Question Two (20 marks) "Financial Institutions are specific" Required: i) Outline the specificities of Banks, insurance companies and MFIs. (6 marks) ii) State the risks that are relevant?

i)

Banks:
- Banks are financial institutions that primarily accept deposits from customers and provide loans and other financial services.
- They are regulated by central banks and other financial regulatory authorities.
- Banks play a crucial role in the economy by facilitating the flow of funds between savers and borrowers.
- They offer a wide range of financial products and services, including savings accounts, checking accounts, loans, and investment products.

Insurance companies:
- Insurance companies provide financial protection against various risks by selling insurance policies to individuals and businesses.
- They collect premiums from policyholders and pay out claims when the insured event occurs.
- Insurance companies are regulated by insurance regulatory authorities to ensure they have sufficient reserves to meet their obligations.
- They offer a variety of insurance products, including life insurance, health insurance, property insurance, and liability insurance.

Microfinance Institutions (MFIs):
- MFIs are financial institutions that provide financial services, such as small loans, savings accounts, and insurance, to low-income individuals and communities.
- They focus on financial inclusion and serving the unbanked and underbanked populations.
- MFIs often operate in developing countries and rural areas where traditional banks may not reach.
- They play a crucial role in poverty alleviation and economic development by providing access to financial services to those who are excluded from the formal financial system.

ii)

Risks relevant to financial institutions include:

- Credit risk: the risk of borrowers defaulting on their loans.
- Market risk: the risk of losses due to changes in market conditions, such as interest rates, exchange rates, and asset prices.
- Liquidity risk: the risk of not being able to meet short-term obligations due to a lack of liquid assets.
- Operational risk: the risk of losses due to internal processes, systems, or human error.
- Regulatory risk: the risk of non-compliance with regulations and facing penalties or sanctions.
- Reputational risk: the risk of damage to the institution's reputation due to negative publicity or customer dissatisfaction.
- Systemic risk: the risk of the entire financial system being affected by the failure of a single institution or a group of interconnected institutions.

i) Specificities of Banks, Insurance Companies, and MFIs

Banks:

- Primary Function: Accept deposits and make loans
- Liquidity: Hold a significant portion of assets in liquid form to meet withdrawal demands
- Regulation: Subject to strict capital and liquidity regulations
- Core Funding: Funded primarily by deposits from customers
- Risk Management: Focus on credit risk, market risk, and operational risk

Insurance Companies:

- Primary Function: Provide financial protection against risks
- Insurance Premiums: Collect premiums from policyholders to cover potential losses
- Underwriting: Evaluate and assume risks based on actuarial principles
- Long-Term Obligations: Have long-term liabilities (e.g., policy obligations)
- Investment Management: Invest premiums to generate returns and cover liabilities

MFIs (Microfinance Institutions):

- Primary Function: Provide financial services to low-income individuals and small businesses
- Small Loans: Offer small loans to unbanked populations
- Group Lending: Often use group lending models to reduce risk
- Social Mission: Aim to promote financial inclusion and poverty alleviation
- Local Focus: Typically operate within specific geographical areas or communities

ii) Relevant Risks

Banks:

- Credit Risk: Risk of borrowers defaulting on loans
- Market Risk: Risk of losses due to fluctuations in interest rates, inflation, or exchange rates
- Operational Risk: Risk of losses from internal failures, fraud, or technology disruptions
- Liquidity Risk: Risk of being unable to meet withdrawal demands

Insurance Companies:

- Underwriting Risk: Risk of overestimating premiums or underestimating losses
- Investment Risk: Risk of losses from investments made to cover liabilities
- Operational Risk: Risk of errors or fraud in claims processing and administration

MFIs:

- Credit Risk: Risk of borrowers defaulting on loans, particularly in low-income populations
- Operational Risk: Risk of mismanagement, fraud, or operational disruptions due to limited infrastructure
- Social Risk: Risk of backlash from community members if loans are not repaid