Eco 531 Chapter 2: An Overview of the Financial System PDF

ECO 531- CHAPTER 2 AN OVERVIEW OF THE FINANCIAL SYSTEM • Functions of Financial markets and Financial Intermediaries • Structure of Financial Markets • Financial Markets Instruments • Financial Intermediaries • Structure of Malaysian Financial System • The financial system is considere...

ECO 531- CHAPTER 2 AN OVERVIEW OF THE FINANCIAL SYSTEM • Functions of Financial markets and Financial Intermediaries • Structure of Financial Markets • Financial Markets Instruments • Financial Intermediaries • Structure of Malaysian Financial System • The financial system is considered as a backbone of an economy. Loading… • An overview of the financial system: • Financial Market • Financial Institutions and Intermediaries • Banking and Non-banking Institutions • Direct Finance and Indirect Finance FINANCIAL SYSTEM • Financial system Financial markets (Bonds and stocks market) Financial Intermediaries (banking system) Financial Institution Non-bank financial Intermediaries 2-4 BANKING INSTITUTIONS CENTRAL BANK COMMERCIAL BANKS Loading… ISLAMIC BANKS FINANCE COMPANIES INVESTMENT BANKS FOREIGN BANK REPRESENTATIVE OFFICES FUNCTION OF FINANCIAL MARKET Direct Finance Indirect finance Debt and equity FINANCIAL MARKET STRUCTURE OF FINANCIAL MARKET Primary and secondary market Exchange and Over the counters Money and capital market. Financial market Instrument Financial market regulators 2-6 Primary Secondary MALAYSIAN FINANCIAL MARKET FINANCIAL MARKET REGULATORS: BNM, SC, ROC, LABUAN OFFSHORE FINANCIAL SERVICES AUTHORITIES LABUAN INTERNATIONAL OFFSHORE FINANCIAL CENTRE MALAYSIAN GOVT SECURITIES OPTION & FUTURE EXCHANGES Kuala Lumpur Options & Financial Future Exchange, Commodity & Monetary Exchange of Malaysia MONEY & FOREIGN EXCHANGE Commercial Banks, Finance Companies, Merchant Banks, Exchange Brokers PRIVATE DEBT SECURITIES STOCK EXCHANGES KLSE FINANCIAL MARKET • Perform the essential economic function of channeling fund from household, firm and governments that saved surplus to those that have a shortage of fund. Flow of Funds Through The Financial System -> -> youtube Into INDIRECT FINANCE question (Banking System) FINANCIAL INTERMEDIARIES FUNDS (Surplus Units) Lenders – Savers 1. Households 2. Business Firms 3. Government 4. Foreigner FUNDS FUNDS FUNDS FINANCIAL MARKETS FUNDS (Bonds and stocks market) DIRECT FINANCE (Deficit Units) Borrowers-Spenders 1. Business Firms 2. Government 3. Households 4. Foreigner A) Direct Finance • Borrowers borrow funds directly from lenders in financial market by a selling securities (or Financial Instruments). • Funds are directly transferred from lenders to borrowers. • Securities are assets for the person who buys them but liability for the individual or firm that sell (issues). • Securities are assets for the holder and liabilities for the issuer. B) Indirect Finance • Indirect finance occurs as a result of financial intermediation, that is a process where government, commercial banks, saving and loan institutions, mutual saving bank, credit unions, insurance companies and mutual funds transfer fund from savers to investor. Loading… • Financial intermediaries receive funds from lenders and lend them to borrowers. • Financial Intermediaries (Indirect Finance) are far more important source of financing for corporations. Flow of Saving and Investment In Two Sector Economy Income HOUSEHOLDS FIRMS Consumer Expenditure Saving Investment Financial Institutions & Intermediaries ● FINANCIAL INSTITUTIONS: • A financial institution (FI) is a company engaged in the business of dealing with monetary transactions, such • • • • • as deposits, loans, investments and currency exchange. A financial institution acts as an agent that provides financial services for its clients. Financial institutions provide a service as intermediaries of the capital and debt markets. They are responsible for transferring funds from investors to companies, to provide funds for loans. The presence of financial institutions facilitate the flow of monies through the economy. Financial institutions generally fall under financial regulation from a government authority. Common types of financial institutions include banks, credit unions, stock brokerages, asset management firms, and similar businesses. Financial Institutions & Intermediaries FINANCIAL INTERMEDIARIES: • Institutions (such as banks, insurance companies, mutual funds, pension funds and finance companies) that collect funds from people who have saved and then make loans to others. • A financial intermediary may refer to an institution, firm or individual who performs intermediation between two or more parties in a financial context. Typically the first party is a provider of a product or service and the second party is a consumer or customer. • In the U.S., a financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as banks), and then that institution in turn gives those funds to spenders (borrowers). ● Financial intermediaries can be: Banks; Credit Unions; Financial adviser or broker; Insurance Companies; Life Insurance Companies; Mutual Funds; or Pension Funds. Note: (broader as includes financial institutions, firms, foreigners or households) Type of Financial Intermediaries: • 1) Commercial Banks • 2) Mutual Funds • 3) Pension Funds • 4) Credit Union • 5) Others 1) Commercial Banks • Is a type of financial intermediaries that we always use. • It raises funds by collecting deposits from businesses and consumers via checkable deposits, saving deposits and time deposits. • It buys corporate bonds and government bonds. • Its primary liabilities are deposits. • Its primary assets are loans and bonds. 2) Mutual Funds • Enables investors to pull their money and place it under professional investment management. • Acquire funds by selling shares to many individuals and use the proceeds to purchase diversified stocks and bonds. 3) Pension Funds • Is a retirement plan intended to provide a person with a secure income for life. • Have traditionally been payments. 4) Credit Union • A cooperative financial institution that is owned and controlled by its members, generally through the election of a Board of Directors. • Only a member of a credit union may deposit money with the credit union or borrow money from it. 5) Others • Savings institutions, loan institutions receive deposits from the person who have surplus and give loan to the person who need the funds. Advantages of Financial Intermediaries: 1) Less Risky • Lending through an intermediary is usually less risky than lending directly. • 2 reasons: • Financial intermediaries can diversify. • They can predict which of the people who want to borrow money will be able to repay or not. • 2) Liquidity • Liquidity is the ability to convert assets into a spendable form, e.g. money, it is very quickly to convert to other form. • If the lenders lent the money directly to another person and suddenly need cash, it is difficult to make the borrower repay quickly. • But Intermediaries can provide the liquid asset to individual depositors. BANKING AND NON-BANKING INSTITUTIONS • Banking Institutions – financial institution that provides banking and other financial services. • Under banking institutions, it is essential to distinguish between the monetary and non-monetary institutions. • where only the commercial banks are regarded as the monetary institution, • whereas the rests are considered as non-monetary institutions. • The principle liability of a monetary institution is generally accepted as money. • On the other hand, the principle liability of a non-monetary institution is generally accepted as near money. Banking Institutions: • 1) Commercial Banks • 2) Saving and loan Associations • 3) Saving Banks • 4) Credit Unions 1) Commercial Banks • Owned by private investors (stockholders) or by companies (bank holding companies). • Specialized in loans to commercial and industrial businesses. • “Profit organization” dividend retained earnings make consumer loans for automobiles and other consumer goods. 2) Saving and Loan Associations • Owned by stockholders, but they can be owned by depositors as well. • “Profit objective”, profit oriented. 3) Saving Banks • Also known as mutual savings banks • No stockholders • Assets are administered for the sole benefit of depositors. 4) Credit Unions • Not - for - profit, cooperative organizations that owned by their members. • The objectives are to minimize the rate members pay on loans and maximize the rate paid to members on deposits. • Historically, it specialized in providing automobile and other personal loans and savings deposits for their members. Non-Banking Institution • Non-Banking-Institution is defined as all corporate bodies other than licensed commercial banks, which accept funds as either deposits or in any other form. • NBI doesn’t have authority to create current deposit and produce cheque to withdraw. • It includes: • Financial companies. • Merchant Banks. Financial Companies • Receive the saving deposits and fixed deposit only. • The main activity is giving loan to consumer to buy consumer goods, such as automobile, furniture, house. • Charge higher interest rate. • E.g; Maybank Finance, Arab Malaysian Finance, Public Bank Finance. Loading… ➢ Fixed Deposit VS Current Account?? Merchant Banks • The main activity focus on wholesale, money market, the company advisor and as a lender. • Gain profit by providing the services, such as: • Company registrar • Company advisor • Encourage the new investment and entrepreneur • Handle loans • E.g: Arab-Malaysian Merchant Bank, Asian Bankers Malaysia Bhd, Bumiputera Merchant Bankers Bhd. • Generally, merchant bank is an investment bank which is well-equipped to handle multinational corporations. Structure of Financial Markets 1) Debt and Equity Market 2) Primary and Secondary Market 3) Exchange and Over-the Counter market 4) Money and Capital Markets 1) Debt and Equity Market Debt instruments – contractual obligation to pay the holder fixed payments at specified dates (e.g.; mortgages, bonds, car loans, student loans). 1. Short-term debt instruments have a maturity of less than one year. • Intermediate-term debt instruments have a maturity between 1 and 10 years. • Long-term debt instruments have a maturity of ten or more years. • Equity – sale of ownership share (owners are residual claimants) 2. • Owners of stock may receive dividends. 2) Primary and Secondary Market Primary Market = financial market in which newly issued securities are sold. Secondary Market = financial market in which previously owned securities are sold. 1. 2. Involve brokers and dealers. • Broker = match buyers and sellers. • Dealers = buy and sell securities. • Role of Secondary Market: 3. Increase liquidity of financial assets ● Determine security prices that help determine the price of securities in primary market. ● 3) Exchange and Over-the Counter market 1. Exchange : buyers and sellers meet in one central location (e.g.; KLSE). 2. Over-the-Counter Market : transactions take place in multiple locations through dealers. 4) Money and Capital Markets • Money market : market for short-term debt instrument. • Capital Market : market for intermediate and long-term debt and equity instruments. FINANCIAL INSTRUMENTS • Financial Instrument is an instrument having monetary value or recording a monetary transaction. • Financial instruments are traded in the financial market, which are categorized into primary market and secondary market. • Both financial market are classified due to the maturity term, which is: ● Capital market (maturity period 1 year or more) ● Money market (maturity period is less than 1 year) Classification of Financial Instruments MONEY MARKET INSTRUMENTS 1) NON-GOVERNMENT PAPERS 1.1 Bankers Acceptance 1.2 Repurchase Agreements (Repos) 1.3 Negotiable Instruments of Deposits (NIDs or NCDs) 1.4 Commercial Paper 2) GOVERNMENT PAPERS 2.1 Malaysian Government Securities (MGS) 2.2 Malaysian Government Treasury Bills (MGTB) 2.3 Cagamas Bonds and Notes 1.1 Bankers Acceptance o o o o o A timed bill of exchange drawn on and accepted by a bank. Drawn for not less than 21 days and not more than 365 days Payable in Ringgit in a multiple of one thousand Ringgit Payable in an amount not less than thirty thousand Ringgit Enfaced with a statement that it was drawn to finance: • • • • Importation into Malaysia Exportation from Malaysia Sale within Malaysia Purchase within Malaysia In terms of yield, it offers better rate of return compared to MGTB and BNBs o BAs with 90 days and less maturity quality for liquid assets. o 1.2 Repurchase Agreements (Repos) o A repurchase agreement is a sale of securities with an undertaking by the seller to repurchase the same securities after a stipulated period of time at a price (yield) determined at the time of the sale. o A repo is similar to a secured loan, with the lender of money receiving securities as collateral to protect against default. 1.3 Negotiable Instruments of Deposits (NIDs or NCDs) o A negotiable certificate of deposit, generally abbreviated to NCD, is a fixed deposit receipt issued by a bank that is negotiable in the secondary market as a financial asset. o The issuer undertakes to pay the amount of the deposit plus the interest to the holder of the certificate on maturity date. An NCD will contain the following information: • name of issuing bank; • issue date; • maturity date; • amount of the deposit; • maturity value; and • rate of interest per annum. CONT’D.. • CDs have terms ranging from a few months to several years; in general, the longer the term, the higher the interest rate that they bear. • At the expiration of the term, investors may withdraw both the principal and the accrued interest. • Penalties are imposed for early withdrawal. 1.4 Commercial Paper • It is a type of short-term negotiable instrument, usually an unsecured promissory note, that calls for the payment of money at a specified date. • Because it is not backed by collateral, commercial paper is usually issued by major firms whose credit- rating is so good that their notes are immediately accepted for trading. • The notes are sold at a discount and mature in from 3 to 6 months. CONT’D.. • It includes only those instruments that are used in commerce in place of money, as distinguished from paper used in investment, personal, estate, speculative, and public transactions. • In addition to promissory notes, commercial paper may include drafts, bills of exchange and checks, acceptances, bills of lading, warehouse receipts, orders for delivery of goods, and express orders. 2) Government Papers 2.1 Malaysian Government Securities (MGS) 2.2 Malaysian Government Treasury Bills (MGTB) 2.3 Cagamas Bonds and Notes Malaysian Government Securities (MGS) Government securities are defined as the obligation of the state in respect of borrowed money. • Government bonds or Malaysian Government Securities issued by Bank Negara Malaysia, in 1959 , to finance public sector development programs. i. loans guaranteed fully by the Federal Government; ii. Bank Negara Malaysia papers with a maturity period of at least three years from the date of issue; iii. any commercial instruments (with elements of negotiability) issued by the State Government or local authorities with a maturity period of at least three years from the date of issue; and iv. any deposits in advance subscription account under section 26(1)(a)(i). • 2.2 Malaysian Government Treasury Bills (MGTB) • Malaysian Treasury Bills (MTB) is a short-term securities issued by the Federal Treasury of Malaysia for working capital. • These is zero-coupon bonds. It’s sold at a discount of the par value to create a positive yield to maturity. • Treasury bills are considered by many the most risk free investment. • Treasury Bills are commonly issued with maturity dates of 91 days, 6 months, or 1 year. 2.3 Cagamas Bonds And Notes • Cagamas Bonds and Notes, first issued in 1987, are medium-term and short-term debt obligations of Cagamas Berhad. • Cagamas Berhad is 20% owned by Bank Negara Malaysia, the Central Bank of Malaysia, and remaining 80% owned by local financial institutions. CONT’D.. • Cagamas Berhad, ("Cagamas"), the National Mortgage Corporation was incorporated on 2 December 1986 as a public limited company to purchase mortgage loans and industrial property loans from primary lenders, who will transfer the beneficial interest in the mortgages to the Cagamas . • To fund its operations, Cagamas raises funds through the issuance of suitable instruments such as bonds and notes. CAPITAL MARKET INSTRUMENTS • 1) Equity Instruments 1.1 Common stock 1.2 Preferred Stock • 2) Debt Instruments 2.1 Mortgages 2.2 Corporate bonds 2.3 Convertible bonds 2.4 Junk bonds 1.1 Common Stock • A security that represents ownership in a corporation. • Holders of common stock exercise control by electing a board of directors and voting on corporate policy. 1.2 Preferred Stock • Preferred stocks represent partial ownership in a company but the holder does not usually have voting rights. • A preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. 2.1 Mortgages • These are loans to households or firms to purchase housing, land or other real structures, where the structure or land itself serves as collateral for the loans. • The mortgage is a contract between a borrower and a lender where the lender guarantees payments until the debt is repaid. • It is also can be defined as a loan to finance the purchase of real estate, usually with specified payment periods and interest rates. 2.2 Corporate Bonds • These are intermediate to long-term debt obligations issued by companies. It can be issued directly or through brokers. 2.3 Convertible Bonds • It is a bond that can be traded for, or converted to other securities after specified period of time. 2.4 Junk Bonds • Junk bonds can be defined as below investment-grade bonds that provide high yields with high risk. TQ NOTES: FINANCIAL MARKET • In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis. • Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity. • Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy. • In finance, financial markets facilitate: • The raising of capital (in the capital markets) • The transfer of risk (in the derivatives markets) • International trade (in the currency markets) • – and are used to match those who want capital to those who have it. • Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. MARKETS • • • • • • • • The financial markets can be divided into different subtypes: Capital markets which consist of: • Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. • Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. • Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign exchange. The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities. • Raising capital • To understand financial markets, let us look at what they are used for, i.e. what is their purpose? • Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages. • More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold. RELATIONSHIP BETWEEN LENDERS AND BORROWERS: • Lenders : Individuals, Companies • Financial Intermediaries : Banks, Insurance Companies, Pension Funds, Mutual Funds • Financial Markets : Interbank, Stock Exchange, Money Market, Bond Market, Foreign Exchange • Borrowers : Individuals, Companies, Central Government, Municipalities, Public Corporations