MANAGEMENT FINANCIAL INSTITUTION MANAGEMENT OF FINANCIAL INSTITUTIONS BCOM 430INTRODUCTIONIn a changing global financial movements particularly in liberalization of participation of financialmarkets. Financial institutions are facing challenges with more entrance into the market creatingcompetition and forcing wither closures, acquisitions, mergers or management over.However, where others fail, others succeed and even new entrants join with different strategies anddifferent products. Therefore to understand how to manage financial institutions successfully, in achanging environment, one needs to appreciate the concepts within money and capital markets theinstitutional framework of financial institutions, the risk managerial strategies of financial institutionsis to identify the functionalities, categorization statements and legal systems. In addition, the riskmanagement takes a major part of the management of the institution because all financialinstitutions hold some assets and liabilities in form of: a) loans or deposits and consequently are exposed to default risk and (credit risk). This is the risk that the borrower may not commit to repayment of the expected amount within the expected time. b) They are also exposed to interest rate risk. This risk relates to the liability to match maturities of liabilities with the maturities of asset. c) They are also exposed to liquidity risk. This is due to unprecedented or unexpected saver withdrawals which may limit the capability of financial institutions to commit to such withdrawals. d) they are also exposed to underwriting risks. This emanates from lack of reliable guarantees or collateral for the loans/assets issued out. e) they are also exposed to operational risks. This is due to high operational leverage resulting from unbalanced usage of real resources e.g. technology, materials, human resource e.t.c. 1
FINANCIAL MARKETS AND FINANCIAL INSTITUTIONSFinancial markets are categorized into; i.THE MONEY MARKETThe money market for financial institutions relates to transactions in exchange that pertains tomoney i.e. borrowing and lending within one year, foreign exchange markets, made up of the spotmarket, daily exchanged of currencies maturing in 48 hours. Capital markets for financial institutionsrelates to securities usually corporate bonds and stock.
ii. PRIMARY MARKETPrimary market is for first issue or transaction in a security. Any subsequent transaction falls into asecondary market. Financial institutions play an important role in both the financial market bymoving funds from the pockets of deposit less into the pockets of borrowers consume more thantheir income and to link the two, interest rates is used which acts as a driving force to allocate theexcess funds with depositors into the pockets of borrowers in the financial markets and thus youcannot separate a financial institution from a financial market.Financial markets therefore have two functions: • Time preference functionIt is provided in the time value of money concept where financial markets provide a forum forfinancial institutions access money at present and re-evaluate values of such money in future undercompetitive environment through interest rates. • Risk separation and distributionThis is through allocation of money or capital and distribution of such capital to a large clientelesubsequently who accept to absorb such risks and thus the concept of risk diversification ofdistribution.ROLES/FUNCTIONS OF FINANCIAL INSTITUTIONS1. Financial Institutions execute payment of finance in the financial market: Payment finance entails facilitating financial transactions between trading partners by use of instruments such as credit card, debit cards, cheque clearing systems, ATMs, electronic money transfer systems, mobile transfer systems which enable execution of payments such as salaries, debts, bills or insurance premiums. In other words it provides liquidity of investment and borrowing.2. Transmutation Function/Transmission of Monitoring Policy: Financial Institution purchases primary securities and issue secondary securities consequently adding value to the supply and demand of money in the economy. Primary securities are those securities that provide a claim e.g. bond certificate, share certificate, loan provide/give the issues a claim. This claim is transformed into a secondary security when these instruments are sold from one point to another or person to another. The process of changing primary securities into secondary securities is known as transmutation. 3
3. Portfolio Management: It relates to an advisory function whereby financial institutions provide advice and also manage securities on behalf of individuals and companies e.g. Investment Company’s advice on issues of I.P.O.s.4. Income Tax Management: This function relation to mitigation of tax preferential between individuals and business e.g. pension schemes/funds, transfer tax deductions from one period to another and from high to low income brackets. This enables individuals to bridge their tax burdens and acts as a tax shield.5. Risk Diversification: Because of the large size of some financial institutions, they are able to purchase large numbers of investment and break it into many small securities/instruments, consequently spreading the risk from one security to many others or from one individual to another.6. Denominational Intermediation: It occurs where capital market institutions transform to money market institutions e.g. bonds transform to unit or current market.CLASIFICATION OF PARTICIPANTS IN THE FINANCIAL MARKET Participants Mode of Operation Reference Institutional Commercial Banks Depository Institutions Financial institution Credit Unions Saving Banks Depository Institutions Finance Companies Micro-Finance Institutions B Insurance Companies Non-Depository Financial institution Financial Institutions Institutions Pension Trust Funds Investment Companies Real Estate Investment Trust
C Mortgage Brokers Agencies Financial institution Investment Brokers Security Dealers D Households Investors or Non-Financial Individual Businesses Depositors/Borrowers Institutions Government DepartmentsDEPOSITORY FINANCIAL INSTITUTIONS a) Commercial BanksThey are depository institutions because they accept deposits in the form of negotiable certificates ofdeposits, non-negotiable certificate of deposits, savings deposits, checking accounts deposits, passbook deposits accounts and current accounts. These liabilities are used to issuing loans and for otherinvestments in money and capital market securities. The assets include other than the loans andsecurities commercial papers such as promissory notes and letter of credit.IllustrationAssume a commercial bank of Africa with the following information available to the new manager asat 31st December 2009:The Bank’s total deposits include; • Transaction accounts (savings accounts worth Kshs. 1,000,000.00 • Cheque book accounts worth Kshs. 2,000,000.00 • Pass book accounts worth Kshs. 1,000,000.00 • Non transaction accounts made up of negotiable certificates of Kshs. 4,000,000.00 • Other miscellaneous deposits worth Kshs. 1,450,000.00The bank has the following loans: • Borrowing from other banks: Kshs. 2,500,000.00 • Borrowing from the central bank Kshs. 1,500,000.00 5
• The following are the loans issued in 6 categories: o Inter-bank loans Kshs. 800,000.00 o Industrial/commercial loans Kshs. 1,000,000.00 o Real estate loans Kshs. 4,000,000.00 o Revolving home loans Kshs. 700,000.00 o Individual consumer loans Kshs. 1,500,000.00 • Investments in securities included: o Owner equity Kshs. 4,000,000.00 o Investment in government bonds Kshs. 1,000,000.00 o Investment in company bonds Kshs. 600,000.00There is a reserve requirement of 10% by the C.B.K. In addition there is a letter of credit involvinginternational trade worth Kshs. 500,000.00Required;a. Prepare the banks balance sheet as at 31st December 2009b. The commercial bank is question given the reserve requirement happens to employ and new Chief Executive just a day after the C.E.O. resuming his position a client (depositor) appears and demands to withdraw his Kshs. 4,000,000.00 from the bank. As an advisor of this C.E.O. assist him to keep the bank afloat.NB:1. Liquidity Management2. Credit Risk Management3. Liability Management4. Capital/Asset ManagementBalance Sheet: Commercial Bank of AfricaAssets LiabilitiesReserves Deposits
Securities (invested) Securities (Issued)Loans BorrowingsPhysical Assets Owners equitya) Management of Commercial Banks Balance Sheet Commercial Bank of Africa’s Balance Sheet as at 31st December 2009ASSETS LIABILITIES Reserves Deposits(10% of total 1,450,000 Transaction a/cdeposits)Securities Saving a/c 1,000,000Government bonds, 1,000,000 Chequeable a/c 2,000,000Company loans 600,000 1,600,000 Passbook 1,000,000 4,000,000Loans: Non-TransactionInter-bank 800,000 a/cIndustrial/Commercial 1,000,000 Negotiable CD a/c 4,000,000Real Estate(Mortgage 4,000,000 Non-Negotiable 2,000,000loans) CDRevolving Loans 700,000 Misc. Deposits 1,450,000Consumer Loans 1,500,00 BorrowingsLetter of Credit 0 • From 2,500,000Physical Assets 500,000 8,500,000 Other 1,000,000 Banks • Central 1,500,000 Bank • Owner 4,000,000 Equity Less Drawing (7,205,000 8,245,000 ) 12,245,00 12,245,000 0 b) Step I: Effect of Deposit WithdrawalDeposit 11,450,000 7
Less Withdrawal (4,000,000) 7,450,000Reserve (10%) 745,000 i.Call loansAssets LiabilitiesReserves 745,000 Deposits 7,450,000Securities 1,600,000 Others(B+OE) 795,000Loans 4,900,000Physical Assets 1,000,000 8,245,000 8,245,000Deposit withdrawals may lead to liquidity problems such that assets may not be liquid enough tocover the unprecedented deposit withdrawals.Four approaches are used to solve this: • The management may borrow additional funds from other financial institution. Borrowing from other financial institutions exposes banks to higher interest rates requiring that banks make prudent choices in borrowing. • Banks to call loans that are almost due. The cost of calling loans leads to the loss of customers. • Borrowing from the Central Bank has the same effect as borrowing from other financial institutions which increases the cost of sourcing money. • The bank may sell some of its securities to overcome the deposit problem. ii.BorrowingAsset LiabilitiesReserves 745,000 Deposits 745,000Securities 1,600,000 Others 795,000Loans 8,500,000 Borrowing 3,600,000Physical Assets 1,000,000 11,845,000 11,845,000 b) SAVINGS INSTITUTIONS
These are institutions that mobilize savings with an intention plus use such savings to advance credit.The savings become part of the security attached to the credit. Institutions with this category usuallyfinance mortgage or real estate development. Such a developing bonds, commercial buildings,residential buildings and purchase of land e.g. saving institutions therefore source most of their fundthrough these methods. • Passbooks • Certificates of deposits a/c • Other sources of funds are securities both money market and capital market. • Also borrowing from other institutions except the C.B.K.Balance SheetAssets Liabilities1. Mortgage Loans 1. Deposits - Fixed Rate Passbook a/c - Adjusted Rate Fixed Deposit a/c2. Non-Mortgage Loans 2. Securities - Commercial Loans Money Market (unit trust) - Physical Assets Capital Market (bonds) 3. Borrowing From Financial InstitutionsSAVINGS INSTITUTIONS BALANCE SHEETIllustrationsAssume Housing Finance Company had the following information relating to its balance sheet for theperiod ending December 2009. The firm had mortgage loans divided into fixed rate and adjustedrate loans worth 1.2 million and 2.8 million respectively. • Cash and investments in securities were worth 3 million and 2.5 million respectively. • Other loans amounted to 0.5 million. • Physical assets amounted to 6.5 million while central bank obligations were worth 2 million. The firm share capital is made of 3 million while deposits tied to loans amounting to 15 million. • Borrowings from other financial institutions were worth 4 million. 9
RequiredPrepare a balance sheet for the saving institution.SolutionsAssets LiabilitiesMortgage Loans Fixed rate 1,200,000 Cash 3,000,000 Adjusted rate 2,800,000 Investment 2,500,000Other loans 500,000 Loans 500,000Physical Assets 6,500,000 Deposits 1,500,000Central Bank Obl. 2,000,000 Share Capital 3,800,000 Borrowings 4,000,000Securities: Cash 3,000,000 Less drawings (3,300,000) : Investments2,500,000 18,500,000 18,500,000 c) CREDIT UNIONSThey are also depository institutions owned by membership through their share capital. Suchmembership usually shares a common activity, i.e. credit unions deposits are derived from a sharecapital or contributions with the objective of mobilizing savings and provide credit without profitorientations. Thus the returns from deposits not interest but rather the dividends. Within thegoverning policy, credit unions are tax exempted in their net incomes. This tax exemption allowscredit unions to charge lower interest rates on loans. Various products offered by credit unions are: • BOSA – Back Office Savings a/c (for savings only) • FOSA – Front Office Savings a/c (acts like a bank) • MAGS – Mutual Assistance Groupings – provision of labour/input/asset sharing.The regulatory system within credit unions is handled through the central banking systems butexecuted by the Co-operative Act.The assets and liabilities of such institutions are such as:ASSETS - Loans (BOSA, FOSA, MAGS) - Obligations or deposits with the Co-operative Bank - Money and Capital Market investments in securities.
- Physical assets.LIABILITIES - Savings (BOSA) in terms of general deposits shares, chequeable deposits, Certificates of deposit, negotiable or non-negotiable. But there are no mutual assistance deposits. - Borrowings from co-operative bank and other financial institutions - Owns equity.NB: Credit Unions just as commercial banks may face unprecedented deposits and withdrawals through both BOSA & FOSA a/cs. d) FINANCE COMPANIESAre financial institutions which do not mobilize deposits and thus known as contractual non-bankingfinancial institutions therefore they source funds from issuing securities such as bonds, commercialinstitutions and thus the only source of funds of finance companies. They issue credit thus the assetsare made up of: • Consumer loans • Commercial loans. • General investment loans • Investment in securities, bonds or shares. • Cash deposits in other institutions. • Physical assets.Liabilities • Securities (issue or sourcing) • Borrowings • Owner’s equityThe finance companies are divided into 3: • Sales Finance Companies make loans to households or other businesses to purchase mainly commercial vehicles and other durables for commercial purposes. Examples: CFC (Credit Finance Co-operation) and NIC (National Finance Co-operation) 11
• Business Finance Companies provide specialized credit to purchase inventory accounts receivable financing companies. They give credit against inventory or stock. Therefore, the inventory acts as collateral against the credit. Examples range from manufacturing firms that give goods on credit. In general these institutions are known as input supply credit providers. Example: Consolidated Bank. • Consumers Finance Companies make loans to household to purchase household items; e.g. furniture, etc., e.g. African Retail Traders (A.R.T.)In general, Finance Companies do not necessarily provide credit in monetary items but in kind (goodand household. e) MICRO-FINANCE AND MICRO-CREDIT INSTITUTIONS These are regulated by the Central Bank through the Association of Micro-Finance Institutions(AMFI) to lend to small and micro-enterprises and to mobilize savings from the same micro and smallenterprises.Therefore, micro-finance institutions operate just like commercial banks, only to small enterprises.They also use groups through collective collateral e.g. KREP holdings, KWFT, Faulu, Equity holdings,Pride Africa, Family Finance.Micro Credit financial institutions issue credit only and source funds from donor agencies or issuingof securities such as bonds. There is no mobilization of loans/funds. Examples; SMEP, NCCK HELB. f) INVESTMENT COMPANIESThese are financial institutions whose ownership is through shares securities such as bonds and allborrowings such as convertible debentures. Thus the liability side of investment companies aremade up of:
Liabilities Assets- share capital - investments in the other companies e.g. shares- securities issued - investments in debt securities e.g bonds.- borrowings - Government’s securities eg. Treasury bills. - investment in commercial papers. - investment in foreign bonds.Investment companies usually act as underwriters for IPOs i.e. after borrowings or sourcing moneythrough share capital and other securities such as funds are invested in the capital market andmoney market securities With the function of underwriting shares during the IPO.The unit trusts fall under the money market are also the instruments traded by the investmentcompanies e.g Diamond Trust Fund.NON-BANKING FINANCIAL INSTITUTIONS WITH THE TERM NON-DEPOSITORY A. Insurance CompaniesAn Insurance Company is a non-depository finance Institution with two major products i.e. lifeassurance and property insurance products. Life Assurance The life assurance products differ from property insurance products in that they allow lendingagainst premiums. e.g. (products): i.Ordinary Life AssuranceThis is where the insured receives the payment when death occurs. i.e. whole life insured, part ofthe premiums can be converted into savings to act as sources of funds for lending. The whole lifeassurance thus has a saving and lending component against the savings and the collaterals arepremiums. ii.Group Life AssuranceThis is a product which involves a large number of insured persons usually its executed through ee’sin a given organization and it has two components. • Contributory It is where the employee and employee both contribute partially to the group life. 13
• Non-Contributory It is where only employee contributes towards life assurance; Group Life Assurance has no savings components and therefore does not qualify for a loan or credit. iii.Industrial Life AssuranceThis policy is contributed by the employer in relation to injuries, accidents and death during theworking hours and at the work place. i.e. workman’s compensation. It does not have a savingscomponent. iv.Credit Life AssuranceIt is a policy tied to borrowing incase the borrower dies prior to loan prepayments are completed. v.AnnuitiesThey are insurance products in relation to liquidation of companies or bankruptcy of companies orany eventuality that may lead to company’s closure. vi.Accidents and Health Life Assurance PoliciesThis is insurance against mobility or ill health e.g. A.A.R. It has no saving components Property InsuranceProperty insurance has another component /variance of liability insurance. It covers loss through firs,theft burglary. However, liability insurance is insurance against obligation such as negligence orfidelity. Fidelity has a variance of surety which relates to agreements and insurance againstdishonesty.The assets of insurance companies are usually made of two components: • Securities – bonds, shares, T-bills • Loans – Policy loans, loans against premiums paid by whole life Assurance clients upto the extent of their premium contributions. • Mortgage Loans – Extended two savings institutions through borrowing from other financial institutions e.g. Housing Finance borrowing from another company.The Liabilities: • Premiums – or policy claims • Policy dividends/bonuses arising from savings components in live assurance products. • Reserve deposits with re-insurance – Reserves 4 insurance are deposits kept by insurance
in re-insurance but they represent future liability commitments, i.e. they are expected to pay out contracts 4 policy holders who happen to withdraw before maturity of their policies.IllustrationsAlico had the following information relating to a company’s operations,Government bonds 1,500,000Preference stock 100,000Common stock 50,000S/term investment • policy loans 140,000 • mortgage loans 480,000 • certificate of deposits 200,000 • promissory notes 240,000Life Assurance premium due 1,450,000Physical assets 450,000Other assets 230,000T bills 185,000Reserves 300,000Dividends on savings 320,000Commission and taxes payable 460,000Other liabilities (borrowings) 110,000Note. Alico is a member of the reserve system of re-insurance and is required to maintain a20%reserve at all time in relation to premiums. Suppose after receiving this information, the salesagent reports to you that one policy holder has applied to withdraw immediately a claim worth400,000.Required a) Determine if Alico with its current B/Sheet has not violated legislative structure of Re- insurance, b) What options would you as a manager undertake after the withdrawal of the client? Alico Insurance 15
Balance sheetAssets liabilities and equity1. Securities policy premiums 1,450,000T bonds 1,500,000 Dividends on savings payables 320,000Pref. shares 100,000 Comm. & taxes Payables 460,000Common stock 50,000 Borrowings from Other FI 110,000T bills 185,000 reserves and claims 300,0002. LoansPolicy loan 140,000 Equity ` 935,000Mortgage loans 480,0003. Short term investmentCertificate of deposits 200,000Promissory notes 240,0004. Physical assets 450,000Other assets 230,000 3,575,000 3,575,000NoteReserve system is 20% of 1,450,000=290,000300,000>290,000b) In circumstance where the client withdraws, the balance sheet is re-organized as follows. are • Borrowings from other financial inst. 400,000/
• Source for more funds from re-insurance • Sell some securities from interest sensitive securities, I,e those maturing in a short period • Recall some of the loans • Call some short term deposits B. Pension trust FundThey are trust schemes created and maintained by employees, unions and individuals.Their assets are made up of 2 parts, investment in securities and physical assets. Whereas liabilitiesare composed of contribution by employees, employer, income and capital growth (if it’s a loss) C. Security Dealers/ BrokersThey operate in primary and secondary stock market e.g Investment brokers who undertake writingof IPO and thus trade in stock market in their own account. Brokers trade in security on behalf ofclients. Assets include; sale of securities, income from securities and any other physical assets.Liabilities are; guarantees insecurities which are issued as IPOs, claims payables etc.NoteFor all financial institutions and at all times, one must maintain a positive net liquidity position (NLP).NLP is the difference between total supply of liquidity and the total demand made upon the bank. Itcan be computed as followsNLP = (deposits + sales of non Deposit + loans & repayment + Sale of bank’s asset + borrowingfrom money market) – ( deposit withdrawals + loans request accepted + repayment of Loans +Other operating expense + dividend payments)Management of Assets and LiabilitiesStrategies employed include managing; asset, liabilities, capital/equity management and liquidity 17
management.Objectives of management of funds • Volume ratio mix. Entails evaluation of the cost/ returns/ price of both asset and liabilities • Maintaining diversification and duration analysis. Duration analysis is the process of matching maturities of assets and that of liabilities • To ensure maximizations of returns and minimizations of costsAsset managementThe basis of asset management is aimed at maximization of profits because profits are derived fromloans issued beside securities. Therefore financial institutions follow the prescribed strategies inasset management in order to maximize returns from loans and related securities.Strategies for asset management include; i.Seeking for high interest loans with low defaults risk ii.Diversification in different asset portfolio for instance spreading investments in securities iii.Banks tends to hold liquid securities / assets even if such assets earn lower returnsStrategies for liability management include; i.Selling negotiable certificates of deposits (CD) ii.Selling callable securities e.g callable bonds iii.Entering into interbank lending systems that allows overnight lending iv.Maintaining a positive reserve requirement above the Central bank’s minimum reserve amountsCapital managementThis requires that financial institution maintains a steady growth in generation of its capital to assetratio. This ensures a retention level and steady dividends payouts.Purpose of equity i.Equity is used to cushion against losses in operations ii.Equity is used in chattering financial institutions before inflows are realized. iii.Used to as basis in access to financial markets in terms of credits iv.Used in growth and development programmes such as branch network v.Used in regulations of financial institution. That is, a certain level of equity must exist overtime in relation to assets.
vi.Used in mergers or other related negotiationFor a steady growth in equity, a financial institution must evaluate internal capital growth rate(I.C.G.R). this is a measure of how fast a financial institution manages its assets growth to overcome adrop decline in equity asset ratio.I.C.G.R = return on Equity X Retention ratio (R.R)R.O.E= Net profit/ Owners EquityR.R= Retained Earnings / Owners EquityRisk management in Financial InstitutionsRiskRisk refers to uncertainties regarding returns expected from various investment. It arises whensignificant variability is experienced when a particular investment is held. There are usually varioussources of risks. Mainly; business risk, financial risk. Liquidity risk, foreign exchange risk and liquidityrisk.In financial institution, the major risk arises from advancing loans to existing and prospectivecustomers. Proper credit evaluation must therefore be carried out before giving loans and advancesso as to reduce credit or defaults risk.A number of sources quality information available to banks includes; a) Audited financial statements of the existing and prospective customers b) Credit rating agencies. This are entities which specializes in collection of credit information about various companies. c) Past experience d) Trade references e) Bank references f) Analysis of the prevailing economic conditionsTECHNIQUES OF MANAGING CREDIT/ DEFAULT RISKS 19
Management of credit risk of a critical in banks and financial institution, financial institutionsmanagers must follow adverse selection and moral hazard concepts to have a framework forunderstanding credit risk minimization. Adverse selection is problem in loan markets because badcredit risks ( borrowers most likely to default) are the ones who line up for loans.The following techniques may be used by banks and financial institutions to reduce defaults of creditrisk; a) Screening and monitoring In relation to screening, adverse selection in loan markets requires that financial institution and banks eliminate credit risk by screening financial loan applicants. To accomplish effective screening, financial institution must collect adequate relevant and reliable credit information from the prospective borrowers. For business entities, audited financial statements may be required on the basis of which various measures of financial performance may be determined. b) Long term customers relationship Financial institution managers may evaluate past activities in the accounts of existing customers. The balances of both current and saving accounts may give loan officers some information about the liquidity of the potential borrowers. c) Loan commitment This is a technique used for institutionalization for loan term relationship. A loans commitment is a banks commitment for a specialized period of time to provide a firm with loan up to a given rate of interest borrower can access any amounts at a specialized interest rate. Provisions in the loan commitment agreement require that the borrower continuously supply the bank with information about financial performance, position and future plans. d) Collateral In most cases where defaults risk is quite apparent from the information of debt information, banks and financial institutions may insist on taking collateral called security to compensate the institution in the event of default. Collateral requirement depends on the on the amount requested by the borrower. Collateral may be free or floating charge and a fixed charge. Factoring may be done with or without recourse or without notifications. Factoring with recourse implies that the borrower will have a responsibility if the bank fails to collect the accounts receivable. Factoring without recourse implies that the borrower has no responsibility even if the bank fails to collect the accounts receivables. Factoring with notifications implies that the factor ( can be a bank or financial institution ) notifies the firm that all the amounts in relation to accounts receivable have been collected. In most cases factoring is from notification basis. e) Compensating balances
This is a form of security required by the bank or a financial institution when it makes commercial loans. The firm or entity that is requesting for a loan is required to maintain a minimum amount of funds in checking account with the bank. f) Credit rationing This is where lenders may refuse to make loans to the borrowers even when they are willing to make principle repayments and interest payments as required. A bank or a financial institution may either refuse to approve certain loan requested or just pay a proportion of the amount requested. Prospective borrowers may be requested to give information about their prospective investments and detailed business plans. If the investment is considered riskier by the bank, credit request may not be approved. g) Credit insurance Banks and financial institution may also take credit insurance. In this arrangement, credit or default risk is transferred to an insurance company.MANAGEMENT OF INTEREST RATE RISKDeposit rateManagers of banks and financial institution must be concerned about the institutions exposure to interestrate changes. Assessment of interest rate changes may enable the bank to determine the effect which suchchanges may have on the banks financial performance.There are usually two categories if interest rates;Lending /borrowing rate which the bank charges on loans and advances it gives its customers. From thebanks perspective, lending rates constitutes income while from the customer’s perspective it constitutescosts.Deposits rates are the interest rates which banks pay on customer’s deposits. The difference betweenthe two constitutes the profit margin.Managers of banks financial institution should identify the assets and liabilities which are sensitive to changesin the level of interest rates. Assessment of interest rate risk therefore requires managers to identify, rate 21
sensitive assets (RSA) and rate sensitive liabilities (RSL)Credit Risk AnalysisCredit risk is a danger or the exposure of a financial institution to an inability for borrowers to pay theirloans / obligations as expected. If borrowers delay payment financial institution cannot match their expectedliabilities to the expected assets. In circumstances where loans are completely unpaid, this leads to bad debtsand bad debts cannot be part of risks management rather bad debts are part of uncertainty management.Credit risk analysis provides an insight/guidance on how loans can be merged with deposits. In addition, incredit risk management, the financial institution can decide on the types of assets to invest in and the typesof liabilities to accept. The ratio used should in credit risk management are ratios for valuation of the abilitiesto commit to loan payment these are