NAME: MUGUONGO FREDRICK MWENDA

ADMISSION: MFI-3-0568-2/2024

INSTITUTE: KENYA METHODIST UNIVERSITY

COURSE: MASTER OF SCIENCE IN FINANCE

AND INVESTMENT

UNIT TITLE: FINANCIAL INSTITUTIONS AND

MARKETS
UNIT CODE: MSFI 507
SCHOOL: BUSINESS AND ECONOMICS

DEPARTMENT: BUSINESS ADMINISTRATION

QUESTION ONE A
The financial institutions, the financial markets and their products are regulated through
various systems of regulations. Discuss any three major regulators of financial systems in
Kenya. 15mks
The regulatory institute members are: the Capital Markets Authority (CMA), Central Bank of
Kenya (CBK), Insurance Regulatory Authority (IRA), Retirement Benefits Authority (RBA) and
Sacco Societies Regulatory Authority (SASRA).

1. The Capital Markets Authority (CMA)

It is an institute charged with the prime responsibility of both regulating and developing an
orderly, fair and efficient capital markets in Kenya with the view to promoting market integrity
and investor confidence.
It has an effective roles as follows:
i. Implementing the Government policy on Capital Market;
ii. Preparing draft policies on capital market;
iii. Advising Government on policy relating to the capital market;
iv. promoting public awareness on the capital market and develop such market;
v. Elaborating action plans and conducting studies in order for CMA to achieve its mission;
vi. Formulating principles and regulations for the capital market;
vii. Making regulations governing capital market business in accordance with the Law
regulating capital market in Rwanda
viii. Controlling and supervising all capital market activities with a view to maintain proper
code of conduct and acceptable practices on the capital market;
ix. Registering capital market business and related instruments provided for by the Law
regulating capital market in Rwanda;
x. Issuing, suspending, and withdrawing licenses and approvals related to capital market
business;
xi. Seeking to achieve fairness, efficiency and transparency in the functioning of the capital
market;
xii. Protecting citizens and investors in capital market from unfair and unsound practices or
practices involving fraud, deceit, cheating or manipulation;
xiii. Monitoring, supervising, and take actions with regard to the compliance with this Law
and regulations thereto related as well as with the Law regulating capital market in
Rwanda and regulations thereto related;

2. Central Bank of Kenya (CBK)

A central bank is a public institution that is responsible for implementing monetary policy,
managing the currency of a country, or group of countries, and controlling the money supply.
It has the following Roles:
I. Monetary Policy Formulation
Monetary policy is a key function of the Central Bank of Kenya that plays a critical role in
managing the country's economy.
The Bank is also mandated to.
 Lowering interest rates makes borrowing cheaper, which stimulates economic growth.
 Increasing interest rates makes borrowing more expensive, which reduces inflationary
pressures.
 Adjusting reserve ratios influences the amount of money banks can lend, which impacts
liquidity in the economy.
 Conducting open market operations involves buying and selling government securities,
which influences the amount of money in circulation.
The Central Bank of Kenya also uses several tools to implement monetary policy, including:
 Setting interest rates
 Adjusting the reserve requirement ratio
 Conducting open market operations

II. Currency Issuance and Management

The Central Bank of Kenya plays a critical role in the issuance and management of the country's
currency. This role ensures that the supply and demand for currency are managed efficiently,
thereby promoting economic stability.
III. Banker to the Government
It is the banker to the government, and plays a critical role in ensuring
 Efficient functioning of the government's financial operations.
 Government transactions and services
 Supporting fiscal policy
 Strengthening Government Financial Management

IV. Financial Stability

In addition to its roles in monetary policy, currency issuance and management, and serving as a
banker to the government, the Central Bank of Kenya also plays a crucial role in promoting
financial stability in the country. Financial stability is essential for the smooth functioning of an
economy, as it allows for sustainable economic growth and development.
 V. Regulation and Supervision of Financial Institutions
The Central Bank of Kenya plays a crucial role in regulating and supervising financial institutions
in the country. This involves overseeing the activities of banks, insurance companies,
microfinance institutions, and other financial service providers to ensure that they comply with
regulatory requirements and operate in a safe and sound manner.

3. The Insurance Regulatory Authority (IRA)

It is a statutory government agency established under the Insurance Act. Purposely to regulate,
supervise and develop the insurance industry in Kenya.
The Authority works collectively and individually with Industry players in achieving the following
fundamental insurance regulatory objectives:
i. Ensure compliance by insurance companies and intermediaries with legal requirements
and sound business practices.
ii. Promote voluntary compliance.
iii. Set clear objectives and standards of intervention for insurance/reinsurance companies
and intermediaries or type of intervention.
iv. Protect consumers and promote high degree of security for policy holders.
v. Promote efficient, fair, safe and stable markets.
vi. Maintain the confidence of consumers in the market.
vii. Ensure insurance companies and intermediaries remain operationally viable and
solvent.
viii. Establish a transparent basis for timely, appropriate and consistent supervisory
intervention, including enforcement.
4. Retirement Benefits Authority (RBA)
The Retirement Benefits Authority (RBA) is a regulatory body established by the Government of
Kenya to supervise the establishment and management of retirement benefits schemes.
Retirement Benefits Authority has the following roles:
i. Protect the interest of members and sponsors of retirement Benefits schemes.
i. Advise the Government on matters relating to retirement benefits.
ii. Develop and promote the retirement benefits sector.
iii. Implement all Government policies relating to retirement benefits.
iv. Regulate and supervise the establishment and management of retirement Benefits
schemes.
5. Sacco Societies Regulatory Authority (SASRA).
The SACCO Societies Regulatory Authority (SASRA) is the government’s principal agency
responsible for the supervision and regulation of SACCO Societies in Kenya
It has the following roles:
I. License SACCO Societies to carry out Deposit-Taking Business in Kenya
The Authority licenses qualifying SACCOs to undertake deposit-taking business pursuant to the
SACCO Societies Act, as read with the SACCO Societies Deposit Taking Business Regulations.
II. Regulate and Supervise SACCO Societies in Kenya
The Authority regulates and supervises the activities of qualifying SACCOs in accordance with
the SACCO Societies Act and the Regulations made thereunder, including the Specified Non-
Deposit taking SACCO business as prescribed under the SACCO Societies Act and read with the
SACCO Societies Non-Deposit Taking Business Regulations 2020.
III. Hold, manage and apply the General Fund of the Authority in accordance with the Act
The General Fund is the statutory fund created under the SACCO Societies Act and is managed
by the Authority in accordance with the same SACCO Societies Act.
IV. Do all such other things as may be lawfully directed by the Cabinet Secretary
The Cabinet Secretary has powers under the SACCO Societies Act and other written legislation
to issue directions to the Authority to do any lawful thing with respect to supervision and
regulation of SACCOs in Kenya
V. Perform such other functions as are conferred on it by the Act or by any other written
law
The Authority performs any other functions that have been assigned to it under the Act or any
other written laws such as the Proceeds of Crimes and Anti-Money Laundering Act, provided in
the SACCO Societies Act

QUESTION ONE B.
Discuss five roles played by a financial system in an economy -10mks
A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges that permit the exchange of funds. Financial systems exist on firm, regional, and
global levels.

Roles:
i. Intermediation
Financial systems act as intermediaries between savers and borrowers, channeling funds from
those who have excess funds (savers) to those who need funds (borrowers). This
intermediation process facilitates the efficient allocation of capital and promotes economic
growth.
ii. Mobilization of savings
Financial systems provide a mechanism for individuals and businesses to save money and earn
a return on their savings. Through banks, investment funds, and other financial institutions,
savings are pooled together and made available for productive investments.
iii. Facilitation of investments
Financial systems enable individuals, businesses, and governments to access the capital needed
for investment in productive activities. They provide various investment options such as stocks,
bonds, and venture capital, allowing entities to raise funds to expand operations, launch new
projects, or develop infrastructure.
iv. Risk management
Financial systems offer a range of risk management tools and instruments, such as insurance,
derivatives, and hedging strategies. These mechanisms help individuals and businesses mitigate
risks associated with fluctuations in interest rates, exchange rates, commodity prices, and other
market uncertainties.
v. Price discovery
Financial markets provide a platform for trading financial instruments, allowing buyers and
sellers to determine fair prices based on supply and demand dynamics. This price discovery
process ensures transparency and efficiency in the valuation of assets and facilitates the
efficient allocation of resources.

vi. Facilitation of payments

Financial systems enable the smooth and secure transfer of funds between individuals,
businesses, and institutions. They provide payment systems, such as electronic funds transfer,
credit cards, and digital wallets, which facilitate the settlement of transactions and support
economic activities.
vii. Capital Formation
Financial systems play a crucial role in capital accumulation within an economy. By mobilizing
savings, facilitating investments, and promoting efficient allocation of capital, they contribute to
capital stock growth, which is essential for long-term economic development.
viii. Monetary policy implementation
Central banks implement monetary policy as part of the financial system by controlling the
economy’s money supply, interest rates, and liquidity. They regulate and stabilize the financial
system, ensuring price stability and fostering macroeconomic stability.
ix. Financial inclusion
Financial systems aim to promote financial inclusion by providing access to financial services for
individuals and businesses, including those in underserved or marginalized communities. This
fosters economic participation, poverty reduction, and social development.
x. Safeguarding financial stability
The financial system maintains stability and mitigates systemic risks. Regulatory authorities
monitor and supervise financial institutions, set prudential standards, and establish risk
management frameworks to safeguard the system’s stability and protect consumers.

QUESTION TWO A
Recently, some financial institutions in Kenya experienced financial distress leading to
financial panics. Briefly explain types of measures that an institution can use mitigate the
effects of distress.
 Financial institutions facing distress can employ a range of measures to mitigate the effects and
stabilize their operations. Here are some key strategies:
i. Liquidity Support: Secure emergency funding or lines of credit from central banks or other
financial institutions to manage short-term liquidity needs.

ii. Capital Infusion: Raise additional capital through equity investment or debt issuance to
strengthen the balance sheet and improve solvency.

iii. Asset Sales: Sell non-core or underperforming assets to generate cash and reduce
leverage.

iv. Restructuring Debt: Negotiate with creditors to restructure debt, such as extending
maturities or reducing interest rates, to ease repayment burdens.

v. Cost Reduction: Implement cost-cutting measures, including reducing operational expenses

and streamlining processes, to improve profitability.

vi. Operational Efficiency: Enhance efficiency through technological upgrades or process

improvements to reduce costs and improve service delivery.

vii. Regulatory Cooperation: Work closely with regulatory authorities to comply with
requirements and access support mechanisms, such as government guarantees or bailouts.

viii. Communication Strategy: Maintain transparent communication with stakeholders,

including investors, customers, and employees, to manage expectations and rebuild
confidence.
These measures help stabilize the institution, restore confidence, and position it for recovery.

QUESTION TWO B
Using suitable examples in Kenya, explain the differences between the following:
 i. Adverse selection and moral hazards
Adverse Selection: Adverse selection occurs when there is an imbalance of information
between parties in a transaction, often leading to the selection of higher-risk candidates or
investments. In essence, the party with more information (often the one seeking to hide it)
ends up making the transaction less favorable for the other party.
Example: insurance industry. Suppose an insurance company offers health insurance policies
without requiring detailed medical examinations. Individuals with pre-existing health conditions
(e.g., chronic illnesses) might be more inclined to purchase the insurance because they know
their health risks better than the insurer. Since the insurer lacks this critical information, it may
end up with a higher-than-expected number of high-risk policyholders, leading to higher claims
and financial strain. This is adverse selection in action, where the insurance company faces
greater risk due to the asymmetric information.
Moral Hazard: Moral hazard occurs when one party takes on more risk because they do not
bear the full consequences of that risk, often due to the presence of insurance or a safety net.
The problem is that this behavior can lead to more risky actions since the party is protected
from the full impact of those risks.
Example: Imagine a scenario with a Kenyan bank that offers subsidized loans to small
businesses with the backing of a government guarantee. If business owners know that their
loans are guaranteed by the government in case of default, they might engage in riskier
business ventures than they would if they were fully responsible for the loan. For instance, a
small business might invest heavily in speculative ventures rather than more conservative, safer
investments, knowing that the government guarantee will cover any potential losses. This
behavior reflects moral hazard, as the business is insulated from the consequences of its risky
decisions.
Key Differences:
 Information Imbalance vs. Risk Behavior:
Adverse Selection is about information imbalance where one party has more or better
information that impacts the transaction negatively for the other party.
Moral Hazard is about risk behavior where one party engages in riskier actions because they do
not bear the full consequences of those actions.

 Timing in the Transaction:

Adverse Selection typically happens before the transaction or contract is finalized, as the party
with more information uses it to their advantage.
Moral Hazard occurs after the transaction or contract is in place, as the presence of insurance
or a safety net influences behavior to take on more risk.
By understanding these concepts with local examples, you can better grasp how they influence
financial decisions and risk management in Kenya’s economic environment.

ii. Maturity intermediation and denomination intermediation

Maturity Intermediation: Maturity intermediation refers to the process by which financial
institutions manage the difference between the short-term deposits they receive and the long-
term loans or investments they make. This involves taking funds from depositors who may want
to withdraw their money on short notice and using these funds to provide long-term loans or
investments.
Example: Consider a commercial bank such as KCB Bank. Suppose KCB Bank offers savings
accounts and fixed deposits with short-term maturities (e.g., 6 months to 1 year). Customers
deposit their money with the expectation that they can withdraw or access these funds
relatively quickly. Meanwhile, the bank uses these deposits to issue long-term loans to
businesses or individuals for purposes such as buying property or funding large-scale projects.
By doing this, KCB Bank is performing maturity intermediation, as it is matching short-term
liabilities (deposits) with long-term assets (loans).

Denomination Intermediation: Denomination intermediation refers to the process by which

financial institutions provide financial products in various denominations to cater to different
types of investors or borrowers. This involves offering financial products in sizes that
accommodate both small and large investment amounts, thus catering to a diverse clientele.
Example: Take the example of government bonds issued by the Kenyan government through
the Central Bank of Kenya. These bonds are available in different denominations. For instance,
the government might issue bonds with minimum investment amounts of KSh 50,000 for
individual investors and larger denominations for institutional investors. This approach allows
both small investors and large institutions to invest in government securities according to their
financial capacity. This is denomination intermediation because the financial product (bonds) is
available in varying sizes to meet the needs of different types of investors.

Key Differences:
 Focus of the Intermediation:
 Maturity Intermediation focuses on the temporal mismatch between the short-term
deposits and long-term loans. It is about managing the liquidity and duration risks associated
with different time horizons.
Denomination Intermediation focuses on catering to different investment sizes. It is about
providing financial products in various denominations to accommodate both small and large
investors.
 Purpose:
Maturity Intermediation aims to balance the timing differences between deposit withdrawals
and loan repayments, ensuring that institutions can meet their short-term obligations while
investing in long-term assets.
Denomination Intermediation aims to broaden the market by offering financial products that
fit the investment sizes of different types of investors.
Understanding these concepts with Kenyan examples highlights how financial institutions
manage risks and cater to diverse client needs in the financial sector.

QUESTION THREE A
in recent past, financial markets and institutions in Kenya experienced tremendous growth.
Discuss the factors that contributed to this growth. 10mks
The tremendous growth of financial markets and institutions in Kenya in recent years can be
attributed to a combination of factors. These are:
1. Technological Advancements
Mobile Banking and Digital Financial Services: The introduction of mobile money services,
notably M-Pesa by Safaricom, has revolutionized financial inclusion in Kenya. Mobile banking
platforms have facilitated easy access to financial services for millions of Kenyans, especially
those in remote areas.
Fintech Innovations: The growth of fintech companies in Kenya has led to the development of
new financial products and services, including online lending, digital wallets, and investment
platforms. Companies like Branch and Tala have expanded access to credit through innovative
digital solutions.

2. Regulatory Reforms
Supportive Regulatory Environment: The Central Bank of Kenya (CBK) and other regulatory
bodies have implemented reforms aimed at fostering a stable and inclusive financial sector. For
example, the CBK has introduced regulations to govern mobile money and fintech, enhancing
the sector’s stability and consumer protection.
Capital Markets Authority (CMA) Initiatives: The CMA has introduced measures to enhance
transparency, improve market infrastructure, and encourage investment. Initiatives like the
introduction of the Nairobi Securities Exchange (NSE) market index and various bond markets
have supported growth in capital markets.

3. Economic Growth and Development

Economic Expansion: Kenya's robust economic growth has created a favorable environment for
financial institutions. Increased economic activity, rising incomes, and a growing middle class
have led to higher demand for financial products and services.
Infrastructure Development: Investments in infrastructure, including transportation and
telecommunications, have facilitated economic activities and improved financial service
delivery.

4. Increased Financial Inclusion

Expansion of Banking Services: The establishment of new banks and branches, especially in
underserved regions, has increased the reach of banking services. The growth of SACCOs
(Savings and Credit Cooperative Organizations) has also contributed to financial inclusion.
Enhanced Accessibility: Initiatives aimed at improving financial literacy and access to financial
services have empowered more individuals to participate in the formal financial system.

5. Foreign Investment and Partnerships

Foreign Direct Investment (FDI): Kenya has attracted significant foreign investment into its
financial sector. International investors have shown confidence in Kenya’s financial markets,
leading to increased capital flows and development of financial products.
Strategic Partnerships: Collaborations between Kenyan financial institutions and global
financial entities have led to the introduction of new technologies, products, and expertise into
the market.

6. Innovative Financial Products

Diverse Investment Products: The growth of various investment products, including
government and corporate bonds, real estate investment trusts (REITs), and mutual funds, has
provided more options for investors.
Alternative Financing: The rise of crowdfunding platforms and peer-to-peer lending has
introduced new avenues for raising capital and investing.

7. Consumer Demand
Growing Middle Class: The expanding middle class has increased demand for sophisticated
financial products and services, including investment opportunities, insurance, and retirement
planning.
Changing Preferences: Increased awareness and changing consumer preferences have driven
demand for more convenient and flexible financial services.

8. Political and Economic Stability

Stable Governance: Relative political stability and a favorable business environment have
contributed to investor confidence and growth in the financial sector.
Economic Policies: Government policies aimed at fostering economic growth and development
have indirectly supported the financial sector’s expansion.

9. Globalization
Integration with Global Markets: Kenya’s integration into global financial markets has brought
in international best practices, investment opportunities, and technological advancements.
Access to Global Capital: Kenyan financial institutions have benefited from access to
international capital markets, leading to increased liquidity and investment opportunities.
These factors, working in concert, have significantly contributed to the growth and
development of financial markets and institutions in Kenya, making it a leading financial hub in
the region.
QUESTION THREE B
Derivative instruments play a great role in financial market. Explain its importance to
investors
Derivative instruments are crucial in financial markets due to their versatility and the range of
benefits they offer to investors. Here’s a detailed explanation of their importance:

1. Risk Management (Hedging)

Mitigating Risk: Derivatives are widely used for hedging purposes to manage and mitigate
various types of financial risks. For example, if an investor holds a large position in a stock and is
concerned about potential declines in its price, they might use put options to hedge against this
risk. By doing so, they limit potential losses.
Currency and Interest Rate Risks: Companies and investors use derivatives like currency
forwards and interest rate swaps to manage risks associated with fluctuating exchange rates
and interest rates. For instance, a Kenyan company with revenues in dollars but expenses in
shillings might use a currency swap to stabilize its cash flows.

2. Leverage
Increased Exposure: Derivatives allow investors to gain exposure to assets with a relatively
small amount of capital. For example, through futures contracts, investors can control a large
amount of an underlying asset (such as a commodity or stock index) with a relatively small
initial investment.
Potential for High Returns: Leveraging through derivatives can amplify both potential returns
and potential losses. Investors might use this leverage to achieve higher returns on their
investment if their market predictions are correct.

3. Speculation
Profiting from Market Movements: Derivatives provide opportunities for speculators to profit
from anticipated changes in asset prices, interest rates, or other financial metrics. For instance,
traders might use options and futures to bet on price movements of commodities, stocks, or
indices.
Varied Strategies: Investors can employ various speculative strategies using derivatives, such as
arbitrage (profiting from price discrepancies) or spread trading (betting on the price difference
between related assets).
4. Price Discovery
Market Information: Derivatives markets contribute to the price discovery process by reflecting
market expectations and providing information about future prices. Futures prices, for
example, incorporate expectations about future supply and demand, helping all market
participants gauge future market conditions.

5. Portfolio Diversification
Access to New Asset Classes: Derivatives can offer exposure to a range of asset classes that
might not be easily accessible through direct investment. For example, using derivatives,
investors can gain exposure to commodities, foreign currencies, or emerging market assets.
Risk Diversification: By incorporating derivatives into a portfolio, investors can diversify their
risk profile. For instance, using options or futures to hedge against market downturns can
protect the overall portfolio from significant losses.

6. Enhancing Returns
Generating Income: Certain derivative strategies can generate additional income for investors.
For example, writing covered call options allows investors to earn premium income while
holding the underlying asset.
Strategic Flexibility: Derivatives enable investors to implement complex strategies, such as
straddles or spreads, to enhance returns based on their market outlook and risk tolerance.

7. Market Efficiency
Liquidity Provision: Derivatives markets add liquidity to the financial system, allowing investors
to enter and exit positions with relative ease. Increased liquidity can lead to tighter bid-ask
spreads and more efficient markets.
Information Transfer: Derivatives can transmit information between different markets and
sectors, helping to align prices across the financial system and improve overall market
efficiency.

8. Customization
Tailored Solutions: Derivatives can be customized to meet specific investment needs and risk
profiles. For example, bespoke derivatives can be designed to match particular cash flow
requirements or risk exposures of a company or investor.
Example in Kenya:
Currency Hedging: Kenyan exporters who sell goods abroad might use currency forwards or
options to lock in exchange rates and protect against adverse currency fluctuations. For
example, a Kenyan flower exporter with revenues in euros but costs in shillings might use a
currency forward contract to hedge against the risk of a declining euro.
Speculation on Commodity Prices: Traders in Kenya might use commodity futures to speculate
on the prices of agricultural products such as tea or coffee. If they anticipate a rise in prices,
they might buy futures contracts to benefit from potential price increases.

QUESTION THREE C
Despite tremendous growth of financial intermediation in Kenya, Kenyans are still using
informal financial institutions. By use of examples explain the role of informal financial
sectors to our economy.
Despite the significant growth of formal financial intermediation in Kenya, informal financial
institutions continue to play a crucial role in the economy. Here’s a detailed look at their roles,
supported by relevant examples:

1. Financial Inclusion
Access for the Unbanked: Informal financial institutions often serve populations that are
underserved or excluded from the formal financial system. For example, in rural areas where
formal banks may not be present, Savings and Credit Cooperative Organizations (SACCOs) and
Village Savings and Loan Associations (VSLAs) provide crucial financial services.
Example: In Kenya, SACCOs like Kenya Police SACCO and Chamas (informal savings groups) offer
financial services to members who might not have access to traditional banks, promoting
financial inclusion and stability among low-income and rural communities.

2. Flexibility and Accessibility

Adaptability: Informal financial institutions often offer more flexible terms and conditions
compared to formal institutions. This flexibility can include less stringent credit requirements,
faster loan processing, and more personalized services.
Example: Chamas are informal groups where members pool their savings and provide loans to
each other. These groups offer quick access to funds for urgent needs or investment
opportunities, often without the lengthy approval processes of formal banks.

3. Community Building and Trust

Social Capital: Informal financial institutions are often deeply rooted in local communities,
fostering strong social ties and trust. This community-based approach can lead to more reliable
repayment and mutual support among members.
Example: In urban and rural areas, Rotating Savings and Credit Associations (ROSCAs), such as
Harambee Groups, are common. Members contribute a fixed amount periodically and receive a
lump sum on a rotating basis. This system not only provides financial support but also
strengthens community bonds and trust.

4. Emergency Financial Support

Crisis Management: Informal financial institutions can provide immediate financial relief in
times of personal or community crises. They often serve as a safety net for individuals who face
emergencies or unexpected expenses.
Example: During times of economic hardship or natural disasters, informal groups and
community networks can quickly mobilize resources to provide support to affected individuals.
For instance, a community savings group might assist a member whose home has been
damaged in a flood by offering emergency loans or grants.

5. Economic Empowerment
Supporting Small Enterprises: Informal financial institutions often support small-scale
businesses and entrepreneurs who may not qualify for traditional bank loans. This support
helps to drive local economic development and job creation.
Example: Small business owners in Kenya frequently rely on informal loans from VSLAs or
microfinance groups to fund their businesses. These loans can be used for inventory purchases,
expanding operations, or covering operating expenses, contributing to the growth of the local
economy.
6. Low Transaction Costs
Cost Efficiency: Informal financial institutions often have lower transaction costs compared to
formal institutions. This can make them more accessible and affordable for low-income
individuals and small businesses.
Example: Mobile money groups (such as those using platforms like M-Pesa) can facilitate
savings and transfers with minimal fees. Community members can use mobile money services
to make small transactions, saving on costs associated with traditional banking.

7. Cultural Relevance
Tailored Services: Informal financial institutions often align with local customs and cultural
practices, making them more relevant and accessible to the community.
Example: Traditional Chamas or ROSCAs in Kenya often align with local cultural practices of
mutual aid and support. This alignment makes financial services more relatable and easier to
integrate into daily life.

8. Supplementing Formal Financial Services

Complementary Role: Informal financial institutions complement the formal financial sector by
filling gaps that formal institutions may not address, particularly in remote or underserved
areas.
Example: In areas where formal banks may have limited reach, SACCOs and ROSCAs provide
financial services that support local economic activities and help individuals build credit
histories.

QUESTION FOUR A
Investment banks play a great role for companies making new issues. Discuss types of
underwriting arrangements between the investment banks and the issuing companies.
Investment banks play a crucial role in helping companies raise capital through new issues, such
as initial public offerings (IPOs) or bond issuances. They do this by providing underwriting
services, which involve various types of arrangements to manage the risks and responsibilities
associated with issuing new securities.

1. Firm Commitment Underwriting

Description: In a firm commitment underwriting arrangement, the investment bank buys the
entire issue of securities from the issuing company and then resells them to the public. The
investment bank assumes the risk of selling the securities at the agreed-upon price.
Risks and Benefits:
For the Issuing Company: The issuer receives the full amount of capital raised from the issue at
the time of the offering, regardless of whether the investment bank is able to sell all the
securities to investors. This arrangement provides certainty and immediate capital.
For the Investment Bank: The bank takes on the risk of being unable to sell the securities at the
offering price. They might incur losses if they cannot sell the securities at or above the price
they paid to the issuer.
Example: A Kenyan company looking to list on the Nairobi Securities Exchange (NSE) might
engage an investment bank like Standard Investment Bank or KCB Capital under a firm
commitment arrangement. The bank buys the shares from the company and resells them to the
public, ensuring the company receives the capital needed.

2. Best Efforts Underwriting

Description: In a best efforts underwriting arrangement, the investment bank agrees to sell as
much of the issue as possible but does not guarantee the sale of the entire issue. The
investment bank acts as an agent for the issuing company and does not take on the risk of
unsold securities.

Risks and Benefits:

For the Issuing Company: The issuer may not receive the full amount of capital it hoped to raise
if the investment bank cannot sell all the securities. However, this arrangement reduces the risk
to the bank.
For the Investment Bank: The bank does not bear the risk of unsold securities but earns a
commission or fee based on the amount of securities sold.
Example: If a Kenyan startup is seeking capital and chooses a best efforts arrangement with an
investment bank like CIC Capital or Dyer & Blair Investment Bank, the bank will attempt to sell
the issue to investors but does not guarantee that the entire amount will be sold.

3. All-or-Nothing Underwriting
Description: In an all-or-nothing underwriting arrangement, the investment bank agrees to
either sell the entire issue or none at all. The issuer only receives capital if the full issue is sold.
Risks and Benefits:
For the Issuing Company: This arrangement ensures that the issuer gets the full amount of
capital it needs or nothing at all. It provides certainty regarding the minimum amount of capital
to be raised but poses a risk of no proceeds if the full issue is not sold.
For the Investment Bank: The bank must work to sell the entire issue or face the possibility of
having to buy the unsold portion itself, thus assuming a high level of risk.
Example: A Kenyan company planning a large IPO might use an all-or-nothing arrangement to
ensure it meets its capital-raising goals. If the arrangement is with an investment bank such as
African Alliance Kenya or Nairobi Securities Exchange, the bank commits to selling the entire
offering or the issue is canceled.

4. Standby Underwriting
Description: In a standby underwriting arrangement, the investment bank agrees to purchase
any unsold portion of the securities issue after a public offering. This arrangement is commonly
used in rights issues, where existing shareholders are given the first option to buy new shares.
Risks and Benefits:
For the Issuing Company: The issuer is assured that all the new shares will be sold, as the bank
will purchase any remaining shares after the rights offering.
For the Investment Bank: The bank earns a fee or commission for providing this standby
commitment and assumes the risk of having to purchase any unsold securities.
Example: A Kenyan company conducting a rights issue might use a standby arrangement with
an investment bank like Barclays Capital Kenya. The bank commits to buying any shares not
subscribed to by existing shareholders, ensuring the company receives the full amount of
capital it seeks.

5. Best Efforts All-or-Nothing

Description: This is a hybrid arrangement combining elements of both best efforts and all-or-
nothing underwriting. The investment bank agrees to sell the entire issue, but if it is unable to
do so, the offering may be canceled.
Risks and Benefits:
For the Issuing Company: The issuer faces the risk of not raising any capital if the full issue is
not sold. However, the bank does not assume the risk of unsold securities.
For the Investment Bank: The bank has to sell the entire issue to fulfill its commitment, but
does not bear the risk of holding unsold securities.
Example: In a scenario where a Kenyan company seeks to raise funds and uses a best efforts all-
or-nothing arrangement, the investment bank must sell the entire issue to proceed, otherwise,
the offering is canceled.

QUESTION FOUR B
Financial innovations have become inevitable tools for financial Systems to improve their
efficiency. Discuss the potential benefits of financial innovations to financial systems in
Kenya.
Financial innovations have had a transformative impact on financial systems globally, and Kenya
is no exception. These innovations have significantly enhanced the efficiency, inclusivity, and
effectiveness of Kenya’s financial system. Here’s a discussion of the potential benefits of
financial innovations to financial systems in Kenya:

1. Increased Financial Inclusion

Access to Financial Services: Financial innovations like mobile banking and digital financial
services have expanded access to financial services for previously underserved populations. For
instance, M-Pesa, a mobile money platform developed by Safaricom, has revolutionized
financial inclusion by providing banking services to millions of Kenyans, including those in rural
and remote areas.
Example: With mobile money services, individuals without traditional bank accounts can
perform transactions, access credit, and make payments, thus integrating them into the
financial system.

2. Improved Efficiency and Cost Reduction

Streamlined Operations: Financial innovations such as digital banking platforms and automated
teller machines (ATMs) have streamlined banking operations, reducing the need for physical
branches and associated costs.
Example: Banks like Equity Bank and KCB have adopted digital banking solutions that allow
customers to perform transactions, check account balances, and transfer money online,
reducing the need for branch visits and lowering operational costs.

3. Enhanced Customer Experience

Convenience and Accessibility: Innovations such as mobile apps and online banking have
improved the convenience and accessibility of financial services. Customers can now manage
their accounts, pay bills, and transfer funds from their smartphones or computers.
Example: The Chama Plus app provides a platform for Chamas (informal savings groups) to
manage their savings and loans digitally, offering members a more organized and efficient way
to handle their financial activities.

4. Risk Management and Fraud Prevention

Advanced Security Measures: Financial technologies have introduced advanced security
measures, such as biometric authentication, encryption, and fraud detection algorithms, which
help protect against financial crimes and improve security.
Example: Kenyan banks and mobile money platforms use biometric authentication and real-
time transaction monitoring to prevent fraud and enhance the security of financial transactions.
5. Fostering Innovation and Competition
Encouraging New Solutions: Financial innovations stimulate competition among financial
institutions, driving them to develop new products and services that meet the evolving needs of
customers.
Example: The rise of fintech startups in Kenya, such as Branch and Tala, has led to innovative
lending solutions and financial products that challenge traditional banks and offer more choices
to consumers.

6. Efficient Financial Transactions

Faster Processing: Innovations such as electronic funds transfer systems, real-time payment
systems, and block chain technology enable faster and more efficient processing of financial
transactions.
Example: PesaLink, a real-time payment system developed by Kenya’s payments association,
enables instant money transfers between different banks, improving the efficiency of domestic
payments.

7. Enhanced Data Analytics and Personalization

Data-Driven Insights: Financial innovations allow institutions to harness big data and analytics
to better understand customer behavior, preferences, and financial needs, leading to more
personalized services and targeted marketing.
Example: M-Shwari, a product from Safaricom and Commercial Bank of Africa, uses data
analytics to offer tailored micro-loans and savings products based on customers’ financial
behavior and transaction history.

8. Support for SMEs and Entrepreneurs

Access to Capital: Innovations such as peer-to-peer lending platforms and crowdfunding
provide alternative sources of funding for small and medium-sized enterprises (SMEs) and
entrepreneurs.
Example: Platforms like Funded Here and M-Changa enable Kenyan entrepreneurs and small
businesses to raise capital from a broad base of investors, facilitating business growth and
development.
9. Regulatory and Compliance Improvements
Enhanced Monitoring and Reporting: Financial innovations enable better regulatory
compliance and monitoring through automated reporting tools and digital compliance
platforms.
Example: The Central Bank of Kenya’s adoption of RegTech solutions helps in automating
compliance processes and improving regulatory oversight, ensuring that financial institutions
adhere to regulations efficiently.

10. Increased Transparency

Better Record-Keeping: Innovations such as block chain technology improve transparency and
traceability of transactions, reducing opportunities for corruption and fraud.
Example: The use of block chain in land registration and transaction tracking can enhance
transparency and reduce disputes in property transactions.

QUESTION FOUR C
By use of practical example, explain how financial institutions solve the asymmetric problems
in Kenya.
In Kenya, financial institutions tackle asymmetric information problems through various
strategies and mechanisms. Asymmetric information occurs when one party in a transaction
has more or better information than the other, leading to potential inefficiencies and risks.
Here’s how financial institutions address these issues with practical examples:

1. Credit Scoring and Risk Assessment

Example: Equity Bank has implemented sophisticated credit scoring systems to evaluate loan
applications. By analyzing borrowers’ credit histories, transaction records, and other relevant
data, the bank can better assess the risk associated with lending. This reduces information
asymmetry between the bank and the borrower, allowing for more informed lending decisions
and minimizing the risk of default.

2. Collateral and Guarantees

Example: KCB Bank often requires collateral or guarantees for loans, especially for small and
medium-sized enterprises (SMEs). By securing loans with tangible assets or third-party
guarantees, the bank mitigates the risk of borrower default and addresses the issue of
asymmetric information regarding the borrower’s creditworthiness. Collateral provides a safety
net for the lender in case the borrower fails to repay.

3. Microfinance and Community-Based Lending

Example: Faulu Microfinance Bank operates in Kenya’s informal sector and provides financial
services to low-income individuals and small businesses. By leveraging community networks
and local knowledge, Faulu can better assess borrowers' reputability and financial needs, thus
reducing information asymmetry. Additionally, microfinance institutions often use group
lending models where borrowers are part of a peer group that collectively guarantees each
other’s loans, further reducing risks associated with asymmetric information.

4. Regulatory Oversight and Standards

Example: The Central Bank of Kenya (CBK) enforces regulations and standards for financial
institutions to ensure transparency and accountability. For instance, CBK requires banks to
conduct due diligence and disclose comprehensive information in their financial statements.
These regulations help reduce information asymmetry between financial institutions and the
public, ensuring that investors and consumers have access to accurate and reliable information.

5. Financial Literacy and Education Programs

Example: Kenya Bankers Association (KBA) runs financial literacy programs to educate the
public about banking products, financial management, and investment strategies. By enhancing
the financial knowledge of individuals and businesses, these programs help reduce information
asymmetry. Better-informed consumers and business owners are more likely to make sound
financial decisions and engage effectively with financial institutions.

6. Technology and Data Analytics

Example: M-Pesa has revolutionized mobile financial services in Kenya by providing a platform
for digital payments and transactions. The extensive use of data analytics helps Safaricom and
its partners to assess the creditworthiness of mobile money users and tailor financial products
accordingly. For instance, M-Shwari, a collaboration between Safaricom and Commercial Bank
of Africa, uses mobile transaction data to offer micro-loans and savings products, addressing
information asymmetry by leveraging user data to make informed lending decisions.
7. Audit and Verification Services
Example: Kenya Revenue Authority (KRA) conducts audits and verification services to ensure
tax compliance and accurate reporting by businesses. This oversight helps reduce information
asymmetry between businesses and financial institutions by verifying the financial health and
tax obligations of companies seeking loans or investments.

8. Insurance and Risk Mitigation Products

Example: UAP Old Mutual provides various insurance products, including health, life, and
property insurance. By offering these products, the insurance company helps mitigate risks for
policyholders and financial institutions. For instance, credit life insurance ensures that loan
repayments are covered in case of the borrower’s death, reducing the information asymmetry
and risk for lenders.

9. Investor Protection Mechanisms

Example: The Capital Markets Authority (CMA) in Kenya oversees the securities markets and
enforces regulations to protect investors. Measures such as mandatory disclosures, periodic
reporting, and compliance checks help reduce information asymmetry between public
companies and investors, ensuring that investors have access to accurate and timely
information about their investments.

Summary
In Kenya, financial institutions address asymmetric information problems through a
combination of advanced credit scoring, collateral requirements, community-based lending
models, regulatory oversight, financial literacy programs, technological innovations, audit
services, insurance products, and investor protection mechanisms. These strategies help
balance the information disparity between financial institutions and their clients, leading to
more efficient and secure financial transactions and relationships.