OverviewOnTheStructureOfFinancialSystem

Chapter1

Overview on the
Structure of Financial
System

This chapter introduces the definitions of financial system, the

structure of Malaysian financial system and the different types of
financial institutions and Function of financial system.

Objective

To understand the basic concept of the financial system in Malaysia, financial markets and
financial claims, recognize the different types of intermediaries with different types of
functions.

Learning objectives
After learning this chapter, you should be able to:

1.

Define the financial system and its role.

2.

Describe Malaysian Financial Structure.

3.

Identify the different types of Financial Institutions.

4.

Describe The Development of Malaysian Financial Structure.

5.

Describe the functions of the financial system.

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OverviewOnTheStructureOfFinancialSystem

OVERVIEW OF THE FINANCIAL SYSTEM

Malaysia has a modern and comprehensive financial system that continues to evolve in
response to the changing domestic and international conditions. Financial reforms, including
the structural changes that proceeded after the Asian financial crisis, have evolved a more
diversified, broader and deeper financial system, supporting Malaysias economic growth
through a more efficient intermediation process and strengthening Malaysians interlink ages
with the global economy and international financial system.

1.1.1

What Is Financial System?

Financial System is a mechanism or a framework in which economics

exchange can be done. In modern society, financial system plays an
important role in influencing the level economic activities and exchange. It can
be simple or complex, free or heavily regulated, efficient or inefficient and is
one of the important components of the global economy; it provides essential
services to public.

1.1.2

Role of the Financial System

The development of a sound and strong financial system is a

necessary pre-condition for steady and balanced economic and social
development in Malaysia. In this regard, Bank Negara Malaysia (BNM)
has

consciously

and

systemically

developed

modern

and

sophisticated financial system which has effectively mobilized and

allocated resources for productive use in tandem with the rapid
transformation of the economy.

The first priority of BNM in the early 1960s was to create the basic
infrastructure for the financial system and develop domestic banks to
complement the already strong foreign banking presence in the
economy. In the 1970s, BNM directed its efforts to introduce other
financial intermediaries, including merchant banks and development
finance institutions to provide other services that were not available
from commercial banks.

New legislation was enacted to enable BNM to supervise all banking

institutions. The Finance Companies Act 1969 was enacted in 1969 to
bring the finance companies under the supervision of BNM. In

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addition, the Banking Ordinance 1958 was amended and replaced by

the Banking Act 1973, which provided BNM with powers to more
effectively regulated and supervise the commercial banks, and
effectively regulated and supervise the commercial banks, and
subsequently the merchant banks in 1979. In the 1980s, BNMs efforts
were focused on further strengthening the regulatory and supervisory
framework for the banking system.

More information can be found in chapter two.

1.1.3

Financial Stability

Financial stability exists when there is stability in both financial institutions and
financial markets. Institutional instability emerges when the failure of one or a
few financial institutions poses systematic consequences on the financial
system as a whole and the economy in general. The challenge is to ensure
that failures of individual institutions are not translated into systematic risk.

Meanwhile financial market instability occurs when volatility in prices (interest

rates, exchange rates as well as asset prices) adversely affects financial
institution and the economy.

Financial stability is important given the critical functions served by the

financial system in an economy, namely the intermediation function and the
role of the financial system in the payment system and as a channel for
transmission of monetary policy. Weak or poor managed financial institutions
or ineffective supervisory authorities could lead to financial instability and,
thereby, diminish the ability of the financial system in performing its functions,
effectively. Inefficient and unstable financial institutions would, therefore, be a
drag on the economy, misallocate resources and hamper economic growth.
Therefore, it is important for BNM to ensure that financial institutions are
financially strong and sound monetary policies. At the same time BNM also
need to ensure that all institutions comply with international best practices to
evolve a sound and effective banking system.

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OverviewOnTheStructureOfFinancialSystem

Lets look at the at the Malaysian financial system and its role in the following
section.

1.1.4

Structure of the Financial System

This section presents the overall structure of Malaysian Financial System,
functions of various types of financial institutions and financial markets.

The structure of the Malaysian Financial System is shown in Figure 1.

FINANCIAL INSTITUTIONS

Banking system:

FINANCIAL MARKETS

Money & Foreign

Markets:

Bank Negara Malaysia

Banking Institutions :

Commercial Banks1

Finance Companies

Merchant Banks

Others

Money Market

Foreign Exchange
Market

Capital Markets:

Discount Houses

Representative Offices of

Equity Market

Foreign Banks

Bond Market

Offshore Banks in Labuan

Public Debt
Securities

IOFC

Private Debt
Securities

Non-Bank Financial Intermediaries :

Derivatives Markets:

Provident and Pension Funds

Commodity Futures

Insurance Companies2

KLSE CI Futures

Development Finance Institutions

KLIBOR Futures

1
2

IncludingIslamicbanks
IncludingTakaful
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FINANCIAL INSTITUTIONS

1.2

FINANCIAL MARKETS

Saving Institutions

National Saving Bank

Co-operative societies

Other Non-Bank Financial

Offshore Market:

Labuan International

Intermediaries

Offshore Financial

Unit Trust

Centre

Pilgrims Fund Board

Housing Credit Institutions

Cagamas Berhad

Credit Guarantee Corporation

Leasing Companies

Factoring Companies

Venture Capital Companies

MALAYSIAN FINANCIAL SYSTEM

This can be divided into two categories:

a)

Financial Institutions

b)

Financial Markets

1.2.1

Financial Institutions
What is a Financial Institutions?
Before we proceed, state your own ideas of a financial institution. What does
a financial institution do?

According to Rose, Kolari (1995), financial institution is a business firm whose

principal claims or assets are stocks, bonds and loans instead of real assets
such as buildings, equipments and raw materials. They also provide loans to
customers or purchase investment services, provision of a mechanism for
making payments, transferring funds and storing financial information.

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Sounders, Cornett (2007), define financial institutions as an institutions that

perform the essential function of channeling funds from those with surplus
funds (suppliers of funds) to those with shortages of funds (users of funds).

In term of structure, financial institutions can broadly be divided into:

Banking System

Non-bank Financial Intermediaries

a)

Banking System
The banking system is the largest component of the financial system.
It consists of:

Bank Negara Malaysia (BNM)

The banking institutions

Other Financial institutions

The Offshore banks in the International Offshore Financial

Centre in Labuan (Labuan IOFC)

In

financial

system,

intermediaries

take

place

so

called

financial

intermediaries. Now, lets discuss the details of financial intermediaries.

Financial intermediaries act as a middleman and middle participant in the

exchange of financial assets. Intermediation and disintermediation process
occurs in financial intermediaries.

Intermediation when funds are deposited with financial intermediaries.

Disintermediation when withdrawal of funds from the intermediaries takes
place.

Financial intermediaries can be a private firms or governmental units. They

obtain funds by selling financial assets with relatively low money yields which
they create and for which they liable. Then, it used these funds to buy
financial assets issued by others, yielding higher money return which can
cover their cost both operations and administrative cost.

Therefore, the basic function of financial intermediaries is to obtain funds from

surplus units and to allocate those funds to deficit units.

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Types of Financial Intermediaries

1.

Depository Intermediaries
Most of secondary securities or sources of funds (loanable funds)
consists of deposits received from economic units. e:g commercial
banks.

2.

Contractual Intermediaries
Enter into contracts with their customers to promote saving and or
financial protection against loss of life or property e:g insurance
company

3.

Secondary Intermediaries
This institutions depend heavily on other intermediaries e:g Bank
Pertanian Malaysia depend on commercial bank, Maybank Finance
de[end on its subsidiaries for loanable funds.

4.

Investment Intermediaries
This type of institutions offer the public securities that can be held
indefinitely as a long term investment or sell quickly when the
customer needs his/her funds returned e:g money market.

Types of Risk Faced By Financial Intermediaries

1.

Credit Risk
Risk that borrower might not be able to repay the loan principal and
interest. Banks will suffer the loss and therefore banks will deal with
credit

risk

problem

through

gathering

information,

monitoring

borrowers and diversifying loan portfolio.

2.

Liquidity Risk
Risk related to cash in hand out of cash problem. Therefore bank
holds reserve in the form of cash or short term marketable securities.

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OverviewOnTheStructureOfFinancialSystem

3.

Interest Rate Risk

This arises from fluctuations in market interest rate. By raising floatingrate debt, financial futures, option and swap are some of the strategies
adopted to reduce interest rate risk.

4.

Market risk
Arises when financial institution actively trade assets and liabilities
rather than holding tem for longer term investment.

Sources and Use of Funds

Two main sources and uses of funds are domestic and foreign sources :

DOMESTIC SOURCES
Capital and reserves

DOMESTIC USES
The funds are allocated for

Deposits from public and

Cash holdings

private sector

Statutory reserve

Monet at call

Amount due from financial,

Negotiable

Certificate

of

Deposits issued

Amounts due to financial

institutions

Bankers acceptance

Other sources include other

forms

of

institutions and investment

deposits

Overdraft,

terms

loans,

trade bills (BA)

Fixed assets

and

REPOs

FOREIGN SOURCES OF
FUNDS
Amount due to financial

FOREIGN USES

institutions and;

Amount due from financial

institutions

Other commercial banks and

Terms loans, trade bills

other financial institutions in

Investment and others

Malaysia

The difference in the uses of funds of finance is that the loans extended by
finance companies are for hire purchase and housing loans.

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At this point you should be able to:

9

Define Financial Institution and the group of financial institutions.

Identify different types of Financial Intermediaries.

Understand the function of Financial Institutions.

Indentify the different types of risks and sources and uses of funds for financial
institutions.

b)

Non-bank Financial Intermediaries (NBFIs)

Not all financial institutions are financial intermediaries, there are
specialized kinds of financial institutions so called Non-bank Financial
Intermediaries.

The non-bank financial intermediaries comprise of five groups of

institutions namely:

Securities Brokers

Securities Dealers

Investment Bankers

Mortgage Bankers

The providend and pension funds

Insurance companies

The development finance institutions

The savings institutions

A group of other non-bank financial intermediaries

NBFIs are supervised by various Government departments and

agencies. The insurance companies were brought under the
supervision of BNM. In addition, with the enactment of the Banking
and Financial Institutions Act 1989 (BAFIA), companies involved in
scheduled business such as leasing, factoring, building credit,
development finance and credit token businesses are required to
register and submit periodic return to BNM for monitoring purpose.

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a.

Security Brokers
Security brokers act as middleman for buyers and sellers of securities,
bringing these two groups together so that financial transactions can take
place. The brokers charge a commission for the services rendered.

b.

Securities Dealers
Security dealers bring buyers and sellers of securities for their own account.
Security dealers accept significant risk by buying securities outright in
anticipation of being able to resell those securities profitably in the future.

c.

Investment Bankers
Investment bankers provide a conduit for the offering of new securities,
underwrite new issues of corporate stock and bonds and purchasing new
securities and then lining up willing buyers to take those securities into their
portfolio at a higher and more favourable price.

d.

Mortgage Bankers
Mortgage bankers perform similar functions as an investment banker. In
addition mortgage bankers also acquire mortgage securities arising from
housing, constructions, apartment and eventually place those mortgage with
long term lenders such as insurance company, pension funds and saving
banks.

e.

Development Finance Institutions

Development Finance Institutions were established by the government to
promote investments in the manufacturing and agricultural sectors. The role
played by development finance institutions tends normally to complement
those of other major financial institutions. They specialised in medium and
long term capital financing as well as supply a range of financial services not
normally provided by the commercial banks and finance companies.

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Borneo Development

The Borneo Corporation was established to assist the

Corporation

diversification of the economies of Sabah and Sarawak

from agriculture activities to manufacturing and commerce.

Sabah Development

The principal objectives of the Sabah Development Bank is

Bank

to promote economic development in Sabah through the

provision of medium and long term loans to private and
state enterprises. The priority sectors of financing included
Bumiputera enterprises, agro-based and wood-based as
well as housing development.

Sabah Credit

The Sabah Credit Corporation was established to provide

Corporation

an interest free loan from the Sabah State Government for

the

purpose

of

promoting

rural

development

and

stimulating private investment in the state through the

provision of medium and long term credit.
Development Bank of Development Bank of Malaysia was formed to promote
Malaysia

Bumiputera equity participation in commerce and industry.

Its financial role includes the provision of medium and long
term loan to Bumiputera, entrepreneurs, hire purchase,
leasing, property development, plant hiring and guarantees
for

industrial

machinery.

The

bank

also

provides

management consultancy and advisory services.

Agriculture

Bank

Malaysia

of The Agriculture Bank was established to promote sound

agriculture development in the country which include
coordination and supervision of credit from public funds for
agricultural purposes, granting of direct financing for
agricultural projects involving production and marketing,
and acting as a mobiliser of savings from the agriculture
sector

Industrial
Malaysia

Bank

of The Industrial Bank of Malaysia was to provide long term

financing to capital intensive and high-technology projects
in the shipping and shipyard, engineering and exportoriented industries and to help the development in growth
areas

such

as

pharmaceutical,

computer

software

development and material technology.

Source : T.S Yin, Financial Institutions in Malaysia, 2nd Ed. IBBM, 1995

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At this point you should be able to identify other types of financial institutions which is a
specialized kind of financial institutions.
We have discussed the nature, services offered and the different types of financial
institutions and intermediaries. We will proceed our discussion with the financial structure in
Malaysia.

1.2.2

The Financial Markets

The financial markets in Malaysia comprise of the following:

a)

Money Markets

b)

Capital Markets

c)

Derivatives Markets

d)

Offshore Markets

The detail discussion on this topic will be covered in chapter four.

Functions of Financial System

a)

The financial system, comprising both financial institutions and financial

markets, acts an intermediary of resources in the economy. This
intermediation function involves the mobilization of resources by providing
means for savers to hold monetary and financial assets and allocating these
resources for productive investment.

b)

An efficient financial intermediation system helps channel resources efficiently

towards activities with high rates of return. Therefore, given its intermediation
function, the financial system has strong linkages to savings and investment
decisions in the economy and, thus, can influence the pace of economic
growth.

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c)

Another important function performed by the financial system is the operation

of the payments system. A payments system essentially refers to a network of
services that facilitates transactions involving the exchange of a means of
payment in return for goods and services, real assets and financial assets.
The means of payments can take on many forms such as currency, cheques
and credit cards, as well as modern electronic means such as stored-value
cards.

In the following chapter I will discuss on structure of interest rates

determinants and development of Based Lending Rate (BLR).

1.

What is the basic function of financial system?

2.

Briefly discuss the different types of intermediaries. Give example of each.

3.

Discuss the three types of risks that normally faced by financial institutions.

4.

What are the sources and uses of funds for a financial institution?

5.

In your opinion, what would be the effect on investment if financial intermediaries did
not exist in an economy?

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OverviewOnTheStructureOfFinancialSystem