers for the acquisition by or on behalf of a company all the share of the offered
company or such share resulting in an offers company acquiring effective control of the offered company.

Operations of Finance Markets


Finance markets operate within framework of a financial system.

Finance System
Framework that facilitates the saving and investment process
▪ Provides an efficient means of transferring/channeling funds from savers to investors
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▪ System is effective in economics for large surplus and deficit units exists (D & S of funds)

The financial system’s components can be defined as follows:-

1. Financial Instruments
Documentary evidence of obligations underlying the exchange of resources among contracting parities e.g.
▪ Government debt instruments such as treasury bonds
▪ Private debt instruments e.g. corporate bond, mortgages, commercial paper etc.
▪ Equity instruments e.g. ordinary shares, preference shares etc.
2. Financial Markets
The arenas or mechanisms by which financial instruments are traded e.g. money & capital markets,
i. Can be primary or secondary markets,
ii. Can be intermediated (direct or indirect flows between surplus & deficit units).
iii. May be organized or informal.

3. Financial Institutions and intermediaries


Institutions that create and trade financial instruments facilitate the flow of resources among market participant e.g.
commercial banks, savings and loan finance institutions.

THE FINANCIAL SYSTEM


There are Surplus Units, Intermediary Units and Deficit Units
-Indirect financing through intermediary
-Direct financing between deficit and surplus Units

Indirect financing & financial intermediaries and the financial system

Financial intermediation facilities the process by which savings by surplus units is exchanged for financial obligation
(promises to pay) of deficit units
Financial intermediation involves the:-

1. Purchase by:- financial institutions (intermediaries) of financial instruments (financial obligations of borrowing
economic unit) in financial market ( the framework in which financial instruments are traded)
2. The purchase effected with funds from savers who acquire indirect securities issued by the intermediaries

Examples of process of Intermediation


Begins with a deposit by a household of saved funds with a commercial bank, savings & loan finance or any similar financial
institutions.

The command of real resources that funds represents is transferred to the financial institution while the household depositor
receives a financial asset (a savings account referred to as an indirect security (secondary)

The financial institution may loan funds to a business to expand plant, and the financial institution holds a mortgage on the
plant.

Mortgage referred to as a direct or primary security since it is issued by one of the non-financial participants in the market
(households business or government)

Thus
Through the use of financial institutions and the securities markets the claim on real resources has been transferred from an
economic unit with a surplus resources to a unit that is deficient of resources.

Direct Financial & Financial System


There is no financial intermediation
▪ The process would be direct transfer of funds from the household sector to the business sector,
▪ The claim on real resources is transferred from (H0 to B) directly and the mortgage transferred from (B to H) sector.
▪ (H) Sector holds the mortgage (direct security or primary security)
The Financial system and the Economic system
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Financial instruments (that carry financial claim) created and traded in financial markets by financial institutions have to
ultimately be seen to constitute financial resources (money)
Money is an integral and important aspect and does the basis of any economy

The function of money facilitates an effective and efficient economic system.

The financial system itself operates within an economic system. Money serves as:
1. A medium of exchange:- Facilitate exchange
2. A unit of account:- Is a measure of value
3. A store of value:- Basis of savings and investments
4. Standard of differed payments:- Payment can be postponed while real resources are relieved now.

Thus
Operations of financial markets are a function of participants and financial instruments

1.
Financial institutions as intermediaries and participants Financial instruments created by financial institutions
and traded in the market
Commercial banks Checking account
Savings and loan finance Savings account
Deposit banks Certificate of deposit
Investment banks Loans/debentures
Insurance Companies Government bonds
Investment and Unit trusts Mortgages
Pension funds Corporate bonds
Pension funds Shares, stocks etc.

2. Fundamental Non-financial participants which deal with the above


-Business units
-Government departments
-Household/individuals

GOING PUBLIC
When a Private Limited company or an utilized public company decides to seek a stock exchange listing for their securities,
they are said to go public
 Public Limited Companies,
 Allowed to attract public money for financing

Motivations for going public


1. A listing gives a company access to:
▪ Additional sources of capital
▪ Flexibility in raising capital
▪ More favourable terms
▪ Major sources of finance include insurance companies, pension funds investment trusts etc.
2. Listing makes a company marketable
▪ Market value of shares readily established
▪ Shares freely bought & sold/transferable
▪ Facilitates liquidation of investments at will
3. Tax liability easily determined e.g. capital gains (where applicable) as well as withholding tax.

4. Listed companies enjoy certain concession from government e.g. tax relief, holidays etc.

5. Facilitates take over bids


▪ Company market value can be easily determined
6. Enhances the perceived strength of financial standing
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▪ Obtaining a listing is costly and time consuming
▪ Many huddles have to be passed to qualify
▪ Only strong and successful companies can pass for listing
▪ Major sources of finance include insurance companies, pension funds investment trusts etc.

7. Shareholders in liased companies get preferential treatment in terms of tax concession e.g. capital gains, and transfer
taxes.

8. Improved company image nationally and internationally (see closed companied)


▪ Ability to attract both local and foreign investments
▪ Quoted companies are open up-to-date information on value of share prices as quoted in the stock exchange.
▪ Comparative information (past ratios) on performance vis-à-vis other companies in same industry (industry average)
Demotivations
1. Underdeveloped secondary market
▪ Absence of private investors, institutional investors etc
2. Tax regime and rates
▪ Capital gains, transfer etc.
3. Stock exchange requirements may be prohibitive – see prospectus and listing agreement
▪ Rules and regulatory regime of stock exchange and capital markets authority e.g. track record disclosure obligation
– desire to remain closed companies.

4. Potential loss of control


▪ Dilution by general/public owner-ship
▪ Fear of potential undesirable take over bid by competitors
5. Cost going public heavy. Only strong and successful companies can manage the costs of going public both explicit and
implicit, including formalities.

6. Stock Exchange crash can have devastating effect on listed companies


▪ Social, political and economic activity can destabilize stock exchange activity.
▪ Loss of value of securities.
Methods of Issue
Securities may be brought to the stock exchange by any of the following methods:-

1. A Prospectus Issue/Public Issue


▪ An offer by the company of its own securities to the public for subs
▪ A company would normally be issuing new shares and offering them direct to the public
▪ Enormous formalities and costs involved
▪ Used by established companies when raising substantial amounts of funds to rationalize floatation costs.
2. An Offer for Sale
▪ An offer to the public by an issuing house or broker of securities already in issue or for which they have agreed to
subscribe.
▪ Shares usually sold to one single investor e.g. institutional investor who is in business of investing in shares of other
companies e.g. investment trust.
▪ Can retain or sell the shares

▪ Method used when an issuing house or broker is better known to the public than the company whose share are being
sold.

3. Offer for Sale by Tender


▪ Several institutional investors will be involved
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▪ Securities sold to highest bidder

4. Private Placing/a Placing


▪ Stock balance placing – coming to market for 1st time
▪ Sale of obtaining subscriptions for securities by an issuing house or broker through the market and to or by their
own clients.
▪ Used where demand for securities is not likely to be significant
▪ Cuts down costs of general floatation e.g. underwriting
▪ Sale directed to specific investors.
5. An Introduction / Stock Exchange Introduction
▪ Used when no marketing arrangements are required
▪ The securities to be listed are already widely held and their marketability can be assumed.
▪ A listing may be obtained from the stock-exchange to facilitate the sale of shares by major share holders without the
company being involved in raising new capital
▪ The company may not be having a listing in the stock exchange.

 Introduction used when


i. Securities are already issued in another stock exchange
ii. An unlisted company fulfils the SE council’s requirements for marketability
iii. The exercise of options or warrants to subscribe for securities
iv. Relates to share warrants issued together with bonds to make debt attractive

6. A Rights Offer
To holders of securities, which enable them to subscribe cash for securities in proportion to other existing holdings.

7. Capitalisation Issue / Script Issue / Bonus Issue


▪ To holders of securities by which further securities are credited as fully paid up out of the company’s reserves in
proportion to existing holdings.
▪ Does not involve any monetary payments.
▪ Share issue made in order to change the ‘nominal’ issue capital without raising new finance.
Example: Suppose that a company’s balance sheet includes the following data (book value):

Authorized Capital Kshs.


1,000,000 ordinary shares of Kshs. 10 each 10,000,000

Issued capital
100,000 ordinary shares of Kshs.10 each fully paid 1,000,000

Undistributed earning 4,000,000

Total share holders interests 5,000,000

Given that the company’s market capitalization is Kshs.2 million each share has a current market price of Kshs.20.

If the company makes a capitalization / script issue of four shares for every share held, the issued capital section of the
balance sheet would be as follows:-

Issued Capita Kshs.


500,000 ordinary shares of Kshs.10 each fully paid 5,000,000
Undistributed earnings -
Total shareholders interests 5,000,000

Effects of Script Issue on Market Capitalisation and Market Share Price


▪ The market price of each share would be Kshs.4 rather than Kshs.20.
▪ But cash shareholder would have five shares of Kshs.4 instead of one share of Kshs.20.
▪ Capitalisation issue ought to have itself no effect on total market capitalization of the company.
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But
The division of share capital into smaller – value units might be expected to increase marketability of share and hence
beneficial affection share price.
▪ As capitalization issue often proceeds improved performance the market often takes such an issue as a signal of
improvements so that expectations and price rise.

Share Split & Share Consolidation


A share split is another very way of changing the share capital of a company but without converting undistributed earning
into share capital.
▪ Existing shares are divided into smaller denominations. Share consolidation is the reverse process, in which existing
shares are amalgamated to produce fewer of larger nominal value.
▪ No change in the market value is implied by either splits or consolidations, except to the extent the market attaches a
value to any resulting change in marketability.

8. Rights Issue – Cont.


The stock exchange’s listing agreement requires that a listed company seeking to raise additional equity capital must first
offer the new shares to existing shareholders, unless the company in general agrees otherwise hence the ‘rights’
allotment.

Once the allotment letters have been sent to existing shareholders, a shareholder can take any of the three options.

9. Ignore the ‘rights’ allotment


Rights ‘shares’ are sold for the benefit of all shareholders (provided the number of shares is small relative to the issue)

Hence
▪ Number of shares held remains the same.
▪ Percentage of equity falls
▪ Market value of holding falls
10. Take up Rights
▪ Increased shareholding
▪ Percentage of equity unchanged
▪ Market value of holding increase
THE NAIROBI STOCK EXCHANGE
The Nairobi Stock Exchange was established in 1954 as a voluntary association of stockbrokers registered under the societies
Act. It is a model for the emerging markets in Africa in view of our high returns on investment and a well developed market
infrastructure. Not surprisingly then, NSE is today one of the vibrant Capital Markets in Africa.

Kenya companies and investors alike, have benefited enormously from the opportunities created by economic liberalization
which has given them a clear head start to take advantage of the largest Eastern and Southern Africa Market.

You could have niche for yourself in our growth market because we understand your needs as an investor. Just to sample
what we offer.
▪ Free repatriation of capital and returns
▪ Sufficient brokerage services
▪ Up to-date market information
▪ A good financial infrastructure
▪ No exchange controls
▪ No capital gains tax, with holding final tax at 10%
▪ Government commitment to market reforms.
▪ Invest now in an economy on the threshold of take-off.
Role of Exchange in the Economy

Raising Capital for Business

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The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing
public.

Mobilising 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 commerce and
industry.

Redistribution of Wealth
By giving a wide spectrum of people a chance to by shares and therefore become part-owners of profitable enterprise, the
stock market helps to reduce large income inequalities because many people get a chance in the profits of business that were
set up by other people.

Improving Corporate Governance


By having a wide and varies scope of owners, companies generally tend to improve on their management standards and
efficiency in order to satisfy the demands of these shareholders. It is evident that generally, public companies tend to have
better management records than private companies.

Creates Investment Opportunities for Small Investors


As opposed to other business that require huge capital outlay, investing in shares is open to both the large and small 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.

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 shares
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.

Barometer of 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. Therefore the movement of share prices can be an
indicator of the general trend in the economy.

Nairobi Stock Exchange History


In Kenya, dealing in shares and stocks started in the 1920’s when the country was still a British colony. There was however
no formal market, no rules and no regulations to govern stock broking activities. Trading took place on gentlemen’s
agreement in which standard commissions were charged with clients being obliged to honour their contractual commitments
of making good delivery and settling relevant costs.

At the time, stock broking was a sideline business conducted by accountants, auctioneers, estate agents and lawyers who met
to exchange prices over a cup of coffee. Because these firms were engaged in other areas of specialization for association did
not arise. The Nairobi Stock Exchange (NSE) was constituted in 1954 as a voluntary association of stockbrokers registered
under the societies Act. This was made possible after clearance was obtained from the London Stock Exchange who
recognized NSE as an Overseas Stock Exchange. This was important because an exchange not recognized by the leading
stock exchange was of little value and credibility. The business of dealing in shares was then confined to the resident
European community since Africans and Asians were not permitted to trade in securities until after the attainment of
independence in 1963, this partly explains why it was difficult to convince the local people who had hitherto been barred
from holding Quoted Shares purely on racial grounds that this institution was a vital vehicle for handing over economic
power from foreign dominance onto local control.

At the dawn of independence, stock market activity slumped due to uncertainty about the future of independent Kenya.
However, after three years of calm and economic growth, confidence in the market was once again rekindled and the
exchange handled a number of highly over – subscribed public issues. The growth was however halted when the oil crisis of
1972 introduced inflationary pressures in the economy, which depressed share prices. A 35% capital gains tax introduced in
1975 (suspended afterwards in 1985) inflicted further losses to the exchange which at the same time lost its regional character
following the nationalization, exchange control and other inter territorial restrictions introduced in neighbouring Tanzania and
Uganda. For instance in 1976 Uganda compulsory acquired a number of companies which were either quoted or subsidiaries
of companies quoted on the Nairobi
Stock Exchange.
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In the 1980’s the Kenyan government realized the need to design and implement policy reforms to foster sustainable
economic development with an efficient and stable financial system. In particular, it set out to enhance the role of the private
sector in the economy, reduce the demands of public enterprises on the exchequer, rationalize the operations of the public
enterprise sector to broaden the base of ownership and enhance capital market development. In 1984 the IFC/CBK study
(“development of Money and Capital Markets in Kenya”) became a blueprint for structural reforms in the financial markets.
This culminated in the formation of a regulatory body “The Capital Markets Authority” (CMA) in 1989, to assist in the
creation of a conducive environment for growth and development of the country’s capital markets.

In 1991, the NSE was registered under the Companies Act and phased out the “Call Over” trading system in favour of the
floor based Open Outcry System. In the last two years the Nairobi Stock Exchange has also embarked on an extensive
modernization exercise including a move to more spacious premises at the Nation Centre in July 1994. The facilities include
modern information centre. Computerization has also been enhanced and with increasing trading volumes, electronic trading
will soon become feasible. Trading take place on Mondays through Fridays between 10:00a.m to 12:00 noon. Today the NSE
is one of the most active capital markets in Sub-Saharan Africa. As at 31 December 1995, market capitalization stood at
Kshs.106 billion (us$ 2 billion) making it the third largest stock exchange in Africa after Johannesburg and Morocco. Some
62 million share valued at Kshs.3.34 billion (US$62 million) were traded giving a turnover ratio of 3.3%.

In the year 1995, the Kenyan Government also ralxed exchange in locally controlled companies subject to an aggregate limit
of 20% and an individual 2.5%, these were doubled to 40% and 5% respectively in June 1995 budget to help encourage
foreign portfolio investments. A series of incentives are in place to encourage investments in the Nairobi Stock Exchange.
Favourable tax regime exempts listed securities from stamp duty, capital gains tax and value added tax. Withholding tax on
dividends is low at 5% for residents and 10% for non-residents. The entire Exchange Control Act was repealed in December
1995. The number of stockbrokers has also grown steadily to twenty from the original six (one still survives) at its inception
1954. Commission rates that were once among the highest have also come down considerably from 2.5% and 1% on a sliding
scale for equities and 0.05% for all fixed interest securities for every shilling.

The Nairobi Stock Exchange is poised to play an increasingly important role in the Kenyan economy especially in the
privatization of the state owned enterprises. In the last ten years, 9 public enterprises have been privatized successfully
though the Nairobi Stock Exchange where the government has raised about Kshs. 5 billion. The privatization process started
in 1988 when the government floated 7.5 million shares (20% equity) of Kenya Commercial Bank. The issue was
oversubscribed 2.3 times! Subsequent issues also proved highly popular with subscription rates being as high as 400%. In the
privatization of Kenya Airways for example, the stock exchange enabled more than 110,000 shareholders to acquire a stake in
the airline. The exchange has enabled the country to receive over US$ 50 million during the last one and half years in form of
foreign portfolio investments.

Nairobi is already being transformed into an important financial centre in the African region. Financial infrastructure is by far
superior than the neighbouring countries and the NSE continues to host a number of nationals from the region who visit the
exchange on learning missions. Officials from Botswana, Namibia, Lesotho, Zambia, Malawi, Tanzania, Uganda and
Ethiopia have in the recent past visited the NSE. The biggest challenge the NSE faces is to increase the turnover ratio
currently standing at only 3%. For the foreseeable future, the exchange will have to be driven by local investors who are now
being targeted by a public education campaign conducted by the exchange through brochure, radio and TV programmes,
seminars and group presentations.

Trading Session
Until otherwise determined by the Board of the Exchange, trading shall be limited to daily sessions on the days and time
stated here under:-
Days: Mondays to Fridays
Time: 10:00 a.m. to 12:00 noon
Except on Public Holidays or any other closure approved by the Board. All trading sessions will be commenced and closed
after the bell is rang by the authorized official of the exchange at exactly 10:00 a.m. and 12:00 noon respectively by the clock
in the Trading Floor.

The trading times can be varied at anytime by an authorized official of the exchange: If this variation will be in the greater
interests of the market.

Where in the opinion of the Chiefs Executive circumstances exist or are about to occur that could result in other than the
transparent, fair and orderly trading of the listed securities, he may, in consultation with the Board or in its absence the
chairman and any two members of the trading Committee, suspend trading for one or more sessions or any part of a trading
session.

Prepared by Mr. Johnbosco Kisimbii

74
No transactions will be executed after the trading session is closed. Trading information including dates, prices, quantities,
lost etc appearing on both the trading boards and trading slips shall not be altered after the close of trading except with the
express authority of the exchange.

The Nairobi Stock Exchange deals in both variable income securities and fixed income securities. Variable income securities
are the ordinary shares that have no fixed rate of dividend payable, as the dividend is dependent upon the profitability of the
company and what the board of directors decides.

The fixed income securities include preference shares, debenture stocks, municipal and Government stocks – these have a
fixed rate of interest/dividend that is not dependent on profitability.

Listed Companies on the Nairobi Stock Exchange


Agricultural Sector

1. Brooke Bond (K) Ltd*


2.

Prepared by Mr. Johnbosco Kisimbii

75

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