FINANCIAL INSTITUTIONS AND MARKETS

INTRODUCTION

• Financial markets refer to an elaborate system of the financial institution

and intermediaries and arrangement put in place and developed to facilitate
the transfer of funds from surplus economic units (Savers) to deficit
economic units (investors) Financial market refers to where financial assets
are traded. It facilitates borrowing and lending by facilitating the sale by
newly issued financial assets.
• Financial markets are critical for producing an efficient allocation of capital
which contributes to higher production and efficiency for the overall
economy as well as economic security for the citizenry as a whole. Financial
markets also improve the lot of individual participants by providing
investment returns to lender-saver and profit and / or use opportunities to
borrower - spenders
 Characteristics of a good financial market
• Providing timely and accurate information: This is necessary for
determining appropriate price
• Liquidity: The ability to sell or buy an asset quickly at a known price.
• Price continuity: Price do not change much from one transaction to the
next unless substantial new information becomes available. A continuous
market without large price changes between trades is a characteristic of a
liquid market
• Low transaction cost: Efficient market is one which the cost of the
transaction is minimal this attribute is referred to as internal efficiency.
FINANCIAL MARKETS – FLOW OF FUNDS
 Significance of financial markets and financial institutions
• Financial markets are crucial in the economy; They channel funds from
savers to the investors thereby promoting economic efficiency. In
return market activity affects personal wealth , the behaviour of
business firms and economy as whole.
• Financial institutions on the other hand are the corporations,
organizations and networks that operate the so called “market places”
• The financial markets and the financial institutions can be simply
referred to a structure of the financial system that helps get funds
from savers to investors.
• Financial markets and institutions are the cornerstones of the overall
financial system in which financial managers operate. Individuals,
corporations and government use both for financing
 Main components of a financial system in an economy
• Financial markets: Facilitate the flow of funds in order to finance investments
by corporations, government and individuals
• Financial intermediaries/Institutions: These are the key players in the financial
markets as they perform the function intermediation and thus determine the
flow of funds
• Financial regulators: Perform the role of monitoring and regulating the
participants
• Financial infrastructure: the set of institutions that enables effective operation
of financial intermediaries and financial markets including such elements as
payment systems, credit information bureaus and collateral registries.
• Financial instruments
 Functions of the financial system
• Mobilise and allocate savings: Linking the savers and investors to mobilise
and allocate the savings efficiently and effectively. (Capital allocation)
• Monitor corporate performance: exchange of goods and services and
transfer of economic resources through time and across geographic regions
and industries. The clearing and settlement mechanism of the stock markets
is done through depositories and clearing operations (Monetary function)
• Optimum allocation and reduction of risk: by framing rules to reduce risk
by laying down the rules governing the operation of the system. This is also
achieved by holding of diversified portfolio
• Disseminate price related information: This acts as an important tool for
taking economic and financial decisions and take an informed opinion about
investment, disinvestment, reinvestment or holding of any particular asset.
 Functions of the financial system CONTINUED…

• Offer portfolio adjustment facility : Services of providing quick, cheap and

reliable way of buying and selling a wide variety of financial assets
• Lower the cost of transactions: This is achieved when the operations are
through and within the financial structure
• Promote the process of financial deepening and broadening. Financial
deepening refers to an increase of financial assets as a percentage of GDP.
Financial depth is an important measure of financial system development
as it measures the size of the financial intermediary sector. Financial
broadening on the other hand refers to building an increasing number of
varieties of participants and instruments
 FINANCIAL INSTITUTIONS REGULATION
• In the current structure, the firm’s legal status (bank broker or insurance
company) determines which regulator is responsible for supervising its
activities.
• There are five key agencies and regimes for prudential regulation
Central bank of Kenya (CBK) for banks and payments settlement
Insurance Regulatory Authority (IRA) for insurance
The Capital Markets Authority (CMA) for capital markets
Retirement Benefits Authority (RBA) for pensions
SACCO Societies Regulatory Authority (SASRA) which has been
mandated to licence and suspense SACCOs
 Financial system
An efficient financial system:
• Encourages savings
• Savings flow to the most efficient users
• Implements the monetary policy of governments by influencing interests
rates
• Ensures a combination of assets and liabilities comprising the desired
attributes of return, risk, liquidity and timing of cashflows
 The matching principle
• Short term assets should be funded with short term liabilities i.e inventory
funded by overdraft
• Long term assets should be funded with equity or long term liabilities i.e
equipment funded by debentures
 Matching principle explained
• In primary markets users of funds raise funds by issuing financial
instruments such as stocks and bonds whereas in secondary markets is
where financial instruments are traded amongst investors
• Money markets trade debt securities with maturities of one year or less i.e
treasury bills whereas capital markets trade debts and equity instruments
with maturities of more than one year.
• Foreign exchange markets deal in trading one currency for another. The
“spot” FX transaction involves the immediate exchange of currencies at the
current exchange rate whereas the “forward” FX transaction involves the
exchange of currencies at a specified date in the future and at a specified
exchange rate.
• Derivative security market deal with derivative security that involve
agreement between two parties to exchange a standard quantity of an asset
at a predermined price on a specified date in the future.
 Types of financial institutions

• Commercial banks: Depository institutions whose major assets are loans and
major liabilities are deposits commercial banks are the most dominant
depository institutions. They offer a wide range of deposit accounts. They
transfer the deposits to deficit units through loans, advances, overdrafts,
letter of credit, letter of guarantee and they can also buy debt securities.
Commercial banks serve both private and public. Their services are utilised
by households, businesses and government.
• Thrifts/Saving institutions: Depository institutions in the form of saving and
loans, credit unions. They include savings and loans(S&L) and savings
banks. Like commercial banks, S&L offer depository facilities to surplus units
they then channel these surplus to deficit units. S&L concentrates on
residential mortgage loans unlike commercial banks who concentrate on
commercial loans
 Types of financial institutions continued…
• Credit unions/ Savings and credit organisations: These institutions differ
from commercial banks and savings institutions in that they are:
Nonprofit making organization
Restrict their credit to the credit union members who share a common
bond e.g common employer, common business, common geographical
location. They use most of their funds to advance loans to their members
• Financial companies: Financial institutions that make loans to individuals
and businesses. Most finance companies obtain funds from issuing
securities then lend the money to individuals and small businesses.
Although the functioning of finance companies overlap those of
depository institutions, each type of institution concentrates on a
particular segment of the financial market.
 Types of financial institutions continued…

• Mutual funds: financial institutions that pool financial resources and

invest in diversified portfolios. The Kenyan capital market is still in its
infancy and such companies are not very common. Some mutual funds
concentrate their investment in capital market securities such as stocks or
bonds. Others known as money market mutual funds concentrate in the
money market securities.
• Insurance companies: Financial institutions that protect individual and
corporations from adverse events. They provide insurance services to
individuals and other firms that reduce the financial burdens associated
with the death illness and damage to properties including theft. Insurance
companies charge premium which is invested mainly in stocks or bonds
that facilitate payment of risks insured when an eventuality demands so
 Types of financial institutions continued…
• Pension funds: offer savings plans for retirement. The working population know very well
that their energy to work is limited. To guard themselves against the eventuality,
employers and employees save for old age where they contribute periodically. Such funds
are available after retirement. The pension funds manage the funds until they are
required. The money saved in normally invested in securities and bonds issued by
corporations and governments. This way the pension savings are used to finance the
deficit units thus acting as intermediaries
• Securities firms and investment banks: Financial institutions that underwrite securities
and engage in securities brokerage and trading. Securities firms use their information
sources to act a brokers executing transactions between two parties. In order to ease the
securities trading process the transactions are normally in multiples of 100 shares and the
delivery procedure is somewhat standard. Brokers earn their profits by charging a
brokerage fee by differentiating between bid and asking prices. Small or unique
transactions are likely to have a higher commission due to time taken to complete the
transactions. They also provide investment banking services. They underwrite new issues
for government and private companies and also advisory services on mergers and other
forms of corporate restructuring.
 Direct and intermediated financial flows

• Direct flow markets: Users of funds obtain finance directly from savers
Advantages
• Avoid cost of intermediation
• Increases range of securities and markets
Disadvantages
• Matching of preferences
• Liquidity and marketability of a security
• Search and transaction costs
• Assessment of risk, especially default risk
 Direct and intermediated financial flow markets continued

• Intermediated flow markets : A financial arrangement involving two

separate contractual agreements whereby saver provides funds to
intermediary, then the intermediary provides funding to the ultimate user
of funds
Advantages
• Asset transformation
• Maturity transformation
• Credit risk diversification and transformation
• Liquidity transformation
• Economies of scale
 Sectorial flow of funds

• The flow of funds between business, financial institutions, government

and household sectors and the rest of the world
• This is majorly influenced by the fiscal and monetary policy
 Services performed by financial intermediaries to individuals

• Monitoring costs
• Liquidity and price risk
• Transaction cost services
• Maturity intermediation
• Denomination intermediation
 Services provided by FI benefiting the overall economy

• Money supply transmission

• Credit allocation
• Intergenerational wealth transfers
• Payment services
 Risks faced by financial institutions

• Foreign exchange risk

• Market risk
• Credit risk
• Liquidity risk
• Off balance sheet risk
• Technology risk
• Operational risk
• Insolvency risk
 Factors leading to significant growth in the foreign markets
• The pool of savings from the foreign investor has increased
• Information on foreign investments and markets is now more accessible
• Some mutual funds allow ability to invest in foreign securities with low
transaction costs
 Impact of globalisation to financial markets
• This refers to the interdependence of national financial systems
• Global standardisation of financial instruments
• Facilitates the movement of funds between saver and borrowers in
different countries
• Financial markets became more global as the value of stocks traded in the
foreign market soared
• Foreign bond markets have served as a major source of international
capital
• Globalisation is also evident in the derivative securities market.
 Money markets and instruments
• These are used to obtain short-term funds. The instruments in this market
include:
• Treasury bills
• Commercial paper
• Repurchase agreements
• Certificates of deposits
Treasury bills
These are sort term obligations issued to cover current shortfalls and
refinance maturing government debts. They are also used by the central
bank as a tool in conducting monetary policy through market operations.
 Money markets and instruments continued

• The T-bills generally are 91, 182 and 364 days in terms of maturity. The
minimum allowable denomination is Ksh. 50,000 from a previous
minimum of Ksh. 100,000.
• T-Bills are generally considered to be free of default risk because they are
obligations of the government of Kenya.
• T-Bills are highly liquid.
 Repurchase agreements

• Is an agreement involving the sale of securities by one party to another

with a promise to repurchase the securities at a specified price and a
specified date in future. The repurchase agreements are essentially
collateralized central bank loans, with the collateral being in form of T-
Bills.
• A reverse repurchase agreements is an agreement involving the purchase
of securities by one party with the promise to sell them back at a given
date in future.
 Commercial papers

• Is an unsecured short-term promissory note issued by a corporation to raise

short-term cash often to finance working capital requirements. Commercial
papers is the largest money market instruments used by corporations. It is
used by firms with strong credit ratings to borrow at a lower interest rates from
banks directly.
• Commercial papers are usually sold in denominations of mostly Ksh.100,000.
The maturity period generally range from one day to 270days
Market for commercial papers
• Commercial papers can be sold directly by a corporation to the buyers mostly
large institutional investors such as mutual funds and pension funds (Direct
placement)
• The investors in commercial papers are generally commercial banks, insurance
companies, mutual funds, pension funds and non financial business.
 Commercial papers continued

• Commercial paper is not actively traded and it is unsecured debt.

Therefore the credit rating of the issuing firm is therefore very important
in determining the marketability of a commercial paper issue. Credit
rating provides potential investors with information regarding the ability
of the issuing firm to repay the borrowed funds. General credit rating
firms include standards and poors , fintch and moodys.
• Commercial papers can also be sold indirectly through brokers and
dealers. This is quite expensive to the issuer because of the underwriting
cost
 Negotiable certificate of deposit

• A negotiable certificate o deposit is a bank issued security that documents

a time deposit and specifies the interest rate and maturity date. Because
the maturity date is unspecified, a certificate of deposit is a term security.
A negotiable Cd is a bearer instrument, meaning whoever holds the
security at maturity receives the principal and interest.
Terms of negotiable certificate of deposits
Negotiable CDs have denomination ranging $10,000 to $1,000,000 making it
too large for individuals to buys. They are mostly purchased by money
market funds. Negotiable CDs have a maturities from two weeks to one year
with most having a maturity of one month to four months.
 Bankers Acceptance
• This is an order to pay a specified amount of money to the bearer on a
given date. They are used to finance goods that have not yet been
transferred from the seller to the buyer. A bankers acceptance is a time
draft. i.e a Kenyan construction firm wants to buy a bull dozer from
komatsu in Japan. Komatsu does not want to ship the bulldozer without
cash because Komatsu has never heard of the Kenyan Company. Similarly
the Kenyan firm is reluctant to send money to Japan before the arrival of
the equipment. A bank can come in through a bankers acceptance to
facilitate the transaction.
• Bankers acceptance are important to international trade
• Low interest rates because default risk is low
• The exporter does not have to access the creditworthiness of the importer
because bankers acceptance guarantees payment
 International monetary fund
• IMF was set after second world war to facilitate borrowing facilities for
nations having deficits.
The major objectives of the IMF includes:
• To promote cooperation among countries on international monetary
issues
• Promote stability in exchange rates
• Provide temporary funds to member countries attempting to correct
imbalances of international payments
• To promote free trades.
• In summary international monetary fund key objective is to encourage
increased internationalization of business.
 World Bank
• The international Bank for Reconstruction and development also referred
to as world Bank was established in 1944. The primary objective of the
world Bank is to make loans to countries in order to enhance economic
development.
• The philosophy behind the World Bank’s objective is profit oriented.
Therefore , loans are not subsidized but are extended at market rates to
government and their agencies that are likely to make payments.
• The world Bank operates a structural adjustment Loan intended to
enhance a country’s long-term economic growth. This can be used to
improve the balance of trade of country.
 International Finance corporation
• Established in 1956 to promote private enterprise initiative within
countries. It is composed of a collection of nations as members.
• While it aims to enhance economic development, it uses the private rather
than government sector to achieve its objectives. It does not only provide
loan to corporations but also purchase stock, thereby becoming a part
owner in some cases rather than a creditor.
• The IFC provides 10 to 15% of the necessary funds in the private
enterprise projects in which it invests and the remainder of the projects
must be financed through other sources. In this the IFC act as a catalyst as
opposed to a sole supporter for private enterprise development projects.
• IFC has traditionally obtained financing from the World Bank but can
borrow within the international financial markets.
 Contemporary issues and innovation in financial sector
• The financial sector is experiencing an era of rapid innovations. The
changes are fuelled by rapid improvements in data processing and
telecommunication.
• The financial sector being highly regulated in Kenya, technological
improvements and innovations are almost always healthy and beneficial
for an economy; However, they can place serious strains on the
incumbents in a particular industry or sector on which they are focussed
thus creating challenges
 Challenges in the financial sector
• Printing fake currency as a result of advanced technology and innovations
• Frauds and forgery as a result of advanced technology
• Rapid/rivalry competition amongst institutions
• Threat of new entrants in the industry
• The bargaining power of the savers resulting to decline of minimum
amounts to open accounts
• Threats of substitute products and services from other institutions
• Therefore financial institutions must make innovations to transform
resources into proper serviced that people want. JIT can be applied in
order to be competitive.
 Contribution of financial sector to the economy
• Improving the economic, social and cultural situation of persons of
limited financial resources and encourage their spirit of initiative
• Increase personal National capital resources encouraging thrift and sound
of credits.
• Contribution to the economy an increased measures of democratic control
of economic activity and equitable distribution of surplus resources
• Increased national income, export revenues and employment by proper
utilization of revenues
• Helping to raise the level of general and technical knowledge for the
customers through seminars and workshops and advertisements through
brochures