College of Business & Economics

Department of Accounting & Finance

Distance Education Material

For
Capital Markets

MSC IN ACCOUNTING AND FINANCE PROGRAM

ADVANCED FINANCIAL ACCOUNTING MODULE

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 ADDIS ABABA UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ACCOUNTING & FINANCE

July, 2016

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Course Material Introduction:
This course is one of the basic and essential courses offered to candidates joining MSC in
Accounting and Finance program. It will lay down the foundation for building other finance
courses that are necessary to students of joining this program. It will discuss the capital market
and financial institutions imperatives that students of this program are required to be aware of to
a reasonable depth.
This material is arranged and structured in two modules and in four units. The first module is to
discuss about the financial system and market operations. It will discuss about the role and
functions of the financial system , the financial markets, financial assets, their characteristics,
roles and functions. It will also discuss the financial institutions-the debt and equity market
operations and the various types and nature of each institution. It also brings to examination the
role and functions of central banking, and the Ethiopian financial system.
The second module will focus on bank risk management. It is arranged in three units and tries to
discuss about the nature of risk in financial institutions, the needs to manage risk, the essential
requisites to manage risk and how each type of risk is managed. It will also identify the parties
involved in managing of different types of risk and outlines what kind of responsibilities are
entrusted to different groups in financial institutions.
Course Material Objectives
At the end of completing this course, you will be able to;
 Describe what a financial system is
 Determine who the players in a financial system are
 Explain the reasons why units come to participate in the financial system
 Tell what financial intermediation, direct and indirect financing are
 Describe the purpose and objectives of financial system regulations
 Itemized the types and functions of different financial institutions
 Determine the role of central banks
 Explain what Ethiopian financial system looks like
 Describe risk in the context of financial institutions

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  Identify the types of risk prevalent in the financial institutions
 Determine the levels of risk management responsibilities of different units in an
institution
 Outline how different types of risk in financial institutions can be managed
 Outline the tasks that different management hierarchies will be responsible with

The material is designed to provide adequate exposure to the workings of the capital market in
general and the role and operational activities of the financial institutions, in particular. Equity
and debt market operations, foreign currency exchanges and risk management imperatives are all
put in order for you to comprehend essential and related subjects. Classes of risk the manner of
approach to manage them is all in order. The profile of Ethiopian financial system is also given
space to provide you chance to draw relationship and internalize its potentials and predicaments.
There are focus areas where you must make sure that those items are understood to at least a
satisfactory level. There are also self assessment questions in every unit discussed to enhance
understanding and self checking. Please attempt them all and check your answers with suggested
ones given at the end of this material. Good luck!

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 Table of Contents
Subject Page
Course Introduction
Course Objectives
Module I .. 1
Module Introduction 1
Module Objectives 1
Unit 1 The Financial System .. . 2
Unit Introduction .. 2
Unit Objectives . 2
1.2 Financial Intermediation . 4
1.3 Functions of the Financial System . 5
1.4 The Financial System & Resource Allocation 7
1.5 Financial System Regulators . 13
Unit 2 The Financial Market 16
Unit Introduction . 16
Unit Objectives 16
2.1 Nature of Financial Markets .. 16
2.2 Financial Assets 16
2.3 Types of Financial Markets 26
2.4 Foreign Exchange Market .. 28
2.5 Primary Market Operations 39
2.6 Secondary Market Operations 43
2.7 Evaluation of Financial Markets . 53
Unit 3 Financial Institutions .. 56
Unit Introduction
Unit Objectives
Financial Institutions and their Roles 56
Unit 4 Central Banking and Ethiopian Financial Institutions . 62
Unit Introduction
Unit Objectives
4.1 Central Banking . 62
4.2 Ethiopian Financial System .. 77

Module II Bank Risk Management 86

Module Introduction
Module Objectives
Unit 1 Banking Risk 87
Unit Introduction
Unit Objectives
1.1 Nature of Risk .. 87
1.2 Risk in Financial Services . 88

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 1.3 Common Types of Risk in Financial Institutions .. 89
Unit 2 Risk Management Essentials in Financial Institutions 92
Unit Introduction
Unit Objectives
2.1 Risk Management 92
2.2 Risk Management Framework .. 94
2.3 Role of Risk Management Function .. 100
2.4 Independent Review . 101
2.5 Integration of Risk Management 102
2.6 Contingency Planning 102
Unit 3 Managing Specific Risk in Financial Institutions .. 103
Unit Introduction
Unit Objectives
3.1 Credit Risk Management . 103
3.2 Liquidity Risk Management . 126
3.3 Market Risk Management .. 147
3.4 Operational Risk Management .. 166
3.5 Strategic Risk Management 183
3.6 Compliance Risk Management . 193

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 Module I
The Financial System and Market Operations

Module Introduction

In this module fundamental financial exchange imperatives will be discussed at length. The
importance of setting up a workable financial system in an economy, its roles, participants and
regulations and control will be discussed. The importance, challenges of expediting the flow of
funds to those demanding it, the instruments used to channel funds, how each is used in the effort
of availing funds and investing the same will be discussed at length.

This module has three units to exhaustively discuss all these items in a manner that is
understandable and coherent in flow of thoughts. The first unit will discuss about the role and
functions of the financial system in one economy. The second unit will deal with the financial
markets, financial assets, their characteristics, roles and functions. The third unit will discuss the
financial institutions. It will discuss about the types and nature of each institution, the role and
functions of central banking, and also the Ethiopian financial system.

Module Objectives

After completing this module, you will be able to;

 Describe what a financial system is
 Determine who the players in a financial system are
 Explain the reasons why units come to participate in the financial system
 Tell what financial intermediation, direct and indirect financing are
 Describe the purpose and objectives of financial system regulations
 Itemized the types and functions of different financial institutions
 Determine the role of central banks
 Explain what Ethiopian financial system looks like
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 Unit 1:
The Financial System

Unit Introduction

This unit will discuss about what a financial system is, its roles, functions and usefulness in an
economic development endeavor. It will elaborate on the types of actors that appear in the
financial system, the purpose and objectives of coming to the financial system and the likely
choice they make in appearing to the system will be discussed.

Unit Objectives
Upon completion of this unit, you will be able to;
 Describe what a financial system is
 Determine what the role and functions of a financial system are
 Identify how financial systems help mobilize capital
 Explain the role of financial system regulators

1.1 Financial System Imperatives

A Financial system is a set of rules and regulations that allows acquisition and selling of financial
assets between and among seekers of finance, suppliers of finance and those intermediating the
transaction. A financial system consists of institutional units and markets that interact, typically
in a complex manner, for the purpose of mobilizing funds for investment and providing facilities,
including payment systems, for the financing of commercial and public activity. The system is a
necessary phenomenon for an economy for it facilitates creation and utilization of credit and
financial assets. Thus the main function of, in particular in a free market financial system, is to
allocate scarce capital to those who can commit it to the most productive and profitable uses.

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The financial system constitutes a set of subsystems of financial institutions, financial markets,
financial instruments and services which helps in the formation of capital. It provides a
mechanism by which savings are transformed to investment. They perform at least two main
types of financial service that reduce the costs of moving funs between borrowers an lenders,
leading to a more efficient allocation of resources an faster economic growth.

The following Diagram depicts the transfer of funds between those seeking it and those who have
spare of it and want to allow others use it.

Direct Financing

Funds
Fund Seeker Surplus
Securities Budget Unit
& Bonds

Indirect Financing

Bonds Funds Securities

Surplus
Fund Seeker Funds Funds Budget Unit
Financial
Intermediation

&

Investment
Bonds Banking Securities
Surplus
Fund Seeker
Budget Unit

Funds Funds

Diagram 1.1: The Financial System Actors

Self Test Question 1.1

How would the Financial System be defined?

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Businesses, the Government and Individual households need funds to make investment or even
to consume. When they have more needs than the resources available to them, they look for fund
suppliers. Others too, when they have excess funds than what they require, they look for
opportunities where they can make invest into. These three, individual households, firms, and the
government are important actors in every economic system. They appear in the financial system
as either fund seekers or surplus budget units. Even simultaneously, some of the households
become fund seekers while other households become surplus budget units. Same is true for
business firms too.

Often the entity needing capital is a business, and specifically a corporation, but it is easy to
visualize the demander of capital being a home purchaser, a small business, a government unit,
or others.

Hence, in a well-functioning economy, the above three actors transact between and among
themselves to cater for their demands. In such economic system, capital/funds will flow
efficiently from those who supply capital to those who demand it. This transfer of capital can
take place in the two different ways, direct and indirect, as indicated on the diagram above
[Diagram 1.1].

1.2 Financial Intermediation

Financial Intermediaries are the facilitators of the financial transactions that take place with the
financial system. They serve as mediators between funds raisers and suppliers of funds, that is,
users and savers of funds respectively. Therefore, they facilitate the issuance and exchange of
financial instruments. Such intermediaries include the following:
 Commercial and merchant banks
 Specialized banks, e.g., investment banks, development banks;
 Primary mortgage institutions; and
 Insurance companies, etc.
The various banks perform profound role in terms of intermediary functions since in the process
of financial intermediation, they source for surplus funds form savers and channel the funds to
the prospective users.

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The Direct Transfer:-Direct transfers of money and securities, as shown in the top section,
occur when a fund seeking entity/business sells its stocks or bonds directly to savers, without
going through any type of financial intermediary. The entity/business delivers its securities to
savers, who in turn give the firm the money it needs.

Indirect Transfer:-As shown above too, transfers may also go through an investment banking
house, which underwrites the issue. An underwriter serves as a middleman and facilitates the
issuance of securities. The company sells its stocks or bonds to the investment bank, which in
turn sells these same securities to savers. The businesses’ securities and the savers’ money merely
“pass through” the investment banking house. However, the investment bank does buy and hold
the securities for a period of time, so it is taking a risk—it may not be able to resell them to
savers for as much as it paid.

Transfers can also be made through a financial intermediary such as a bank or mutual fund. Here
the intermediary obtains funds from savers in exchange for its own securities. The intermediary
uses this money to buy and hold businesses’ securities. For example, a saver might deposit birrs
in a bank, receiving from it a certificate of deposit, and then the bank might lend the money to a
small business as a mortgage loan. Thus, intermediaries literally create new forms of capital —in
this case, certificates of deposit, which are both safer and more liquid than mortgages and thus
are better for most savers to hold. The existence of intermediaries greatly increases the efficiency
of money and capital markets.

Self Test Question 1.2

Identify and describe the difference between

the two types of fund Transfer.

1.3 Functions of the Financial System

From the foregoing discussions, it becomes possible to narrate that the financial system performs
some vital functions to the economy, which tend to enhance the performance of the economy
toward its growth and development. Such functions include the following:

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 I. Saving function: An important function of a financial system is to mobilize
savings and channelize them into productive activities. It is through financial
system the savings are transformed into investments.
II. Liquidity function: The most important function of a financial system is to
provide money and monetary assets for the production of goods and services.
Monetary assets are those assets which can be converted into cash or money easily
without loss of value. All activities in a financial system are related to liquidity-
either provision of liquidity or trading in liquidity.
III. Payment function: The financial system offers a very convenient mode of
payment for goods and services. The cheque system and credit card system are the
easiest methods of payment in the economy. The cost and time of transactions are
considerably reduced.
IV. Risk function: The financial markets provide protection against life, health and
income risks. These guarantees are accomplished through the sale of life, health
insurance and property insurance policies.
V. Information function: A financial system makes available price-related
information. This is a valuable help to those who need to take economic and
financial decisions. Financial markets disseminate information for enabling
participants to develop an informed opinion about investment, disinvestment,
reinvestment or holding a particular asset.
VI. Transfer function: A financial system provides a mechanism for the transfer of
the resources across geographic boundaries.
VII. Reformatory functions: A financial system undertaking the functions of
developing, introducing innovative financial assets/instruments services and
practices and restructuring the existing assts, services etc, to cater the emerging
needs of borrowers and investors (financial engineering and re engineering).
VIII. Other functions: It assists in the selection of projects to be financed and also
reviews performance of such projects periodically. It also promotes the process of
capital formation by bringing together the supply of savings and the demand for
investible funds.

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Self Test Question 1.3

What are the functions of a financial system?

1.4 The Financial System and Resource Allocation

In an ideal world, we should like to think that the financial system functions in such
a way that it channels funds from lenders to their most productive use. Where the
funds are borrowed for real investment projects, for example, these should be the
projects which society values most. For this to happen, a number of conditions
have to be met. If we assume that they are met, we are assuming that the financial
system has the characteristics of a perfectly competitive system. The assumptions are:
 there are many lenders and borrowers;

 all lenders and borrowers have perfect information;

 new lenders and borrowers can enter the market without

restraint;
 there are no taxes;

 there are no costs to be borne (or benefits to be enjoyed) by people

outside the loan contract.
In this setting, lenders know where they can find the best returns. (We would
normally say ‘best returns for a given level of risk’ but with the assumption of per-
fect information there is strictly speaking no risk!) The best returns will be offered
by the borrowers whose projects earn the highest rates of profit. These high profits
will be available because of the high price which customers are prepared to pay for
the product which is produced. If there are no taxes, this price represents the
marginal benefit which consumers derive from the good.

With no externalities, there are no hidden costs of production being carried by

other members of society. Since lenders know where the best returns are, they will
ensure that there is a steady flow of funds towards these activities which society
seems to value highly. The supply of funds competing for these high returns will
encourage firms to expand their activities. With expansion, the rate of profit may
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fall and the rate of return offered to lenders may also fall. It may fall to a point
where the existing lenders are just happy with the return. There is no incentive
for additional lenders to join in.

Expansion stops, but only after society’s need for this desirable product or service
has been met. Looking at the other end of the spectrum, firms whose profits do
not enable them to pay at least the minimum rate of return required by lenders
will find it impossible to obtain funds for expansion and may, in the long run, be
forced to contract. So long as our assumptions hold, then we can be confident that
the pressures on declining firms represent the preferences of ‘society at large’ and
that the decline is part of the mechanism whereby funds are directed towards the
activities that society values most highly and away from those that are less highly
rated.

\In practice, however, life is neither so simple nor so benevolent. There are a
number of respects in which the financial system fails to match the assumptions of
perfect competition. We shall consider just some of these. We shall then show how
the failures affect the allocation of funds and also, briefly, how the failures may
also affect the allocation of management expertise.

Traditionally, financial activity has been subject to extensive regulation by gov-

ernment. This is partly because of something called ‘asymmetric information’. In
this case, borrowers have better information about the likely risk and return from
their projects than lenders have and so some degree of regulation is necessary to
prevent lenders from being exploited. Regulation is also thought to be necessary
to prevent financial institutions from taking on too much risk. This is because the
costs associated with the failure of a financial firm, especially if it is a bank, are very
high. Although the tendency has been to reduce the extent of financial regulation
in recent years, rules about the type and volume of business that financial firms
can do remain. The next sectionprovides some examples in the case of banks and
building societies.

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Such regulation, drawing dividing lines between different types of institution,
reduces competition. A surplus, for example, of loanable funds in one part of the
system cannot be made available to satisfy excess demand elsewhere. For many
years (before 1986 when steps were taken to broaden the borrowing and lending
powers of building societies) it was argued that the UK financial system was biased
towards channelling funds into the domestic property market and against
supplying cheap funds to industry.

The result, it was said, was to produce a booming housing market and a low rate of
growth of productivity and output. The situation arose because building societies
offered savings products which were very attractive to house- holds (partly
because of their tax treatment). Thus building societies received large flows of
funds which they could lend quite cheaply to people who wished to buy (largely
secondhand) unproductive assets. Meanwhile firms (even firms wishing to buy
buildings) had to borrow elsewhere at higher rates of interest. As the next
sectionshows, the 1986 Building Societies Act, and later legislation, allowed build-
ing societies more freedom in their source and use of funds, but restrictions remain
and building societies still do very little ‘commercial’ lending.

In t h i s one example, we see that information is not perfectly available to all,

lenders and borrowers are not entirely free to lend to and borrow from
whomsoever they wish, and taxes can certainly influence decisions. As a result, the
flow of funds can be distorted.

A different illustration is provided by securities markets, the market for ordinary

company shares, for example. The shareholders of a firm are its legal owners and
they appoint the Board of Directors who in turn give general direction to a firm
and appoint its managers. Taking control of a firm thus requires either ownership
of, or influence over, at least 50 per cent of the ordinary shares. In a takeover
battle, this is the target for the ‘predator’ firm. Clearly, the higher the price of a
firm’s shares, the more costly it is to buy 50 per cent. Thus, other things being

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equal, a high share price provides an element of security against takeover, while a
low share price may invite predators.

In theory, the price of a company’s shares should reflect the ‘fundamental value’ of
the firm. As we explain in Section6, this means that the price should be deter-
mined by the profits that the firm can earn from its assets. As above, the level of
profit is seen as some indicator of the value which society places on the firm’s
activities. Low profits, and a low share price, indicate that the firm is not
providing goods or services which people want particularly strongly, or that it is
not doing so efficiently. In these circumstances, it could be argued, it might be a
good idea if the firm were taken over (by another firm with high profits and a high
share price) and reorganised into a more valuable productive unit.

In these circumstances, a takeover is one way of bringing superior management

expertise to a poorly performing firm. It might be uncomfortable for the
management (and workers) of the firm being taken over, but there would be a
sound economic rationale. Notice though that the rationale depends critically
upon share prices. For the process to work correctly, a company’s share price has
to accurately reflect the performance of its underlying assets. If the predator firm
has a high share price for reasons not associated with its assets’ performance, there
can be no guarantee of superior management. Equally, if the target firm has a
low share price for reasons which have little to do with its economic
performance, this may be no indication of poor management expertise. So far as
getting the best management resources to places where they are most needed, the
results of takeovers in these circumstances will be a lottery.

A further consequence of mispricing can be seen in the cost of capital to a firm.

Imagine a firm whose capital structure is financed entirely by the issue of ordinary
shares. If the firm wishes to expand by raising new capital, the rate of return to
existing shareholders tells us the rate that will have to be available on the new
shares. The shareholders’ return, in other words, is the firm’s cost of capital. As we
shall see latter this rate of return varies inversely with the price of the shares.

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Thus, a firm whose share price is ‘high’ can raise new funds more cheaply than
when the price is ‘low’. (Think of this as the difference between the number of
pounds that the firm can buy in return for a given dividend payment.) With a low
cost of capital a firm may be encouraged to expand, while if capital is costly it may
be deterred. As we said above, provided that the price of shares reflects the
‘fundamentals’ of the business, a ‘high’ or ‘low’ price conveys a signal to the firm that
will ultimately benefit society. But if the price has nothing to do with a firm’s
earnings and therefore nothing to do with the utility that consumers derive from
its products, firms may be encouraged to expand or contract with no corresponding
benefit to the community at large.

An extreme example of this was provided by the ‘dot.com’ boom of 2000, when
investors queued up to buy internet businesses which were being floated on the
stock exchange with no earnings history at all, and no prospect of making a profit
for some years. When the flotation of Lastminute.com was announced in March
2000 the response was so enthusiastic that the issuing bank revised the offer price,
raising it by 67 per cent.

While companies like Lastminute.com found investors fighting to supply it with

funds, the prices of utility companies (water, gas, electricity, etc.) were depressed to
the point that some lost their position in the FTSE-100 index. How much of
investors’ capital was to be wasted in this craze became apparent a year later. As
one broker later said, with the benefit of hindsight: ‘We all invested in a few
[dot.coms]. You look at it now and think you must have been a bit crackers . . .’ (10
March 2001, Financial Times).

So far, we have considered several ways in which the financial system can con-
tribute to the functioning of a developed economy. In recent years, however, there
has been a growth of interest in the way in which financial systems may contribute
to the development of low-income countries. Clearly, a less-developed country
should benefit from a financial system which encourages lending and borrowing

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in the same way that a developed economy should benefit. There should be more
saving and investment, less consumption and a higher rate of economic growth
(as we described in section 2.3).

But in many low-income countries we find that govern- ments impose many
restrictions on the functioning of the financial system and even interfere directly
in its working. This is a situation that has come to be known as ‘financial
repression’. A common example of such interference is a ceiling (or ‘cap’) on
interest rates to hold them below the market clearing level. Sometimes this is
done in the misguided belief that by keeping the cost of borrowing artificially low,
firms will be encouraged to borrow and invest and so raise the level of productivity.

Sometimes, however, it is simply a way of making it cheaper for the government

itself to borrow in order to finance a large budget deficit. Whatever the reason for
such a cap, the effects on investment and growth are usually negative for two
reasons: one fairly obvious, the other more complex.

To understand the first problem, we have to visualise a diagram rather like

Figure 2.1a but with only a single supply curve. Instead of the rate of interest
settling where the demand and supply curves intersect, a rate of interest below the
market-clearing rate is imposed. There is an excess demand for funds. (This low rate
of interest encourages firms to borrow for investment, but it discourages lending.)
Since firms can only borrow what is lent, the low price has only succeeded in
limiting investment.

The second problem begins with the excess demand. The standard test of a worth-
while investment project is that its rate of return should equal or exceed the cost
of capital. With a low rate of interest, the threshold test is set very low and there
are potentially many profitable projects amongst which the limited funds must be
allocated. Furthermore, many of these potentially profitable projects will have low
rates of return (equal to or just above the low rate of interest) indicating that they

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have low productivity and will contribute little to increasing the economy’s rate of
economic growth.

In short, the average productivity of the potential projects will be lower than it
would be if the test rate were set higher (say, at the market-clearing level). The
question then is: how are lenders to allocate the limited funds? They may do it by
lending to the lowest risk projects (which are also likely to be low productivity);
they may lend ‘by name’, i.e. to borrowers with an established reputation for being
creditworthy; they may lend to firms whose owners occupy a powerful political
position and may be able to bring more business in future; or they may lend to
firms whose owners are prepared to pay bribes.

From an economic viewpoint, it does not matter much which method is used. The
point is that the average productivity of the potential projects is low and lenders
have no mechanism at their disposal which is bound to select only the few
genuinely high-productivity schemes.

So, not only will the quantity of investment funds be limited, they are likely to be
channelled into relatively poor-quality projects. Even if the financial repression is
well-meant (i.e. to encourage development) it is more likely to do the opposite.

1.5 Financial System Regulators

The operation of the financial system can have a key impact on economic growth and the
stability of the economy. It affects long-term economic growth through its effect on the
efficiency of intermediation between the savers and final borrowers of funds; through the extent
to which it allows for monitoring of the users of external funds, affecting thereby the productivity
of capital employed; and through its implications for the volume of saving, which influences the
future income-generating capacity of the economy. It affects the stability of the economy because
of the high degree of leverage of its activities and its pivotal role in the settlement of all
transactions in the economy, so that any failure in one segment risks undermining the stability of
the whole system.

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The banking sector has witnessed tremendous competition not only from the domestic banks but
from foreign banks alike. In fact, competition in the banking sector has emerged due to
disintermediation and deregulation. The liberalized economic scenario of countries has opened
various new avenues for increasing revenues of banks. In order to grab this opportunity,
commercial banks of many countries have launched several new and innovated products,
introduced facilities like ATMs, Credit Cards, Mobile banking, Internet banking etc.

Apart from the traditional banking products, it is seen that Mutual Funds, Insurance etc. are being
designed/ upgraded and served to attract more customers to their fold. In the backdrop of all
these developments i.e., deregulation in the countries economy and product/ technological
innovation, risk exposure of banks has also increased considerably.

Banking regulation, for instance, has often been put in place with several – and sometimes
conflicting – objectives in mind, such as promoting strong national financial institutions, offering
consumer protection, assisting industrial and/or regional development and preserving financial
stability, in particular the safeguarding of the payment and settlement system. This has led in the
past to tight and widespread regulation, ranging from interest rate ceilings and branching
restrictions to capital requirements and deposit insurance. The most important duty and
responsibility of central banks of the respective countries has become overseeing bank activities
and trying to protect banks falling into risk of going out of business.

Self Test Question 1.4

What is the purpose of financial system

regulation?

There are also agencies that regulate the operations of the financial system in free market
economies without direct government intervention. The usual form of intervention by the
government is through the enactment of relevant laws. Such Acts of Parliament are laws meant to
provide equal opportunity or platform for all players, smooth operations, and safeguarding the
national interest of the country. Financial institutions are regulated and monitored through central
banks. Therefore, all the participants in the financial system are under obligations to adhere to.

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The relevant regulators of financial systems in free market economies as well as mixed
economies include institutions like, in the US for example, the Central bank, Securities and
Exchange Commission (SEC) and The Stock Exchange (like NYSE-New York Stock Exchange),
among other regulatory agencies that may evolved out of necessity. There are contemporary
issues such as corporate governance and accounting standards that prompt the formation of
agencies to mount surveillance on the practices in various economies.

Self Test Question 1.5

Name any two possible financial

system regulators.

Summary

A financial system is a mechanism set in place that promotes transfer of finance from suppliers to
demanders. It exists in every country regardless of depth and complexity. There can be
intermediaries that include brokers, dealers and others or it can be direct dealings. The financial
system has got several functions to perform including saving, liquidity, payment, risk functions
and others. Proper function of the financial system in every country calls for regulations. It can
perform as intended and enhance mobility of financial resources when properly and regularly
followed up. There are government and professional bodies that perform regulation and control
of the workings of the financial system.

Regardless of the volume of lending and borrowing which it encourages, the

financial system may be efficient in directing the funds to their most productive use
or it may not. The system is not perfect. Not everyone knows the opportunities
available; not everyone can get access to them. The tax system is not always neutral
between different types of lending/borrowing, and government regulation,
designed to protect lenders and borrowers, may also create distortions. Furthermore,
we cannot be certain that financial markets always price financial assets ‘correctly’,
in relation to their fundamental values. Where this happens, the ownership of the
underlying assets may change for no good reason.
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 Unit 2:

The Financial Market

Unit Introduction

This unit is to focus on the workings of the financial market and its constituents. It will elaborate
on the types of markets with their characteristics. The unit will also discuss on the types of
financial assets, their nature and to which type of investor or debtor they are attractive and
appealing. It will introduce and elaborate the manner how foreign currencies are traded between
investors in the market they are available.

Unit Objectives

Upon completion of this unit, you will be able to;

 describe what financial markets are
 tell the types of financial markets commonly available in a financial system
 explain what types of assets and instruments are being traded
 determine specific characteristics of each type of financial asset
 calculate the bid and ask prices of assets

2.1 Nature of Financial Markets

Financial markets are places or circumstances that permit and facilitate the trade of financial
assets. The stock exchanges, the bond markets are good examples of financial markets. Financial
markets provide quite a lot of benefits who come and transact assets. They will get funds if they
need any provided they fulfill what is required of them. They offload excess funds on to
profitable opportunities. Financial markets contribute a lot to the development of countries ’
economies.
2.2 Financial Assets
Financial Assets are different from real or physical assets. Physical asset markets (also called
“tangible” or “real” asset markets) are those for products such as wheat, coffee, real estate,

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computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds,
notes, mortgages, and other claims on real assets, as well as with derivative securities whose
values are derived from changes in the prices of other assets. A share of Bank of Abyssinia is a
“pure financial asset,” while an option contract to buy Awash International Bank’s shares ninety
days after today, for example, is a derivative security whose value depends on the price of Awash
Bank’s stock.

Therefore, the financial assets are the representations of real assets and they don’t have physical
usefulness. They only represent values of an underlying asset.
Hence, essentially, stocks and bonds are pieces of papers that represent values and claims. They
are commonly called financial instruments and include the following:
 Common Shares;
 Preference Shares;
 Government Bonds;
 Corporate Bonds;
 Debenture;
 Equipment Leases;
The financial assets can be grouped into two main categories such as debt instruments and equity
instruments.
Self Test Question 1.6

What is the difference between a

physical asset and a financial asset?

2.2.1 Debt Instruments

These are the financial instruments that are normally used by corporate entities and government
to raise funds on the basis of debt obligations. This implies that such financial instruments are
repayable by the organizations issuing them for raising funds from the financial markets from
their operations. Therefore, they become assets not to those who issues them rather to those who
buy them.
The various debt instruments being used for financial transactions in money market include the
following:

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 i) Treasury Bills;
ii) Commercial Papers; and
iii) Certificate of Deposits.

The holders, therefore, are entitled to the funds at maturity dates in addition to the regular income
accruing to them on them on the basis of interest payments by the corporate entities and
government. Some of such instruments can be redeemed before their maturity dates as agreed to
by the parties involved in the transactions. Such financial assets or instruments are also
negotiable, being capable of being traded for cash before their maturity date.
The various debt instruments being used for financial transactions in capital market include the
following:

i) Development Loan;
ii) Debenture;
iii) Bonds;
iv) Mortgage Loan;
v) Leases; and
vi) Hire Purchase Contracts.

Self Test Question 1.7

Give two examples from each of the money market

instruments and the capital market instruments.

2.2.2 Equity Instruments

There are some financial instruments that are being used in the financial markets to raise equity funds
by corporate entities. Such financial instruments are essentially Ordinary or Common Shares being
used to raise funds to enhance the capital base of corporate organizations. Preferred shares are also
means of obtaining funds. Once again the holders of these instruments consider them as assets.

Self Test Question 1.8

What are equity instruments used to

raise capital?
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 2.2.3 Characteristics of Financial Assets
There are peculiar characteristics that are inherent in financial assets that are normally used
partly to determine their pricing in the financial markets. These characteristics are identified and
discussed below.
a. Moneyness
The monyness feature of the financial assets implies that they are easily convertible to cash
within a defined time and determinable value. The cost of transactions involved in securing funds
from them before the maturity date can be likened to agency cost besides the cost of discounting
some of them, which reduces their face value. Therefore, these financial instruments are regarded
as near money because of the ease with which they can be traded for cash. Examples are
Treasury bills, Treasury certificates, Trade bills, Commercial papers, and Certificate of Deposits,
among others.

b. Divisibility & Denomination

The financial assets are usually made out in denominations depending on the face value that the
corporate organizations and institutions that are using them to raise funds from the financial
markets. The divisibility of such near money refers to the minimum monetary value in which a
financial asst can be liquidated or exchanged for money by the holder.

Divisibility for financial assets is imperative so as to enable both suppliers and borrowers to
understand the magnitude of funds involved in each of them; the borrowers have certain amount
to source and the suppliers will like to know the amount that is required of them to part with for
the transaction. It is also necessary so that a limit cap set for the minimum amount of
subscription for each instrument and the overall amount of subscription that may accrue to a
particular investor. For instance, Awash International sold 10 shares at a minimum while Bank of
Abyssinia caped it at 25 shares.
c. Reversibility
The financial assets are highly reversible in the sense that they are like deposits in accounts of
customers with the banks. This implies that the cost of investing in the financial assets and

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getting them back into cash is negligible. Hence reversibility of financial assets is often regarded
as turnaround cost or roundtrip cost.

The most relevant part of the roundtrip cost as associated with financial assets constitutes what is
known as the ‘bid-ask spread’ in which commissions cost of delivery an asset is entrenched. In
the well-organized financial market there are market makers who take responsibility of assuming
risk in associated with the financial assets while making the market or carrying inventory of
financial assets.

Therefore, the spread being charged by the market makers varies in line with financial assets that
are traded. Some financial assets carry less risk than others; for instance, marketable securities
that can easily be converted into liquid cash with little or no hassles because they are more liquid
than other financial assets. The risk involved in marketable securities or mortgage loan stock
cannot be comparable with risk inherent in bond issue of a fledgling company.

The risk involved in market making is related to market forces that are two-fold such as:
Variability of the price; and Thickness of the market.

i. Variability of Price of financial asset

This is determined by some measure of dispersion in the price. It implies that the greater the
variability in price, the greater the probability that the market maker may lose in the bargain. For
instance, a speculative stock such as shares will be fraught with much larger short-run variations.
On the other hand, Treasury bills, which government securities (or gilt-edged securities) exhibit
is stable price with less short-run variation.

ii. Thickness of the Market for financial asset

The thickness of the market implies the frequency of transactions on a given financial asset. A
thin market reflects a financial asset that has few trades on a regular or continuous basis, hence
the greater the order flows on it the shorter the time that the asset will be held in the inventory of
market makers. Therefore, such financial asset will exhibit smaller probability of an unfavorable
price movement while it is in the inventory of market makers.

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A thick market is associated with market where frequent transaction on financial assets is being
exhibited and this varies from market to market. Hence a particular market for a financial asset
such as shares may be thick while in another such financial asset may be thin. For instance, the
shares of ‘blue-chip’ firms [ established and profitable firms’ shares] will exhibit thickness in
transactions while the shares of small companies may exhibit thinness in transactions in a given
market situation.

Self Test Question 1.9

Differentiate between Variability of Price and

Thickness of the Market for financial assets.

d. Cash Flow

This refers to the return that an investor will derive from holding a financial asset, which
invariably depends on all the cash distributions that the asset will pay holders. This is expressed
in terms of the dividend on shares or coupon yield payments that are associated with bonds. The
return on investment in a financial asset is also affected by the repayment of the principal amount
for a debt instrument and any expected price variation of the stock.

In calculation of expected returns on a financial asset, factors that should be considered include
non-cash payments in form of stock dividend yield and options to purchase additional stock or
the distribution of other securities that must be factored in the consideration. The issue of
inflation implies that there is difference between normal effective return and real effective return
on financial assets. Therefore, the net real return on financial assets is the amount of cash returns
that are accruable after adjusting the nominal returns against inflation.

e. Maturity Period
In financial parlance, the maturity period refers to the length of time within which the corporate
entity or institution that employs a financial instrument to raise funds will use the funds before its
payment back to the holders of such instrument. For instance, a bond can be held by a corporate
entity for a period of thirty (30) years while that of government can extend to a period of ninety-
nine (99) years before their repayment to the holders.

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Self Test Question 1.10

What do we mean by the characteristics of

Moneyness and reversibility?

There are some financial instruments being traded in the financial markets that may not reach the
stated maturity dates before they are terminated by the corporate entities that use them to raise
funds. There are reasons that may be responsible for such situation which include the following:

Bankruptcy:- a situation in which the company is being unable to meet its external financial
obligations and therefore, declared bankrupt;
Reorganization:- a situation in which the company is restructuring its ownership structure and
operations; and
Call Provision:- the financial instrument being associated with call provision.
The case of call provision implies that the company as the debtor or user of the funds takes
responsibility of setting aside sinking funds with which to redeem the instruments eventually.
The sinking fund is normally made as one of the contractual obligations that are established in
the agreement or indenture regulating the usage of the funds from the financial instrument.

Self Test Question 1.11

What are the reasons that may be responsible for terminating

financial assets by corporate entities before their stated maturity
dates?

f. Convertibility
This characteristic implies that a financial asset or instrument can be converted into another class
of asset which will still be held by the corporate entity that has original used to raise funds for its
operations. The conversion can take a form of bond being converted to bond, preference shares
being converted to equity shares, and a company bond being converted into equity shares of the
company.

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The opportunity for convertibility of financial instruments into another form of financial assets
has to be entrenched in the covenant which has been written to guide the contractual agreement
on the instrument or to regulate the behavior of the company using the funds from the
instruments. Nevertheless, such a provision can be negotiated in the course of the usage of the
funds by a company especially when the holders discover that the company is manipulating its
operational and financial records for various reasons it says is essential to.

g. Currency
Financial assets are normally denominated in currencies of the various countries around the
world. This implies financial assets of the Ethiopian financial system are denominated in Birr
such as Federal Government Loan Stock, Treasury Bills, Treasury Certificate, Shares and
Corporate and State Government Bonds. Those financial assets in Japan are denominated in Yen,
those in the United States of America are in Dollars, those in United Kingdom are in Pounds
Sterling while those in China are in Yuan, etc.

Dear learner, you have also learned from the initial section of this study unit that financial assets
as products of transactions in the financial markets can be denominated in various currencies
particularly the local currencies of various economies around the world. Nevertheless, there are
those financial instruments that are traded across international boundaries in some countries
especially in highly developed capital markets in US, UK, Japan, France, and South Africa, just
to mention but a few. Such financial assets are usually denominated mainly in American dollars
and any other international money that is acceptable around the world. Recently, Ethiopian
Government has sold bonds worth $1 billion, denominated in US Dollar.

Furthermore, it is important for investors to know the currency in which certain financial assets
are denominated when buying them. Likewise, the recent ECO Bank shares were denominated in
US dollars when they were offered to the public for subscription. These shares were floated
across international boundaries in many countries in Africa. Therefore, the use of an international
currency such as the US dollars made it easier for the bank to handle the transactions in the stock
easily. Nevertheless, subscribers were made to pay the equivalent of their total amount of
subscription in their local currencies. The dividends for these shares are also being paid in US
dollars.

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Dual currency securities may be issued in some instances. For instance, the EURO Bonds are
issued in dual currencies for ease of transactions by multiple subscriptions by various investors
around the world. Therefore, it is the policy on EURO Bonds to pay interest in one currency
while the principal repayment is effected in another currency.

h. Liquidity
You have learned from above that one of the main characteristics of financial assets is the
moneyness of such instruments which implies that they are easily convertible to cash within a
defined time and determinable value. The cost of transactions involved in securing funds from
them before the maturity date can be likened to agency cost besides the cost of discounting some
of them, which reduces their face value.

Hence, these financial instruments are regarded as near money because they are highly liquid in
terms of the ease with which they can be traded for cash. Good examples of highly liquid
financial instruments include Treasury bills, Treasury certificates, Certificate of Deposits, Bills
of Exchange, and shares of blue chip companies, e.g., Shares of Cadbury, First Bank, Guaranty
Trust Bank, etc.

However, there are some financial instruments that cannot be easily converted to cash whenever
the holders need money. Therefore, they are illiquid because the holders may have to retain them
till they are matured; alternatively they can only trade them for very insignificant value in capital
markets where there are jobbers that may be willing to carry them in their stock of securities.

i. Predictable Returns
The return on financial assets must be predictable for the purpose of their being patronized by
investors. For instance, the investors should be able to know the percentage of interest that are
attached to certain debt instruments before they will be prepared to stake their funds on them.
This is because performance of a company cannot be taken for granted due to the mere fact that
top management and the boards of directors, in some countries, are known to be manipulating the
accounting records of their companies these days-agency problem.

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This is more reason why investors are always very skeptical in patronizing financial instruments
of some corporate entities due to their antecedents in manipulating their accounting records. The
cases of Cadbury in Nigeria and Enron in the US are classical testimonies to the unwholesome
accounting practices in the operations of companies around the world.

However, the returns on bonds, development loan stocks, and preference shares are determinable
so that the investors are aware about the expected returns on their investment. There are also
other government securities such as Treasury bills and Treasury certificates which are traded in
money market that command fixed returns. The central bank of each country has the
responsibility in their issuance and also their repayment as well as the payment of their returns to
the subscribers. Therefore, State government bonds, Federal Government development loan
stocks, Treasury bills and Treasury certificates are regarded as gilt-edged securities because their
returns as well as principal amount of investment in these securities must be paid as at when due
for settlement.

The issue of unpredictability of future returns on some securities such as equity shares results
from volatility in earnings by the companies in their operations. However, the unpredictability to
future returns can be measured on how it relates to the level of volatility of a given financial
asset. The returns on equity shares like dividends are the residual payments from the earnings of
corporations. Nevertheless, the attraction in these shares is the possibility of capital appreciation
in their value but subject to the performance of their corporations and capital market operational
forces.

j. Tax Status of Returns

The returns on various financial assets are subject to tax status because they are taxable earnings.
The tax authorities are interested in collection of taxes on earnings from financial assets as
securities which are regarded as incomes for investors. However, the tax status on financial
assets varies from one economy to another.

The rate of such taxes on financial assets is also subject to variation from time to time depending
on the interest of the government which must be adhered to by the tax authorities. The tax status
on financial assets also differs from one type of security to another depending on the nature of

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the issuing companies or institutions such as Federal, State, or local government. For instance,
tax on treasury bills is zero in Ethiopia while it is 10% on dividend from share companies.

Self Test Question 1.12

Mention and explain the various characteristics that are inherent

in financial instruments.

2.3 Types of Financial Markets

People and organizations wanting to borrow money are brought together with those having
surplus funds in the financial markets. Note that “markets” is plural; there are a great many
different financial markets in a developed economies such as in Europe and in North America.

As far as our observation in countries of the above stated regions is concerned, different financial
markets serve different types of customers or different parts of the country. Financial markets
also vary depending on the maturity of the securities being traded and the types of assets used to
back the securities. For these reasons it is often useful to classify markets along the following
dimensions:

1. Spot versus futures markets: Spot markets are markets in which assets are bought or sold
for “on-the-spot” delivery (literally, within a few days). Futures markets are markets in
which participants agree today to buy or sell an asset at some future date. For example, a
farmer may enter into a futures contract in which he agrees today to sell 5,000 quintals of
wheat six months from now at a price of BR500 a quintal. On the other side, a baker or a
flour mill owner looking to buy wheat in the future may enter into a futures contract in
which it agrees to buy wheat six months from now.

Self Test Question 1.13

What’s the difference between spot and

futures markets?

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 2. Money versus capital markets: Money markets are the markets for short-term, highly
liquid debt securities. In Ethiopia, Treasury Bills market, Foreign exchange market and
Certificate of Deposits could be cited as examples. In the international market, The New
York, London, and Tokyo money markets are among the world’s largest. Capital
markets are the markets for intermediate- or long-term debt and corporate stocks. The
Bank Term loans, the Government Bond sale could be sited as those in the capital market
in Ethiopia. In the International scene, The New York Stock Exchange, where the stocks
of the largest U.S. corporations are traded, is a prime example of a capital market. There
is no hard and fast rule on this, but when describing debt markets, “short term” generally
means less than 1 year, “intermediate term” means 1 to 10 years, and “long term” means
more than 10 years.

3. Primary versus secondary markets: Primary markets are the markets in which
corporations raise new capital. If Nib or United Bank were to sell a new issue of common
stock to raise capital, this would be a primary market transaction. The corporation selling
the newly created stock receives the proceeds from the sale in a primary market
transaction. Secondary markets are markets in which existing, already outstanding,
securities are traded among investors. Thus, if Mr X decided to buy 1,000 shares of Bank
of Abyssinia’s stock, the purchase would occur in the secondary market. Thus far there is
no organized or institutionalized secondary market in Ethiopia. In the international scene
again, The New York Stock Exchange is an organized or institutionalized secondary
market because it deals in outstanding, as opposed to newly issued, stocks and bonds.
Secondary markets also exist for mortgages, various other types of loans, and other
financial assets. The corporation whose securities are being traded is not involved in a
secondary market transaction and, thus, does not receive any funds from such a sale.

4. Private placement versus public issue markets. Private markets, where transactions are
negotiated directly between two parties, are differentiated from public markets, where
standardized contracts are traded on organized exchanges. Bank loans and private debt
placements with insurance companies are examples of private market transactions.
Because these transactions are private, they may be structured in any manner that appeals
to the two parties. By contrast, securities that are issued in public markets (for example,
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 common stock and corporate bonds) are ultimately held by a large number of individuals.
Public securities must have fairly standardized contractual features, both to appeal to a
broad range of investors and also because public investors do not generally have the time
and expertise to study unique non-standardized contracts. Their wide ownership also
ensures that public securities are relatively liquid. Hence, private market securities are
more tailor-made but less liquid, whereas publicly traded securities are more liquid but
subject to greater standardization.

Self Test Question 1.14

Distinguish between physical asset and

financial asset markets.

Other classifications could be made, but this breakdown is sufficient to show that there are many
types of financial markets. Also, note that the distinctions among markets are not very important
except as a general point of reference. You should be aware of the important differences among
types of markets, but don’t be carried away trying to distinguish them at the boundaries.

A healthy economy is dependent on efficient funds transfers from people who are net savers to
firms and individuals who need capital. In the absence of easy transfer of funds, it becomes
difficult to invest, produce and market products and services. Obviously, the level of
employment and productivity, hence our standard of living, would be much lower. Therefore, it
is absolutely essential that our financial markets function efficiently —not only quickly, but also
at a low cost.

Self Test Question 1.15

a. What’s the difference between primary and

secondary markets?
b. Differentiate between private and public

2.4 The Foreign exchange Market

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The foreign exchange market is the "place" where currencies are traded. Currencies are important
to most people around the world, whether they realize it or not, because currencies need to be
exchanged in order to conduct foreign trade and business. A business firm here in Addis if is
interested to import goods from Dubai, has to buy Dubai’s currency to pay for the exporter there
in Dubai. The same goes for traveling. A French tourist in Egypt can't pay in Euros to see the
pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the
Euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most
liquid financial market in the world. It dwarfs other markets in size. The total volume changes all
the time, but as of April 2004, the Bank for International Settlements (BIS) reported that the
forex market traded U.S. $1,900 billion per day.

One unique aspect of this international market is that there is no central marketplace for
currency exchange. Rather, trade is conducted electronically over-the-counter (OTC), which
means that all transactions occur via computer networks between traders around the world, rather
than on one centralized exchange. The market is open 24 hours a day, five and a half days a
week, and currencies are traded worldwide in the major financial centers of London, New York,
Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time
zone. This means that when the trading day in the U.S. ends, the forex market begins anew in
Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day,
with price quotes changing constantly.

Foreign exchange (forex or FX for short) is one of the most exciting, fast-paced markets around
developed and developing countries alike. Until recently, worldwide, trading in the forex market
had been the domain of large financial institutions, corporations, central banks, hedge funds and
extremely wealthy individuals. The emergence of the internet has changed all of this, and now it
is possible for average investors to buy and sell currencies easily with the click of a mouse.

Daily currency fluctuations are usually very small. Most currency pairs move less than one cent
per day, representing a less than 1% change in the value of the currency. This makes foreign

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exchange one of the least volatile financial markets around. Therefore, many speculators rely on
the availability of enormous leverage to increase the value of potential movements.

Foreign exchange positions can be opened and closed within minutes or can be held for months.
Currency prices are based on objective considerations of supply and demand and cannot be
manipulated easily because the size of the market does not allow even the largest players, such as
central banks, to move prices at will. The forex market provides plenty of opportunity for
investors. However, in order to be successful, a currency trader has to understand the basics
behind currency movements.

Dear Student, we will cover the basics of foreign exchange, its history and the key concepts you
need to understand in order to be able to understand this market. You will also see into how to
start trading currencies and the different types of strategies that can be employed.

2.4.1 Types of the Currency market

There are actually three ways that institutions, corporations and individuals trade forex: Note that
currencies are traded by banks only currently in Ethiopia.
 The spot market,
 The forwards market and
 The futures market.

The Spot Market: The spot market is when currencies are exchanged on the date transacted and
price agreed on that particular day of delivery. The spot market always has been the largest
market because it is the "underlying" real asset that the forwards and futures markets are based
on. In the past, the futures market was the most popular venue for traders because it was
available to individual investors for a longer period of time. However, with the advent of
electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the
futures market as the preferred trading market for individual investors and speculators.

When people refer to the forex market, they usually are referring to the spot market. The
forwards and futures markets tend to be more popular with companies that need to hedge their

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foreign exchange risks out to a specific date in the future. Spot Market More specifically, the spot
market is where currencies are bought and sold according to the current price. That price,
determined by supply and demand, is a reflection of many things, including current interest rates,
economic performance, sentiment towards ongoing political situations (both locally and
internationally), as well as the perception of the future performance of one currency against
another.

When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction by which one
party delivers an agreed-upon currency amount to the counter party and receives a specified
amount of another currency at the agreed-upon exchange rate value. After a position is closed,
the settlement is in cash. Although the spot market is commonly known as one that deals with
transactions in the present (rather than the future), these trades actually take, among banks, two
days for settlement.

Forwards and Futures Markets: Unlike the spot market, the forwards and futures markets do
not trade actual currencies. Instead they deal in contracts that represent claims to a certain
currency type, a specific price per unit and a future date for settlement. In the forwards market,
contracts are bought and sold Over the Counter [OTC] between two parties, who determine the
terms of the agreement between themselves.

In the futures market, futures contracts are bought and sold based upon a standard size and
settlement date on public commodities markets, such as the Chicago Mercantile Exchange in the
US for instance. In the U.S, again, the National Futures Association regulates the futures market.
Futures contracts have specific details, including the number of units being traded, delivery and
settlement dates, and minimum price increments that cannot be customized.

The exchange acts as a counterpart to the trader, providing clearance and settlement. Dear
Student, although Ethiopian Commodities Exchange did not yet introduce such market, when it
does, it is likely to become the provide clearing and settlement procedures and rules.

Both types of contracts are binding and are typically settled for cash for the exchange in question
upon expiry, although contracts can also be bought and sold before they expire. The forwards and

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futures markets can offer protection against risk when trading currencies. Usually, big
international corporations and banks use these markets in order to hedge against future exchange
rate fluctuations, but speculators take part in these markets as well. Please also note that you'll
see the terms: FX, forex, foreign-exchange market and currency market. These terms are
synonymous and all refer to the forex market.

2.4.2 Quoting of Forex Transaction

One of the biggest sources of confusion for those new to the currency market is the standard for
quoting currencies. In the following discussions, you will see how currency quotations are made
and how they work in pair trades.

When a currency is quoted, it is done in relation to another currency, so that the value of one is
reflected through the value of another. Therefore, if you are trying to determine the exchange rate
between the U.S. dollar (USD) and the Japanese yen (JPY), the quote would look like this:
USD/JPY = 119.50
This is referred to as a currency pair. The currency to the left of the slash is the base currency,
while the currency on the right is called the quote or counter currency. The base currency (in this
case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in
this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The
quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese
yen.

Self Test Question 1.16

What is the difference between a Base currency

and a Quote currency?

Direct Quote vs. Indirect Quote There are two ways to quote a currency pair, either directly or
indirectly. A direct quote is simply a currency pair in which the domestic currency is the base
currency; while an indirect quote, is a currency pair where the domestic currency is the quoted
currency. So if you were looking at the Ethiopian Birr as the domestic currency, which actually

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is, and U.S. dollar as the foreign currency, a direct quote would be ETB/USD, while an indirect
quote would be USD/ETB. If you visit banks in this country, you see their quotation as indirect
than the former.

The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed
at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the
foreign currency is fixed at one unit. For example, if Canada is the domestic currency, a direct
quote would be 0.85 CAD/USD, which means with C$1, you can purchase US$0.85. The indirect
quote for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that USD$1
will purchase C$1.18.

In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is
frequently the base currency in the currency pair. In these cases, it is called a direct quote in US.
This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to
119.50 Japanese yen. However, not all currencies have the U.S. dollar as the base. The Queen's
currencies - those currencies that historically have had a tie with Britain, such as the British
pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the
U.S. dollar. The euro, which is relatively new, is quoted the same way as well.

In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an
indirect quote. This is why the EUR/USD quote is given as 1.25, for example, because it means
that one euro is the equivalent of 1.25 U.S. dollars. Most currency exchange rates are quoted out
to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is
quoted out to two decimal places.

Cross Currency: When a currency quote is given without the U.S. dollar as one of its
components, this is called a cross currency. The most common cross currency pairs are the
EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the
forex market, but it is important to note that they do not have as much of a following (for
example, not as actively traded) as pairs that include the U.S. dollar, which also are called the
majors.

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Self Test Question 1.17

When do we say there is Cross Currency quote?

Bid and Ask: Terms of ‘Bid’ and ‘Ask’ are common in the financial asset market. As with most
trading in the financial markets, when one is trading a currency pair there is a bid price (buy) and
an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair
(going long), the ask price refers to the amount of quoted currency that has to be paid in order to
buy one unit of the base currency, or how much the market will sell one unit of the base currency
for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the
quoted currency will be obtained when selling one unit of the base currency, or how much the
market will pay for the quoted currency in relation to the base currency. The quote before the
slash is the bid price, and the two digits after the slash represent the ask price (only the last two
digits of the full price are typically quoted). Note that the bid price is always smaller than the ask
price. Let's look at an example:
USD/CAD = 1.2000/05
BID =1.2000
ASK =1.2005

If you want to buy this currency pair, this means that you intend to buy the base currency and are
therefore looking at the ask price to see how much (in Canadian dollars) the market will charge
for U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian
dollars. However, in order to sell this currency pair, or sell the base currency in exchange for the
quoted currency, you would look at the bid price. It tells you that the market will buy US$1 base
currency (you will be selling the market the base currency) for a price equivalent to 1.2000
Canadian dollars, which is the quoted currency.

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Self Test Question 1.18

 What is the difference between Bid and Ask price of a

Currency?
 Which one is larger if quoted on same day?

Whichever currency is quoted first (the base currency) is always the one in which the transaction
is being conducted. You either buy or sell the base currency. Depending on what currency you
want to use to buy or sell the base with, you refer to the corresponding currency pair spot
exchange rate to determine the price.

Spreads and Pips: The difference between the bid price and the ask price is called a spread. If
we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3
pips, also known as points. Although these movements may seem insignificant, even the smallest
point change can result in thousands of dollars being made or lost due to leverage. Again, this is
one of the reasons that speculators are so attracted to the forex market; even the tiniest price
movement can result in huge profit.

Self Test Question 1.19

What is a spread in the currency market?

The pip is the smallest amount a price can move in any currency quote. In the case of the U.S.
dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one
pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex quote of
USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to
150 pips a day.
Currency Quote Overview
USD/CAD = 1.2232/37
Base Currency Currency to the left (USD)
Quote/Counter Currency to the right (CAD)

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Currency
Bid Price 1.2232 Price for which the market
maker will buy the base
currency. Bid is always
smaller than ask.
Ask Price 1.2237 Price for which the market
maker will sell the base
currency.
Pip One point move, in USD/CAD it is .0001 The pip/point is the smallest
and 1 point change would be from 1.2231 movement a price can make.
to 1.2232
Spread Spread in this case is 5 pips/points;
difference between bid and ask price
(1.2237-1.2232).

Currency Pairs in the Forwards and Futures Markets: One of the key technical differences
between the forex markets is the way currencies are quoted. In the forwards or futures markets,
foreign exchange always is quoted against the U.S. dollar. This means that pricing is done in
terms of how many U.S. dollars are needed to buy one unit of the other currency.

Dear Student, remember that in the spot market some currencies are quoted against the U.S.
dollar, including our Birr, while for others, the U.S. dollar is being quoted against them. As such,
the forwards/futures market and the spot market quotes will not always be parallel one another.
For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD.
This is the same way it would be quoted in the forwards and futures markets.

Thus, when the British pound gets strength against the U.S. dollar in the spot market, it will also
rise in the forwards and futures markets. On the other hand, when looking at the exchange rate
for the U.S. dollar and the Japanese yen, the former is quoted against the latter. In the spot
market, the quote would be 115 for example, which means that one U.S. dollar would buy 115
Japanese yen. In the futures market, it would be quoted as (1/115) or .0087, which means that 1
Japanese yen would buy .0087 U.S. dollars. As such, a rise in the USD/JPY spot rate would

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equate to a decline in the JPY futures rate because the U.S. dollar would have strengthened
against the Japanese yen and therefore one Japanese yen would buy less U.S. dollars. Now, Dear
Student, you know a little bit about how currencies are quoted, let's move on to the benefits and
risks involved with trading forex.

2.4.3 Benefits and Risks

In the following discussion, you will take a look at some of the benefits and risks associated with
the forex market. You will also discuss how it differs from the equity market in order to get a
greater understanding of how the forex market works.

We already have mentioned that factors such as the size, volatility and global structure of the
forex market have all contributed to its rapid success. Given the highly liquid nature of this
market, investors are able to place extremely large trades without affecting any given exchange
rate. These large positions are made available to traders because of the low margin requirements
used by the majority of the industry's brokers. For example, it is possible for an investor to
control a position of US$100,000 by putting down as little as US$1,000 up front and borrowing
the remainder from his or her broker. This amount of leverage acts as a double-edged sword
because investors can realize large gains when rates make a small favorable change, but they also
run the risk of a massive loss when the rates move against them. Despite the risks, the amount of
leverage available in the forex market is what makes it attractive for many speculators.

The currency market is also the only market that is truly open 24 hours a day with decent
liquidity throughout the day. For traders who may have a day job or just a busy schedule, it is an
optimal market to trade in. Besides, the major trading hubs are spread throughout many different
time zones, eliminating the need to wait for an opening or closing bell. As the U.S. trading
closes, other markets in the East are opening, making it possible to trade at any time during the
day.

Self Test Question 1.20

Where is low margin required in trading? Is it the Equity

market or the Currency market?

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While the forex market may offer more excitement to the investor, the risks are also higher in
comparison to trading equities. The ultra-high leverage of the forex market means that huge gains
can quickly turn to damaging losses and can wipe out the majority of your account in a matter of
minutes. This is important for all new traders to understand, because in the forex market - due to
the large amount of money involved and the number of players - traders will react quickly to
information released into the market, leading to sharp moves in the price of the currency pair.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a
company's stock can lose a large portion of its value in a matter of minutes after a bad
announcement), it is the leverage in the spot market that creates the volatility. For example, if
you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put
$100,000 into a currency and the currency's price moves 1% against you, the value of the capital
will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a
100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the
stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to
take into account the risks involved in the forex market before diving in.

2.4.4 Forex and Equities

A major differenc between the forex and equities markets is the number of traded instruments:
the forex market has very few compared to the thousands found in the equities market. The
majority of forex traders focus their efforts on seven different currency pairs: the four majors,
which include (EUR/USD, USD/JPY, GBP/USD, USD/CHF); and the three less so pairs
(USD/CAD, AUD/USD, NZD/USD). All other pairs are just different combinations of the same
currencies, otherwise known as cross currencies. This makes currency trading easier to follow or
pick for investment than thousands of stocks to find the best value for your money. On the other
hand, all that FX traders need to do is “keep up” on the economic and political news of eight
countries.

The equity markets at times can be thin, resulting in shrinking volumes and activity. As a result,
it may be hard to open and close positions when desired. Furthermore, in a declining market, it is

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only with extreme ingenuity that an equities investor can make a profit. It is difficult to short-sell
in the U.S. equities market because of strict rules and regulations regarding the process.

Self Test Question 1.21

Where is more variability in prices? Is it in equity

market or in the currency market?

On the other hand, forex offers the opportunity to profit in both rising and declining markets
because with each trade, you are buying and selling simultaneously, and short-selling is,
therefore, inherent in every transaction. In addition, since the forex market is so liquid, traders
are not required to wait for an uptick before they are allowed to enter into a short position - as
they are in the equities market.

Due to the extreme liquidity of the forex market, margins are low and leverage is high. It just is
not possible to find such low margin rates in the equities markets. Furthermore, commissions in
the equities market are much higher than in the forex market. Traditional brokers ask for
commission fees on top of the spread, plus the fees that have to be paid to the exchange. Spot
forex brokers take only the spread as their fee for the transaction. Dear Student, by now you
should have a basic understanding of what the forex market is and how it works.

2.5. Primary Market Operations

The capital market is operated in two main segments such as the primary market and the
secondary market. The primary market is used for transactions on new stocks or bond issues,
which are handled by issuing houses and underwriters.

The main entities seeking to raise long-term funds on the primary capital markets are
governments (which may be local, state or federal) and business enterprises (companies).
Governments tend to issue only bonds, whereas companies often issue either equity or bonds.

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The main entities purchasing the bonds or stock include pension funds, hedge funds, sovereign
wealth funds, and less commonly wealthy individuals and investment banks trading on their own
behalf.

2.5.1 Government Issues

When a government wants to raise long term finance it will often sell bonds to the capital
markets. In the 20th and early 21st century, many governments would use investment banks to
organize the sale of their bonds. The leading bank would underwrite the bonds, and would often
head up a syndicate of brokers, some of whom might be based in other investment banks. The
syndicate would then sell to various investors.

For developing countries, a multilateral development bank would sometimes provide an

additional layer of underwriting, resulting in risk being shared between the investment bank(s),
the multilateral organization, and the end investors. However, in recent years, it has been
increasingly common for governments of the larger nations to bypass investment banks by
making their bonds directly available for purchase over the Internet. Many governments now sell
most of their bonds by computerized auction. Typically
Large volumes of bonds are put up for sale in one tranche and a government may only, through
the apex bank, hold a small number of auctions each year.

Some governments will also sell a continuous stream of bonds through other channels. The
biggest single seller of debt is the US Government; there are usually several transactions for such
sales every second, which corresponds to the continuous updating of the US real time debt clock.

2.5.2 Corporate Issues

When a company wants to raise money for long-term investment, one of its first decisions is
whether to do so by issuing bonds or shares. If it chooses shares, it avoids increasing its debt, and
in some cases the new shareholders may also provide non monetary help, such as expertise or
useful contacts.

On the other hand, a new issue of shares can dilute the ownership rights of the existing
shareholders, and if they gain a controlling interest, the new shareholders may even replace

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senior managers. From an investor's point of view, shares offer the potential for higher returns
and capital gains if the company does well.

Conversely, bonds are safer if the company does poorly, as they are less prone to severe falls in
price, and in the event of bankruptcy, bond owners are usually paid before shareholders. When a
company raises finance from the primary market, the process is more likely to involve face-to-
face meetings than other capital market transactions.

When they choose to issue bonds or shares, Companies will typically enlist the services of an
investment bank to mediate between themselves and the market. A team from the investment
bank often meets with the company's senior managers to ensure their plans are sound.

The bank then acts as an underwriter, and will arrange for a network of brokers to sell the bonds
or shares to investors. This second stage is usually done mostly through computerized systems,
though brokers will often phone up their favored clients to advise them of the opportunity.

Companies can avoid paying fees to investment banks by using a direct public offering, though
this is not a common practice as it incurs other legal costs and can take up considerable
management time.

Self Test Question 1.22

Differentiate between the nature of transactions on

government securities and that of the corporate
securities.

2.5.3 Methods of Issuing Instruments

The major issuers of securities particularly the shares are the corporate entities. Government
bonds are commonly referred to as "gilt-edged" securities. Intermediaries such as brokers and
banks (especially merchant banks) are often used by borrowers to administer the issuing of new
bonds.

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Bonds can be issued in the primary market using several different methods. Both equities and
bonds can be issued through the following ways:

Public Subscription
This presupposes that a prospectus is issued. The document contains details of the company
issuing the security such as bond or shares, and of the securities themselves. Members of the
public can then subscribe to the security, and the borrower or an intermediary on behalf of the
borrower will allocate the securities to subscribers on issue date by means of a certain process.

Private Placing
The securities (e.g., shares or bonds can also be issued through private placing. This method is
used when the borrower (or an intermediary on behalf of the borrower) places bonds or shares
with certain investors selected by the borrower. The selected investor would then receive a
certain amount of bonds or shares at issue date and pay the borrower the issue price for the bonds
received.

Tender Method
A third method used to issue bonds or shares is known as the "tender" method. The borrower or
intermediary will issue a media statement that bonds shares will be issued in the market on a
certain date.

The details of the bonds shares and the capitalization of the issue (total nominal amount to be
issued) will also be communicated. Interested parties are then invited to tender before a certain
date for these bonds. Tenders from interested parties would normally consist of the nominal
amount plus the percentage of the nominal amount that the interested party is willing to pay for
the shares or bonds at issue. The company or borrower usually allots the shares or bonds in order
of highest tenders first, but it is in his power to decide who will receive the securities at issue
date.

Tap Method

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Another method that is used to issue new instruments is known as the "tap" method, whereby not
all the shares or bonds are allocated at the first issue through any of the above three methods. If,
for instance, the company or borrower wants to issue N1,000,million worth of shares or bonds he
can choose to issue only N600 million at the first issue. The borrower or intermediary then starts
creating a secondary market for these instruments by buying and selling the issued instruments in
the secondary market. This process, where one party buys and sells the same instrument in the
market, is known as market making.

The market maker thus has a bid (to buy) and an offer (to sell) in the market for the same
instrument, trying to create an active and liquid market in this instrument. The "tap" method is
then used by the borrower or intermediary, whereby more instruments are sold in the market than
that bought back. By using this method, the amount of the issue is increased, often without the
market realizing it.

This method can also be used in inverse form to decrease the total outstanding loan. The ultimate
user of the funds from the securities in the capital market can use the tap method, because the
company is allowed to trade in its own securities. This is possible in the equities market because
a company is allowed to buy its own shares.

2.6 Secondary Market Operations

IN the secondary markets, existing securities are sold and bought among investors or traders,
usually on a stock exchange, characterized by over-the counter, or operated electronically in
highly developed economies. The existence of secondary markets increases the willingness of
investors in primary markets, as they know they are likely to be able to swiftly cash out their
investments if the need arises.

Transactions in secondary markets: Most capital market transactions are executed electronically,
but in less developed stock exchanges sometimes traders are directly involved and sometimes
unattended computer systems in highly developed stock exchanges execute the transactions, such
as in algorithmic trading system.

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Most capital market transactions take place on the secondary market. On the primary market,
each security can be sold only once, and the process to create batches of new shares or bonds is
often lengthy due to regulatory requirements.

On the secondary markets, there is no limit on the number of times a security can be traded, and
the process is usually very quick. With the rise of strategies such as highly frequency trading, a
single security could in theory be traded thousands of times within a single hour.

Transactions on the secondary market don't directly help raise finance, but they do make it easier
for companies and governments to raise finance on the primary market, as investors know if they
want to get their money back in a hurry, they will usually be easily able to re-sell their securities.

Sometimes secondary capital market transactions can have a negative effect on the primary
borrowers - for example, if a large proportion of investors try to sell their bonds, this can push up
the yields for future issues from the same entity.

In modern time, several governments have tried to avoid as much as possible the penchant for
borrowing into long dated bonds, so they are less vulnerable to pressure from the markets.

A variety of different players are active in the secondary markets. Regular individuals account
for a small proportion of trading, though their share has slightly increased; in the 20th century it
was mostly only a few wealthy individuals who could afford an account with a broker, but
accounts are now much cheaper and accessible over the internet.

There days there are now numerous small traders who can buy and sell on the secondary markets
using platforms provided by brokers which are accessible with web browsers. When such an
individual trades on the capital markets, it will often involve a two stage transaction. First they
place an order with their broker, then the broker executes the trade. If the trade can be done on an
exchange, the process will often be fully automated. If a dealer needs to manually intervene, this
will often mean a larger fee.

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Traders in investment banks will often make deals on their bank's behalf, as well as executing
trades for their clients. Investment banks will often have a department called capital markets:
staff in this department try to keep aware of the various opportunities in both the primary and
secondary markets, and will advise major clients accordingly. Pension and Sovereign wealth
funds tend to have the largest holdings, though they tend to buy only the highest grade (safest)
types of bonds and shares, and often don't trade all that frequently.

Self Test Question 1.23

Differentiate between primary market and secondary

market.

2.6.1 Financial Market instruments

are usually fixed-income obligations that trade in the secondary market, which means anyone can
buy and sell them to other individuals or institutions. Marketable securities are exchanged
through the organized markets for example, stock exchanges and its Representative dealers and
brokers who sell and buy marketable securities on behalf of their customer in exchange of
commission.

Essentially there are money market instruments and capital market instruments. The vehicles
used in both markets are different at least in features. The following discussion will be on these
two market instruments.

In terms of its operations, the money market consists of financial institutions and dealers in
money or credit facilities who wish to either borrow or lend. Participants in the money market
normally borrow and lend for short periods of time, ranging from some days such as money at
calls and short notices to thirteen (13) months. The operations in money market generally involve
trades in short-term financial instruments which are commonly called "paper." This is in contrast
with the operations of the capital market which are essentially for longer-term funding, which is
supplied by bonds and equity issues.

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The core of the operations of the money market is the area of interbank lending. The commercial
banks normally borrow and lend to each other using commercial papers, repurchase agreements
and similar financial instruments. These financial instruments are often benchmarked, that is
priced by reference, to the London Interbank Offered Rate (LIBOR) for the appropriate term and
currency.

The finance companies typically fund themselves through the issue large amounts of asset-
backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an
ABCP conduit. Examples of such eligible assets include auto loans, credit card receivables,
residential and commercial mortgage loans, mortgage-backed securities and similar financial
assets.

There are, however, certain large corporations or corporate entities that command strong credit
ratings, such as General Electric Corporation and International Business Machines that issue
commercial papers on their own credit. Other large corporations normally arrange for banks to
issue commercial papers on their behalf through the commercial paper lines.

In countries like the United States, federal, state and local governments do all issue paper to meet
their funding needs. States and local governments issue municipal paper while the federal
government through the US Treasury (the apex bank of the US) issues Treasury bills to fund the
public debts.

In the case of Nigeria, the federal government does issue Treasury Bills and Treasury Certificates
to finance recurrent operations through the apex bank, that is, the Central Bank of Nigeria. Such
operations are in the realm of the open market operations as the system is called in Nigeria.

The trading companies often purchase bankers’ acceptances which are normally tendered for
payment to overseas suppliers. In this connection, the retail and institutional money market
funds, some specific banks, the central banks of various countries, cash management programs,
and merchant banks are often involved in the operations of the money market.

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In terms of its participants in relation to the operations of the money market, there are financial
institutions and dealers in money or credit facilities. These participants include the following.
 Central banks
 Commercial banks
 Investment banks
 Merchant banks
 Mortgage banks
 Insurance companies
 Corporate entities
 Mortgage Institutions
 Pension Funds Institutions
 Discount Houses

The capital market instruments fall into four categories such as: Treasury securities; government
agency securities; municipal bonds; and corporate bonds.

1. Treasury Instruments
All government securities issued by the Treasury department of Govt. are fixed income
instruments. They may be bills, notes, or bonds depending on their times to maturity.
Specifically, bills mature in one year or less, notes in over one to 10 years, and bonds in more
than 10 years from time of issue government securities which confer debt obligations on the
government.

2. Government Bonds and Loan Stocks

Government y securities are sold by the apex banks on behalf of the government to support
specific programs, but they are not direct obligations of the treasury department. Mortgage bonds
are issued and sold for the purpose of using the proceeds to purchase mortgages from insurance
companies or savings and loans; and the home loan which sells bonds and loans the money to its
banks, which in turn provide credit to savings and loans and other mortgage-granting institutions.
Other agencies are the government banks for cooperatives.

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3. State and Local Government Bonds
These bonds are issued by local government entities as either general obligation or revenue
bonds. General obligation bonds are backed by the full taxing power of the municipality, whereas
revenue bonds pay the interest from revenue generated by specific projects. These bonds differ
from other fixed-income securities because they are tax-exempt. The interest earned from them is
exempt from taxation by the government and by the state that issued the bond, provided the
investor is a resident of that state. For this reason, these bonds are popular with investors in high
tax brackets.

4. Corporate Bonds Corporate bonds are fixed-income securities issued by industrial

corporations, public utility corporations, or railroads to raise funds to invest in plant, equipment,
or working capital. They can be broken down by issuer, in terms of credit quality in terms of
maturity i.e. short term, intermediate term, or long term, or based on some component of the
indenture.

These are fixed-income obligations that trade in the secondary market, which means anyone can
buy and sell them to other individuals or institutions. Marketable securities are exchanged
through the organized markets for example, stock exchanges and its Representative dealers and
brokers who sell and buy marketable securities on behalf of their customer in exchange of
commission.

2.6.2 Financial Market Securities

Instruments issued and traded in the capital market differ in certain characteristics, such as: term
to maturity; interest rate paid on the nominal value; interest payment dates; and nominal amount
in issue.

1. Interest Rate Securities

The interest paid on the nominal amount of capital market securities (called the coupon rate)
appears on the certificate received by the holder (the investor) of such a security. This coupon
rate is one of the parameters used to determine the consideration paid for the security when
traded in the secondary market. Most securities are issued at a fixed coupon rate.

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Capital market securities are physical certificates and the issuer of the security keeps a register of
owners. This register is used by the borrower (issuer) to pay interest to the lender (owner of the
security) on the interest payment dates indicated on the certificate. When an instrument is sold to
a new owner in the secondary market, the buyer is registered as the new owner on the settlement
date of the transaction.

For administrative purposes the register of the issuer closes for registration of new owners,
normally one month prior to the interest payment date. The date when the register closes is
known as the last day to register. This means that the person or company, who is registered as the
owner one month before the interest payment date on the register, will receive the interest on the
payment date.

If a bond is sold and settled between the last day to register and the interest payment date, the
seller will receive the interest payment. The buyer is then known to buy the instrument "ex
interest" (without interest). Nevertheless, if a transaction takes place before the last day to the
register, the buyer buys the instrument "cum interest" (including interest), because he will be
registered as the owner before the register closes, and will receive the next interest payment.

2. Zero-rated coupons
These are long-dated securities with many terms to maturity with zero-rated coupons which are
capital market instruments issued by borrowers of money such as blue chip firms. These
instruments do not earn interest on the capital amount invested by the lender, and are therefore
issued and traded at a discount on the nominal value, similar to discount instruments in the
money market such as bankers acceptances and treasury bills.
The market value (nominal value less discount) of zero or nil-rated coupon bonds depends on the
yield that the investor (lender) expects on his investment. The redemption amount, which is the
only cash inflow for the investor, is equal to the nominal value of the bond, and is thus known to
the investor.

Since the redemption date is also known, the investor can calculate the amount that he is willing
to pay for the bond according to the yield (expressed in terms of interest rate) that he wants to

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earn on the investment. This yield on zero-rated coupon bonds is normally linked to the market
rate on long-term (capital market) investments.

3. Asset-backed Securities

Where an asset exists which represents cash inflow stream such as a normal loan or investment, a
bond can be issued to fund this asset. The bond income is then derived or backed by the income
stream of the asset. The performance on the bond is then dependent on the asset performance.

2.6.3 Market Participants

In respect of the operations of the capital market, there are different players that are active in the
secondary segment of the market. Such players include institutional and non institutional
investors. The later are the following:

Regular individual investors

These participants in the market account for a small proportion of trading, though their share still
plays some significant role in the market. A few wealthy individuals who could afford an account
with a broker, but transactions are now much cheaper and accessible over the internet.

Traders
These are the jobbers and stock brokers. The jobbers in highly developed capital markets operate
by buying securities with the intention of making profits. The do not transact business on behalf
of any investors but behave like real traders who engage in buying and selling of capital market
securities. The profit earned by the jobbers is called the jobbers turn.

On the other hand, the stock brokers transact business on behalf of investors who pay
commission on volume of transactions done for them by the stockbrokers.

There are numerous small traders who can buy and sell securities on the secondary markets using
platforms provided by brokers which are accessible through electronics means such as with web

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browsers. When such an individual trades on the capital markets, it will often involve a two stage
transaction.
First they place an order with their broker, on the strength of which the broker executes the trade.
If the trade can be done on an exchange, the process will often be fully automated. If a dealer
needs to manually intervene, this will often mean a larger fee.

Investment banks

Traders in investment banks will often make deals on their bank's behalf, as well as executing
trades for their clients. Investment banks will often have a department called capital markets.
Staff in such department try to keep abreast of the various opportunities in both the primary and
secondary markets, and will advise major clients accordingly.

Pension and Sovereign Wealth Funds

These players tend to have the largest holdings, though they tend to buy only the highest grade
securities which are safest types of bonds and shares, and often don't trade all that frequently.

Hedge funds

These are increasingly making most of the short-term trades in large sections of the secondary
markets of advanced economies such as the UK and US stock exchanges, which is making it
harder for them to maintain their historically high returns, as they are increasingly finding
themselves trading with each other rather than with less sophisticated investors.

There are a number of financial institutions which are directly involved with real investment in
the economy. These institutions mobilize the saving from the people and channel funds for
financing the development expenditure of the industry and government of a country.

The financial institutions take maximum care in investing funds in those projects where there is
high degree of security and the income is certain. The main institutional sources of capital market
are as follows:

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Insurance Companies. Insurance companies are financial intermediaries. They call money by
providing protection from certain risks to individuals and firms. The insurance companies invest
the funds in long term investments primarily mortgage loans and corporate bonds.

Pension Funds. The pension funds are provided by both employees and employers. These funds
are now increasing utilized in the provision of long term loans for the industry and government.

Building Societies. The building societies are now activity engaged in providing funds for the
construction, purchase of buildings for the industry and houses for the people.

Investment Trusts. The investment trust mobilize saving and meet the growing, need of
corporate sector, The income of the investment trust depends upon the dividend it receives from
shares invested in various companies.

Unit Trust. The Unit Trust collects the small savings of the people by selling units of the trust.
The holders of units can resell the units at the prevailing market value to the trust itself.

Saving Banks. The saving banks collect the savings of the people. The accumulated saving is
invested in mortgage loans, corporate bonds.

Specialized Finance Corporation. The specialized finance corporations are being established to
help and provide finance to the private industrial sector in the form of medium and long term
loans or foreign currencies.

Commercial banks. The commercial banks are also now activity engaged in the provision of
medium and long terms loans to the industrialists, agriculturists, specialist finance institutions,
etc., etc.

Stock Exchange. The stock exchange is a market in existing securities (shares, debentures and
securities issued by the public authorities). The stock exchange provides a place for those persons

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who wish to sell the shares and also wish to buy them. Stock Exchange, thus helps in raising
equity capital for the industry

2.7 Evolution of Financial Markets

Financial markets have experienced many changes during the last two decades. Technological
advances in computers and telecommunications, along with the globalization of banking and
commerce, have led to deregulation, and this has increased competition throughout the world.
The result is a much more efficient, internationally linked market, but one that is far more
complex than existed a few years ago.

While these developments have been largely positive, they have also created problems for policy
makers. At one conference, the former Federal Reserve Board in US America, Chairman Alan
Greenspan stated that modern financial markets “expose national economies to shocks from new
and unexpected sources and with little if any lag.” He went on to say that central banks must
develop new ways to evaluate and limit risks to the financial system.

Large amounts of capital move quickly around the world in response to changes in interest and
exchange rates, and these movements can disrupt local institutions and economies.

Globalization has exposed the need for greater cooperation among regulators at the international
level. Various committees are currently working to improve coordination, but the task is not
easy. Factors that complicate coordination include:
A. The differing structures among nations’ banking and securities industries,
B. The trend in Europe toward financial services conglomerates, and
C. Reluctance on the part of individual countries to give up control over their national
monetary policies.
Still, regulators are unanimous about the need to close the gaps in the supervision of worldwide
markets. Another important trend in recent years has been the increased use of
Derivatives. [Remember, earlier discussion about the option of buying stocks in some later days
to come].

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A derivative is any security whose value is derived from the price of some other “underlying”
asset. An option to buy Bank of Abyssinia’s stock is a derivative, as is a contract to buy Japanese
yen six months from now. The value of the Bank of Abyssinia’s option depends on the price of
Abyssinia’s stock, and the value of the Japanese yen “future” depends on the exchange rate
between yen and dollars. The market for derivatives has grown faster than any other market in
recent years, providing corporations with new opportunities but also exposing them to new risks.

Derivatives can be used either to reduce risks or to speculate. Risk can be reduced by changing
one asset to another one. Speculations are trying to derive benefits out of price changes in the
future. However, risk is there in all kinds of involvements on derivatives.

Suppose an importer’s costs rise and its net income falls when the dollar falls relative to the yen.
That company could reduce its risk by purchasing derivatives whose values increase when the
dollar declines. This is a hedging operation, and its purpose is to reduce risk exposure.

Speculation, on the other hand, is done in the hope of high returns, but it raises risk exposure. For
example, in United states of America, several years ago, Procter & Gamble disclosed that it lost
$150 million on derivative investments, and Orange County (California) went bankrupt as a
result of its treasurer’s speculation in derivatives.

The size and complexity of derivatives transactions concern regulators, academics, and other
stakeholders though.

Self Test Question 1.24

What is a derivative, and how is its value

related to that of an “underlying asset”?

Summary
The topics that we have discussed in this study unit include the exposition on the term financial
assets, identifying the types of financial assets (such as debt instruments and equity instruments)

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traded in money and capital markets and mentioning and explanation of the various
characteristics of financial assets.

The discussion in this unit, as you have observed, is indicative of the fact that there exists some
financial instruments regarded as financial assets that are involved in transactions in the financial
markets, which comprise money market and capital market.

Accordingly, the financial assets are in two categories for the two financial markets. Therefore,
from the discussion, we have identified Treasury Bills, Treasury Certificates, Trade Bills,
Commercial Papers, and Certificate of Deposits as financial instruments for the money market.
Those of the capital market from the discussion include term bank loans, Debenture Stocks,
Bonds, Mortgage Loan Stocks, Leases, Preference Shares, and Hire Purchase Contracts. The
peculiar characteristics of these financial assets, as we have enumerated and discussed in this
study unit, include moneyness, divisibility & denomination, reversibility, cash flow, maturity,
convertibility, currency, liquidity, predictable returns, and tax status of the returns.

Financial markets help savers and fund demanders meet to satisfy their desires. The types of
these markets include spot and future markets, money and capital markets, primary and
secondary markets.

The foreign exchange market too facilitates exchange of currencies while trading, traveling or
similar other purposes. There are spot and forward or future currency markets too. Quotation of
foreign currencies can be direct or indirect using bid and ask prices to realize spread for dealers.
There are benefits in the currency market as are risks too. The currency market is less risky than
the equity market.

There are fundamental differences between the primary market operations and the secondary
market operations too. The actors in each market can be different and the cash or the fund goes to
different participants in the two markets.

The financial market is undergoing changes through time. Corporations and banks are getting
bigger through merger or acquisition arrangements and avoiding or reducing transaction costs.
There strength has given way to develop new products like derivatives in the financial markets.
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 Unit 3
Financial Institutions

Unit Introduction

Unit three will discuss on the nature and role of financial institutions. It will identify the various
types of financial institutions that operate in various economies. It will elaborate the different
features of various types of financial institutions with the type of services they provide. The
conventional ways of doing business with these types of institutions will be looked into for
comparison purposes too.

Unit Objectives

Upon completion of this unit, you will be able to;

 Identify the different types of financial institutions
 Determine the nature and characteristics of the financial institutions
 Explain the major differences between different types of financial institutions

Financial Institutions and their roles

Direct funds transfers are more common among individuals and small businesses and in
economies where financial markets and institutions are less developed. This is what exists
presently in Ethiopia. While businesses in more developed economies do occasionally rely on
direct transfers, they generally find it more efficient to enlist the services of one or more financial
institutions when the need to raise finance becomes obvious.

On the other hand, for instance, in the United States and other developed nations, a set of highly
efficient financial intermediaries has evolved. Their original roles were generally quite specific,
but many of them have diversified to the point where they serve many different markets. As a
result, the differences between institutions have tended to become blurred. Still, there remains a
degree of institutional identity, and therefore it is useful to describe the major categories of
financial institutions here:

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1. Investment banking houses: They are institutions such as well known ones in the world,
Merrill Lynch, Morgan Stanley, Goldman Sachs, or Credit Suisse Group provide a number of
services to both investors and companies planning to raise capital. Such organizations
a. help corporations design securities with features that are currently attractive to
investors,
b. then buy these securities from the corporation, and
c. Resell the securities to savers. Although the securities are sold twice, this
process is really one primary market transaction, with the investment banker
acting as a facilitator to help transfer capital from savers to businesses.

2. Commercial banks: These are mostly short term retail fund availing institutions such as those
known worldwide as Bank of America, Wells Fargo, Wachovia, and J. P. Morgan Chase. They
are the traditional “department stores of finance” because they serve a variety of savers and
borrowers. Historically, commercial banks were the major institutions that handled checking
accounts and through which the central banks of countries expanded or contracted the money
supply. Today, however, several other institutions also provide checking services and
significantly influence the money supply. Conversely, commercial banks are providing an ever-
widening range of services, including stock brokerage services and insurance.

Self Test Question 1.25

What is the difference between a pure

commercial bank and a pure investment bank?

3. Financial services corporations: These are large conglomerates that combine many different
financial institutions within a single corporation. Examples of financial services corporations,
most of which started in one area but have now diversified to cover most of the financial
spectrum, include Citigroup, American Express, Fidelity, and Prudential.

4. Savings and loan Associations (S&Ls): These are traditionally serving individual savers and
residential and commercial mortgage borrowers, taking the funds of many small savers and then

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lending this money to home buyers and other types of borrowers. These institutions can
experience severe problems when:
a. short-term interest rates paid on savings accounts rises well above the returns
earned on the existing mortgages held by S&Ls and
b. Commercial real estate suffers a severe slump, resulting in high mortgage
default rates. As history has shown, together, these events forced many S&Ls
to merge with stronger institutions or close their doors.

5. Mutual savings banks: These are similar to S&Ls, traditionally, they accept savings primarily
from individuals, and lend it to, mainly on a long-term basis, home buyers and consumers.

6. Credit unions: These are cooperative associations whose members are supposed to have a
common bond, such as being employees of the same firm. Members’ savings are loaned only to
other members, generally for various personal needs, home improvement loans, and home
mortgages. Credit unions are often the cheapest source of funds available to individual
borrowers.

7. Pension funds: are retirement plans funded by corporations or government agencies for their
workers and administered primarily by the trust departments of commercial banks or by life
insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate.

8. Life insurance companies: This are institutions which take savings in the form of annual
premiums; invest these funds in stocks, bonds, real estate, and mortgages; and finally make
payments to the beneficiaries of the insured parties. In recent years, in developed economies, life
insurance companies have also offered a variety of tax-deferred savings plans that are designed
to provide benefits to the participants when they retire.

9. Mutual funds: These are corporations that accept money from savers and then use these funds
to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or
government units. These organizations pool funds and thus reduce risks by diversification. They
also achieve economies of scale in analyzing securities, managing portfolios, and buying and
selling securities. Different funds are designed to meet the objectives of different types of savers.

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Hence, accordingly, there are bond funds for those who desire safety, stock funds for savers who
are willing to accept significant risks in the hope of higher returns, and still other funds that are
used as interest-bearing checking accounts (money market funds). In one economy/country
there can be different mutual funds with many different goals and purposes.

Still in developed economies, mutual funds have grown more rapidly than most other institutions
in recent years, in large part because of a change in the way corporations provide for employees ’
retirement. Earlier than in 1980s in US America, for instance, most corporations said, in effect,
“Come work for us, and when you retire, we will give you a retirement income based on the
salary you were earning during the last five years before you retired.” The company was then
responsible for setting aside funds each year to make sure it had the money available to pay the
agreed-upon retirement benefits.

That situation is changing rapidly. Today, new employees are likely to be told, “Come work for
us, and we will give you some money each payday that you can invest for your future retirement.
You can’t get the money until you retire (without paying a huge tax penalty), but if you invest
wisely, you can retire in comfort.” Most workers recognize that they don’t know enough to invest
wisely, so they turn their retirement funds over to a mutual fund. Hence, mutual funds are
growing rapidly.

10. Hedge funds are similar to mutual funds because they accept money from savers and use the
funds to buy various securities, but there are some important differences, as far as their
operations in North America, are concerned. In US for instance, while mutual funds are
registered and regulated by the Securities and Exchange Commission (SEC), hedge funds are
largely unregulated. This difference in regulation stems from the fact that mutual funds typically
target small investors, whereas hedge funds typically have large minimum investments (often
exceeding $1 million) that are effectively marketed to institutions and individuals with high net
worths.

Different hedge fund managers follow different strategies. For example, a hedge fund manager
who believes that the spreads between corporate and Treasury bond yields are too large might

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simultaneously buy a portfolio of corporate bonds and sell a portfolio of Treasury bonds. In this
case, the portfolio is “hedged” against overall movements in interest rates, but it will do well if
the spread between these securities narrows.

Self Test Question 1.26

Differentiate between the following:

I. Mutual Funds and Pension funds
II. Saving and Loan Association and Commercial Banking
III. Commercial banking and Investment banking

Likewise, hedge fund managers may take advantage of perceived incorrect valuations in the
stock market, that is, where a stock’s market and intrinsic values differ. As performance
documented on Hedge funds in developed economies indicate, generally they charge large fees,
often a fixed amount plus 15 to 20 percent of the fund’s capital gains.

Besides, the average hedge fund has done quite well in recent years. In a recent report, Citigroup
estimates that the average hedge fund has produced an annual return of 11.9 percent since 1990.
Over the same time period, the average annual returns of the overall stock market were 10.5
percent, and the returns on mutual funds were even lower, 9.2 percent. Dear student, from this
result you can see the difference in risk inherent in these assets being different too.

In some economies, after noting the stock market’s relatively dull performance in recent years, an
increasing number of investors have flocked to hedge funds. Between 1999 and 2004, the money
managed by them more than quadrupled to roughly $800 billion.

Indeed, some hedge funds take on risks that are considerably higher than that of an average
individual stock or mutual fund. Moreover, in recent years, in US America for instance, some
have also produced spectacular losses. For example, many hedge fund investors suffered large
losses in 1998 when the Russian economy collapsed. That same year, the Federal Reserve had to
step in to help rescue Long Term Capital Management, a high-profile hedge fund whose

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managers included several well-respected practitioners as well as two Nobel Prize –winning
professors who were experts in investment theory.

As hedge funds have become more popular, many have begun to lower their minimum
investment requirements. Perhaps not surprisingly, their rapid growth and shift toward smaller
investors have also led to a call for more regulation.

With the notable exception of hedge funds, financial institutions have been heavily regulated to
ensure the safety of these institutions and thus to protect investors. Historically, many of these
regulations—which have included a prohibition on nationwide branch banking, restrictions on
the types of assets the institutions could buy, ceilings on the interest rates they could pay, and
limitations on the types of services they could provide—tended to impede the free flow of capital
and thus hurt the efficiency of the concerned countries’ capital markets.

Recognizing this fact, policy makers in US for instance, took several steps during the 1980s and
1990s to deregulate financial services companies. For example, the barriers that restricted banks
from expanding nationwide were eliminated. Likewise, regulations that once forced a strict
separation of commercial and investment banking have been relaxed.

The result of the ongoing regulatory changes has been a blurring of the distinctions
between the different types of institutions. Indeed, the trend in the United States today is toward
huge financial services corporations, which own banks, S&Ls, investment banking houses,
insurance companies, pension plan operations, and mutual funds, and which have branches
across the country and around the world. For example, Citigroup combines one of the world’s
largest commercial banks (Citibank), a huge insurance company (Travelers), and a major
investment bank (Smith Barney), along with numerous other subsidiaries that operate throughout
the world. Citigroup’s structure is similar to that of major institutions in Europe, Japan, and
elsewhere around the globe.

Self Test Question 1.27

What are some important differences between mutual

and hedge funds?

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 Unit 4
Central Banking and Ethiopian Financial Institutions

Unit Introduction

The fourth and last unit of this module will show first the role and functions of the central banks
and later the working of Ethiopian financial system. The unit will elaborate the role of the central
banks in the effort of managing the economy of a country. It will identify the the various tasks
these banks are entrusted to do. The second part of this unit will introduce you to the Ethiopian
financial system in a historical perspective.

Unit Objectives

Upon completion of this unit, you will be able to;

 Identify the different responsibilities central banks are assigned to discharge
 Describe the types of functions central banks perform
 Account the development of Ethiopian financial system

4.1 Central Banking

A central bank, Reserve bank, or Monetary authority is an institution that manages

a state's currency, money supply, and interest rates. Central banks also usually oversee
the commercial banking system of their respective countries. In contrast to a commercial bank, a
central bank possesses a monopoly on increasing the monetary base in the state, and usually also
prints the national currency, which usually serves as the state's legal tender. Examples include the
National Bank of Ethiopia (NBE), the European Central Bank (ECB), the Bank of Japan,
the Bank of England, the Federal Reserve of the United States, the People's Bank of China, etc.

The primary function of a central bank is to control the nation's money supply (monetary policy),
through active duties such as managing interest rates, setting the reserve requirement, and acting
as a lender of last resort to the banking sector during times of bank insolvency or financial crisis.

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Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce
the risk that commercial banks and other financial institutions engage in reckless or fraudulent
behavior. Central banks in most developed nations are institutionally designed to be independent
from political interference. However, limited control by the executive and legislative bodies
usually exists.

REMEMBER!

Central Banks, among others,

 Control money supply

 Mange interest rate

 Set reserve requirement

 Act as a lender of the last resort

The establishment of the central banks in countries has become necessary for the obvious
reasons. Governments can function with those activities that central banks perform when in
place. In many regions, however, there are typical reasons for their coming to being. Central
banks were established in many European countries during the 19th century. For instance,
the War of the Second Coalition led to the creation of the Banque de France in 1800, in an effort
to improve the public financing of the war.

Although central banks today are generally associated with fiat money (the legal tender), the 19th
and early 20th centuries central banks in most of Europe and Japan developed under the
international gold standard, elsewhere free banking or currency boards were more usual at this
time. Problems with collapses of banks during downturns, however, led to wider support for
central banks in those nations which did not as yet possess them, most notably in Australia.

There is no standard terminology for the name of a central bank, but many countries use the
"Bank of Country" form—for example: Bank of England (which is in fact the central bank of
the United Kingdom as a whole), Bank of Canada, Bank of Mexico. Some are styled "national"

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banks, such as the National Bank of Ukraine, the National Bank of Ethiopia, although the
term national bank is also used for private commercial banks in some countries.

In other cases, central banks may incorporate the word "Central" (for example, European Central
Bank, Central Bank of Ireland, Central Bank of Brazil). The word "Reserve" is also often
included, such as the Reserve Bank of India, Reserve Bank of Australia, Reserve Bank of New
Zealand, the South African Reserve Bank, and U.S. Federal Reserve System. Other central banks
are known as monetary authorities such as the Monetary Authority of Singapore, Maldives
Monetary Authority and Cayman Islands Monetary Authority. Many countries have state-owned
banks or other quasi-government entities that have entirely separate functions, such as financing
imports and exports.

In some countries, particularly in some Communist countries, the term national bank may be
used to indicate both the monetary authority and the leading banking entity, such as the Soviet
Union's Gosbank (state bank). In other countries, the term national bank may be used to indicate
that the central bank's goals are broader than monetary stability, such as full employment,
industrial development, or other goals. Some state-owned commercial banks have names
suggestive of central banks, even if they are not: examples are the Bank of India and the Central
Bank of India. The chief executive of a central bank is normally known as the Governor,
President or Chairman.

Functions of Central banks may include

 implementing monetary policies.

 determining Interest rates
 controlling the nation's entire money supply
 the Government's banker and the bankers' bank ("lender of last resort")
 managing the country's foreign exchange and gold reserves and the
Government's stock register
 regulating and supervising the banking industry

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  setting the official interest rate – used to manage both inflation and the
country's exchange rate – and ensuring that this rate takes effect via a variety
of policy mechanisms

Self Test Question 1.28

What are the main functions of a central bank?

4.1.1 Monetary policy

Central banks implement a country's chosen monetary policy. At the most basic level, this
involves establishing what form of currency the country may have, whether a fiat currency, gold-
backed currency (disallowed for countries with membership of the International Monetary
Fund), currency board or a currency union. When a country has its own national currency, this
involves the issue of some form of standardized currency, which is essentially a form
of promissory note: a promise to exchange the note for "money" under certain circumstances.

Historically, this was often a promise to exchange the money for precious metals in some fixed
amount. Now, when many currencies are fiat money, the "promise to pay" consists of the
promise to accept that currency to pay for taxes.

A central bank may use another country's currency either directly (in a currency union), or
indirectly (a currency board). In the latter case, exemplified by Bulgaria, Hong Kong and Latvia,
the local currency is backed at a fixed rate by the central bank's holdings of a foreign currency.

The expression "monetary policy" may also refer more narrowly to the interest-rate targets and
other active measures undertaken by the monetary authority.

4.1.2 Goals of Monetary Policy

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High employment: Frictional unemployment is the time period between jobs when a worker is
searching for, or transitioning from one job to another. Unemployment beyond frictional
unemployment is classified as unintended unemployment.

For example, structural unemployment is a form of unemployment resulting from a mismatch

between demand in the labour market and the skills and locations of the workers seeking
employment. Macroeconomic policy generally aims to reduce unintended unemployment.

Keynes labeled any jobs that would be created by a rise in wage-goods (i.e., a decrease in real-
wages) as involuntary unemployment:

People are involuntarily unemployed if, in the event of a small rise in the price of wage-goods
relatively to the money-wage, both the aggregate supply of labour willing to work for the current
money-wage and the aggregate demand for it at that wage would be greater than the existing
volume of employment.

Price stability: Inflation is defined either as the devaluation of a currency or equivalently the rise
of prices relative to a currency.

Since inflation lowers real wages, Keynesians view inflation as the solution to involuntary
unemployment. However, "unanticipated" inflation leads to lender losses as the real interest rate
will be lower than expected. Thus, Keynesian monetary policy aims for a steady rate of inflation.

Economic growth: Economic growth can be enhanced by investment in capital, such as more or
better machinery. A low interest rate implies that firms can loan money to invest in their capital
stock and pay less interest for it. Lowering the interest is therefore considered to encourage
economic growth and is often used to alleviate times of low economic growth. On the other hand,
raising the interest rate is often used in times of high economic growth as a contra-cyclical device
to keep the economy from overheating and avoid market bubbles.

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Goals frequently cannot be separated from each other and often conflict. Costs must therefore be
carefully weighed before policy implementation.

Currency issuance: Similar to commercial banks, central banks hold assets (government bonds,
foreign exchange, gold, and other financial assets) and incur liabilities (currency outstanding).
Central banks create money by issuing interest-free currency notes and selling them to the public
(government) in exchange for interest-bearing assets such as government bonds. When a central
bank wishes to purchase more bonds than their respective national governments make available,
they may purchase private bonds or assets denominated in foreign currencies.

The European Central Bank remits its interest income to the central banks of the member
countries of the European Union. The US Federal Reserve remits all its profits to the U.S.
Treasury. This income, derived from the power to issue currency, is referred to as seigniorage,
and usually belongs to the national government. The state-sanctioned power to create currency is
called the Right of Issuance. Throughout history there have been disagreements over this power,
since whoever controls, typically a central bank controls certain types of short-term interest rates.
These influence the stock- and bond markets as well as mortgage and other interest rates. The
European Central Bank for example announces its interest rate at the meeting of its Governing
Council; in the case of the U.S. Federal Reserve, the Federal Reserve Board of Governors.

Both the Federal Reserve and the ECB are composed of one or more central bodies that are
responsible for the main decisions about interest rates and the size and type of open market
operations, and several branches to execute its policies. In the case of the Federal Reserve, they
are the local Federal Reserve Banks; for the ECB they are the national central banks.

REMEMBER!

Goals of monetary policy are:

 High employment
 Price stability
 Economic growth

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 4.1.3 Limits on policy effects:

Although the perception by the public may be that the "central bank" controls some or all interest
rates and currency rates, economic theory (and substantial empirical evidence) shows that it is
impossible to do both at once in an open economy. Robert Mundell's "impossible trinity" is the
most famous formulation of these limited powers, and postulates that it is impossible to target
monetary policy (broadly, interest rates), the exchange rate (through a fixed rate) and maintain
free capital movement. Since most Western economies are now considered "open" with free
capital movement, this essentially means that central banks may target interest rates or exchange
rates with credibility, but not both at once.

In the most famous case of policy failure, Black Wednesday, George Soros arbitraged the pound
sterling's relationship to the ECU and (after making $2 billion himself and forcing the UK to
spend over $8bn defending the pound) forced it to abandon its policy. Since then he has been a
harsh critic of clumsy bank policies and argued that no one should be able to do what he did.

The most complex relationships are those between the Yuan and the US dollar, and between
the euro and its neighbors. The situation in Cuba is so exceptional as to require the Cuban peso to
be dealt with simply as an exception, since the United States forbids direct trade with Cuba. US
dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were officially
removed from circulation in 2004 and replaced by the convertible peso.

Policy instruments: The main monetary policy instruments available to central banks
are open market operation, bank reserve requirement, interest rate policy, re-lending and re-
discount (including using the term repurchase market), and credit policy (often coordinated
with trade policy). While capital adequacy is important, it is defined and regulated by the Bank
for International Settlements, and central banks in practice generally do not apply stricter rules.

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To enable open market operations, a central bank must hold foreign exchange reserves (usually
in the form of government bonds) and official gold reserves. It will often have some influence
over any official or mandated exchange rates: Some exchange rates are managed, some are
market based (free float) and many are somewhere in between ("managed float" or "dirty float").

Interest rates: By far the most visible and obvious power of many modern central banks is to
influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed
number. Although the mechanism differs from country to country, most use a similar mechanism
based on a central bank's ability to create as much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is
generally to lend money or borrow money in theoretically unlimited quantities, until the targeted
market rate is sufficiently close to the target. Central banks may do so by lending money to and
borrowing money from (taking deposits from) a limited number of qualified banks, or by
purchasing and selling bonds.

As an example of how this functions, for example, if the Bank of Canada sets a target overnight
rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this
band, but never above or below, because the central bank will always lend to them at the top of
the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and
lend at the extremes of the band are unlimited. Other central banks use similar mechanisms.

It is also notable that the target rates are generally short-term rates. The actual rate that borrowers
and lenders receive on the market will depend on (perceived) credit risk, maturity and other
factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but
rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield
curves, even below the short-term rate. Many central banks have one primary "headline" rate that

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is quoted as the "central bank rate". In practice, they will have other tools and rates that are used,
but only one that is rigorously targeted and enforced.

"The rate at which the central bank lends money can indeed be chosen at will by the central bank;
this is the rate that makes the financial headlines. This kind of thing is more evident in developed
nations and we take examples directly from there. Take the following illustration Dear Student!

Note that "the U.S. central-bank lending rate is known as the Fed funds rate. The Fed sets a
target for the Fed funds rate, which its Open Market Committee tries to match by lending or
borrowing in the money market ... a fiat money system set by command of the central bank. The
Fed is the head of the central-bank because the U.S. dollar is the key reserve currency for
international trade. The global money market is a USA dollar market. All other currencies
markets revolve around the U.S. dollar market." Accordingly the U.S. situation is not typical of
central banks in general.

A typical central bank has several interest rates or monetary policy tools it can set to influence
markets.

 Marginal lending rate (currently 0.30% in the Eurozone) – a fixed rate for institutions
to borrow money from the central bank. (In the USA this is called the discount rate).
 Main refinancing rate (0.05% in the Euro zone) – the publicly visible interest rate the
central bank announces. It is also known as minimum bid rate and serves as a bidding
floor for refinancing loans. (In the USA this is called the federal funds rate).
 Deposit rate, generally consisting of interest on reserves and sometimes also interest
on excess reserves (-0.20% in the Euro zone) – the rates parties receive for deposits
at the central bank.

These rates directly affect the rates in the money market, the market for short term loans.

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4.1.4 Open market operations:

Through open market operations, a central bank influences the money supply in an economy.
Each time it buys securities (such as a government bond or Treasury bill), it in effect creates
money. The central bank exchanges money for the security, increasing the money supply while
lowering the supply of the specific security. Conversely, selling of securities by the central bank
reduces the money supply.

Open market operations usually take the form of:

 Buying or selling securities ("direct operations") to achieve an interest rate target in

the interbank market.
 Temporary lending of money for collateral securities ("Reverse Operations" or
"repurchase operations", otherwise known as the "repo" market). These operations
are carried out on a regular basis, where fixed maturity loans (of one week and one
month for the ECB, for example) are auctioned off.
 Foreign exchange operations such as foreign exchange swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange
rate. For example the People's Bank of China and the Bank of Japan have on occasion bought
several hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S.
dollar versus their own currencies.

REMEMBER!

Open Market operations include:

 Buying and selling of securities
 Temporary lending of money
 Foreign exchange dealings

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4.1.5 Capital requirements

All banks are required to hold a certain percentage of their assets as capital, a rate which may be
established by the central bank or the banking supervisor. For international banks, including the
55 member central banks of the Bank for International Settlements, the threshold is 8% of
risk-adjusted assets, whereby certain assets (such as government bonds) are considered to have
lower risk and are either partially or fully excluded from total assets for the purposes of
calculating capital adequacy. Partly due to concerns about asset inflation and repurchase
agreements, capital requirements may be considered more effective than reserve requirements in
preventing indefinite lending: when at the threshold, a bank cannot extend another loan without
acquiring further capital on its balance sheet.

4.1.6 Reserve requirements:

Historically, bank reserves have formed only a small fraction of deposits, a system
called fractional reserve banking. Banks would hold only a small percentage of their assets in
the form of cash reserves as insurance against bank runs. Over time this process has been
regulated and insured by central banks. Such legal reserve requirements were introduced in the
19th century as an attempt to reduce the risk of banks overextending themselves and suffering
from bank runs, as this could lead to knock-on effects on other overextended banks.

As the early 20th century gold standard was undermined by inflation and the late 20th century
fiat dollar hegemony evolved, and as banks proliferated and engaged in more complex
transactions and were able to profit from dealings globally on a moment's notice, these practices
became mandatory, if only to ensure that there was some limit on the ballooning of money
supply. Such limits have become harder to enforce. The People's Bank of China retains (and
uses) more powers over reserves because the Yuan that it manages is a non-convertible currency.

Loan activity by banks plays a fundamental role in determining the money supply. The central-
bank money after aggregate settlement – "final money" – can take only one of two forms:

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  physical cash, which is rarely used in wholesale financial markets,
 central-bank money which is rarely used by the people

The currency component of the money supply is far smaller than the deposit component.
Currency, bank reserves and institutional loan agreements together make up the monetary base,
called M1, M2 and M3. The Federal Reserve Bank stopped publishing M3 and counting it as part
of the money supply in 2006, in UK for instance.

4.1.7 Exchange requirements:

To influence the money supply, some central banks may require that some or all foreign
exchange receipts (generally from exports) be exchanged for the local currency. The rate that is
used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is
generally used in countries with non-convertible currencies or partially convertible currencies.
The recipient of the local currency may be allowed to freely dispose of the funds, required to
hold the funds with the central bank for some period of time, or allowed to use the funds subject
to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be
otherwise limited.

In this method, money supply is increased by the central bank when it purchases the foreign
currency by issuing (selling) the local currency. The central bank may subsequently reduce the
money supply by various means, including selling bonds or foreign exchange interventions.

Self Test Question 1.29

What is meant by the following?:

I. capital requirement
II. reserve requirement
III. currency requirement

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4.1.8 Margin requirements and other tools:

In some countries, central banks may have other tools that work indirectly to limit lending
practices and otherwise restrict or regulate capital markets. For example, a central bank may
regulate margin lending, whereby individuals or companies may borrow against pledged
securities. The margin requirement establishes a minimum ratio of the value of the securities to
the amount borrowed.

Central banks often have requirements for the quality of assets that may be held by financial
institutions; these requirements may act as a limit on the amount of risk and leverage created by
the financial system. These requirements may be direct, such as requiring certain assets to bear
certain minimum credit ratings, or indirect, by the central bank lending to counterparties only
when security of a certain quality is pledged as collateral.

In some countries a central bank, through its subsidiaries, controls and monitors the banking
sector. In other countries banking supervision is carried out by a government department such as
the UK Treasury, or by an independent government agency (for example, UK's Financial
Conduct Authority). It examines the banks' balance sheets and behaviour and policies toward
consumers. Apart from refinancing, it also provides banks with services such as transfer of funds,
bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Many countries such as the United States will monitor and control the banking sector through
different agencies and for different purposes, although there is usually significant cooperation
between the agencies. For example, money center banks, deposit-taking institutions, and other
types of financial institutions may be subject to different (and occasionally overlapping)
regulation. Some types of banking regulation may be delegated to other levels of government,
such as state or provincial governments.

Any cartel of banks is particularly closely watched and controlled. Most countries control bank
mergers and are wary of concentration in this industry due to the danger of groupthink and

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runaway lending bubbles based on a single point of failure, the credit culture of the few large
banks.

4.1.9 Independence:

In the 2000s there has been a trend towards increasing the independence of central banks as a
way of improving long-term economic performance. However, while a large volume of
economic research has been done to define the relationship between central bank independence
and economic performance, the results are ambiguous.

Advocates of central bank independence argue that a central bank which is too susceptible to
political direction or pressure may encourage economic cycles ("boom and bust"), as politicians
may be tempted to boost economic activity in advance of an election, to the detriment of the
long-term health of the economy and the country. In this context, independence is usually
defined as the central bank's operational and management independence from the government.

The literature on central bank independence has defined a number of types of independence.

 Legal independence

The independence of the central bank is enshrined in law. This type of independence is limited in
a democratic state; in almost all cases the central bank is accountable at some level to
government officials, either through a government minister or directly to a legislature. Even
defining degrees of legal independence has proven to be a challenge since legislation typically
provides only a framework within which the government and the central bank work out their
relationship.

 Goal independence

The central bank has the right to set its own policy goals, whether inflation targeting, control of
the money supply, or maintaining a fixed exchange rate. While this type of independence is more

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common, many central banks prefer to announce their policy goals in partnership with the
appropriate government departments. This increases the transparency of the policy setting
process and thereby increases the credibility of the goals chosen by providing assurance that they
will not be changed without notice. In addition, the setting of common goals by the central bank
and the government helps to avoid situations where monetary and fiscal policy are in conflict; a
policy combination that is clearly sub-optimal.

 Operational independence

The central bank has the independence to determine the best way of achieving its policy goals,
including the types of instruments used and the timing of their use. This is the most common
form of central bank independence. The granting of independence to the Bank of England in
1997 was, in fact, the granting of operational independence; the inflation target continued to be
announced in the Chancellor's annual budget speech to Parliament.

 Management independence

The central bank has the authority to run its own operations (appointing staff, setting budgets,
and so on.) without excessive involvement of the government. The other forms of independence
are not possible unless the central bank has a significant degree of management independence.
One of the most common statistical indicators used in the literature as a proxy for central bank
independence is the "turn-over-rate" of central bank governors. If a government is in the habit of
appointing and replacing the governor frequently, it clearly has the capacity to micro-manage the
central bank through its choice of governors.

It is argued that an independent central bank can run a more credible monetary policy, making
market expectations more responsive to signals from the central bank. Recently, both the Bank of
England (1997) and the European Central Bank have been made independent and follow a set of
published inflation targets so that markets know what to expect. Even the People's Bank of
China has been accorded great latitude due to the difficulty of problems it faces, though in
the People's Republic of China the official role of the bank remains that of a national bank rather

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than a central bank, underlined by the official refusal to "unpeg" the yuan or to revalue it "under
pressure". The People's Bank of China's independence can thus be read more as independence
from the USA which rules the financial markets, than from the Communist Party of China which
rules the country. The fact that the Communist Party is not elected also relieves the pressure to
please people, increasing its independence.

Governments generally have some degree of influence over even "independent" central banks;
the aim of independence is primarily to prevent short-term interference. For example, the Board
of Governors of the U.S. Federal Reserve are nominated by the President of the U.S. and
confirmed by the Senate. The Chairman and other Federal Reserve officials often testify before
the Congress.

International organizations such as the World Bank, the Bank for International Settlements (BIS)
and the International Monetary Fund (IMF) are strong supporters of central bank independence.
This results, in part, from a belief in the intrinsic merits of increased independence. The support
for independence from the international organizations also derives partly from the connection
between increased independence for the central bank and increased transparency in the policy-
making process. The IMF's Financial Services Action Plan (FSAP) review self-assessment, for
example, includes a number of questions about central bank independence in the transparency
section. An independent central bank will score higher in the review than one that is not
independent.

4.2 Ethiopian Financial System

The agreement that was reached in 1905 between Emperor Minilik II and Mr.Ma Gillivray,
representative of the British owned National Bank of Egypt marked the introduction of modern
banking in Ethiopia. Following the agreement, the first bank called Bank of Abyssinia was
inaugurated in Feb.16, 1906 by the Emperor. The Bank was totally managed by the Egyptian
National Bank and the following rights and concessions were agreed upon the establishment of
Bank of Abyssinia:- [information are obtained from National Bank of Ethiopia, 2015]

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 A. The capital of the Bank was agreed to be Pound Sterling 500,000 and one-
fifth was subscribed and the rest was to be obtained by selling shares in
some important cities such as London, Paris and New York.
B. The Bank was given full rights to issue bank notes and monitor coins
which were to be legal tender and all the profits there from a ruing to the
bank and freely exchangeable against gold and silver on cover by the Bank
as well as to establish silver coins and abolish the Maria Theresa.
C. Land was given to the Bank free of charges & permitted to build offices
and warehouses. Government and public funds were to be deposited with
the bank and all payments to be made by checks.
D. The government promised not to allow any bank to be established in the
country within the 50-year concession period.
Within the first fifteen years of its operation, Bank of Abyssinia opened
branches in different areas of the country. In 1906 a branch in Harar
(Eastern Ethiopia) was opened at the same time of the inauguration of
Bank of Abyssinia in Addis Ababa. Another at Dire Dawa was opened two
years later and at Gore in 1912 and at Dessie and Djibouti in 1920. Mac
Gillivray, the then representative and negotiator of Bank of Egypt, was
appointed to be the governor of the new bank and he was succeeded by H
Goldie, Miles Backhouse, and CS Collier were in change from 1919 until
the Bank’s liquidation in 1931.

The society at that time being new for the banking service, Bank of Abyssinia had faced
difficulty of familiarizing the public with it. It had also need to meet considerable cost of
installation and the costly journeys by its administrative personnel. As a result, despite its
monopolistic position, the Bank earned no profit until 1914. Profits were recorded in 1919, 1920
and from 1924 onwards.

Generally, in its short period of existence, Bank of Abyssinia had been carrying out limited
business such as keeping government accounts, some export financing and undertaking various
tasks for the government. Moreover, the Bank faced enormous pressure for being inefficient and
purely profit motivated and reached an agreement to abandon its operation and be liquidated in

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order to disengage banking from foreign control and to make the institution responsible to
Ethiopia’s credit needs. Thus by 1931 Bank of Abyssinia was legally replaced by Bank of
Ethiopia shortly after Emperor Haile Selassie came to power.

The new Bank, Bank of Ethiopia, was a purely Ethiopian institution and was the first indigenous
bank in Africa and established by an official decree on August 29, 1931 with capital of £750,000.

Bank of Egypt was willing to abandon its on cessionary rights in return for a payment of Pound
Sterling 40,000 and the transfer of ownership took place very smoothly and the offices and
personnel of the Bank Of Abyssinia including its manager, Mr. Collier, being retained by the
new Bank. Ethiopian government owned 60 percent of the total shares of the Bank and all
transactions were subject to scrutiny by its Minister of Finance.

Bank of Ethiopia took over the commercial activities of the Bank of Abysinia and was authorized
to issue notes and coins. The Bank with branches in Dire Dawa, Gore, Dessie, Debre Tabor,
Harar, agency in Gambella and a transit office in Djibouti continued successfully until the Italian
invasion of the country in 1935.

During the invasion, the Italians established branches of their main Banks namely Banca d’Italia,
Banco di Roma, Banco di Napoli and Banca Nazionale del lavoro and started operation in the
main towns of Ethiopia. However, they all ceased operation soon after liberation except Banco di
Roma and Banco di Napoli which remained in Asmara.

In 1941 another foreign bank, Barclays Bank, came to Ethiopia with the British troops and
organized banking services in Addis Ababa, until its withdrawal in 1943. Then on 15th April
1943, the State Bank of Ethiopia commenced full operation after 8 months of preparatory
activities. It acted as the central Bank of Ethiopia and had a power to issue bank notes and coins
as the agent of the Ministry of Finance. In 1945 and 1949 the Bank was granted the sole right of
issuing currency and deal in foreign currency. The Bank also functioned as the principal
commercial bank in the country and engaged in all commercial banking activities.

The State Bank of Ethiopia had established 21 branches including a branch in Khartoum, Sudan

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and a transit office on Djibouti until it eased to exist by bank proclamation issued on December,
1963. Then the Ethiopian Monetary and Banking law that came into force in 1963 separated the
function of commercial and central banking creating National Bank of Ethiopia and commercial
Bank of Ethiopia. Moreover it allowed foreign banks to operate in Ethiopia limiting their
maximum ownership to be 49 percent while the remaining balance should be owned by
Ethiopians.

The National Bank of Ethiopia with more power and duties started its operation in January 1964.
Following the incorporation as a share company on December 16, 1963 as per proclamation
No.207/1955 of October 1963, Commercial Bank of Ethiopia took over the commercial banking
activities of the former State Bank of Ethiopia. It started operation on January 1,1964 with a
capital of Eth. Birr 20 million. In the new Commercial Bank of Ethiopia, in contrast with the
former State Bank of Ethiopia, all employees were Ethiopians.

There were two other banks in operation namely Banco di Roma S. . and Bank o di Napoli S.C.
that later reapplied for license according to the new proclamation each having a paidup capital of
Eth. Birr 2 million.

The first privately owned bank, Addis Ababa Bank share company, was established on
Ethiopians initiative and started operation in 1964 with a capital of 2 million in association with
National and Grindlay Bank, London which had 40 percent of the total share. In 1968, the
original capital of the Bank rose to 5.0 million and until it ceased operation, it had 300 staff at 26
branches.

There were other financial institutions operating in the country like the Imperial Savings and
Home Ownership public Association (ISHOPA) which specialized in providing loans for the
construction of residential houses and to individuals under the guarantee of their savings. There
was also the Saving and Mortgage Corporation of Ethiopia whose aims and duties were to accept
savings and trust deposits account and provide loans for the construction, repair and
improvement of residential houses, commercial and industrial buildings and carry out all
activities related to mortgage operations.

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On the other hand, there was a bank called Agricultural Bank that provides loan for the
agricultural and other relevant projects established in 1945. But in 1951 the Investment Bank of
Ethiopia replaced it. In 1965, the name of the bank once again hanged to Ethiopian Investment
Corporation Share Company and the capital raised to Eth. Birr 20 million, which was fully paid
up. However, proclamation No.55 of 1970 established the Agricultural and Industrial
Development Bank Share Company by taking over the asset and liability of the former
Development Bank and Investment Corporation of Ethiopia.

Following the declaration of socialism in 1974 the government extended its control over the
whole economy and nationalized all large corporations. Organizational setups were taken in
order to create stronger institutions by merging those that perform similar functions.
Accordingly, the three private owned banks, Addis Ababa Bank, Banco di Roma and Banco di
Napoli Merged in 1976 to form the second largest Bank in Ethiopia called Addis Bank with a
capital of Eth. birr 20 million and had a staff of 480 and 34 branches. Before the merger, the
foreign participation of these banks was first nationalized in early 1975.

Then Addis Bank and Commercial Bank of Ethiopia S.C . were merged by proclamation No.184
of August 2, 1980 to form the sole commercial bank in the country till the establishment of
private commercial banks in 1994. The Commercial Bank of Ethiopia commenced its operation
with a capital of Birr 65 million, 128 branches and 3,633 employees. The Savings and Mortgage
Corporation S. . and Imperial Saving and Home Ownership Public Association were also merged
to form the Housing and Saving Bank with working capital of Birr 6.0 million and all rights,
privileges, assets and liabilities were transferred by proclamation No.60, 1975 to the new bank.

Proclamation No.99 of 1976 brought into existence the Agricultural and Industrial Bank, which
was formed in 1970 as a 100 percent state ownership, was brought under the umbrella of the
National Bank of Ethiopia. Then it was reestablished by proclamation No. 158 of 1979 as a
public finance agency possessing judicial personality and named Agricultural and Industrial
Development Bank (AIDB). It was entrusted with the financing of the economic development of
the agricultural, industrial and other sectors of the national economy extending credits of medium
and long-term nature as well as short-term agricultural production loans.

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The financial sector that the socialist oriented government left behind constituted only 3 banks
and each enjoyed monopoly in its respective market. The following was the structure of the
sector at the end of the era.
 The National Bank of Ethiopia (NBE)
 The Commercial Bank of Ethiopia (CBE)
 Agricultural and Industrial Development Bank (AIDB)

Following the overthrow of the Dergue regime in 1991 that ruled the country for 17 years under
the rule of command economy, the EPRDF declared a liberal economy system. In line with this,
Monetary and Banking proclamation of 1994 established the national bank of Ethiopia as a
judicial entity, separated from the government and outlined its main function.

Monetary and Banking proclamation No.83/1994 and the Licensing and Supervision of Banking
Business No.84/1994 laid down the legal basis for investment in the banking sector.
Consequently several private commercial banks were established.

On the other hand, modern forms of insurance service, which were introduced in Ethiopia by
Europeans, trace their origin as far back as 1905 when the Bank of Abyssinia began to transact
fire and marine insurance as an agent of a foreign insurance company. According to a survey
made in 1954, there were 9 insurance companies that were providing insurance service in the
country.

Except Imperial Insurance company that was established in 1951, the rest of the insurance
companies were branches or agents of foreign companies. The number of insurance companies
increased significantly and reached 33 in 1960. At that time insurance business like any business
undertaking was classified as trade and was administered by the provisions of the commercial
code. This was the only legislation in force in respect of insurance except the maritime code of
Ethiopia that was issued to govern the operations of maritime business and the related marine
insurance. The minimum paid-up capital required to establish an insurance company was as little
as 12,500 Ethiopian dollars as stipulated in the commercial code. There was no restriction on
foreign insurers.

The first remarkable event that the Ethiopian insurance market witnessed was the promulgation
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of proclamation No. 281/1970. This proclamation was issued to provide for the control &
regulation of insurance business in Ethiopia. It is peculiar in that it created an Insurance Council
and an Insurance Controller's Office.

The controller of insurance licensed 15 domestic insurance companies, 36 agents, 7 brokers, 3

actuaries & 11 assessors in accordance with the provisions of the proclamation immediately in
the year after the issuance of the law.

The law required an insurer to be a domestic company whose share capital (fully subscribed) to
be not less than Ethiopian dollars 400,000 for a general insurance business and Ethiopian dollars
600,000 in the case of long-term insurance business and Ethiopian dollars 1,000,000 to do both
long-term & general insurance business. Non-Ethiopian nationals were not barred from
participating in insurance business. However, the proclamation defined 'domestic company' as a
share company having its head office in Ethiopia and in the case of a company transacting a
general insurance business at least 51% and in the case of a company transacting life insurance
business, at least 30% of the paid-up capital must be held by Ethiopian nationals or national
companies.

Four years after the enactment of the proclamation, the military government that came to power
in 1974 put an end to all private entrepreneurship. Then all insurance companies operating were
nationalized and from January 1, 1975 onwards the government took over the ownership and
control of these companies & merged them into a single unit called Ethiopian Insurance
Corporation. In the years following nationalization, Ethiopian Insurance Corporation became the
sole operator.

Following the change in the political environment in 1991, the proclamation for the licensing and
supervision of insurance business heralded the beginning of a new era. Immediately after the
enactment of the proclamation private insurance companies began to flourish. Currently There
are 16 private banks and 3 government-owned banks, 17 private and 1 government owned
insurance companies, and 38 MFIs (as of June, 2015.)

Although banking business in Ethiopia dates back to this, the National Bank of Ethiopia (NBE)
was established in 1963 by proclamation 206 of 1963 and began operation in January 1964. Prior
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to this proclamation, the Bank used to carry out dual activities, i.e. commercial banking and
central banking. The National Bank of Ethiopia was entrusted with the following responsibilities.
 To regulate the supply, availability and cost of money and credit.
 To manage and administer the country's international reserves.
 To license and supervise banks and hold commercial banks
reserves and lend money to them.
 To supervise loans of commercial banks and regulate interest rates.
 To issue paper money and coins.
 To act as an agent of the Government.
 To fix and control the foreign exchange rates.

However, monetary and banking proclamation No. 99 of 1976 came into force on September
1976 to shape the Bank's role adoring to the socialist economic principle that the country
adopted. Hence the Bank was allowed to participate actively in national planning, specifically
financial planning, in cooperation with the concerned state organs. The Bank's supervisory area
was also increased to include other financial institutions such as insurance institutions, credit
cooperatives and investment-oriented banks. Moreover the proclamation introduced the new
Ethiopian currency called 'birr' in place of the former Ethiopia Dollar that eased to be legal tender
thereafter.

The proclamation revised the Bank's relationship with Government. It initially raised the legal
limits of outstanding government domestic borrowing to 25% of the actual ordinary revenue of
the government during the preceding three budget years as against the proclamation 206/1963,
which set it to be 15%.

This proclamation was in force till the new proclamation issued in 1994 to reorganize the Bank
according to the market-based economic policy so that it could foster monetary stability, a sound
financial system and such other credit and exchange conditions as are conducive to the balanced
growth of the economy of the country. Accordingly the following are some of the powers and
duties vested in the Bank by proclamation 83/1994.
A. Regulate the supply and availability of money & credit and applicable
interest and other changes.

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 B. Set limits on gold and foreign exchange assets which banks and other
financial institutions authorized to deal in foreign exchange an hold in
deposits.
C. Set limits on the net foreign exchange position and on the terms and
amount of external indebtedness of banks and other financial institutions.
D. Make short and long-term refinancing facilities available to banks and
other financial institutions.
Moreover, the proclamation has also raised the paid-up capital of the Bank
from Birr 30.0 million to Birr 50.0 million.

Currently, (June, 2015) we have, over 30,000,000 people employed by the financial institutions
alone. Use of technology is rampant, products are diversified, effort to bank the unbanked public
is [financial inclusion effort in general] is significant. Banks, insurance, and microfinance
institutions, through their branches and networks, have reached/ proliferated to much more places
of the country than ever. Still, however, there is more to be done to strengthen the institutions to
make them capable of withstanding shocks during adverse economic conditions or when
challenged by entry of foreign banks-which is not yet legalized.

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 MODULE II
BANK RISK MANAGEMENT
Module Introduction

This module will provide adequate exposure to the concept of risk in the context of financial
institutions and will also identify the types of risk banks, in particular, are exposed to. It is to
deliberate on the unforeseen circumstances a banking business is likely face. It will bring
together the best practices financial institutions are advised to put in place in their system to try
to ward off risk in its multi facets.

Module Objectives

Candidates who complete this module successfully are expected to be able to:
 Describe risk in the context of financial institutions
 Identify the types of risk prevalent in the financial institutions
 Determine the levels of risk management responsibilities of different units in an
institution
 Outline how different types of risk in financial institutions can be managed
 Outline the tasks that different management hierarchies will be responsible with

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 Unit I
Banking Risk

Unit Introduction

This unit will dwell on the task of describing the nature of risk that Financial institutions/banks
are likely to face. It will explain to you what its features are and how it affects business. It will
also discuss on the types of risk and their peculiar nature.

Unit Objectives
After completing this unit, you will be able to;
 Describe risk
 Identify the types of risk financial institutions are exposed to
 Determine the unique nature of each type of risk and its relationship with other
forms

1.1 Nature of Risk

Like other kinds of businesses, banks and other financial institutions shoulder risks in
order to realize returns on their investments. On the other hand, risks assumed have
the potential to wipe out expected returns and may result into losses to the
institutions. These losses could be either expected or unexpected. Expected losses are
those that an institution knows with reasonable certainty will occur (e.g. the
expected default rate of loan portfolio) and are typically reserved for in some manner.

Unexpected losses are those associated with unforeseen events (e.g. losses due to a
sudden downturn in market conditions, falling interest rates, natural disasters
resulting in major business failures, or human action that affects business).
Institutions rely on their capital as a buffer to absorb such losses.

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Due to this fact, there is the need to know the types of risk, their nature and how they
can be managed to reduce their impact on the value of the firm. Hence, the need for
effective risk management framework in institutions cannot be over emphasized.
Through effective risk management framework, institutions will be able to optimize
their risk-return trade off too. However, let us first understand the nature of risk.

1.2 Risk in Financial Services

It seems appropriate to begin the discussion of the place of risk and risk management in the
financial sector with the two key issues, viz., why risk matters and what approaches can be taken
to mitigate the risks that are an integral part of the sector’s product array. Understanding these
two issues leads to a greater appreciation of the nature of the challenge facing managers in the
financial community. Specifically, it explains why managers wish to reduce risk, and approaches
taken to mitigate something that is an inherent part of the financial services offered by these
firms.

Why Does Risk Matter?

According to standard economic theory, firm managers ought to maximize expected profits
without regard to the variability of reported earnings. However, there is now a growing literature
on the reasons for managerial concern over the volatility of financial performance, dating back,
as many argue to early eighties. An economist called Stulz was the first to offer a viable
economic reason why firm managers might concern themselves with both expected profit and the
variability around this value. Since that time a number of alternative theories and explanations
have been offered to justify active risk management, with a recent review of the literature
presenting four distinct rationales. These include:
o managerial self-interest
o tax effects
o the cost of financial distress
o capital market imperfections

In each case, the volatility of profit leads to a lower value to at least some of the firm ’s

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stakeholders. In the first case, it is noted that managers have limited ability to diversify their
investment in their own firm, due to limited wealth and the concentration of human capital
returns in the firm they manage. This fosters risk aversion and a preference for stability. In the
second case, it is noted that, with progressive tax schedules, the expected tax burden is reduced
by reduced volatility in reported taxable income. The third and fourth explanations focus on the
fact that a decline in profitability has a more than proportional impact on the firm ’s fortunes.
Financial distress is costly and the cost of external financing increases rapidly when firm
viability is in question.

Any one of these reasons is sufficient to motivate management to concern itself with risk and
embark upon a careful assessment of both the level of risk associated with any financial product
and potential risk mitigation techniques.

1.3 Common Types of Risk in Financial Institutions

These thought s cover six most common risks in banking i.e. credit, liquidity,
market, operational, strategic and compliance risks. Description of these risks is as
follows:
(a) Credit Risk: Credit risk arises from the potential that an
obligor is either unwilling to perform on an obligation or its ability
to perform such obligation is impaired resulting in economic loss to
the institution.

(b) Liquidity Risk: Liquidity risk is the potential for loss to an

institution arising from either its inability to meet its obligations as
they fall due or to fund increases in assets without
incurring unacceptable cost or losses. Liquidity risk includes
inability to manage unplanned decreases or changes in funding
sources. Liquidity risk also arises from the failure to recognize or
address changes in market conditions that affect the ability to
liquidate assets quickly and with minimal loss in value.

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 (c) Market Risk: Market risk is the risk of losses in on and off
balance sheet positions as a result of adverse changes in market
prices i.e. interest rates, foreign exchange rates, equity prices
and commodity prices. Market risk exists in both trading and
banking book. A trading book consists of positions in financial
instruments and commodities held either with trading intent or
in order to hedge other elements of the trading book.

(d) Operational Risk: Operational risk is the current and

prospective risk to earnings and capital arising from inadequate or
failed internal processes, people and systems or from external
events.

(e) Strategic Risk: Strategic risk is the current and prospective impact
on earnings, capital, reputation or good standing of an institution
arising from poor business decisions, improper implementation of
decisions or lack of response to industry, economic or
technological changes. This risk is a function of the compatibility
of an organization’s strategic goals, the business strategies
developed to achieve these goals, the resources deployed to meet
these goals and the quality of implementation.

(f) Compliance Risk: Compliance risk is the current or

prospective risk to earnings, capital and reputation arising from
violations or non-compliance with laws, rules,
regulations, agreements, prescribed practices, or ethical standards,
as well as from incorrect interpretation of relevant laws or
regulations. Institutions are exposed to Compliance risk due to
relations with a great number of stakeholders, e.g. regulators,
customers, counter parties, as well as, tax authorities, local
authorities and other authorized agencies.

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 Self Test Question 2.1
 As per most economists’ views, what are the rationale for being bothered about
risk?
 What are the types of risk financial institutions are exposed to?

Self Test Question 2.2

I. Identify the types of risk banks are likely to face
II. How would credit risk affect liquidity of a bank?

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 Unit 2
Risk Management Essentials in Financial Institutions
Unit Introduction

This unit will discuss the purpose and objectives of managing financial institution based
risks. It will elaborate the need for the risk management framework in banks/financial
institutions, how it is implemented and who are responsible in each stage of work. It will
elaborate the duties and responsibilities of units and groups in a functioning financial
institution that will effectively undermine risk exposure.

Unit objectives
At the end of this unit, you would be able to;
 describe what risk management is
 identify the parties involved in managing each type of risk a financial institution is
exposed to
 determine the tasks each participant unit in a financial institution is to do to manage
each type of risk
 explain the role of a supervisory organ that the government establishes to oversee
financial institutions.

Institutions may have different risk management systems in place depending

on their sizes and complexity. Due to this, in every country, the instititution
entrusted to control and supervise financial institutions, NBE in our case, requires each
institution to prepare a comprehensive Risk Management Programme (RMP) tailored to
its needs and circumstances under which it operates. The RMPs should be reviewed at
least annually. It is expected that RMPs prepared by institutions should at minimum
cover the six risks contained in these thoughts:

2.1 Risk Management

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Risk Management is a discipline at the core of every f i n a n c i a l institution and
encompasses all the activities that affect its risk profile. Risk management is
commonly perceived as getting rid of risk. It does not mean so; rather the goal of
risk management is to optimize risk-reward trade-off. This can be achieved through
putting in place an effective risk management framework which can adequately capture
and manage all risks a financial institution is exposed to. Risk Management entails
four key processes:

Risk Identification: In order to manage risks, an institution must identify

existing o f risks or risks that may arise from both existing and new business
initiatives for example, risks inherent in lending activity include credit,
liquidity, interest rate and operational risks. Risk identification should be a
continuing process, and should occur at both the transaction and portfolio level.

Risk Measurement: Once risks have been identified, they should be measured
in order to determine their impact on the institution’s profitability and
capital. This can be done using various techniques ranging from simple to
sophisticated models. Accurate and timely measurement of risk is essential to
effective risk management systems. An institution that does not have a risk
measurement system has limited ability to control or monitor risk levels. An
institution should periodically test to make sure that the measurement tools it
uses are accurate. Good risk measurement systems assess the risks of both
individual transactions and portfolios.

Risk Control: After measuring risk, an institution should establish and

communicate risk limits through policies, standards, and procedures that define
responsibility and authority. Institutions may also apply various mitigating
tools in minimizing exposure to various risks. Institutions should have a process
to authorize exceptions or changes to risk limits when warranted.

Risk Monitoring: Institutions should put in place an effective management

information system (MIS) to monitor risk levels and facilitate timely review of

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 risk positions and exceptions. Monitoring reports should be frequent, timely,
accurate, and informative and should be distributed to appropriate individuals to
ensure action, when needed.

Self Test Question 2.3

I. What are the four main activities of risk management process?
II. How do you explain each of this activities?

2.2 Risk Management Framework

A risk management framework encompasses the scope of risks to be managed, the

process/systems and procedures to manage those risks and the roles and responsibilities
of individuals involved in risk management. The framework should be comprehensive
enough to capture all risks an institution is exposed to and have flexibility to
accommodate any change in business activities. Key elements of an effective risk
management framework are:

(a) Active board and senior management oversight;

(b) Adequate policies, procedures and limits;
(c) Adequate risk measurement, monitoring and management
information systems; and
(d) Comprehensive internal controls.

2.2.1 Active Board and Senior Management Oversight

Boards of directors have ultimate responsibility for the level of risk taken by their
institutions. Accordingly, they should approve the overall business strategies and
significant policies of their institutions, including those related to managing and taking
risks, and should also ensure that senior management is fully capable of managing the
activities that their institutions conduct.

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While all boards of directors are responsible for understanding the nature of the
risks significant to their institutions and for ensuring that management is taking the
steps necessary to identify, measure, monitor, and control these risks, the level of
technical knowledge required of directors may vary depending on the particular
circumstances at the institution.

Directors should have a clear understanding of the types of risks to which their institutions are
exposed and should receive reports that identify the size and significance of the risks in terms
that are meaningful to them. In addition, directors should take steps to develop an appropriate
understanding of the risks their institutions face, possibly through briefings from
auditors and experts external to the institution. Using this knowledge and information,
directors should provide clear guidance regarding the level of exposures acceptable to
their institutions and have the responsibility to ensure that senior management implements
the procedures and controls necessary to comply with adopted policies.

Senior management is responsible for implementing strategies in a manner that limits

risks associated with each strategy and that ensures compliance with laws and
regulations on both a long- term and day-to-day basis. Accordingly, management
should be fully involved in the activities of their institutions and possess sufficient
knowledge of all major business lines to ensure that appropriate policies, controls, and
risk monitoring systems are in place and that accountability and lines of authority are
clearly delineated.

REMEMBER!

The key elements of risk management framework are:

 Active board and senior management oversight;

 Adequate policies, procedures and limits;
 Adequate risk measurement, monitoring and management
information systems; and
 Comprehensive internal controls.

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Senior management is also responsible for establishing and communicating a
strong awareness of and need for effective internal controls and high ethical standards.
Meeting these responsibilities requires senior managers of an institution to have a
thorough understanding of banking and financial market activities and detailed
knowledge of the activities their institution conducts, including the nature of
internal controls necessary to limit the related risks.

2.2.2 `Adequate Policies, Procedures and Limits

An institution's directors and senior management should tailor their risk

management policies and procedures to the types of risks that arise from the activities
the institution conducts. Once the risks are properly identified, the institution's
policies and its more fully articulated procedures provide detailed guidance for the
day-to-day implementation of broad business strategies, and generally include limits
designed to shield the institution from excessive and imprudent risks. While all
institutions should have policies and procedures that address their significant
activities and risks, management is expected to ensure that they are modified when
necessary to respond to significant changes in the institution's activities or business
conditions.

To ensure that, an institution's policies, procedures, and limits are adequate, the same
should at minimum address the following:

(i) Policies, procedures, and limits should provide for adequate

identification, measurement, monitoring, and control of the
risks posed by its significant activities;

(ii) Policies, procedures, and limits should be consistent with

complexity and size of the business, the institution's stated
goals and objectives, and the overall financial strength of the
institution;

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 (iii) Policies should clearly delineate accountability and lines of
authority across the institution's activities; and

(iv) Policies should provide for the review of activities new to the
institution to ensure that the infrastructures necessary to
identify, monitor, and control risks associated with an activity are
in place before the activity is initiated.

2.2.3 Adequate Risk Measurement, Monitoring and Management

Information Systems

Effective risk monitoring requires institutions to identify and measure all

material risk exposures. Consequently, risk monitoring activities must be supported by
information systems that provide senior managers and directors with timely reports on the
financial condition, operating performance, and risk exposure of the institution, as well as
with regular and sufficiently detailed reports for line managers engaged in the day-to-
day management of the institution's activities.

Institutions should have risk monitoring and management information systems in

place that provide directors and senior management with a clear understanding of the
institution's positions and risk exposures.

In order to ensure effective measurement and monitoring of risk and management

information systems, the following should be observed:

(a) the institution's risk monitoring practices and reports address all of
its material risks;

(b) key assumptions, data sources, and procedures used in measuring

and monitoring risk are appropriate and adequately documented
and tested for reliability on an on- going basis;

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 (c) reports and other forms of communication are consistent with
the institution's activities, structured to monitor exposures
and compliance with established limits, goals, or objectives and,
as appropriate, compare actual versus expected performance; and

d) reports to management or to the institution's directors are

accurate and timely and contain sufficient information for decision-
makers to identify any adverse trends and to evaluate adequately
the level of risk faced by the institution.

2.2.4 Adequate Internal Controls

An institution's internal control structure is critical to its safe and sound functioning
generally and to its risk management system, in particular. Establishing and
maintaining an effective system of controls, including the enforcement of official lines
of authority and the appropriate separation of duties such as trading, custodial,
and back-office is one of management's more important responsibilities.

Indeed, appropriately segregating duties is a fundamental and essential element of a

sound risk management and internal control system. Failure to implement and
maintain an adequate separation of duties can constitute an unsafe and unsound practice
and possibly lead to serious losses or otherwise compromise the financial integrity of
the institution. Serious lapses or deficiencies in internal controls, including inadequate
segregation of duties, may warrant supervisory action.

When properly structured, a system of internal controls promotes effective operations

and reliable financial and regulatory reporting, safeguards assets, and helps to
ensure compliance with relevant laws, regulations, and institutional policies. Internal
controls should be tested by an independent internal auditor who reports directly
either to the institution's board of directors or its audit committee. Given the
importance of appropriate internal controls, the results of audits or reviews, whether

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conducted by an internal auditor or by other personnel, should be adequately
documented, as should management's responses to them.

In order to ensure the adequacy of an institution's internal controls and audit procedures,
the following should be observed:

(a) the system of internal controls is appropriate to the type and

level of risks posed by the nature and scope of the institution's
activities;
(b) the institution's organizational structure establishes clear lines
of authority and responsibility for monitoring adherence to
policies, procedures, and limits;

(c) reporting lines provide sufficient independence of the

control areas from the business lines and adequate separation of
duties throughout the institution such as those relating to trading,
custodial, and back-office activities;

(d) official institutional structures reflect actual operating practices;

(e) financial, operational, and regulatory reports are reliable, accurate,

and timely; wherever applicable, exceptions are noted and
promptly investigated;

(f) adequate procedures exist for ensuring compliance with applicable

laws and regulations;

(g) internal audit or other control review practices provide for

independence and objectivity;

(h) internal controls and information systems are adequately tested and
reviewed; the coverage, procedures, findings, and responses to

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 audits and review tests are adequately documented; identified
material weaknesses are given appropriate and timely high level
attention; and management's actions to address material
weaknesses are objectively verified and reviewed; and

(i) the institution's audit committee or board of directors reviews

the effectiveness of internal audits and other control review
activities on a regular basis.

2.3 Role of Risk Management Function

Institutions should put in place a setup that supervises overall risk management
responsible for overseeing management of risks inherent in their operations. Such a
setup could be in a form of risk manager, committee or department depending on the
size and complexity of the institution. Overall risk management function should
be independent from those who take or accept risks on behalf of the institution.

The risk management function is responsible for ensuring that effective processes
are in place for:

(i) Identifying current and emerging risks;

(ii) Developing risk assessment and measurement systems;

(iii) Establishing policies, practices and other control

mechanisms to manage risks;

(iv) developing risk tolerance limits for Senior Management and board
approval;

(v) monitoring positions against approved risk tolerance limits;

and

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 (vi) reporting results of risk monitoring to Senior Management and
the board.
However, it must not be construed that risk management is only restricted to
individual(s) responsible for overall risk management function. Business lines are
equally responsible for the risks they are taking. Because line personnel, more than
anyone else, understand the risks of the business, such a lack of accountability can lead to
problems.

2.4 Independent Review

Institutions should ensure that there is an independent person(s) responsible for

reviewing the effectiveness of, and adherence to, the institution’s risk management
policies and practices. These could be internal auditor, external auditors or any
other person(s) who should be independent from risk taking units and should report
directly to the board or its designated committee. To be effective the independent
reviewer(s) should have sufficient authority, expertise and corporate stature so
that the identification and reporting of their findings could be accomplished
without hindrance. Such an independent reviewer should consider, among others, the
following:

(a) whether the institution's risk management system is appropriate

to the nature, scope, and complexity of the institution and its
activities;

(b) whether the institution has an independent risk management

function;

(c) whether the board of directors and senior management are actively
involved in the risk management process;

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 (d) whether policies, controls and procedures concerning risk
management are well documented and complied with;

(e) whether the assumptions of the risk measurement system are

valid and well documented, data accurately processed,
and data aggregation is proper and reliable; and

(f) whether the institution has adequate staffing to conduct a sound

risk management process.

2.5 Integration of Risk Management

Risks must not be viewed and assessed in isolation, not only because a single
transaction might have a number of risks but also one type of risk can trigger other
risks. Since interaction of various risks could result in diminution or increase in risk, the
risk management process should recognize and reflect risk interactions in all business
activities as appropriate. While assessing and managing risk the management should
have an overall view of risks the institution is exposed to. This requires having a
structure in place to look at risk interrelationships across the institution.

2.6 Contingency Planning

Institutions should have a mechanism to identify stress situations ahead of time and
plans to deal with such unusual situations in a timely and effective manner. Stress
situations to which this principle applies include risks of all types. For instance
contingency planning activities include disaster recovery planning, public relations
damage control, litigation strategy, responding to regulatory criticism, liquidity crisis,
etc. Contingency plans should be reviewed regularly to ensure they encompass reasonably
probable events that could impact the institution. Plans should be tested as to the
appropriateness of responses, escalation and communication channels and the impact on
other parts of the institution.

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 Unit 3
Managing Specific Risks in Financial Institutions
Unit Introduction

This unit is designed to discuss the kinds of tasks risk managers will be involved in
managing risk. It will identify the types of risk along with the kinds of measures that are
due to take to reduce financial institutions exposure. It will address each type of risk
independently along with the manner in which each will be subdued to the benefit of the
institution.

Unit Objectives
Upon completion of this unit, you will be able to;

 identify what circumstances will expose institutions to what type of risk

 determine what actions are proposed to manage which type of risk

 relate one type of risk to another type of risk and

3.1 Credit Risk Management

Credit risk arises from the potential that an obligor is either unwilling to
perform on an obligation or its ability to perform such obligation is impaired
resulting in economic loss to the institution. Credit risk arises from on balance sheet
claims such as loans and overdrafts as well as off balance sheet commitments such
as guarantees, letters of credit, and derivative instruments. For most institutions,
loans are the largest and most obvious source of credit risk.

In addition, an institution may also be exposed to credit risk when dealing with
foreign exchange operations. This may arise when a domestic borrower involved in
export business fails to compete in foreign markets due to domestic currency
appreciation and thus resulting in inability to repay the domestic loan.

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In an institution’s portfolio, losses stem from outright default due to inability or
unwillingness of a customer or counter party to meet commitments in relation
to lending, trading, settlement and other financial transactions. Alternatively,
losses may result from reduction in portfolio value due to actual or perceived
deterioration in credit quality. Credit risk emanates from an institution ’s dealing
with individuals, corporate, financial institutions or a sovereign.

Credit risk not necessarily occurs in isolation. The same source that endangers
credit risk for the institution may also expose it to other risk. For instance a bad
portfolio may attract liquidity problems.

Common sources of credit problems are:

(a) Credit concentrations: these are viewed as any exposure

where the potential losses are large relative to the institution’s
capital, its total assets or, where adequate measures exist,
the institution’s overall risk level. This may be in the form of
single borrowers or counterparties, a group of connected
counterparties, and sectors or industries, such as trade,
agriculture, etc or in the form of common or correlated
factors e.g. the Asian crisis demonstrated how close linkages
among emerging markets under stress situations and
correlation between market and credit risks as well as
between those risks and liquidity risk, can
produce widespread losses;
(b) Credit process issues: Many credit problems reveal basic
weaknesses in the credit granting and monitoring processes.
While shortcomings in underwriting and management of
credit exposures represent important sources of losses in

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 institutions, many credit problems would have been avoided or
mitigated by a strong internal credit process.

3.1.1 Board and Senior Management’s Oversight

Board Oversight

The board of directors has a critical role to play in overseeing the credit-granting
and credit risk management functions of the institution. It is the overall
responsibility of institution’s board to approve institution’s credit risk strategy and
significant policies relating to credit risk and its management which should
be based on the institution’s overall business strategy. To keep them current, the
overall strategy as well as significant policies have to be reviewed by the board,
at least annually. The responsibilities of the board with regard to credit risk
management shall, inter alia, include :

(a) describing the institution’s overall risk tolerance in relation

to credit risk;

(b) ensuring that institution’s significant credit risk exposure is

maintained at prudent levels and consistent with the
available capital;

(c) setting up the overall lending authority structure

and explicitly delegate credit sanctioning authority, where
appropriate, to senior management and the credit
committee;

(d) ensuring that top management as well as individuals

responsible for credit risk management possess sound

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 expertise and knowledge to accomplish the risk
management function;

(e) ensuring that the institution implements sound fundamental

principles that facilitate the identification, measurement,
monitoring and control of credit risk;

(f) ensuring that appropriate plans and procedures for credit

risk management are in place;

(g) ensuring that internal audit reviews the credit operations

to assess whether or not the institution’s policies
and procedures are adequate and being adhered to;

(h) reviewing exposures to insiders and their related parties,

including policies related thereto;

(i) ratifying exposures exceeding the level of the management

authority delegated to management and be aware of
exposures that, while worthy of consideration ,are not
within the ambits of existing credit policies of the
institution;

(j) reviewing trends in portfolio quality and the adequacy of

institution’s provision for credit losses; and

(k) outlining the content and frequency of management

report to the board on credit risk management.

Self Test Question 2.4

I. What are the main causes of credit risk?

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 II. Describe each how it causes risk.

Senior Management Oversight

Management of institutions is responsible for implementing institution’s

credit risk management strategies and policies and ensuring that the procedures are
put in place to manage and control credit risk and the quality of credit
portfolio in accordance with these policies. The responsibilities of the Senior
Management with regard to credit risk management shall include:

(a) developing credit policies and credit administration

procedures as a part of overall credit risk management
framework for approval by the board;

(b) implementing credit risk management policies;

(c) ensuring the development and implementation of

appropriate reporting system with respect to the content,
format, and frequency of information concerning the credit
portfolio and the credit risk to permit the effective analysis
and the sound and prudent management and control of
existing and potential credit risk exposure;

(d) monitoring and controlling the nature and composition

of the institution’s portfolio;

(e) monitoring the quality of credit portfolio and ensuring that

portfolio is soundly and conservatively valued,
uncollectible exposure written off and probable losses
adequately provided for;

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 (f) establishing internal controls including putting in place
clear lines of accountability and authority to ensure
effective credit risk management process; and

(g) developing lines of communications to ensure the timely

dissemination of credit risk management policies,
procedures and other credit risk management information
to all individuals involved in the process.

3.1.2 Policies, Procedures and Limits

Credit Strategy

The very first purpose of institution’s credit strategy is to determine the risk
appetite of the institution. Once it is determined the institution could develop a
plan to optimize return while keeping credit risk within predetermined limits.
The institution’s credit risk strategy thus should spell out:

(a) the institution’s plan to grant credit based on various

client segments and products, economic sectors,
geographical location, currency and maturity;

(b) target market within each lending segment and level of

diversification/concentration; and

(c) pricing strategy.

It is essential that institutions give due consideration to their target market

while devising credit risk strategy. The credit procedures should aim to
obtain an in depth understanding of the institution’s clients, their
credentials & their businesses in order to fully know their customers.

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 The strategy should provide continuity in approach and take into account
cyclic aspect of country’s economy and the resulting shifts in composition
and quality of overall credit portfolio. While the strategy would be reviewed
periodically and amended, as deemed necessary, it should be viable in long
term and through various economic cycles.

REMEMBER!

The institution’s credit risk strategy thus should spell out:

(a) the institution’s plan to grant credit based on various client segments
and products, economic sectors, geographical location, currency and
maturity;

(b) target market within each lending segment and level of

diversification/concentration; and

(c) pricing strategy.

Policies

Credit policies establish framework for the making of investment and lending
decisions and reflect an institution’s tolerance for credit risk. To be effective,
policies should be communicated in a timely fashion, and should be
implemented through all levels of the institution by appropriate procedures.
Any significant deviation/exception to these policies must be communicated
to the senior management/board and corrective measures should be taken. At
minimum credit policies should include:

(a) general areas of credit in which the institution is prepared to

engage or is restricted from engaging such as type
of credit facilities, type of collateral security, types of

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 borrowers, geographical areas or economic sectors on
which the institution may focus on;

(b) detailed and formalized credit evaluation/ appraisal

process, administration and documentation;

(c) credit approval authority at various hierarchy levels

including authority for approving exceptions such as
credit extension beyond prescribed limits;

(d) concentration limits on single counterparties and groups

of connected counterparties, particular industries or
economic sectors, geographical areas and specific
products. Institutions should ensure that their own internal
exposure limits comply with any prudential limits or
restrictions set by central bank of the country;

(e) authority for approval of allowance for probable losses and

write-offs;

(f) credit pricing;

(g) roles and responsibilities of units/staff involved in

origination and management of credit;

(h) thought s on management of problem loans; and

(i) the credit policy should explicitly provide guidance

for internal rating systems including definition of
each risk grade; criteria to be fulfilled while assigning a

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 particular grade, as well as the circumstances under which
deviations from criteria can take place.

In order to be effective, credit policies must be communicated throughout the

institution, implemented through appropriate procedures, and periodically revised
to take into account changing internal and external circumstances.

Procedures

Credit Origination

Establishing sound, well-defined credit-granting criteria is essential to

approving credit in a safe and sound manner. The criteria should set out who is
eligible for credit and for how much, what types of credit are available, and under
what terms and conditions the credits should be granted.

Institutions must receive sufficient information to enable a comprehensive

assessment of the true risk profile of the borrower or counterparty. At minimum,
the factors to be considered and documented in approving credits must include:
(a) the purpose of the credit and source of repayment;
(b) the integrity and reputation of the borrower or
counterparty;

(c) the current risk profile (including the nature and aggregate
amounts of risks) of the borrower or counterparty and its
sensitivity to economic and market developments;

(d) the borrower’s repayment history and current capacity to

repay, based on historical financial trends and cash flow
projections;

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 (e) a forward-looking analysis of the capacity to repay based
on various scenarios;

(f) the legal capacity of the borrower or counterparty to

assume the liability;

(g) for commercial credits, the borrower’s business

expertise and the status of the borrower’s economic sector
and its position within that sector;

(h) the proposed terms and conditions of the credit, including

covenants designed to limit changes in the future risk
profile of the borrower; and

(i) where applicable, the adequacy and enforceability of

collateral or guarantees.

Once credit-granting criteria have been established, it is essential for the

institution to ensure that the information it receives is sufficient to make
proper credit-granting decisions. This information may also serve as the basis
for rating the credit under the institution’s internal rating system.

Institutions need to understand to whom they are granting credit. Therefore, prior to
entering into any new credit relationship, an Institution must become familiar with
the borrower or counterparty and be confident that they are dealing with an individual or
organization of sound repute and creditworthiness. In particular, strict policies must be
in place to avoid association with individuals involved in fraudulent activities and other
crimes. This can be achieved through a number of ways, including asking for
references from known parties, accessing credit reference bureau, and becoming
familiar with individuals responsible for managing a company and checking their
personal references and financial condition. However, an institution should not grant

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credit simply because the borrower or counterparty is familiar to them or is perceived to
be highly reputable.

Self Test Questions 2.5

Describe the factors to be considered and documented in approving credits.

Institutions should have procedures to identify situations where, in considering

credits, it is appropriate to classify a group of borrowers as connected
counterparties and, thus, as a single borrower. This would include aggregating
exposures to groups of accounts, corporate or non-corporate, under common
ownership or control or with strong connecting links (for example, common
management, family ties).

In loan syndications, participants should perform their own independent credit

risk analysis and review of syndicate terms prior to committing to the
syndication. Each institution should analyze the risk and return on syndicated
loans in the same manner as other loans.

Institutions should assess the risk/return relationship in any credit as well as the
overall profitability of the account relationship. Credits should be priced in such
a way as to cover all of the embedded costs and compensate the institution for
the risks incurred. In evaluating whether, and on what terms, to grant credit,
institutions need to assess the risks against expected return, factoring in, to the
greatest extent possible, price and non-price (e.g. collateral, restrictive covenants,
etc.) terms. In evaluating risk, institutions should also assess likely downside
scenarios and their possible impact on borrowers or counterparties. A
common problem among institutions is the tendency not to price a credit or
overall relationship properly and therefore not receive adequate compensation for
the risks incurred.

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In considering potential credits, institutions must recognize the necessity of
establishing provisions for expected losses and holding adequate capital to
absorb risks and unexpected losses. The institution should factor these
considerations into credit- granting decisions, as well as into the overall
portfolio monitoring process.

Institutions can utilize credit risk mitigants such as collateral, guarantees, and credit
derivatives or on balance sheet netting to help mitigate risks inherent in individual
credits. However, credit transactions should be entered into primarily on the strength of
the borrower’s repayment capacity. Credit risk mitigants should not be a substitute
for a comprehensive assessment of the borrower or counterparty, nor can it compensate
for insufficient information. It should be recognized that any credit enforcement actions
(e.g. foreclosure proceedings) typically eliminate the profit margin on the
transaction. In addition, institutions need to be mindful that the value of collateral
may well be impaired by the same factors that have led to the diminished
recoverability of the credit.

Institutions should have policies covering the acceptability of various forms

of collateral, procedures for the ongoing valuation of such collateral, and a
process to ensure that collateral is, and continues to be, enforceable and
realizable. With regard to guarantees, institutions should evaluate the level of
coverage being provided in relation to the credit-quality and legal capacity of the
guarantor. Institutions should only factor explicit guarantees into the credit
decision and not those that might be considered implicit such as anticipated
support from the government.

Approving New Credits and Extension of Existing Credits

In order to maintain a sound credit portfolio, an institution must have an

established formal evaluation and approval process for the granting of credits.
Approvals should be made in accordance with the institution’s written thought s

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and granted by the appropriate level of management. There should be a clear
audit trail documenting that the approval process was complied with and
identifying the individual(s) and/or committee(s) providing input as well as
making the credit decision.

Each credit proposal should be subject to careful analysis by a credit analyst

with expertise commensurate with the size and complexity of the transaction. An
effective evaluation process establishes minimum requirements for the
information on which the analysis is to be based. There should be policies in
place regarding the information and documentation needed to approve new
credits, renew existing credits and/or change the terms and conditions of
previously approved credits. The information received will be the basis for
any internal evaluation or rating assigned to the credit and its accuracy and
adequacy is critical to management making appropriate judgments about the
acceptability of the credit.

An institution’s credit-granting approval process should establish accountability

for decisions taken and designate who has the authority to approve credits or
changes in credit terms.

A potential area of abuse arises from granting credit to connected and

related parties, whether companies or individuals. Consequently, it is important
that institutions grant credit to such parties on an arm’s-length basis and that the
amount of credit granted is monitored. Such controls should be implemented by
requiring that the terms and conditions of such credits not be more
favourable than credit granted to non-related borrowers under similar
circumstances and by imposing strict limits on such credits.

Transactions with related parties should be subject to the approval of

the board of directors. Any board member who stands to benefit from that
transaction should not be part of the approval process.

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Limit setting

An important element of credit risk management is to establish exposure limits for

individual borrowers and counterparties and group of connected counterparties
that aggregate in a comparable and meaningful manner different types of
exposures, Both in the banking and trading book as well as on and off balance
sheet. Institutions are expected to develop their own limit structure while
remaining within the exposure limits set by NBE. The size of the limits
should be based on the credit strength of the counterparty, genuine requirement
of credit, economic conditions and the institution’s risk tolerance. Limits should
also be set for respective products, activities, specific industry, economic sectors
and/or geographic regions to avoid concentration risk.

Credit limits should be reviewed regularly at least annually or more

frequently if counterparty’s credit quality deteriorates. All requests of increase in
credit limits should be substantiated.

3.1.3 Risk Measurement, Monitoring and Management

Information System
Measurement and Monitoring

Institutions should have methodologies that enable them to quantify the risk
involved in exposures to individual borrowers or counterparties. Institutions
should also be able to analyze credit risk at the product and portfolio level in
order to identify any particular sensitivities or concentrations. The
measurement of credit risk should take account of (i) the specific nature of the
credit (loan, derivative, etc.) and its contractual and financial conditions
(maturity, interest rate, etc); (ii) the exposure profile until maturity in relation
to potential market movements; (iii) the existence of collateral or guarantees; and
(iv) the potential for default based on the internal risk rating. The analysis of credit

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risk data should be undertaken at an appropriate frequency with the results
reviewed against relevant limits. Institutions should use measurement techniques
that are appropriate to the complexity and level of the risks involved in their
activities, based on robust data, and subject to periodic validation.

Institutions’ management should conduct periodic stress tests of its major credit
risk concentrations and review the results of those tests to identify and respond to
potential changes in market conditions that could adversely impact their
performance.

Credit Administration

Credit administration is a critical element in maintaining the safety and

soundness of an institution. Once a credit is granted, it is the responsibility of the
business function, often in conjunction with a credit administration support
team, to ensure that the credit is properly maintained. This includes keeping
the credit file up to date, obtaining current financial information, sending out
renewal notices and preparing various documents such as loan agreements.

In developing their credit administration areas, institutions should ensure:

(a) the efficiency and effectiveness of credit administration

operations, including monitoring documentation,
contractual requirements, legal covenants, collateral, etc;

(b) the accuracy and timeliness of information provided to

management information systems;

(c) the adequacy of controls over all back office procedures;

and

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 (d) compliance with prescribed policies and procedures as
well as applicable laws and regulations.

For the various components of credit administration to function appropriately,

senior management must understand and demonstrate that it recognizes the
importance of this element of monitoring and controlling credit risk.

The credit files should include all of the information necessary to ascertain the
current financial condition of the borrower or counterparty as well as sufficient
information to track the decisions made and the history of the credit.

Institutions need to develop and implement comprehensive procedures and

information systems to monitor the condition of individual credits and single
obligors across the institution’s various portfolios. These procedures need to
define criteria for identifying and reporting potential problem credits and other
transactions to ensure that they are subject to more frequent monitoring as well as
possible corrective action, classification and/or provisioning.

An effective credit monitoring system will include measures to:

(a) ensure that the institution understands the current financial

condition of the borrower or counterparty;

(b) ensure that all credits are in compliance with existing

covenants;

(c) follow up of customer’s utilization of the approved

credit lines;

(d) ensure that projected cash flows on major credits meet

debt servicing requirements;

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 (e) ensure that, where applicable, collateral provides
adequate coverage relative to the obligor’s current
condition; and

(f) identify and classify potential problem credits on a

timely basis.

Institutions need to enunciate a system that enables them to monitor quality

of the credit portfolio on day-to-day basis and take remedial measures as and
when any deterioration occurs. Such a system would enable an institution to
ascertain whether loans are being serviced as per facility terms, the adequacy of
provisions, the overall risk profile is within limits established by management and
compliance of regulatory limits. Establishing an efficient and effective credit
monitoring system would help senior management to monitor the overall
quality of the total credit portfolio and its trends.

Consequently, the management could fine tune or reassess its credit strategy
/policy accordingly before encountering any major setback. The institutions credit
policy should explicitly provide procedural thought relating to
credit risk monitoring. At the minimum it should lay
down procedures relating to:

(a) the roles and responsibilities of individuals responsible

for credit risk monitoring;

(b) the assessment procedures and analysis techniques (for

individual loans & overall portfolio);

(c) the frequency of monitoring;

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 (d) the periodic examination of collaterals and loan
covenants;

(e) the frequency of site visits;

(f) the identification of any deterioration in any loan.

REMEMBER!

In developing their credit administration areas, institutions should ensure:

(a) the efficiency and effectiveness of credit administration operations,

including monitoring documentation, contractual requirements, legal
covenants, collateral, etc;

(b) the accuracy and timeliness of information provided to management

information systems;

(c) the adequacy of controls over all back office procedures;

and

(d) compliance with prescribed policies and procedures as well as

applicable laws and regulations.

3.1.4 Internal Risk Rating and Provisioning

An important tool in monitoring the quality of individual credits, as well as the

total portfolio, is the use of an internal risk rating system. A well-structured

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internal risk rating system is a good means of differentiating the degree of
credit risk in the different credit exposures of an institution. This will allow more
accurate determination of the overall characteristics of the credit portfolio,
concentrations, problem credits, and the adequacy of loan loss reserves. In
determining loan loss reserves, institutions should ensure that NBE
classifications criteria are the minimum.

Typically, an internal risk rating system categorizes credits into various

classes designed to take into account the gradations in risk. Simpler systems
might be based on several categories ranging from satisfactory to
unsatisfactory; however, more meaningful systems will have numerous gradations
for credits considered satisfactory in order to truly differentiate the relative credit
risk they pose. In developing their systems, institutions must decide whether to
rate the riskiness of the borrower or counterparty, the risks associated with a
specific transaction, or Both.

Internal risk ratings are an important tool in monitoring and controlling

credit risk. In order to facilitate early identification, the institution’s internal risk
rating system should be responsive to indicators of potential or actual deterioration
in credit risk e.g. financial position and business condition of the
borrower, conduct of the borrower’s accounts, adherence to loan covenants, value
of collateral, etc.

Credits with deteriorating ratings should be subject to additional oversight and

monitoring, for example, through more frequent visits from credit officers and
inclusion on a watch list that is regularly reviewed by senior management. The
internal risk ratings can be used by line management in different departments to
track the current characteristics of the credit portfolio and help determine
necessary changes to the credit strategy of the institution. Consequently, it is
important that the board of directors and senior management also receive
periodic reports on the condition of the credit portfolios based on such ratings.

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The ratings assigned to individual borrowers or counterparties at the time the
credit is granted must be reviewed on a periodic basis and individual credits
should be assigned a new rating when conditions either improve or deteriorate.
Because of the importance of ensuring that internal ratings are consistent and
accurately reflect the quality of individual credits, responsibility for setting or
confirming such ratings should rest with a credit review function independent
of that which originated the credit concerned. It is also important that the
consistency and accuracy of ratings is examined periodically by a function
such as an independent credit review group.

3.1.5 Managing Problem Credits

The institution should establish a system that helps identify problem loan
ahead of time when there may be more options available for remedial measures.
Once the loan is identified as problem, it should be managed under a dedicated
remedial process.

Responsibility for such credits may be assigned to the originating business

function, a specialized workout section, or a combination of the two,
depending upon the size and nature of the credit and the reason for its problems.
When an institution has significant credit-related problems, it is important to
segregate the workout function from the credit origination function. The additional
resources, expertise and more concentrated focus of a specialized workout
section normally improve collection results.

A problem loan management process encompasses the following basic

elements:

(a) Negotiation and follow-up: Proactive effort should be

taken in dealing with obligors to implement remedial plans,

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 by maintaining frequent contact and internal records
of follow-up actions. Often rigorous efforts made at an
early stage prevent institutions from litigations and loan
losses.
(b) Workout remedial strategies: Sometimes appropriate
remedial strategies such as restructuring of loan facility,
enhancement in credit limits or reduction in interest
rates help improve obligor’s repayment capacity. However,
it depends upon business condition, the nature of problems
being faced and most importantly obligor’s commitment
and willingness to repay the loan. While such remedial
strategies often bring up positive results, institutions need
to exercise great caution in adopting such measures
and ensure that such a policy must not encourage obligors
to default intentionally. The institution’s interest should be
the primary consideration in case of such workout plans. It
is important that competent authority approves such
workout plans before their implementation.

(c) Review of collateral and security documents:

Institutions have to ascertain the loan recoverable
amount by updating the values of available collateral with
formal valuation. Security documents should also be
reviewed to ensure the completeness and enforceability
of contracts and collaterals/guarantees.

(d) Status Report and Review: Problem credits should

be subject to more frequent review and monitoring. The
review should update the status and development of the
loan accounts and progress of the remedial plans.

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 Progress made on problem loans should be reported to the
senior management.

3.1.6 Management Information System

The effectiveness of an institution’s credit risk measurement process is

highly dependent on the quality of management information systems. The
information generated from such systems enables the board and all levels of
management to fulfill their respective oversight roles, including determining
the adequate level of capital that the institution should be holding. Therefore, the
quality, detail and timeliness of information are critical.

In particular, information on the composition and quality of the various

portfolios, including on a consolidated basis, should permit management to
assess quickly and accurately the level of credit risk that the institution has
incurred through its various activities and determine whether the institution’s
performance is meeting the credit risk strategy.

It is also important that institutions have a management information

system in place to ensure that exposures approaching risk limits are brought to
the attention of senior management. All exposures should be included in a
risk limit measurement system. The institution’s information system should be
able to aggregate credit exposures to individual borrowers and counterparties
and report on exceptions to credit risk limits on a meaningful and timely basis.

Institutions should have information systems in place that enable management to

identify any concentrations of risk within the credit portfolio. The adequacy
of scope of information should be reviewed on a periodic basis by business
line managers, senior management and the board of directors to ensure that it is
sufficient to the complexity of the business.

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REMEMBER!

A problem loan management process encompasses the following basic elements:

 Negotiation and Followup

 Workout remedial strategies
 Review of collateral and security documents
 Status review and reports

3.1.7 Internal Controls

Risk Review

Institutions must establish a mechanism of independent, ongoing assessment of

credit risk management process. The purpose of such review is to assess the
credit administration process, the accuracy of credit rating including adequacy of
provisions for losses, and overall quality of credit portfolio. All facilities
should be subjected to risk review at least quarterly. The results of such review
should be properly documented and reported directly to the board, or its sub-
committee.

Institutions should conduct credit review with updated information on

the obligor’s financial and business conditions, as well as conduct of account.
Exceptions noted in the credit monitoring process should also be evaluated for
impact on the obligor’s creditworthiness. Credit review should also be
conducted on a consolidated group basis to factor in the business
connections among entities in a borrowing group.

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As stated earlier, credit review should be performed on quarterly basis, however
more frequent review should be conducted for new accounts where institutions
may not be familiar with the obligor, and for classified or adverse rated accounts
that have higher probability of default.

3.2 Liquidity Risk Management

Liquidity risk is the potential for loss to an institution arising from either its
inability to meet its obligations as they fall due or to fund increases in assets
without incurring unacceptable cost or losses.

Liquidity risk is considered a major risk for institutions. It arises when the
cushion provided by the liquid assets are not sufficient enough to meet
maturing obligations. In such a situation institutions often meet their
liquidity requirements from the market. However conditions of funding
through the market depend upon liquidity in the market and borrowing
institution’s creditworthiness. Accordingly, an institution short of liquidity may
have to undertake transactions at heavy cost resulting in a loss of earnings or in
worst case scenario, the liquidity risk could result in bankruptcy of the
institution if it is unable to undertake transactions even at current market prices.

Institutions with large off-balance sheet exposures or institutions, which rely

heavily on large corporate deposits, have relatively high level of liquidity risk.
Further, institutions experiencing a rapid growth in assets should have major
concerns for liquidity.

Liquidity risk should not be seen in isolation, because financial risks are not
mutually exclusive and liquidity risk is often triggered by consequences of
other financial risks such as credit risk, interest rate risk, foreign exchange
risk, etc. For instance, an institution increasing its credit risk through asset
concentration may be increasing its liquidity risk as well. Similarly a large loan

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default or changes in interest rate can adversely impact an institution’s liquidity
position. Further, if management misjudges the impact on liquidity of entering
into a new business or product line, the institution’s strategic risk would increase.

An incipient liquidity problem may initially reveal in the institution's financial

monitoring system as a downward trend with potential long-term consequences
for earnings or capital. Given below are some early warning indicators
that may not necessarily always lead to liquidity problem for an institution;
however, these have potential to ignite such a problem. Consequently,
management needs to watch carefully such indicators and exercise further
scrutiny/analysis wherever it deems appropriate. Examples of such internal
indicators are:

(a) A negative trend or significantly increased risk in any

area or product line;
(b) Concentrations in either assets or
liabilities;

(c) Deterioration in quality of credit

portfolio;

(d) A decline in earnings performance or projections;

(e) Rapid asset growth funded by volatile large

deposit;

(f) A large size of off-balance sheet exposure; and

(g) Deteriorating third party evaluation about the institution.

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Liquidity risk management involves not only analyzing institutions on and off-
balance sheet positions to forecast future cash flows, but also how the funding
requirement would be met. The latter involves identifying the funding market the
institution has access to, understanding the nature of those markets, evaluating
institutions current and future use of the market and monitor signs of confidence
erosion.

The formality and sophistication of risk management processes established to

manage liquidity risk should reflect the nature, size and complexity of an
institution’s activities. Sound liquidity risk management employed in measuring,
monitoring and controlling liquidity risk is critical to the viability of any
institution. Institutions should have a thorough understanding of the factors that
could give rise to liquidity risk and put in place mitigating controls.

REMEMBER!

Indicative circumstances that management has to keep an eye on are

(a) A negative trend or significantly increased risk in any area or

product line;
(b) Concentrations in either assets or liabilities;
(c) Deterioration in quality of credit portfolio;
(d) A decline in earnings performance or projections;

(e) Rapid asset growth funded by volatile large deposit;

(f) A large size of off-balance sheet exposure; and
(g) Deteriorating third party evaluation about the institution.

3.2.1 Board and Senior Management Oversight

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 Board Oversight

The prerequisites of an effective liquidity risk management include an

informed board, capable management, staff having relevant expertise and
efficient systems and procedures. It is primarily the duty of board of directors to
understand the liquidity risk profile of the institution and the tools used to manage
liquidity risk. The board has to ensure that the institution has necessary liquidity
risk management framework and the institution is capable of dealing with
uneven liquidity scenarios. The board should approve the strategy and
significant policies related to the management of liquidity. Generally speaking
responsibilities of the board include:

(a) providing guidance on the level of tolerance for

liquidity risk;
(b) appointing senior managers who have ability to manage
liquidity risk and delegate to them the required
authority to accomplish the job;

(c) continuously monitoring the institution's performance and

overall liquidity risk profile through reviewing
various reports; and

(d) ensuring that senior management takes the steps

necessary to identify, measure, monitor and
control liquidity risk.

Senior Management Oversight

Senior management is responsible for the implementation of sound policies

and procedures keeping in view the strategic direction and risk appetite specified

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by the board. To effectively oversee the daily and long-term management of
liquidity risk, senior managers should:

(a) develop and implement procedures and practices that

translate the board's goals, objectives, and risk tolerances
into operating standards that are well understood by
institution personnel and consistent with the board's
intent;

(b) adhere to the lines of authority and responsibility that

the board has approved for managing liquidity risk;

(c) oversee the implementation and maintenance of management

information and other systems that identify, measure,
monitor, and control the institution's liquidity risk; and

(d) establish effective internal controls over the liquidity risk

management process and ensure that the same is
communicated to all staff.

Liquidity Management Structure

The responsibility for managing the overall liquidity of the institution

should be delegated to a specific, identified group within the institution. This
may be in the form of an Asset Liability Committee (ALCO) comprised of
senior management or the treasury function.

Since liquidity management is a technical job requiring specialized

knowledge and expertise, it is important that responsible officers not only have
relevant expertise but also have a good understanding of the nature and level
of liquidity risk assumed by the institution and the means to manage that risk.

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It is critical that there be close links between those individuals responsible for
liquidity and those monitoring market conditions, as well as other individuals
with access to critical information. This is particularly important in developing
and analyzing stress scenarios.

3.2.3 Policies, Procedures and Limits

Liquidity Risk Strategy

Each institution should have an agreed liquidity strategy for the day-to-day
management of liquidity. The strategy should set out the general approach the
institution will have to liquidity, including various quantitative and
qualitative targets. This strategy should address the institution’s goal of
protecting financial strength and the ability to withstand stressful events in the
market place.

The liquidity risk strategy defined by board should articulate specific

policies on particular aspects of liquidity risk management, such as:

(a) Composition of Assets and Liabilities: The strategy

should outline the mix of assets and liabilities to maintain
liquidity. Liquidity risk management and asset/liability
management should be integrated to avoid high costs
associated with having to rapidly reconfigure the asset
liability profile from maximum profitability to increased
liquidity.

(b) Diversification and Stability of Liabilities: A funding

concentration exists when a single decision or a
single factor has the potential to result in a significant and

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 sudden withdrawal of funds. Since such a situation could
lead to an increased risk, the board of directors and
senior management should specify guidance relating to
funding sources and ensure that the institution has
diversified sources of funding day-to-day liquidity
requirements. An institution would be more resilient to tight
market liquidity conditions if its liabilities were derived
from more stable sources. To comprehensively analyze the
stability of liabilities/funding sources the institution need to
identify:

(i) liabilities that would stay with the institution under

any circumstances;
(ii) liabilities that run-off gradually if problems arise; and

(iii) liabilities that run-off immediately at the first

sign of problems.

(c) Managing Liquidity in different currencies: The

institution should have a strategy on how to manage
liquidity in different currencies.

(d) Dealing with liquidity disruptions: The institution

should put in place a strategy on how to deal with the
potential for Both temporary and long-term liquidity
disruptions. The strategy should take into account the fact
that in crisis situations access to interbank market could
be difficult as well as costly.

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The liquidity strategy must be documented in a liquidity policy, and
communicated throughout the institution. The strategy should be evaluated
periodically to ensure that it remains valid.

Self Test Questions 2.6

What is meant by each of the following related to liquidity risk management?

 Composition of Assets and liabilities
 Diversification and stabilities of liabilities
 Managing liquidity in different currencies
 Dealing with liquidity disruptions
Liquidity Policies

Board of directors should ensure that there are adequate policies to

govern liquidity risk management process. While specific details vary across
institutions according to the nature of their business, the key elements of any
liquidity policy include:

(a) general liquidity strategy (short- and long-term),

specific goals and objectives in relation to liquidity risk
management, process for strategy formulation and the
level within the institution it is approved;

(b) roles and responsibilities of individuals performing

liquidity risk management functions, including
structural balance sheet management, pricing,
marketing, contingency planning, management reporting,
lines of authority and responsibility for liquidity decisions;

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 (c) liquidity risk management tools for identifying, measuring,
monitoring and controlling liquidity risk (including the
types of liquidity limits and ratios in place and rationale for
establishing limits and ratios); and

(d) contingency plan for handling liquidity crises.

To be effective the liquidity policy must be communicated down the line

throughout the institution. It is important that the board and senior
management ensure that policies are reviewed at least annually and when
there are any material changes in the institution’s current and prospective
liquidity risk profile. Such changes could stem from internal circumstances (e.g.
changes in business focus) or external circumstances (e.g. changes in economic
conditions).

Reviews provide the opportunity to fine-tune the institution’s liquidity

policies in light of the institution’s liquidity management experience and
development of its business. Any significant or frequent exception to the policy is
an important barometer to gauge its effectiveness and any potential impact on
institution’s liquidity risk profile.

Procedures and Limits

Institutions should establish appropriate procedures, processes and limits to

implement their liquidity policies. The procedural manual should explicitly
narrate the necessary operational steps and processes to execute the relevant
liquidity risk controls. The manual should be periodically reviewed and
updated to take into account new activities, changes in risk management
approaches and systems.

III.2.4 Risk Measurements, Monitoring and Management

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 Information System

Besides the institutional structure discussed earlier, an effective liquidity risk

management include systems to identify, measure, monitor and control its
liquidity exposures. Management should be able to accurately identify and
quantify the primary sources of an institution's liquidity risk in a timely
manner. To properly identify the sources, management should understand
Both existing as well as future risk that the institution can be exposed to.
Management should always be alert for new sources of liquidity risk at
Both the transaction and portfolio levels.

Key elements of an effective risk management process include an efficient

MIS to measure, monitor and control existing as well as future liquidity risks
and reporting them to senior management and the board of directors.

As far as information system is concerned various units related to treasury

activities and risk management function should be integrated. Furthermore,
management should ensure proper and timely flow of information among front
office, back office and middle office in an integrated manner; however, their
reporting lines should be kept separate to ensure independence of these
functions.

Periodic reviews should be conducted to determine whether the institution complies with
its liquidity risk policies and procedures. Positions that exceed established limits should
receive prompt attention of appropriate management and should be resolved according
to the process described in approved policies. Periodic reviews of the liquidity
management process should also address any significant changes in the nature of
instruments acquired, limits, and internal controls that have occurred since the last
review.

Measurement and Monitoring of Liquidity Risk

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An effective measurement and monitoring process is essential for adequately
managing liquidity risk. At a very basic level, liquidity measurement involves
assessing all of an institution’s cash inflows against its outflows to identify the
potential for any net shortfalls going forward. This includes funding
requirements for off-balance sheet commitments. A number of techniques can be
used for measuring liquidity risk, ranging from simple calculations and static
simulations based on current holdings to highly sophisticated modeling
techniques. As all institutions are affected by changes in the economic climate
and market conditions, the monitoring of economic and market trends is key to
liquidity risk management.

An important aspect of managing liquidity is making assumptions

about future funding needs. While certain cash inflows and outflows can be
easily calculated or predicted, institutions must also make assumptions about
future liquidity needs, Both in the very short-term and for longer time periods.
One important factor to consider is the critical role an institution’s
reputation plays in its ability to access funds readily and at reasonable terms.

For that reason, institution staff responsible for managing overall liquidity
should be aware of any information (such as an announcement of a decline in
earnings or a downgrading by a rating agency) that could have an impact on
market and public perceptions about the soundness of the institution.

An effective liquidity risk measurement and monitoring system not only helps
in managing liquidity in times of crisis but also optimize return through efficient
utilization of available funds. Discussed below are some commonly used
liquidity measurement and monitoring techniques that may be adopted by the
institutions.

Contingency Funding Plans (CFP)

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In order to develop comprehensive liquidity risk management framework,
institutions should have in place plans to address stress scenarios. Such a plan
commonly known as CFP is a set of policies and procedures that serves as
a blue print for an institution to meet its funding needs in a timely manner
and at a reasonable cost. A CFP is a projection of future cash flows and funding
sources of an institution under market scenarios including aggressive asset growth
or rapid liability erosion. To be effective it is important that a CFP should
represent management’s best estimate of balance sheet changes that may
result from a liquidity or credit event. A CFP can provide a useful
framework for managing liquidity risk Both short term and in the long term.
Further, it helps to ensure that a financial institution can prudently and efficiently
manage routine and extraordinary fluctuations in liquidity. The scope of the CFP
is discussed in more detail below.

For day-to-day liquidity risk management integration, liquidity scenarios will

ensure that the institution is best prepared to respond to an unexpected
problem. In this sense, a CFP is an extension of ongoing liquidity management and
formalizes the objectives of liquidity management by ensuring:

(a) a reasonable amount of liquid assets are maintained;

(b) measurement and projection of funding

requirements during various scenarios; and

(c) management of access to funding

sources.

It is not always that liquidity crisis shows up gradually. In case of a sudden

liquidity stress, it is important for an institution to seem organized, candid, and
efficient to meet its obligations to the stakeholders. Since such a situation

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requires a spontaneous action, institutions that already have plans to deal with
such situation could address the liquidity problem more efficiently and effectively.
A CFP can help ensure that institution management and key staff are ready to
respond to such situations.

Institution liquidity is very sensitive to negative trends in credit, capital, or

reputation. Deterioration in the institution’s financial condition (reflected in items
such as asset quality indicators, earnings, or capital), management composition, or
other relevant issues may result in reduced access to funding.

The sophistication of a CFP depends upon the size, nature, complexity of

business, risk exposure, and institutional structure. To begin, the CFP should
anticipate all of the institution's funding and liquidity needs by:
(a) Analyzing and making quantitative projections of all
significant on and off balance sheet funds flows and their
related effects;

(b) Matching potential cash flow sources and uses of funds;

and

(c) Establishing indicators that alert management to a

predetermined level of potential risks.

The CFP should project the institution's funding position during both
temporary and long-term liquidity changes, including those caused by liability
erosion. The CFP should explicitly identify, quantify, and rank all sources of
funding by preference, such as:

(a) Reducing assets;

(b) Modification or increasing liability structure; and

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 (c) Using other alternatives for controlling balance
sheet changes.

The CFP should include asset side as well as liability side strategies to deal with
liquidity crises. The asset side strategy may include; whether to liquidate surplus
money market assets, when to sell liquid or longer-term assets etc. While
liability side strategies specify policies such as pricing policy for funding, the
institution/dealer who could assist at the time of liquidity crisis, policy for
early redemption request by retail customers, etc. A CFP should also indicate
roles and responsibilities of various individuals at the time of liquidity crises and
the management information system between management, ALCO, traders, and
others.

This outline of the scope of a good CFP is by no means exhaustive.

Institutions should devote significant time and consideration to scenarios that
are most likely given their activities.

Maturity Ladder

A maturity ladder is a useful device to compare cash inflows and outflows Both
on a day-to-day basis and over a series of specified time periods. The
number of time frames in such maturity ladder is of significant
importance and up to some extent depends upon the nature of
institution’s liabilities or sources of funds.

Institutions, which rely on short term funding, will concentrate primarily on

managing liquidity for very short term. Whereas, other institutions might
actively manage their net funding requirement over a slightly longer period.
In the short term, institution’s flow of funds could be estimated more
accurately and also such estimates are of more importance as these provide an

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indication of actions to be taken immediately. Further, such an analysis for
distant periods will maximize the opportunity for the institution to manage
the gap well in advance before it crystallizes. Consequently, institutions
should use short time frames to measure near term exposures and longer
time frames thereafter.

It is suggested that institutions calculate daily gap for next one or two weeks,
monthly gap for next six months or a year and quarterly thereafter. While
making an estimate of cash flows, the following aspects need attention:

(a) the funding requirement arising out of off- balance sheet

commitments also need to be accounted for;

(b) many cash flows associated with various products are

influenced by interest rates or customer behavior.
Institutions need to take into account behavioral aspects
instead of contractual maturity. In this respect past
experiences could give important guidance to make any
assumption;

(c) some cash flows may be seasonal or cyclical;

and

(d) management should also consider increases or decreases

in liquidity that typically occur during various phases of an
economic cycle.

While the institutions should have liquidity sufficient enough to meet

fluctuations in loans and deposits, as a safety measure institutions should maintain
a margin of excess liquidity. To ensure that this level of liquidity is maintained,
management should estimate liquidity needs in a variety of scenarios.

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 Liquidity Ratios and Limits

Institutions may use a variety of ratios to quantify liquidity. These ratios can
also be used to create limits for liquidity management. However, such ratios
would be meaningless unless used regularly and interpreted taking into account
qualitative factors. Ratios should always be used in conjunction with more
qualitative information about borrowing capacity, such as the likelihood of
increased requests for early withdrawals, decreases in credit lines, decreases
in transaction size, or shortening of term funds available to the institution.

To the extent that any asset-liability management decisions are based on

financial ratios, an institution's asset-liability managers should understand how a
ratio is constructed, the range of alternative information that can be placed in
the numerator or denominator, and the scope of conclusions that can be drawn
from ratios. Because ratio components as calculated by institutions are sometimes
inconsistent, ratio-based comparisons of institutions or even comparisons of
periods at a single institution can be misleading. Examples of ratios and limits
that can be used are:

(a) Liability Concentration Ratios and Limits:

Liability concentration ratios and limits help to prevent
an institution from relying on too few providers or funding
sources. Limits are usually expressed as a percentage of
deposits or liabilities; and

(b) Other Balance Sheet Ratios: Total loans/total

deposits, liquid assets/demand liabilities, borrowed
funds/total assets, etc are examples of common ratios used
by institutions to monitor current and potential funding
levels.

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In addition to the statutory limits of liquid assets requirement and cash reserve
requirement, the board and senior management should establish limits on the
nature and amount of liquidity risk they are willing to assume. The limits should
be periodically reviewed and adjusted when conditions or risk tolerances
change. When limiting risk exposure, senior management should consider the
nature of the institution's strategies and activities, its past performance, the
level of earnings, capital available to absorb potential losses, and the
board's tolerance for risk.

Balance sheet complexity will determine how much and what types of limits an
institution should establish over daily and long- term horizons. While limits will
not prevent a liquidity crisis, limit exceptions can be early indicators of
excessive risk or inadequate liquidity risk management.

Foreign Currency Liquidity Management

Each institution should have a measurement, monitoring and control system

for its liquidity positions in the major currencies in which it is active. In addition
to assessing its aggregate foreign currency liquidity needs and the acceptable
mismatch in combination with its domestic currency commitments, an
institution should also undertake separate analysis of its strategy for each
currency individually.

Managing Market Access

Each institution should periodically review its efforts to establish and maintain
relationships with liability holders, to maintain the diversification of liabilities,
and aim to ensure its capacity to sell assets.

Review of Assumptions Utilized in Managing Liquidity

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Since an institution’s future liquidity position will be affected by factors that
cannot always be forecast with precision, assumptions need to be reviewed
frequently to determine their continuing validity, especially given the rapidity of
change in the markets.

Management Information System

An effective management information system (MIS) is essential for sound

liquidity management decisions. Information should be readily available for day-
to-day liquidity management and risk control, as well as during times of stress.
Data should be appropriately consolidated, comprehensive yet succinct, focused
and available in a timely manner. Ideally, the regular reports an institution
generates will enable it to monitor liquidity during a crisis; such reports would
have to be prepared more frequently under a crisis situation.

Managers should keep crisis monitoring in mind when developing liquidity MIS.
There is usually a trade-off between accuracy and timeliness. Liquidity problems
can arise very quickly, and effective liquidity management may require daily
internal reporting. Since institution liquidity is primarily affected by large,
aggregate principal cash flows, detailed information on every transaction may not
improve analysis.

The management information system should be used to check for compliance

with the institution’s established policies, procedures and limits and with
NBE’s prudential requirements on liquidity. Reporting of risk measures should be
done on a timely basis and compare current liquidity exposures with any set
limits. The information system should also enable management to evaluate the
level of trends in the institution’s aggregate liquidity exposure.

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Management should develop systems that can capture significant
information. The content and format of reports depend on an institution's
liquidity management practices, risks, and other characteristics. Routine reports
may include a list of large funds providers, a cash flow or funding gap
report, a funding maturity schedule, and a limit monitoring and exception report.
Day-to-day management may require more detailed information, depending on
the complexity of the institution and the risks it undertakes.

Management should regularly consider how best to summarize complex or

detailed issues for senior management or the board. Besides, other types of
information important for managing day-to-day activities and for understanding
the institution's inherent liquidity risk profile include:

(a) Asset quality and its

trends; (b) Earnings
projections;
(c) The institution's general reputation in the market and
the condition of the market itself;

(d) The type and composition of the overall balance sheet

structure; and

(e) The type of new deposits being obtained, as well as

its source, maturity, and price.

3.2.5 Internal Controls

Institutions should have adequate internal controls to ensure the integrity of

their liquidity risk management process. These internal controls should be an
integral part of the institution’s overall system of internal control. They should
promote effective and efficient operations, reliable financial and regulatory

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reporting, and compliance with relevant laws, regulations and institutional
policies. An effective system of internal control for liquidity risk includes:

(a) a strong control environment;

(b) an adequate process for identifying and evaluating liquidity

risk;

(c) the establishment of control activities such as policies

and procedures;

(d) adequate information systems; and,

(e) continual review of adherence to established policies and

procedures.

With regard to control policies and procedures, attention should be given to

appropriate approval processes, limits, reviews and other mechanisms designed to
provide a reasonable assurance that the institution's liquidity risk management
objectives are achieved.

Many attributes of a sound risk management process, including risk

measurement, monitoring and control functions, are key aspects of an effective
system of internal control. Institutions should ensure that all aspects of the internal
control system are effective, including those aspects that are not directly part of the
risk management process.

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 REMEMBER!

Information important for managing day-to-day activities and for understanding the
institution's inherent liquidity risk profile include:

(a) Asset quality and its trends;

(b) Earnings projections;

(c) The institution's general reputation in the market and the

condition of the market itself;

(d) The type and composition of the overall balance sheet structure;
and

(e) The type of new deposits being obtained, as well as its source,
maturity, and price.

In addition, an important element of an institution's internal control

system over its liquidity risk management process is regular evaluation
and review. This includes ensuring that personnel are following established
policies and procedures, as well as ensuring that the procedures that were
established actually accomplish the intended objectives. Such reviews and
evaluations should also address any significant change that may impact on the
effectiveness of controls. The board should ensure that all such reviews and

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evaluations are conducted regularly by individuals who are independent of the
function being reviewed. When revisions or enhancements to internal controls
are warranted, there should be a mechanism in place to ensure that these are
implemented in a timely manner.

3.3 Market Risk Management

Market risk refers to the risk to an institution resulting from movements

in market prices, in particular, changes in interest rates, foreign exchange
rates, equity and commodity prices. Market risk is often propagated by other
forms of financial risks such as credit and market liquidity risks. For example, a
downgrading of the credit standing of an issuer could lead to a drop in the
market value of securities issued by that issuer. Likewise, a major sale of a
relatively illiquid security by another holder of the same security could
depress the price of the se

The market risk factors cited above are not exhaustive. Depending
on the instruments traded by an institution, exposure to other factors may also
arise. The institution’s consideration of market risk should capture all risk factors
that it is exposed to, and it must manage these risks soundly.

Self Test Question 2.7

What is market risk?

3.3.1 Board and Senior Management Oversight

Effective oversight by an institution's board of directors and senior management is

critical to a sound market risk management process. It is essential that these
individuals are aware of their responsibilities with regard to market risk
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management and that they are capable of performing their roles in overseeing and
managing market risk.

Board Oversight

The board of directors has the ultimate responsibility for understanding the
nature and the level of market risk taken by the institution. The board
should approve broad business strategies and policies that govern or
influence the market risk of the institution. It should review the overall objectives
of the institution with respect to market risk and should ensure the
provision of clear guidance regarding the level of risk acceptable to the
institution. The board should also approve policies that identify lines of authority
and responsibility for managing market risk exposures.

The board should ensure that senior management has sufficient knowledge and
is fully capable of managing market risk including taking the steps
necessary to identify, measure, monitor, and control this risk. The board or a
specific committee of the board should periodically review information
that is sufficient in detail and timeliness to allow it to understand and assess the
performance of senior management in monitoring and controlling market risk
in compliance with the institution's board-approved policies. In addition, the board
or one of its committees should periodically re-evaluate market risk management
policies as well as overall business strategies that affect the market risk exposure
of the institution.

The board of directors should be informed regularly of the market risk exposure
of the institution in order to assess the monitoring and controlling of such
risk. Using this knowledge and information, directors should provide
clear guidance regarding the level of exposures acceptable to their institution.

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The board should review market risk policies in order to align them with
significant changes in internal and external environment. In absence of
any uneven circumstances, it is expected that board would review these
policies at least annually.

Senior Management Oversight

Senior management is responsible for developing policies and procedures for

managing market risk on both a long-term and day-to-day basis. It should
maintain clear lines of authority and responsibility for managing and controlling
this risk. It should implement strategies in a manner that limits risks associated
with each strategy and that ensures compliance with laws and regulations.
Management is also responsible for:

(a) setting appropriate limits on risk taking;

(b) developing standards for valuing positions and

measuring performance;

(c) comprehensive market risk reporting and management

review process;

(d) effective internal controls and ethical standards;

(e) developing and implementing procedures and practices

that translate the board's goals, objectives, and
risk tolerances into operating standards that are well
understood by institution personnel and consistent with the
board's intent;

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 (f) adhering to the lines of authority and responsibility that the
board has established for managing foreign exchange risk;
and

(g) oversee the implementation and maintenance of

management information and other systems that identify,
measure, monitor, and control the institution's market risk.

Market risk reports to senior management should provide aggregate

information as well as sufficient supporting detail to enable management to assess
the sensitivity of the institution to changes in market conditions and other
important risk factors. Senior management should also review periodically the
institution’s market risk management policies and procedures to ensure that they
remain appropriate and sound.

3.3.2 Policies, Procedures and Limits

Risk Management Strategy

Every institution should develop a sound and well informed strategy to

manage market risk. The strategy should first determine the level of market risk
the institution is prepared to assume. Once its market risk tolerance is
determined, the institution should develop a strategy that balances its
business goals with its market risk appetite.

In setting its market risk strategy, an institution should consider the following
factors:

(a) economic and market conditions and their impact on market

risk;

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 (b) whether the institution has the expertise to profit in
specific markets and is able to identify, monitor and
control the market risk in those markets; and

(c) the institution’s portfolio mix and how it would be affected

if more market risk was assumed.

The institution’s market risk strategy should be periodically reviewed and

effectively communicated to the relevant staff. There should be a process to
detect deviations from the approved market risk strategy and target markets.
The Board of Directors and senior management should periodically review the
institution’s market risk strategy taking into consideration its financial
performance and market developments.

Risk Management Policies

An institution should formulate market risk policies which should be approved

by the Board. These policies should reflect the strategy of the institution,
including its approach to controlling and managing market risk. The Board
should approve any changes and exceptions to these policies.

Policies should be applied on a consolidated basis and, where appropriate, to

specific subsidiaries, affiliates or units within an institution. The policies should
clearly:

(a) prescribe how market risk is measured and communicated to

the Board;

(b) spell out the process by which the Board decides on

the maximum market risk the institution is able to take, as
well as the frequency of review of risk limits;

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 (c) delineate the lines of authority and the responsibilities of
the Board, senior management and other personnel
responsible for managing market risk;

(d) set out the scope of activities of the business units

assuming market risk; and

(e) identify and set thought s on market risk limit

structure, delegation of approving authority for market risk
limit setting and limit excesses, capital requirements, and
investigation and resolution of irregular or disputed
transactions.

Risk Management Procedures

An institution should establish appropriate procedures and processes to

implement the market risk policy and strategy. These should be
documented in a manual and the staff responsible for carrying out the
procedures should be familiar with the content of the manual. The manual
should spell out the operational steps and processes for executing the
relevant market risk controls. It should also be periodically reviewed and updated
to take into account new activities, changes in systems and structural changes in
the market. The procedures should cover all activities that are exposed to
market risk.

III.3.3 Risk Measurement, Monitoring and Management Information

System

Processes and Systems

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An institution should establish a sound and comprehensive risk management
process. This should, among other things, comprise:
(a) a framework to identify, measure and monitor market risk;

(b) an appropriately detailed structure of risk limits, thought s and

other parameters used to govern market risk taking;

(c) an appropriate management information system (MIS) for

controlling, monitoring and reporting market risk, including
transactions between and with related parties; and

(d) accounting policies on the treatment of market risk.

An institution should incorporate its market risk management process into

its overall risk management system. This would enable it to understand
and manage its consolidated risk exposure more effectively. Where the
institution is part of a financial services group, the risk management
process should also be integrated with that of the group’s where practicable.

The risk management system should be commensurate with the scope, size and
complexity of an institution's trading and other financial activities and the market
risks assumed. It should also enable the various market risk exposures to be
accurately and adequately identified, measured, monitored and controlled. All
significant risks should be measured and aggregated on an institution-wide basis.

An institution’s risk management system should be able to quantify risk

exposures and monitor changes in market risk factors (e.g. changes in interest
rates, foreign exchange rates, and equity prices) and other market conditions
on a daily basis. An institution whose risk levels fluctuate significantly within a
trading day should monitor its risk profile on an intra-day basis. The risk
management system should, wherever feasible, be able to assess the probability

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of future losses. It should also enable an institution to identify risks promptly
and take quick remedial action in response to adverse changes in market
factors.

An institution should ensure that its treasury and financial derivative

valuation processes are robust and independent of its trading function. Models
and supporting statistical analyses used in valuations and stress tests should be
appropriate, consistently applied, and have reasonable assumptions. These should
be validated before deployment. Staff involved in the validation process should be
adequately qualified and independent of the trading and model development
functions.

Models and analyses should be periodically reviewed to ascertain the

completeness of position data, the accuracy of volatility, valuation and risk
factor calculations, as well as the reasonableness of the correlation and stress test
assumptions. More frequent reviews may be necessary if there are changes in
models or in the assumptions resulting from developments in market
conditions.

An institution should have a unit dedicated to the management of market risks.

Typically this is the responsibility of the Asset Liability Management
Committee (ALCO). ALCO is usually responsible for developing and maintaining
appropriate risk management policies and procedures, MIS reporting, limits, and
oversight programmes. It should include senior management from each
functional area that assumes and manages market risks. ALCO should meet
on a frequency that is commensurate with the institution’s business activities.
The terms of reference, composition, quorum and frequency of meetings should
also be formalized and clearly documented.

Interest Rate Risk Measurement and Monitoring

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In general, but depending on the complexity and range of activities of
the individual institution, institutions should have interest rate risk
measurement systems that assess the effects of rate changes on both earnings
and economic value. These systems should provide meaningful measures of an
institution's current levels of interest rate risk exposure, and should be
capable of identifying any excessive exposures that might arise.

Measurement systems should:

(a) assess all material interest rate risk associated with

an institution's assets, liabilities, and OBS positions;

(b) utilize generally accepted financial concepts

and risk measurement techniques; and

(c) have well documented assumptions and parameters.

As a general rule, it is desirable for any measurement system to incorporate

interest rate risk exposures arising from the full scope of an institution's
activities, including Both trading and non- trading sources. This does not
preclude different measurement systems and risk management approaches
being used for different activities; however, management should have an
integrated view of interest rate risk across products and business lines.

An institution's interest rate risk measurement system should address all

material sources of interest rate risk including re- pricing, yield curve,
basis and option risk exposures. In many cases, the interest rate characteristics
of an institution's largest holdings will dominate its aggregate risk profile.
While all of an institution's holdings should receive appropriate treatment,
measurement systems should evaluate such concentrations with particular rigor.
Interest rate risk measurement systems should also provide rigorous treatment of

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those instruments, which might significantly affect an institution's aggregate
position, even if they do not represent a major concentration. Instruments with
significant embedded or explicit option characteristics should receive special
attention.

A number of techniques are available for measuring the interest rate risk
exposure of both earnings and economic value. Their complexity ranges from
simple calculations to static simulations using current holdings to highly
sophisticated dynamic modeling techniques that reflect potential future business
and business decisions.

The simplest techniques for measuring an institution's interest rate risk exposure
begin with a maturity/re-pricing schedule that distributes interest-sensitive assets,
liabilities and OBS positions into "time bands" according to their maturity (if
fixed rate) or time remaining to their next re-pricing (if floating rate).
These schedules can be used to generate simple indicators of the interest
rate risk sensitivity of Both earnings and economic value to changing interest
rates. When this approach is used to assess the interest rate risk of current
earnings, it is typically referred to as gap analysis. The size of the gap for a
given time band - that is, assets minus liabilities plus OBS exposures that
re-price or mature within that time band - gives an indication of the
institution's re-pricing risk exposure.

A maturity/re-pricing schedule can also be used to evaluate the effects of

changing interest rates on an institution's economic value by applying
sensitivity weights to each time band. Typically, such weights are based on
estimates of the duration of the assets and liabilities that fall into each time-band,
where duration is a measure of the percent change in the economic value of a
position that will occur given a small change in the level of interest rates.
Duration-based weights can be used in combination with a maturity/re-pricing
schedule to provide a rough approximation of the change in an institution's

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economic value that would occur given a particular set of changes in market
interest rates.

More sophisticated interest rate risk measurement systems include

Simulation Techniques. Simulation techniques typically involve detailed
assessments of the potential effects of changes in interest rates on earnings and
economic value by simulating the future path of interest rates and their impact on
cash flows. In static simulations, the cash flows arising solely from the
institution's current on and off-balance sheet positions are assessed. In a dynamic
simulation approach, the simulation builds in more detailed assumptions about
the future course of interest rates and expected changes in an institution's
business activity over that time. These more sophisticated techniques allow
for dynamic interaction of payments streams and interest rates, and better capture
the effect of embedded or explicit options.

Regardless of the measurement system, the usefulness of each technique depends

on the validity of the underlying assumptions and the accuracy of the basic
methodologies used to model interest rate risk exposure. In designing interest rate
risk measurement systems, institutions should ensure that the degree of detail
about the nature of their interest-sensitive positions is commensurate with the
complexity and risk inherent in those positions. For instance, using gap analysis,
the precision of interest rate risk measurement depends in part on the number of
time bands into which positions are aggregated. Clearly, aggregation of
positions/cash flows into broad time bands implies some loss of precision. In
practice, the institution must assess the significance of the potential loss of
precision in determining the extent of aggregation and simplification to be built
into the measurement approach.

Estimates of interest rate risk exposure, whether linked to earnings or economic

value, utilize, in some form, forecasts of the potential course of future
interest rates. For risk management purposes, institutions should incorporate a

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change in interest rates that is sufficiently large to encompass the risks
attendant to their holdings. Institutions should consider the use of multiple
scenarios, including potential effects in changes in the relationships among
interest rates (i.e. yield curve risk and basis risk) as well as changes in the
general level of interest rates. For determining probable changes in interest rates,
simulation techniques could be used. Statistical analysis can also play an important
role in evaluating correlation assumptions with respect to basis or yield curve
risk.

In assessing the results of interest rate risk measurement systems, it is important

that the assumptions underlying the system are clearly understood by risk
managers and institution management. In particular, techniques using
sophisticated simulations should be used carefully so that they do not become
"black boxes", producing numbers that have the appearance of precision, but
that in fact are not very accurate when their specific assumptions and
parameters are revealed.

Key assumptions should be recognized by senior management and risk

managers and should be re-evaluated at least annually. They should also be
clearly documented and their significance understood. Assumptions used in
assessing the interest rate sensitivity of complex instruments and instruments
with uncertain maturities should be subject to particularly rigorous
documentation and review.

Foreign Exchange Risk Measurement and Monitoring

Managing foreign exchange risk requires a clear understanding of the amount

at risk and the impact of changes in exchange rates on this foreign
currency exposure. To make these determinations, sufficient information
must be readily available to permit appropriate action to be taken within
acceptable, often very short, time periods.

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Institutions may use various techniques to measure exposure to foreign
exchange risk. One approach could be through setting limits on the size of the
net open position in each currency in which the institution is authorized to have
exposure and the aggregate of all currencies. This may be expressed as a
percentage of core capital or total assets. Other approaches could be through the
use of ratios such as:

(a) foreign currency assets to foreign currency

liabilities;

(b) change in net open position;

(c) growth in international assets/liabilities; and

(d) growth in off-balance sheet business.

Hedging of Foreign Exchange Risk

The use of hedging techniques is one means of managing and controlling foreign
exchange risk. In this regard, many different financial instruments can be used for
hedging purposes; the most commonly used, however, are derivative instruments.
Examples include forward foreign exchange contracts, foreign currency futures
contracts, foreign currency options, and foreign currency swaps.

Each institution should consider which techniques are appropriate

for the nature and extent of its foreign exchange risk activities, the skills and
experience of management, and the capacity of foreign exchange risk reporting
and control systems.

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Financial instruments used for hedging are not distinguishable in form from
instruments that may be used to take risk positions. Before using hedging
products, institutions must ensure that they understand the hedging technique
and that they are satisfied That the instrument meets their specific hedging needs
in a cost-effective manner.

Further, the effectiveness of hedging activities should be assessed not

only on the basis of the technical attributes of individual transactions, but also in
the context of the overall risk exposure of the institution resulting from a potential
change in asset/liability mix and other risk exposures such as credit and
foreign exchange risks. For example, foreign exchange swaps involve the
replacement of foreign exchange risk by credit risk (the risk that the
counterparty to the swap may be unable to fulfill its obligations).

In this context, hedging activities need to take place within the framework of a
clear hedging strategy, the implications of which are well understood by the
institution under varying market scenarios. In particular, the objectives and
limitations of using hedging products should be uniformly understood, so as
to ensure that hedging strategies result in an effective hedge of an exposure
rather than the unintentional assumption of additional or alternate forms of risk.

Before an institution is engaged in derivative instruments, either for hedging or

position-taking, it must ensure that appropriate policies and procedures, as well
as the capability to implement them are in place.

One can use any one or a combination of the following ratio/s to measure foreign currency
REMEMBER!
exposure risk:

(a) foreign currency assets to foreign currency liabilities;

(b) change in net open position;

(c) growth in international assets/liabilities; and

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(d) growth in off-balance sheet business.

 Stress Testing

The market risk management process should, where appropriate, include regular
scenario analysis and stress tests. An institution may choose scenarios based on
either analyzing historical data or empirical models of changes in market risk
factors. The objective should be to allow the institution to assess the effects of sizeable
changes in market risk factors on its holdings and financial condition. Hence,
scenarios chosen could include low probability adverse scenarios that could result in
extraordinary losses. Scenario analysis and stress tests should be Both quantitative
and qualitative.

Scenario analysis and stress testing should, as far as possible, be conducted on

an institution-wide basis, taking into account the effects of unusual changes in
market and non-market risk factors. Such factors include prices, volatilities, market
liquidity, historical correlations and assumptions in stressed market conditions, the
institution’s vulnerability to worst case scenarios or the default of a large
counterparty and maximum cash inflow and outflow assumptions.

Scenario analysis and stress testing would enable the Board and senior management to
better assess the potential impact of various market-related changes on the

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institution’s earnings and capital position. The Board and senior management should
regularly review the results of scenario analyses and stress testing, including the major
assumptions that underpin them. The results should be considered during the
establishment and review of policies and limits. Depending on the potential losses
projected by the scenario analysis and stress tests and the likelihood of such losses
occurring, the Board and senior management may consider additional measures
to manage the risks or introduce contingency plans.

Management Information System

An accurate, informative, and timely management information system is

essential for managing market risk exposure, Both to inform management
and to support compliance with board policy. Reporting of risk measures
should be regular and should clearly compare current exposure to policy limits.
In addition, past forecasts or risk estimates should be compared with actual
results to identify any shortcomings.

Reports detailing the market risk exposure of the institution should be reviewed
by the board on a regular basis. While the types of reports prepared for the board
and for various levels of management will vary based on the institution’s
market risk profile, they should, at a minimum include the following:

(a) summaries of the institution's aggregate market risk exposures

(i.e. interest rate and foreign exchange exposures);

(b) results of stress tests for market risk including those assessing
breakdowns in key assumptions and parameters;

(c) foreign exchange exposure reports by currency and in

aggregate;

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 (d) maturity distribution by currency of foreign currency
denominated assets and liabilities including off
balance sheet contingencies;

(e) summaries of the findings of reviews of market risk policies,

procedures, and the adequacy of the interest rate risk
measurement systems, including any findings of internal
and external auditors or any other independent reviewer;

(f) list of outstanding contracts amounts by settlement date and

currency Both spot and forward;

(g) reports demonstrating compliance with internal policies and

prudential limits on market risk including exceptions; and

(h) daily foreign exchange operations gain/loss, in

comparison with previous day’s results.

3.3.4 Internal Controls

Institutions should have adequate internal controls to ensure the integrity of

their market risk management process. These internal controls should be an
integral part of the institution's overall system of internal controls. They
should promote effective and efficient operations, reliable financial and
regulatory reporting, and compliance with relevant laws, regulations and
institutional policies. An effective system of internal controls for market risk
should ensure that:

(a) there is a strong control

environment;

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 (b) an adequate process for identifying and evaluating risk is
in place;

(c) there are adequate control tools such as

policies, procedures and methodologies; and

(d) there is an effective management information

system.

Limits for market risks that are consistent with the maximum exposures
authorized by the Board and senior management should be set. An
independent risk management function should be established, with the
responsibility for defining risk management policies, setting procedures for
market risk identification, measurement and assessment, and monitoring the
institution's compliance with established policies and market risk limits. It should
also ensure that market risk exposures are reported in a timely manner to the
Board and senior management. Risk management staff should be separate from
and independent of position-taking staff.

Institutions should have their measurement, monitoring and control

functions reviewed on a regular basis by an independent party. It is essential that
any independent reviewer ensures that the institution's risk measurement system
is sufficient to capture all material elements of market risk, whether arising from
on- or off- balance sheet activities.

Lines of Responsibility and Authority

Care should be taken to ensure that there is adequate separation of

duties in key elements of the risk management process to avoid potential
conflicts of interest. Management should ensure that sufficient safeguards exist

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to minimize the potential that individuals initiating risk-taking positions may
inappropriately influence key control functions of the risk management process
such as the development and enforcement of policies and procedures, the
reporting of risks to senior management, and the conduct of back-office
functions. The nature and scope of such safeguards should be in accordance
with the size and structure of the institution. They should also be commensurate
with the volume and complexity of market risk incurred by the institutions and
the complexity of its transactions and commitments.

Although the controls over market risk will vary among institutions depending
on the nature and extent of their activities, the key elements of any control
program are well-defined procedures governing:

(a) organizational controls to ensure that there exists a clear

and effective segregation of duties between those persons
who initiate transactions and those who are responsible
for operational functions such as arranging prompt and
accurate settlement, and timely exchanging
and reconciliation of confirmations, or account for market
activities;

(b) procedural controls to ensure that:

(i) transactions are fully recorded in the records

and accounts of the institution;

(ii) transactions are correctly settled; and

(iii) unauthorized dealing is promptly identified

and reported to management;

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 (c) controls to ensure that market activities are monitored
frequently against the institution's market risk, counterparty
and other limits and that excesses are reported; and

(d) controls to ensure institution’s compliance with

applicable laws and regulations.

Independent audits are a key element in managing and controlling an

institution's market risk management program. Each institution should use
them to ensure compliance with, and the integrity of, the market risk
policies and procedures.

Independent audits should, over a reasonable period of time, test the

institution's market risk management activities in order to:

(a) ensure market risk management policies and procedures

are being adhered to;

(b) ensure effective management controls over market

positions;

(c) verify the adequacy and accuracy of management information

reports regarding the institution's market risk management
activities;

(d) ensure that personnel involved in market risk management

are provided with accurate and complete information
about the institution's market risk policies and risk limits
and have the expertise required to make effective decisions
consistent with the risk management policies.

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Assessments of the market risk operations should be presented to the institution's
board of directors for review on a timely basis. Identified material weaknesses
should be given appropriate and timely high level attention and management's
actions to address those weaknesses should be objectively verified and reviewed.

3.4 Operational Risk Management

Globalization of financial services, together with increased financial

innovation, are making the activities of institutions and their risk profiles (i.e.
the level of risk across an institution’s activities and/or risk categories) more
complex. Due to these developments, operational risk is becoming more
pronounced. Examples of these developments include:

(a) The increased use of highly automated technology which

has the potential to transform risks from manual processing
errors to system failure risks, as greater reliance is placed
on automated systems;

(b) Growth of e-banking brings with it potential risks

(e.g. internal and external fraud and system security
issues) that are not yet fully understood;

(c) Acquisitions, mergers, and consolidations bringing the risk

of system incompatibility and loss of staff morale;

(d) Engagement in risk mitigation techniques (e.g.

collateral and derivatives) by institutions to optimize their
exposure to market risk and credit risk, but which in turn
may produce other forms of risk (e.g. legal risk); and

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 (e) Growing use of outsourcing arrangements and the
participation in clearing and settlement systems, which can
mitigate some risks but can also present other
significant risks to institutions.
The diverse set of risks resulting from the above developments can be
grouped under the heading of ‘operational risk’, which is defined as the risk of
loss resulting from inadequate or failed internal processes, people and systems
or from external events.

Operational risk is a term that has a variety of meanings within the banking
industry. Whatever the exact definition, a clear understanding by institutions of
what is meant by operational risk is critical to the effective management and
control of this risk category. It is also important that the definition considers the
full range of material operational risks facing the institution and captures the most
significant causes of severe operational losses.

Operational risk may arise from a number of sources as follows:

(a) People: Events that may result into substantial loss include
frauds like intentional misreporting of positions,
employee theft, insider dealings, robbery, forgery, cheque
kiting, and damage from computer hacking. Some of the
contributing factors are as follows:

(i) Lack of adequate skills and

knowledge;

(ii) Inadequate training and

development;

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 (iii) Improperly aligned compensation schemes and
incentives;

(iv)Lack of understanding of performance standards

or expectations; and

(v) Inadequate human resource control

(including supervision and segregation
of incompatible duties)

(b) Internal processes and systems: Business disruption

and system failures such as hardware and software failures,
telecommunication problems, and utility outages, data entry
errors, collateral management failures, unapproved access
given to client accounts, non-client counterparty
misperformance, and vendor disputes are examples of
operational risk resulting from internal processes and
systems. Some of the contributing factors are as follows:

(i) Damage to physical assets;

(iii) Inadequate or obsolete

technology;

(iii) Lack of proper documentation;

(iv) Lack of or inadequate policies, procedures and

controls;

(v) Poor management information system; and

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 (vi) Lack of or inadequate contingent plans.

(c) External events: Terrorism, vandalism, earthquakes,

fires and floods are examples of events that may cause
operational risk in an institution.

It is clear that operational risk differs from other risks in that it is typically not
directly taken in return for an expected reward, but exists in the natural course of
corporate activity, and that this affects the risk management process. At the same
time, failure to properly manage operational risk can result in a misstatement of
an institution’s risk profile and expose the institution to significant losses.

3.4.1 Board and Senior Management Oversight

Failure to understand and manage operational risk, which is present in

virtually all transactions and activities, may greatly increase the likelihood that
some risks will go unrecognized and uncontrolled. Board and senior management
are responsible for creating an organizational culture that places high priority on
effective operational risk management and adherence to sound operating
controls. Operational risk management is most effective where an institution’s
culture emphasizes high standards of ethical behaviour at all levels of the
institution. The board and senior management should promote an
organizational culture, which establishes through Both actions and words the
expectations of integrity for all employees in conducting the business of the
institution.

Board Oversight

Boards of directors have ultimate responsibility for the level of operational risk
taken by their institutions. The board of directors should approve the
implementation of an institution-wide framework to explicitly manage

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operational risk as a distinct risk to the institution’s safety and soundness.
The board should provide senior management with clear guidance and direction
regarding the principles underlying the framework and approve the
corresponding policies developed by senior management.

An operational risk framework should be based on an appropriate

definition of operational risk, which clearly articulates what constitutes
operational risk in that institution. The framework should cover the institution’s
tolerance for operational risk, as specified through the policies for managing
this risk and the institution’s prioritization of operational risk management
activities, including the extent of, and manner in which, operational risk is
transferred outside the institution. It should also include policies outlining the
institution’s approach to identifying, assessing, monitoring and
controlling/mitigating the risk. The degree of formality and sophistication of
the institution’s operational risk management framework should be
commensurate with the institution’s risk profile.

The board is responsible for establishing a management structure capable of

implementing the institution’s operational risk management framework.
Since a significant aspect of managing operational risk relates to the
establishment of strong internal controls, it is particularly important that
the board accountability and reporting. In addition, there should be separation of
responsibilities and reporting lines between operational risk control functions,
business lines and support functions in order to avoid conflict of interest. The
framework should also articulate the key processes the institution needs to have in
place to manage operational risk.

The board should review the framework regularly to ensure that the institution
is managing the operational risks arising from external market changes
and other environmental factors, as well as those operational risks associated
with new products, activities or systems. This review process should establishes

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clear lines of management responsibility, also aim to assess industry best
practice in operational risk management appropriate for the institution’s
activities, systems and processes. If necessary, the board should ensure that the
operational risk management framework is revised in light of this analysis, so
that material operational risks are captured within the framework.

Senior Management Oversight

Management should translate the operational risk management framework

established by the board of directors into specific policies, processes and
procedures that can be implemented and verified within the different
business units. Senior management should clearly assign authority,
responsibility and reporting relationships to encourage and maintain this
accountability and ensure that the necessary resources are available to manage
operational risk effectively. Moreover, senior management should assess the
appropriateness of the management oversight process in light of the risks inherent
in a business unit’s policy.

Senior management should ensure that institution activities are conducted by

qualified staff with the necessary experience, technical capabilities and access to
resources, and that staff responsible for monitoring and enforcing compliance with
the institution’s risk policy have authority and are independent from the units
they oversee. Management should ensure that the institution’s operational risk
management policy has been clearly communicated to staff at all levels in units
that are exposed to material operational risks.

Senior management should also ensure that the institution’s remuneration policies
are consistent with its appetite for risk. Remuneration policies which reward
staff that deviate from policies (e.g. by exceeding established limits) weaken
the institution’s risk management processes. documentation controls and to
transaction-handling practices. Policies, processes and procedures related to

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advanced technologies supporting high transactions volumes, in particular,
should be well documented and disseminated to all relevant personnel.

3.4.2 Policies, Procedures and Limits

The institution should put in place an operational risk management

policy. The policy should, at minimum, include:

(a) The strategy given by the board of the institution;

(b) The systems and procedures to institute

effective operational risk management framework;
and

(c) The structure of operational risk management function

and the roles and responsibilities of individuals involved.

Particular attention should be given to the quality of documentation controls and to

transaction-handling practices. Policies, processes and procedures related to
advanced technologies supporting high transactions volumes, in particular,
should be well documented and disseminated to all relevant personnel.

3.4.3 Policies, Procedures and Limits

The institution should put in place an operational risk management

policy. The policy should, at minimum, include:

(a) The strategy given by the board of the institution;

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 (b) The systems and procedures to institute
effective operational risk management framework;
and

(c) The structure of operational risk management function

and the roles and responsibilities of individuals involved.

The policy should establish a process to ensure that any new or changed
activity, such as new products or systems conversions, will be evaluated for
operational risk prior to its implementation. It should be approved by the board
and documented. The management should ensure that it is communicated and
understood throughout in the institution. The management also needs to place
proper monitoring and control processes in order to have effective
implementation of the policy. The policy should be regularly reviewed and
updated, to ensure it continues to reflect the environment within which the
institution operates.

Institutions should also establish policies for managing the risks associated with
outsourcing activities. Outsourcing of activities can reduce the institution’s risk
profile by transferring activities to others with greater expertise and scale to
manage the risks associated with specialized business activities. However, an
institution’s use of third parties does not diminish the responsibility of the board
of directors and management to ensure that the third-party activity is conducted
in a safe and sound manner and in compliance with applicable laws. Outsourcing
arrangements should be based on robust contracts and/or service level agreements
that ensure a clear allocation of responsibilities between external service
providers and the outsourcing institution. Furthermore, institutions need to
manage residual risks associated with outsourcing arrangements, including
disruption of services.

Business Continuity and Disaster Recovery Plan

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For reasons that may be beyond an institution’s control, a severe event may result in the
inability of the institution to fulfill some or all of its business obligations, particularly
where the institution’s physical, telecommunication, or information technology
infrastructures have been damaged or made inaccessible. This can, in turn, result in
significant financial losses to the institution, as well as broader disruptions to the
financial system through channels such as the payments system. This requires
that institutions establish disaster recovery and business continuity plans that
take into account different types of plausible scenarios to which the institution
may be vulnerable, commensurate with the size and complexity of the institution’s
operations.

Institutions should identify critical business processes, including those where

there is dependence on external vendors or other third parties, for which rapid
resumption of service would be most essential. For these processes, institutions
should identify alternative mechanisms for resuming service in the event of an
outage. Particular attention should be paid to the ability to restore
electronic or physical records that are necessary for business resumption.
Where such records are backed-up at an off-site facility, or where an
institution’s operations must be relocated to a new site, care should be taken that
these sites are at an adequate distance from the impacted operations to minimize
the risk that Both primary and back-up records and facilities will be unavailable
simultaneously.

Institutions should periodically review their disaster recovery and business

continuity plans so that they are consistent with their current operations and
business strategies. Moreover, these plans should be tested periodically to ensure
that the institution would be able to execute the plans in the unlikely event of a
severe business disruption.

3.4.4 Risk Measurement, Monitoring and Management

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 Information System

Risk identification is paramount for the subsequent development of a viable

operational risk monitoring and control system. Effective risk identification
considers Both internal factors (such as the institution’s structure, the nature of
the institution’s activities, the quality of the institution’s human resources,
organizational changes and employee turnover) and external factors (such as
changes in the industry and technological advances) that could adversely affect
the achievement of the institution’s objectives.

In addition to identifying the most potentially adverse risks, institutions

should assess their vulnerability to these risks. Effective Risk assessment allows
the institution to better understand its risk profile and most effectively target risk
management resources.

Amongst the possible tools that may be used by institutions for identifying
and assessing operational risk are:

(a) Self Risk Assessment: an institution assesses its

operations and activities against a menu of potential
operational risk vulnerabilities. This process is internally
driven and often incorporates checklists and/or workshops
to identify the strengths and weaknesses of the
operational risk environment.

(b) Risk Mapping: in this process, various business units,

organizational functions or process flows are mapped by
risk type. This exercise can reveal areas of weakness and
help prioritize subsequent management actions.

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 (c) Risk Indicators: risk indicators are statistics and/or
metrics, often financial, which can provide insight into an
institution’s risk position. These indicators are to be
reviewed on a periodic basis (such as monthly or
quarterly) to alert institutions to changes that may
be indicative of risk concerns. Such indicators may
include the number of failed trades, staff turnover rates
and the frequency and/or severity of errors and
omissions. Threshold/limits could be tied to these
indicators such that when exceeded, could alert
management on areas of potential problems.

(d) The use of data on an institution’s historical loss

experience could provide meaningful information for
assessing the institution’s exposure to operational risk and
developing a policy to mitigate/control the risk. An
effective way of making good use of this
information is to establish a framework for
systematically tracking and recording the frequency,
severity and other relevant information on individual loss
events. Institutions may also combine internal loss data
with external loss data (from other institutions), scenario
analyses, and risk assessment factors.

Depending on the scale and nature of the activity, institutions should

understand the potential impact on their operations and their customers of any
potential deficiencies in services provided by vendors and other third-party or
intra-group service providers, including both operational breakdowns and the
potential business failure or default of the external parties. The board and
management should ensure that the expectations and obligations of each party
are clearly defined, understood and enforceable. The extent of the external

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party’s liability and financial ability to compensate the institution for errors,
negligence, and other operational failures should be explicitly considered as part
of the risk assessment.

Institutions should carry out an initial due diligence test and monitor the
activities of third party providers, especially those lacking experience of
the banking industry’s regulated environment, and review this process
(including re-evaluations of due diligence) on a regular basis. For critical
activities, the institution may need to consider contingency plans, including the
availability of alternative external parties and the costs and resources required to
switch external parties, potentially on very short notice.

Control activities are designed to address the operational risks that an

institution has identified. For all material operational risks that have been
identified, the institution should decide whether to use appropriate procedures
to control and/or mitigate the risks, or bear the risks. For those risks that
cannot be controlled, the institution should decide whether to accept these
risks, reduce the level of business activity involved, or withdraw from this
activity completely.

Some significant operational risks have low probabilities but potentially

very large financial impact. Moreover, not all risk events can be controlled
e.g. natural disasters. Risk mitigation tools or programmes can be used to
reduce the exposure to, or frequency and/or severity of such events. For example,
insurance policies can be used to externalize the risk of “low frequency, high
severity” losses which may occur as a result of events such as third-party
claims resulting from errors and omissions, physical loss of securities, employee
or third-party fraud, and natural disasters.

However, institutions should view risk mitigation tools as complementary to,

rather than a replacement for, thorough internal operational risk control. Having

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mechanisms in place to quickly recognize and rectify legitimate operational
risk errors can greatly reduce exposures. Careful consideration also needs to be
given to the extent to which risk mitigation tools such as insurance truly reduce
risk, or transfer the risk to another business sector or area, or even create
a new risk e.g. legal or counterparty risk.

Investments in appropriate processing technology and information

technology security are also important for risk mitigation. However, institutions
should be aware that increased automation could transform high-frequency,
low-severity losses into low-frequency, high-severity losses. The latter may be
associated with loss or extended disruption of services caused by internal factors
or by factors beyond the institution’s immediate control e.g. external events.

Such problems may cause serious difficulties for institutions and could
jeopardize an institution’s ability to conduct key business activities. Institutions
should therefore establish disaster recovery and business continuity plans
that address this risk.

An effective monitoring process is essential for adequately managing

operational risk. Regular monitoring activities can offer the advantage of quickly
detecting and correcting deficiencies in the policies, processes and procedures for
managing operational risk. Promptly detecting and addressing these deficiencies
can substantially reduce the potential frequency and/or severity of a loss event.

In addition to monitoring operational loss events, institutions should

identify appropriate indicators that provide early warning of an increased risk
of future losses. Such indicators (often referred to as key risk indicators
or early warning indicators) should be forward-looking and could reflect
potential sources of operational risk such as rapid growth, the introduction of new
products, employee turnover, transaction breaks, system downtime, and so on.
When thresholds are directly linked to these indicators an effective

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monitoring process can help identify key material risks in a transparent
manner and enable the institution to act upon these risks appropriately.
The frequency of monitoring should reflect the risks involved and the frequency
and nature of changes in the operating environment. Monitoring should
be an integrated part of an institution’s activities. The results of these
monitoring activities should be included in regular management and board
reports, as should compliance reviews performed by the internal audit and risk
management functions.

Senior management should receive regular reports from appropriate areas such
as business units, the operational risk management office and internal audit.
The operational risk reports should contain internal financial,
operational, and compliance data, as well as external market information about
events and conditions that are relevant to decision making. Reports should
be distributed to appropriate levels of management and to areas of the
institution on which concerns may have an impact. Reports should fully reflect
any identified problem areas and should motivate timely corrective action on
outstanding issues.

To ensure the usefulness and reliability of these reports, management should

regularly verify the timeliness, accuracy, and relevance of reporting systems
and internal controls in general. Management may also use reports prepared by
external sources (auditors, supervisors) to assess the usefulness and reliability of
internal reports. Reports should be analyzed with a view to improving existing
risk management performance as well as developing new risk management
policies, procedures and practices.

In general, the board of directors should receive sufficient higher- level

information to enable them to understand the institution’s overall operational risk
profile and focus on the material and strategic implications for the business.

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 3.4.5 Internal Controls

Internal control system should be established to ensure adequacy

of the risk management framework and compliance with a documented set of
internal policies concerning the risk management system. Principle elements of
this could include, for example:

(a) Top-level reviews of the institution's progress towards

the stated objectives;

(b) Checking for compliance with management controls;

(c) Policies, processes and procedures concerning the review,

treatment and resolution of non-compliance issues; and

(d) A system of documented approvals and authorizations to

ensure accountability to the appropriate level of
management.

Although a framework of formal, written policies and procedures is critical, it

needs to be reinforced through a strong control culture that promotes sound
risk management practices. Board and senior management are responsible for
establishing a strong internal control culture in which control activities are an
integral part of the regular activities of an institution. Controls that are an
integral part of the regular activities enable quick responses to changing conditions
and avoid unnecessary costs.

Operational risk can be more pronounced where institutions engage in new

activities or develop new products (particularly where these activities or products
are not consistent with the institution’s core business strategies), enter unfamiliar
markets, and/or engage in businesses that are geographically distant from the

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head office. It is therefore important for institutions to ensure that special
attention is paid to internal control activities including review of policies and
procedures to incorporate such conditions.

Institutions should have in place adequate internal audit coverage to

verify that operating policies and procedures have been implemented effectively.
The board (either directly or indirectly through its audit committee) should
ensure that the scope and frequency of the audit programme is appropriate to
the risk exposures. Audit should periodically validate that the institution’s
operational risk management framework is being implemented effectively across
the institution.

To the extent that the audit function is involved in oversight of the operational
risk management framework, the board should ensure that the
independence of the audit function is maintained. This independence may
be compromised if the audit function is directly involved in the operational risk
management process. The audit function may provide valuable input to those
responsible for operational risk management, but should not itself have direct
operational risk management responsibilities.

REMEMBER!
Fundamental principles of internal control are:
Principle elements of this could include, for example:

(a) Top-level reviews of the institution's progress towards the

stated objectives;

(b) Checking for compliance with management controls;

(c) Policies, processes and procedures concerning the review, treatment

and resolution of non-compliance issues; and

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(d) A system of documented approvals and authorizations to Page
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accountability to the appropriate level of management.
An effective internal control system also requires existence of appropriate
segregation of duties and that personnel are not assigned responsibilities which
may create a conflict of interest. Assigning such conflicting duties to individuals,
or a team, may enable them to conceal losses, errors or inappropriate actions.
Therefore, areas of potential conflict of interest should be identified,
minimized, and subjected to careful independent monitoring and review.

In addition to segregation of duties, institutions should ensure that other internal

practices are in place as appropriate to control operational risk. Examples of these
include:

(a) Close monitoring of adherence to assigned risk limits

or thresholds;

(b) Maintaining safeguards for access to, and

use of, institution’s assets and
records;
(c) Ensuring that staff have appropriate expertise and training;
(d) Identifying business lines or products where returns
appear
to be out of line with reasonable expectations e.g. where a
supposedly low risk, low margin trading activity
generates high returns that could call into question
whether such returns have been achieved as a result
of an internal control breach; and

(e) Regular verification and reconciliation of transactions

and accounts.

3.5 Strategic Risk Management

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Strategic risk is the current or prospective risk to earnings and capital arising
from adverse business decisions, improper implementation of decisions, or
lack of responsiveness to changes in the business environment, both internal
and external. This risk is a function of the compatibility of an
institution’s strategic goals, the business strategies developed and resources
employed to achieve strategic goals, and the quality of implementation of those
goals.

Strategic risk can arise from two main sources: external and internal risk
factors. External risk factors are difficult for the institution to control or
that the institution has no control over, and affect or deter the realization of the
goals determined in the strategic plan. Such factors include:

(a) Competition - a strategic plan and business plan must be

in line with current and anticipated future competition.
Competitive factors must be taken into consideration in
the institution’s pricing practices and when developing new
products.

(b) Change of target customers - changes in demographics

and consumer profiles may affect the customer base,
earnings and capital funding of an institution.

(c) Technological changes – an institution may face risks from

changing technology because its competitors can develop
more efficient systems or services at lower costs.
The institution should ensure that the level of technology in
use is sufficient to retain its customer base.

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 (d) Economic factors - global, regional or national economic
conditions affect the level of profits of an institution. Thus,
continual assessment and monitoring of economic trends
and forecasts are needed.

(e) Regulations – changes in laws and regulations of

the supervisor, tax authorities, local authorities and other
authorized agencies may affect the implementation of
strategic and business plans established to meet the
institution’s goals; and may require adjustments to the
plans in order to ensure compliance.

Internal risk factors are controllable by the institution but can affect or deter the
implementation of the strategic plan. Such factors include:

(a) Organizational structure – it is important for the

implementation of strategic and business plans, and in
meeting overall goals in the most efficient manner, for the
institution to establish an understandable organizational
structure. An institution should have an organizational
structure consistent with its plans and that prevents
conflicts of interest among its directors, managers,
shareholders and staff.

(b) Work processes and procedures – these factors

enable timely and accurate implementation of business
plans. The Board and Directors should establish
responsibilities and clear thought s, policies and
procedures in order to prevent deficiencies in internal
controls.

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 (c) Personnel – the success of accomplishing strategic
and business plan is dependent on the knowledge,
experience, and vision of the Board, management and staff.
The staff should have the necessary expertise and
training to conduct their assignments in an efficient and
effective manner. Lack of competent and sufficient staff
levels can increase risk exposures, impair financial
performance and damage the institution’s reputation.

(d) Information - adequate, appropriate, accurate and timely

information will provide a clear understanding of the
institution and its market place, thereby positively
affecting the formulation of strategic and business
plans, and management decisions.

(e) Technology – technology systems should serve and

support complex transactions and all customers’ needs, as
well as maintain the competitiveness and support of new
business lines.

Risk mitigation factors help in the implementation of a strategic plan. Such

factors include a qualified Board of Directors, adequate preparation of
strategic and business plans, quality personnel and their ongoing training, an
effective risk management system, adequate access to information, and
timely and efficient introduction of new products or services.

Strategic risk, if not adequately managed, may gradually manifest itself

in different units of an institution. It has a tendency of attaching itself in the
‘institutional culture’ and might not easily
Be recognized. It can further affect an institution’s position in the market e.g. through
falling share of the target market.

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Self Test Questions 2.8

From the following name which one of the following is an internal strategic risk factor
and which other one is external strategic risk factor.
 Technology
 Information
 Personnel
 Regulations
 Economic factors
 Technological developments
 Organizational structure
 Completion
 Change of target customers
 Work process

3.5.1 Board and Senior Management Oversight

Board Oversight

The board of directors is responsible for the strategic direction of the

institution. The vision and mission of the institution should reflect the
direction to which the institution is heading in the medium to long term. It is the
overall responsibility of the board to provide the strategic direction
documented in a strategic plan setting out in clear terms objectives and goals in
all major areas of the institution’s business. On the basis of the approved strategic
plan, the board should, among others, set up corporate governance structure
which clearly indicates lines of responsibilities and accountability; establish
communication channels appropriate for effective implementation of the plans,

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approve strategic risk management policies and ensure that senior
management is sufficiently qualified and experienced.

A strategic plan is a document reflecting the mission and strategic goals

of an institution, generally for a period of at least four years. A good strategic
plan must be clear, consistent with goals, flexible, and adjustable to changes in
the environment. A strategic plan should contain, at least the following:

(a) Analysis of the external environment in which the

institution operates, including the PEST analysis;

(b) Critical review of the institutional performance including SWOT

analysis;

(c) Institution’s strategic goals and objectives;

(d) Description of the institution’s risk management system;

(e) Mission, goals and operating plans for each of the

institution’s units; and

(f) Institution’s quantitative projection of financial statements

for the planning period.

The Board should be knowledgeable about the institution’s market,

economic and competitive conditions and ensure that the strategic plan is
implemented effectively and reviewed at least annually. They should receive
relevant reports that are accurate and timely, and can be appropriately used in the
decision making process.

Senior Management Oversight

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Management of an institution is responsible for implementing the institution’s
approved strategic and business plans. Creation of adequate conditions for
implementation, including the design and adoption of a strategic risk
management policy, procedures, as well as duties and responsibilities of
different units is the most critical step towards effective implementation of the
strategic and business plans. Of importance in the effective implementation of the
strategic plan is the whole architecture of the internal infrastructure including an
effective organizational structure, quality personnel, robust budgeting
processes, availability of resources, effective and timely management information
systems, and monitoring and control systems that accomplish the business goals
in an effective and efficient manner.

Thus management must translate the strategic goals into attainable

operational goals, prioritizing them in terms of their strategic importance.
Strategic goals should be cascaded down into smaller executable bits assigned to
different business units within the overall set up of the institution.

The plans and objectives should be compatible with the nature, size and the
complexity of the institution and the activities it performs as well as the market of
the institution’s operations.

3.5.2 Policies, Procedures and Limits

Strategic risk management should be based on an approved Strategic Risk

Management Policy, which is in compliance with the institution’s overall
policy of risk management. The strategic risk management policy should provide
general thought s to strategic risk management. The policy should contain at least
the following:

(a) Definition of strategic risk;

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 (b) Sources of strategic risk (external and internal risk
factors);

(c) Risk mitigation factors to strategic risk;

(d) Manner of managing strategic risk;

(e) Institution’s accepted tolerance for strategic risk exposure.

3.5.3 Risk Measurement, Monitoring and Management

Information System

An effective measurement and monitoring process is essential for adequately

managing strategic risk. Identification and measurement of strategic
risk can be determined through strategic planning, the preparatory process
of a strategic plan and the reasonableness of a strategic plan. Both the
strategic plan and the operational plans and budget should be consistent with the
business scope, complexity, external environment and internal factors of the
institution, including its size and resources.

Management should fully participate and carefully decide on the basis of

information that business and strategic plans are feasible and appropriate.
Management should ensure good communication and cooperation between all
employees and departments involved in the strategic planning process.

The goals of the operational plans should be consistent with the strategic plan
and overall objectives of the institution as well as allocation of budget. The
institution should set goals, such as the quality of credit portfolio, that are
consistent with its capacity, current market share, and competitive environment.

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An institution should periodically evaluate actual performance against the
strategic plan in order to monitor and adjust its plans appropriately and
consistently with changes. The evaluation should be measurable, and with
adequate frequency.

An effective measurement and monitoring process is essential for adequately

managing strategic risk. To assess the adequacy and appropriateness of strategic
risk monitoring and reports, as well as the information system of the
institution, each business unit must consider the following factors:

(a) Contents of the reports submitted to inform decisions at

higher level;

(b) Frequency of the reports;

(c) Presentation styles of the should facilitate understandability;

(d) The reports should highlight material risks and

strategies mounted to counter them.

Management Information System

For effective monitoring of strategic risk, a robust management information

system (MIS) should be in place. MIS supports the implementation of the strategic
plan, through the following:

(a) Provides, collects, and processes

data;

(b) Reduces operating cost;

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 (c) Enhances communication among staff; and

(d) MIS should enable the institution to identify and measure

its strategic risk on a timely manner and generate data
and reports for use by the board and management.

The effectiveness of risk monitoring depends on the ability to identify and

measure all risk factors, and must be supported by appropriate, accurate and
timely MIS with analysis and decision making. Therefore, management must
develop and upgrade its information system to identify and measure risks in an
accurate and timely manner.

The MIS should be consistent with the complexity and diversity of the
institution’s business operations. For example, large institution with many
complex transactions should have a reporting system and risk monitoring system
that can measure the overall risk level. It should have ability to collect, store
and retrieve Both internal and external data including financial data; economic
condition data, the competition data, technology and regulatory
requirements.

MIS should ensure timely and continuous monitoring and control of strategic
risk, as well as reporting to the board and senior management on the
implementation of the strategic risk management process. Accordingly, MIS
should provide proper information and data on the institution’s business activities.

Effective MIS must be adequately supportive of objectives, goals, and provisions

of the services provided by the institution, be able to timely report in a desirable
format, and appropriately specify information access levels.

3.5.4 Strategic Risk Control

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The Board and senior management should monitor market changes and
advancements in technology, to determine new services or products that
maintain the institution’s competitiveness and allow timely responses to
customers’ needs.

Offering new services or products, however, may increase the risk to the
institution if proper considerations are not taken. Therefore, the Board and senior
management must carefully formulate a strategic plan for all new products.

In order to effectively fulfill strategic plan, an institution should:

(a) Review performance of senior management against set goals

at least annually. The review should determine
if performance is satisfactory and management is capable of
achieving the goals.

(b) Establish a policy or plan for management succession.

The policy or plan should be reviewed at least annually, be
consistent with the organizational structure and job
descriptions, and cover the necessary training and minimum
qualifications for each position and career path.

(c) Monitor and control performance of

outsourcing arrangements.

(d) Set compensation thought s and methods for management

and employees. The compensation should be appropriate to
the financial standing of the institution.

(e) Set a training plan and adequately budget for training. It

should also have staff retention plan to retain capable

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 individuals who have the proper knowledge and
understanding of the institution’s business and operations.

3.6 Compliance Risk Management

Compliance risk is the current or prospective risk to earnings and capital arising
from violations or non-compliance with laws, rules, regulations, agreements,
prescribed practices, or ethical standards, as well as from the possibility of
incorrect interpretation of effective laws or regulations. Institutions are exposed to
Compliance risk due to relations with a great number of stakeholders, e.g.
regulators, customers, counter parties, as well as, tax authorities, local
authorities and other authorized agencies.

Compliance risk arises from the necessity of the institution to conduct its
businesses in conformity with the business and contractual legal principles
applicable in each of the jurisdictions where the institution conducts its business,
as well as, when there is a possibility that the institution’s failure to meet
legal requirements may result in unenforceable contracts, litigation, or other
adverse consequences. Compliance risk can lead to licenses revocation,
fines and penalties, payment of damages, deteriorating position in the market,
reduced expansion potential, and lack of contract enforceability.

Compliance risk can also lead to a diminished reputation, also known

as Reputation risk, arising from an adverse perception of the image of the
institution by customers, counter parties, shareholders, or regulators. This affects
the institution’s ability to establish new relationships, services or products, or
service existing relationships. This risk may also expose the institution to
administrative, civil and criminal liability, financial loss or a decline in its
customer base.

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Compliance risk is difficult to measure, but it can be defined, understood
and controlled within the institution’s capacity and its readiness to confront
non-compliance. Compliance risk can occur whether deliberate or unintentional.

Appropriate actions for the institution to take in mitigating compliance

risk would include: reducing exposures of sources of compliance risk, an
appropriate compliance risk management process and putting in place an effective
compliance function in the institution.

The institution should identify sources of compliance risk. For instance,

common sources of Compliance risk are:

(a) Violations or noncompliance with laws and regulations

and prescribed standards;

(b) Lack of or inadequate compliance with contractual

obligations and other legal documentation;

(c) Inadequate identification of rights and

responsibilities between the institution and its customers;

(d) Complaints by customers and other

counterparties;

(e) Harming the interests of third parties;

(f) Litigation procedures, potential exposure (including cost of

litigation) and nature of pending or threatened litigation;

(g) Involvement in money laundering, insider trading, violation

of taxation rules, forgery and damage from computer

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 hacking by the institution, its intermediaries or its customers;
and/or

(h) Limited knowledge and postponed response

by management to implement legal and reputation risk
management.

3.6.1 Board and Senior Management Oversight

Board Oversight

The Board should be aware of the major aspects of the institution's

compliance risk as a separate risk category that should be managed. The
Board of directors of an institution is responsible for the following:

(a) defining the compliance risk management system and

ensure that the system is aligned with overall
business activities;

(b) approving compliance risk management policy that

provides the senior management with clear thought s and
procedures for managing compliance risk;

(c) establishing a management structure capable of

implementing the institution's compliance risk management
process; and

(d) periodically reviewing the institution's compliance risk

management policy to ensure proper guidance is provided
for effectively managing the institution’s compliance risk.

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The Board should ensure that the institution's compliance risk management system
is subject to implementation by the senior management and a qualified
compliance officer/staff, and reviewed by an effective and comprehensive
internal audit function.

Self Test Question 2.9

What are the sources of compliance risk in an institution?
Describe each source.

Senior Management Oversight

Senior management is responsible for running the institution on a day-to-day

basis, to manage and monitor the institution's overall risk environment. Senior
management is therefore responsible for the effective management of the
institution’s compliance risk including:

(a) Implementing the compliance risk management system

approved by the Board;

(b) Establishing an effective organizational structure for

compliance risk management, and be in regular contact
with employees that are directly responsible for conducting
compliance risk management (institution’s compliance staff
and lawyers);

(c) Ensuring that all employees are working in order to

protect the institution's reputation;

(d) Ensuring that sufficient human and technical resources are

devoted for compliance risk management; and

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 (e) Ensuring ongoing compliance training that covers
compliance requirements for all business lines,
particularly when entering new markets or offering new
products.

The size of the institution and the complexity of its business activities
dictate the scope of the compliance function and staffing requirements (number
and competencies) of a compliance function unit. Not all compliance
responsibilities are necessarily carried out by a compliance unit. Compliance
responsibilities may be exercised by staff in different departments or all
compliance responsibilities may be conducted by the compliance unit/department.

Regardless of how the compliance function is organized within the institution,

it should be independent, with sufficient resources and clearly specified
activities. The compliance staff, especially the head of compliance, should not
be in a position where there may arise a conflict of interest between their
compliance responsibilities and any other responsibilities they may have.

The head of compliance function may or may not be a member of senior

management. If the head of compliance function is a member of senior
management, he or she should not have direct business line responsibilities.
If the head of compliance function is not a member of senior management,
he or she should have a direct reporting line to a member of senior management
who does not have direct business line responsibilities.

Compliance risk should be included in the risk assessment methodology of the

internal audit function, and an audit program that covers the adequacy and
effectiveness of the institution’s compliance function should be established,
including testing of controls commensurate with the perceived level of risk. This
principle implies that the compliance function and the internal audit
function should be separate to ensure that the activities of the compliance function

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are subject to independent review. However, the audit function should keep the
head of compliance informed of any audit findings related to compliance.

3.6.2 Policies, Procedures and Limits

Institutions should put in place adequate policies and procedures for

managing compliance risk. Compliance policy should explain the main processes
by which compliance risk is to be identified and managed through all levels of the
institution’s organizational structure. The policy should also define the compliance
function as an independent function, with specific roles and responsibilities of
the compliance staff, and detailing the compliance officer’s communication
methods with the management and staff in the various business units.

Compliance risk management policy should be part of the overall risk

management policy of the institution, and should precisely determine all important
processes and procedures in minimizing the institution’s compliance risk exposure.
The policy should be clearly formulated and in writing. The policy must contain,
at least the following:

(a) Definition of compliance risk;

(b) Objectives of compliance risk management;

(c) Procedures for identifying, assessing, monitoring,

controlling and managing compliance risk;

(d) Well defined authorities, responsibilities and information

flows for compliance risk management at all management
levels; and
(e) Clear statement of the institution’s accepted tolerance for
compliance risk exposure.

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Procedures for compliance risk should contain at a minimum:

(a) Definition of the required legal documents establishing the

collateral on loans for clients. These also include
verification, by the institution's legal expert, of the legitimacy
of the collateral on the basis of the available documentation.

(b) Definition of standard procedures for foreclosures.

(c) Standardized contracts for similar institution’s

products, clients, and other services with third parties. The
terms or conditions of a contract should be confirmed
by the institution's legal expert. Special attention should
be paid to the procedures for changing the terms of a
signed contract. The institution's legal expert should also
confirm annexes to any contract.

(d) Legal due diligence of the institution’s major clients and

counterparties, vendors and outsourcing companies.

(e) Documentation standards for all initiated court proceedings

against or on behalf of the institution. Permanent
and accurate information and documents of the institution’s
effectiveness in court proceedings is also needed.
Institution's legal experts should keep a list of all court
proceedings with their opinion on the possible result of the
case, as well as, a list of court cases that in the name of the
institution are lead by outside attorneys. In addition, the
institution should separately retain data describing the
types of claims for which the institution has usually

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 initiated litigation and in which cases the institution was
sued.

(f) Definition of the major mitigating actions to compliance

risk (e.g., through reviewing contract terms by experienced
lawyers, restricted dealings to reputable counterparts,
placing limits on exposure to legal interpretations, etc.).

(g) Clear documentation standards for the institution’s

shareholders.

(h) Documentation standards for all decisions made by the Bank

of in respect of the institution and written
communications between the NATIONAL BANK OF
ETHIOPIA and the institution

(i) Procedures for safeguarding of original legal

documents. (j) Regular compliance checks.

3.6.3 Risk Measurement, Monitoring and Management

Information System

An effective measurement and monitoring process is essential for adequately

managing compliance risk. In order to understand its compliance risk profile an
institution should identify the sources of compliance risk that it is exposed to and
assess its vulnerability to these risks.

If a new compliance risk is not recognized, the institution's legal experts may
never thoroughly review the existing contracts. Thus, the institution should

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identify and assess the Compliance risk inherent in all existing or new, rules,
procedures, internal processes, activities, contracts and court cases.

The institution needs to define the appropriate approach to assessing each

identified source of risk. There are various tools used for identifying and
assessing compliance risk, such as:

(a) Self-Assessment - An institution assesses its operations and

activities against a list of potential risk vulnerabilities. This
process is internally driven and often incorporates
checklists to identify the strengths and weaknesses of the
compliance risk environment.

(b) Risk Indicators - Risk indicators are statistics or matrices

that can provide insight into an institution’s risk position.
Such indicators may include the volume and/or frequency
of law violations, frequency of complains, number of
initiated litigation procedures, payments of damages, fines
and court expenses, unfavorable court verdicts or number
of finalized court cases on a periodical basis, and
frequency of actual or suspected fraud or money laundering
activities. These indicators should provide good
incentives, tying risk to capital to desirable
improvement in the compliance function.

(c) Risk Mapping - In this process, various departments or

units are outlined by risk types (for example credit
unit/department can be outlined by the risk of the lack of
contract enforcement or incorrect interpretation of the
agreements). This exercise can disclose areas of

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 weakness and help to identify priorities for management
action.

The institution should consider ways to measure compliance risk by using

performance indicators, such as the increasing number of customer complaints,
corrective measures taken against the institution, or litigation procedures as a
result of noncompliance with laws and regulations.

Compliance risk can also be measured by regular legal reviews on different

institution’s products and services, and their relevant documentation in order to
ensure that all contracts are in conformity with laws and regulations. This review
may take place on each transaction individually or may cover the legal
adequacy of standardized documentation and procedures.

Institutions are responsible for monitoring their compliance risk profiles on

an on-going basis by reviewing defined compliance risk indicators in order
to provide management with early warning. Monitoring should be an
integrated part of an institution's activities. The results of these monitoring
activities should be included in regular management and Board reports.

Institutions should have processes and procedures in place to control

compliance risk. There should also be a constant review of the institution’s
progress towards meeting legal objectives, and checking for compliance with
policies and procedures and defined duties and responsibilities.

Management Information System

For effective monitoring of compliance risk, a robust management

information system (MIS) should be in place. MIS should enable the institution
to identify and measure its compliance risk on a timely manner and generate
data and reports for use by the board and management;

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The effectiveness of risk monitoring depends on the ability to identify and
measure all risk factors, and must be supported by appropriate, accurate and
timely MIS with analysis and decision making. Therefore, management must
develop and upgrade its information system to identify and measure risks in an
accurate and timely manner. The MIS should be consistent with the complexity
and diversity of the institution’s business operations.

The institution should establish a database of its legal documents. This database should
contain at least: type of legal documents (contracts, memorandum of understanding,
etc.), period of document validation, and responsible department/unit for document
enforcement.

3.6.4 Internal Controls

Institutions should have proper internal control systems that integrate compliance risk
management into its overall risk management process. The audit of compliance
risk management should be incorporated into the annual plan of the Internal Audit
function.

The Internal Audit function should, within its scope of operations, cover the following
aspects of compliance risk management:

(a) Verifying that compliance risk management policies and

procedures have been implemented effectively across the
institution;

(b) Assessing the effectiveness of controls for mitigating

fraud and risks to reputation;

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 (c) Determining that senior management takes appropriate
corrective actions when compliance failures are identified;

(d) Ensuring that the scope and frequency of the audit

plan/program is appropriate to the risk exposures;

(e) Determining the level of senior management compliance

with central bank directives;

(f) Monitoring compliance risk profiles on an on-going basis;

and

(g) Analyzing the timeliness and accuracy of compliance risk

reports to senior management and board of directors.

REMEMBER!

The various tools used to identify compliance risk are:

 Self Assessment
 Risk matrices
 Risk mapping

Self Test Question 2.10

What is the objective of internal control in compliance risk management?

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