The Nature And Role Of The Financial System Finance Essay

The Nature And Role Of The pecuniary System Finance EssayFinancial corpse is a mechanism where stinting exchange activities gutter be done. The economic activities can be done through the interaction mingled with fiscal sanctuarys and the fiscal market. The purposes of this interaction are to mobilize fund and providing payment facilities for the financing of commercial activities. With the emergence of Islamic finance, the dual pecuniary systems being introduce. In dual financial system the conventional financial systems operating side by side with the Islamic financial systems.The Islamic Financial system consists of the role of quadruple essential mechanisms The Islamic banking institutions, Takaful, Islamic Capital Market and Islamic Money market. The structure of this financial system may consist of tell apartd and non-specialized financial institutions, of organise and unorganized financial markets, of financial instruments and ope deem which facilitate transfer of silver. It similarly comprises of procedures and practices adopted in the Islamic financial markets. The operation and mechanism of the financial system is scrutinized by hope Negara Malaysia advisory board and Securities thrill Syariah Advisory Board to ensure compliance of Islamic rules and regulations.The Islamic financial institutions which are govern and go for under Bank Negara Malaysia are the organizations that mobilize the depositors savings, and provide financing, acting as creditor or in the form of capital bet on or financing in the form of profit and loss sharing (PLS). They as well provide various financial services to the commwholey, particularly business line organizations. The activities will be mussinessing in financial as sits much(prenominal) as deposits, loans, securities or dealing in very assets such as machinery, equipment, stocks of goods and real estate. The activities of contrary financial institutions may be each specialized or their portion may be overlap. They may be classified base on the basis of their patriarchal activity or the just point of their specialization with relation to savers or borrowers with whom they customarily deal or scope of activity or the type of ownership are some of the criteria which are ofttimes used to classify a large flesh and variety of financial institutions which exist in the economy.Financial institutions are divided into banking and non-banking institutions. The banking institutions tradition on the wholey participate in the economys payments mechanism, i.e., they provide transactions services, their deposit liabilities constitute a major part of the national money summate, and they can, as a whole, create deposits or credit, which is money and Banks, issuing to legal reserve requirements, can advance credit by creating claims against themselves. Financial institutions are excessively classified as intermediaries and non-intermediaries. As the term indicates, intermediaries intermediate between savers and investors they lend money as well as mobilize savings their liabilities are towards the net savers, while their assets are from the investors or borrowers. Non-intermediary institutions do the loan business but their resources are not contractly obtained from the savers. All banking institutions are intermediaries. Many non-banking institutions also act as intermediaries) and when they do so they are cognize as Non-Banking Financial Intermediaries.The Evolution of Financial Intermediaries in MalaysiaIn this section, our task is to survey the landscape and identify the institutional players. By describing what financial intermediaries look alike(p) today, it is also revealing to see how financial intermediaries have 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, commercial banks, Islamic banks, International Islamic banks, Inv estment bank, separate non bank institutions and money brokers. Which are all regulated and superintend by Bank Negara Malaysia.The some other non-bank institutions are supervised by other government agencies. These institutions can be divided into four major stems, consisting of the development finance institutions, the saving institutions, the provident and pension notes, and a group of other financial intermediaries, comprising of building societies, unit trusts and property trusts, leasing companies, factoring companies, credit token companies, venture capital companies, special investment agencies and several financial institutions such as the National Mortgage Corporation (Cagamas) and Credit Guarantee Corporation.The traditional banking system role has been to make long-term loans and fund them by issuing short-term deposits.1But banking systems are prohibited from engaging in securities market activities such as securities underwriting or the sale of trust cash. Theref ore, 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 each non-bank financial institutions indemnification companies and pension funds they receive investment funds from their customers, both(prenominal) of these institutions place their money in a variety of money-earning investments. Leasing companies they purchase equipment/asset and then lease to businesses for a set number of years. Factoring companies provide specialized forms of credit to businesses by making loans and purchasing accounts receivable at a brush aside, usually assumes responsibility for collecting the debt, specialize in bill processing and collections and to take advantage of economies of scale. Market makers as an agent that propose to buy or grass security ( barter in securities),2 store the securities and insured the securities against loss, provide margin credit,3ca sh management account services.4Trust funds pool the funds of many small investors and purchase large quantities of securities, gallop a wide 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 reduce the risk by diversifying the portfolio. The National Mortgage Corporation is to promote the utility(prenominal) mortgage market in Malaysia, with the issuance of supplementary mortgage securities, Cagamas Berhad performs the function of an intermediary to bring together the primary loaners of housing loans and investors of long-term funds.EvolutionThe evolution of financial intermediation in Malaysia is reflected in plug-in 1. remand 1 shows the major financial intermediaries by assets and also by percentage share (in parentheses) from 1960 to 2000. To the extent that we can view the pace of financial intermediation as a horse race, there seem to be a clear winn ers and losers. For example, in terms of relative 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 raise some disporting 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 Interest RateInterest rate deregulation that affects loan pricing takes its earliest form.5Canada, in 1960, was the first to deregulate its use up rate. other countries deregulated in the 1980s or thereafter.6This deregulation allows more freedom and activity to the banks and other institutions to issue tender 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 foreign equity.8This make viable with the establishment of the foreign exchange market and the expansion of the underwriting activities of the financial intermediaries. Liberalization in Japan and Germany for instance, brings sunrise(prenominal) 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 go overer 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 new dimension that is the establishment of Islamic banking.9The increasing exact on the interest free banking offer by the Islamic financial institutions leads many conventional banks to offer Islamic counter or rather known as dual banking. This development happens to Muslim and non-Muslim countries.The entrusts show that the exclusives prefer to diversify their investment other than deposits. In particular, they invest in securities such as stocks, bonds and unit trusts. Therefore, new 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 ontogeny of these financial intermediaries, particularly pension and unit trust.10Pension fund growth was encouraged by government policy. Tax laws, for instance, encourage employers to help their employees by modify pension benefits for wages. This is good for employees because they do not pay taxes on their pens ion benefits until they are received after retirement.Unit trusts gained considerably from these changes in pension devise 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 attractiveness of specialized funds such as bond funds and index funds has also fueled unit trust fund growth.The Transformation of Traditional BankingThe fact that banks are exposed to the non-performing loans that stood at 9.1% for the periods of 1997 to 1999 and it seems to us that banking is a declining industry. However, first, the so-called decline of commercial banking is limited to a decline in the relative importance of commercial banking. As 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 a ctually increased just not as fast as the assets of other financial intermediaries. Second, many of the new 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, occupation in interest rate and currency swaps, selling derivative instruments and issuing credit guarantees.Third, banks have a strong comparative advantage in impart 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, merchant banks, insurance companies and finance companies. Bank acquisitions of non-bank financial intermediaries are part of broader consolidation of the entire financial services industry.Diagram 1 Structure of Regulatory FrameworkMinister of Land and Co-operative victimizationLicensing of Brokers RepresentativesTrading Adviser RepresentativesFund Managers RepresentativesMinister of FinanceMinister of Domestic Trade Consumer AffairsSecurities Commission Act 1993Securities Industry 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 Clearing automated Network Sdn Bhd (SCANS) Malayan 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 Clearing 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 Ban ks1,232(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)Total3,55311,62274,153320,4001243,000Source Bank Negara Malaysia, Annual Reports (various issues)Financial MarketsFinancial markets are the centers or an arrangement that provide facilities for buying and selling of financial claims and services the corporations, financial institutions, individuals and gover nments trade in financial products in these markets either directly or through brokers and dealers on organized exchanges or off-exchanges. The participants 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, brings, covenants and communication networks. Financial markets are sometimes classified as primary (direct) and secondary (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 deviance between the two as both perform the said(prenominal) 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. bandage 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 market. Similarly, it is not always 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 following categories (a) organized and unorganized, (b) formal and informal, (c) official and parallel, and (d) domestic and foreign. There is no precise intension with which the words unorganized and informal are used in this context. They are quite often used interchangeably. The financial transactions which take place international 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 rural areas, but they exist in urban 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 borrowing from each other. This description cannot be strictly employ 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 kind 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 individually 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 future (repayment of of import) and/or a periodic (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 fixed date. Whereas with regard to ordinary share or perpetual bond, only periodic payments are received (which are regular in the case 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 as 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 character istics 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 evasion 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 call-back or buy-back option, (x) volatility of prices, and (xi) the rate of return-nominal, effective, and real.DEFINITION AND SCOPE OF A CAPITAL MARKET (THE ECONOMIC FUNCTIONS OF FINANCIAL INSTITUTIONS)The previous section gave a brief overview of the major 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 tak e aim to borrow funds (borrowers) and those that have sur positivist funds to lend (investors). In a very simple economy without financial institutions, transactions between, different borrowers and lenders are difficult to arrange. Borrowers and savers incur significant search and schooling costs trying 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 pocket-size 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 unwilling to supply funds. Investors also have little ability to diversify their risk, due 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 efficient payment system between entities and in managing sensitive risk (insurance). The upper 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 amount invested plus interest (i.e., a bond, or some other sort of IOU). These are examples of direct or primary securities. As an economy develops, markets emerge for trading direct securities. Some function as auction markets, where trading is carried out in one physical location, as occurs on the New 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 protective covering 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. Secondary 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 SECURITIESPrimary SecuritiesSecondary SecuritiesCommercial loansSavings depositsMortgage loansTransaction depositsConsumer loansCertificates of deposit governing body bondsInsurance policyholders reservesCorporate bondsMutual fund sharesCorporate common stockPension fund reservesTable 1.2 shows this type of indir ect 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 previously 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 handle 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 financial 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 specialist traders are known to be actively particip ating 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 potential 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 alike by reducing the search costs which each has to incur to get in touch with the other, and also maintains 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 ma rket is another traditional financial market, but one which operates 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. Two 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 creation or in the extinction of financial claims. The creation of a new loan causes the transfer of cash from a lender to a borrower in exchange for a financial claim on the latter. The claim is extinguished 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 out between borrowers and lenders, but existing issues simply change hands. The borrower remains unaffected 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 unwilling 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 setting 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