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DFI 503 FINANCIAL
MARKETS
INSTITUTIONS
COURSE FACILI TATION MATERIAL
COMPILED BY
ANGELA M. KITHINJI
UNIVERSITY OF NAIROBI
1
AND
UNIVERSITY OF NAIROBI
SCHOOL OF BUSINESS
DFI 503: FINANCIAL INSTITUTIONS & MARKETS
COURSE OUTLINE
COURSE 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
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1.7Financial Markets and Macro-Economic Policy 1




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
Term Paper
Total-Coursework Marks
Final Examination
Total
30%
20%
50%
50%
100%
4
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 SubSaharan 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 Supplements
The Banking Laws
The Insurance Act
Other Financial Market Laws
Any 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.
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Types of Financial Instruments
- 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 decisionmaking 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 shortterm 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
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Lack of credit rating agencies
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Lack of international integration:
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Limited cross-boarder listing
-
Limited foreign investor participation
-
Under and over pricing of securities
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Few securities traded – lacks options, swaps e.t.c
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High Market concentration
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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
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Low market concentration
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Presence of international integration
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Many securities traded: shares, bonds and derivatives
-
Low volatility of market returns
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Size – reasonable big
-
High activity
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Advanced technology: CDs, ETS
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Foreign investor participation
-
Presence of international integration
-
Qualified personnel
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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

Disclosure requirement

Minimum share issue requirement

Minimum number of shareholders

Furnish accounts every year with CMA
years
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
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efficiency and stability of financial systems. Conventional wisdom
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
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4.3 Other Regulatory Mechanisms
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.
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Functions of the Central Bank
 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.
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Capital Adequacy
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:
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prepare quarterly financial statements according to the financial
reporting standards, have them audited, and to register or publish
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.
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Deposit Production Fund
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 CHARACTERISTICS
Among 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
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 Risk
 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
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Disadvantages
 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
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6.0 INFORMATION ASYMMETRY AND FINANCIAL
CONTRACTING
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
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presumption that markets, in the absence of government
intervention are not efficient.
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
32
of information are imperfectly competitive; for example, customers
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.
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 Capital resources will not be allocated as efficiently as
investors
will
not
place
reliance
on
financial
institutions.
 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
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6.1.6 Banks as Monitoring Institutions
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
35
firms ability to raise equity capital because potential investors
have that assurance that the firm will be supervised by the bank.
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
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6.1.9 Financial Market Failure
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
37
markets. Systems of recording, analysis, accumulation
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
38
6.2 Moral Hazard
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
39
-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
40
- 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
asymmetry
-Embracing technology in the financial market
41
information
-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
42
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
43
- 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
44
- 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
45
- 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
46
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
47
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
48
-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
49
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
50
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
51
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.
52
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
53
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
54
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
55
-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
56
-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
57
-Product innovations
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,
58
use of computers in accounting systems
and client data
management software.
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
59
Include introduction of new deposit accounts, new credit
arrangement, credit cards, debit cards, insurance and other
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
60
-Greater
efficiency
and
diversity
in
financial
intermediation as a result of financial innovation which
increase productivity and growth potential of the economy
-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.
61
Financial repression is defined as the set of policies, laws,
regulation,
distortions,
qualitative
and
quantative
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:
62
-Capital controls (both inflows and outflows)
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
63
improving the quality of loan applicants by selecting
high-risk projects.
-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
64
Consequences of Financial Repression
-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
65
-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.
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
66
-A more efficient banking system with lower transactions
margins, wider product ranges and better client service
arising from competition between more banks and nonbank financial intermediaries
-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,
67
 Treasury bills are highly demanded in the financial
market,
 Equity stocks attract foreign investors and,
 Foreign capital inflows increase
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
68
-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)
-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
69
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
 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
70
Financial Liberalization in Kenya
-Was embarked on in 1992
-Investments were made heavily in Treasury Bills thus
crowding out private sector
- 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.
71
Theories have been developed by researchers on how financial
crises occur, early warning systems and how they can be
prevented.
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.
72
 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)
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
73
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
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.
74
 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
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
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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
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
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-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
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
77
Kenya, Savings and Loan Institutions and the Credit
Unions.
Crises in the Kenya Financial Sector
-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
78
with the stock market. Insurance sector was also affected when
Stallion, Kenya National assurance and Invesco Insurance went
into receivership.
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;
79
-Cash ratio requirements
- Reserve requirements
- Use of Open Market Operations
- 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
80
Constitution and Procurement Laws are among the major laws that
govern use of Government funds.
11.0 INFORMAL FINANCE
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
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-Low levels and irregular incomes
- Highly skewed incomes
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
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- Access to credit is simple, non-bureaucratic, and little based on
written documents
-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
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- Charges competitive lending rates though at times comparable to
those that are charged by formal financial institutions
- 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,
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no lengthy appraisal process, little or no paper work. Maintaining
the longterm relationship far outways the cost of default
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.
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Tied Credit: Loans are frequently tied to complementary
transactions in land, labour or commodities to minimize problems
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
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with the borrower. Shopkeepers may sometimes double as
merchants. At higher level however merchants may extend
relatively huge amounts of loans
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.
87
Semi-formal finance institutions are gradually penetrating the
countryside with deposit and loan services packaged appropriately
for SMEs and low-income households.
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
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-Putting in place measures for enforcing policies to enable
enforcement of contracts
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
89
demonstrate that small enterprises and low-income households can
be much better served through either informal markets or
innovative formal sector programs.
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
90
promote more affordable and better integrated flows of informal
finance for SMEs and low-income households.
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
91
12.1 PUBLIC ENTERPRISE RESTRUCTURING
12.1.1 Profile of Public Enterprises Sector
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
92
Governments. The Central PEs differs from State PEs in that
firstly; Central PEs are generally much larger, and secondly, the
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 socioeconomic 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
93
from doing so just become equal to the marginal cost (Jones and
Mason, 1982). To adequately summarize all these theories is a
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)
94
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
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
95
the economy, private investors (particularly foreigners) sought
government participation in joint ventures to ensure continued
government support for such ventures.
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
96
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,
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.
97
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
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 subSaharan 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
98
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
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
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 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
 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.
100
However, no one can argue that there is some scope for
improvement. The objective of the current concern among policy
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
101
control over a public enterprise. This provides the agents (Public
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
102
have been put in place to facilitate improvement of the PES.
Among the Committees include;
 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
103
this stage include; preparation of the sales documentation such as
the prospectuses, completion of any financial and operational
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
104
reduce both their commitment to and participation in economic
enterprises. Public Sector Restructuring, and in particular the
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
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management, co-ordination and implementation of the
privatization/divestiture programme as approved by PRPC.
 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
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of funding for institutions and type of assets to hold. Other
characteristics are statutory interest rate ceilings, where interest
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
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bargaining skills, political leverage and loan size than the
expected productivity of the investment.
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
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majorly from domestic sources with reduction in external
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 expost 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
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at efficient operation of the monetary system. The Central Bank
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
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banking professionals, and the development of a capital market.
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;
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 Inadequate regulatory and legal frameworks for the
financial system, coupled with weaknesses in prudential
supervision
 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
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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
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
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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
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
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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
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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