The Nature And Role Of The Financial System Finance Essay

The Nature And Role Of The monetary System finance Essay monetary system is a mechanics where scotch shift solveivities fag end be done. The economic activities can be done through the fundamental interaction amongst fiscal institutions and the monetary merchandise. The purposes of this interaction argon to fling on fund and providing honorarium facilities for the financing of mercenary activities. With the outcome of Moslem finance, the dual monetary systems being introduce. In dual fiscal system the conventional monetary systems operating post by side with the Islamic pecuniary systems.The Islamic fiscal system consists of the role of quadruplet essential apparatuss The Islamic situateing institutions, Takaful, Islamic Capital Market and Islamic specie grocery store place. The structure of this fiscal system whitethorn consist of nimietyise and non- specialize financial institutions, of unionised and unorganized financial markets, of financial ins truments and service which facilitate conveying of gold. It in like manner comprises of procedures and practices adopted in the Islamic financial markets. The operation and mechanism of the financial system is scrutinized by Bank Negara Malaysia advisory board and Securities consignment Syariah Advisory Board to ensure compliance of Islamic rules and regulations.The Islamic financial institutions which be govern and control under Bank Negara Malaysia argon the organizations that mobilize the determineors savings, and provide financing, acting as creditor or in the form of jacket venture or financing in the form of profit and qualifying sharing (PLS). They besides provide various financial services to the commwholey, in percenticular business organizations. The activities ordain be par pose ining in financial assets much(prenominal) as deposits, loans, securities or dealing in real assets such as machinery, equipment, subscriber lines of goods and real estate. The ac tivities of different financial institutions may be both specialized or their buy the farm may be overlap. They may be categorize base on the basis of their particular activity or the dot of their specialization with relation to savers or borrowers with whom they customarily deal or range of mountains of activity or the type of ownership argon some of the criteria which be often used to classify a large subjugate and mixture show of financial institutions which exist in the economy. pecuniary institutions ar divided into cussing and non-banking institutions. The banking institutions tradition completelyy participate in the economys payments mechanism, i.e., they provide minutes services, their deposit liabilities constitute a major part of the national bullion put out, and they can, as a whole, ca-ca deposits or credit, which is bills and Banks, subject to legal reserve requirements, can arrive at credit by creating phone calls against themselves. Financial insti tutions be also classified as intermedi read/write memory and non-intermediaries. As the term indicates, intermediaries intermediate between savers and directors they modify money as comfortably as mobilize savings their liabilities ar towards the net savers, charm their assets atomic number 18 from the investors or borrowers. Non-intermediary institutions do the loan business but their resources are non directly obtained from the savers. All banking institutions are intermediaries. Many non-banking institutions also act as intermediaries) and when they do so they are known as Non-Banking Financial Intermediaries.The topic of Financial Intermediaries in MalaysiaIn this section, our task is to survey the adorn and identify the institutional players. By describing what financial intermediaries look like today, it is also revealing to see how financial intermediaries fox evolved over the last century.institutional PlayersThe banking system in Malaysia, which is the major component of the financial sector, consists of Bank Negara Malaysia, commercialised banks, Islamic banks, worldwide Islamic banks, Investment bank, early(a)(a) non bank institutions and money brokers. Which are all regulated and supervised by Bank Negara Malaysia.The a nonher(prenominal) non-bank institutions are supervised by other government agencies. These institutions can be divided into four major groups, consisting of the development finance institutions, the saving institutions, the prospicient and tribute silver, and a group of other financial intermediaries, comprising of building societies, building block charges and property trusts, leasing companies, factoring companies, credit token companies, venture capital companies, special enthronization agencies and several financial institutions such as the National owe Corporation (Cagamas) and Credit Guarantee Corporation.The traditional banking system role has been to execute long-term loans and fund them by issu ing perfectly-term deposits.1But banking systems are prohibited from engaging in securities market activities such as securities underwriting or the sale of trust gold. Therefore, the current design of non-bank financial institution are allowed to deal in the securities market a part of providing services which are similar to the banking system.The contribution of to each one non-bank financial institutions insurance companies and pension funds they nail investment funds from their customers, twain of these institutions place their money in a variety of money-earning investments. Leasing companies they purchase equipment/asset and then l repose to businesses for a set number of divisions. Factoring companies provide specialized forms of credit to businesses by qualification loans and purchasing accounts receivable at a discount, usually assumes right for collecting the debt, specialize in bill processing and collections and to take value of economies of scale. Market makers as an agent that offer to buy or lot security ( work in securities),2storage the securities and insured the securities against loss, provide margin credit,3 property management account services.4Trust funds pool the funds of numerous shrimpy investors and purchase large quantities of securities, offer a big variety of funds designed to appeal to most investment strategies, allow the small investors to obtain the benefits of lower transaction costs in purchasing securities and sicken the risk by diversifying the portfolio. The National owe Corporation is to promote the substitute(prenominal) mortgage market in Malaysia, with the issuance of secondhand mortgage securities, Cagamas Berhad effects the function of an intermediary to bring to arresther the master(a) lenders of housing loans and investors of long-term funds.EvolutionThe evolution of financial intermediation in Malaysia is reflected in remit 1. tabulate 1 shows the major financial intermediaries by assets and also by per centum share (in parentheses) from 1960 to 2000. To the extent that we can view the pace of financial intermediation as a horse race, thither seem to be a clear winners and losers. For example, in name of sexual relation importance the winners are unit trust, Cagamas Berhad, leasing companies, factoring companies and venture capital companies. Commercial banks and finance companies are losers.These findings hiking some interesting questions. First, what caused the change in the mix of financial intermediaries? In this section, we will examine this evolutionary process via three factors.Deregulation of become-to doe with RateInterest rate deregulation that affects loan determine takes its earlier form.5Canada, in 1960, was the first to deregulate its interest rate. Other countries deregulated in the eighties or thereafter.6This deregulation allows more freedom and activity to the banks and other institutions to government issue revolutionary depository products as well as diversified short and long term credit instruments.7Leightner and Lovell (1998) state that some relaxation to the banks portfolio were part of the liberalization that enables bank to diversify investment to private as well as the unconnected equity.8This do possible with the establishment of the foreign transposition market and the expansion of the underwriting activities of the financial intermediaries. Liberalization in Japan and Germany for instance, brings naked as a jaybird paradigm to the roles of the banking institutions. The bank in Germany and Japan is no longer to be a creditor, but can also be the equity holder and in the board of directors and management. Liberalization of the banking industry, for example in Malaysia and some other countries, take banking institution into a rude(a) dimension that is the establishment of Islamic banking.9The increasing demand on the interest free banking offer by the Islamic financial institutions leads many conventional b anks to offer Islamic riposte or rather known as dual banking. This development happens to Muslim and non-Muslim countries.The results show that the man-to-mans prefer to diversify their investment other than deposits. In particular, they invest in securities such as declinations, bonds and unit trusts. Therefore, freshly investment in unit trust for the small saver altered permanently the financial landscape.The Institutionalization of Financial MarketsInstitutionalization refers to the fact that more and more funds in Malaysia have been flowing indirectly into the financial markets through financial intermediaries, particularly pension funds, trust funds and insurance companies rather than directly from savers. As a result, these institutional players have become much more important in the financial markets relative to individual investors.What caused institutionalization? Quite simply, it was driven by the step-up of these financial intermediaries, particularly pension and u nit trust.10 tribute fund growth was encouraged by government policy. Tax laws, for instance, encourage employers to help their employees by substituting pension benefits for wages. This is good for employees because they do non pay taxes on their pension benefits until they are received after retirement.Unit trusts gained considerably from these changes in pension plan laws. Defined contribution plans were allowed to include unit trust on the menu of assets for which plan members could choose. In addition, the increasing attr progressiveness of specialized funds such as bond funds and index funds has also fueled unit trust fund growth.The Transformation of conventional BankingThe fact that banks are exposed to the non-performing loans that stood at 9.1% for the achievements of 1997 to 1999 and it seems to us that banking is a declining industry. However, first, the supposed decline of commercial banking is limited to a decline in the relative importance of commercial banking. A s shown in Table 1, the decline of commercial banks assets as a fraction of total intermediated assets from 43.4% in 1980 to 41.3% in 2001. Table 1 also shows that banking industry assets actually increased between 1960 and 2000. In other words, bank assets have actually increased just not as fast as the assets of other financial intermediaries. Second, many of the bracing innovative activities in which banks engage are not reflected on bank balance sheets as assets even though they add significantly to bank revenue.11These include, for example, handicraft in interest rate and currency swaps, merchandising first derivative instruments and issuing credit guarantees.Third, banks have a strong comparative profit in lending to individuals and small businesses.12Finally, banks have joined forces with a number of other types of financial intermediaries.13For example, banks have combined with unit trust funds, merchandiser banks, insurance companies and finance companies. Bank acqui sitions of non-bank financial intermediaries are part of broader integration of the entire financial services industry.Diagram 1 Structure of regulative FrameworkMinister of Land and Co-operative DevelopmentLicensing of Brokers RepresentativesTrading Adviser Representatives stemma Managers RepresentativesMinister of FinanceMinister of Domestic Trade Consumer AffairsSecurities representation Act 1993Securities patience Act 1983Registrar of CompaniesSecurities CommissionFuture Industry Act 1993Companies Act 1965Cooperative Act 1993Kuala Lumpur Stock exchange(KLSE)BNMIslamic Banking Act 1983Licensing ofDealers RepresentativesInvestment Adviser RepresentativesFund Managers RepresentativesSecurities clear Automated vane Sdn Bhd (SCANS)Malaysian Central Depository Sdn Bhd (MCD)Kuala Lumpur Commodity Exchange(KLCE)Malaysian Futures Clearing Corporation Sdn Bhd (MFCC)Kuala Lumpur Options Financial Futures Exchange(KLOFFE)Malaysian Monetary Exchange(MME)Malaysian Derivative Clear ing House Sdn Bhd (MDCH)Table 1 Malaysia Assets of the Financial System, 1960-2000As at end of (RM million)19601970198019902000Banking System2,356(66.3)7,455(64.1)54,346(73.3)223,500(69.8)829,900(66.8)Central Bank1,114(31.4)2,422(20.8)12,994(17.5)37,500(11.7)148,900(12.0)Commercial Banks1,232(34.7)4,460(38.4)32,186(43.4)130,600(40.8)513,600(41.3)Finance Companies10(0.3)531(4.6)5,635(7.6)39,400(12.3)109,400(8.8)Merchant Banks2,229(3.0)11,100(3.5)36,900(3.0)Discount Houses42(0.4)1,292(1.7)4,900(1.5)21,100(1.7)Non-Bank FinancialIntermediries1,197(33.7)4,167(35.9)19,807(26.7)96,900(30.2)413,100(33.2)Provident and Pension Funds733(20.6)2,717(23.4)11,370(15.3)51,800(16.2)217,600(17.5)Life and General InsuranceFunds103(2.9)439(3.8)2,476(3.3)10,300(3.2)52,200(4.2)Development Financial Institutions113(1.0)2,193(3.0)6,000(1.9)25,100(2.0)Savings Institutions267(7.5)645(5.5)2,463(3.3)10,000(3.1)32,300(2.6)Other Intermediaries93(2.6)233(2.0)1,305(1.8)19,800(6.2)85,900(6.9)Total3,55311,62274,1533 20,4001243,000Source Bank Negara Malaysia, yearly Reports (various issues)Financial MarketsFinancial markets are the c take parts or an arrangement that provide facilities for get and selling of financial claims and services the corporations, financial institutions, individuals and governments trade in financial products in these markets either directly or through brokers and dealers on organized exchanges or off-exchanges. The players on the demand and supply sides of these markets are financial institutions, agents, brokers, dealers, borrowers, lenders, savers, and others who are interlinked by the laws, packs, covenants and communication networks. Financial markets are sometimes classified as primary (direct) and utility(prenominal) (indirect) markets. The primary markets deal in the new financial claims or new securities and, therefore, they are also known as new issue markets. On the other hand, secondary markets deal in securities already issued or existing or outstanding. The primary markets mobilize savings and supply fresh or additional capital to business units. Although secondary markets do not contribute directly to the supply of additional capital, they do so indirectly by rendering securities issued on the primary markets liquid. Stock markets have both primary and secondary market segments.Very often financial markets are classified as money markets and capital markets, although there is no essential difference between the two as both perform the same function of transferring resources to the producers. This conventional distinction is based on the differences in the period of maturity of financial assets issued in these markets. While money markets deal in the short-term claims (with a period of maturity of one year or less), capital markets do so in the long-term (maturity period above one year) claims. Contrary to popular usage, the capital market is not only co-extensive with the stock market but it is also much wider than the stock marke t. Similarly, it is not al shipway possible to include a given participant in either of the two (money and capital) markets alone. Commercial banks, for example, belong to both. While treasury bills market, call money market, and commercial bills market are examples of money market, stock market and government bonds market are examples of capital market. Keeping in view different purposes, financial markets have also been classified into the avocation categories (a) organized and unorganized, (b) formal and open, (c) official and parallel, and (d) domestic and foreign. There is no particular connotation with which the words unorganized and informal are used in this context. They are quite often used interchangeably. The financial transactions which take place outside the well-established exchanges or without systematic and orderly structure or arrangements constitute the unorganized markets. They generally refer to the markets in villages or uncouth areas, but they exist in urb an areas also. Interbank money markets and most foreign exchange markets do not have organized exchanges. But they are not unorganized markets in the same way the rural markets are. The informal markets are said to usually involve families and small groups of individuals lending and borrow from each other. This description cannot be strictly applied to the foreign exchange markets, but they are also mostly informal markets. The nature, meaning, and scope of activities of these types of markets will be discussed later in the book.As mentioned earlier, financial systems deal in financial services and claims or financial assets or securities or financial instruments. These services and claims are many and varied in character. This is so because of the transmutation of motives behind borrowing and lending. The stage of development of the financial system can often be judged from the diversity of financial instruments that exist in the system. It is not possible here to discuss individ ually the nature of various financial claims that exist in the financial system.The financial assets represent a claim to the payment of a sum of money sometime in the approaching (repayment of principal) and/or a periodical (regular or not so regular) payment in the form of interest or dividend. With regard to bank deposit or government bond or industrial debenture, the holder receives both the regular periodic payments and the repayment of the principal at a bushel date. Whereas with regard to ordinary share or eternal bond, only periodic payments are received (which are regular in the moorage of perpetual bond but may be irregular in the case of ordinary share). Financial securities are classified as primary (direct) and secondary (indirect) securities. The primary securities are issued by the ultimate investors directly to the ultimate savers as ordinary shares and debentures, while the secondary securities are issued by the financial intermediaries to the ultimate savers a s bank deposits, units, insurance policies, and so on. For the purpose of certain types of analysis, it is also useful to talk about ownership securities (viz., shares) and debt securities (viz., debentures, deposits). Financial instruments differ from each other in respect of their investment characteristics which, of course, are interdependent and interrelated. Among the investment characteristics of financial assets or financial products, the following are important (i)liquidity, (ii) marketability, (iii) reversibility, (iv) transferability, (v) transactions costs, (vi) risk of default or the degree of capital and income uncertainty, and a wide array of other risks, (vii) maturity period, (viii) tax status, (ix) options such as come back or buy-back option, (x) volatility of prices, and (xi) the rate of return-nominal, effective, and real.DEFINITION AND SCOPE OF A bully MARKET (THE ECONOMIC FUNCTIONS OF FINANCIAL INSTITUTIONS)The previous section gave a brief overview of the m ajor types of financial institutions. To understand why financial institutions exist and the economic services that they provide, it is important to understand the different ways in which funds are transferred within an economy between businesses, government, and households (economic entities) that need to borrow funds (borrowers) and those that have surplus funds to lend (investors). In a very frank economy without financial institutions, transactions between, different borrowers and lenders are difficult to arrange. Borrowers and savers incur significant search and development costs assay to find each other. Transactions between borrowers and savers may also be limited, because few financial contracts involve only two parties. Similarly, risks are great, since individual entities have little or no knowledge of each other and little ability to monitor each others actions. Also, the transactions costs may be so high that small entities may be grudging to supply funds. Investors also have little ability to diversify their risk, ascribable to the high cost of many financial contracts.Supplier of funds surplus (savings) unitsLenders Housesolders, companies, governments, rest of the worldsDemand of funds deficit unitBorrowers Housesolders, companies, governments, rest of the worldsFinancial MarketsFinancial institutions help to reduce transactions, search, monitoring, and information costs. They provide risk management services and allow investors to diversify their risk and hold portfolios of financial assets by creating ways of indirect financing. Financial institutions also play important roles in an competent payment system between entities and in managing pure risk (insurance). The velocity panel of Figure 1 shows the role of financial institutions as intermediaries between borrowers and lenders.The term primary securities refers to direct financial claims against individuals, governments, and non-financial firms. A simple economy without any financial institutions would accommodate only direct financial claims or financial contracts. In effect, a borrower gives an investor a financial contract or direct financial claim or security that promises a stake in the borrowers company (i.e., shares of stock) or future payments returning the do invested plus interest (i.e., a bond, or some other separate of IOU). These are examples of direct or primary securities. As an economy develops, markets pop for trading direct securities. Some function as auction markets, where trading is carried out in one physical location, as occurs on the spick-and-span York Stock Exchange others function as over-the-counter markets, where trading is carried out by distant contacts, perhaps over the phone and computer, as on the National Association of Security Dealers Automated Quotation (NASDAQ) system. Loans made directly with borrowers are another example of a primary or direct security, where a direct contract is made between a borrower and a bank or other individual lender. Table 1.2 provides examples of primary securities in the first column. The financial assets owned by banks, insurance companies, and mutual funds, such as loans, bonds, and common stock, are all direct securities, where the lenders give funds to the borrowers, and the lenders receive financial contracts guaranteeing repayment of funds plus interest or shares of ownership in the borrower companies.Investors lend funds in return for a direct or primary security. supplemental securities, in contrast, are financial liabilities of financial institutions-that is, claim against financial institutions. In Table 1.2, financial institutions liabilities-deposits, policyholder reserve obligations, and mutual fund shares-are secondary securities or claims against financial institutions. In effect, financial institutions created secondary securities that offer advantages over primary securities or direct financial claims.EXAMPLES OF PRIMARY AND SECONDARY SECURITIESPrima ry SecuritiesSecondary SecuritiesCommercial loansSavings depositsMortgage loansTransaction depositsConsumer loansCertificates of depositGovernment bondsInsurance policyholders militiaCorporate bonds vernacular fund sharesCorporate common stockPension fund reservesTable 1.2 shows this type of indirect financing.Unfortunately, like most fields, finance sometimes uses confusing terminology. Readers should carefully avoid confusing the use of the words primary and secondary in this discussion with their use in other contexts. For example, students who have antecedently studied corporate finance or investments may have encountered the terms primary and secondary markets primary markets are those for originally issued securities, and secondary markets plow resale of securities. In the context of this chapter, primary and secondary distinguish between issuers of securities and not between changes in securities ownership.PRIMARY AND SECONDARY MARKETIn a market economy the existence of fin ancial markets can greatly ease the process of exchanging loanable funds for financial claims. A firm that wants to borrow money can go to the market in the knowledge that those with funds to lend will be there. The process is made easier still if specia identify traders are known to be actively participating in the markets, buying and selling financial claims on their own account, thereby smoothing over days on which trading is thin or when there is an excess of emf borrowers or lenders. Further economies are achieved if agents or brokers can be employed to enter the market representing the customer to buy and sell securities. The existence of the market serves borrowers and lenders equivalent by reducing the search costs which each has to incur to get in touch with the other, and also master(prenominal)tains confidence in market prices. Markets do not always have a physical location. A market for loanable funds might consist of nothing more than a list of known dealers who can be contacted by letter or telephone. The International Stock Exchange is the centre of the securities market. It has both a physical trading site which is used for a very small number of securities, and a highly developed system of trading which takes place in a number of locations via computer linkages. The discount market is another traditional financial market, but one which ope range without a physical site at all.This market operates by representatives of the discount houses maintaining close daily contact with the leading banks, either by telephone or personal visits, to determine where trading opportunities are. 2 types of financial markets exist for real and financial assets, and it is important to distinguish between them. A primary market for financial assets deals in new issues of all types of loanable funds. Transactions in primary markets result either in the initiation or in the extinction of financial claims. The creation of a new loan causes the transfer of cash fr om a lender to a borrower in exchange for a financial claim on the latter. The claim is snuff out when the cash, usually interest and principal, has been repaid to the lender. A secondary market is a market in old issues. Transactions in secondary markets do not create or extinguish financial claims. Cash does not pass between borrowers and lenders, but existing issues simply change hands. The borrower remains insensible(p) by the transaction while the lender transfers the right of repayment to another. The main economic function of the secondary markets is to support the operations of the associated primary markets for new issues by providing liquidity to lenders. In the absence of a developed secondary market an individual saver might be very loath to lend out money for long periods of time, except at rates of high interest too high to be attractive to borrowers. If the chances of making a sale when necessary are unacceptably low, no lender would commit funds. Therefore an active secondary market is essential for an active primary one. However, there is no guarantee that the lender will receive back in sale proceeds the full amount at the time they are sold, since markets fluctuate all the time, and prices are not constant.Secondary markets also contribute to the efficiency of the primary market by providing pricing information. In the share market, for example, the current prices of traded securities significantly reduce the problem of consideration a price on new issues with similar risk profiles, and information from the secondary market will also influence the attitude of potential participants in primary markets. Figure 3.2 illustrates the connections between primary and secondary markets. not all primary markets have secondary markets associated with them and some securities are issued for which there are no secondary markets