Introduction



DFI 503 FINANCIAL INSTITUTIONS AND MARKETSCOURSE FACILI TATION MATERIALCOMPILED BYANGELA M. KITHINJIUNIVERSITY OF NAIROBIUNIVERSITY OF NAIROBISCHOOL OF BUSINESSDFI 503: FINANCIAL INSTITUTIONS & MARKETS COURSE OUTLINECOURSE FACILITATOR MRS KITHINJI [Financial Markets, Financial Institutions, the Power of Information, and Financial Policies]WEEKAn Overview of Financial Institutions and MarketsThe Financial System of an EconomyThe Structure of a Financial SystemThe Stock MarketEmerging Markets, African Markets and Capital Market DevelopmentFinancial Markets and the Organized ExchangeCharacteristics of Emerging Capital MarketsIndicators of Capital Market DevelopmentFinancial Regulation, Intermediation, Capital Market Structures and DevelopmentThe Players in a Typical Capital Market: - Capital Market Intermediaries- The Regulator: The Capital Market Authority - The Stock Exchange [NSE]- Investors- GovernmentThe Institutional, Regulatory and Legal Framework in Financial Markets- Types of Regulations in Financial Markets- Market Based Banking Regulations- Crisis in Banking Regulation.Securities and Their CharacteristicsShares, Fixed Income Securities, DerivativesChallenges of Trading of securities in the Stock MarketWhy Derivatives Trading is Absent in Most Emerging MarketsFinancial Contracting Under Imperfect Information Sources of Financial InformationThe Principal-Agent Problem(Jensen & Meckling, Hairs & Raviv, Townsend’s CSV Model)Asymmetric information and Financial Market Failure Moral Hazard in Financial MarketsFinancial Market FailureCredit Rationing in Financial MarketsAdverse Selection: Screening with Market Power MechanismMoney Laundering in Financial MarketsApproaches to Outside Finance and Capital Structure with Imperfect InformationContemporary Theories of Financial IntermediationMonitoring and Insurance (Diamond & Dybvig, Bhattachrya & Thakor) in Capital Markets and Banking System.Financial Sector Policy and DevelopmentFinancial DevelopmentFinancial Deepening (Model by Gurley-Shaw)Financial Repression Hypothesis (Mckinnon Shaw)Finance in Endogenous Growth ModelsFinancial Markets and Macro-Economic Policy 1Financial Sector Policies: Monetary and Fiscal PoliciesFinancial LiberalizationInformal FinanceMonetary Policy with Informal Financial Markets1.8 Financial Market and Macro-Economic Policy 11Financial Innovation and Monetary PolicyFinancial Crisis and Macro-economic Policy1.9 Public Enterprise Restructuring and Financial Sector ReformsDivestiture Versus PrivatizationPublic Enterprise Restructuring Financial Sector ReformsRole of Financial Sector Reforms in Public Enterprise Restructuring Privatization of Public InstitutionsPrivatization of Infrastructure COURSE EVALUATIONCourse- Work MarksC.A.T 30%Term Paper 20%Total-Coursework Marks 50%Final Examination 50%Total 100%REFERENCESFry, Maxwell (1995) Money, Interest and Banking in Economic Development, Baltimore: John HopkinsGuley, 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, 1-24Stiglitz, 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, 19-52World Bank (1989) World Development Report, Oxford: Oxford University Press and World BankSelected 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. 4636Nissanke, Machiko (1993) “Savings and Fiscal Policy Issues in Sub-Saharan Africa” in Akyuz, Yilmaz and Gunter Held (eds) Finance and The Real Economy: Issues and Case Studies In Developing Contries, New York: U.N University/WiderIOSCO (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 ExchangeCapital Markets Authority Act and its SupplementsThe Banking LawsThe Insurance ActOther Financial Market LawsAny Other Relevant Material.1.0 THE FINANCIAL SYSTEM OF AN ECONOMY1.01 The Environment for Financial DecisionsFinancial 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 markets3. Third tier markets 4. Fourth tier marketsFinancial 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 BanksInsurance companiesPension fundsSavings and loansMutual fundsInvestment fundsFinance companiesMoney market fundsCredit unions.Types of Financial InstrumentsCurrency – coins and paperDebtEquityDerivatives1.02 Role of Financial System and Financial IntermediationThe Role of a Financial SystemProvides a payment system for the exchange of goods and services.Provides a mechanism for aggregating funds to embark on large-scale indivisible ventures.Provides a means of transferring economic resources through time and across geographic regions.Provides a means for managing risks.Provides price information for co-coordinating decision-making in various sectors of the economy.Reduces the cost of asymmetric information problems – imperfect informationAn 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.INTERMEDIATION AND FUNCTIONS OF FINANCIAL INTERMEDIARIES:The main functions of financial intermediaries include;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.Reduction of Transaction costsLowering 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 rmation processing and monitoring functionReducing agency costs arising either from information asymmetry between market participants or incomplete monitoring of their agents.Operator of the payment system function.2.0 CAPITAL MARKET STRUCTURE AND DEVELOPMENTIn most African countries the chronic problems of national and corporate indebtness have criticized combining too much short-term debt with too little long-term equity.2.01 Characteristics of Emerging Capital MarketsAfrican 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 ReturnsSize – 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 CDsLack of credit rating agencies Lack of international integration:- Limited cross-boarder listing- Limited foreign investor participation- Under and over pricing of securities- Few securities traded – lacks options, swaps e.t.c- High Market concentration- Few Intermediaries:Presence of rules and regulations that do not favor the development of the market2.02 Indicators of Capital Market DevelopmentHigh liquidityLow market concentration Presence of international integrationMany securities traded: shares, bonds and derivativesLow volatility of market returnsSize – reasonable bigHigh activityAdvanced technology: CDs, ETSForeign investor participation Presence of international integrationQualified personnelFair pricing of securitiesMarket friendly Regulations:Supervised closelyClear regulations which do not conflict3.0 PLAYERS IN A CAPITAL MARKET Investors: Individual investorsInstitutional investorsLocal investors – individual, institutionalForeign investors – individual, institutionalRegulations – Restrictions of holdings by foreign investors in total and in any one company.Capital Market IntermediariesInvestment Banks– Underwrite new issuesStock Brokers – intermediaries between the investor and NSE Investment AdvisorsCustodiansCredit Rating AgenciesMutual Funds - Money market funds and Capital market fundsThe Stock ExchangeIs the market where trading in securities takes place. The Stock Exchange is guided by Rules and Regulations. Some of the general Rules include;Those that regulate dealings of members with clientsDetermine and standardize charges for membersCorrelate stock broking activities and facilitate exchange of information including lists of prices of shares dealt in by membersNetwork with stock exchange in other countries 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 AuthorityThere are various rules that govern the activities of the capital market. Among the many rules include: Listing manualRules 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 requirementsProspectus showing accounts for the last 5 yearsDisclosure requirement Minimum share issue requirementMinimum number of shareholdersFurnish accounts every year with CMACMA 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 regulationsFor 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 MARKETS4.01 Goals of Financial Regulation4.01.1 Why regulate at all? Key Functions of Regulation:To prevent market failure (financial collapse) due to externalitiesRegulation of Competitive markets Enhancement of consumer welfare including protection from fraud and monetary (macro-economic) policy considerationsEnhancing market power and addressing problems relating to informationHelm 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)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 RegulationShould 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 Salient Issues to Describe the Role of GovernmentRegulators 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 marketSetting Regulatory StandardIssues 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 accountsLimitation on Government in risk assessmentOperating in turbulent environment and measurement of risk accurately is almost ernment 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 regulationsEnforcing regulations – to ensure that regulations are adhered to.Regulations could breed corruptionThere may be those who might have the motive to avoid or evade regulations. In addition could have a monitoring of monitorsProblem: monitors of monitors lack information. Where, government ministry lacks information sometimes the only way out is to have the monitors monitoring each ernment could make use of the private sector e.g. private firms to monitor each other, such as the Private Auditing Firms.4.2 Types of Financial RegulationMacroeconomic controlsAllocation controlsStructure controlsPrudential controlsOrganizational controlsProtective controlsMacroeconomic ControlsRegulators (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 ControlsIn 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.Structure ControlsDriven largely by political and economic considerations and are targeted at problems relating to market power. To prevent the concentration of economic financial power several countries institute legal separation of commercial and merchant (investment) banking activities and place restrictions on the activities which these entities can conduct.Formal separation of banking and securities business may entail costly inefficiencies whereas a laxer regime in which the two businesses are allowed to be freely combined creates risks for the financial system, the deposit insurance fund as well as for the lender of last resort. Given that neither approach meets the dual policy objective of efficiency and stability a good deal of emphasis has been placed on devising an approach which will facilitate banks (operating as groups of companies) to diversify into securities business, with the risks attached to conducting such business contained within its securities unit.Policy makers should therefore pay particular attention to such schemes that purport to explicitly resolve the conflicts between efficiency and stability of financial systems. Conventional wisdom 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 RegulationDeals 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 anizational ControlsSeek to deal with externalities resulting from the existence of network such as stock and other trading exchanges, clearing systems and information net-works. To achieve the stated aim as well as promote the efficiency and integration of networks without discrimination against new institutions, the rights and obligations of market participants are set out, using clearly defined objective criteria, such as competence and financial status.Protective Controls Controls are directed at the informational problems which affect dealings and relations between the providers of financial services (institutions) and their consumers, especially non-institutional investors. The most crucial information asymmetries in most markets, relate to difficulties in assessing the quality of services being supplied (provided). Quite often, financial institutions as in the insurance market, lack adequate information about their customer behaviour and the potential impact on their (financial institution’s) credit standing.As you read through, identify the Inter-relationships between Various Types of Financial Regulations 4.3 Other Regulatory Mechanisms 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 banksTo protect all stakeholders from suffering major losses. Banks put in place systems of deposit insurance The Central Bank Act There is need to control the banking institutions through the Central Bank’s supervision. The objects are to regulate the issue of notes and coins, to assist in maintenance and development of a sound monetary, credit and banking system and to maintain external stability of the currency. Functions of the Central BankIssuance of notes and coinsMaintenance of external reserves.Relations with other commercial banksRegulation of commercial banksCredit Control: CBK is empowered to issue instructions to commercial banks for the purpose for which loans are to be issued.Bank of government4.4 Aspects of Success of Financial Regulation in the Banking Sector in KenyaRisk ManagementCentral bank of Kenya has been effective to a large extent in assisting Banks to manage their risks through the Risk management guidelines. The banks are specifically required to manage their Strategic, Credit, Capital, Liquidity, Interest rate, Price, Foreign exchange, Operational, Reputation and Regulator risks. These have enabled managers to put in place policies that protect the interest of all stakeholders in the bank.Capital AdequacyAccording 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 BanksCentral 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 EducationCentral Bank of Kenya through various research organizations such as Research International has been providing meaningful information to consumers on summarized bank charges and lending rates of products of every bank to help their customers in making better-informed choices. Adequate Financial Reporting Financial reporting and disclosure requirements have been emphasized adequately by the Central Bank of Kenya. Banks are required to:prepare quarterly financial statements according to the financial reporting standards, have them audited, and to register or publish 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 RegulationsThe 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 outcomesThe full implementation of Base I Accord;Adoption of Risk Based Supervision; and Adherence to the Basel Core Principles for Effective Banking Supervision.Deposit Production FundThe DPF is put in place for the purpose of protecting depositors by compensating depositors should their commercial banks experience failure.5.0 SECURITIES AND THEIR CHARACTERISTICSAmong the securities that trade in the capital market include;Ordinary SharesCharacteristics:Claim on incomeClaim on assetsRight to controlVoting rightsPre-emptive rightsLimited liabilityAdvantages:From Company Perspective:Permanent capitalBorrowing baseDividend payment discretionDisadvantages:More costlyRiskEarnings DilutionOwnership DilutionPreference SharesHave both the characteristics of ordinary shares and fixed income instruments and thus referred to as hybrid securities.Fixed Income InstrumentsBonds, debentures and other debt instrumentsCharacteristics:Fixed incomeMaturity periodRedemptionIndenture or Debenture Trust DeedSecurityClaim on assets and incomeAdvantages:Less costlyNo ownership dilutionFixed payment of interestReduced real obligationDisadvantagesObligatory paymentsCash outflowsRestrictive covenantsPreference SharesCharacteristics:Claims on assetsFixed dividendCumulative dividendsRedemptionVoting rightsConvertibilityDerivative InstrumentsFutures contractsForward contractsOption contractsSWAPSCAP and Floor Agreements6.0 INFORMATION ASYMMETRY AND FINANCIAL CONTRACTING 6.1 Asymmetric Information and Financial Market FailureFinancial 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 EfficiencyTheories 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 inefficientIf information is costly, the presumption is that markets will not, in general, be carefully competitive, strengthening the presumption that markets, in the absence of government intervention are not efficient.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 goodIf a financial analyst has information about a Company A and invests in Company A, investors are likely to follow suit and invest in that company.-Information and Externalities – Difficult to apportion returns relating to information. Other people benefit from information paid for by another party-Information and imperfect competition – Expenses relating to information can be viewed as fixed costs. Markets that require a lot of information are imperfectly competitive; for example, customers may be informed about lending institutions but lending institutions may not be well informed about the customers.6.1.3 Failures in Financial MarketsMonitoring as a Public GoodSolvency as a financial institutions of great value to investors – can deposit or withdraw their deposits in financial institutionsManagement of financial institutions – affects the risk and returns of investmentMonitoring solvency – One person knowledge about an impending solvency of a financial institution does not subtract from what another person knowsA person with information about a certain institution will guide the actions of other persons. 6.1.4 Consequence of Inadequate MonitoringUndersupply of information – Information available may not be sufficient to enable monitoring of financial institutions.Capital resources will not be allocated as efficiently as investors will not place reliance on financial institutions.Cases of fraud arise in financial institutionsGovernment may intervene by delegating monitoring powers to private institutions such as private auditors6.1.5 Monitoring Management as a Public GoodManagement 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 incentivesCreditors 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 returns6.1.6 Banks as Monitoring InstitutionsBanks 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 MarketsWillingness of a financial institution to lend a borrower may be an indicator to other lending institutions that the borrower is credit worth.Problems in three or more commercial banks may prompt depositors to withdraw their deposits and invest in other assets De-listing of companies from the Stock Exchange may prompt investors to shift their investors from equities to fixed deposits or real assets.Actions in the credit market affect the equity market and vice versa. For example; a bank willingness to led money affects the firms ability to raise equity capital because potential investors have that assurance that the firm will be supervised by the bank.6.1.8 Externalities and Financial DisruptionBankruptcy 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 ernment 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 MarketsAt 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 institutions6.1.9 Financial Market FailureInformation 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 priceIt also becomes difficult to apportion the benefits accruing from informationThe 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 intermediationAgglomerating Capital Selecting Projects and borrowers Monitoring borrowers Enforcing contracts - Enforcement of debt contracts and equity contractsTransfer of resources - Across time, from one institution to another and from one individual to anotherSharing and Pooling of Risk Recording of transactions such that information is available for use by various parties in the financial markets. Systems of recording, analysis, accumulation and dissemination of information should be in place in the financial market. 6.1.10 Implications Of Financial Market FailureCollapse of financial institutionsFinancial institutions can take advantage of weak regulationsUninformed investors may have wrong information, thus they end up making wrong choices of investmentIf investors do not have confidence in financial institutions they may opt to keep money in other forms of investment leading to financial market failureLeads to imperfect markets thus limiting competitionExternalities leads to poor selection of projects Poor selection of projects and externalities leads to bank runsPoorly performing firms end up obtaining funds from the equity marketFinancial disruption leads to financial crisis Government intervention may be crucial requiring enhancement of regulations6.2 Moral HazardFrom 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 HazardDeposit 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 instabilityIf 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-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 etcFailure of companies – Owners may not have information that their companies are likely to fail but get to know about it once their companies have failedInsider dealing and trading – trading on information which is not available to othersInadequate performance evaluation of firms even when information is availableInadequate monitoring of financial institutionsLaxity in supervision of financial institutionsUse of inappropriate models and methods of evaluation of financial institutionsBorrower attitudes such as borrowing loans with no intention of repayingAgent-Principle relationshipInappropriate regulatory frameworkInadequate and inaccurate information – Information asymmetryMoney laundering – such as transfer of illegally obtained moneyRelated 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 reportsAbuse of regulationsEngagement in risky projects by financial institutionsPossible Solutions To Moral Hazard Problems-Having in place systems and methods for evaluating projects to minimize risk on investment-Deposit insurance reduces the impact of loss to investors-Criteria for manger assessment- Use of CAMEL (Capital Adequacy, Asset Quality, Management, Earnings and Liquidity), Basle Accord and other recommended models for vetting financial institutions- Improvement in systems of reducing information asymmetry-Embracing technology in the financial market-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 conductIdentify cases of moral hazard in the Kenya financial market6.4 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 bankCauses of Adverse SelectionInformation asymmetry; affects borrowers, investors, financial institutions, financial marketsInsider dealingsFinancing ArrangementsInefficient financial intermediariesTechnological weaknessesWeaknesses in regulationsManagerial weaknessesInstitutional factors; shortcomings in networking, structural factorsRegulatory weaknessesBorrowers misrepresent their risk characteristics in order to access credit and to secure more favourable termsPossible 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- 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 dealingsWhat implications does adverse selection have on financial Markets?-Failure of financial institutions-Limitation on innovations-Information asymmetry- Mispricing of riskIdentify adverse selection in the Kenya financial market6.5 Credit RationingEntails 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 growthcredit 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 borrowerInformation 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 borrowerCommercial banks impose limits in lending (lending limits) by any single customerCentral Bank imposes regulations that have implications on credit extended by commercial banksPortfolio composition guidelines have an effect on the amount allocated for each category of investment6.6 Deposit InsuranceDeposit 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 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 pocket. Instances when certain banks threaten to fail are bailed out by government to promote confidence in the banking sectorContagion 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 bankObjectives 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 -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 depositsInstitutional Set –UpDPF is an insurer which is usually a statutory body with its own legal and corporate governance structuresThe most common approach to funding DPF is through mandatory premiums that are paid by all licensed banks within the system.Legal and Regulatory FrameworkAs stipulated in the Banking Act Cap 488DepositsMost 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 records, change of address and relocation of the depositors to other countriesContributory 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 interestDetermining Contribution to DPFThe major sources of moneys for the DPF include;Seed capital at the establishment of the FundContributions to the Fund by individual institutions – Form the biggest contribution to the FundIncome from investments of DPFMoney borrowed for purposes of the Fund ManagementGrants and Donations to the FundOwnership and Management of DPFDPF 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 depositsFund 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 DPFFailure of financial institutions - Financial institutions failed due poor corporate governance, lack of timely intervention by the regulator and weaknesses in the legal frameworkDebt Collection – Collection of troubled loans is made complicated because of poor records, unsecured loans, and lengthy litigation procedures among othersDeposit 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 other elements of the financial safety net are likely to be ineffective7.0 FINANCIAL SECTOR POLICIES AND DEVELOPMENT7.1 FINANCIAL DEVELOPMENTFinancial 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 generationRisk sharing Financing MonitoringFinancial 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. 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 populationTheoretical FrameworkMain functions of financial intermediaries:Savings mobilizationRisk managementAcquisition of informationMonitoring borrowersFacilitating exchange of goods and servicesPre-requisites for Successful Financial Sector Development and Growth:Good governance; Rule of Law Good public sector management Macroeconomic stabilityFinancial market safety netsCompetitive environmentAreas of the Financial sector that Need Strengthening to Fast Track Financial Development:Basic legal and regulatory frameworkFinancial markets and financial institutionsCapacity to prevent and monitor crisis in the financial market sectorKenya case:Interest margins and overhead costs are almost twice as in other countriesHigh concentration of banksCustomers tend to be concentrated on few banks Areas that policy should focus on:Information on borrowers Functioning credit registry with a firm legal basisSharing of positive information benefits small borrowersDeficiencies in legal and institutional frameworksStrengthening the legal frameworkRegulatory and supervisory efforts to strengthen the banking systemUncertainty in the policy environmentRole of government in fostering transparencyDivesting ownership, particularly in government owned banks7.2 FINANCIAL DEEPENINGFinancial 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-GovernmentWhy 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 governmentWhat Facilitates financial deepening?Legal frameworkTechnologyInstitutional reformsRegulatory institutionsInnovations in financial marketsNeed for risk diversificationRole of Government in Financial Deepening:-Regulatory-Defining standards-Policy driverBenefits of financial deepening:-Improved technology-Improved financial innovations-Institutional diversification-Improvement in offering of financial servicesShortcomings of financial deepening:Dominance of few large banksInformation asymmetryHigh risk of default of financial instrumentsMany documents required in effecting financial transactions7.3 FINANCIAL INNOVATIONSFinancial innovations refers to development of new products, formation of new institutions, embracing new technology and other aspects that portray newness in the financial markets. -Other activities that portray financial innovations include;strategic decision making, system realignment, institutional setting, injecting new management, expanding to new markets-Financial innovations enable institutions to raise their competitive strengths, improve their risk management skills and better satisfy the needs of their customers and market requirements.The main types of financial innovations include; -Institutional innovations-Process innovations-Product innovationsInstitutional 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 LawProcess InnovationsThese innovations include the introduction of new business processes leading to increased efficiency and market expansion. Among the main process innovations include; office automation, use of computers in accounting systems and client data management software.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 continuouslyProduct InnovationsInclude 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 conceptPersonal unsecured loansMoney transfer servicesProducts tailored to favour certain groups; Diva, X bank accounts of Standard CharteredThe 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 competitionBenefits of Financial Innovations-Greater efficiency and diversity in financial intermediation as a result of financial innovation which increase productivity and growth potential of the economy-Funds are made available at lower costs-Many financial products are available to investors and depositors-Enhances financial stabilityDemerits 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 LIBERALIZATION8.1 FINANCIAL REPRESSIONDeveloping countries for a long time adopted policies that impeded or imposed restrictions in financial markets. Financial repression is defined as the set of policies, laws, regulation, distortions, qualitative and quantative restrictions and controls imposed by the government which do not allow financial intermediaries to operate at their full technological ernments have been accused of adopting financial repression as a way of imposing restrictions to encourage or discourage savings or direct savings to certain sectors of the economy.Most countries use financial repression to generate revenues for financing public expenditures at one time or another.The outcome of financial repression has been economic contraction, not sustained growth. Governments use financially repressive policies to allow budget deficits to be financed through domestic credit creation at lower rates of inflation than would otherwise be possible.The following policies are usually implemented mostly hitting the banking system:-Capital controls (both inflows and outflows)Domestic residents have restrictions on their transactions abroad and foreigners have restrictions on holding or owning local assets.Absence of a competitive systemArena 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 liabilitiesThis may be direct or indirect-Restrictions on composition of assets portfolios-Credit ceilingsWhat are the Arguments for Financial Repression?-Raising interest institutional interest rates might have strong negative effects on savings, investment, output, and growth -Proponents of optimal financial repression argue that financial controls can correct market failures in financial markets, lower the cost of capital for companies, and improving the quality of loan applicants by selecting high-risk projects.-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 programmesHow 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 economyConsequences 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 regulations8.2 FINANCIAL LIBERALIZATIONFinancial liberalization is defined as the process that involves the elimination of various forms of government intervention in financial markets or the process of removing elements of financial repression.-Liberalization was triggered by the need to exploit opportunities presented by the Global financial market.-However bank fragility and balance of payments challenges have forced many developing countries to rethink the process of financial liberalization-Many Less Developed Countries (LDC’s) embarked on rapid financial liberalization as part of a wider process of structural adjustment or transition to a market economy.Genesis of Financial LiberalizationMost 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 BankElements of Financial LiberalizationElimination of credit controlsFreeing of foreign exchange rateDeregulation of interest ratesFree entry into the banking sector and financial market in generalBank autonomyPrivatization of the banking sectorLiberalization of the international capital flowsBenefits of Financial Liberalization-A more efficient banking system with lower transactions margins, wider product ranges and better client service arising from competition between more banks and non-bank financial intermediaries-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 informationMost countries that embark on financial liberalization benefit from :A rise in asset prices,Fall in the rates of inflation,Rise in bank deposits, Rapid rise in other forms of financial savings, Entry of new financial intermediaries in the market and improvement of customer services, Treasury bills are highly demanded in the financial market, Equity stocks attract foreign investors and,Foreign capital inflows increase 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 graduallyIt 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 linkagesNew problems have however been associated with success of financial liberalization:-Emergence of unsustainable balance of payments deficits-Instability of domestic commercial banks-Lack of long-term resources for productive capital formation-Greater competition between banks and Non Banking Financial Institutions (NBFI’s)-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 controlShort-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 possibleStrengthen domestic savings by appropriate institutional change and possibly constraints on consumer credit and company borrowing abroadEnsure that priority investment, particularly in export sectors and by small producers, continue to have access to long-term credit on reasonable terms – possibly by rediscount facilities at the central bankAllocate scarce human resources to a strict and independent prudential regulation of all financial intermediaries using international arrangements wherever possibleLiberalize foreign trade and domestic prices to avoid putting pressure on the financial sector from excess demand or distorted pricesStrengthen macroeconomic policies touching on; inflation, balance of payments, repressed financial sector, subsidized credit and negative economic growth.Challenges of Financial LiberalizationPolitical challengeAsymmetric informationRegulatory challengeRevenue costs; where revenue might decrease following deregulationExternality challenge; Negative external effects may erode the benefits of financial liberalizationManagement of capital inflows and outflowsEmergence of Informal financial institutions Financial Liberalization in Kenya-Was embarked on in 1992-Investments were made heavily in Treasury Bills thus crowding out private sector- 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 pressures9.0 FINANCIAL CRISES 9.1 Nature of Financial CrisesFinancial crises are usually associated with bank panics since many recessions in the financial market coincided with these panics.Other situations that are often referred to as financial crises include stock market crashes and the bursting of other financial bubbles and currency crises.Theories have been developed by researchers on how financial crises occur, early warning systems and how they can be prevented.9.2 Types of financial CrisesFinancial crises globally take many forms:Banking crises which majorly take the form of bank runs. When cheques and cash are suddenly demanded by customers, banks are not able to respond to this demand. A situation without widespread bank runs, but in which banks are reluctant to lend, because they worry that they have insufficient funds available, is often called credit crunch. In this situation banks become an accelerator of a financial crises.Speculative bubbles and crashes: A financial asset exhibits a bubble when its price exceeds the present value of the future income that would be received by owning it to maturity. If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying as long as they expect others to buy, and when many decide to sell the price will fall. Researchers however do argue that it is difficult to detect bubbles reliably.International financial crises: Devaluation of the local currency because of speculation or otherwise may lead to a currency crisis or balance of payments crisis. When a country fails to pay back its debt (solveign debt default) can also lead to a crisis. Capital flight could also cause financial crisisWider 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 stagnation9.3 Causes of Financial CrisesStrategic 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 riseLeverage: This means borrowing to finance investments and is frequently cited as a contributor to financial crisis. Leverage magnifies the potential returns from investment but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to anotherAsst-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.Fraud: Fraud in institutions has played a role in collapse of some financial institutionsContagion: 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 institutionsRecessionary 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 economy9.4 Theories of Financial Crises-Marxist theories : Emphasis on the role of supply and demand in financial markets and that imbalances could lead to crises-Minsky’s theory :Theorized that financial fragility is a typical feature of any capitalist economy-Herding models and learning models : A variety of models have been developed in which asset values may spiral excessively up or down as investors learn from each other. In these models, asset purchases by a few agents encourage others to buy too, not because the true value of the asset increases when many buy but because investors come to believe the true asset value is high when they observe others buying.9.5 Recorded Financial CrisesIn the 20th Century a few crises were recorded:-Shanghai rubber stock crisis – 1910-The Great Depression – 1930s-Was a major economic depression in the 20th century-Oil crisis – 1973 when oil prices soared, leading to the 1973-74 stock market crash-Latin American debt crisis – beginning in Mexico – 1980s-Black Monday – 1987 – one of the largest percentage decline in stock market history-Mexican Economic crisis –default in Mexican debt -1994-1995-Asian financial crises – 1997-1998 – devaluations and banking crisis across Asia-The American financial crisis – 2007-2009 – lead to the Global financial crisis of 2008-2009. Researchers and practitioners do argue that this crisis is still ongoing9.6 Financial Crises in KenyaCharacteristics of Kenya economy: –Mainly Agro-based- Service sector such as tourism also play an important role in the economyGDP fluctuatesConditionalities from bilateral and multilateral agenciesPlaces importance on Loans and Grants received from the World Bank, IMF and other Development PartnersKenya Financial Market :Dominated by commercial banksOther financial institutions; Insurance Companies, Investment Banks, Mortgage Financial Institutions, Stock Brokerage Firms, Retirement Benefit Institutions such as Pension Funds, Regulatory Authorities such as Capital markets Authority and The Central Bank of Kenya, Savings and Loan Institutions and the Credit Unions.Crises in the Kenya Financial Sector-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 downCauses of Financial Crises in Kenya:-Governance issues- Fraud-Unfavourable economic conditions- Weaknesses in lending policies-Regulatory failuresNotably, Kenya financial crises has been more pronounced in commercial banks. Recently however the crises has also caught up with the stock market. Insurance sector was also affected when Stallion, Kenya National assurance and Invesco Insurance went into receivership.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 subsectors9.2 MONETARY AND FICAL POLICIESGovernments put in place policies to govern activities of financial and non-financial institutions.Monetary Policies : Policies the Government, through the Central Bank puts in place to regulate money supply.This may take the form of;-Cash ratio requirements- Reserve requirements- Use of Open Market Operations- Increase in the money in circulation or control the amount of money in circulation -Liquidity Requirements- discounting provisionsFiscal 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 ernment Expenditure : Capital Expenditure or Development Expenditure : Recurrent ExpenditureGovernment Laws, Financial regulations and Government Circulars impose controls on Government spending. The Constitution and Procurement Laws are among the major laws that govern use of Government funds.11.0 INFORMAL FINANCE11.1 Nature of Informal FinanceThe informal financial markets provide financial services to economic agents that do not have access to formal financial markets. The majority of rural population in many developing economies rely on informal financial market. Small irregular savers cannot not access credit from many financial institutions, thus they have to rely on informal finance. Notably, although credit services command center stage in most discussions relating to informal finance, deposit services are also important.Borrowing may be imprudent for many Small and Micro enterprises but virtually all can benefit from access to conventional, safe, and remunerative deposit facilities for storing liquidity and accumulating capital. In many economies the formal sector is not able to serve all the SMEs thus the need for informal finance. Small borrowers are limited by:-Collateral requirements-Low levels and irregular incomes- Highly skewed incomesSmall 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 consumption11.2 Characteristics of Informal Financial Institutions-Informal finance is able to tailor contracts to fit the individual dimension, requirements, and tastes of a wide spectrum of lenders and borrowers. Informal financial institutions: -Operate in the form of selp-help organizations-Provides savings and credit facilities for small farmers in rural areas and for lower-income households and small-scale enterprises in urban areas-Procedures for informal schemes are usually simple and straight forward; as they emanate from local cultures and customs- Mobilizes rural savings and small savings from low income urban areas- Provide their services at times and days which are convenient for their members- Access to credit is simple, non-bureaucratic, and little based on written documents-Processing of credit is simple and direct which allows for prompt approval and a minimum delay in disbursement. Rejections are rare, but the level of risk is reflected in the interest rate charged- Collateral requirements on loans are to local conditions and borrowers capacity. The conditions might be based either on regular contributions or other regular activity to determine the borrowers capacity to repay the loans- Transactions costs are low compared to those of formal institutions- Informal groups are conversant to problems of their members and therefore they are able to deal with repayment difficulties of their members in a pragmatic manner which might call for rescheduling of debt- The informal sector has dense and effective network at the grass roots level for close supervision and monitoring of borrower activity; particularly their cash flows; whether they are members of an informal association or not. This contributes to efficient mobilization of savings and high repayment rates- Information tends to be easily transmitted because regular meetings of members serve as a forum for dissemination of information - Charges competitive lending rates though at times comparable to those that are charged by formal financial institutions- 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 savings11.3 Types of Informal Financial InstitutionsRelatives and Friends: These are close lenders with collateral free loans and usually at no interest. The borrower is able to finance urgently needed expenditures quickly with little transaction cost, no lengthy appraisal process, little or no paper work. Maintaining the longterm relationship far outways the cost of defaultRotating Credit and savings Associations (ROSCAs): Provides a means of accumulating savings for the purchase of indivisible goods more quickly. They pool in savings from members each period and rotate the resulting funds among them using certain rules. The process is repeated each period until each member receives their credit. Examples include the Merry-Go-Round and the Village Table Banking Associations.Moneylenders: Borrowers approach money lenders when the amount of credit required is larger than can be obtained from socially close lenders. Money lenders charge explicit interest rates in order to obtain real positive returns on their capital. Moneylenders lend to well known borrowers although they can also lend to unknown borrowers if punitive measures on default are feasible. Lending may be secured by physical collateral or by social collateral such as group gurantees. These loans are generally expensive but they are usually open to the public. SMEs are said to prefer borrowing from moneylenders because such loans can be arranged promptly, involve low transaction costs and bear no restrictions on the use of funds.Tied Credit: Loans are frequently tied to complementary transactions in land, labour or commodities to minimize problems 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 loansLoan 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 clientsLandlords 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 relationshipMerchants who exchange goods for credit or extend credit and promise to receive repayments in terms of real goods as agreed with the borrower. Shopkeepers may sometimes double as merchants. At higher level however merchants may extend relatively huge amounts of loansWelfare Associations: Persons who share common interests come together, make contributions and provide certain agreed services to the membersSelf-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 activities11.4 Other Categorization of Informal FinanceSemi-formal financial institutions: Semi-formal finance refers to grassroots financial networks supported by a formal institution structure. Others provide in-kind loans through “farmers” clubs. These loans reach both farm and nonfarm enterprises through fungibility effects. Farmers receiving loans can reallocate their own cash to nonfarm activities. Village Funds organizes low income farmers into savings and credit groups of a specified number, like five or ten members. Semi-formal finance institutions are gradually penetrating the countryside with deposit and loan services packaged appropriately for SMEs and low-income households. 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 PolicyCredible longterm partnerships which enhances self enforceability is importantTailoring financial services to specific demand patterns; such as emergency loans, education loans and others made available on short notice is another considerationPromoting more efficient informal financial institutions to formal financial institutions11.6 Linking Informal Markets to Formal Markets-Encouraging offering of institutional financial services to SMEs-Putting in place measures for enforcing policies to enable enforcement of contractsIt remains to be demonstrated that SMEs can finance productive investments using short-term loans at extremely high real interest charges. It is valid to assume that when small businesses borrow they expect a return in excess of the cost of funds. Yet it would be astonishing to find investments yielding a return of more than 40% per month in the normal course of business given that most SMEs operate in intensely competitive industries. Moreover, at such high profit rates no business would remain small for very long. While little is known about why SMEs borrow on very unfavourable terms, it is quite clear that a profitable market exists for loans bearing interest rates far higher than those currently charged by formal and semi-formal institutions. Robust activity and high monopoly rents by moneylenders imply that they face insufficient competition from alternative agents, be they formal or informal.The absence of competitive, efficient and well-integrated financial markets implies loss of potential welfare, efficiency and growth. Most informal finance takes place in extremely fragmented transactions some at zero interest. Experience in many countries demonstrate that small enterprises and low-income households can be much better served through either informal markets or innovative formal sector programs.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 developmentAt a minimum, government can encourage informal financial markets by broadcasting information to potential financial entrepreneurs about the legal environment, business opportunities and techniques for establishing informal saving and credit associations. These low-cost options can be pursued without introducing the heavy hand of bureaucracy into the informal financial market mechanism. Even such limited efforts to intensify competition and diversify IFMs will pay off if they help to promote more affordable and better integrated flows of informal finance for SMEs and low-income households.Market promoting interventions directed to formal sector institutions are likely to be most effective. Incentives and assistance can be provided to facilitate the testing of innovative programs to deliver low-cost financial services to nontraditional clientele.At the micro-level, providing secure and remunerative deposit facilities for storing liquidity and accumulating savings will generate direct utility gains. With improved access to finance, entrepreneurs can take advantage of income-generating opportunities and smooth out income fluctuations. In the long-run, the goal should not be to extend credit to the SMEs but rather to make more widely available an efficient mix of competitive financial services – both deposits and loans – through financially sound formal, semi-formal, and informal institutions.12.0 PUBLIC ENTERPRISE RESTRUCTURING AND FINANCIAL SECTOR REFORMS 12.1 PUBLIC ENTERPRISE RESTRUCTURING 12.1.1 Profile of Public Enterprises SectorPublic 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 EnterprisesNon-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 EnterprisesAnother distinction within the Public Enterprise Sector is with regard to the control structure. Public Enterprises are set up and controlled by the Central Government as well as the State Governments. The Central PEs differs from State PEs in that firstly; Central PEs are generally much larger, and secondly, the two types of enterprises do not appear to compete with each other directly. The Central PEs is majorly in the heavy industry sub sector, but this does not imply other PEs are not important. On the contrary, State PEs serves an important purpose in the socio-economic setting of individual states.12.1.2 What Can Possibly Explain the Rapid Growth of Public Enterprise Sector in Most Economies?Evidently, the reasons for growth of many PEs are unclear and remain debatable. In some instances, even the theory regarding the determinants of the size of the public enterprise sector in a country is extremely under-developed. Notably, public production of goods and services is some what of an embarrassment to most economists. It exists, and will in all likelihood increase in importance, but it is difficult to explain. An acceptable theory of public production has not emerged. There are those who use a political-economy approach to show that the size and nature of the public sector in a country depends upon the class interest of the dominant political groups (Ahmad, 1982). There others who assume that governments are pragmatic and rational and claim that the size of the public sector increases until the marginal benefit from doing so just become equal to the marginal cost (Jones and Mason, 1982). To adequately summarize all these theories is a great task, but it is possible to identify some reasons which stand out as the major explanations for the growth of public enterprises.New undertakings in defense, key and public utility industries should be started under public ownership. New undertakings which are in the nature of monopolies or in view of their scale of operations serve the country as a whole or cover more than one province should be run on the basis of public ownership. This is subject to the limit of the State’s resources and capacity at the time and the need of the nation to enlarge production and speed up development. Reliance on the private sector to achieve these objectives was considered unwise and the argument was that the private sector left to itself had no capital neither managerial capability to undertake the large investments required by the basic and capital goods industries. Apart form India other countries such as Germany, Japan and Korea concurred with this view. The general ideology is that the private sector is incapable of serving the interests of the nation and pursuit of profit is likely to work against the general good.12.1.3 What is Public Enterprise Restructuring (PER) Public Enterprise Restructuring also known as Public Sector Reform was conceptualized long before the era of privatization. Some pressure had to be put on governments both inside and 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 KenyaThe period after independence in Kenya was marked by a deliberate policy of direct participation by the Government in production and trade over and above the control structures inherited from the colonial regime. A variety of social, economic and political objectives were set, including decolonization, rapid development, the redress of regional imbalances, increased participation by Kenyan citizens in the economy and promotion of indigenous entrepreneurship. In addition to the Government’s desire to participate directly in the production and trade sectors of the economy, private investors (particularly foreigners) sought government participation in joint ventures to ensure continued government support for such ventures.Later Development Finance Institutions (DAIS) were created to provide financing for development projects unable to obtain financing from conventional private sector sources. Similarly, investments made in enterprises by the Government, in its role as trustee for Kenyans who were not endowed with risky capital resources or the necessary entrepreneurial skills at the time of independence, became permanent holdings by the Government due to a lack of a conscious effort to divest those investments to criticize as they became wealthier and gained business skills.During the 1970’s, it became increasingly apparent that government participation in the economy had grown well beyond the Government’s original intentions. A large debt exposure among PEs resulted in increased vulnerability which caused them to be highly leveraged because of their static equity base. Operating losses and inadequate returns on investments further eroded the already weak capital bases of the PEs. The resultant administrative and regulatory interventions introduced to protect the ailing PEs resulted in a diversion of limited managerial capabilities and resources from the fundamentally more important areas of policy, infrastructural investment, development of social services and the management of the economy. While the creation of the PEs was perharps appropriate at independence, the changed circumstances, together with poor performance record of the PEs, have mandated the need to review continued government participation in them and/or the macroeconomic policy environment, and the sectoral policies as well as enterprise specific policies in which the PEs operate. 12.1.5 What Triggered the Reforms of Public Enterprises?State owned companies rarely make a reasonable return on investments but continue to benefit from government subsidies. In the era of Public Sector Reforms, Government owned entities ere expected to be more efficient and generate “higher margins for investment to sustain the desired growth rate”. In many African countries poor macroeconomic management resulted in overvalued currencies, tight foreign exchange controls, artificially fixed prices, and overstaffed civil services, unsustainable public expenditures and high level of debt. Whereas finances could be raised from taxation, borrowing or by improving the efficiency of Public Enterprises, improving the performance of Public Enterprises (PE) sector is one of the top priorities of every Government. As it became a condition for further financial support from the Bretton Woods Institutions, governments in the sub-Saharan regions embarked on privatization and restructuring of entities. This was triggered by the fact that Tax Revenue had already increased substantially and it was difficult to squeeze more revenue out of the economic system. Additionally, public borrowing was also already very high and the interest burden of borrowings increasingly pre-empted revenues raised by the Government from tax and enterprises for raising resources for investment. But the road to privatization was and remains tortuous, rendered so by the need to concurrently, or in rapid sequence, implement economic liberalization programmes, other economic reforms, and political reforms.The term “privatization” is in such common use, especially in sub-Saharan African countries, that it has almost become a generic term for several transactions involving the transfer of rights of ownership of service-provision from the public sector to the private sector. However, since privatization to a large extent forms an important component in the large economic liberalization programmed, popularly known as structural adjustment programmes (SAP), it received an initial cold reception—not only because of some short-term side effects of SAP but also as a result of political sensitivities aroused by the sale of public property to private individuals.In Kenya, for want of sufficient indigenous private entrepreneurships after independence, government had to use parastatals “to fill the existing entrepreneurship gap.” Thus, public enterprises “served as a means to promote the establishment of private African enterprises.” During the early days of their 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 SectorPerformance 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 increasePublic enterprises are set up to achieve a large number of non-commercial objectives. Thus to judge them exclusively on basis of profitability may be unfairPublic enterprises produce a very different output-mix than private enterprises. Many of their markets are less protected and manufacturing involves complex processesThe Assets of most public enterprises are usually understated because they are rarely revalued. Hence any assessment based on the book value of net assets biases the results against public enterprises. Additionally, assets that are acquired more recently tend to have a higher book value because their prices reflects the most recent market price which is the characteristic of most assets acquired by the Private Sector.Since the Public Sector undertakes high value investments than the Private Sector, PE has a higher proportion of total assets as capital Work-in-Progress. They bias the results by making the denominator larger while by definition not contributing to the output of PEs.While there are weighty arguments on both sides, the truth lies somewhere in between the two positions. PEs in India is probably not doing as badly as depicted by their financial profitability. However, no one can argue that there is some scope for improvement. The objective of the current concern among policy makers is to reduce this slack. However, before we can attempt to correct the problem we must know its nature.The agency relationship between a public enterprise and the government is such that PEs are created by the Government to accomplish various goals. One might expect that the relationship between these two parties would be construed so that the public policy objectives of the Government could be achieved through the Public Enterprise Operations. This has however not happened since it has been alleged by a wide spectrum of non-governmental parties that the agent (Public Enterprises) has gone on an uncontrolled trend of poor performance. Analysis shows that it is the inefficiency or greed of public managers (the agents) which fundamentally causes this problem. Additionally, there is lack of autonomy as the root cause for cramping the “Enterprise” aspects of public enterprises placing the blame invariably on the doorstep of the Government (the Principle).The poor state of affairs in Public Entities has nothing to do with the intrinsic nature of Public Enterprise Managers. Government’s abdication of the role as a Principal has resulted from the proliferation of Principals such that multiple principles with multiple (and often conflicting) goals end up trying to exercise control over a public enterprise. This provides the agents (Public 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 EnterprisesThe Government Kenya has made a number of attempts to improve performance of the Public Enterprise Sector. Various Committees have been put in place to facilitate improvement of the PES. Among the Committees include;The Parastatal Advisory Committee which was formed in 1979 and the role of the Inspectorate of State Corporations was enlarged to serve a troubleshooting, management audit and consulting service for parastatals. The Government released the findings of a Working Party on Public Expenditure, suggested a series of reforms and proposed the possibility of reducing the role of PEs and replacing it with increased private sector activity. The output was that direct budget transfers to the PEs were severally restricted.12.1.7 What Should Be the Pace of Reform of Public Enterprises?The privatization process is perceived as involving two main and distinct phases. The first phase is the preparation entailing a detailed review of the Public Enterprise, covering operational, financial and legal issues, in order to determine its current condition, potential strengths, weaknesses, and financial restructuring requirements. The second and final phase is the execution and entails the implementation of the transaction. All key decision makers by this stage would have approved the privatization Action Plan. Identification of tasks to be performed at this stage include; preparation of the sales documentation such as the prospectuses, completion of any financial and operational 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 SectorContemporary reforms have largely focused on the public sector with governments aiming to introduce greater economy, effectiveness, transparency, accountability and efficiency in the public service. In the process, governments have attempted to reduce both their commitment to and participation in economic enterprises. Public Sector Restructuring, and in particular the restructuring of public enterprises, have thus become a worldwide phenomenon beginning in the early to mid-1980s. To facilitate the achievement of Government objectives in PE reform and privatization programme, the Government has put in place various institutions;The Parastatal Reform Programme Committee (PRPC) with functions of; Supervising and co-ordinating the implementation of the PE reform programme, prioritizing and determining the timing of the sale for each non-strategic PE, approving the operational guidelines for privatization to be followed as well as the criteria and procedures to be followed in the divestiture decisions, to give final approval or rejection for the sale of public assets, to monitor and evaluate the progress of implementing the programmes and to provide political impetus for privatization and participate in building public awareness and the national consensus in support of the Government programme.The Executive Secretariat and Technical Unit (ESTU) was established to act as an autonomous execution agency and as the Secretariat of the PRPC. The ESTU is responsible for the management, co-ordination and implementation of the privatization/divestiture programme as approved by PRPC.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 REFORMS12.2.1 Nature and Rationale for Financial Sector ReformsDeveloping countries financial sectors are said to be characterized by unsound financial institutions with the absence of prudent regulations and supervision, uncompetitive financial markets with a few commercial banks dominating the sector, the existence of informal financing; and segmented financial institutions in terms of activities and economic sectors, sources of funding for institutions and type of assets to hold. Other characteristics are statutory interest rate ceilings, where interest rate levels were set administratively, accommodation of government borrowing, and weak monetary controls.Mckinnon (1973) and Shaw (1973) popularized the concept of financial repression as financial system with policies that distort domestic financial markets, including inflexible interest rates, higher reserve requirements and credit controls. The observation is that a repressed financial system interferes with economic development as the intermediaries are not well developed for mobilization of savings, while the allocation of financial resources among competing uses is evident. Low interest rates are insufficient to generate savings, and even reduce savings especially if substitution effects dominate the income effect for households. Further, low rates raise the expected profitability of investment projects by raising the net present value of future earnings from the project. The net effect is to raise the demand for funds without raising the supply of financial resources. The outcome is rationing of credit among the competing investors based on non-price methods as credit is allocated according to the quality of collateral, client’s bargaining skills, political leverage and loan size than the expected productivity of the investment. Negative real deposit rates and lending rates adversely affect development, discouraging the accumulation of wealth in the financial form and limiting the rate of capital accumulation. Administratively, predetermined interest rates are not only low, but lack flexibility making it impossible for many lending institutions to absorb any loss that may be incurred in lending to high risk projects. Reforms refer to changes in a system, law, organization usually with the objective of enhancing competitiveness. Reforming the financial sector is usually part of the broad agenda for reforming the financial sector.Structural Adjustment Programmes (SAPs) were implemented in the 1980’s with the objective of revitalizing the growth of the economy. Following the introduction of SAPs inflation increased which was attributed to the increase in money supply in excess of the targeted level, depreciation of the Kenya shilling, erratic weather conditions, price decontrols, and activities of the multiparty politics. Government deficit worsened during the period despite the tight fiscal policy. Domestic borrowing lead to an increase in the placement of government securities at increasing interest rates. Financing was majorly from domestic sources with reduction in external financing. Additionally financing of Government deficit increasingly relied on domestic sources.There was uncertainty in the financial sector about mounting of reform policies and liberalization of interest rates, and the withholding of foreign aid by donor countries led to scarcity of foreign exchange. Assessment of financial reforms and their impact on growth continue to be a debatable and still controversial issue. Research by the United Nations (2008) revealed the macroeconomic stability is a critical factor of financial sector services and overall economic growth. This suggests that there is complexity in underpinning the causal relationship among macroeconomic stability, financial sector development and growth. They further alluded to the fact that assessment of financial sector reforms could be examined on ex-post versus ex-ante basis regarding the performance of key indicators of financial sector reforms. After independence, Kenya inherited a financial system composed of the Currency Board of East Africa, a commercial bank sector dominated by foreign banks, and a small number of specialized financial institutions. Since the Currency Board lacked monetary and financial independence, the Government found it necessary to establish national monetary controls aimed at efficient operation of the monetary system. The Central Bank was established in 1966. The financial sector was to ensure growth and the stability so that it could stimulate growth in other sectors of the economy thus achieving a high economic growth rate. The narrow financial sector was characterized by government control on the allocation and pricing of financial resources. The inherited financial system expanded and became more diversified in the 1970’s and 1980s especially with the government policy to encourage local participation in the financial system and setting up of specialized institutions to collect savings and finance investment through issuing new bank and Non Banking Financial Institutions (NBFIs). A comprehensive financial sector adjustment programme was launched in early 1989. The main objective was to improve the mobilization and allocation of domestic resources. Institutional reforms which were designed to restore public confidence in the financial system and to upgrade the skills required to supervise and regulate financial institutions included strengthening prudential regulations and supervision of financial system, development and implementation of specific restructuring programmes for weak and solvent financial institutions, development of a strong cadre of Central Bank and other banking professionals, and the development of a capital market. The policy reforms involved reducing budget deficits and government reliance on domestic bank borrowing, developing more flexible monetary policy instruments, liberalizing interest rates, and improving efficiency of financial intermediation by removing distortions in financial resources mobilization and allocation. 12.2.2 Why Financial Sector Reforms?Deterioration of Kenya’s financial sector impacted negatively on the growth of the economy. Despite having a diversified financial system, financial savings remained at a low level. In 1986, the financial sector faced a crisis with most of the institutions experiencing undercapitalization. It is during this period that Structural Adjustment Programmes (SAPs) were introduced with one of the objective of Reforming the Financial Sector as well as Restructuring and Privatizing Government owned entities to relieve the Exchequer the burden of having to fund the then loss making Government owned institutions. Financial sector reform programmes were implemented to address: included;Inadequate regulatory and legal frameworks for the financial system, coupled with weaknesses in prudential supervisionWeak monetary policy control by the central bankSegmentation of the financial sector by activitiesCentral 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 ReformsCaskey (1992) argue that administratively, set interest rates expose depositors to low non-negotiable rates, and they cannot benefit from higher rates offered by banks competing for deposits in a free market. Low interest rates inhibit entry of new financial institutions, stifling competition and causing capital flight leading to foreign exchange shortages if international capital controls are relatively ineffective at preventing capital flows. Financially repressed systems abolish or relax interest rate controls, eliminate or greatly reduce controls on allocation of credit; switch to market based indirect methods of money supply control; and develop money and capital markets. Flexible interest rates allow more diversity in interest rate structure where institutions are able to consider lending proposals involving higher 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 LiberalizationInterest 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 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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