Answer to Question #165230 in Finance for Bishem

Question

QUESTION ONE

(a) Discuss in detail the roles played by financial institutions (FIs) in the economy with particular reference to Zambia citing particular examples of financial institutions that you are familiar with in Zambia.

(b)List and explain the major risks that financial institutions in general face? How do these risks manifest or affect the FIs?

QUESTION TWO

(I) Using appropriate illustrations discuss in detail the factors that affect demand for loanable funds according to the Loanable Funds Theory of interest rate determination.

(ii) What impact would these have on demand and supply of funds and on the interest rate?

QUESTION THREE

(a) Discuss the term Monetary Policy in relation to the Zambian economy.

(b) Zambia as a developing country may have problems in establishing an effective operating Monetary Policy.

(I) Explain at least five major problems which may prevent Zambia from establishing an effective Monetary Policy.

(ii)Describe the main Monetary Policy tools which Zambia may use to influence economic growth.

QUESTION FOUR

(a)What is risk management? Discuss the two major ways in which exposure can be managed and/or reduced.

(b)Financial institutions face a number of risks in their operations. How are these risks mitigated or managed? What techniques are used to mitigate each type of risk you have identified?

Answer 1

Question 1

(a)

There are different roles played by both bank and non-bank financial institutions in Zambia. They act as a channel between borrowers and lenders, they pull funds from those individuals and organizations with excess in form of deposits and lend to those in need of funds. Financial institutions thrive on these intermediation abilities as they take funds in form of deposits at lower interest and then lend out as loans at much higher interest.

For instance, the Bank of Zambia ensures efficient allocation of resources by taking resources from where they are least needed to where they are required. This results in economic development.

Non-depository financial institutions such as FMC Finance Limited provide insurance policies and pension funds to their clients in exchange for premium payments from clients. Financial institutions have broadened access to capital mainly to SMEs. Since SMEs are labor-intensive sector it increases the level of employment in the country.

Financial institutions such as Business Partners International Zambia SME Fund Limited, provide information on investment opportunities as well as channeling funds to those investments.

Generally, financial institutions in Zambia manage financial risks, provide loans, encourage saving and control the flow of money and liquidity.

(b)

Credit risks –Occurs when the borrowers fail to honor their contractual obligations. This may bring great loss to financial institutions.

Operational risk- This comes mainly from internal employees mainly with intent to defraud the financial institution.

Market risk- Given that interest rates, equity markets and asset markets are unpredictable, it sometimes sinks the funds of financial institutions when they invest in such markets.

Liquidity risk- which occurs when financial institutions fail to meet the cash demand of customers in time. This leads to a snowball problem.

These risks manifest when there are changes in technology and regulations, the financial institution is affected by cybercrimes, if the reputation of the financial institution is damaged, when there is a decline in the general economy and when they are affected negatively by competition.

Question 2

(I)

Investments

Low-interest rate causes demand for loanable funds for investment to be high and vice versa.

Hoarding

When the rate of interest is low the demand for loanable funds for hoarding will be high and when the rate of interest is high the demand for loanable funds for hoarding is low.

Dissaving

When the rate of interest is low the demand for loanable funds for dissaving is high. That is, dissaving is a decreasing function of the interest rate.

 

(ii)

Individuals will save more with high-interest rates.

At higher interest rates, idle cash of the past becomes active balances of today, therefore, increasing investments.

Disinvestments will be high when present interest rates provide better returns in comparison to present earnings and therefore the demand for funds will be high.

Question 3

(a)

The Bank of Zambia has a role to implement the main objective of monetary policy which is the regulation of monetary supply. Often as an attempt to reduce inflation (*price stability) and general trust of value and stability of Zambia's currency.

(b)

(i)

Developing countries such as Zambia struggle to maximize the output and employment levels hence the amount in the banks is a small fraction of the money in the economy which makes monetary policies ineffective.

The difference in consumer prices and aggregate monetary prices is a great challenge in developing countries like Zambia.

The volatile interest rates also affect the Monetary policy-making as it affects both output and inflation.

Inflation also affects the efficiency of the Monetary policy in Zambia as it affects prices and money supply in the economy hence adjusting to inflationary monetary policy can be a challenge.

Fiscal factors such as technology also pose a challenge to Monetary policy in Zambia.

(ii)

Open market operations

The Bank of Zambia sells government securities in these markets to ensure price stability and control liquidity by manipulating the short-term interest rate and the supply of base money in an economy.

The discount rate

The Bank of Zambia regulates the interest rates favorably to sets the floor for the interest rate which in turn determines saving and investments.

Reserve requirements

The Bank of Zambia requires the other banks in the country to hold a certain percentage of money to regulate loans and therefore limiting the money supply in the economy.

Question 4

a)

Risk management is the procedure of identifying potential risks early enough, analyzing them and taking measures to minimize or avoid the risks.

Ways of reducing risks include;

Taking insurance covers to cover financial risks such that in the event of the risk occurring an insurance firm takes up some or all the responsibility of the losses incurred.

Diversifying investments

This involves investing in different portfolios to maximize returns and minimize risks.

(b)

Risks are mitigated through scheduling regular and comprehensive risk assessments, taking a risk-based approach and investing time and resources in high-risk sectors and coming up with programs to manage and mitigate risk.

The technique used to mitigate credit risk is making credit risk models and rechecking the credibility of loan borrowers.

The technique used to manage operational risks includes using management approaches.

The technique used to manage market risks is using the value at risks method.

The technique used to manage liquidity risk is by the use of the liquidity risk control method.