Learning Guide: Accounting Department Basic Accounting Works Level Ii

Rift Valley University Nekemte Campuse
Training, Teaching and Learning Materials
ACCOUNTING DEPARTMENT
BASIC ACCOUNTING WORKS LEVEL II
Learning Guide
Unit of Competence: Develop Understanding of the
Ethiopian
Financial System and Markets
Module Title: Developing Understanding of the
Ethiopian Financial System and Markets
LG Code: BUF BAW2 06 0812
CONTENTS PAGE
INTRODUCTION…………………………………………………………………… 3
LO1………………………………………………………………………… 4
Describe what is meant by the Ethiopian financial markets
 financial markets in Ethiopia
 The purpose of financial markets
 participants in the financial markets
LO2 ………………………………………………………………………… 11
Explain the function and role of the National Bank of Ethiopia (NBE)
 role of the NBE
 The importance and effect of the NBE's monetary policy
LO3 … …………………………………………………………………..… 14
Explain Ethiopia's monetary system
 functions of money
 motivations for holding money
instruments traded on the short term money market
The impact of increases and decreases in the money supply
LO4 … …………………………………………………………………..… 20
Explain the key factors that influence the Ethiopian economy
 The role and impact of global market situation
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Complaid By:-Segni Diriba Accounting
Department
 The impact of a change in domestic interest rates

 The impact of changes in consumer activity
LO5 … …………………………………………………………………..… 24
Describe the role of regulators
 The main regulator of the financial system
 The role of each regulator in protecting investor
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LO1 Ethiopian financial markets

1.1. Specific financial markets in Ethiopia are identified and discussed
1.2. The purpose of financial markets and when they emerged in Ethiopia is
researched and discussed
1.3. The participants in the financial markets and the roles of banks and financial
institutions as financial intermediaries are identified and their roles analyzed and discussed
Specific financial markets in

Information Sheet – 1
Ethiopia
Financial system in today’s world is perhaps the most important system among all the systems as
all the economics of the world have become interlinked it has become a very complex system.
The financial system in it includes all whether its banks or stock market or financial institutions.
Let’s see some of the important functions which are performed by the financial system –
1. The first and foremost function which financial system perform is the channelization the
savings of individuals and making it available for various borrowers which are the companies
which take loan in order to increase the production of goods and services, which in turn increases
the overall growth of the economy.
2. It is with the help of financial system that one can make payment whenever and wherever he
or she wants with the help of checks, credit card and debit card. In the absence of financial
system one has to take cash wherever he or she goes which would have been impossible.
3. Financial system also provide an individual various options when it comes to protecting
against various risks like risk arising from accidents, health related, etc… through various life
insurance options.
4. Financial system also makes sure that one can liquidate his or her savings whenever he or she
wants it and therefore individuals can have both the things, which involve return on investments
as well as comfort that they can liquidate their investments whenever they want.
5. All transactions whether they involve individual buying house or a big company coming with
an initial public offer they are effected smoothly because of financial system.
Functions performed by a financial system are :
 Saving function: Public saving find their way into the hands of those in production
through the financial system. Financial claims are issued in the money and capital
markets which promise future income flows. The funds with the producers result in
production of goods and services thereby increasing society living standards.
 Liquidity function: The financial markets provide the investor with the opportunity to
liquidate investments like stocks bonds debentures whenever they need the fund.
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 Payment function: The financial system offers a very convenient mode for payment of
goods and services. Cheque system, credit card system etc are the easiest methods of
payments. The cost and time of transactions are drastically reduced.
 Risk function: The financial markets provide protection against life, health and income
risks. These are accomplished through the sale of life and health insurance and property
insurance policies. The financial markets provide immense opportunities for the investor
to hedge himself against or reduce the possible risks involved in various investments.
 Policy function: The government intervenes in the financial system to influence
macroeconomic variables like interest rates or inflation so if country needs more money
government would cut rate of interest
The purpose of  enabling participants to invest surplus funds by buying

financial markets securities
includes:  enabling participants to raise required funds by issuing
securities
The Importance and Limitations of Financial Markets
I would like to begin by discussing the role of the financial system and why it is different from
other sectors of the economy. Individual entrepreneurs rarely have enough of their own capital
to undertake investments themselves. Individual savers, without pooling their money, would not
be able to take advantage of the potential increasing returns to scale of their investments, and
would face a large degree of risk with little liquidity. The financial system – including banks
and other financial intermediaries, equity markets, and debt markets – solves these problems by
agglomerating capital from many smaller savers, allocating capital to the most important uses,
and monitoring to ensure that it is being used well. At the same time, the financial system
transfers, pools, and reduces risk, increases liquidity, and conveys information.
Well-functioning financial systems do a very good job of selecting the most productive
recipients for these resources and ensuring that they are using them in high return activities. In
contrast, poorly functioning financial systems often allocate capital in low-productivity
investments. The differences in terms of growth and total factor productivity can be enormous.
http://www.worldbank.org/html/extdr/extme/jssp062998.htm 20:11:52 11.10.02
The Role of the Financial System in Development (Speech) Seite 2
In introductory economics courses we are taught to use demand and supply diagrams to analyze
markets for apples and bananas. We are also taught that, provided there are no externalities, the
competitive price is efficient. Some go on to apply this theory to financial markets, looking at
the supply of funds, the demand for funds, and the market clearing interest rate. This simplistic
theory is the basis for the belief that financial markets need to be fully liberalized from the
"interference" of governments. Unfortunately, this framework makes little sense in approaching
finance, which is concerned with the exchange of money today for the promise of repayment.
Given the existence of uncertainty and the lack of complete futures markets, this intertemporal
transaction entails risks, especially the risk of bankruptcy. Information about these risks – both
about the type of borrower and the actions he or she undertakes after borrowing the money – is
essential.
The fundamental theorems of welfare economics, which assert that every competitive
equilibrium is Pareto efficient, provide no guidance with respect to the question of whether
financial markets, which are essentially concerned with the production, processing,
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dissemination, and utilization of information, are efficient (Greenwald and Stiglitz 1986). On
the contrary, economies with imperfect information or incomplete markets are, in general, not
Pareto efficient; there are feasible government interventions that can make all individuals better
off.
These are not just academic details. Governments play a large role in all of the most successful
financial markets. Wall Street, the international emblem of free markets, is one of the most
highly regulated markets in the United States. But let me also be clear: this observation should
not be the basis for the government to take over the financial system. History does not offer
many examples of highly successful economies that did not accord the market a central role in
the allocation and monitoring of capital. Theoretically, the case for a government run economy
rests on the same highly restrictive assumptions as the case for a purely free market economy,
notably the assumption that there is perfect information (Stiglitz 1994b). Governments are
often at an even bigger informational disadvantage than the market, and can suffer from more
serious principal-agent problems.
I would like to illustrate the importance of these informational problems by discussing the three
most important forms of capital: equity, long-term loans, and short-term loans. This discussion
will form the basis of my discussion of the role of financial markets in macroeconomic
fluctuations and growth.
Equity
Equity has several advantages. It allows companies to share risks with their investors. There is
no fixed obligation to repay and the value of the equity investment itself varies with the
condition of the firm. Unlike debt, equity does not encourage companies to take excessive risks.
With debt, a company gets the full benefit of the upside realization of the risk, while the
marginal cost of bad realizations is limited. In contrast, the risk incentives are more aligned
with equity.
Despite these advantages, in most countries equity is a trivial source of new finance, and net
issuance of equity has actually been negative in the United States and United Kingdom over the
past decades. While equity markets are a relatively more important source of finance in many
emerging economies, they are still much smaller than bank finance or retained earnings. Equity
also plays a smaller role in international flows. In 1997, $33 billion worth of net long-term debt
flowed into Latin America compared to $16 billion in portfolio equity investment (World Bank
1998).
The reason for the pervasiveness of what I shall call "equity rationing" is that the new issuance
of equity tends to have a negative impact on the valuation of the firm (Asquith and Mullins
1986).
From the perspective of imperfect information, the reason for this is clear. Equity gives rise to
serious adverse selection and moral hazard problems. The adverse selection problem is that
those entrepreneurs who are most willing to sell shares in their firms include those who believe,
or know, that the market has overvalued their shares. If I put up 1 percent of the contents of my
wallet for auction, without showing you the wallet and while reserving the right to refuse low
bids, there is no way you could end up making a profit. There are, of course, good reasons for
issuing equities: risk averse individuals with good investment projects, requiring more capital
than they have will also issue shares. But these individuals and firms are mingled together with
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those who see an opportunity to cash in on the markets’ ignorance. And unfortunately, the
market cannot easily distinguish among the two (see Greenwald, Stiglitz, and Weiss 1984).
The moral hazard problem results from the incentive of management to divert money from
shareholders and majority shareholders to divert money from minority shareholders (see Jensen
1986). Takeovers and other market mechanisms provide only a limited discipline for managers
and no market mechanism can protect minority shareholders (see Stiglitz 1982b and Shleifer
and Vishny 1989).
The experience of one Central European economy shows what can happen if securities markets
are left alone. In this country closed-end mutual funds were trading at 40 to 80 percent
discounts, representing the market’s assessment of the value taken away from assets by the
manager. In addition, there are large differences in the price of a "control bloc" of a company
and the price of individual shares. Both of these phenomenon happen because management and
controlling shareholders are able to "tunnel" the assets out of the firms they control (Nikitin and
Weiss 1997).
Government can help mitigate the adverse selection and moral hazard problems in securities
markets by promulgating standard accounting procedures, creating and enforcing a legal
structure that allows for well-designed contracts, establishing a securities and exchange
commission, formulating laws to protect minority shareholders against majority shareholders,
and all shareholders against fraud, and providing a balanced approach to bankruptcy. The
experience of the United States shows, however, that even with all of these legal protections,
the informational problems are so severe that equity will still play only a limited role in new
finance.
Short-term Bank Loans
With debt, the expected return incentives of suppliers and users of capital are in some respects
more closely aligned than they are with equity. Unlike with equity, an entrepreneur will not
borrow if he has secret information that his project is worthless. And the entrepreneur gets the
full marginal benefit of increased returns past the cost of repaying the loan, thus not creating
any incentive to shirk or divert revenues.
Also, banks are often in a better position to monitor firms than are equity holders (Stiglitz
1985). Because they can threaten to withdraw credit, banks have management on a short leash,
giving them considerable influence over a firm’s decisions (Stiglitz and Weiss 1983). The
possibility of bankruptcy, however, can reverse this relationship, especially when the borrower
has substantial debts to a lender, allowing the borrower to "coerce" the lender into rolling over
existing credits or even extending new ones. This provides an incentive to monitor, something
banks have a comparative advantage in, in part because there are usually only one or a few
lenders, thus reducing the "public good" problems associated with monitoring.
Although bank loans suffer less from problems of monitoring and diversion, they do create
selection and incentive problems with regard to risk. Entrepreneurs with risky projects will be
attracted to debt finance because they enjoy the full benefits of the upside risk while the
downside risk is limited to the value of their collateral. Crucially, the borrower may have more
information than the lender about the ex ante riskiness of the project and the lender almost
certainly cannot perfectly monitor the actions of the borrower to ensure that they are prudent.
As the interest rate charged increases, the "safer" applicants for loans drop out leaving a riskier
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and less desirable pool of applicants. Similarly, borrowers have more incentive to take risky
actions. As a result, banks may not raise interest rates even when there is excess demand for
credit.
The interest rate does not perform its market clearing role and the market equilibrium
may be – and frequently is – characterized by credit rationing (Stiglitz and Weiss 1981). This is
the standard result when one instrument (the price) is being used to hit two targets (or possibly
three: clearing the market, attracting the right mix of applicants, and inducing the right levels of
risk-taking and effort). Although banks typically use another instrument, such as detailed
convenants governing the behavior of the borrower, these may limit credit rationing but do not
overcome it (Stiglitz and Weiss 1986). (In effect there are a large set of admissible actions, and
even though the set of instruments is large, typically the later is insufficient to exercise perfect
control.)
Bonds
Bonds represent a halfway house between short-term loans and equity. With a bond, a firm has
a fixed commitment. It must pay interest every year, and it must repay the principal at a fixed
date. As a result, all the problems we have discussed above with loans arise with bonds.
Bonds have one significant advantage – and disadvantage. Because the lender cannot recall the
funds, even if he is displeased with what the firm is doing, the firm is not on a "short" leash, the
way it is with loans. This has the advantage of enabling the firm to pursue long-term policies –
but has the disadvantage of allowing the firm to pursue policies which adversely effect the
interests of bondholders. Bond covenants may provide some restrictions, but these generally
only foresee a few of the possible contingencies facing firms. In addition, issuing bonds may
send a signal that a firm does not want to be put on a short leash, that it is not willing to subject
its actions to the scrutiny of bankers. This may further restrain bond issuances (Stiglitz 1982a).
Primary vs. Secondary Markets
So far I have been discussing primary markets, the place where new finance is issued. But the
majority of financial market activity is in the secondary market, where equity claims and debt
are traded. Secondary markets are an important complement to primary markets, increasing
liquidity and facilitating diversification. An important development in recent years has been the
extension of securitization, which by standardizing and pooling loans has translated into lower
But secondary markets have other, less beneficial aspects. The volatility in secondary markets
is well beyond what can be explained by movements in fundamentals (Shiller 1989). One of the
most plausible explanations for this excess volatility is irrational market psychology and
bubbles. Keynes put this well when he compared secondary markets to a beauty contest, in
which each judge is not concerned with identifying the most beautiful contestant, but in
figuring out who the other judges think
speculative activity has zero or negative social value. The informational value of secondary
markets is one of their most overrated benefits. Managers usually have both a better
understanding of their own firm and private information that render the information contained
in their stock price of relatively little value. Much of the investment by financial institutions
concerns getting information earlier than other investors in order to "trick" the other investors
into buying or selling shares (Stiglitz and Weiss 1990).
A parable due to Summers and Summers (1989) illustrates this nicely. Suppose that one were to
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drop $100 bills on the floor in the middle of a large lecture. The equilibrium would be for
everyone to bend down and pick up the $100 bill at their feet, thus disrupting the lecture. A
more efficient outcome, however, would be for everyone to wait until the lecture was over,
which would allow them to pick up the same money without disrupting the lecture. This,
however, is not an equilibrium because each person worries, correctly, that their neighbor will
pick up their $100 bill. As a result, everyone makes a costly investment in getting the $100 bills
earlier – with no social benefits. The implication is that taxes on speculative activity could, in
some cases, increase the efficiency of the market by reducing transactions costs and rent
seeking.
Participants in the financial markets may include
 banks and non-banking financial institutions

 investors:
 corporations
 individuals
 local and international governments
 speculators:
 corporations
individuals.
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Explain the function and role

LO2 of the National Bank of
Ethiopia (NBE)
The role of the NBE includes:

 regulating banks and other financial institutions
 maintaining financial stability and regulating the Ethiopian Payments System
 managing government debt
 regulating the payments system
setting and implementing monetary policy
Information Sheet – 1 The National Bank of Ethiopia
The National Bank of Ethiopia is the central bank of Ethiopia. Its headquarters are in the
capital city of Addis Ababa. The bank's name is abbreviated to NBE.
History
February 15, 1906 marked the beginning of banking in Ethiopia when the first Bank of Abyssinia
was inaugurated by Emperor Menelik II. It was a private bank whose shares were sold in Addis
Ababa, New York, Paris, London, and Vienna. One of the first projects financed by the bank was
the Franco-Ethiopian Railway which reached Addis Ababa in 1917. In 1931, Emperor Haile
Selassie introduced reforms into the banking system and the Bank of Abyssinia became the Bank
of Ethiopia, a fully government-owned bank providing central and commercial banking services.
The Italian invasion in 1935 brought the demise of one of the earliest initiatives in African
banking. During the Italian occupation, Italian banks were active in Ethiopia.
On April 15, 1943, the State Bank of Ethiopia became the central bank and was active until 1963.
The National Bank of Ethiopia was established in 1963 by Proclamation 206 of 1963 and began
operation in January 1964. The establishment of the new organization was aided by U.S
Department of State emissary, Earle O. Latham, who was the first Vice President of the Federal
Reserve Bank of Boston.
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Prior to this proclamation, the Bank carried out dual activities, i.e. commercial banking and
central banking. The proclamation raised the Bank's capital to 10 million Ethiopian dollars and
granted broad administrative autonomy and juridical personality. Following the proclamation the
National Bank of Ethiopia was entrusted with the following responsibilities:
 To regulate the supply, availability and cost of money and credit.

 To manage and administer the country's international reserves.
 To license and supervise banks and hold commercial banks reserves and lend money to them.
 To supervise loans of commercial banks and regulate interest rates.
 To issue paper money and coins.
 To act as an agent of the Government.
 To fix and control the foreign exchange rates.
However, monetary and banking proclamation No. 99 of 1976 came into force on September
1976 to shape the Bank's role according to the socialist economic Principle that the country
adopted. Hence the Bank was allowed to participate actively in national planning, specifically
financial planning, in cooperation with the concerned state organs. The Bank's supervisory area
was also increased to include other financial institutions such as insurance institutions, credit
cooperatives and investment-oriented banks. Moreover the proclamation introduced the new
'Ethiopian birr' in place of the former Ethiopian Dollar that ceased to be legal tender.
The proclamation revised the Bank's relationship with Government. It initially raised the legal
limits of outstanding government domestic borrowing to 25% of the actual ordinary revenue of
the government during the proceeding three budget years as against the proclamation 206/1963,
which set it to be 15%.
This proclamation was in force till the new proclamation issued in 1994 to reorganize the Bank
according to the market-based economic policy so that it could foster monetary stability, a sound
financial system and such other credit and exchange conditions as are conductive to the balanced
growth of the economy of the country. Accordingly the following are some of the powers and
duties vested in the Bank by proclamation 83/1994.
 Regulate the supply and availability of money and credit and applicable interest and other
hanges.
 Set limits on gold and foreign exchange assets which banks and other financial institutions
authorized to deal in foreign exchange and hold in deposits.
 Set limits on the net foreign exchange position and on the terms and amount of external
indebtedness of banks and other financial institutions.
 Make short and long-term refinancing facilities available to banks and other financial
institutions.
Lastly, the proclamation has also raised the paid-up capital of the Bank from Birr 30.0 million to
Birr 50.0 million.
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The effect of the NBE's monetary policy may include:
 changes in interest rates

 flow on changes to employment, prices and production levels
 increases or decreases in the supply of money in the Ethiopian economy
 acting to avoid or minimise a systemic collapse of financial institutions
 The role of the NBE in regulating the Ethiopian Payments System may include:
 fulfilling its regulatory responsibilities by controlling risks and promoting
efficiencies
 participating in the financial system as banker to the national payment system of
government
providing facilities for final settlement of transactions
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LO3 Ethiopia's monetary system

The different functions  as a means of exchange for acquiring goods and services
of money may include:  indications of relative values between goods and services
 measure of liquidity
Information Sheet – 1 The National Bank of Ethiopia

This section discusses the main functions of financial intermediaries and financial markets, and
their comparative roles. Financial systems, i.e. financial intermediaries and financial markets,
channel funds from those who have savings to those who have more productive uses for them.
They perform two main types of financial service that reduce the costs of moving funds between
borrowers and lenders, leading to a more efficient allocation of resources and faster economic
growth. These are the provision of liquidity and the transformation of the risk characteristics of
assets.
Provision of liquidity
The link between liquidity and economic performance arises because many high return
investment projects require long-term commitments of capital, but risk adverse lenders (savers)
are generally unwilling to delegate control over their savings to borrowers (investors) for long
periods. Financial systems mobilise savings by agglomerating and pooling funds from disparate
sources and creating small denomination instruments. These instruments provide opportunities
for individuals to hold diversified portfolios. Without pooling individuals and households would
have to buy and sell entire firms (Levine 1997).
Diamond and Dybvig (1983) show how financial intermediaries can enhance risk sharing, which
can be a precondition of liquidity, and can thus improve welfare. In their model, without an
intermediary (such as a bank), all investors are locked into illiquid long-term investments that
yield high payoffs only to those who consume at the end of the investment. Those who must
consume early receive low payoffs because early consumption requires premature liquidation of
long-term investments. When agents need to consume at different (random) times, an
intermediary can improve risk sharing – by promising investors a higher payoff for early
consumption and a lower payoff for late consumption relative to the non-intermediated case.
Financial markets can also transform illiquid assets (long-term capital investments in illiquid
production processes) into liquid liabilities (financial instrument). With liquid financial markets
savers/lenders can hold assets like equity or bonds, which can be quickly and easily converted
into purchasing power, if they need to access their savings.
For lenders, the services performed by financial markets and intermediaries are substitutable
around the desired risk, return and liquidity provided by particular investments. Financial
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intermediaries and markets make longer-term investments more attractive and facilitate
investment in higher return, longer gestation investment and technologies. They provide different
forms of finance to borrowers. Financial markets provide arms length debt or equity finance (to
those firms able to access markets), often at a lower cost than finance from financial
intermediaries.
Transformation of the risk characteristics of assets
The second main service financial intermediaries and markets provide is the transformation of
the risk characteristics of assets. Financial systems perform this function in at least two ways.
First, they can enhance risk diversification and second, they resolve an information asymmetry
problem that may otherwise prevent the exchange of goods and services, in this case the
provision of capital (Akerlof 1970).
Financial systems facilitate risk-sharing by reducing information and transactions costs. If there
are costs associated with the channelling of funds between borrowers and lenders, financial
systems can reduce the costs of holding a diversified portfolio of assets. Intermediaries perform
this role by taking advantage of economies of scale, markets do so by facilitating the broad offer
and trade of assets comprising investors’ portfolios.
Financial systems can reduce information and transaction costs that arise from an information
asymmetry between borrowers and lenders.[3] In credit markets an information asymmetry arises
because borrowers generally know more about their investment projects than lenders. A
borrower may have an entrepreneurial “gut feeling” that can not be communicated to lenders, or
more simply, may have information about a looming financial risk to their firm that they may not
wish to share with past or potential lenders. An information asymmetry can occur ex ante or ex
post. An ex ante information asymmetry arises when lenders can not differentiate between
borrowers with different credit risks before providing a loan and leads to an adverse selection
problem. Adverse selection problems arise when lenders are more likely to make a loan to high-
risk borrowers, because those who are willing to pay high interest rates will, on average, be
worse risks. The information asymmetry problem occurs ex post when only borrowers, but not
lenders, can observe actual returns after project completion. This leads to a moral hazard
problem. Moral hazard problems arise when borrowers engage in activities that reduce the
likelihood of their loan being repaid. They also arise when borrowers take excessive risk because
the costs may fall more on lenders compared to the benefits, which can be captured by
borrowers.
The problem with imperfect information is that information is a “public good”. If costly
privately-produced information can subsequently be used at less cost by other agents, there will
be inadequate motivation to invest in the publicly optimal quantity of information (Hirshleifer
and Riley 1979). The implication for financial intermediaries is as follows. Once financial
intermediaries obtain information they must be able to obtain a market return on that information
before any signalling of that information advantage results in it being bid away. If they can not
prevent information from being revealed prior to obtaining that return, they will not commit the
resources necessary to obtain it. One reason financial intermediaries can obtain information at a
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lower cost than individual lenders is that financial intermediation avoids duplication of the
production of information faced by multiple individual lenders. Moreover, financial
intermediaries develop special skills in evaluating prospective borrowers and investment
projects. They can also exploit cross- customer information and re-use information over time.
Financial intermediaries thus improve the screening of potential borrowers and investment
projects before finance is committed and enforce monitoring and corporate control after
investment projects have been funded. Financial intermediation thus leads to a more efficient
allocation of capital. The information acquisition cost may be lowered further as financial
intermediaries and borrowers develop long-run relationships (Petersen and Rajan 1994 and
Faulkender and Petersen 2003).
Financial markets create their own incentives to acquire and process information for listed firms.
The larger and more liquid financial markets become the more incentive market participants
have to collect information about these firms. However, because information is quickly revealed
in financial markets through posted prices, there may be less of an incentive to use private
resources to acquire information. In financial markets information is aggregated and
disseminated through published prices, which means that agents who do not undertake the costly
process of ex ante screening and ex post monitoring, can freely observe the information obtained
by other investors as reflected in financial prices. Rules and regulation, such as continuous
disclosure requirements, can help encourage the production of information.
Financial intermediaries and financial markets resolve ex post information asymmetries and the
resulting moral hazard problem by improving the ability of investors to directly evaluate the
returns to projects by monitoring, by increasing the ability of investors to influence management
decisions and by facilitating the takeover of poorly managed firms. When these issues are not
well managed, investors will not be willing to delegate control of their savings to borrowers.
Diamond (1984), for example, develops a model in which the returns from firms’ investment
projects are not known ex post to external investors, unless information is gathered to assess the
outcome, i.e. there is “costly state verification” (Townsend 1979). This leads to a moral hazard
problem. Moral hazard arises when a borrower engages in activities that reduce the likelihood of
a loan being repaid. For example, when firms’ owners “siphon off” funds (legally or illegally) to
themselves or their associates through loss-making contracts signed with associated firms.
Definition Of Money
Whenever an article is generally acceptable in exchange in a community so that B will take it from A in
exchange for what A wants, not because B desires the article but because he knows that practically all
other persons will take it from him in exchange for the things which they have and which he wants, that
article is money; or, to put it more briefly, any commodity which is generally acceptable as a medium of
exchange is money.
The term money is sometimes used in other senses. For example, some authors mean by money what
we shall call standard money. In this sense gold coin would be the only money in the United States at the
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present time. Lawyers sometimes define money as legal tender. In this sense gold coins, silver dollars,
subsidiary coins, and greenbacks are money, but not silver certificates nor gold certificates
Forms Of Money
Many different commodities have served mankind as money. In the Homeric poems oxen served as a
measure of value. Where slavery has prevailed slaves have often served as the medium of exchange and
the standard of value. The American Indian used strings of beads called wampum as money; in
Massachusetts in 1649 wampum was made legal tender among the settlers in the payment of debts to
the amount of forty shillings. In the East Indies cowry shells have been used for small change, while
among the Fijians whales' teeth have served the same purpose. Wheat, lumps of salt, cubes of tea,
cacao beans, and birds' heads are a few of the commodities which at different times and in different
places have served as money. Professor Carl Bucher in speaking of the variety of kinds of money among
primitive peoples writes, "The money of each tribe is that trading commodity which it does not itself
produce but which it regularly acquires from other tribes by way of exchange." Of the commodities which
have already been mentioned as money some served the purpose well and some poorly, but none of
them would prove satisfactory in an advanced commercial state.
The Functions Of Money
Money serves as a medium of exchange. It is the intermediary third commodity which makes exchange
possible where direct barter would be impossible. This is the first and most important function of money.
In the second place, money serves as a measure of value. As we have already seen, the processes of
exchange are very much simplified because of the fact that all commodities may have their values
estimated in terms of the value of some one commodity, and need not have their values estimated in
terms of the value of any other commodity. In the third place, money may serve as a standard of deferred
payment. Thus, A borrows a quantity of some commodity from B with the understanding that he will repay
it at the end of a year. If the value of the commodity should increase during the year, and if he should
return the exact quantity of the good which he had borrowed, he would overpay the debt. On the other
hand, if the value of the commodity should decrease during the year, and if he pays back the exact
quantity which he borrowed, he will have underpaid the debt. In order that he may return exactly the
amount of value which he has received it is desirable that the value of the commodity borrowed should be
reckoned in terms of the value of some commodity which is not likely to fluctuate much in value. A good
money serves this purpose. Fourthly, money serves as a storehouse of value. A man may desire to
change his other property into the form of money in order to keep it until he may make a desirable
investment. He can store his wealth in the form of money at less expense and with greater security than
he could store it in many other forms. A fifth function of money is to serve as a basis for credit
transactions. This function will be discussed in the next chapter.
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Classification Of Money
Money may be classified as standard, token, credit, and representative. Standard money is money to the
value of which the values of other kinds of money are referred. Standard money is further classified as
commodity money and fiat money. Commodity money is subject to free coinage and its supply is
regulated automatically. Gold coin will serve as an example in the United States. There is a parity
between the value of commodity money and the value of the commodity out of which the money is made.
Fiat money is money the value of which is regulated artificially by regulating its supply. Its value is
independent of the value of the material out of which it is made. The greenbacks during and for some time
after the Civil War were fiat money. As soon as provision was made for their redemption they became
credit money. Token money, also called subsidiary money, is small change. In the United States it
includes pennies, nickels, dimes, quarter dollars, and half dollars. Credit money is money redeemable in
standard money on demand. Representative money is a sort of warehouse receipt certifying that the
money upon which it is based is withdrawn from circulation and can be had upon demand. In the United
States the gold certificate and the silver certificate are of this character. They certify that gold and silver,
respectively, have been deposited in the United States Treasury and are payable to the bearer on
demand. Representative money does not increase the quantity of money. It merely furnishes a more
convenient form for handling the money already in circulation
The Value Of Money
Value is power in exchange. The value of money is its power in exchange. The value of money just like
the value of anything else depends upon the demand for it and the supply of it. Its value depends upon its
marginal utility. If the supply of money is increased, the demand remaining the same, the marginal utility
of money is lowered and its value is lessened, and if the supply is decreased, the marginal utility rises and
with it the value. On the other hand, if the demand for money increases, the marginal utility rises and with
it the value of the money, and if the demand decreases, its marginal utility and likewise its value falls.
When the value of money falls, if all other values remain practically the same, the prices of all other
commodities rise, for the prices of commodities are the reciprocals of the value of money. If the value of
money rises, and all other values remain approximately the same, the prices of all commodities fall.
Likewise, if the value of money remains constant, and all other values increase, the prices of all
commodities will increase. If all values other than the value of money fall, all prices will fall
The Demand For Money
Simple desire for money does not constitute demand for it any more than desire for any other economic
good constitutes demand for it. Demand is effective desire. It is desire coupled with the ability to pay the
current price for the thing desired. Demand for money, then, is desire for money together with the ability
to give some other commodity which will be accepted in exchange for money. The demand for money
depends upon the amount of business which is transacted for which money payment must be made and
upon the extent to which money is required as a reserve for credit operations. It is influenced also by the
extent to which money is hoarded, and by the demand for the metal of the money for use in the arts
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because of the effect of these things in reducing the supply of money in circulation. Substitutes for money,
such as checks, have the effect of lessening the demand for money.
Instruments traded  bills of exchange

on the short term  commercial bills
money market  government bills
include:  promissory notes
 treasury bills.
Motivations for holding money may include:
 precautionary demand for money to pay future expenses which may not be
anticipated
 speculative demand for money to be able to take advantage of future price changes
in favour of the purchaser
transactions demand for money to pay everyday predictable expenses.
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factors that influence the

LO4
Ethiopian economy
4.1. The role and impact of global market situation and Federal and Regional State
governments action on the economy is explored with reference to current events
and issues
4.2. The impact of a change in domestic interest rates on different sectors of the
economy is analyzed and discussed
4.3. The impact of changes in consumer activity on the Ethiopian economy is analyzed and
discussed
Consumer activity  applications for home loans

may include:  purchase of private health insurance
 purchase of university education
 purchase or building of residential accommodation
 retail spending
 tourism within Ethiopia by Ethiopians.
Sales Order Processing
A sales order application system comprises the procedures involved in accepting and shipping
customer orders and in preparing invoices that describe products; services and assessments. The
sales order is the interface between the various functions necessary to process a customer order.
These functions are sales order, credit, finished goods, shipping, billing, accounts receivable, and
general ledger.
Sales Order -- The sales order function initiates the processing of customer orders with the
preparation of a sales order. The sale order contains descriptions of Products ordered, their prices
and descriptive data concerning the customer such as name shipping address, and, if necessary,
billing address. At this point, the actual quantities shipped and freight charges (if any) are not
known. The invoice will be prepared after the goods have been shipped and notice of this event is
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forwarded to billing. Because the invoice is prepared after shipment, separate order and billing is
also called post-billing.
Credit- A customer’s credit standing should be verified prior to the shipment of goods. For regular
customers, the credit check involves determining that the total amount of credit granted does not
exceed management’s general or specific authorization. For new customers a credit check is
necessary to establish the terms of sale to the customer. The sales order function should be
subjected to the control of an independent credit function to maintain the separation of duties.
Once credit has been approved, the sales order function distributes the sales order set. One copy of
each sales order is forwarded to billing. These are filed as open orders, allowing the billing function
to anticipate the receipt of matching shipping advices from the shipping function. One copy –
usually called the packing slip copy- is forwarded to shipping. This copy authorizes shipping to
receive goods from finished goods for shipping. Another copy – usually called the packing slip copy
– is forwarded to shipping. This copy authorizes shipping to receive goods from finished goods for
shipping. Another copy – usually called the stock copy – is forwarded to finished goods. This copy
authorizes finished goods to release goods from its custody for shipment to customers.
In some cases, a customer’s order may require that a production order be issued to produce the goods,
because the goods are not in stock. Such situations arise when the order is for a special nonstick item.
They also may arise as standard company practice due to either the customized nature of the product or
a short production cycle that alleviates the need for an inventory of finished goods. Such situations also
occur when items are out of-stock and must be back ordered. If the time between receiving an order
and actual shipment of the order is significant, an acknowledgment copy of the sales order may be sent
to the customer to inform the customer that the order has been received and is being processed.
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Finished Goods- Finished goods pick the order as described on the stock copy of the sales order
(copy 3). Stock records are updated to reflect the actual quantities to be forwarded to shipping.
Actual quantities are noted on the stock copy of the sales order, which is then forwarded along with
the goods to shipping. Shipping should sign the stock copy to acknowledge receipt of the quantities
noted there on form of finished goods.
Shipping- Shipping accepts the order for shipment after matching the packing slip copy to the
stock copy of the sales order. Shipping documentation is prepared according to the situation.
Frequently, this requires the preparation of a bill of lading. A bill of lading is the documentation
exchanged between a shipper and a carrier such as a trucking company. The bill of lading
documents freight charges and the transfer of goods from the shipping company to the
transportation company. Frequently, freight charges are paid by the shipper but billed to the
customer on the sales invoice. The packing slip copy of the sales order is usually included
with the customer’s order when it is shipped.
Billing - Shipping forwards documentation of the shipment to the billing function. This
documentation is termed the shipping advice and is usually the stock copy of the sales order and
a copy of the bill of lading. Billing pulls the related open order documentation, verifies the order,
then prepares the invoice by extending the charges for actual quantities shipped, freight charges
(if any), and taxes (if any). Invoices are mailed to customers. Invoices are recorded in the sales
journal and posting copies are sent to accounts receivable. Periodically, a journal voucher is
prepared and forwarded to the general ledger function for posting to the general ledger.
Accounts receivable and General Ledger- The distinction between billing and accounts
receivable is important to maintain separation of functions. Billing is responsible for invoicing
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individual sales transactions, and accounts receivable maintains customer-accounts information
and sends periodic statements of accountant to customers. Billing does not have access to the
financial records (the receivables ledger), and the financial records are independent of the
invoicing operation. The control total of postings to the accounts receivable ledger that is sent to
the general ledger by accounts receivable is compared to the journal voucher sent from billing to
validate shipping, and, finished goods is importance to the establishment of accountability for the
release of finished goods from inventory.
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Describe the role of

LO5
regulators
5.1. The main regulator of the financial system is identified
5.2. The role of each regulator in protecting investors and consumers and promoting
confidence in the financial system is explained using example
Main regulator in the financial

Information Sheet – 1
system
Policies, Procedures and Limits
Credit Policies
The foundation for effective credit risk management is the identification of existing and
potential risks in the bank’s credit products and credit activities. This creates the need for
development and implementation of clearly defined policies, formally established in writing,
which set out the credit risk philosophy of the bank and the parameters under which credit
risk is to be controlled. Measuring the risks attached to each credit activity permits a
platform against which the bank can make critical decisions about the nature and scope of
the credit activity it is willing to undertake.
A cornerstone of safe and sound banking is the design and implementation of written
policies and procedures related to identifying, measuring, monitoring and controlling credit
risk. Credit policies establish the framework for lending and guide the credit-granting
activities of the bank. The policies should be designed and implemented with consideration
for internal and external factors such as the bank’s market position, trade area, staff
capabilities and technology; and should particularly establish targets for portfolio mix and
exposure limits to single counterparties, groups of connected counterparties, industries or
economic sectors, geographic regions and specific products. Effective policies and
procedures enable a bank to: maintain sound credit-granting standards; monitor and control
credit risk; properly evaluate new business opportunities; and identify and administer
problem credits. Credit policies need to contain, at a minimum:
• a credit risk philosophy2 governing the extent to which the bank is willing to assume
credit risk;
• general areas of credit in which the bank is prepared to engage or is restricted from
engaging;
• clearly defined and appropriate levels of delegation of approval, and provision or writeoff
authorities; and
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• sound and prudent portfolio concentration limits.

The basis for an effective credit risk management process is the identification and analysis of
existing and potential risks inherent in any product or activity. Consequently, it is important
that banks identify the credit risk inherent in all the products they offer and the activities in
which they engage. This is particularly true for those products and activities that are new to
the bank where risk may be less obvious and which may require more analysis than
traditional credit-granting activities. Although such activities may require tailored procedures
and controls, the basic principles of credit risk management will still apply. All new products
and activities should receive board approval before being offered by the bank.
Credit Analysis and Approval Process
Prior to entering into any new credit relationship, consideration shall be given to the integrity
and reputation of the party as well as their legal capacity to assume the liability. Banks need
to understand to whom they are granting credit. Therefore, prior to entering into any new
credit relationship, a bank shall become familiar with the borrower or counterparty and be
confident that they are dealing with an individual or organization of sound repute and
creditworthiness. In particular, strict policies shall be in place to avoid association with
individuals involved in criminal activities.
Establishing sound, well-defined credit-granting criteria is essential to approving credit in a
safe and sound manner. In order to conduct an effective credit-granting program, banks
shall receive sufficient information to enable a comprehensive assessment of the risk profile
of the counterparty. Depending on the type of credit exposure and the nature of the credit
relationship with the counterparty, the factors to be considered and documented in credit
granting include:
• purpose of the credit and sources of repayment;
• borrower’s repayment history and current capacity to repay, based on historical financial
trends and future cash flow projections under various scenarios;
2 The credit risk philosophy is a statement of principles and objectives that outline a bank’s
willingness to
assume credit risk. It will vary with the nature and complexity of its business, the extent of other
risks
assumed, its ability to absorb losses and the minimum expected return acceptable for a specific
level of
risk.
• terms and conditions of the credit including covenants designed to limit changes in the
future risk profile of the borrower;
• adequacy and enforceability of collateral or guarantees under various scenarios;
• current risk profile of the counterparty (including the nature and aggregate amounts of
risk), and sensitivity to economic and market developments, especially for major
exposures; and
• borrower’s business expertise and management capability.
Occasionally, banks may participate in loan syndications or other such loan consortia. In
such cases, undue reliance should not be placed on the risk analysis performed by the lead
underwriter or external credit assessors. Rather, syndicate participants should perform their
own risk analysis prior to committing to the syndication. Such analysis should be conducted
in the same manner as directly sourced loans.
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In order to maintain a sound credit portfolio, a bank must have a clearly established process
in place for approving new credits as well as extensions or renewal and refinancing of
existing credits. Approvals should be made in accordance with the bank’s written guidelines
and granted by the appropriate level of management. There should be a clear audit trail
documenting the approval process and identifying the individual(s) and/or committee(s)
making the credit decision.
Each credit proposal should be subject to careful analysis by a qualified credit analyst with
expertise commensurate with the size and complexity of the transaction. An effective
evaluation process establishes minimum requirements for the information on which the
analysis is to be based as listed above. The information received will be the basis for any
internal evaluation or rating assigned to the credit and its accuracy and adequacy is critical to
management making appropriate judgments about the acceptability of the credit.
Authority for Loan Approval
Banks must develop a corps of credit analysts who have the experience, knowledge and
background to exercise prudent judgment in assessing, approving and managing credit. A
bank’s credit approval process should establish accountability for decisions taken and
designate the individuals who have authority to approve credits or changes in credit terms.
Depending upon its size and nature, credit may be approved through individual authority,
joint authorities or through a committee. Approval authorities should be commensurate with
the expertise of the individuals involved and the delegation of authority should include, as a
minimum:
• the absolute and/or incremental credit approval authority being delegated;
• the provision or write –off authority being delegated;
• the officers, positions or committees to whom authority is being delegated;
• the ability of recipients to further delegate risk approval and write-off authority; and
• the restrictions, if any, placed on the use of delegated risk approval and write-off
authorities.
The degree of delegation of authority will depend on a number of variables, including:
• the bank’s credit risk philosophy;
• the quality of the credit portfolio;
• the degree of market responsiveness required;
• the types of risks being assessed; and
• the experience of lending officers.
2.3.4 Related Party Transactions
A potential area of abuse arises from granting credit to related parties, whether companies or
individuals3. Consequently, it is important that banks grant credit to such parties on an
arm’s-length basis and that the amount of credit granted is suitably monitored. Such controls
are most easily implemented by requiring that the terms and conditions of such credits not
be more favorable than credit granted to non-related borrowers under similar circumstances
and by imposing absolute limits on such credits. The bank’s credit-granting criteria should
not be altered to accommodate related companies and individuals. Material transactions with
related parties should be subject to the prior approval of the board of directors (excluding
board members with conflicts of interest), and reported to the banking supervisory
authorities.
Lending to Connected Parties
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Banks should have credit granting procedures in place that identify connected counterparties
as a single obligor which means aggregating exposures to groups of counterparties
(corporate or non-corporate) that exhibit financial interdependence by way of common
ownership, common control, or other connecting links (for example, common Management,
familiar ties). Identification of connected counterparties requires a careful analysis of the
impact of the above factors (e.g. common ownership and control) on the financial
interdependence of the parties involved.
Credit Limits and Credit Concentration
To ensure diversification, exposure limits are needed in all areas of the bank’s activities that
involve credit risk. Banks should establish credit limits for individual counterparties and
groups of connected counterparties that aggregate different types of on and off balance
sheet exposures. Such limits are frequently based on internal risk ratings that allow higher
exposure limits for counterparties with higher ratings. Under no circumstance can limits
established by banks be higher than regulatory limits set by NBE. Limits should also be
established for particular industries or economic sectors, geographic regions specific
products, a class of security, and group of associated borrowers.
Credit Concentration
3Related parties can include the bank’s subsidiaries and affiliates, its major (owning 2% and
above)
shareholders, directors and senior management, and their direct and related interests, as well as
any party
that the bank exerts control over or that exerts control over the bank.
Credit concentration can occur when a bank’s portfolio contains a high level of direct or
indirect credits to:
• a single counterparty;
• a group of related counter parties;
• an industry;
• a geographical region;
• a type of credit facility (i.e. overdrafts); and
• a class of collateral.
Excessive concentration renders a bank vulnerable to adverse changes in the area in which
the credit is concentrated and to violations of statutory and regulatory limits. Sound and
prudent risk management involves the minimization of concentration risk by diversifying the
credit portfolio. At a minimum, credit diversification policies should:
• be stated clearly
• include goals for portfolio mix;
• place exposure limits on single counter parties and groups of associated counter parties,
key industries or economic sectors, geographical regions and new or existing products;
and
• be in compliance with NBE statutory and regulatory limits on large exposures.
In considering potential credits, banks must recognize the necessity of establishing
provisions for identified and expected losses in line with the NBE directives on provisions
and holding adequate capital to absorb unexpected losses. These considerations should
factor into credit-granting decisions as well as the overall portfolio risk management process.
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Credit Risk Mitigation

A number of techniques are available to banks to assist in the mitigation of credit risk.
Collateral and guarantees are the most commonly used. Notwithstanding the use of various
mitigation techniques individual credits transactions should be entered into primarily on the
strength of the borrower’s repayment capacity. Banks should also be mindful that the value
of collateral might well be impaired by the same factors that have led to the diminished
recoverability of the credit.
Banks should have policies covering the acceptability of various forms of collateral,
procedures for the ongoing valuation of such collateral, and a process to ensure that
collateral is, and continues to be, enforceable and realizable. With regard to guarantees,
banks should evaluate the level of coverage being provided in relation to the credit-quality
and legal capacity of the guarantor. Banks should be careful when making assumptions
about implied support from third parties including government entities. When engaged in
interbank transactions, banks often rely on netting agreements as a means of reducing credit
risks. It should be noted, however, that such agreements need to be sound and legally
enforceable.
Measurement, Monitoring and Control
Failure to establish adequate procedures to effectively monitor and control the credit
function within established guidelines has resulted in credit problems for many banks around
the world. Compromising credit policies and procedures has been another major cause of
credit problems. Accordingly, each bank needs to develop and implement comprehensive
procedures and information systems to effectively monitor and control the risks inherent in
its credit portfolio. These procedures need to define prudent criteria for identifying and
reporting potential problem accounts to ensure that such accounts are identified for more
frequent review, followed up with appropriate corrective action, adversely classified where
appropriate and that provisions are made where necessary. Categorization of the credit
portfolio by credit characteristics, risk rating and regular review of individual and groups of
credits within the portfolio and independent internal credit inspections or audits are integral
elements of effective and prudent portfolio monitoring and control.
Credit Administration Policies
Credit administration is a critical element in maintaining the safety and soundness of a bank.
Once a credit is granted, it is the responsibility of the bank to ensure that the credit is
properly maintained. This includes keeping the credit file up to date, obtaining current
financial information, sending out renewal notices and preparing various documents such as
loan agreements. In larger banks4, the responsibility for credit administration may be split
among different departments, but in smaller banks these responsibilities may be assigned to
individuals. Where individuals perform such sensitive functions as custody of key
documents, entering credit limits into the computer database etc, they should report to
managers who are independent of the business origination and credit approval processes. In
some cases where this is practically difficult, banks shall devise ways and means by which
related risks shall be minimized. In developing credit administration arrangements, banks
should ensure:
• the efficiency and effectiveness of credit administration operations, including monitoring
of credits, maintenance of adequate documentation, observance of contractual
obligations and legal covenants and maintenance of collateral, etc.;
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Department
• the accuracy and timeliness of information generated by management information

systems;
• the effectiveness of the segregation of duties;
• the adequacy of controls over all “back office” procedures; and
• compliance with prescribed management policies and procedures as well as applicable
laws and regulations.
Credit Files
The credit files of a bank should include all the information necessary to ascertain the
current financial condition of counterparties as well as sufficient information to track the
4 The NBE considers banks with total assets greater than Birr 9 billion as large, between Birr 3
billion and
Birr 9 billion as mid-size, and less than Birr 3 billion as small.
decisions made and credit history of borrowers. Each credit file needs at a minimum
information that:
• identifies the borrower by name and occupation or type of business, and identifies
guarantors and connected parties;
• provides evidence of the borrower’s legal ability to borrow, financial condition and the
ability to repay, including the timing and source of repayment;
• describes the terms of the credit obligation, including the purpose of the credit;
• describes and evaluates the collateral, indicating the marketability and/or condition
thereof; and
• provides a history of the credit, including copies of the most recent credit authorization
and internal credit reviews and evidence of the level of approval.
Credit Monitoring Procedures
Banks need to develop and implement comprehensive procedures and information systems
for monitoring the condition of individual counterparties across the bank’s various
portfolios. These procedures should define the criteria for identifying and reporting potential
problem credits and other transactions to ensure that they are subject to more frequent
monitoring, corrective action, and proper classification/provisioning. An effective credit
monitoring system will include measures to:
• ensure that the bank understands the current financial condition of the counterparty;
• monitor actual exposures against established limits;
• monitor compliance with existing covenants;
• assess, where applicable, collateral coverage relative to the obligor’s current condition;
• identify contractual payment delinquencies and classify potential problem credits on a
timely basis;
• determine if payments are being made from the source that was anticipated at the time
the credit was approved; and
• direct promptly problems for remedial management.
Specific individuals should be responsible for monitoring credit quality; including ensuring
that relevant information is passed to those responsible for assigning internal risk ratings to
the credit. In addition, individuals should be made responsible for monitoring on an ongoing
basis any underlying collateral and guarantees. Such monitoring will assist the bank in
making necessary changes to contractual arrangements as well as maintaining adequate
reserves for credit losses.
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Banks should develop an adequate framework for managing their exposure in off-balance
sheet products as a part of overall credit to an individual customer and subject them to the
same credit appraisal, limits and monitoring procedures. Banks should classify their offbalance
sheet exposures into three broad categories:
• full risk (credit substitutes) – e.g. standby letters of credit or money guarantees;
• medium risk (not direct credit substitutes) – e.g. bid bonds, indemnities and warranties;
and
• low risk – e.g. cash against document (CAD).
Internal Risk Rating
An important tool in monitoring the quality of individual credits, as well as the total
portfolio, is the use of an internal risk rating system. A well-structured internal risk rating
system is a good means of differentiating the degree of credit risk in the different credit
exposures of a bank. This will allow more accurate determination of the overall
characteristics of the credit portfolio, problem credits, and the adequacy of loan loss
reserves. Detailed and sophisticated internal risk rating systems can also be used to
determine internal capital allocation, pricing of credits, and profitability of transactions and
relationships.
Stress Testing
An important element of sound credit risk management involves discussing what could
potentially go wrong with individual credits and within the various credit portfolios, and
considering this information in the analysis of the adequacy of capital and provisions. This
exercise can reveal previously undetected areas of potential credit risk exposure. The linkages
between different categories of risk that are likely to emerge in times of crisis should be fully
understood. In case of adverse circumstances, there may be a substantial correlation of
various risks. Scenario analysis and stress testing are useful ways of assessing areas of
potential problems.
Stress testing should involve identifying possible events or future changes in economic
conditions that could have unfavorable effects on a bank’s credit exposures and assessing the
bank’s ability to withstand such changes. Three areas that banks could usefully examine are:
(i) local or international economic or industry downturns; (ii) market-risk events; and (iii)
liquidity conditions. Stress testing can range from relatively simple alterations in
assumptions about one or more financial, structural or economic variables, to the use of
highly sophisticated financial models.
Whatever the method of stress testing used, the output of the tests should be reviewed
periodically by senior management and appropriate action taken in cases where the results
exceed agreed tolerances. The output should also be incorporated into the process for
assigning and updating policies and limits.
Managing Problem Loans

Banks must have a system in place for early remedial action on deteriorating credits,
managing problem credits and similar workout situations.
One reason for establishing a systematic credit review process is to identify weakened or
problem credits. A reduction in credit quality should be recognized at an early stage when
there may be more options available for improving the credit. Banks must have disciplined
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and vigorous remedial management process, triggered by specific events, that are
administered through the credit administration and problem recognition systems.
A bank’s credit risk policies should clearly set out how the bank will manage problem credits.
Banks should document how various courses of actions should be applied. These include
renewal, and extension of impaired credit facilities. The procedures should clearly set out
authority limits within the organization that will have responsibility to make such decisions
and how standard credit approval practices will be enhanced in the case of impaired credit.
Management Information System and Measuring Credit Risk
Banks should establish management information systems and analytical techniques that
enable management to measure the credit risk inherent in all on- and off-balance sheet
activities. The effectiveness of a bank’s risk measurement process is highly dependent on the
quality of its management information systems since this information is used by the board
and management to fulfill their respective oversight roles. Therefore, the quality, detail and
timeliness of information are critical. The information system should provide adequate
information on the composition of the credit portfolio, including identification of any
concentrations of risk. The measurement of risk should take into consideration:
• the specific nature of the credit (loan, guarantee, etc) as well as its contractual and
financial conditions (maturity, rate, etc.);
• the exposure to potential market movements;
• the existence of collateral or guarantees; and
• the potential for default based on internal risk rating.
The analysis of credit risk data should be undertaken at an appropriate frequency with the
results reviewed against relevant limits. Banks should use measurement techniques that are
appropriate to the complexity and level of the risks involved in their activities, based on
robust data, and subject to periodic validation.
In particular, information on the composition and quality of the various portfolios, including
on a consolidated bank basis, should permit management to assess quickly and accurately the
level of credit risk that the bank has incurred through its various activities and determine
whether the bank’s performance is within the tolerance limits of the credit risk strategy.
It is important that banks have a management information system in place to ensure that
exposures approaching risk limits are brought to the attention of senior management. All
exposures should be included in a risk limit measurement system. The bank’s information
system should be able to aggregate credit exposures to individual borrowers and
counterparties and report on exceptions to credit risk limits on a meaningful and timely
basis.
Internal Controls
Banks must establish a system of independent, ongoing assessment of their credit risk
management processes and the results of such reviews should be communicated directly to
the board of directors and senior management.
The bank should have an efficient internal review and reporting system as an effective
oversight mechanism in respect of its credit function. This system should provide the board
of directors and senior management with sufficient information to evaluate the performance
of account or relationship officers and the condition of the credit portfolio.
Internal credit reviews conducted by individuals independent from the business function
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Department
provide an important assessment of individual credits and the overall quality of the credit
portfolio. Such a credit review function can help evaluate the overall credit administration
process, determine the accuracy of internal risk ratings and judge how effectively credits are
being monitored. The credit review function should report directly to the board of directors,
a board committee with audit responsibilities, or senior management without lending
authority (e.g., senior management within the risk control function.)
The goal of credit risk management is to maintain a bank’s credit risk exposure within
parameters set by the board of directors and senior management. The establishment and
enforcement of internal controls, operating limits and other practices will help ensure that
credit risk exposures do not exceed levels acceptable to the individual bank. Such a system
will enable bank management to monitor adherence to the established credit risk objectives.
Internal audits of the credit risk processes should be conducted on a periodic basis. They
should be used to confirm that :
• credits have been granted in compliance with the bank’s credit policies and procedures;
• periodic reports on all the exposures are available to senior management and are
submitted to the board;
• weaknesses in the credit risk management process are identified and reported to the
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Rift Valley University Nekemte Campuse

Training, Teaching and Learning Materials

 The impact of a change in domestic interest rates

LO1 Ethiopian financial markets

Specific financial markets in

Functions performed by a financial system are :

The purpose of  enabling participants to invest surplus funds by buying

Participants in the financial markets may include

 banks and non-banking financial institutions

Explain the function and role

The role of the NBE includes:

 To regulate the supply, availability and cost of money and credit.

The effect of the NBE's monetary policy may include:

 changes in interest rates

LO3 Ethiopia's monetary system

Information Sheet – 1 The National Bank of Ethiopia

Transformation of the risk characteristics of assets

The Functions Of Money

The Value Of Money

The Demand For Money

Instruments traded  bills of exchange

Motivations for holding money may include:

factors that influence the

Consumer activity  applications for home loans

Sales Order Processing

also called post-billing.

noted there on form of finished goods.

with the customer’s order when it is shipped.

receivable is important to maintain separation of functions. Billing is responsible for invoicing

individual sales transactions, and accounts receivable maintains customer-accounts information

release of finished goods from inventory.

Describe the role of

confidence in the financial system is explained using example

Main regulator in the financial

• sound and prudent portfolio concentration limits.

Credit Risk Mitigation

• the accuracy and timeliness of information generated by management information

Managing Problem Loans

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