Unit Code : FNCE 414

Unit title : MANAGEMENT OF FINANCIAL INSTITUTIONS

Unit Hours : 3 .0 CF

Purpose of the course

The purpose of the course is to enlighten the learners on the role of financial Institutions in an
economy, structure of Kenyan financial markets, regulation of financial institutions and
management of risks faced by commercial banks and other financial institutions in contemporary
financial market environment with special emphasis on the Kenyan financial system. It is an
essential course for learners who intend to engage in or seek a career in the Banking and
Financial Service industry.

Expected Learning outcomes

Upon successful completion of this course, the learners should be able to:

1. Explain fundamental concepts and principles of financial institutions.

2. Apply concepts, principles and theories of management of financial institutions in
analyzing and diagnosing problems faced by financial institutions.
3. Explain the role of financial institutions in the economy
4. Analyze the need for financial institutions regulations and the tools used by various
regulatory bodies.
5. Discuss various risks faced by financial institutions and mechanism used to solve them.
6. Compute the sensitivity of equity and fixed income securities to interest rate changes
with a view to provide informed investment advice

Course contents

No. Indicative Content week

1. Overview of Financial Institutions 1

 Introduction
 Types of Financial Institutions
 Functions of Financial Institutions
 Difference between financial Intermediation and Facilitation
 Financial Markets
 Types of markets
 Role of financial markets 2
 The main players in the Kenyan Capital Market
 CAT ONE
2. Regulatory Environment

 Regulatory bodies in Kenya 3

 Need for financial institutions Regulations
 Definition of bank regulation
 Types of Bank regulations
 Tools of Bank regulation 4
 Reasons for bank regulations

3. Capital adequacy and Liquidity Management

 Purpose of capital adequacy 5

 Measuring capital
 Measures of capital adequacy 6
 Basel Accord and tier 1 and tier 2 capital
 CAMELS Rating
 Group Presentations
4. Types of risks faced by Financial Institutions

 Credit risk
 Liquidity risk
 Interest rate risk 7
 Market risk
 Off balance sheet risk
 Foreign exchange risk
 Country or sovereign risk 8
 Technology and operation risk
 Insolvency risk
4. Interest rate and foreign exchange risk Management

 The role of interest rates in the economy 9

 Components of interest rate risk
 Models of interest rates
 Gap management
 Duration management
 CAT II
5. Credit risk management and Insolvency risk

 Credit analysis 10
 Credit investigation
 Loan policy
 Alt mans Z-score
6.  Financial Innovations-meaning, types and importance of financial 11
innovations, Theories of financial innovations
12
 Financial Engineering-Meaning and Types of financial engineering
 7. Global view of financial services

 International financial services 13

 Foreign direct investments
 International financial markets
8 Emerging issues 14

End of Semester Examination 15

Mode of Delivery

Lectures, exercises, Group discussions, Case studies, Student presentations, Library research,
Internet research and online learning

Instructional Materials/Equipment

Handouts, whiteboard, Laptop and videotapes

Assessment

Continuous assessment tests, individual and group presentations, assignments, and final
examination.

CATS 20%

Assignments, Group Presentations 10%

End of Semester Exam 70%

100%

Recommended text books

Gardener M.I, D.I Mills and Cooperman E.S (2000): Managing Financial Institutions
“An Asset-Liability Approach”4th .Ed. Harcourt College Publishers
Jeff Madura, Financial markets and Institutions, Florida Atlantic University, India
Edition

Saunders, Cornett, and McGraw (2010): Financial Institutions Management, A Risk

Management Approach, 4th Canadian Edition, McGraw-Hill Ryerson,

Sounders A., Cornet M.M, (2008): Financial Institutions Management, McGraw Hill.

FNCE 414: MANAGEMENT OF FINANCIAL INSTITUTIONS

LECTURE ONE NOTES

SEP-DEC, 2023 SEMESTER

Financial Institutions

Financial institutions are what make financial markets work. Without them, financial markets
would not be able to move funds from people who save to people who have productive
investment opportunities. Financial institutions thus play a crucial role in improving the
efficiency of the economy.

Financial Institutions are entities that act as agents that provide financial services for their clients
as intermediaries of financial markets and these include Commercial banks, investment banks,
mutual fund, or pension fund. They have been created to facilitate transfer of funds from
economic agents with surplus funds to economic agents in need of funds (Deficit Units). These
institutions facilitate the flow of funds in the economy and fall under financial regulation from a
government authority. Advances in technology threatens to eliminate the financial intermediary,
disintermediation is much less of a threat in other areas of finance, including banking and
insurance.

There are three main reasons why financial intermediaries exist:

1. Different requirements of lenders and borrowers;
2. Transaction costs, and
3. Problems arising out of information asymmetries

Surplus and deficit agents

In an economy, one can observe two distinct groups of economic agents: those that have surplus
funds (surplus agents) and those that require funds to finance expenditure which exceeds their
income (deficit agents).

Surplus agents are made up of individuals and firms and have a wide variety of motives for
saving surplus funds such as the need to meet unforeseen contingencies, to finance future
investments or future purchases or simply to make a good return and some save for retirement.

Surplus agents will want a range of savings products that provide them with a desirable mixture
of liquidity, return and protection against the effects of inflation.

Deficit agents are made up of individuals, firms and government agencies that have a wide
variety of motives for borrowing funds. Many firms wish to borrow funds to finance investment;
Individuals borrow to finance expenditure above current income.

NB: Clearly there is potential for surplus funds to be transferred to deficit agents, and this is done
with the help of financial intermediaries and through a variety of financial securities.
Economic agents therefore have different financial positions, investment and financial needs and
for this reason, there are a wide range of financial intermediaries and financial instruments
servicing these needs.

NB:It is therefore important to know that financial institutions gather excess funds from the
surplus spending units and allocate them in the economy to the deficit spending units in the most
efficient manner to ensure adequate capital formation, investment and economic growth.

Direct Financing and Indirect Financing

a) Direct financing

In direct finance, borrowers borrow funds directly from lenders in financial markets by
selling them securities (also called financial instruments), which are claims on the
borrower’s future income or assets. Securities are assets for the person who buys them,
but they are liabilities.

-or the ultimate funds suppliers (lenders) lend funds directly to the funds demander
(borrower) with or without the help of an intermediary such a bank.

b) Indirect financing, the funds demanders (borrowers) obtain financing from a financial
intermediary. The intermediary and the borrower negotiate the terms and cost. The
intermediary obtains funds by offering different claims to fund suppliers (lenders). In
this case the intermediary is usually responsible for monitoring the contractual conditions
of the financing agreement and perhaps updating the cost if needed

Or indirect finance, in which a financial intermediary borrows funds from lender-savers

and then uses these funds to make loans to borrower-spenders

Direct financing allocation process can be illustrated as follows:

Surplus Units Deficits Units

Lending

Borrowing
Distinguish between financial intermediation and financial facilitation

Financial intermediation is the process of transferring (channeling) funds from economic

agents with surplus funds (Lenders) to economic agents that would like to utilize those funds
(borrowers). This is done with the help of financial intermediaries and through a variety of
financial securities- Intermediary acts like a middle-man in the process.

Financial facilitation can be either the act of preserving a market's liquidity or the act of
supplying a market for a security i.e. market makers facilitate markets when they trade on their
own accounts to try to preserve equilibrium of supply and demand. A finance facilitator is a
seasoned professional educated in finance as well as having a list of bonafide funding sources.

How financial intermediaries meet the needs of lenders and borrowers in an economy

1. Financial intermediation- they link ultimate providers of funds (lenders) with ultimate
users (borrowers) and creating financial assets in the process.
2. Maturity transformation of funds -Converting short-term liabilities to long term assets
(banks deal with large number of lenders and borrowers, and reconcile their conflicting
needs)
3. Risk transformation (Reduction)-Converting risky investments into relatively risk-free
ones (lending to multiple borrowers to reduce the risk)
4. The law of large numbers - Matching small deposits with large loans and large deposits
with small loans
5. Providing investment advice to investors
6. Professional Management of funds
7. Solve the problem of Geographical location

Types of Financial Institutions:

Broadly speaking, there are (three) major types of financial institutions:

1. Depository institutions – deposit-taking institutions that accept and manage deposits and
make loans, including banks, building societies, credit unions, trust companies, and
mortgage loan companies;
2. Contractual institutions – Insurance companies and Pension funds
3. Investment institutions – investment banks, underwriters, brokerage firms.
4. Foreign Banks and Local Banks
5. Government owned, Publicly Owned, Private Banks
The common types of financial institutions in Kenya include:
 Commercial banks,
 Non-bank financial institutions,
 Mortgage companies,
 Forex bureaus,
 Investment Banks/Development finance institutions,
 Pension funds/ Pension Schemes/ Collective investment Schemes
 Investment brokers i.e. Stock brokers/ Financial advisers
 Savings Banks/Micro Finance Banks/SACCOs/ Cooperative societies
 Insurance companies/ Life insurance companies
 Mutual Funds and Stock exchange
 Building societies

Figure 1: Components of financial intermediaries

Functions performed by financial Institutions/financial intermediaries

1) Financial intermediation- linking ultimate providers of funds with ultimate users and
creating financial assets in the process.
2) Maturity transformation of funds -Converting short-term liabilities to long term assets
(banks deal with large number of lenders and borrowers, and reconcile their conflicting
needs)
3) Risk transformation (Reduction)-Converting risky investments into relatively risk-free
ones (lending to multiple borrowers to reduce the risk)
4) The law of large numbers - Matching small deposits with large loans and large deposits
with small loans
5) Create financial assets for their customers and then selling these assets in the market ie
underwriting new issues
6) Exchanging financial assets on behalf of their customers- acting as brokers or agents
for clients
7) Exchanging financial assets on their own accounts
8) Providing investment advice to others e.g. people seeking personal pension funds or to
firms seeking mergers and acquisitions
9) Professional Management of funds
10) Solve the problem of Geographical location

According to the structural approach, the financial system of an economy consists of main
components:

1. Financial markets – facilitate the flow of funds in order to finance investments by

corporations, governments and individuals
2. Financial intermediaries( institutions) – key players in the financial markets as they perform
the function of intermediation and thus determine the flow of funds
3. Financial regulators – perform the role monitoring and regulating the participants
4. Financial infrastructure – set of institutions that enables effective operation of financial
intermediaries and financial markets, including such elements as payments systems, credit
information bureaus and collateral registries
5. Financial services
6. Financial instruments