FINANCIAL INSTITUTIONS AND

MARKETS
COURSE OUTLINE
The Financial
System
OVERVIEW
Watch the
following Video
and write one
problem of How to avoid the next finan
what you think cial crisis? | MICHEL GIRAR
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the problem in deo

the financial
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 KEY TERMS
financial assets, financial instruments,
issuer, investor, debt instrument, equity
instrument, fixed income instruments,
maturity, coupon rate, floating-rate
securities, amortizing instrument, call
provision, put provision, prepayment,
search costs, liquidity, price discovery
process, capital market, secondary market,
primary market, over-the-counter market,
derivatives markets, derivative
instruments, futures contract, option
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 Learning
Outcomes

Discuss • Discuss the financial system

• Explain the importance of

Explain indirect finance as opposed
to direct finance

• Discuss the financial

Discuss institutions and their
intermediary roles
 Definition of
Financial System

Composed of a network of financial

markets, institutions, businesses,
households, and governments that
participate in that system and regulate its
operation
 Financial System
• The financial system includes markets and
various financial intermediaries that help
transfer financial assets, real assets, and
financial risks in various forms from one entity
to another, from one place to another, and
from one point in time to another.
• These transfers take place whenever someone
exchanges one asset or financial contract for
another.
• The assets and contracts that people trade
include notes, bonds, stocks, exchange-traded
funds, currencies, forward contracts, futures
contracts, option contracts, swap contracts,
and certain commodities.
• When the buyer and seller voluntarily arrange
their trades, as is usually the case, the buyer
and the seller both expect to be better off.
 Why do people need
financial system

PEOPLE USE THE TO SAVE MONEY TO BORROW TO RAISE EQUITY

FINANCIAL SYSTEM FOR THE FUTURE; MONEY FOR CAPITAL;
FOR SIX MAIN CURRENT USE;
PURPOSES:

TO MANAGE RISKS; TO EXCHANGE TO TRADE ON

ASSETS FOR INFORMATION.
IMMEDIATE AND
FUTURE
DELIVERIES; AND
 Functions of the financial system
To facilitate:
• the achievement of the purposes for which people use the financial
system;
• the discovery of the rates of return that equate aggregate savings
with aggregate borrowings; and
• the allocation of capital to the best uses.
These functions are extremely important to economic welfare. In a
well-functioning financial system, transaction costs are low, analysts
can value savings and investments, and scarce capital resources are
used well.
 NOTE:

Helping People Achieve Their Purposes in Using the

Financial System
• People often arrange transactions to achieve
more than one purpose when using the financial
system.
• For example,
an investor who buys the stock of an oil producer may
do so to move her wealth from the present to the
future, to hedge the risk that she will have to pay
more for energy in the future, and to exploit insightful
research that she conducted that suggests the
company’s stock is undervalued in the marketplace. If
the investment proves to be successful, she will have
saved money for the future, managed her energy risk
exposure, and obtained a return on her research.
 Saving

• People or firms often have money that they choose not to spend now and that they want available in the
future.
• To move money from the present to the future, savers buy notes, certificates of deposit, bonds, stocks,
mutual funds, or real assets such as real estate. These alternatives generally provide a better expected rate of
return than simply storing money.
• When savers commit money to earn a financial return, they commonly are called investors. They invest when
they purchase assets, and they divest when they sell them.
• Investors require a fair rate of return while their money is invested to compensate them for the use of their
money and for the risk that they may lose money if the investment fails or if inflation reduces the real value
of their investments.
• The financial system facilitates savings when institutions create investment vehicles, such as bank deposits,
notes, stocks, and mutual funds, that investors can acquire and sell without paying substantial transaction
costs. When these instruments are fairly priced and easy to trade, investors will use them to save more.

ESS Earn – Save - Spend

And not
ESS Earn – Spend - Save
 BORROWING
• The financial system facilitates borrowing.
Lenders aggregate from savers the funds that
borrowers require.
• Borrowers must convince lenders that they can
repay their loans, and that, in the event they
cannot, lenders can recover most of the funds
lent.
 Raising Equity
Capital
• Companies often raise money for projects by selling
(issuing) ownership interests (e.g., corporate common
stock or partnership interests).
• Although these equity instruments legally represent
ownership in companies rather than loans to the
companies, selling equity to raise capital is simply
another mechanism for moving money from the future
to the present
• The financial system helps promote capital formation by
producing the financial information needed to determine
fair prices for equity
• Share capital required Ksh 10,000,000
• Price per share Ksh 10
• Number of shares: 1,000,000
• OTC market (private issue)
 Managing
risks
• The financial system facilitates
risk management when liquid
markets exist in which risk
managers can trade
instruments that are correlated
(or inversely correlated) with
the risks that concern them
without incurring substantial
transaction
Exchanging Assets
for Immediate
Delivery (Spot
Market Trading)
They may trade one currency for
another currency, or money for a
needed commodity or right
 Information-
Motivated Trading

Information-motivated traders trade to

profit from information that they believe
allows them to predict future prices.
Like all other traders, they hope to buy at low
prices and sell at higher prices.
Unlike pure investors, however, they expect
to earn a return on their information in
addition to the normal return expected for
bearing risk through time
 Determining
Rates of Return
Savers move money from the present to the future
whereas borrowers and equity issuers move money from
the future to the present.

Because time machines do not exist, money can travel

forward in time only if an equal amount of money is
travelling in the other direction.

This equality always occurs because borrowers and equity

sellers create the securities in which savers invest
 One of the most important functions of
the financial system is to ensure that
only the best projects obtain scarce
capital funds; the funds available from
savers should be allocated to the most
productive uses.
Capital
Allocation
Efficiency
Economies are said to be allocationally
efficient when their financial systems
allocate capital (funds) to those uses that
are most productive
 General
Functions of
financial
System

• Supplies Credit to support

purchases of goods and
services and to finance
capital investment
• Supplies a mechanism for
making payments in the
form of currency, credit
cards, ATMs etc
• Creation of money
• Provides a profitable outlet
for savings
General Functions
of intermediaries

• Pool funds from surplus units

and Lend the same to deficit
unit. (Commercial banks)
• Pool funds and invest on
behalf of the investors (Mutual
funds, brokerage, insurance
Cos
 Direct and Indirect Finance

• Indirect finance through intermediaries from

surplus units to deficit units
• Direct from surplus units to deficit units in
the economy
The Financial System
 Financial
Intermediation
This is the primary route for moving funds from
lenders to borrowers using intermediaries.

It is the process of indirect finance through

financial intermediaries

Financial intermediation (indirect finance is

important because of
• Reduction of transaction costs (economies of scale advantage)
• Risk sharing –reducing exposure of investors to risk
• Reduction of Information costs because of information
asymmetry (adverse selection and moral hazard, conflict of
interest)
 Financial Intermediaries

• Financial intermediaries help entities achieve

their financial goals.
• These intermediaries include commercial
banks, mortgage, and investment banks; credit
unions, credit card companies, and various
other finance corporations; brokers and
exchanges; dealers and arbitrageurs;
clearinghouses and depositories; mutual funds
and hedge funds; and insurance companies.
 Financial
Intermediaries

• The services and products that

financial intermediaries
provide allow their clients to
solve the financial problems
that they face more efficiently
than they could do so by
themselves
 Financial Intermediation – bank
Transformation Risk
• The problem is that the bank faces maturity transformation risk.
In the event there is a surge in demand for cash withdrawals that is
attributable to depositors fearing losing their money, rush to the bank
in droves to withdraw their money (bank runs) not in only one bank but
in a wave that affects many banks in the financial system.
Such fears are sparked by news about bank mismanagement and fraud,
impending policy, mere speculation, or economic slowdown.

This creates a serious problem that forces banks to first seek assistance
from other banks through interbank market, then lender of last resort,
and finally if all that fails to deliver, resorting to selling assets at fire
sales, recall loans before maturity, among other efforts, all of which
undermine their solvency in the process.
 Financial Intermediaries
• Brokers, exchanges, and various alternative trading systems match
buyers and sellers interested in trading the same instrument at the
same place and time.
• Dealers and arbitrageurs connect buyers to sellers interested in trading
the same instrument but who are not present at the same place and
time.
• Dealers connect buyers to sellers who are present at the same place but
at different times,
• whereas arbitrageurs connect buyers to sellers who are present at the
same time but in different places. These financial intermediaries trade
for their own accounts when providing these services.
• Dealers buy or sell with one client and hope to do the offsetting
transaction later with another client.
• Arbitrageurs buy from a seller in one market while simultaneously
selling to a buyer in another market.
 Financial
Intermediaries
Many financial intermediaries create new instruments
that depend on the cash flows and associated financial
risks of other instruments thus effectively arrange trades
among traders who otherwise would not trade with each
other.
Arbitrageurs who conduct arbitrage among securities and
contracts whose values depend on common factors
convert risk from one form to another. Their trading
connects buyers and sellers who want to trade similar
risks expressed in different forms.
Banks, clearinghouses, and depositories provide services
that ensure traders settle their trades and that the
resulting positions are not stolen or pledged more than
once as collateral.
 Financial Intermediation
Types of intermediation

1. Maturity
2. Information
3. Denomination
4. Default risk
 Intermediation
Risk Intermediation
• Asset Transformation: Transforming more risky assets into less risky. It is
performed through the administration of the portfolio by skilled analysts
and portfolio managers and also through the ability of the investor to
achieve a more broadly diversified portfolio by investing indirectly through
an investment company rather than investing directly in primary securities
• Risk Sharing: They create and. sell assets with risk characteristics that
people are more comfortable with
• Diversification : Investing in a collection of assets (efficient portfolio)
whose returns do not always move together.
 Maturity intermediation
• Maturity intermediation is an investment term that describes a bank's
long-term lending on funds borrowed for a short-term investment.
• When a financial institution borrows money from certificates of deposit or
demand deposits and then loans that money out as a 30-year mortgage, it
engages in maturity intermediation. This practice puts banks in a
vulnerable position due to short-term funding costs that may rise quickly.
• The point of maturity intermediation is to make profits off the differences
in interest rates. Banks transform short-term debt into long-term credit
using maturity intermediation. Banks borrow money from depositors and
pay those customers interest. Banks, in turn, take that money and lend it to
people who need funds to pay for vehicles, houses and other large items.
The short-term interest paid out to depositors is less than the long-term
interest gained over a 30-year mortgage, so the financial institution profits.
 Information
intermediation

• Financial institutions engage in

information intermediation by providing
information to users hence reducing
transaction costs because they have
developed expertise in the data they have
about financial instruments
• Note that time and money spent in
carrying out financial transactions
increase transactions cost in the absence
of accurate information
 Denomination intermediation

• Denomination intermediation is the process whereby small

investors are able to purchase pieces of assets that normally
are sold only in large denominations.
• Individual savers often invest small amounts in mutual funds.
• The mutual funds pool these small amounts and purchase a
well diversified portfolio of assets. Therefore, small investors
can benefit in the returns and low risk which these assets
typically offer.
 Default risk intermediation

• The letter of credit (LC) is one of the main tools available to

traders willing to reduce commercial default risk.
• A LC is a promise by an importer’s bank to pay upon
presentation by an exporter’s bank of shipping documents.
(LCs account for around 15 percent of the value of world
merchandise trade).
 Types of Financial Institutions

Other
Financial
financial
intermediaries Commercial banks institutions
Credit unions Security brokers and
Mutual savings banks dealers.
Savings and Loan Investment bankers
Associations

Investment Co
Pension funds
Finance Cos Mortgage bankers
Life insurance Cos
 Depository
institutions
Include commercial banks and thrift institutions:
savings and loans associations, Micro-Finance
Institutions (MFIs) and credit unions
 Depository
institutions
Commercial banks
• Transaction accounts: used to make payments for
purchases of goods and services Direct loans to
businesses, individuals and other institutions.
• Deposits
• Loan
 Depository institutions
Commercial banks
• Asset Financing
• Bills discounting: Supplier’s debt will be paid,
not 100% guaranteed. Letter of credit: 100%
guarantee
• Overdraft facilities: import machinery, short
term 12 months, the rate will be different.
• Foreign exchange services
 Depository
institutions
Savings and Loan Associations
These institutions serve mainly individuals and
families, accepting savings and payment accounts
from household and devoting most of their assets
to home mortgage loans
 Depository institutions

Credit Unions (SACCOs)

• Non profit associations, operated solely for the benefit of their
members.
• They are unique in focusing almost exclusively upon credit
and savings needs of households- individual and families
 Contractual Savings
Institutions

Pension Funds
• Hold employee’s funds on behalf of employers. The funds are
paid to the employee on retirement.
• Open-end; open to all employees e.g NSSF
• Closed-end : Serves a particular group e.g bankers
 Contractual Savings
Institutions

Pension Funds
Compare and contrast
• Defined Benefit Plan
• Defined Contribution Plan
 Contractual Savings
Institutions

Insurance Companies
• They sell protection against the occurrence of future events as
death or fire to residents or commercial property
• They receive a premium for the protection
• Invest the proceeds in the financial market
 Contractual Savings
Institutions

Insurance Companies
Read and make notes
• The importance of demutualization and securitization of assets
in insurance companies
• How insurance mitigate information asymmetry effects
Mishkin . F.S. and Eakins. S. G Financial Markets and
Institutions Ch 22 pages 561-578
 Investment Intermediaries

• They sell shares and use these funds to purchase direct

financial claims
• They offer investors the benefit of both denomination
flexibility and default-risk intermediation
 Investment
Intermediaries
Mutual funds
• Pool funds for investment
• More conservative than other investment Cos.
• Open-end; Investment Companies that are ready to
redeem the investors shares at market value
• Closed-end : Issue shares that are then traded in the
secondary markets
 Investment
Intermediaries
Mutual funds
• Open –end Funds (Mutual Funds): are portfolios of
securities mainly stocks bonds and money market
instruments. Investors in mutual funds own pro-
rata share of the overall portfolio which is
managed by an investment manager of the mutual
fund who buys some securities and sells others
 Investment
Intermediaries
Mutual funds

• The net asset value equals the market value-

liabilities/No of shares outstanding.
• An example Old mutual, Britam etc
 Investment Intermediaries

Mutual funds

• Close-end is an investment company that sells

shares to potential investors and the shares are
traded on securities market
• Example TransCentury/Centum
 REGULATIONS

Reasons for regulation

• To protect consumers against industry abuses

• To stabilize the financial system (Market

Failure)
• Control of monetary policy
 TYPES OF REGULATIONS

Disclosure regulation
• Requires issuers of securities to make public a large amount of
financial information to actual and potential investors
(Problem agency-principal relationship-information
asymmetry)
 TYPES OF REGULATIONS

Financial activity Regulation

• Consists of rules about traders of securities and trading on the
financial markets
• Problem-Insider trading
 TYPES OF
REGULATIONS

Regulation of Financial
Institutions
It is that form of government monitoring
that restricts these institutions’ activities
in the vital areas of lending, borrowing
and funding
 TYPES OF
REGULATIONS

Regulation of Foreign
Participants
• It is that form of government activity
that limits the roles foreign firms can
have in domestic markets and their
ownership on control of Financial
institutions
 TYPES OF
REGULATIONS
Issues in regulation
Safety net deposit insurance
Contagion effect
Lender of the last resort
Moral hazard
 Monetary Policy

There are three major tools the Bank uses to implement monetary
policy:
• Open Market Operations
• Discount window operations
• Reserve Requirements
 Monetary Policy

There are three major tools the Bank uses to

implement monetary policy:

• Open Market Operations

• Discount window operations

• Reserve Requirements
 Monetary Policy
There are three major tools the Central Bank uses to implement monetary policy:

• Open Market Operations: Through open market operations, the Central

Bank buys or sells government securities in the secondary market in order to

achieve a desired level of Bank reserves. Alternatively, the Bank injects

money into the economy through buying securities in exchange for money.

As the law of supply and demand takes effect to determine the cost of credit

(interest rates) in the money market, money supply adjusts itself to the

desired level. This process influences availability of money in the economy.

 Monetary Policy

• Discount window operations: The Bank, as lender of last

resort, may provide secured short-term loans to commercial

banks on overnight basis at punitive rates, thus restricting banks

to seek funding in the market resorting to Central Bank funds

only as a last solution. The discount rate is set by the Central

Bank to reflect the monetary policy objectives.

 Monetary Policy

• Reserve Requirements: The Central Bank is empowered by

the law to retain a certain proportion of commercial banks'
deposits to be held as non-interest bearing reserves at the
Central Bank. An increase in reserve requirements restricts
commercial banks ability to expand bank credit and the
reverse is regarded as credit
 CENTRAL BANK

• It is found in Nairobi’ Kisumu and Mombasa

• The currency centres are Eldoret and Nyeri
• Imperfection in the market lead to bank failures
• 1999-34 banks failed. Businessmen Vs Bankers
• Depository protection
• CDS accounts
• Buying of Treasury bills
 CENTRAL BANK

• National treasury-deals with fiscal policy-macro economic policies

• Central bank deals with the monetary policy to assist National treasury to
achieve its objectives
 CENTRAL BANK

• Manipulate money supply so that there are low and stable prices
3 general instruments
• Selective controls
 CENTRAL
BANK
• Moral suasion: informal request by central bank
to banks to control the exchange rate
• Instrument independence
 CENTRAL
BANK
Issues
• Open market operation; the fiscal side does not
balance??
• Discount rate?
• How do you determine the CBR?
 Reading assignment
• Read on Information asymmetry, adverse
Selection and Moral hazard.
• Mishkin.F.S and Eakins .S.G (2005). Financial
Markets and Institutions. Pgs 26-28
• Kidwell; Blackwell; Whidbee, Sias (2013).
Financial Institutions Markets and Money. Pgs
18-21
•
 Reference
• CBK Website