Chapter one

Summary

NATURE OF FINANCIAL INTERMEDIATION

 Financial claim carries an obligation on the issuer to pay interest periodically and to
redeem the claim at a stated value in one of three ways:

 on demand;

 after giving a stated period of notice;

 on a definite date or within a range of dates.

 Financial claims can take the form of any financial asset, such as money, bank deposit
accounts, bonds, shares, loans, life insurance policies, etc.

 The lender of funds holds the borrower’s financial claim and is said to hold a financial
asset.

 The issuer of the claim (borrower) is said to have a financial liability.

 Lenders’ requirements:

 The minimization of risk.

 The minimization of cost. their costs.

 Liquidity.

 Borrowers’ requirements:
 Funds at a particular specified date.
 Funds for a specific period of time.
 Funds at the lowest possible cost.

Financial intermediaries can bridge the gap between borrowers and lenders and
reconcile their often incompatible needs and objectives.
Financial intermediaries help minimize the with direct lending
o particularly transactions costs and
 those derived from information asymmetries
 Transactions costs

 Cost relate to the costs of searching for a counterparty to a financial transaction;

 The costs of obtaining information about them;

 The costs of negotiating the contract;

 The costs of monitoring the borrowers; and the eventual enforcements costs should the
borrower not fulfil its commitments.

 Asymmetric information

 Lenders are also faced with the problems caused by asymmetric information.

 These problems arise because one party has better information than the counterparty.

 In this context, the borrower has better information about the investment (in terms of risk
and returns of the project) than the lender.

 Information asymmetries create problems in all stages of the lending process.

 In a net shell
 Transaction costs and information asymmetries are examples of market
failures;
 that is, they act as obstacles to the efficient functioning of financial
markets.
 One solution is the creation of organized financial markets. However,
transaction costs and information asymmetries, though reduced, still
remain
 Modern banks offer a wide range of financial services, including:
• Deposit and lending services
• Payment services
• Investment, pensions and insurance services
• E-banking
Banking Activities:
• Accepting deposits
• Issuing e-money (digital money)
• Dealing in investments (as principal or agent)
• Managing and/or Advising on investments
• Advising on investments
• Arranging deals in investments and arranging regulated mortgage activities
• Advising on regulated mortgage contracts.

Banking business has experienced substantial change over the last 30 years.
Banks have transformed their operations from relatively narrow activities to full service
financial firms.
 Banks can be classified based on their clients or function:
1. Retail Banks
2. Private Banking
3. Corporate Banking
4. Investment Banking
PARTS OF FINANCIAL SYSTEM

1. Money

To pay for purchases and store wealth.

2. Financial Instruments

To transfer resources from savers to investors and to transfer risk to those best equipped
to bear it.

3. Financial Markets
To buy and sell financial instruments.

4. Financial Institutions

To provide access to financial markets, collect information & provide services.

5. Regulatory Agencies

To provide oversight for financial system.

 6. Central Banks

To monitor financial Institutions and stabilize the economy

Chater two

IFRS 9 FINANCIAL INSTRUMENTS

 A new accounting standard on financial instruments which replaces IAS 39.

 New version of IFRS 9 issued in 24 July 2014

 Effective date: 1 January 2018.

 IFRS9 Standard includes requirements for

 Recognition

 Measurement

 Impairment

 Derecognition and

 General hedge accounting.

 KEY CHANGES FROM IAS 39

Key changes Implication

Different asset classification criteria Change in classification criteria

and how financial assets are reported in

the financial statements

New impairment approach Early recognition of impairment loss

IFRS 9 OBJECTIVE

The objective of this Standard is to establish principles for the financial reporting of financial
assets and financial liabilities that will present relevant and useful information to users of
financial statements for their assessment of the amounts, timing and uncertainty of an entity’s
future cash flows.”

What is a Financial Instrument?

A contract giving rise to

 Financial asset of one entity

 Financial liability or equity of another entity

Financial Asset

A. Cash;

B. An equity instrument of another entity;

C. Contractual right to receive cash from another party (e.g., loans, receivables, and
bonds).

D. A contract that may or will be settled in the entity’s own equity instrument

IFRS 9 RECOGNITION

B. An entity shall recognize a financial asset or a financial liability in its statement of

financial position when, and only when, the entity becomes party to the contractual
provisions of the instrument (Par 3.1.1).
C. When an entity first recognizes a financial asset, it shall classify it in accordance with
paragraphs 4.1.1–4.1.5 and measure it in accordance with paragraphs 5.1.1–5.1.3. (Par
3.1.1).

D. When an entity first recognizes a financial liability, it shall classify it in accordance with
paragraphs 4.2.1 and 4.2.2 and measure it in accordance with paragraph 5.1.1. (Par 3.1.1).

Derecognition of Financial Assets

E. Derecognition is removal of an asset or liability from the balance sheet

F. The standard combines the ‘risk and rewards approach’ and ‘control approach.

G. An entity shall derecognize a financial asset when, and only when:

(a) the contractual rights to the cash flows from the financial asset expire, or

(b) it transfers the financial asset as set out in paragraphs 3.2.4 and 3.2.5 and the transfer
qualifies for derecognition in accordance with paragraph 3.2.6

Financial Instruments: Presentation

− The classification of financial instruments between liabilities and equity.

− Presentation of certain compound instruments (instruments combining

debt and equity)

− Liability or Equity

− Classify the instrument, or its component parts, on initial recognition as a

financial liability, a financial asset or an equity instrument in accordance with the
substance of the contractual arrangement and the definitions of a financial
liability, a financial asset and an equity instrument.

− If a financial instrument contains both a liability and an equity element, the

instrument’s component parts should be classified separately.

− Classification - substance of a financial instrument rather than its legal form .

 − Debt - Contractual obligation to deliver cash or another financial asset under
conditions that are potentially unfavorable.

− Equity - Exposure to the risk of fluctuations in price or residual interest of

issuer’s equity .

Compound Financial Instruments

− Most common type of compound instrument is convertible debt.

 − This creates a primary financial liability of the issuer and grants an option to the
holder of the instrument to convert it into equity instrument (usually ordinary
shares) of the issuer.

− Compound Financial Instruments: Illustration

− Rathbone Co issues 2,000 convertible bonds at the start of 20X2.The bonds have a three
year term, and are issued at par with a face value of $1,000 per bond, giving total
proceeds of $2,000,000. Interest is payable annually in arrears at a nominal annual
interest rate of 6%. Each bond is convertible at any time up to maturity into 250 ordinary
shares.

− When the bonds are issued, the prevailing market interest rate for similar debt without
conversion options is 9%.

− Required

− What is the value of the equity component in the bond?

− Compound Financial Instruments: Illustration

− Solution

− Principal

− $2,000,000 discounted at 9% over 3 years:

− 2,000,000 ÷ 1.09^3 $1,544,367

− Interest

− Year 1 120,000 ÷ 1.09 110,091

− Year 2 110,091 ÷ 1.09 101,002

− Year 3 101,002 ÷ 1.09 92,662

303,755

− Value of liability component $1,848,122

− Equity component (balancing figure) $151,878

 − Proceeds of bond issue

− Redeemable Preference Shares

− Many entities issue preference shares which must be redeemed by the issuer for a
fixed (or determinable) amount at a fixed (or determinable) future date.

− Alternatively, the holder may have the right to require the issuer to redeem the
shares at or after a certain date for a fixed amount.

− In such cases, the issuer has an obligation. Therefore the instrument is a financial
liability and should be classified as such.

− Treasury Shares

− Acquisition of own equity instruments (treasury shares) should be deducted from

equity.

− No gain or loss shall be recognized in profit or loss on the purchase, sale, issue or
cancellation of an entity’s own equity instruments.

However, an obligation to purchase own equity instruments for cash or another financial asset
gives rise to a financial liability for the present value of the redemption amount

Interest, Dividends, Losses and Gains

− Interest, dividends, losses and gains relating to a financial instrument or a

component that is a financial liability shall be recognized as income or expense in
profit and loss.

− Distributions to holders of an equity instrument shall be debited by the entity

directly to equity.

− Disclosures:

− Objectives

Information about FAs & their impact on financial performance

Assessment of risk and how it is managed

Disclosures:

− Qualitative description

− Quantitative data

− Level of information

Overburdening vis a vis obscuring due to aggregation

– All entities – not just banks or financial institutions

– All financial instruments except those covered by more specific standard

 interests in subsidiaries, associates and joint ventures

 interests in post employment benefits

 share-based payments

 insurance contracts

DISCLOSURES TYPES

Accounting

significance of financial instruments to financial position and performance

Risk

extent of exposure to risks arising from financial instruments

Accounting Disclosures

 Financial assets and financial liabilities

– measurement categories

– fair value through profit or loss

– reclassifications

– compound instruments with multiple embedded derivatives

– fair value
  Financial assets

transfers not qualifying for derecognition

collateral

allowance for credit losses

defaults and breaches

RISK DISCLOSURES

 Credit Risk

maximum exposure to credit risk, past due and impaired financial assets, collateral

 Liquidity Risk

maturity analysis and how liquidity risk is managed

 Market Risk

– sensitivity analysis

Capital Disclosures

objectives, policies and processes for managing capital

description and quantification of what bank regards as capital

if subject to externally imposed capital requirement

 nature of requirements

 whether complied with requirements and, if not, the consequences

Risk Disclosures

 Qualitative Information

– exposures to risk and how they arise

– objectives, policies and process for managing risk

– methods used to measure risk

 – changes from previous period

 Quantitative Information

based on information provided to key management personnel

concentrations

Qualitative Disclosures:

− For each type of risk, an undertaking shall disclose

− The exposures to risk and how they arise

− Its objectives, policies and processes for managing the risk and the methods used
to measure the risk and

- Any changes in (i) or (ii) from the previous period

Qualitative Disclosures

 Credit Quality Disclosures

about the credit quality of financial assets that are neither past due nor impaired

For ex - the amounts of credit exposures for each external credit grade

the rating agencies used;

the amount of an entity’s rated and unrated credit exposures

 Market Risks

Open positions in interest rate, currency and equity products, all of which are exposed to general
and specific market movements

Quantitative Disclosures

For each type of risk, an undertaking shall disclose

 Summary quantitative data about its exposure to that risk at the reporting date.
  Based on the information provided to key management, such as the board of
directors or chief executive officer.

Quantitative Disclosures

 Disclosure of Concentrations of Risk

From financial instruments that have

 Similar characteristics and

 Affected similarly by changes in economic or other conditions.

Requires judgement reflecting the circumstances of the undertaking.

For each type of risk, an undertaking shall disclose

 Summary quantitative data about its exposure to that risk at the reporting date.

 Based on the information provided to key management, such as the board of

directors or chief executive officer.

 Disclosure of Concentrations of Risk

From financial instruments that have

 Similar characteristics and

 Affected similarly by changes in economic or other conditions.

Requires judgement reflecting the circumstances of the undertaking.

 Disclosure of Concentrations of Risk

Includes

 how management determines concentrations;

 the shared characteristic that identifies each concentration (e.g.

counterparty, geographical area, currency or market)

 the amount of the risk exposure associated with all financial instruments
sharing that characteristic
  Disclosure of Concentrations of Risk

Concentrations of assets, liabilities and off-balance sheet items

 Geographical

 Currency

 Industry

 Market

 Type of counterparty

 Credit Risk Disclosures

Failure to pay by a counterparty causing financial loss

Maximum credit exposure for each class of FI.

Collateral and other credit enhancements obtained