DFI 503 FINANCIAL INSTITUTIONS AND MARKETS

COURSE FACILI TATION MATERIAL

COMPILED BY

ANGELA M. KITHINJIUNIVERSITY OF NAIROBI

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UNIVERSITY OF NAIROBISCHOOL OF BUSINESS

DFI 503: FINANCIAL INSTITUTIONS & MARKETS COURSE OUTLINECOURSE FACILITATOR MRS KITHINJI

[Financial Markets, Financial Institutions, the Power of Information, and Financial Policies]

WEEK

1.1An Overview of Financial Institutions and Markets

The Financial System of an Economy The Structure of a Financial System The Stock Market

1.2Emerging Markets, African Markets and Capital Market Development

Financial Markets and the Organized Exchange Characteristics of Emerging Capital Markets Indicators of Capital Market Development

1.3Financial Regulation, Intermediation, Capital Market Structures and Development

The Players in a Typical Capital Market:

- Capital Market Intermediaries- The Regulator: The Capital Market Authority - The Stock Exchange [NSE]- Investors- Government

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The Institutional, Regulatory and Legal Framework in Financial Markets

- Types of Regulations in Financial Markets- Market Based Banking Regulations- Crisis in Banking Regulation.

1.4Securities and Their Characteristics

Shares, Fixed Income Securities, Derivatives Challenges of Trading of securities in the Stock Market Why Derivatives Trading is Absent in Most Emerging Markets

1.5Financial Contracting Under Imperfect Information

Sources of Financial Information The Principal-Agent Problem(Jensen & Meckling, Hairs & Raviv,

Townsend’s CSV Model) Asymmetric information and Financial Market Failure Moral Hazard in Financial Markets Financial Market Failure Credit Rationing in Financial Markets Adverse Selection: Screening with Market Power Mechanism Money Laundering in Financial Markets Approaches to Outside Finance and Capital Structure with Imperfect

Information Contemporary Theories of Financial Intermediation Monitoring and Insurance (Diamond & Dybvig, Bhattachrya &

Thakor) in Capital Markets and Banking System.

1.6Financial Sector Policy and Development

Financial Development Financial Deepening (Model by Gurley-Shaw) Financial Repression Hypothesis (Mckinnon Shaw) Finance in Endogenous Growth Models

1.7Financial Markets and Macro-Economic Policy 1

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Financial Sector Policies: Monetary and Fiscal Policies Financial Liberalization Informal Finance Monetary Policy with Informal Financial Markets

1.8 Financial Market and Macro-Economic Policy 11

Financial Innovation and Monetary Policy Financial Crisis and Macro-economic Policy

1.9 Public Enterprise Restructuring and Financial Sector Reforms

Divestiture Versus Privatization Public Enterprise Restructuring Financial Sector Reforms Role of Financial Sector Reforms in Public Enterprise Restructuring Privatization of Public Institutions Privatization of Infrastructure

COURSE EVALUATION

Course- Work Marks

C.A.T 30%Term Paper 20%Total-Coursework Marks 50%Final Examination 50%Total 100%

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REFERENCES

Fry, Maxwell (1995) Money, Interest and Banking in Economic Development, Baltimore: John Hopkins

Guley, John G. and Edward Shaw (1962) Money in a Theory of Finance, Washington D.C: Brookings Institution.

Chandravarkar, Anand (1992) “Of Finance and Development” World Development, 20, 133-143 Mackinnon, R.I (1973) Money and Capital in Economic Development Washington D.C: Brookings Institution.

Mckinnon, R.L (1992) The Order of Economic Liberalization Baltimore: John Hopkins Press Diaz-Alejandro, Caros (1985) “Goodbye Financial Repression, Hello Financial Crash” Journal of Development Economics, 19, 1-24

Stiglitz, Joseph E.(1994) “The Role of the State in Financial Markets” in Proceedings of the World Bank Annual Conference of Development 1993, Washington D.C: World Bank, 19-52

World Bank (1989) World Development Report, Oxford: Oxford University Press and World Bank

Selected Additional References

Gertler, M (1988) “Financial Structure and Aggregate Economic Activity” Journal of Money, Credit and Banking, Vol.20, 559-88 (Review Article)

Mishkin, Frederic S. (1994) “Preventing Financial Crisis: An International Perspective” NBER Working Paper No. 4636

Nissanke, Machiko (1993) “Savings and Fiscal Policy Issues in Sub-Saharan Africa” in Akyuz, Yilmaz and Gunter Held (eds) Finance and The Real Economy: Issues and Case Studies In Developing Contries, New York: U.N University/Wider

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IOSCO (1998) “Causes, Effects and Regulatory Implications of Financial and Economic Turbulence in Emerging Markets” Interim Report by Emerging Markets Committee IOSCO.

NSE (1989) Rules and Regulations of the Nairobi Stock Exchange

Capital Markets Authority Act and its SupplementsThe Banking LawsThe Insurance ActOther Financial Market LawsAny Other Relevant Material.

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1.0 THE FINANCIAL SYSTEM OF AN ECONOMY

1.01 The Environment for Financial Decisions

Financial decisions within the firm must take into account the

external and internal economic, financial and social environments.

The main types of financial markets are capital markets and money

markets.

Financial Markets:

A financial market is a market for funds for financial managers and

its purposes is to allocate financial capital efficiently among

alternative physical uses in the economy. Transactions in financial

markets give rise to financial assets and financial liabilities.

Trading in a financial market takes place through:

1. Organized exchanges, such as The Nairobi Stock Exchange

(NSE) and The New York Stock Exchange (NYSE)

2. Over the counter markets

3. Third tier markets

4. Fourth tier markets

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Financial markets may be categorized into:

Money market - Financial claims and obligations traded in these

markets have maturities of less than one year.

Capital Markets - Financial claims and obligations traded in these

markets have maturities of more than one year.

Financial Intermediaries - Are specialized business firms whose

activities include the creation of financial assets and financial

liabilities. With financial intermediation, savings are transferred to

economic units that have opportunity for profile investment. Real

resources are therefore allocated more effectively and real output

for the economy as a whole is increased.

Among the main financial intermediaries include;

- Commercial Banks- Insurance companies- Pension funds- Savings and loans- Mutual funds- Investment funds- Finance companies- Money market funds- Credit unions.-

Types of Financial Instruments

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- Currency – coins and paper

- Debt

- Equity

- Derivatives

1.02 Role of Financial System and Financial Intermediation

The Role of a Financial System

1. Provides a payment system for the exchange of goods and

services.

2. Provides a mechanism for aggregating funds to embark on

large-scale indivisible ventures.

3. Provides a means of transferring economic resources through

time and across geographic regions.

4. Provides a means for managing risks.

5. Provides price information for co-coordinating decision-

making in various sectors of the economy.

6. Reduces the cost of asymmetric information problems –

imperfect information

An important role of the capital market is to act as a major source

of information for co-coordinating decision-making in various

sectors of the economy.

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INTERMEDIATION AND FUNCTIONS OF FINANCIAL

INTERMEDIARIES:

The main functions of financial intermediaries include;

1. Satisfying the needs of investors to complete the markets

(where market gaps exist) with new instruments that offer a

wider range of opportunities for risk management and

transfer of resources.

2. Reduction of Transaction costs

Lowering transactions costs or increasing liquidity is a

function of financial intermediaries. Financial intermediaries

can reduce such costs through brokerage and the creation of

their own financial liabilities e.g banks – issuing loans.

3. Information processing and monitoring function

Reducing agency costs arising either from information

asymmetry between market participants or incomplete

monitoring of their agents.

4. Operator of the payment system function.

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2.0 CAPITAL MARKET STRUCTURE AND

DEVELOPMENT

In most African countries the chronic problems of national and

corporate indebtness have criticized combining too much short-

term debt with too little long-term equity.

2.01 Characteristics of Emerging Capital Markets

African markets are emerging markets or markets at an infant stage

of development. These markets have the following characteristics.

They are markets;

- At infant stage

- Illiquid [Shares change hands very slowly and may not be

sellable when investor needs money]

- Activity concentrates within one locality.

- Volatility of returns – Uncertainty of Returns

- Size – small {few securities}

{Few quoted companies}

{Low turnover}

- Low activity [few share traded]

[Investors adopt the buy and hold approach]

- Lack of Electronic trading – such as CDs

- Lack of credit rating agencies

- Lack of international integration:

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- Limited cross-boarder listing

- Limited foreign investor participation

- Under and over pricing of securities

- Few securities traded – lacks options, swaps e.t.c

- High Market concentration

- Few Intermediaries:

- Presence of rules and regulations that do not favor the

development of the market

2.02 Indicators of Capital Market Development

- High liquidity

- Low market concentration

- Presence of international integration

- Many securities traded: shares, bonds and derivatives

- Low volatility of market returns

- Size – reasonable big

- High activity

- Advanced technology: CDs, ETS

- Foreign investor participation

- Presence of international integration

- Qualified personnel

- Fair pricing of securities

- Market friendly Regulations:

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- Supervised closely

- Clear regulations which do not conflict

3.0 PLAYERS IN A CAPITAL MARKET Investors: Individual investors

Institutional investors

Local investors – individual, institutional

Foreign investors – individual, institutional

Regulations – Restrictions of holdings by foreign

investors in total and in any one company.

Capital Market Intermediaries

Investment Banks– Underwrite new issues

Stock Brokers – intermediaries between the investor and

NSE

Investment Advisors

Custodians

Credit Rating Agencies

Mutual Funds - Money market funds and Capital market

funds

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The Stock Exchange

Is the market where trading in securities takes place. The Stock

Exchange is guided by Rules and Regulations. Some of the general

Rules include;

o Those that regulate dealings of members with clients

o Determine and standardize charges for members

o Correlate stock broking activities and facilitate exchange of

information including lists of prices of shares dealt in by

members

o Network with stock exchange in other countries

o Investigate any inefficiencies or irregularities in the dealings

of members with their clients.

NSE has rules that regulate its own activities (self- regulations)

including rules to oversee the activities of the members.

>For details read through rules and regulations relating to the

Stock Exchange published by the Stock Exchange, by the Capital

markets Authority or published by other credible bodies.<

The Capital Markets Authority

There are various rules that govern the activities of the capital

market. Among the many rules include:

- Listing manual

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- Rules guiding licensing of investment banks, stock

brokers, investment advisors, custodians, and credit

rating institutions among others.

- NSE rules: for a company to be listed it has to meet the

listing requirements

Minimum capital requirements

Prospectus showing accounts for the last 5 years

Disclosure requirement

Minimum share issue requirement

Minimum number of shareholders

Furnish accounts every year with CMA

CMA has Rules to govern;

Investment banks, Stock Brokers, Investment Advisors and other

capital market intermediaries such as;

-Licensing Rules

-Minimum capital requirements

-Brokerage regulations e.t.c

-Insider trading and other insider dealings

-Disclosure regulations

-Operating regulations

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For details on Capital Markets Laws, read through the Capital

Markets Act and other regulations and rules that regulate the

Capital Markets.

4.0 REGULATING FINANCIAL MARKETS

4.01 Goals of Financial Regulation

4.01.1 Why regulate at all?

Key Functions of Regulation:

To prevent market failure (financial collapse) due to

externalities

Regulation of Competitive markets

Enhancement of consumer welfare including protection

from fraud and monetary (macro-economic) policy

considerations

Enhancing market power and addressing problems

relating to information

Helm and Yarrow (1988) argue that the fact that markets fail in a

number of ways does not itself imply that regulation is the

preferred option (in other words market failure is a necessary but

not a sufficient condition for regulation)

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In reaching a well considered judgment regarding alternative

policy options, it is essential to balance market failures against

regulatory failures. Evidence of regulatory failures abounds in both

developing and established markets and may be due to various

reasons.

Regulators may inter alia fail to maximize economic welfare due to

for example, their exposure to capture by special interest groups

[Stigler, 1971] or more commonly to interest group pressure.

A good deal of the ongoing debate on alternative theories of

regulation centers more on the cost and effectiveness (benefits) of

regulation rather than the rationale (goals)

4.01.2 Rationale of Financial Regulation

Should be based on the recognition of the fact that monitoring

financial markets

-Is costly and necessarily imperfect;

-Monitoring agencies face severe information problems.

-There are incentive problems facing the government

bureaucrats.

-The government bureaucrats may be at a further disadvantage

relative to those in the sector as a result of the limitations in the

salaries which the government can pay

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4.01.3 Salient Issues to Describe the Role of Government

Regulators must have indirect control mechanism encompassing:

Incentives – where regulations are designed to provide the

regulated with an environment in which the incentives are

more appropriately aligned with that of the regulators e.g.

in insurance, the higher the risk, the higher the rate of

premiums; matatu owners pay higher premiums than

personal car owners.

Restraints – imposing: minimum capital requirements,

such as those to be met by companies to be listed; trading

licenses, restricting entry in the market

Setting Regulatory Standard

Issues to consider include:

-Imperfection of information.

-Information asymmetries – may lead to disclosure of distorted

information to meet the requirements of the regulators e.g.

Disclosure requirement: KASI or IAS; Window-dressing of

accounts

Limitation on Government in risk assessment

Operating in turbulent environment and measurement of risk

accurately is almost impossible.

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Government faced with two main problems: lack of incentives

and resources.

The government should recognize the limitations in the design

of regulations and regulatory structure and take advantage of

information and incentives within the market place.

Designing regulations – cost effective regulations

Enforcing regulations – to ensure that regulations are adhered

to.

Regulations could breed corruption

There may be those who might have the motive to avoid or

evade regulations. In addition could have a monitoring of

monitors

Problem: monitors of monitors lack information. Where,

government ministry lacks information sometimes the only way

out is to have the monitors monitoring each other.

Government could make use of the private sector e.g. private

firms to monitor each other, such as the Private Auditing Firms.

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4.2 Types of Financial Regulation

- Macroeconomic controls

- Allocation controls

- Structure controls

- Prudential controls

- Organizational controls

- Protective controls

Macroeconomic Controls

Regulators (government) use market mechanisms(instrument) such

as government bonds and money market instruments, rather than

resorting to the use of credit ceilings and interest rate controls

which hinder competition and stifle innovation.

Allocation Controls

In Africa, the absence of effective capital markets and other

sources of long-term finance (e.g. venture capital and equity

finance) compounds the acute shortage of investment and small

firm finance, and imposing allocation controls such as preferential

interest rates and targeted credit programmes. Failure to adequately

monitor the activities of lenders (banks) and their consumers

(borrowers) creates moral hazard problems caused by attempts to

divert subsidized resources to unauthorized uses.

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Structure Controls

Driven largely by political and economic considerations and are

targeted at problems relating to market power. To prevent the

concentration of economic financial power several countries

institute legal separation of commercial and merchant (investment)

banking activities and place restrictions on the activities which

these entities can conduct.

Formal separation of banking and securities business may entail

costly inefficiencies whereas a laxer regime in which the two

businesses are allowed to be freely combined creates risks for the

financial system, the deposit insurance fund as well as for the

lender of last resort. Given that neither approach meets the dual policy objective of

efficiency and stability a good deal of emphasis has been placed on

devising an approach which will facilitate banks (operating as

groups of companies) to diversify into securities business, with the

risks attached to conducting such business contained within its

securities unit.

Policy makers should therefore pay particular attention to such

schemes that purport to explicitly resolve the conflicts between

efficiency and stability of financial systems. Conventional wisdom

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would suggest that placing limits on the diversification and size of

individual firms may lead to fragmentation and segregation of the

financial system and may prevent large firms from achieving both

economies of scale and scope.

Prudential Regulation

Deals with the accepted practices of firms in their chosen activities

and are geared towards reducing the risk of systematic failure and

thereby avoiding the disruption caused by financial collapse.

These require financial institutions to satisfy capital adequacy

requirements, diversify their risk, adopt generally accepted

accounting policies, engage professionally suitable managers,

report their true financial position and be subject to effective

supervision. Managers, owners and financial institutions are

mandated to minimize adverse selection and detailed conduct rules

to guard against moral hazard.

The key objective of prudential regulation is to achieve stability

without comprising efficiency. The extent and success of designing

prudential regulations based on market mechanisms which do not

distort competition and financial behaviour remains an enigma.

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Organizational Controls

Seek to deal with externalities resulting from the existence of

network such as stock and other trading exchanges, clearing

systems and information net-works. To achieve the stated aim as

well as promote the efficiency and integration of networks without

discrimination against new institutions, the rights and obligations

of market participants are set out, using clearly defined objective

criteria, such as competence and financial status.

Protective Controls

Controls are directed at the informational problems which affect

dealings and relations between the providers of financial services

(institutions) and their consumers, especially non-institutional

investors. The most crucial information asymmetries in most

markets, relate to difficulties in assessing the quality of services

being supplied (provided). Quite often, financial institutions as in

the insurance market, lack adequate information about their

customer behaviour and the potential impact on their (financial

institution’s) credit standing.

As you read through, identify the Inter-relationships between

Various Types of Financial Regulations 4.3 Other Regulatory Mechanisms

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There are various regulatory mechanisms that have been put in

place by the Central Bank of Kenya, Kenya Bankers Association,

Capital Markets Authority and Nairobi Stock Exchange among

other major regulators in the Banking industry. The major reasons

why banks should be regulated include:

To minimize the problem of information asymmetry in the

industry by requiring banks to make periodic disclosures on

their financial positions and state of operations.

To enhance the efficiency of the payment system by

providing guideline on how various operations are to be

conducted.

To prevent collapse of banks

To protect all stakeholders from suffering major losses.

Banks put in place systems of deposit insurance

The Central Bank Act

There is need to control the banking institutions through the

Central Bank’s supervision. The objects are to regulate the issue of

notes and coins, to assist in maintenance and development of a

sound monetary, credit and banking system and to maintain

external stability of the currency.

Functions of the Central Bank

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Issuance of notes and coins

Maintenance of external reserves

.Relations with other commercial banks

Regulation of commercial banks

Credit Control: CBK is empowered to issue instructions to

commercial banks for the purpose for which loans are to be

issued.

Bank of government

4.4 Aspects of Success of Financial Regulation in the Banking

Sector in Kenya

Risk Management

Central bank of Kenya has been effective to a large extent in

assisting Banks to manage their risks through the Risk

management guidelines. The banks are specifically required to

manage their Strategic, Credit, Capital, Liquidity, Interest rate,

Price, Foreign exchange, Operational, Reputation and Regulator

risks. These have enabled managers to put in place policies that

protect the interest of all stakeholders in the bank.

Capital Adequacy

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According to prudential guidelines developed from the Base I

Accord, unless a higher ratio has been set by the Central Bank for

an individual institution; all banks must adhere to the capital

standards as stipulated by the Basle Accord.

Surveillance of Banks

Central Bank of Kenya has been firmly in control of the banking

sector and usually carries out independent audits and investigations

commercial banks suspected not to be complying with the

regulations.

Consumer Education

Central Bank of Kenya through various research organizations

such as Research International has been providing meaningful

information to consumers on summarized bank charges and

lending rates of products of every bank to help their customers in

making better-informed choices. Adequate Financial Reporting

Financial reporting and disclosure requirements have been

emphasized adequately by the Central Bank of Kenya. Banks are

required to:

prepare quarterly financial statements according to the financial

reporting standards, have them audited, and to register or publish

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them, prepare more frequent financial disclosures, e.g. Quarterly

Disclosure Statements, and have directors of the bank attest to the

accuracy of such financial disclosures. This has been followed

effectively and has helped reduce the problem of information

asymmetry. Credit Referencing Regulations

The Ministry of Finance launched the Banking (Credit Reference

Bureau, Regulations, 2008). These regulations set out the

framework for the establishment and operations of Credit

Reference Bureaus (CRBs) in Kenya to facilitate credit sharing of

information on credit among all credit providers licensed under the

Banking Act.

Based Accord Adoption in Kenya: Expected outcomes

- The full implementation of Base I Accord;

- Adoption of Risk Based Supervision; and

- Adherence to the Basel Core Principles for Effective

Banking Supervision.

Deposit Production Fund

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The DPF is put in place for the purpose of protecting depositors by

compensating depositors should their commercial banks

experience failure.

5.0 SECURITIES AND THEIR CHARACTERISTICSAmong the securities that trade in the capital market include;

Ordinary Shares

Characteristics:

Claim on income

Claim on assets

Right to control

Voting rights

Pre-emptive rights

Limited liability

Advantages:

From Company Perspective:

Permanent capital

Borrowing base

Dividend payment discretion

Disadvantages:

More costly

Risk

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Earnings Dilution

Ownership Dilution

Preference Shares

Have both the characteristics of ordinary shares and fixed income

instruments and thus referred to as hybrid securities.

Fixed Income Instruments

Bonds, debentures and other debt instruments

Characteristics:

Fixed income

Maturity period

Redemption

Indenture or Debenture Trust Deed

Security

Claim on assets and income

Advantages:

Less costly

No ownership dilution

Fixed payment of interest

Reduced real obligation

Disadvantages

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Obligatory payments

Cash outflows

Restrictive covenants

Preference Shares

Characteristics:

Claims on assets

Fixed dividend

Cumulative dividends

Redemption

Voting rights

Convertibility

Derivative Instruments

Futures contracts

Forward contracts

Option contracts

SWAPS

CAP and Floor Agreements

6.0 INFORMATION ASYMMETRY AND FINANCIAL CONTRACTING

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6.1 Asymmetric Information and Financial Market Failure

Financial markets entail the allocation of resources and can be

thought of as the central locus of decision making. Where financial

markets fail in performing their role they are said to have failed.

6.1.1 Information and Market Efficiency

Theories of efficiency of competitive markets are based on the

premise that there is perfect information. Thus whatever

information individuals or firms have is not affected by what

they observe in the market and cannot be altered by any action

which they can undertake such as spending time and resources

on acquiring information.

Financial markets are concerned with; production or

accumulation, processing or analyzing, dissemination and

utilization of information to enable the various interested parties

to make informed decisions.

Notably, competitive markets in many economies tend to be

inefficient

If information is costly, the presumption is that markets will not,

in general, be carefully competitive, strengthening the

presumption that markets, in the absence of government

intervention are not efficient.

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Aspects of Market failures which provide the basis of

government intervention in financial markets include;

6.1.2 Information and Market Failure

-Information is a public good and posses the principles of;

Non-rivarlous consumption – The consumption of the good by

one individual does not reduce the availability the good to

others.

Non-excludability – it is very costly and also impossible to

exclude any one from the enjoyment of the public good

If a financial analyst has information about a Company A and

invests in Company A, investors are likely to follow suit and invest

in that company.

-Information and Externalities – Difficult to apportion returns

relating to information. Other people benefit from information paid

for by another party

-Information and imperfect competition – Expenses relating to

information can be viewed as fixed costs. Markets that require a lot

of information are imperfectly competitive; for example, customers

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may be informed about lending institutions but lending institutions

may not be well informed about the customers.

6.1.3 Failures in Financial Markets

Monitoring as a Public Good

- Solvency as a financial institutions of great value to

investors – can deposit or withdraw their deposits in

financial institutions

- Management of financial institutions – affects the risk

and returns of investment

- Monitoring solvency – One person knowledge about an

impending solvency of a financial institution does not

subtract from what another person knows

- A person with information about a certain institution

will guide the actions of other persons.

6.1.4 Consequence of Inadequate Monitoring

Undersupply of information – Information available

may not be sufficient to enable monitoring of financial

institutions.

Capital resources will not be allocated as efficiently as

investors will not place reliance on financial

institutions.

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Cases of fraud arise in financial institutions

Government may intervene by delegating monitoring

powers to private institutions such as private auditors

6.1.5 Monitoring Management as a Public Good

Management of firms are charged with the responsibility

of monitoring the activities and allocation of resources of

their institution.

Managers are in theory monitored by the Board of

Directors who have inadequate information. Where Board

of Directors are required to monitor management they may

require monitoring and need incentives

Creditors may also enter into contracts with management

(bond covenants) to put restrictions on debt issuing. This

reduces default risk but may reduce shareholders expected

return, and reduce the variability of the returns

6.1.6 Banks as Monitoring Institutions

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Banks monitor companies by imposing restrictions on lending –

assessing company performance and scrutinizing company

annual reports.

Legal provisions however imply that banks that get actively

involved in the management of the firms to which they have lent

money may lose their seniority status as creditors in the event of

bankruptcy; which limits active bank involvement in the firms

to which they have extended credit.

6.1.7 Externalities, Monitoring, Selection, and Lending

within and across Markets

Willingness of a financial institution to lend a borrower may be

an indicator to other lending institutions that the borrower is

credit worth.

Problems in three or more commercial banks may prompt

depositors to withdraw their deposits and invest in other assets

De-listing of companies from the Stock Exchange may prompt

investors to shift their investors from equities to fixed deposits

or real assets.

Actions in the credit market affect the equity market and vice

versa. For example; a bank willingness to led money affects the

firms ability to raise equity capital because potential investors

have that assurance that the firm will be supervised by the bank.

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6.1.8 Externalities and Financial Disruption

Bankruptcy of one financial institution may give a negative

signal concerning the financial position of other financial

institutions.

A run on one commercial bank is likely to have an effect on

other financial institutions.

Government is usually looked at as a risk bearer – Engages in

some kind of rescue to bail out the troubled financial

institutions.

Moral hazard may be pronounced in insurance by imposing

restrictions or regulations on those whom they insure.

6.1.9 Missing and Incomplete Markets

At times some markets may have gaps such as, absence of bond

markets from the capital market, absence of insurance market

from the financial market etc.

Capital market may be incomplete by having gaps in certain

institutions such as absence of credit rating institutions

6.1.9 Financial Market Failure

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Information is a public good and exhibits the characteristic of

non-rivarlous consumption, nonexcludability and undersupply.

Additionally, information faces the challenge of reliability such

that the price paid for information ends up being an average

price

It also becomes difficult to apportion the benefits accruing from

information

The following are the functions of financial markets failure to

perform of which financial markets are said to have failed.

- Capital and wealth allocation to owners through

financial intermediation

- Agglomerating Capital

- Selecting Projects and borrowers

- Monitoring borrowers

- Enforcing contracts - Enforcement of debt contracts and

equity contracts

- Transfer of resources - Across time, from one

institution to another and from one individual to another

- Sharing and Pooling of Risk

- Recording of transactions such that information is

available for use by various parties in the financial

markets. Systems of recording, analysis, accumulation

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and dissemination of information should be in place in

the financial market.

6.1.10 Implications Of Financial Market Failure

- Collapse of financial institutions

- Financial institutions can take advantage of weak

regulations

- Uninformed investors may have wrong information,

thus they end up making wrong choices of investment

- If investors do not have confidence in financial

institutions they may opt to keep money in other forms

of investment leading to financial market failure

- Leads to imperfect markets thus limiting competition

- Externalities leads to poor selection of projects

- Poor selection of projects and externalities leads to

bank runs

- Poorly performing firms end up obtaining funds from

the equity market

- Financial disruption leads to financial crisis

- Government intervention may be crucial requiring

enhancement of regulations

6.2 Moral Hazard

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From a broad perspective, moral hazard refers to malpractices in

financial institutions.

- Moral hazard may also refer to the prospect that a party

insulated from risk will be less concerned about he negative

consequences of the risk than they otherwise might be.

- Moral hazard may arise because and individual or institution

in a transaction does not bear the full consequences of its actions,

and therefore has a tendency or incentive to act less carefully than

would otherwise be the case, leaving another party in the

transaction to bear some responsibility for the consequences of

those actions.

6.2.1 Causes of Moral Hazard

Deposit Insurance – Deposit insurance can stabilize a bank’s

deposit base and discourage contagious bank runs to the extent that

it offers the assurance that the depositors will be repaid in full and

in time

On the other hand, while preventing bank runs, deposit insurance

creates a new source of potential instability

If depositors know that they will be repaid, they will require no

risk premium on their funds and banks, being able to borrow at a

risk – free interest rate, will have an incentive to incur greater risks

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-Free-rider-problem – The free-rider problem occurs because

people who do not spend resources on collecting information can

still take advantage of the information that other have collected.

Parties that do not pay for information end up benefiting from the

information others have paid for without acknowledging them.

The free-rider-problem is particularly import in the securities

market where trading in information is important.

- Corporate Strategies – Mergers, take-overs etc

- Failure of companies – Owners may not have

information that their companies are likely to fail but

get to know about it once their companies have failed

- Insider dealing and trading – trading on information

which is not available to others

- Inadequate performance evaluation of firms even when

information is available

- Inadequate monitoring of financial institutions

- Laxity in supervision of financial institutions

- Use of inappropriate models and methods of evaluation

of financial institutions

- Borrower attitudes such as borrowing loans with no

intention of repaying

- Agent-Principle relationship

- Inappropriate regulatory framework

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- Inadequate and inaccurate information – Information

asymmetry

- Money laundering – such as transfer of illegally

obtained money

- Related party transactions, such as owning and

management of financial institutions by relatives and

friends which could impair their stability and survival.

- Auditors and manipulated financial reports

- Abuse of regulations

- Engagement in risky projects by financial institutions

Possible Solutions To Moral Hazard Problems

-Having in place systems and methods for evaluating projects

to minimize risk on investment

-Deposit insurance reduces the impact of loss to investors

-Criteria for manger assessment

- Use of CAMEL (Capital Adequacy, Asset Quality,

Management, Earnings and Liquidity), Basle Accord and

other recommended models for vetting financial institutions

- Improvement in systems of reducing information

asymmetry

-Embracing technology in the financial market

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-Increasing information availability, processing and

dissemination

- Sensitizing owners on possible failure of their institutions

-Improvement of the monitoring systems

- Continuous review of financial regulations

- Enforcement of contracts; debt, equity and other contracts

signed in the financial markets

- Implement systems of reducing insider dealings

- Streamlining systems of debt collection

- Activating credit rating systems

- Engaging the private sector in activities of financial markets

-Regulations and monitoring of money laundering activities

- Enforcement of regulations on owner manger in financial

institutions

- Discipline of Auditors engaged in faulty financial

information

- Monitoring enhancement

- Putting in place codes of conduct

Identify cases of moral hazard in the Kenya financial market

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6.4 Adverse Selection

- Adverse selection is a situation of information asymmetry that

occurs before the transaction. In financial markets investors are

likely to undertake investments in which they are not able to

maximize the net present value because information about the

viability of investment projects may not be available

- For example, a bank that sets one price for all its checking

account customers runs the risk of being adversely selected against

by its high-balance, low-activity customers.

- Notably, the people who are most likely to engage in activities

that may cause bank failure are those who might be keen on taking

advantage of deposit insurance.

- Depositors who are protected by government safety net have little

reason to impose discipline on the bank

Causes of Adverse Selection

- Information asymmetry; affects borrowers, investors,

financial institutions, financial markets

- Insider dealings

- Financing Arrangements

- Inefficient financial intermediaries

- Technological weaknesses

- Weaknesses in regulations

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- Managerial weaknesses

- Institutional factors; shortcomings in networking,

structural factors

- Regulatory weaknesses

- Borrowers misrepresent their risk characteristics in

order to access credit and to secure more favourable

terms

Possible Solutions to Adverse selection

-If a project can be financed with riskless debt, the firm should

take the project so long as it has a positive Net Present Value

(NPV). The value of the firm increases when the company

commits to a positive NPV project financed by a riskless debt.

- A firm must therefore compare the costs of deviating from its

optimal capital structure, and the associated financial distress with

the NPV of the particular investment project.

- One could show that firms have an incentive to take on negative

NPV projects and become under leveraged if it allows them to

issue over priced securities. Thus issuing securities is considered to

be an indication that a firm is overvalued.

- Sharing of information between various organizations

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- In the case of borrowers, relating the screening procedures with

the repayment history of the borrowers and enhancing mechanisms

of ensuring that funds are not deviated to non-productive projects

-Investor education on risk analysis

- Enhancing regulations on insider dealings

What implications does adverse selection have on financial

Markets?

-Failure of financial institutions

-Limitation on innovations

-Information asymmetry

- Mispricing of risk

Identify adverse selection in the Kenya financial market

6.5 Credit Rationing

Entails limiting the amount of funds that borrowers can access

from the financial market. Notably, information sharing is a crucial

precondition for the development of a thriving credit market and

access of finance by firms. In addition, access to finance is a

crucial pre-coordination for the healthy development of credit

markets and for increased investment that translates into economic

growth

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- credit markets are characterized by asymmetric

information between borrowers and creditors that lead

to credit rationing, inefficient allocation and credit

decisions based upon an incomplete picture of credit

risk associated with the borrower

- Information sharing among banks and other lender via

credit rating agencies help to reduce symmetric

information and establish a reputation system that

generates disciplinary effects for the borrower

- Commercial banks impose limits in lending (lending

limits) by any single customer

- Central Bank imposes regulations that have

implications on credit extended by commercial banks

- Portfolio composition guidelines have an effect on the

amount allocated for each category of investment

6.6 Deposit Insurance

Deposit insurance is a guarantee to the holders of insured

deposits in member deposit taking institutions that they

will be paid the principal value and in most cases the

accrued interest on their deposits, in the event of failure of

the institution with which the deposits were made. The

principle objective of deposit insurance system is to

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protect both small and the less financially knowledgeable

depositors from losing their savings if a bank fails thus

contributing to confidence in and the stability of a

country’s financial system

-Deposit insurance is important to an economy as it

provides a safety net for investors should commercial

banks experience a run

-Whereas the responsibility of solvency of a financial

institution lies with the Board of Directors and

Management, in reality when a bank fails the public

perceives the failure not as a bank’s responsibility or a

supervisory or deposit insurer but a failure of the

government to protect its people.

- When a bank fails, depositors are relieved when they

receive information that their deposits are protected and

that they will be reimbursed

Why Depositors Need to Be Protected

Protect from social costs – Funds held with banks are viewed by

the public as government guaranteed since banks are regulated and

supervised by the government through the Central Bank. For the

public to have confidence in the banking system they must

perceive that money held as deposits is the same as money in their

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pocket. Instances when certain banks threaten to fail are bailed out

by government to promote confidence in the banking sector

Contagion Effect – Deposit insurance is considered a necessary but

not sufficient condition for a stable financial system. Close

monitoring and supervision are an essential part of deposit

insurance. The existence of an explicit deposit insurance scheme

would assure depositors that they would have immediate access to

their insured funds even if their banks fails, thereby reducing their

incentive to “run” on the bank

Objectives of Deposit Protection Fund (DPF)

-To protect the interest of depositors, particularly small depositors

who may be unable to evaluate the financial condition of an

institution

-Provide deposit insurance scheme for customers of member

institutions

-Liquidate and wind-up the operation by any member institution in

respect of which the fund has been appointed as a liquidator

-Promote public confidence in the banking system by limiting runs

on banks

-Streamline the operations of representative officers of foreign

banks and financial institutions

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-Deal with information accumulation for member institutions for

the Central Bank in its inspections and supervision effectively

-Initiates procedures to protected depositors in ailing or failed

member institutions after closure

-Guarantees members that they will be paid in event their

institution fails

- Guarantees holders of insured deposits in member deposit-taking

institutions that they will be repaid their deposits and in most

cases, the accrued interest on their deposits

Institutional Set –Up

DPF is an insurer which is usually a statutory body with its own

legal and corporate governance structures

The most common approach to funding DPF is through mandatory

premiums that are paid by all licensed banks within the system.

Legal and Regulatory Framework

As stipulated in the Banking Act Cap 488

Deposits

Most depositors with small amounts do not turn up to make up

their claims. Payment to depositors is complex in instances where

customers do not have bank accounts, in cases of inaccurate

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records, change of address and relocation of the depositors to other

countries

Contributory Arrangements

-Membership of DPF is compulsory to all deposit taking financial

institutions licensed under the Banking Act.

-Annual premiums

- Institutions that donot pay their premiums in time pay a penalty

by way of interest

Determining Contribution to DPF

The major sources of moneys for the DPF include;

- Seed capital at the establishment of the Fund

- Contributions to the Fund by individual institutions –

Form the biggest contribution to the Fund

- Income from investments of DPF

- Money borrowed for purposes of the Fund Management

- Grants and Donations to the Fund

Ownership and Management of DPF

DPF was introduced in 1986 following review of the banking Act.

Increase in the number of institutions in the banking industry

triggered constitution of the DPF to protect customer deposits

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Fund run by a board consisting of the governor of Central Bank as

Chairman, and the Permanent Secretary to the Treasury as one of

the members.

Central Bank discharges its supervisory responsibilities of

depositor protection through onsite inspections, and by periodic

monitoring of the capital, profit and loss, as well as the liquidity of

commercial banks and other financial institutions.

Challenges of Operating DPF

- Failure of financial institutions - Financial institutions

failed due poor corporate governance, lack of timely

intervention by the regulator and weaknesses in the

legal framework

- Debt Collection – Collection of troubled loans is made

complicated because of poor records, unsecured loans,

and lengthy litigation procedures among others

- Deposit insurance alone cannot increase financial

system stability.

- Without a sound system of banking supervision that

includes strong capital standards as well as mechanisms

for enlisting assistance from the market in imposing

discipline on system participants, deposit insurance and

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other elements of the financial safety net are likely to be

ineffective

7.0 FINANCIAL SECTOR POLICIES AND

DEVELOPMENT

7.1 FINANCIAL DEVELOPMENT

Financial development has been looked at as facilitating the

efficient allocation of resources. Banks are said to identify

investors with good growth prospects and therefore help allocate

resources to their most productive uses. Further an efficient

financial sector is one of the pillars of a well functioning market

economy.

Financial development may affect allocative efficiency through:

Information generation

Risk sharing

Financing

Monitoring

Financial sector are the ingredients of the structure of

arrangements in an economy which facilitates the conduct and

growth of economic transactions through the use of money

payments, savings and investments.

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Financial sector is governed by policies which include; money

supply, interest rates, and public deficit financing among others.

Financial institutions include; government owned financial entities,

financial intermediaries and financial facilitators.

Financial markets instruments comprise money markets

instruments and capital market instruments.

What is financial sector development?

-Improvement of the efficiency and competitiveness of the sector

-Availability of a wide range of financial services

-Increase in diversity of institutions

-Increase in the amount of money intermediated through the

financial system

-Enhancing capital allocation by private sector

-Enhancing regulation and stability of the financial sector

-Access of more financial services by the population

Theoretical Framework

Main functions of financial intermediaries:

Savings mobilization

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Risk management

Acquisition of information

Monitoring borrowers

Facilitating exchange of goods and services

Pre-requisites for Successful Financial Sector Development and

Growth:

Good governance; Rule of Law

Good public sector management

Macroeconomic stability

Financial market safety nets

Competitive environment

Areas of the Financial sector that Need Strengthening to Fast Track

Financial Development:

Basic legal and regulatory framework

Financial markets and financial institutions

Capacity to prevent and monitor crisis in the financial market

sector

Kenya case:

Interest margins and overhead costs are almost twice as in other

countries

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High concentration of banks

Customers tend to be concentrated on few banks

Areas that policy should focus on:

Information on borrowers

Functioning credit registry with a firm legal basis

Sharing of positive information benefits small borrowers

Deficiencies in legal and institutional frameworks

Strengthening the legal framework

Regulatory and supervisory efforts to strengthen the banking

system

Uncertainty in the policy environment

Role of government in fostering transparency

Divesting ownership, particularly in government owned banks

7.2 FINANCIAL DEEPENING

Financial deepening refers to increase in investments in financial

instruments or a shift in investment s from the real estate to

financial market.

Institutions that spearhead financial deepening are:

-Financial intermediaries

-Regulatory Agencies

-Financial market systems

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-Government

Why financial deepening:

-Need for access to financial services

-To facilitate legal, regulatory and institutional reforms

-Need for portfolio diversification

-To clearly define the role of government

What Facilitates financial deepening?

- Legal framework

- Technology

- Institutional reforms

- Regulatory institutions

- Innovations in financial markets

- Need for risk diversification

Role of Government in Financial Deepening:

-Regulatory

-Defining standards

-Policy driver

Benefits of financial deepening:

-Improved technology

-Improved financial innovations

-Institutional diversification

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-Improvement in offering of financial services

Shortcomings of financial deepening:

Dominance of few large banks

Information asymmetry

High risk of default of financial instruments

Many documents required in effecting financial transactions

7.3 FINANCIAL INNOVATIONS

Financial innovations refers to development of new products,

formation of new institutions, embracing new technology and other

aspects that portray newness in the financial markets. -Other activities that portray financial innovations include;

strategic decision making, system realignment, institutional setting,

injecting new management, expanding to new markets

-Financial innovations enable institutions to raise their competitive

strengths, improve their risk management skills and better satisfy

the needs of their customers and market requirements.

The main types of financial innovations include;

-Institutional innovations

-Process innovations

-Product innovations

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Institutional Innovations

-Includes, changes in business structure, establishment of new

types of financial intermediaries, or changes in the legal and

supervisory framework. For example; introduction of Credit

Reference Bureaus

-Mobile banking involves provision and availing banking and

financial services with the help of mobile telecommunication

devices.

-Banks getting into investment banking services – Commercial

banks are moving to acquire stock brokerage and investment banks

to get involved in the stock market activity.

-Banks offering insurance services on behalf of insurance

companies

-Islamic Banking – Banking that is guided by Islamic law or

Islamic Sharia Law

Process Innovations

These innovations include the introduction of new business

processes leading to increased efficiency and market expansion.

Among the main process innovations include; office automation,

use of computers in accounting systems and client data

management software.

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Among the main innovations include;

-Electronic Banking – Mainly takes the form of Automated Teller

Machines (ATM), Internet Banking and telephone transactions.

Access to the banking services is thus convenient, fast and

available throughout the clock. Banks are also able to provide

services more efficiently and at relatively low cost.

-Transactions are effected in batches

-Real Time Gross Settlement (RTGS)

RTGS system is a funds transfer mechanism where transfer of

money takes place from one bank to another on a “real time” and

Gross basis. Real time means the transactions are processed as they

are received. Gross settlement means the transactions are settled on

one to one basis without bunching with any other transaction.

RTGS system is primarily for large value transactions. As soon as

transactions are remmited by the paying bank they are credited in

the receiving bank.

-Transactions are effected continuously

Product Innovations

Include introduction of new deposit accounts, new credit

arrangement, credit cards, debit cards, insurance and other

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financial products. Product innovations are introduced to respond

better to changes in market demand or to improve efficiency.

Among the main product innovations include;

- Business Club concept

- Personal unsecured loans

- Money transfer services

- Products tailored to favour certain groups; Diva, X

bank accounts of Standard Chartered

The Role of the State in Financial Innovations

-Influences financial innovations through regulations

-Government should actively drive the construction of a

market environment that is suitable for financial

innovations, promote the formation of fair trading rules for

financial innovation activities, create a market

environment for fair competition, and establish a good

order for financial competition

Benefits of Financial Innovations

-Greater efficiency and diversity in financial

intermediation as a result of financial innovation which

increase productivity and growth potential of the economy

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-Funds are made available at lower costs

-Many financial products are available to investors and

depositors

-Enhances financial stability

Demerits of Financial Innovations

-Financial institutions engage in high risk behaviour

-Some risks may not be visible or may be unknown which

can expose the financial system to shocks

-Promotes Money laundering

-May course moral hazard especially if too much credit is

extended

- Increased Crime rates through the ATMs, mobile

banking and so on.

8.0 FINANCIAL REPRESSION AND

FINANCIAL LIBERALIZATION

8.1 FINANCIAL REPRESSION

Developing countries for a long time adopted policies that

impeded or imposed restrictions in financial markets.

Financial repression is defined as the set of policies, laws,

regulation, distortions, qualitative and quantative

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restrictions and controls imposed by the government

which do not allow financial intermediaries to operate at

their full technological potential.

Governments have been accused of adopting financial

repression as a way of imposing restrictions to encourage

or discourage savings or direct savings to certain sectors

of the economy.

Most countries use financial repression to generate

revenues for financing public expenditures at one time or

another.

The outcome of financial repression has been economic

contraction, not sustained growth.

Governments use financially repressive policies to allow

budget deficits to be financed through domestic credit

creation at lower rates of inflation than would otherwise

be possible.

The following policies are usually implemented mostly

hitting the banking system:

-Capital controls (both inflows and outflows)

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Domestic residents have restrictions on their transactions

abroad and foreigners have restrictions on holding or

owning local assets.

- Absence of a competitive system

Arena for competition is limited. Most domestic banks are

state owned. The banking sector is dominated by few

banks; majorly public owned with considerable level of

inefficiency.

-High reserve and liquidity requirements

-Interest rate ceilings on bank assets and liabilities

This may be direct or indirect

-Restrictions on composition of assets portfolios

-Credit ceilings

What are the Arguments for Financial Repression?

-Raising interest institutional interest rates might have

strong negative effects on savings, investment, output, and

growth

-Proponents of optimal financial repression argue that

financial controls can correct market failures in financial

markets, lower the cost of capital for companies, and

improving the quality of loan applicants by selecting

high-risk projects.

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-If used in conjunction with export promotion scheme, or

preferential credit schemes, financial repression could

encourage the flow of capital to sectors with beneficial

technological spillovers

-Equity markets in developing economies are small,

underdeveloped and restricted. Non-residents are not

allowed to participate in the domestic equity markets.

- Where development of financial markets is programmed

financial repression assists in adherence to the designed

programmes

How is Financial Repression Achieved?

-Interest rates

-Liquidity requirements

-Size of the bank loans

-Prohibitions of foreign currency denominated deposits

and loans

-Exchange rates

-Capital markets and capital flows

-High Reserve restriction on government portfolio

composition directed to favored sectors of the economy

Consequences of Financial Repression

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-It creates distortions on financial markets such as;

negative real interest rates, a gap between borrowing and

lending rates

-Slow development of the financial market

-Low returns in financial market

-Shift of investment from the financial market to

investment in non-financial assets

-Promotes moral hazard because of the desire to evade

regulations

8.2 FINANCIAL LIBERALIZATION

Financial liberalization is defined as the process that

involves the elimination of various forms of government

intervention in financial markets or the process of

removing elements of financial repression.

-Liberalization was triggered by the need to exploit

opportunities presented by the Global financial market.

-However bank fragility and balance of payments

challenges have forced many developing countries to

rethink the process of financial liberalization

-Many Less Developed Countries (LDC’s) embarked on

rapid financial liberalization as part of a wider process of

structural adjustment or transition to a market economy.

65

Genesis of Financial Liberalization

Most LDC’s inherited a repressed financial system

dominated by a few commercial banks – often

nationalized or supplemented by parastatal development

banks under close administration control of the Central

Bank

Elements of Financial Liberalization

- Elimination of credit controls

- Freeing of foreign exchange rate

- Deregulation of interest rates

- Free entry into the banking sector and financial market

in general

- Bank autonomy

- Privatization of the banking sector

- Liberalization of the international capital flows

Benefits of Financial Liberalization

-A more efficient banking system with lower transactions

margins, wider product ranges and better client service

arising from competition between more banks and non-

bank financial intermediaries

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-A positive effect of higher real interest rates on domestic

savings and thus higher levels of investment in more

efficient projects

- Greater fiscal discipline as the government can no longer

oblige banks to accept government debt or force the public

to pay the inflation tax from excess money supply

-The spreading of risk and corporate ownership through

the creation of a stock market and

- The attraction of foreign capital by high rates of return,

modern institutions and clear information

Most countries that embark on financial liberalization

benefit from :

A rise in asset prices,

Fall in the rates of inflation,

Rise in bank deposits,

Rapid rise in other forms of financial savings,

Entry of new financial intermediaries in the market

and improvement of customer services,

Treasury bills are highly demanded in the financial

market,

Equity stocks attract foreign investors and,

Foreign capital inflows increase

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Researchers and practitioners argue that financial liberalization

should be undertaken once both fiscal restructuring and the

deregulation of local financial and non financial markets have been

undertaken so that the financial sector is not placed under pressure

from excess demand or distorted prices.

Many countries have however undertaken the process of financial

liberalization rapidly to tap the benefits accruing from Treasury

bill market.

Successful countries have undertaken the process gradually

It would be far better to establish before embarking on a reform

programme what markets are best at, and what the best practice is

in combining markets and institutions.

Any measure which reduces global financial market volatility and

facilitates international investment benefits developing countries

with positive external linkages

New problems have however been associated with success of

financial liberalization:

-Emergence of unsustainable balance of payments deficits

-Instability of domestic commercial banks

-Lack of long-term resources for productive capital formation

-Greater competition between banks and Non Banking Financial

Institutions (NBFI’s)

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-Bank fragility as competition forces them to acquire more risky

assets

-Shallow and narrow domestic capital markets which are find it

difficult to provide ready longterm finance to firms.

Lessons Learnt of Strategies Adopted for Financial Liberalization:

The process should be undertaken slowly, with care that

banks are in fact solvent before liberalization and that budget

deficits are under control

Short-term capital inflows should not be encouraged, but

usage of fiscal and monetary mechanisms where appropriate,

and promotion of direct foreign investment in traded sectors

where possible

Strengthen domestic savings by appropriate institutional

change and possibly constraints on consumer credit and

company borrowing abroad

Ensure that priority investment, particularly in export sectors

and by small producers, continue to have access to long-term

credit on reasonable terms – possibly by rediscount facilities

at the central bank

Allocate scarce human resources to a strict and independent

prudential regulation of all financial intermediaries using

international arrangements wherever possible

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Liberalize foreign trade and domestic prices to avoid putting

pressure on the financial sector from excess demand or

distorted prices

Strengthen macroeconomic policies touching on; inflation,

balance of payments, repressed financial sector, subsidized

credit and negative economic growth.

Challenges of Financial Liberalization

- Political challenge

- Asymmetric information

- Regulatory challenge

- Revenue costs; where revenue might decrease

following deregulation

- Externality challenge; Negative external effects may

erode the benefits of financial liberalization

- Management of capital inflows and outflows

- Emergence of Informal financial institutions

Financial Liberalization in Kenya

-Was embarked on in 1992

-Investments were made heavily in Treasury Bills thus

crowding out private sector

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- Private sector was further crowed out by use of ceilings on

bank credit to accommodate the financing needs of the public

sector

-Public sector deficit financing lead to balance of payments

difficulties and inflationary pressures

9.0 FINANCIAL CRISES

9.1 Nature of Financial Crises

Financial crises are usually associated with bank panics since

many recessions in the financial market coincided with these

panics.

Other situations that are often referred to as financial crises

include stock market crashes and the bursting of other financial

bubbles and currency crises.

Theories have been developed by researchers on how financial

crises occur, early warning systems and how they can be

prevented.

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9.2 Types of financial Crises

Financial crises globally take many forms:

Banking crises which majorly take the form of bank runs.

When cheques and cash are suddenly demanded by

customers, banks are not able to respond to this demand. A

situation without widespread bank runs, but in which

banks are reluctant to lend, because they worry that they

have insufficient funds available, is often called credit

crunch. In this situation banks become an accelerator of a

financial crises.

Speculative bubbles and crashes: A financial asset exhibits

a bubble when its price exceeds the present value of the

future income that would be received by owning it to

maturity. If there is a bubble, there is also a risk of a crash

in asset prices: market participants will go on buying as

long as they expect others to buy, and when many decide

to sell the price will fall. Researchers however do argue

that it is difficult to detect bubbles reliably.

International financial crises: Devaluation of the local

currency because of speculation or otherwise may lead to a

currency crisis or balance of payments crisis. When a

country fails to pay back its debt (solveign debt default)

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can also lead to a crisis. Capital flight could also cause

financial crisis

Wider economic crises: Negative GDP (recession if it lasts

for two or more quarters) which is consistent may lead to

an economic depression, while a long period of slow but

not necessarily negative growth is called stagnation.

Financial crises, mortgage crises and bank runs have been

known to preceed economic crises and stagnation

9.3 Causes of Financial Crises

Strategic complementaries in the financial markets. If

depositors expect a bank to fail, the bank will probably

fail; if investors expect the value of the dollar to rise

this may cause its value to rise

Leverage: This means borrowing to finance investments

and is frequently cited as a contributor to financial

crisis. Leverage magnifies the potential returns from

investment but also creates a risk of bankruptcy. Since

bankruptcy means that a firm fails to honor all its

promised payments to other firms, it may spread

financial troubles from one firm to another

Asst-liability mismatch: This is a situation in which risk

associated with debts and assets are not appropriately

73

aligned. The mismatch between banks’ short-term

liabilities (its deposits) and its long-term assets (its

loans) is seen as one of the reasons bank runs occur

(when depositors panic and decide to withdraw their

funds more quickly than the bank can get back the

proceeds of its loans)

Uncertainty and herd behaviour: Certain financial

institutions tend to drive the market. When assets of the

market leaders rise other institutions might follow suite

but might have no indication (uncertain) as when the

price is likely to fall.

Regulatory failures: Regulations relating to sset levels,

capital levels, reporting standards and disclosure

requirements may be too excessive for financial

institutions. It has been argued that certain failures have

been blamed on in insufficient regulations or too much

of regulations leaving the regulator with the challenge

of determining the standard level or to strike a balance

on regulations.

Fraud: Fraud in institutions has played a role in collapse

of some financial institutions

Contagion: Contagion refers to the idea that financial

crises may spread from one institution to another, as

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when a bank run spreads from a few banks to many

others, or from one country to another, as when

currency crises, sovereign defaults, or stock market

crashes spread across countries. Systemic risk occurs

when the failure of one particular financial institution

threatens the stability of many other institutions

Recessionary effects: Stock market crashes are said to

mainly affect the financial market but other crises such

as banking panics are believed to have a role to play in

decreasing growth in the rest of the economy

9.4 Theories of Financial Crises

-Marxist theories : Emphasis on the role of supply and

demand in financial markets and that imbalances could

lead to crises

-Minsky’s theory :Theorized that financial fragility is a

typical feature of any capitalist economy

-Herding models and learning models : A variety of

models have been developed in which asset values may

spiral excessively up or down as investors learn from each

other. In these models, asset purchases by a few agents

encourage others to buy too, not because the true value of

the asset increases when many buy but because investors

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come to believe the true asset value is high when they

observe others buying.

9.5 Recorded Financial Crises

In the 20th Century a few crises were recorded:

-Shanghai rubber stock crisis – 1910

-The Great Depression – 1930s-Was a major economic

depression in the 20th century

-Oil crisis – 1973 when oil prices soared, leading to the

1973-74 stock market crash

-Latin American debt crisis – beginning in Mexico –

1980s

-Black Monday – 1987 – one of the largest percentage

decline in stock market history

-Mexican Economic crisis –default in Mexican debt -

1994-1995

-Asian financial crises – 1997-1998 – devaluations and

banking crisis across Asia

-The American financial crisis – 2007-2009 – lead to the

Global financial crisis of 2008-2009. Researchers and

practitioners do argue that this crisis is still ongoing

9.6 Financial Crises in Kenya

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Characteristics of Kenya economy:

–Mainly Agro-based

- Service sector such as tourism also play an important

role in the economy

- GDP fluctuates

- Conditionalities from bilateral and multilateral

agencies

- Places importance on Loans and Grants received from

the World Bank, IMF and other Development Partners

Kenya Financial Market :

- Dominated by commercial banks

- Other financial institutions; Insurance Companies,

Investment Banks, Mortgage Financial Institutions,

Stock Brokerage Firms, Retirement Benefit Institutions

such as Pension Funds, Regulatory Authorities such as

Capital markets Authority and The Central Bank of

Kenya, Savings and Loan Institutions and the Credit

Unions.

Crises in the Kenya Financial Sector

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-1986 baking crisis- several commercial banks failed and

11non-bank and one commercial bank were merged to

form Consolidated Bank

- 1993-1994 baking crisis –Closure of Exchange Bank and

a few other banks

-1997- 2003 – Several banks collapsed and Government

bailed out National bank by Injecting additional capital

-2008 Turbulence in the Kenya Stock Market when

activity in the stock market was one of the lowest;

Discount Securities closed down

Causes of Financial Crises in Kenya:

-Governance issues

- Fraud

-Unfavourable economic conditions

- Weaknesses in lending policies

-Regulatory failures

Notably, Kenya financial crises has been more pronounced in

commercial banks. Recently however the crises has also caught up

with the stock market. Insurance sector was also affected when

Stallion, Kenya National assurance and Invesco Insurance went

into receivership.

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9.7 Possible Solutions to Financial Crises

-Regulation: Develop a more comprehensive and enforceable

regulatory framework ; Capital requirements and enhanced

supervision

-Monitoring of financial institutions – Enhance by government

agents

-Reforms; In the financial market as a whole but focus more on the

banking sector

-Consideration of the possibility of setting up a single Regulatory

Authority because of the interdependence of financial market

segments or subsectors

9.2 MONETARY AND FICAL POLICIES

Governments put in place policies to govern activities of financial

and non-financial institutions.

Monetary Policies : Policies the Government, through the Central

Bank puts in place to regulate money supply.

This may take the form of;

-Cash ratio requirements

- Reserve requirements

- Use of Open Market Operations

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- Increase in the money in circulation or control the amount of

money in circulation

-Liquidity Requirements

- discounting provisions

Fiscal Policies: Deal with control of Government Revenue and

Government Expenditure

-Government Revenue : Taxation policies; such as tax rates and

taxable goods and services; Sale of Government assets through

privatization or otherwise; Income from Lease of Government

Assets; Receipt of dividends paid by Government owned (partial)

institutions; Interest received by Government form interest bearing

investments; Profits made by Government owned institutions and

other incomes.

Government Expenditure : Capital Expenditure or Development

Expenditure

: Recurrent Expenditure

Government Laws, Financial regulations and Government

Circulars impose controls on Government spending. The

Constitution and Procurement Laws are among the major laws that

govern use of Government funds.

11.0 INFORMAL FINANCE

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11.1 Nature of Informal Finance

The informal financial markets provide financial services to

economic agents that do not have access to formal financial

markets. The majority of rural population in many developing

economies rely on informal financial market. Small irregular

savers cannot not access credit from many financial institutions,

thus they have to rely on informal finance. Notably, although credit

services command center stage in most discussions relating to

informal finance, deposit services are also important.

Borrowing may be imprudent for many Small and Micro

enterprises but virtually all can benefit from access to

conventional, safe, and remunerative deposit facilities for storing

liquidity and accumulating capital. In many economies the formal

sector is not able to serve all the SMEs thus the need for informal

finance.

Small borrowers are limited by:

-Collateral requirements

-Low levels and irregular incomes

- Highly skewed incomes

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Small borrower households therefore are exposed to high risk

profile which makes them less attractive to the formal lenders.

They thus rely on informal financial markets for credit for both

investment and consumption

11.2 Characteristics of Informal Financial Institutions

-Informal finance is able to tailor contracts to fit the individual

dimension, requirements, and tastes of a wide spectrum of lenders

and borrowers. Informal financial institutions: -Operate in the form of selp-help organizations

-Provides savings and credit facilities for small farmers in rural

areas and for lower-income households and small-scale enterprises

in urban areas

-Procedures for informal schemes are usually simple and straight

forward; as they emanate from local cultures and customs

- Mobilizes rural savings and small savings from low income urban

areas

- Provide their services at times and days which are convenient for

their members

- Access to credit is simple, non-bureaucratic, and little based on

written documents

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-Processing of credit is simple and direct which allows for prompt

approval and a minimum delay in disbursement. Rejections are

rare, but the level of risk is reflected in the interest rate charged

- Collateral requirements on loans are to local conditions and

borrowers capacity. The conditions might be based either on

regular contributions or other regular activity to determine the

borrowers capacity to repay the loans

- Transactions costs are low compared to those of formal

institutions

- Informal groups are conversant to problems of their members and

therefore they are able to deal with repayment difficulties of their

members in a pragmatic manner which might call for rescheduling

of debt

- The informal sector has dense and effective network at the grass

roots level for close supervision and monitoring of borrower

activity; particularly their cash flows; whether they are members of

an informal association or not. This contributes to efficient

mobilization of savings and high repayment rates

- Information tends to be easily transmitted because regular

meetings of members serve as a forum for dissemination of

information

- Charges competitive lending rates though at times comparable to

those that are charged by formal financial institutions

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- There is little connection between lending and deposit rates

- Donot usually keep written records, but may sometimes maintain

a listing of borrowers and members contributions or savings

- The volume and availability of loanable funds are subject to

seasonal fluctuations

- Doesnot receive subsidies from government or any other form of

support

- Have been accused of charging exorbitant interest rates

particularly the moneylenders

- Some are said to operate within highly localized social spheres

due to the lender’s need for intimate knowledge of borrowers, for

social leverage in lieu of collateral or for opportunities to recover

debt through interlinked contracts.

- Lenders do not mobilize funds from the community, so there

occurs no intermediation of public savings

11.3 Types of Informal Financial Institutions

Relatives and Friends: These are close lenders with collateral free

loans and usually at no interest. The borrower is able to finance

urgently needed expenditures quickly with little transaction cost,

no lengthy appraisal process, little or no paper work. Maintaining

the longterm relationship far outways the cost of default

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Rotating Credit and savings Associations (ROSCAs): Provides a

means of accumulating savings for the purchase of indivisible

goods more quickly. They pool in savings from members each

period and rotate the resulting funds among them using certain

rules. The process is repeated each period until each member

receives their credit. Examples include the Merry-Go-Round and

the Village Table Banking Associations.

Moneylenders: Borrowers approach money lenders when the

amount of credit required is larger than can be obtained from

socially close lenders. Money lenders charge explicit interest rates

in order to obtain real positive returns on their capital.

Moneylenders lend to well known borrowers although they can

also lend to unknown borrowers if punitive measures on default are

feasible. Lending may be secured by physical collateral or by

social collateral such as group gurantees. These loans are generally

expensive but they are usually open to the public. SMEs are said to

prefer borrowing from moneylenders because such loans can be

arranged promptly, involve low transaction costs and bear no

restrictions on the use of funds.

Tied Credit: Loans are frequently tied to complementary

transactions in land, labour or commodities to minimize problems

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of inadequate information about the credit worthiness of the

borrower and lack of suitable physical or social collateral. Traders

disburse credit to farmers in exchange fro the right to market the

growing crop, shopkeepers increase sales by providing credit for

food, farm inputs, and household necessities. The lender is able to

keep close association with the borrower and can screen the

borrower better for future loans

Loan Brokers who act as intermediaries between those who have

excess credit and those who are in need of credit at a fee. Where

they have a contact point, it becomes relatively easier for both

category of clients

Landlords who extend credit and expect payments from the tenant

based on an arrangement such as sale of crops grown on the land.

This has been applicable where in the land tenant-landlord

relationship

Merchants who exchange goods for credit or extend credit and

promise to receive repayments in terms of real goods as agreed

with the borrower. Shopkeepers may sometimes double as

merchants. At higher level however merchants may extend

relatively huge amounts of loans

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Welfare Associations: Persons who share common interests come

together, make contributions and provide certain agreed services to

the members

Self-Help Groups: Members come together, make contributions

and the activities are guided by certain principles. These groups

usually extend credit to their members and organize other activities

such as get-togethers among other activities

11.4 Other Categorization of Informal Finance

Semi-formal financial institutions: Semi-formal finance refers to

grassroots financial networks supported by a formal institution

structure. Others provide in-kind loans through “farmers” clubs.

These loans reach both farm and nonfarm enterprises through

fungibility effects. Farmers receiving loans can reallocate their

own cash to nonfarm activities.

Village Funds organizes low income farmers into savings and

credit groups of a specified number, like five or ten members.

Semi-formal finance institutions are gradually penetrating the

countryside with deposit and loan services packaged appropriately

for SMEs and low-income households.

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In Kenya the majority of the Micro Finance Institutions fit this

description. Informal financial institutions have been known to

graduate to the next level such as graduation of MFIs to formal

financial institutions such as commercial banks.

11.5 Implications of Informal Finance to Policy

Credible longterm partnerships which enhances self enforceability

is important

Tailoring financial services to specific demand patterns; such as

emergency loans, education loans and others made available on

short notice is another consideration

Promoting more efficient informal financial institutions to formal

financial institutions

11.6 Linking Informal Markets to Formal Markets

-Encouraging offering of institutional financial services to SMEs

-Putting in place measures for enforcing policies to enable

enforcement of contracts

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It remains to be demonstrated that SMEs can finance productive

investments using short-term loans at extremely high real interest

charges. It is valid to assume that when small businesses borrow

they expect a return in excess of the cost of funds. Yet it would be

astonishing to find investments yielding a return of more than 40%

per month in the normal course of business given that most SMEs

operate in intensely competitive industries. Moreover, at such high

profit rates no business would remain small for very long.

While little is known about why SMEs borrow on very

unfavourable terms, it is quite clear that a profitable market exists

for loans bearing interest rates far higher than those currently

charged by formal and semi-formal institutions. Robust activity

and high monopoly rents by moneylenders imply that they face

insufficient competition from alternative agents, be they formal or

informal.

The absence of competitive, efficient and well-integrated financial

markets implies loss of potential welfare, efficiency and growth.

Most informal finance takes place in extremely fragmented

transactions some at zero interest. Experience in many countries

demonstrate that small enterprises and low-income households can

be much better served through either informal markets or

innovative formal sector programs.

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Experience from other countries indicate that informal financial

markets tend to expand in response to repression of the formal

financial market; but this is not a constructive basis for policy.

A more positive policy proposal for promoting informal finance is

to eliminate restrictions hindering their growth.

Given the inherently bureaucratic nature of government programs

it is tempting to conclude that government can do nothing to foster

informal markets beyond establishing a facilitating legal

environment. Government can however pursue limited indirect

actions to help nurture informal financial market development

At a minimum, government can encourage informal financial

markets by broadcasting information to potential financial

entrepreneurs about the legal environment, business opportunities

and techniques for establishing informal saving and credit

associations. These low-cost options can be pursued without

introducing the heavy hand of bureaucracy into the informal

financial market mechanism. Even such limited efforts to intensify

competition and diversify IFMs will pay off if they help to

promote more affordable and better integrated flows of informal

finance for SMEs and low-income households.

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Market promoting interventions directed to formal sector

institutions are likely to be most effective. Incentives and

assistance can be provided to facilitate the testing of innovative

programs to deliver low-cost financial services to nontraditional

clientele.

At the micro-level, providing secure and remunerative deposit

facilities for storing liquidity and accumulating savings will

generate direct utility gains. With improved access to finance,

entrepreneurs can take advantage of income-generating

opportunities and smooth out income fluctuations.

In the long-run, the goal should not be to extend credit to the SMEs

but rather to make more widely available an efficient mix of

competitive financial services – both deposits and loans – through

financially sound formal, semi-formal, and informal institutions.

12.0 PUBLIC ENTERPRISE RESTRUCTURING AND

FINANCIAL SECTOR REFORMS

12.1 PUBLIC ENTERPRISE RESTRUCTURING

12.1.1 Profile of Public Enterprises Sector

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Public Enterprises can be classified according to various criteria;

namely, their legal form, the function they perform, or the level at

which they are incorporated (Central Government level, State

Corporations or Municipal Level Institutions).

Financial Versus Non-Financial Public Enterprises

Non-financial enterprises are generally registered under the

Companies Act and a separate legislation covers banking

institutions and other financial enterprises. In Countries such as

India, the term “Public Enterprises” refers to non-financial public

enterprises only. Observably, while the growth of the absolute size

of the PE sector is remarkable in itself, its growth relative to the

private sector is even more striking. The case suggesting the

dominance of the public sector becomes an open and shut one,

once we note that in some key industries, it has a near or complete

monopoly.

Central Versus State Government Owned Public Enterprises

Another distinction within the Public Enterprise Sector is with

regard to the control structure. Public Enterprises are set up and

controlled by the Central Government as well as the State

Governments. The Central PEs differs from State PEs in that

firstly; Central PEs are generally much larger, and secondly, the

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two types of enterprises do not appear to compete with each other

directly. The Central PEs is majorly in the heavy industry sub

sector, but this does not imply other PEs are not important. On the

contrary, State PEs serves an important purpose in the socio-

economic setting of individual states.

12.1.2 What Can Possibly Explain the Rapid Growth of Public Enterprise Sector in Most Economies?

Evidently, the reasons for growth of many PEs are unclear and

remain debatable. In some instances, even the theory regarding the

determinants of the size of the public enterprise sector in a country

is extremely under-developed. Notably, public production of goods

and services is some what of an embarrassment to most

economists. It exists, and will in all likelihood increase in

importance, but it is difficult to explain. An acceptable theory of

public production has not emerged. There are those who use a

political-economy approach to show that the size and nature of the

public sector in a country depends upon the class interest of the

dominant political groups (Ahmad, 1982). There others who

assume that governments are pragmatic and rational and claim that

the size of the public sector increases until the marginal benefit

from doing so just become equal to the marginal cost (Jones and

Mason, 1982). To adequately summarize all these theories is a

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great task, but it is possible to identify some reasons which stand

out as the major explanations for the growth of public enterprises.

New undertakings in defense, key and public utility industries

should be started under public ownership. New undertakings which

are in the nature of monopolies or in view of their scale of

operations serve the country as a whole or cover more than one

province should be run on the basis of public ownership. This is

subject to the limit of the State’s resources and capacity at the time

and the need of the nation to enlarge production and speed up

development. Reliance on the private sector to achieve these

objectives was considered unwise and the argument was that the

private sector left to itself had no capital neither managerial

capability to undertake the large investments required by the basic

and capital goods industries. Apart form India other countries such

as Germany, Japan and Korea concurred with this view.

The general ideology is that the private sector is incapable of

serving the interests of the nation and pursuit of profit is likely to

work against the general good.

12.1.3 What is Public Enterprise Restructuring (PER)

Public Enterprise Restructuring also known as Public Sector

Reform was conceptualized long before the era of privatization.

Some pressure had to be put on governments both inside and

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outside public service for parastatals to be run in a business-like

manner. In Kenya public enterprise reform focuses on divesting

large infrastructure and service enterprises like Telkom Kenya,

Kenya Railways, Kenya Ports Authority, and Kenya Pipeline

Corporation. Public Sector Reforms focused on establishing

performance-oriented public sector management. The main

elements of the reform are public service management programme,

legal and judicial reform, efforts to enhance integrity and

accountability, and efforts to increase interaction with civil society.

12.1.4 The Genesis of Public Enterprises in Kenya

The period after independence in Kenya was marked by a

deliberate policy of direct participation by the Government in

production and trade over and above the control structures

inherited from the colonial regime. A variety of social, economic

and political objectives were set, including decolonization, rapid

development, the redress of regional imbalances, increased

participation by Kenyan citizens in the economy and promotion of

indigenous entrepreneurship. In addition to the Government’s

desire to participate directly in the production and trade sectors of

the economy, private investors (particularly foreigners) sought

government participation in joint ventures to ensure continued

government support for such ventures.

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Later Development Finance Institutions (DAIS) were created to

provide financing for development projects unable to obtain

financing from conventional private sector sources. Similarly,

investments made in enterprises by the Government, in its role as

trustee for Kenyans who were not endowed with risky capital

resources or the necessary entrepreneurial skills at the time of

independence, became permanent holdings by the Government due

to a lack of a conscious effort to divest those investments to

criticize as they became wealthier and gained business skills.

During the 1970’s, it became increasingly apparent that

government participation in the economy had grown well beyond

the Government’s original intentions. A large debt exposure

among PEs resulted in increased vulnerability which caused them

to be highly leveraged because of their static equity base.

Operating losses and inadequate returns on investments further

eroded the already weak capital bases of the PEs. The resultant

administrative and regulatory interventions introduced to protect

the ailing PEs resulted in a diversion of limited managerial

capabilities and resources from the fundamentally more important

areas of policy, infrastructural investment, development of social

services and the management of the economy. While the creation

of the PEs was perharps appropriate at independence, the changed

circumstances, together with poor performance record of the PEs,

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have mandated the need to review continued government

participation in them and/or the macroeconomic policy

environment, and the sectoral policies as well as enterprise specific

policies in which the PEs operate.

12.1.5 What Triggered the Reforms of Public Enterprises?State owned companies rarely make a reasonable return on

investments but continue to benefit from government subsidies. In

the era of Public Sector Reforms, Government owned entities ere

expected to be more efficient and generate “higher margins for

investment to sustain the desired growth rate”. In many African

countries poor macroeconomic management resulted in overvalued

currencies, tight foreign exchange controls, artificially fixed prices,

and overstaffed civil services, unsustainable public expenditures

and high level of debt. Whereas finances could be raised from

taxation, borrowing or by improving the efficiency of Public

Enterprises, improving the performance of Public Enterprises (PE)

sector is one of the top priorities of every Government.

As it became a condition for further financial support from the

Bretton Woods Institutions, governments in the sub-Saharan

regions embarked on privatization and restructuring of entities.

This was triggered by the fact that Tax Revenue had already

increased substantially and it was difficult to squeeze more

revenue out of the economic system. Additionally, public

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borrowing was also already very high and the interest burden of

borrowings increasingly pre-empted revenues raised by the

Government from tax and enterprises for raising resources for

investment. But the road to privatization was and remains tortuous,

rendered so by the need to concurrently, or in rapid sequence,

implement economic liberalization programmes, other economic

reforms, and political reforms.

The term “privatization” is in such common use, especially in sub-

Saharan African countries, that it has almost become a generic

term for several transactions involving the transfer of rights of

ownership of service-provision from the public sector to the

private sector. However, since privatization to a large extent forms

an important component in the large economic liberalization

programmed, popularly known as structural adjustment

programmes (SAP), it received an initial cold reception—not only

because of some short-term side effects of SAP but also as a result

of political sensitivities aroused by the sale of public property to

private individuals.

In Kenya, for want of sufficient indigenous private

entrepreneurships after independence, government had to use

parastatals “to fill the existing entrepreneurship gap.” Thus, public

enterprises “served as a means to promote the establishment of

private African enterprises.” During the early days of their

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establishment, some public enterprises operated at a profit. In

Kenya, especially in the 1970’s, state-owned banks spurred growth

and were important in the establishment of non bank financial

institutions as well as extensive rural banking.

It can be argued that if, in those days, public enterprises were

efficient in operation, then they can surely be made to operate

profitably once again. It has been suggested, in this connection,

that one of the steps that can be taken would be for the government

to re-examine the relationship that exists between them as

proprietors of these enterprises and the boards and managements of

the enterprises.

12.1.6 Performance of the Public Enterprise Sector

Performance of the Public Enterprise Sector has been consistently

below that of is Private Enterprises. Views that have been put

forward to defend this position include;

Public enterprises are usually faced with controlled output

prices while input prices continue to increase

Public enterprises are set up to achieve a large number of

non-commercial objectives. Thus to judge them exclusively

on basis of profitability may be unfair

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Public enterprises produce a very different output-mix than

private enterprises. Many of their markets are less protected

and manufacturing involves complex processes

The Assets of most public enterprises are usually understated

because they are rarely revalued. Hence any assessment

based on the book value of net assets biases the results

against public enterprises. Additionally, assets that are

acquired more recently tend to have a higher book value

because their prices reflects the most recent market price

which is the characteristic of most assets acquired by the

Private Sector.

Since the Public Sector undertakes high value investments

than the Private Sector, PE has a higher proportion of total

assets as capital Work-in-Progress. They bias the results by

making the denominator larger while by definition not

contributing to the output of PEs.

While there are weighty arguments on both sides, the truth lies

somewhere in between the two positions. PEs in India is probably

not doing as badly as depicted by their financial profitability.

However, no one can argue that there is some scope for

improvement. The objective of the current concern among policy

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makers is to reduce this slack. However, before we can attempt to

correct the problem we must know its nature.

The agency relationship between a public enterprise and the

government is such that PEs are created by the Government to

accomplish various goals. One might expect that the relationship

between these two parties would be construed so that the public

policy objectives of the Government could be achieved through the

Public Enterprise Operations. This has however not happened

since it has been alleged by a wide spectrum of non-governmental

parties that the agent (Public Enterprises) has gone on an

uncontrolled trend of poor performance. Analysis shows that it is

the inefficiency or greed of public managers (the agents) which

fundamentally causes this problem. Additionally, there is lack of

autonomy as the root cause for cramping the “Enterprise” aspects

of public enterprises placing the blame invariably on the doorstep

of the Government (the Principle).

The poor state of affairs in Public Entities has nothing to do with

the intrinsic nature of Public Enterprise Managers. Government’s

abdication of the role as a Principal has resulted from the

proliferation of Principals such that multiple principles with

multiple (and often conflicting) goals end up trying to exercise

control over a public enterprise. This provides the agents (Public

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Enterprise Managers) with an excellent opportunity to resolve the

ambiguity of multiple goals in ways that suit them best.

The contemplated solution to the problem of poor performance of

Public Enterprises lies in getting the Government back into the

business of being a “Principal”. Government has to decide on the

criteria to monitor public enterprises and has to secondly devise a

control mechanism with appropriate incentives and dis-incentives

to motivate its agents (Public Enterprises) to pursue these criteria.

Secondly, the Public Enterprise Sector could be divided into two

groups; the group of PEs that are expected to make profits which

should then be treated like any other commercial undertaking. This

is also likely to have its own shortcomings since it is difficult to

search for a universal criterion applicable to all public enterprises,

which would be the counterpart of the profits sector. Whereas

Public Enterprises have the sole objective as that of making profits,

the Public Sector has multiple objectives.

12.1.6 Previous Attempts to Improve Performance of Public

Enterprises

The Government Kenya has made a number of attempts to improve

performance of the Public Enterprise Sector. Various Committees

have been put in place to facilitate improvement of the PES.

Among the Committees include;

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The Parastatal Advisory Committee which was formed in

1979 and the role of the Inspectorate of State Corporations

was enlarged to serve a troubleshooting, management audit

and consulting service for parastatals.

The Government released the findings of a Working Party on

Public Expenditure, suggested a series of reforms and

proposed the possibility of reducing the role of PEs and

replacing it with increased private sector activity. The output

was that direct budget transfers to the PEs were severally

restricted.

12.1.7 What Should Be the Pace of Reform of Public Enterprises?

The privatization process is perceived as involving two main and

distinct phases. The first phase is the preparation entailing a

detailed review of the Public Enterprise, covering operational,

financial and legal issues, in order to determine its current

condition, potential strengths, weaknesses, and financial

restructuring requirements. The second and final phase is the

execution and entails the implementation of the transaction. All

key decision makers by this stage would have approved the

privatization Action Plan. Identification of tasks to be performed at

this stage include; preparation of the sales documentation such as

the prospectuses, completion of any financial and operational

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restructuring required prior to divestiture, resolution of all

outstanding legal issues that affect the sale, the design and

implementation of a Public restructuring campaign to inform the

public of the impending sale and finally the execution of the sale

itself.

Reforms in the Public Sector can be rapid or gradual. A rapid

process is one that is undertaken quickly without adequate time to

assess the implication of each stage adopted in the process of

reforms. This gives the process no time to correct any oversights

in the previous stages and weaknesses tend to be carried forward

from one stage to another. A gradual process on the other hand is

one that is undertaken slowly with time to evaluate and re-evaluate

each stage so that in case there are weaknesses these can be

addressed before embarking on the implementation of the next

stage.

12.1.8 The Institutional Structure of Public Enterprise Sector

Contemporary reforms have largely focused on the public sector

with governments aiming to introduce greater economy,

effectiveness, transparency, accountability and efficiency in the

public service. In the process, governments have attempted to

reduce both their commitment to and participation in economic

enterprises. Public Sector Restructuring, and in particular the

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restructuring of public enterprises, have thus become a worldwide

phenomenon beginning in the early to mid-1980s.

To facilitate the achievement of Government objectives in PE

reform and privatization programme, the Government has put in

place various institutions;

The Parastatal Reform Programme Committee (PRPC) with

functions of; Supervising and co-ordinating the

implementation of the PE reform programme, prioritizing

and determining the timing of the sale for each non-strategic

PE, approving the operational guidelines for privatization to

be followed as well as the criteria and procedures to be

followed in the divestiture decisions, to give final approval or

rejection for the sale of public assets, to monitor and evaluate

the progress of implementing the programmes and to provide

political impetus for privatization and participate in building

public awareness and the national consensus in support of the

Government programme.

The Executive Secretariat and Technical Unit (ESTU) was

established to act as an autonomous execution agency and as

the Secretariat of the PRPC. The ESTU is responsible for the

management, co-ordination and implementation of the

privatization/divestiture programme as approved by PRPC.

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Department of Government Investments and Public

Enterprise (DGIPE) which is housed by the Ministry of

Finance is charged with the responsibility addressing the

reform aspects that are related to parastatals which are to

remain in state hands. This Government department is

expected to carry out effective oversight and leadership of the

PE reform process which would include roles traditionally

carried out by the Parent Ministries. The sector ministry’s

functions in relation to PEs are expected to be responsible for

setting corporate operational policies and to ensure that

executive managements carry them out.

12.2 FINANCIAL SECTOR REFORMS

12.2.1 Nature and Rationale for Financial Sector Reforms

Developing countries financial sectors are said to be

characterized by unsound financial institutions with the absence

of prudent regulations and supervision, uncompetitive financial

markets with a few commercial banks dominating the sector, the

existence of informal financing; and segmented financial

institutions in terms of activities and economic sectors, sources

of funding for institutions and type of assets to hold. Other

characteristics are statutory interest rate ceilings, where interest

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rate levels were set administratively, accommodation of

government borrowing, and weak monetary controls.

Mckinnon (1973) and Shaw (1973) popularized the concept of

financial repression as financial system with policies that distort

domestic financial markets, including inflexible interest rates,

higher reserve requirements and credit controls. The observation

is that a repressed financial system interferes with economic

development as the intermediaries are not well developed for

mobilization of savings, while the allocation of financial

resources among competing uses is evident.

Low interest rates are insufficient to generate savings, and even

reduce savings especially if substitution effects dominate the

income effect for households. Further, low rates raise the

expected profitability of investment projects by raising the net

present value of future earnings from the project. The net effect

is to raise the demand for funds without raising the supply of

financial resources. The outcome is rationing of credit among

the competing investors based on non-price methods as credit is

allocated according to the quality of collateral, client’s

bargaining skills, political leverage and loan size than the

expected productivity of the investment.

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Negative real deposit rates and lending rates adversely affect

development, discouraging the accumulation of wealth in the

financial form and limiting the rate of capital accumulation.

Administratively, predetermined interest rates are not only low,

but lack flexibility making it impossible for many lending

institutions to absorb any loss that may be incurred in lending to

high risk projects.

Reforms refer to changes in a system, law, organization usually

with the objective of enhancing competitiveness. Reforming the

financial sector is usually part of the broad agenda for reforming

the financial sector.

Structural Adjustment Programmes (SAPs) were implemented

in the 1980’s with the objective of revitalizing the growth of the

economy. Following the introduction of SAPs inflation

increased which was attributed to the increase in money supply

in excess of the targeted level, depreciation of the Kenya

shilling, erratic weather conditions, price decontrols, and

activities of the multiparty politics. Government deficit

worsened during the period despite the tight fiscal policy.

Domestic borrowing lead to an increase in the placement of

government securities at increasing interest rates. Financing was

majorly from domestic sources with reduction in external

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financing. Additionally financing of Government deficit

increasingly relied on domestic sources.

There was uncertainty in the financial sector about mounting of

reform policies and liberalization of interest rates, and the

withholding of foreign aid by donor countries led to scarcity of

foreign exchange. Assessment of financial reforms and their

impact on growth continue to be a debatable and still

controversial issue. Research by the United Nations (2008)

revealed the macroeconomic stability is a critical factor of

financial sector services and overall economic growth. This

suggests that there is complexity in underpinning the causal

relationship among macroeconomic stability, financial sector

development and growth. They further alluded to the fact that

assessment of financial sector reforms could be examined on ex-

post versus ex-ante basis regarding the performance of key

indicators of financial sector reforms.

After independence, Kenya inherited a financial system

composed of the Currency Board of East Africa, a commercial

bank sector dominated by foreign banks, and a small number of

specialized financial institutions. Since the Currency Board

lacked monetary and financial independence, the Government

found it necessary to establish national monetary controls aimed

at efficient operation of the monetary system. The Central Bank

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was established in 1966. The financial sector was to ensure

growth and the stability so that it could stimulate growth in

other sectors of the economy thus achieving a high economic

growth rate. The narrow financial sector was characterized by

government control on the allocation and pricing of financial

resources. The inherited financial system expanded and became

more diversified in the 1970’s and 1980s especially with the

government policy to encourage local participation in the

financial system and setting up of specialized institutions to

collect savings and finance investment through issuing new

bank and Non Banking Financial Institutions (NBFIs).

A comprehensive financial sector adjustment programme was

launched in early 1989. The main objective was to improve the

mobilization and allocation of domestic resources. Institutional

reforms which were designed to restore public confidence in the

financial system and to upgrade the skills required to supervise

and regulate financial institutions included strengthening

prudential regulations and supervision of financial system,

development and implementation of specific restructuring

programmes for weak and solvent financial institutions,

development of a strong cadre of Central Bank and other

banking professionals, and the development of a capital market.

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The policy reforms involved reducing budget deficits and

government reliance on domestic bank borrowing, developing

more flexible monetary policy instruments, liberalizing interest

rates, and improving efficiency of financial intermediation by

removing distortions in financial resources mobilization and

allocation.

12.2.2 Why Financial Sector Reforms?

Deterioration of Kenya’s financial sector impacted negatively

on the growth of the economy. Despite having a diversified

financial system, financial savings remained at a low level.

In 1986, the financial sector faced a crisis with most of the

institutions experiencing undercapitalization. It is during this

period that Structural Adjustment Programmes (SAPs) were

introduced with one of the objective of Reforming the Financial

Sector as well as Restructuring and Privatizing Government

owned entities to relieve the Exchequer the burden of having to

fund the then loss making Government owned institutions.

Financial sector reform programmes were implemented to

address: included;

Inadequate regulatory and legal frameworks for the

financial system, coupled with weaknesses in prudential

supervision

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Weak monetary policy control by the central bank

Segmentation of the financial sector by activities

Central bank regulatory differences across financial

institutions, especially between commercial banks and

NBFIs.

Facilitation of financial innovations in the broader

financial market.

12.2.3 Macroeconomic Implications of Financial Sector Reforms

Caskey (1992) argue that administratively, set interest rates expose

depositors to low non-negotiable rates, and they cannot benefit

from higher rates offered by banks competing for deposits in a free

market. Low interest rates inhibit entry of new financial

institutions, stifling competition and causing capital flight leading

to foreign exchange shortages if international capital controls are

relatively ineffective at preventing capital flows.

Financially repressed systems abolish or relax interest rate

controls, eliminate or greatly reduce controls on allocation of

credit; switch to market based indirect methods of money supply

control; and develop money and capital markets. Flexible interest

rates allow more diversity in interest rate structure where

institutions are able to consider lending proposals involving higher

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levels of risk since they are able to charge higher rates reflecting

the risk component. Flexible rates also mean that borrowers

without access to loans can access credit, and credit increasingly

flows toward more profitable projects, ensuring economic growth.

Financial liberalization theory argues for improved economic

growth through financial sector reforms. The supporters of

financial liberalization argue that positive real deposit rates raise

the saving rate, thus increasing the flow of financial savings.

Developing countries with repressed financial systems mounted

financial reforms aimed at; mobilizing financial resources with

increased amounts of domestic savings channeled through the

formal financial sector, reducing the role of direct controls in

determining the allocation of credit, and increasing reliance on

market based system of monetary control broadening the range of

domestic sources of finance.

12.2.4 Interest Rate Liberalization

Interest rate liberalization was introduced in Kenya in 1992 with

the objective of keeping the general level of interest rates positive

in real terms in order to encourage savings and to contribute to the

maintenance of financial stability; to allow greater flexibility and

encourage greater competition among the banks and non-bank

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financial institutions to enhance efficient allocation of resources, to

reduce the differential to maximize lending for banks and NBFIs.

With liberalization, the interest rate policy aimed to harmonize the

competitiveness among the commercial banks and NBFIs by

removing the differential that had existed for maximum lending

rates to allow greater flexibility and encourage greater competition

in interest rate determination so that the needs of both borrowers

and lenders could be better met through the cooperation of market

forces and to maintain the general positive levels of interest rates

in real terms in order to encourage the mobilization of savings and

contribute to the maintenance of financial stability.

Other reforms that were undertaken in the Kenya financial sector

include; exchange rate and trade liberalization. In the financial

sector there was a move toward the use of indirect monetary policy

instruments, including reserve ratios, variable liquidity ratios and

liberalized market based interest rates. The government took

measures to eradicate the policy and institutional constraints in the

operations of treasury bill and treasury bond markets, including the

attraction of auction, reforms in the leading mechanism and issue

of a broader range of treasury bills. The period following the

interest rate liberalization saw an upward review of cash ratio and

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liquidity ratio aimed at regulating the liquidity in banking

institutions.

The Government sought to strengthen the legal and technical

capacity of the Central Bank to carry out its regulatory and

supervisory functions.

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