Chapter 02: Financial Intermediaries

and Financial Innovation

Financial institutions
The business enterprise that always deals with financial asset in the financial market either for raising
required fund for doing its own business or for exchanging funds between surplus and deficit parties
is known as financial institutions.
Functions of financial institutions
They transfer financial asset from deficit to surplus party on the other hand transfer fund from surplus to
deficit party. They deal with financial assets on behalf of investors and clients and they deal with
their own account. They finally deliver Payment mechanism, methods and instruments in the market.
Direct and indirect investment
An allocation of a specific amount of fund in a financial asset for a certain time period for earning desired
rate of return is known as investment.
If individual process analyze all info and makes investment based on his own decision then it is called
direct investment.
If the individual transfer the fund to a bank / investment company or brokerage house to make the
investment then it is an indirect investment
Financial intermediaries – The financial institutions that channels fund between surplus parties and
deficit parties through exchange of financial assets.

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Financial System of Bangladesh
1. Central Bank:
i. Nationalized commercial banks: 4
ii. Local Private commercial banks: 44
iii. Foreign commercial banks: 9
iv. Specialized banks: 4
v. Non-bank financial institutions: 33
2. Insurance companies: State owned 2, Privately owned
general insurance 45 and Privately owned life insurance
30
3. Bangladesh Securities and Exchange Commission
4. Bangladesh Micro Credit Regulatory Authority
5. Insurance Development & Regulatory Authority Bangladesh
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 Role of financial intermediaries:

1. Providing maturity intermediation

Surplus group may have fund for different time periods and and the same is the case with deficit
group. Large number of surplus and deficit parties are brought together for solving this
mismatch.

2. Reducing the cost of contracting and information processing

Contract cost and cost of collecting processing and using relevant information in investment decision.
3. Reducing risk via diversification
For individual the fund may not be adequate for portfolio investment in diversified securities to
minimize risk
4. Providing payments mechanism
Transfer instruments – Check, Debit cards, Electronic transfer etc.

5. Providing efficient micro-finance to the poor

The fund is allocated to the poorest and improving productivity of the economy

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 Overview of asset/liability management for financial institutions

Except common share all collected funds / deposits are liability to the financial
intermediary. The amount and timing of cash outlays that must be made to
satisfy the contractual terms of the obligation issued is the liability..

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 Nature of liabilities
1.Type-I liability: Both the amount and timing of payment are
known with certainty. For example-Fixed deposit.
2. Type-II liability: The amount of payment is known with
certainty and the timing of payment is unknown. For
example – Life insurance policy.
3. Type-III liability: The amount of payment is unknown and
the timing of payment is known. For example – Flexible
rate certificate of deposit. Islamic banking.
4. Type –IV liability: The amount of payment and the timing of
payment both are unknown. For example – Property and
casualty insurance. Savings account , current account are
type 4 liabilities.

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 Liquidity concern
Since financial intermediaries/institutions deal with other savers and depositors
money, they have obligations to make repayment upon savers and depositors’ demand.
Depositors can demand any time for withdrawing their amount. If financial intermediaries
failure to meet up demand then they will be defaulter. So they have to maintain a certain
amount or a certain percentage of total deposit as liquid money for meeting depositors’
demand and for avoiding default ness.

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 Financial innovation
The creation of a new investment vehicle such as one may
structure a derivative in a way that has never been done
before. It can increase efficiency and profits for certain parties.
However, it often takes time for regulation catch up to
financial innovation, which can make it risky. To add new
characteristics in financial assets and markets. Followings are
the different financial innovations:
New financial asset
Improving the featues and chaeceristics of an existing asset
Technology

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 Financial innovation
1. Market broadening instruments- to increase the
liquidity of markets and the availability of funds by
attracting new investors and offering new
opportunities for borrowers.
2. Risk-managed instruments – to reallocate financial
risks to those who are less risk averse.
3. Arbitraging instruments and processes – to enable
investors and borrowers to take advantage of
differences in costs and returns between markets.

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 Motivation for financial
innovation
1. arbitraging regulations and find loopholes in tax rules -
2. introduction of financial instruments that are more efficient for redistributing risks among market
participants.
3. increased volatility of interest rates, inflation, equity prices and exchange rates.
4. advances in computer and telecommunication technologies.
5. greater sophistication and educational training among professional market participants.
6. financial intermediary competition.

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 Asset securitization
To take a large amount of loan by securing financial assets is
called asset securitization. It is the process that is involved
with the collection or pooling of loans and the sale of
securities backed by those loans. It also means that more
than one institution may be involved in lending capital.
Taking loan by showing / securing financial asset.

3 parties involved. Issuer, Investor and lender.

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 Asset securitization
Securitization is basically the process where the company
pooled its illiquid assets together and issued a claim to a
pool of assets. When the assets are securitized, it made the
assets tradable in the financial market. It is a process of
pooling of “homogeneous”, “financial”, “cash flow
producing”, “illiquid” assets and issuing claims on those
assets in the form of marketable securities.

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 Benefits of Asset securitization
 From originator point of view, the main benefit that
they can gain from securitization is illiquid assets are
moved “off-balance sheet” and replaced by a cash
equivalent. This process has improved the originator’s
balance sheet.
 a pool of assets has better credit characteristic. It is
achieved through diversification of credit risk,
transaction size, and geography than an individual
asset. Thus reduces the risk of holding the assets.
fixed income.
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Benefits of Asset securitization

 From the investor point of view, they could

earn better yield and liquidity for their
investment in securities. Besides that, they
also can predict prepayment with better
certainty since security paid a fixed income.

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Asset securitization in Islam
Islamic securitization, just like any other dealings including day-to-day activities, must be in
line with the teachings in Quran and Sunnah; furthermore, the sayings and practices of
companions (Sahabah), and sayings and practices of the great peoples in the history of
Islamic teachings should also be referred to. The teaching of Islam promotes ethics in
commercial dealings, and so, in Islamic securitization, ethics is an important aspect.

It is allowed in Islam. Taking loan by providing Islamic financial asset as securities from Islamic
financial institutions. There cannot be any fixed rate.

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Asset securitization in Islam

For instance
“The Messenger of God passed by a heap of
foodstuffs. He thrust his hand into it, and his
fingers encountered dampness. He said, “What is
this, O owner of the foodstuffs?” He said, “Rain has
stricken it, O Messenger of God.” He said, “Why do
you not put it at the top of the foodstuffs, so that
the people may see it? He who deceives is not of
me.
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Asset securitization in Islam

In Islamic securitization, companies, which plan to

securitize their assets, must make sure that proper
valuations of the assets are carried out, and if there
are any defects in the assets, they must be revealed
to the investors. Furthermore, to express the
importance of ethical conduct, Prophet Muhammad
said: “A trustworthy, an honest and a truthful
businessman will rise up with martyrs on the
Day of Resurrection.”(Ibn Majah)
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STRUCTURES OF ISLAMIC ASSET
SECURITIZATION

i) Murabahah –
Buying asset and selling asset in terms of earning exta profit and benefit.
These are sort term. Less than one year period. Taking fund with
securing financial asset for short term product buying selling business.

ii) Al-Bai-Bithaman-Ajil (ABBA) Taking fund with securing financial asset for
long term for buying machinay equipment etc.
iii) Ijarah
Making contact for using an asset. The property is brought with loan taken
by securing Islamic financial asset.

i) Istisna’ - ) Taking fund with securing financial asset for doing product
manufacturing business

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 Terminologies
 Disclosure regulation: To disclose material information to all existing and potential
investors.
 Asymmetric information: Different types of information, different level of access
and different level of possession of information to different interested parties.
 Agency problem: Confliction of interest between managers and investors or
owners. Conflict between different stakeholders and beneficiaries of an enterprise.
Directors shareholders and managers, lenders.
 Insider trading: To trade between internal parties for taking the advantage of
immediate future price change for important decisions made. Buying and selling of
security by managers and directors.

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