1. MANAGEMENT FINANCIAL INSTITUTION
MANAGEMENT OF FINANCIAL INSTITUTIONS
BCOM 430
INTRODUCTION
In a changing global financial movements particularly in liberalization of participation of financial
markets. Financial institutions are facing challenges with more entrance into the market creating
competition and forcing wither closures, acquisitions, mergers or management over.
However, where others fail, others succeed and even new entrants join with different strategies and
different products. Therefore to understand how to manage financial institutions successfully, in a
changing environment, one needs to appreciate the concepts within money and capital markets the
institutional framework of financial institutions, the risk managerial strategies of financial institutions
is to identify the functionalities, categorization statements and legal systems. In addition, the risk
management takes a major part of the management of the institution because all financial
institutions 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.
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2. FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS
Financial markets are categorized into;
i.THE MONEY MARKET
The money market for financial institutions relates to transactions in exchange that pertains to
money i.e. borrowing and lending within one year, foreign exchange markets, made up of the spot
market, daily exchanged of currencies maturing in 48 hours. Capital markets for financial institutions
relates to securities usually corporate bonds and stock.

3. ii. PRIMARY MARKET
Primary market is for first issue or transaction in a security. Any subsequent transaction falls into a
secondary market. Financial institutions play an important role in both the financial market by
moving funds from the pockets of deposit less into the pockets of borrowers consume more than
their income and to link the two, interest rates is used which acts as a driving force to allocate the
excess funds with depositors into the pockets of borrowers in the financial markets and thus you
cannot separate a financial institution from a financial market.
Financial markets therefore have two functions:
• Time preference function
It is provided in the time value of money concept where financial markets provide a forum for
financial institutions access money at present and re-evaluate values of such money in future under
competitive environment through interest rates.
• Risk separation and distribution
This is through allocation of money or capital and distribution of such capital to a large clientele
subsequently who accept to absorb such risks and thus the concept of risk diversification of
distribution.
ROLES/FUNCTIONS OF FINANCIAL INSTITUTIONS
1. 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.
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4. 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

5. C Mortgage Brokers Agencies Financial institution
Investment Brokers
Security Dealers
D Households Investors or Non-Financial
Individual Businesses Depositors/Borrowers Institutions
Government Departments
DEPOSITORY FINANCIAL INSTITUTIONS
a) Commercial Banks
They are depository institutions because they accept deposits in the form of negotiable certificates of
deposits, non-negotiable certificate of deposits, savings deposits, checking accounts deposits, pass
book deposits accounts and current accounts. These liabilities are used to issuing loans and for other
investments in money and capital market securities. The assets include other than the loans and
securities commercial papers such as promissory notes and letter of credit.
Illustration
Assume a commercial bank of Africa with the following information available to the new manager as
at 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. 1,450,000.00
The bank has the following loans:
• Borrowing from other banks: Kshs. 2,500,000.00
• Borrowing from the central bank Kshs. 1,500,000.00
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6. • 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. 600,000.00
There is a reserve requirement of 10% by the C.B.K. In addition there is a letter of credit involving
international trade worth Kshs. 500,000.00
Required;
a. Prepare the banks balance sheet as at 31st December 2009
b. 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 Management
2. Credit Risk Management
3. Liability Management
4. Capital/Asset Management
Balance Sheet: Commercial Bank of Africa
Assets Liabilities
Reserves Deposits

7. Securities (invested) Securities (Issued)
Loans Borrowings
Physical Assets Owners equity
a)
Management of Commercial Banks Balance Sheet
Commercial Bank of Africa’s Balance Sheet as at 31st December 2009
ASSETS LIABILITIES
Reserves Deposits
(10% of total 1,450,000 Transaction a/c
deposits)
Securities Saving a/c 1,000,000
Government bonds, 1,000,000 Chequeable a/c 2,000,000
Company loans 600,000 1,600,000 Passbook 1,000,000
4,000,000
Loans: Non-Transaction
Inter-bank 800,000 a/c
Industrial/Commercial 1,000,000 Negotiable CD a/c 4,000,000
Real Estate(Mortgage 4,000,000 Non-Negotiable 2,000,000
loans) CD
Revolving Loans 700,000 Misc. Deposits 1,450,000
Consumer Loans 1,500,00 Borrowings
Letter of Credit 0 • From 2,500,000
Physical 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 Withdrawal
Deposit 11,450,000
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8. Less Withdrawal (4,000,000)
7,450,000
Reserve (10%) 745,000
i.Call loans
Assets Liabilities
Reserves 745,000 Deposits 7,450,000
Securities 1,600,000 Others(B+OE) 795,000
Loans 4,900,000
Physical Assets 1,000,000
8,245,000 8,245,000
Deposit withdrawals may lead to liquidity problems such that assets may not be liquid enough to
cover 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.Borrowing
Asset Liabilities
Reserves 745,000 Deposits 745,000
Securities 1,600,000 Others 795,000
Loans 8,500,000 Borrowing 3,600,000
Physical Assets 1,000,000
11,845,000 11,845,000
b) SAVINGS INSTITUTIONS

9. 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 usually
finance 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 fund
through 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 Sheet
Assets Liabilities
1. Mortgage Loans 1. Deposits
- Fixed Rate Passbook a/c
- Adjusted Rate Fixed Deposit a/c
2. Non-Mortgage Loans 2. Securities
- Commercial Loans Money Market (unit trust)
- Physical Assets Capital Market (bonds)
3. Borrowing
From Financial Institutions
SAVINGS INSTITUTIONS BALANCE SHEET
Illustrations
Assume Housing Finance Company had the following information relating to its balance sheet for the
period ending December 2009. The firm had mortgage loans divided into fixed rate and adjusted
rate 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.
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10. Required
Prepare a balance sheet for the saving institution.
Solutions
Assets Liabilities
Mortgage Loans
Fixed rate 1,200,000 Cash 3,000,000
Adjusted rate 2,800,000 Investment 2,500,000
Other loans 500,000 Loans 500,000
Physical Assets 6,500,000 Deposits 1,500,000
Central Bank Obl. 2,000,000 Share Capital 3,800,000
Borrowings 4,000,000
Securities: Cash 3,000,000 Less drawings (3,300,000)
: Investments2,500,000
18,500,000 18,500,000
c) CREDIT UNIONS
They are also depository institutions owned by membership through their share capital. Such
membership usually shares a common activity, i.e. credit unions deposits are derived from a share
capital or contributions with the objective of mobilizing savings and provide credit without profit
orientations. Thus the returns from deposits not interest but rather the dividends. Within the
governing policy, credit unions are tax exempted in their net incomes. This tax exemption allows
credit 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 but
executed 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.

11. - 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 COMPANIES
Are financial institutions which do not mobilize deposits and thus known as contractual non-banking
financial institutions therefore they source funds from issuing securities such as bonds, commercial
institutions and thus the only source of funds of finance companies. They issue credit thus the assets
are 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 equity
The 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)
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12. • 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 (good
and 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 small
enterprises.
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 issuing
of securities such as bonds. There is no mobilization of loans/funds. Examples; SMEP, NCCK HELB.
f) INVESTMENT COMPANIES
These are financial institutions whose ownership is through shares securities such as bonds and all
borrowings such as convertible debentures. Thus the liability side of investment companies are
made up of:

13. 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 money
through share capital and other securities such as funds are invested in the capital market and
money 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 investment
companies e.g Diamond Trust Fund.
NON-BANKING FINANCIAL INSTITUTIONS WITH THE TERM NON-DEPOSITORY
A. Insurance Companies
An Insurance Company is a non-depository finance Institution with two major products i.e. life
assurance and property insurance products.
Life Assurance
The life assurance products differ from property insurance products in that they allow lending
against premiums. e.g. (products):
i.Ordinary Life Assurance
This is where the insured receives the payment when death occurs. i.e. whole life insured, part of
the premiums can be converted into savings to act as sources of funds for lending. The whole life
assurance thus has a saving and lending component against the savings and the collaterals are
premiums.
ii.Group Life Assurance
This is a product which involves a large number of insured persons usually its executed through ee’s
in a given organization and it has two components.
• Contributory
It is where the employee and employee both contribute partially to the group life.
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14. • 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 Assurance
This policy is contributed by the employer in relation to injuries, accidents and death during the
working hours and at the work place. i.e. workman’s compensation. It does not have a savings
component.
iv.Credit Life Assurance
It is a policy tied to borrowing incase the borrower dies prior to loan prepayments are completed.
v.Annuities
They are insurance products in relation to liquidation of companies or bankruptcy of companies or
any eventuality that may lead to company’s closure.
vi.Accidents and Health Life Assurance Policies
This is insurance against mobility or ill health e.g. A.A.R. It has no saving components
Property Insurance
Property 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 or
fidelity. Fidelity has a variance of surety which relates to agreements and insurance against
dishonesty.
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

15. 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.
Illustrations
Alico had the following information relating to a company’s operations,
Government bonds 1,500,000
Preference stock 100,000
Common stock 50,000
S/term investment
• policy loans 140,000
• mortgage loans 480,000
• certificate of deposits 200,000
• promissory notes 240,000
Life Assurance premium due 1,450,000
Physical assets 450,000
Other assets 230,000
T bills 185,000
Reserves 300,000
Dividends on savings 320,000
Commission and taxes payable 460,000
Other liabilities (borrowings) 110,000
Note. Alico is a member of the reserve system of re-insurance and is required to maintain a
20%reserve at all time in relation to premiums. Suppose after receiving this information, the sales
agent reports to you that one policy holder has applied to withdraw immediately a claim worth
400,000.
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
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16. Balance sheet
Assets liabilities and equity
1. Securities policy premiums 1,450,000
T bonds 1,500,000 Dividends on savings payables
320,000
Pref. shares 100,000 Comm. & taxes Payables
460,000
Common stock 50,000 Borrowings from Other FI
110,000
T bills 185,000 reserves and claims
300,000
2. Loans
Policy loan 140,000 Equity `
935,000
Mortgage loans 480,000
3. Short term investment
Certificate of deposits 200,000
Promissory notes 240,000
4. Physical assets 450,000
Other assets 230,000
3,575,000 3,575,000
Note
Reserve system is 20% of 1,450,000=290,000
300,000>290,000
b) In circumstance where the client withdraws, the balance sheet is re-organized as follows. are
• Borrowings from other financial inst. 400,000/

17. • 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 Fund
They 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 liabilities
are composed of contribution by employees, employer, income and capital growth (if it’s a loss)
C. Security Dealers/ Brokers
They operate in primary and secondary stock market e.g Investment brokers who undertake writing
of IPO and thus trade in stock market in their own account. Brokers trade in security on behalf of
clients. 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.
Note
For 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. It
can be computed as follows
NLP = (deposits + sales of non Deposit + loans & repayment + Sale of bank’s asset + borrowing
from money market) – ( deposit withdrawals + loans request accepted + repayment of Loans +
Other operating expense + dividend payments)
Management of Assets and Liabilities
Strategies employed include managing; asset, liabilities, capital/equity management and liquidity
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18. 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 costs
Asset management
The basis of asset management is aimed at maximization of profits because profits are derived from
loans issued beside securities. Therefore financial institutions follow the prescribed strategies in
asset 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 returns
Strategies 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
amounts
Capital management
This requires that financial institution maintains a steady growth in generation of its capital to asset
ratio. 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.

19. vi.Used in mergers or other related negotiation
For 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 a
drop decline in equity asset ratio.
I.C.G.R = return on Equity X Retention ratio (R.R)
R.O.E= Net profit/ Owners Equity
R.R= Retained Earnings / Owners Equity
Risk management in Financial Institutions
Risk
Risk refers to uncertainties regarding returns expected from various investment. It arises when
significant variability is experienced when a particular investment is held. There are usually various
sources of risks. Mainly; business risk, financial risk. Liquidity risk, foreign exchange risk and liquidity
risk.
In financial institution, the major risk arises from advancing loans to existing and prospective
customers. Proper credit evaluation must therefore be carried out before giving loans and advances
so 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 conditions
TECHNIQUES OF MANAGING CREDIT/ DEFAULT RISKS
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20. Management of credit risk of a critical in banks and financial institution, financial institutions
managers must follow adverse selection and moral hazard concepts to have a framework for
understanding credit risk minimization. Adverse selection is problem in loan markets because bad
credit 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 credit
risk;
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

21. 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 RISK
Deposit rate
Managers of banks and financial institution must be concerned about the institutions exposure to interest
rate changes. Assessment of interest rate changes may enable the bank to determine the effect which such
changes 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 the
banks perspective, lending rates constitutes income while from the customer’s perspective it constitutes
costs.
Deposits rates are the interest rates which banks pay on customer’s deposits. The difference between
the two constitutes the profit margin.
Managers of banks financial institution should identify the assets and liabilities which are sensitive to changes
in the level of interest rates. Assessment of interest rate risk therefore requires managers to identify, rate
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22. sensitive assets (RSA) and rate sensitive liabilities (RSL)
Credit Risk Analysis
Credit risk is a danger or the exposure of a financial institution to an inability for borrowers to pay their
loans / obligations as expected. If borrowers delay payment financial institution cannot match their expected
liabilities to the expected assets. In circumstances where loans are completely unpaid, this leads to bad debts
and 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, in
credit risk management, the financial institution can decide on the types of assets to invest in and the types
of liabilities to accept. The ratio used should in credit risk management are ratios for valuation of the abilities
to commit to loan payment these are