Risk Management in Bank Institutions

Daystar University (Nairobi Campus)

Assignment in partial fulfillment of the course ECO 212X

Presented to: M.R Jimnah Waweru

Presented by: Betsy Mbinya Mulwa.

Admission Number: 10-1026

Topic on research: Money and Banking in both Kenya and the developing countries.

Date due: 16/04/2012

Table of contents

Section A

Introduction ……………………………………………..

The history and creation of money………………………………

The nature and functions of money…………………………….

The demand for and supply of money…………………………

Banking system in Kenya and developing countries…………………………………….

Section B

The open economy…………………………………………….

Theory of comparative advantage……………………………..

Free trade vs. protectionism………………………………….

The balance of payments…………………………………

National debt………………………………………………..

Introduction

There have been more changes brought about in the world of money and banking. In determination of income and employment money plays a central role. Federal Reserve controls money growth and interest rates.

History of money

First there used to be presence of barter trade moved to commodity money where a commodity would be of intrinsic value like Gold and finally came fiat money used because of government decree.

Money: these are assets in economy that buy goods and services for people.

Creation of money

Supply of money is affected by amount deposited in banks and the amount that the bank’s loan. There also the aspect of money multiplier which is the reciprocal reserve ratio

Money multiplier= 1/required reserve ratio.

The multiplier process

The public

Excess reserves leakage into

Required reserves

New bank deposit leaks into required reserves. The excess reserves used to make loans which in turn become deposits elsewhere. Creation of money continues until all available reserve are required.

Functions of money

Money as a unit of account:

Unit of account is simply measuring rod of value. It ceased to be associated with a particular commodity like gold. In most countries unit of account has become an abstract intangible measure. It is the money’s principle to serve the unit of account.

The unit of account in Kenya is in shillings.

As a medium of exchange:

A common unit of account facilitates trade but the economy keeps on increasing. It is difficult for barter transactions to be effective, instead of using other goods money is used in terms of paper or coins

The unit of money in Kenya

Kenyan shilling (KES)

Iso 4217 code KES

User: Kenya

Subunit: 1/100 cnt

Symbol: Ksh

Coins; frequently used: 1, 5, 10, 20 shillings

Rarely used: 50 cent, 40 shillings

Bank notes: frequently used: 50,100,200,500, and 1000 shillings.

Rarely used: 10, 20 shillings

Central bank: central bank of Kenya

Money as a store of value: people can store assets for future consumptions to leave inheritance to a group. These assets must be converted into some money, other people hold their wealth in form of money and this is where it performs store of value function when wealth is held in monetary form.

As a standard of deferred payments:

Lately contracts involving future payments are denominated in money. For example getting a house by mortgage one is required to pay either in cash. In Kenya people sell their lands to get paid in Ksh.

The demand for and supply for money

a. The demand for money

This is the demand for real money balances because people hold money for what it will buy. Nominal balances are more when the price level is high; a person has to hold to purchase a given quantity of goods. Doubling of price level will lead to individual holding twice nominal balance in order to buy same goods.

The real income and interest rate determines demand for real balances. It depends on real because the money held by individuals to pay for their purchases depends also on the incomes they receive. Cost of holding money is in interest forgone by holding money rather than other assets. It is costly to hold money when interest rate is high and hence less cash held.

If interest rate is high it is wise not to hold more money it is good rather to hold bonds. Demand for real balances denoted as L. demand for real balances increases with level of real income and decrease with interest rate.

L=KY-hi k, h, ≥ 0

K and h reflect sensitivity of demand for real balances to level of income and interest rate.

The demand curve for higher level of real income

i

Interest rate K y L2=KY2-hi

L1=KY1-hi

O L1 l2

L

Demand for money

The supply of money

Nominal quantity of money is controlled by federal reserve system. Central bank in Kenya known as. C.B. Nominal quantity of money at level M. So real money supply is at the level M/P

i E2 I E2 LM

i2

L2=ky2-hi

E1

I1 E1

Interest rate L1=ky1-hi

m/p l Y1 Y2

Real balances (a income/ output (b

In figure (a combination of interest rates and income levels are such that demand for real balances exactly matches available supply.

Y1-level of income

L1- demand curve for real balances

L1 in figure (a is diagram for demand for money it draws as decreasing function of interest rate. Supply of real balances m/p since it is independent of interest rate is shown by a vertical line therefore independent of interest rate.

Demand for real balance= supply

E1 is equilibrium point in money market shown in figure (b

Y2 is increase in income

In figure (a demand for real balances are higher when the level of income goes up and demand curve E1 real balance shifts up=L2

I2- interest rate increase to maintain equilibrium in money market at high income. E2 is new equilibrium point LM is money market equilibrium schedule shows combinations of interest rates and levels of income

The banking system

Banks are institutions that specialize in borrowing and lending one person giving her saving account in form of lending funds to bank which promise to pay in future.

Financial institutions: are firms providing access to financial markets both to savers wishing to purchase financial instruments directly and borrowers who want to issue them. This includes insurance companies, securities firms, and banks. Any disturbance to them causes adverse effects on economy. The importance: people wishing to save can store their money in a safe place.

Role of financial institutions

a. They reduce costs of specialing in issuance of standardized securities

b. Reduce information costs of screening and monitoring borrowers to make sure they are credit worthy.

c. Helps resources flow to most productive uses

d. Make long term goals

e. Savers gain access to funds any time.

There are two types of financial institutions: the ones providing brokerage services (top) and the ones transforming assets (bottom)

Broker gives households access to financial markets and direct finance to financial markets and direct finance

Banking in Kenya

Banking is found to be easy and efficient but most of institutions prefer not to use credit cards, loans, and overdraft allowances. For one to have an account he must bring identification with them working visa, and a passport photo. The following are big banks in Kenya who offer banking and foreign exchange services.

a. Barclays bank of Kenya

b. Standard chartered bank

c. Kenya commercial bank

d. Stanbic bank

e. Commercial bank of Africa

f. Cooperative bank of Kenya

g. African banking corporation

h. Citi bank

i. National bank of Kenya

j. National industrial/ credit bank

k. Equity bank

In developing countries recently there has been presence of mobile banking where money is sent mostly through the cell phone.

They are believed to have population with poor health, low levels of literacy, inadequate dwellings. The incomes are understated by a factor of three.

The commercial banks provide a full range of banking services including savings, checking loans and accounts for all purposes. They hold total savings deposits and all demand deposits.

Section B

Open economy

Closed economy consist of following two equations

M=L(y, r)

S(y) = I ®

In open economy the LM schedule does not need to be changed because it shows real money must be Equilibrium which is assumed to be controlled by domestic policy maker. Policy makers control the nominal stock of money. In the figure below open economy is shown to be downward sloping low levels of investments are caused by high values of interest rate. IS schedule is shifted to right when there is an increase in government spending a cut in taxes or increase in government spending a cut in taxes or increase in export demand.

r LM

BP

IS

Y

Open economy will contain a balance of payments equilibrium schedule. In figure above BP schedule plots all interest rate income combinations resulting in balance of payments equilibrium at a given exchange rate.

Theory of comparative advantage

Refers to the ability of a person or country to produce goods and services at a lower marginal and opportunity cost over another, described by David Ricardo on the principles of political economy and taxation book.

Assumptions of Ricardian model

Two countries denoted home and foreign

Final products goods M and F

Supply of labor in an inelastic way.

Use of one output by each good in production.

International immobility of labor within each country.

Requirement of constant labor per unit of output.

Difference in technology between two countries.

No trade barrier or cost of transportation

Product markets perfect competition in factor

If a good is produced more efficiently the country has absolute advantage in the production of the good

Ricardian theory: a commodity is exported most if it has a comparative labor productivity advantage. The absolute advantage does not say much about trade. The two main concepts in this theory are opportunity cost and production possibility frontier.

Production possible frontier: represents different combinations of output produced by a country at a specific level of technology

Free trade vs. protectionism