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MANAGEMENT FINANCIAL INSTITUTIONMANAGEMENT OF FINANCIAL INSTITUTIONS

BCOM 430

INTRODUCTION

In a changing global financial movements

particularly in liberalization of participation of

financial markets. Financial institutions are facing

challenges with more entrance into the marke

creating competition and forcing wither closures

acquisitions, mergers or management over.

However, where others fail, others succeed and

even new entrants join with different strategies

and different products. herefore to understand

how to manage financial institutions successfully

in a changing environment, one needs to

appreciate the concepts within money and capita

markets the institutional framework of financia

institutions, the risk managerial strategies of

financial institutions is to identify thefunctionalities, categorization statements and lega

systems. In addition, the risk management takes

a major part of the management of the institution because all financial institutions hold some

assets and liabilities in form of!

a) loans or deposits and consequently are e"posed to default risk and #credit risk$. his

is the risk that the borrower may not commit to repayment of the e"pected amount

within the e"pected time.

b) hey are also e"posed to interest rate risk. his risk relates to the liability to match

maturities of liabilities with the maturities of asset.

c) hey are also e"posed to liquidity risk. his is due to unprecedented or une"pected

saver withdrawals which may limit the capability of financial institutions to commit to

such withdrawals.

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d) they are also e"posed to underwriting risks. his emanates from lack of reliable

guarantees or collateral for the loans%assets issued out.

e) they are also e"posed to operational risks. his is due to high operational leverage

resulting from unbalanced usage of real resources e.g. technology, materials, human

resource e.t.c.

FI&'&(I') *'+- '&/ FI&'&(I') I&I0I1&

Financial markets are categorized into2

i. H- *1&-3 *'+-

he money market for financial institutions relates to transactions in e"change that pertains

to money i.e. borrowing and lending within one year, foreign e"change markets, made up of

the spot market, daily e"changed of currencies maturing in 45 hours. (apital markets for

financial institutions relates to securities usually corporate bonds and stock.

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ii. 6+I*'+3 *'+-

6rimary market is for first issue or transaction in a security. 'ny subsequent transaction falls

into a secondary market. Financial institutions play an important role in both the financia

market by moving funds from the pockets of deposit less into the pockets of borrowers

consume more than their income and to link the two, interest rates is used which acts as a

driving force to allocate the e"cess funds with depositors into the pockets of borrowers in the

financial markets and thus you cannot separate a financial institution from a financial market.

Financial markets therefore have two functions!

ime preference function

It is provided in the time value of money concept where financial markets provide a forum for

financial institutions access money at present and re7evaluate values of such money in future

under competitive environment through interest rates.

+isk separation and distribution

his is through allocation of money or capital and distribution of such capital to a large

clientele subsequently who accept to absorb such risks and thus the concept of risk

diversification of distribution.

+1)-%F0&(I1& 1F FI&'&(I') I&I0I1&

8. Financial Institutions e"ecute payment of finance in the financial market! 6aymenfinance entails facilitating financial transactions between trading partners by use of

instruments such as credit card, debit cards, cheque clearing systems, '*s, electronic

money transfer systems, mobile transfer systems which enable e"ecution of payments

such as salaries, debts, bills or insurance premiums. In other words it provides liquidity of

investment and borrowing.

9. ransmutation Function%ransmission of *onitoring 6olicy! Financial Institution

purchases primary securities and issue secondary securities consequently adding value

to the supply and demand of money in the economy. 6rimary securities are those

securities that provide a claim e.g. bond certificate, share certificate, loan provide%give the

issues a claim. his claim is transformed into a secondary security when these

instruments are sold from one point to another or person to another. he process of

changing primary securities into secondary securities is known as transmutation.

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:. 6ortfolio *anagement! It relates to an advisory function whereby financial institutions

provide advice and also manage securities on behalf of individuals and companies e.g

Investment (ompany;s advice on issues of I.6.1.s.

4. Income a" *anagement! his function relation to mitigation of ta" preferentia

between individuals and business e.g. pension schemes%funds, transfer ta" deductions

from one period to another and from high to low income brackets. his enables

individuals to bridge their ta" burdens and acts as a ta" shield.

. /enominational Intermediation! It occurs where capital market institutions transform to

money market institutions e.g. bonds transform to unit or current market.

()'IFI('I1& 1F 6'+I(I6'& I& H- FI&'&(I') *'+-

6articipants *ode of 1peration +eferenceInstitutional

' (ommercial =anks

(redit 0nions

aving =anks

/epository Institutions

Finance (ompanies

*icro7Finance Institutions

/epository

Institutions

Financial institution

= Insurance (ompaniesFinancial Institutions

6ension rust Funds

Investment (ompanies

+eal -state Investment rust

&on7/epositoryInstitutions

Financial institution

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( *ortgage =rokers

Investment =rokers

ecurity /ealers

'gencies Financial institution

/ Households

Individual =usinesses

?overnment /epartments

Investors or

/epositors%=orrower

s

&on7Financial

Institutions

DEPOSITORY FINANCIAL INSTITUTIONS

a) (ommercial =anks

hey are depository institutions because they accept deposits in the form of negotiable

certificates of deposits, non7negotiable certificate of deposits, savings deposits, checking

accounts deposits, pass book deposits accounts and current accounts. hese liabilities are

used to issuing loans and for other investments in money and capital market securities. he

assets include other than the loans and securities commercial papers such as promissory

notes and letter of credit.

Illustration

'ssume a commercial bank of 'frica with the following information available to the new

manager as at :8st/ecember 9@@A!

he =ank;s total deposits include2

ransaction accounts #savings accounts worth shs. 8,@@@,@@@.@@

(heque book accounts worth shs. 9,@@@,@@@.@@

6ass book accounts worth shs. 8,@@@,@@@.@@

&on transaction accounts made up of negotiable certificates of shs

4,@@@,@@@.@@ 1ther miscellaneous deposits worth shs. 8,4


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o Inter7bank loans shs. 5@@,@@@.@@

o Industrial%commercial loans shs. 8,@@@,@@@.@@

o +eal estate loans shs. 4,@@@,@@@.@@

o +evolving home loans shs. B@@,@@@.@@

o Individual consumer loans shs. 8,@@,@@@.@@

here is a reserve requirement of 8@C by the (.=.. In addition there is a letter of credit

involving international trade worth shs.


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a$

*anagement of (ommercial =anks =alance heet

(ommercial =ank of 'frica;s =alance heet as at :8st/ecember 9@@A

ASSETS LIABILITIES

+eserves#8@C of totaldeposits$

8,4@@,@@@

8,>@@,@@@

aving a%c(hequeable a%c6assbook

8,@@@,@@@9,@@@,@@@8,@@@,@@@

4,@@@,@@@

)oans!

Inter7bankIndustrial%(ommercial+eal-state#*ortgageloans$+evolving )oans(onsumer )oans)etter of (redit6hysical 'ssets

5@@,@@@8,@@@,@@

@4,@@@,@@

@

B@@,@@@8,


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'ssets )iabilities

+eserves B4


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(ertificates of deposits a%c

1ther sources of funds are securities both money market and capital market.

'lso borrowing from other institutions e"cept the (.=..

=alance heet

'ssets )iabilities8. *ortgage )oans 8. /eposits

7 Fi"ed +ate 6assbook a%c

7 'djusted +ate Fi"ed /eposit a%c

9. &on7*ortgage )oans 9. ecurities

7 (ommercial )oans *oney *arket #unit trust$

7 6hysical 'ssets (apital *arket #bonds$

:. =orrowing From Financial Institutions

'I&? I&I0I1& =')'&(- H--

Illustrations

'ssume Housing Finance (ompany had the following information relating to its balance

sheet for the period ending /ecember 9@@A. he firm had mortgage loans divided into fi"ed

rate and adjusted rate loans worth 8.9 million and 9.5 million respectively.

(ash and investments in securities were worth : million and 9.< million respectively.

1ther loans amounted to @.< million.

6hysical assets amounted to >.< million while central bank obligations were worth 9

million. he firm share capital is made of : million while deposits tied to loans

amounting to 8< million.

=orrowings from other financial institutions were worth 4 million.

+equired

6repare a balance sheet for the saving institution.

olutions'ssets )iabilities*ortgage )oans Fi"ed rate 8,9@@,@@@ (ash :,@@@,@@@ 'djusted rate 9,5@@,@@@ Investment 9,


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ecurities! (ash :,@@@,@@@ )ess drawings #:,:@@,@@@$ ! Investments9,


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&=! (redit 0nions just as commercial banks may face unprecedented deposits and

withdrawals through both =1' F1' a%cs.

d) FI&'&(- (1*6'&I-

're financial institutions which do not mobilize deposits and thus known as contractual non7

banking financial institutions therefore they source funds from issuing securities such as

bonds, commercial institutions and thus the only source of funds of finance companies. hey

issue credit thus the assets are made up of!

(onsumer loans

(ommercial loans.

?eneral investment loans

Investment in securities, bonds or shares.

(ash deposits in other institutions.

6hysical assets.

)iabilities

ecurities #issue or sourcing$

=orrowings

1wner;s equity

he finance companies are divided into :! ales Finance (ompanies make loans to households or other businesses to

purchase mainly commercial vehicles and other durables for commercial purposes

-"amples! (F( #(redit Finance (o7operation$ and &I( #&ational Finance (o7

operation$

=usiness Finance (ompanies provide specialized credit to purchase inventory

accounts receivable financing companies. hey give credit against inventory or

stock. herefore, the inventory acts as collateral against the credit. -"amples

range from manufacturing firms that give goods on credit. In general these

institutions are known as input supply credit providers. -"ample! (onsolidated

=ank.

(onsumers Finance (ompanies make loans to household to purchase household

items2 e.g. furniture, etc., e.g. 'frican +etail raders #'.+..$11


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In general, Finance (ompanies do not necessarily provide credit in monetary items but in

kind #good and household.

e) *I(+17FI&'&(- '&/ *I(+17(+-/I I&I0I1&

hese are regulated by the (entral =ank through the 'ssociation of *icro7Finance

Institutions #'*FI$ to lend to small and micro7enterprises and to mobilize savings from the

same micro and small enterprises.

herefore, micro7finance institutions operate just like commercial banks, only to smal

enterprises. hey also use groups through collective collateral e.g. +-6 holdings, DF

Faulu, -quity holdings, 6ride 'frica, Family Finance.

*icro (redit financial institutions issue credit only and source funds from donor agencies or

issuing of securities such as bonds. here is no mobilization of loans%funds. -"amples

*-6, &(( H-)=.

f) I&-*-& (1*6'&I-

hese are financial institutions whose ownership is through shares securities such as bonds

and all borrowings such as convertible debentures. hus the liability side of investment

companies are made up of!

)iabilities 'ssets

7 share capital 7 investments in the other companies e.g

shares

7 securities issued 7 investments in debt securities e.g bonds.

7 borrowings 7 ?overnment;s securities eg. reasury bills.

7 investment in commercial papers.

7 investment in foreign bonds.

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Investment companies usually act as underwriters for I61s i.e. after borrowings or sourcing

money through share capital and other securities such as funds are invested in the capita

market and money market securities Dith the function of underwriting shares during the I61.

he unit trusts fall under the money market are also the instruments traded by the investment

companies e.g /iamond rust Fund.

NON-BANKING FINANCIAL INSTITUTIONS WITH THE TERM NON-DEPOSITORY

A. Insuran! C"#$an%!s

'n Insurance (ompany is a non7depository finance Institution with two major products i.e. life

assurance and property insurance products.

)ife 'ssurance

he life assurance products differ from property insurance products in that they allow lending

against premiums. e.g. #products$!

i. 1rdinary )ife 'ssurance

his is where the insured receives the payment when death occurs. i.e. whole life insured,

part of the premiums can be converted into savings to act as sources of funds for lending

he whole life assurance thus has a saving and lending component against the savings and

the collaterals are premiums.ii. ?roup )ife 'ssurance

his is a product which involves a large number of insured persons usually its e"ecuted

through ee;s in a given organization and it has two components.

(ontributory

It is where the employee and employee both contribute partially to the group life.

&on7(ontributory

It is where only employee contributes towards life assurance2 ?roup )ife

'ssurance has no savings components and therefore does not qualify for a loan or

credit.

iii. Industrial )ife 'ssurance

his policy is contributed by the employer in relation to injuries, accidents and death during

the working hours and at the work place. i.e. workman;s compensation. It does not have a

savings component.

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iv. (redit )ife 'ssurance

It is a policy tied to borrowing incase the borrower dies prior to loan prepayments are

completed.

v. 'nnuities

hey are insurance products in relation to liquidation of companies or bankruptcy of

companies or any eventuality that may lead to company;s closure.

vi. 'ccidents and Health )ife 'ssurance 6olicies

his is insurance against mobility or ill health e.g. '.'.+. It has no saving components

6roperty Insurance

6roperty insurance has another component %variance of liability insurance. It covers loss

through firs, theft burglary. However, liability insurance is insurance against obligation such

as negligence or fidelity. Fidelity has a variance of surety which relates to agreements and

insurance against dishonesty.

he assets of insurance companies are usually made of two components!

ecurities G bonds, shares, 7bills

)oans G 6olicy loans, loans against premiums paid by whole life 'ssurance clients

upto the e"tent of their premium contributions.

*ortgage )oans G -"tended two savings institutions through borrowing from othefinancial institutions e.g. Housing Finance borrowing from another company.

he )iabilities!

6remiums G or policy claims

6olicy dividends%bonuses arising from savings components in live assurance

products.

+eserve deposits with re7insurance G +eserves 4 insurance are deposits kept by

insurance in re7insurance but they represent future liability commitments, i.e. they

are e"pected to pay out contracts 4 policy holders who happen to withdraw before

maturity of their policies.

I&&us'ra'%"ns

'lico had the following information relating to a company;s operations,

?overnment bonds 8,


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(ommon stock


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bills 85


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hey operate in primary and secondary stock market e.g Investment brokers who undertake

writing of I61 and thus trade in stock market in their own account. =rokers trade in security

on behalf of clients. 'ssets include2 sale of securities, income from securities and any other

physical assets. )iabilities are2 guarantees insecurities which are issued as I61s, claims

payables etc.

N"'!

For all financial institutions and at all times, one must maintain a positive net liquidity position

#&)6$.

&)6 is the difference between total supply of liquidity and the total demand made upon the

bank. It can be computed as follows

NLPK,deposits sales of non /eposit loans repayment ale of bank;s asset

borrowing from money market$ . , deposit withdrawals loans request accepted

repayment of )oans 1ther operating e"pense dividend payments/

Mana!#!n' "1 Ass!'s an( L%a2%&%'%!s

trategies employed include managing2 asset, liabilities, capital%equity management and

liquidity management.

O2!'%!s "1 #ana!#!n' "1 1un(s

olume ratio mi". -ntails evaluation of the cost% returns% price of both asset and

liabilities

*aintaining diversification and duration analysis. /uration analysis is the process of

matching maturities of assets and that of liabilities

o ensure ma"imizations of returns and minimizations of costs

Ass!' #ana!#!n'

he basis of asset management is aimed at ma"imization of profits because profits are

derived from loans issued beside securities. herefore financial institutions follow the

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prescribed strategies in asset management in order to ma"imize returns from loans and

related securities.

trategies for asset management include2

i. eeking for high interest loans with low defaults risk

ii. /iversification in different asset portfolio for instance spreading investments in

securities

iii. =anks tends to hold liquid securities % assets even if such assets earn lower returns

trategies for liability management include2

i. elling negotiable certificates of deposits #(/$

ii. elling callable securities e.g callable bonds

iii. -ntering into interbank lending systems that allows overnight lending

iv. *aintaining a positive reserve requirement above the (entral bank;s minimum

reserve amounts

Ca$%'a& #ana!#!n'

his requires that financial institution maintains a steady growth in generation of its capital to

asset ratio. his ensures a retention level and steady dividends payouts.

6urpose of equity

i. -quity is used to cushion against losses in operations

ii. -quity is used in chattering financial institutions before inflows are realized.iii. 0sed to as basis in access to financial markets in terms of credits

iv. 0sed in growth and development programmes such as branch network

v. 0sed in regulations of financial institution. hat is, a certain level of equity must e"ist

overtime in relation to assets.

vi. 0sed in mergers or other related negotiation

For a steady growth in equity, a financial institution must evaluate internal capital growth rate

#I.(.?.+$. this is a measure of how fast a financial institution manages its assets growth to

overcome a drop decline in equity asset ratio.

I.(.?.+ K return on -quity M +etention ratio #+.+$

+.1.-K &et profit% 1wners -quity

+.+K +etained -arnings % 1wners -quity

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R%s+ #ana!#!n' %n F%nan%a& Ins'%'u'%"ns

R%s+

+isk refers to uncertainties regarding returns e"pected from various investment. It arises

when significant variability is e"perienced when a particular investment is held. here are

usually various sources of risks. *ainly2 business risk, financial risk. )iquidity risk, foreign

e"change risk and liquidity risk.

In financial institution, the major risk arises from advancing loans to e"isting and prospective

customers. 6roper credit evaluation must therefore be carried out before giving loans and

advances so as to reduce credit or defaults risk.

' number of sources quality information available to banks includes2

a) 'udited financial statements of the e"isting and prospective customers

b) (redit rating agencies. his are entities which specializes in collection of credit

information about various companies.

c) 6ast e"perience

d) rade references

e) =ank references

f) 'nalysis of the prevailing economic conditions

TECHNIQUES OF MANAGING CREDIT/ DEFAULT RISKS

Management of c!edit !i"# of a c!itica$ in ban#" and financia$ in"tit%tion& financia$ in"tit%tion"

manage!" m%"t fo$$o' adve!"e "e$ection and mo!a$ (aa!d conce*t" to (ave a f!ame'o!# fo!%nde!"tanding c!edit !i"# minimiation. Adve!"e "e$ection i" *!ob$em in $oan ma!#et" beca%"e bad

c!edit !i"#" + bo!!o'e!" mo"t $i#e$, to defa%$t) a!e t(e one" '(o $ine %* fo! $oan".

(e fo$$o'ing tec(ni%e" ma, be %"ed b, ban#" and financia$ in"tit%tion" to !ed%ce defa%$t" of c!edit!i"#/

a$ creening and monitoring

In relation to screening, adverse selection in loan markets requires that financial institutionand banks eliminate credit risk by screening financial loan applicants. o accomplish effective

screening, financial institution must collect adequate relevant and reliable credit information

from the prospective borrowers. For business entities, audited financial statements may be

required on the basis of which various measures of financial performance may be determined.

b$ )ong term customers relationship

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Financial institution managers may evaluate past activities in the accounts of e"isting

customers. he balances of both current and saving accounts may give loan officers some

information about the liquidity of the potential borrowers.

c$ )oan commitment

his is a technique used for institutionalization for loan term relationship. ' loans commitment

is a banks commitment for a specialized period of time to provide a firm with loan up to a

given rate of interest borrower can access any amounts at a specialized interest rate.

6rovisions in the loan commitment agreement require that the borrower continuously supply

the bank with information about financial performance, position and future plans.

d$ (ollateral

In most cases where defaults risk is quite apparent from the information of debt information,

banks and financial institutions may insist on taking collateral called security to compensate

the institution in the event of default.

(ollateral requirement depends on the on the amount requested by the borrower. (ollateral

may be free or floating charge and a fi"ed charge.

Factoring may be done with or without recourse or without notifications. Factoring with

recourse implies that the borrower will have a responsibility if the bank fails to collect the

accounts receivable. Factoring without recourse implies that the borrower has no

responsibility even if the bank fails to collect the accounts receivables.

Factoring with notifications implies that the factor # can be a bank or financial institution $

notifies the firm that all the amounts in relation to accounts receivable have been collected. In

most cases factoring is from notification basis.

e$ (ompensating balances

his is a form of security required by the bank or a financial institution when it makes

commercial loans. he firm or entity that is requesting for a loan is required to maintain a

minimum amount of funds in checking account with the bank.

f$ (redit rationing

his is where lenders may refuse to make loans to the borrowers even when they are willing

to make principle repayments and interest payments as required. ' bank or a financial

institution may either refuse to approve certain loan requested or just pay a proportion of theamount requested. 6rospective borrowers may be requested to give information about their

prospective investments and detailed business plans. If the investment is considered riskier by

the bank, credit request may not be approved.

g$ (redit insurance

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=anks and financial institution may also take credit insurance. In this arrangement, credit or

default risk is transferred to an insurance company.

MANAGEMENT OF INTEREST RATE RISK

/eposit rate

*anagers of banks and financial institution must be concerned about the institutions e"posure to

interest rate changes. 'ssessment of interest rate changes may enable the bank to determine the

effect which such changes may have on the banks financial performance.

here are usually two categories if interest rates2

)ending %borrowing rate which the bank charges on loans and advances it gives its customers. From

the banks perspective, lending rates constitutes income while from the customer;s perspective it

constitutes costs.

e*o"it" !ate" a!e t(e inte!e"t !ate" '(ic( ban#" *a, on c%"tome!" de*o"it". (e diffe!ence bet'eent(e t'o con"tit%te" t(e *!ofit ma!gin.*anagers of banks financial institution should identify the assets and liabilities which are sensitive to

changes in the level of interest rates. 'ssessment of interest rate risk therefore requires managers to

identify, rate sensitive assets #+'$ and rate sensitive liabilities #+)$

Cr!(%' R%s+ Ana&)s%s

(redit risk is a danger or the e"posure of a financial institution to an inability for borrowers to pay

their loans % obligations as e"pected. If borrowers delay payment financial institution cannot match

their e"pected liabilities to the e"pected assets. In circumstances where loans are completely

unpaid, this leads to bad debts and bad debts cannot be part of risks management rather bad debts

are part of uncertainty management.

(redit risk analysis provides an insight%guidance on how loans can be merged with deposits. In

addition, in credit risk management, the financial institution can decide on the types of assets to

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invest in and the types of liabilities to accept. he ratio used should in credit risk management are

ratios for valuation of the abilities to commit to loan payment these are

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