TOPIC 1

Introduction
& Overview
of Financial
System
The
Financial System
 01
In line with the needs of a more market oriented financial products and

services various types of financial institutions were established. These

financial institutions are operating in a network, under supervision of a

regulator, with the purpose of meeting the needs of the participants of

financial transaction. In other words, these financial institutions help

efficient flow of funds between the suppliers of funds (depositors/investors)

and the demanders or users of funds. The role of these financial institutions

and the importance of financial markets can be best seen by looking at how

Chapter the financial system works.

Description
 Explain the importance of financial stability, components and structure
01
of financial system, and functions and benefits of financial
intermediation.

Learning
State the role, functions and sources & uses of funds of commercial
02
banks, investment banks and NBFIs.

03 Define Islamic Banking.

Outcomes 04 Describe the four financial markets.

05 Identify risks of financial institutions.

01
Importance of financial
stability, components and
structure of financial system,
and functions and benefits of
financial intermediation.
+
FINANCIAL SYSTEM

✔ Plays a critical role for INTERMEDIATION PROCESS to function efficiently.

✔ Enables lenders and borrowers to exchange funds

✔ Mechanism where funds can flow effectively from surplus units to deficit units.

✔ Monitored closely by a supervisory authority to ensure rules and regulations are followed.
+ FLOWS OF FUNDS THROUGH THE
FINANCIAL SYSTEM
+
FUNCTIONS OF FINANCIAL
INTERMEDIARIES
1. Lower transaction costs (time and money spent in carrying out financial transactions)

2. Reduce exposure of investors to risk (risk sharing & diversification)

3. Deal with asymmetric information problems

Before transaction:

Adverse selection – try to avoid selecting the risky borrower (gather information
about potential borrower)

After transaction:

Moral hazard – ensure borrower will not engage in activities that will prevent him/her
to repay the loan (sign a contract)
+
BENEFITS OF FINANCIAL INTERMEDIARIES

1. Well diversified portfolio of depository or investment instruments

2. More options of borrowing, financing or advances at LOWEST POSSIBLE PRICES

3. Reliable information of instruments – such as level of safeties and liquidity

4. Act as advisor to participants

5. Offer products and services through virtual banking or internet banking

6. Identify actual provider and users of funds through EFFECTIVE BANKING NETWORK
+
FUNCTIONS OF FINANCIAL SYSTEM
+ COMPONENTS OF FINANCIAL SYSTEM
+ STRUCTURE OF FINANCIAL SYSTEM
Malaysian Financial
System

Financial Bank Negara

Markets Malaysia

Securities
Commission Banking Non-Bank
System Financial
Intermediary
Money Capital Derivatives Offshore
Commercial
market market market market Provident & Pension
Bank
Funds
Money Equity Finance
Labuan Development Finance
market markets Companies
Institutions
Foreign
Exchange Bond Investment
markets Bank Savings Institutions
Market

Others Insurance Companies

Other Financial
Intermediaries
+
FINANCIAL STABILITY & ITS IMPORTANCE
02
The role, functions and sources
& uses of funds of commercial
banks, investment banks and
NBFIs.
+
BANK NEGARA MALAYSIA: ROLES

Established on Jan 26, 1959 to:

1. Issue currency (issue, re-issue and exchange notes and coins)

2. Keeper of international reserves and safeguarding the value of RM

⮚ Gold
⮚ Reserves position in IMF, SDR
⮚ Diversified portfolio of FOREX assets denominated in foreign
currencies (bank balances, Tbills, long-term securities)
+
CONT: BANK NEGARA MALAYSIA: ROLES

3. Act as a banker and financial advisor to the government

⮚ Manage national debt
⮚ Raise government loan through well managed loan programs
⮚ Manage government’s accounts
⮚ Provide temporary advances and finances government’s
investments in Treasury Bills and other government securities
⮚ Represent in government bodies or committees as nation’s
policy maker
+
CONT: BANK NEGARA MALAYSIA: ROLES

4. Banker to other banks

⮚ Distribute currency when receive order from commercial banks
and charge their clearing account.
⮚ Lender of last resort – by extending credit to ensure confidence
in orderly operations of the banking system
⮚ Recommend MOF to issue license to commercial banks,
merchant banks and financial companies.
+
CONT: BANK NEGARA MALAYSIA: ROLES

5. Promote monetary stability and a sound financial structure

⮚ Regulate volume of money and generation of credit through wide range of
monetary instruments
⮚ Ensure price stability / inflation remains at low level

6. Influence credit situation to the advantage of the country

⮚ Ensure flexible and sufficient money supply to sustain economic growth
(by imposing SRR, interest rate regulation)

7. Supervise, regulate and develop insurance industry.

8. Administer the Exchange Control Act 1953
+
COMMERCIAL BANKS: ROLES

1. Raise funds by collecting deposits thru savings, current and fixed deposit accounts

2. Provide current account facilities where payments / deposits can be made through issuing or
receiving checks

3. Accept deposits for savings account, FD and negotiable instruments.

4. Offer financing and other financial services – remittances and letters of credit.
+
COMMERCIAL BANKS: FUNCTIONS
1. Mobilize savings

2. Provide facilities to make payments and receive money

3. Extend loans and advances for working capital, investment and consumption

4. Finance government paper – MGS and TBs

5. Provide various banking facilities and services as authorized by BNM

✔ Execution of standing instructions
✔ Transfer funds
✔ Collection of zakat
✔ Issue letter of credit
✔ Lockers facility
✔ Foreign exchange transactions
✔ Others
+ COMMERCIAL BANKS: SOURCES OF FUNDS

1. DEPOSIT ACCOUNT
1. Capital and reserves
2. Deposits (public and private sectors)
3. Negotiable certificate of deposits (NCDs)
4. Amount due to financial institutions
5. Bankers acceptances (BA)
6. Other liabilities

2. FOREIGN
1. Amounts due to financial institutions
2. Other liabilities
+
COMMERCIAL BANKS: USES OF FUNDS

1. DOMESTIC
1. Cash
2. Statutory reserves
3. Money at call
4. Amounts due from financial institutions
5. Investments (T-Bills, govt and private securities)
6. Loans (overdraft, term loans, trade bills, other loans)
7. Fixed and other assets

2. FOREIGN
1. Amounts due from financial institutions
2. Term loans, trade bills, investments and other assets
+
INVESTMENT BANKS: ROLES

1. Provide banking facilities and services to meet financial needs of participants.

Example:
❑ help a company to raise capital.
❑ Provide services such as advisory and management services, stock broking
services, loan syndication, portfolio management and others.

2. Main contributors of assets in the financial system

❑ Assist public and private corporations in raising funds in the capital markets
(both equity and debt)
❑ Provide strategic advisory services for mergers, acquisitions and other types
of financial transactions.
+
INVESTMENT BANKS: EXAMPLES

1. Affin Investment Bank Berhad

2. Alliance Investment Bank Berhad

3. Maybank Investment Bank Berhad

4. RHB Investment Bank Berhad

5. Kenanga Investment Bank Berhad

6. Hong Leong Investment Bank Berhad

7. CIMB Investment Bank Berhad

8. AmInvestment Bank Berhad

9. ECM Libra Investment Bank Berhad

+
INVESTMENT BANKS:
SOURCES AND USES OF FUNDS
1. Sources of funds
❑ Deposits from customers
❑ Borrowing
❑ Deposits and placement of bank and other financial institutions
❑ Balance due to clients and brokers
+ NON-BANK FINANCIAL INSTITUTIONS (NBFI)

1. Movement of funds from surplus to deficit units

2. Their roles are specialized in nature such as:

⮚ Pension fund
⮚ Provide insurance business
⮚ Promote economic activities for economic development
⮚ Credit institutions
⮚ Others

3. Provide capital for industrial, agriculture, commercial or other economic development

(specialized in nature)

4. Support development in strategic and new growth area, to complement the financial
service in meeting the national policies.

5. Provide managerial and technical assistance apart from financing.

+
NBFI: EXAMPLES
1. Development Financial Institutions (DFIs) - SME Bank, Bank Rakyat, Agrobank

2. Savings institutions - Bank Simpanan Nasional

3. Provident and pension funds - EPF

4. Insurance companies - All insurance companies

5. Housing credit institutions

6. Cagamas Berhad - Mortgage Housings

7. Pilgrims Fund Board - Lembaga Tabung Haji

8. Leasing, factoring and venture capital companies

9. Mutual fund companies - All unit trust funds companies

+
NBFI: PROVIDENT AND PENSION FUND
1. Safeguard savings of members and provide future benefits upon retirement, death or
disabilities.

2. Main source of funds: Deductions from employees/employers + return on investment.

3. Main use of funds: investment in securities, withdrawals

4. Examples:
❑ EPF
❑ Pension Trust Fund
❑ Social Security Organization
❑ Armed Forces Fund
❑ Malaysian Estates Staff Provident Fund
❑ Teachers Provident Fund
+
NBFI: INSURANCE COMPANIES

1. Provide financial coverage to policyholders in the event of death / loss of property / etc.

2. Main source of funds: sum of money (premium) paid by policyholders

3. Main use of funds: investment in securities, claims, financing to corporations

 Financial Institutions
Financial
Institutions
Bank
Negara
Malaysia
Banking Non-Bank
System Financial
Intermediary

Commercial
Carries Bank
banking business safeguard savings of members and provide future
Provident & Pension Funds
benefits

Carries finance
Finance co. business
Companies provide capital Finance
for industrial, agriculture, commercial or
Development Institutions
other economic development
Provide services to corporate
Investment
sector Bank Savings
promote Institutions
and mobilize savings among the middle and
lower-income groups
Provide services conform to
Islamic Banks
Shariah
Insurance Companies
provide financial coverage to policyholders

Other Financial Intermediaries

03
The Islamic Banking.
+ ISLAMIC BANKING
Defined as banking system which is in consonance with the spirit, ethos and value system of
Islam and governed by the principles laid down by Islamic Shariah.

Philosophical Foundations:

❑ Tawhid

❑ Khilafah

❑ Amanah

❑ Al-adalah

❑ Tazkiyah

❑ Huriyyah
+
PRINCIPLES OF ISLAMIC BANKING

❑ Based on Shariah laws

❑ Prohibition of riba’

❑ Equity participation – profit and risk sharing in business venture

❑ Prohibition of gharar – undertake a venture blindly without sufficient knowledge

❑ Contractual relationship – depends on nature of transactions (seller-buyer, lessor-lessee,

partnership, etc)

❑ Money as potential capital

+ OBJECTIVES OF ISLAMIC BANKING
+ OBJECTIVES OF ISLAMIC BANKING
+
ISLAMIC vs CONVENTIONAL BANKS
CHARACTERISTICS ISLAMIC BANKS CONVENTIONAL BANKS
Business framework Based on Shariah laws Based on secular principles,
not any religious law
Shariah supervisory Each bank should have SSB to No SSB
board (SSB) ensure all activities are in line with
Shariah requirements.
Risk sharing Risk sharing based on pre-agreed Predetermined interest rate
proportion
Moral dimension All economic agents have to work Little attention to the moral
within the Islamic moral values. implications of the activities.
Prohibition of riba’ Financing is not interest-oriented. It Financing is interest-oriented
is based on principle of buying and (fixed/floating interest)
selling assets whereby the selling
price includes profit margin.
+
CONT: ISLAMIC vs CONVENTIONAL BANKS

CHARACTERISTICS ISLAMIC BANKS CONVENTIONAL BANKS

Restrictions Restricted to participate in economic No such restrictions.
activities which are not shariah-
compliant.
Zakat Pay zakat and tax required by the Only pay tax as required by
government the government.
+
DEVELOPMENT OF ISLAMIC BANKING
❑ The 1st Islamic savings institution for special purpose of performing hajj (Lembaga Urusan
dan Tabung Haji) was developed in 1963.

❑ A resolution was passed calling off the government to allow LUTH to establish the 1st Islamic
bank in Malaysia in order to mobilise and invest funds of the Muslims.

❑ BIMB was incorporated and officially launched on July 1, 1983.

❑ To ensure its compliance with Shariah principles, the bank had to set up a Shariah
Supervisory Council.

❑ In March 1993, BNM introduced Interest-Free Banking scheme to allow existing

conventional banking system to offer Islamic banking services.
+
SOURCES OF FUNDS – SAVING

❑ Al-Wadiah (saving)
❑ Safekeeping guards with guarantee
❑ Bank becomes the guarantor or custodian
❑ Depositor grants the bank to utilize the money for whatever purpose permitted by Shariah
❑ Possibility of earning some profits known as a gift (Hibah) to the depositors as a token of
appreciation
+
CONT: SOURCES OF FUNDS – INVESTMENT

❑ Al-Mudharabah (investment)
❑ Contract made between provider of capital (depositor) and an entrepreneur or fund
manager (the Bank) to enable the bank to carry out business ventures within the Shariah
guidelines
❑ Both parties agree to share the profits from investment according to a mutually agreed
ratio.
❑ Depositors don’t participate in the management of the investment.
❑ Profits will be distributed at the agreed pre-determined ratio and paid when the
investment is due (stated in the investment certificate)
+
USES OF FUNDS
❑ Home / property financing - BBA / Musharakah / Musharakah Mutanaqisah

❑ Motor vehicle financing - Ijarah / Ijarah Thumma al-Bai’

❑ Personal financing - Bai’ al-Inah

❑ Credit cards - al-Wadiah / Bai’ al-Inah / Qard al-Hasan

❑ Project financing - Mudharabah / Musharakah

❑ Working capital financing - Murabahah

❑ Letter of credit - Wakalah / Musharakah / Murabahah

❑ Islamic accepted bills - Bai al-Dayn

❑ Bank guarantee - al-Kafalah

+
HOME/PROPERTY FINANCING:
AL-BAI BITHAMAN AJIL (BBA)
❑ Customer identifies the asset he wants to purchase and approach the bank for financing.

❑ The bank will purchase the asset at cost and sell the same asset to the customer at cost +
profit of deferred payment basis at the duration and price agreed by both parties payable by
fixed installment.
+
HOME/PROPERTY FINANCING:
MUSHARAKAH
❑ Partnership whereby 2 or more persons combine either capital or labor or creditworthiness
together to carry on a business venture on condition that they will share profits, enjoying
similar rights and liabilities.

❑ Profit and loss sharing partnership whereby the ratio for the distribution of profits must be
determined and specified in advance.
+
HOME/PROPERTY FINANCING:
MUSHARAKAH MUTANAQISAH
❑ Partnership – one partners promises to buy the equity share of other partner gradually until
the title of the equity is completely transferred to him.
❑ The financier and the client participate in a joint commercial enterprise or property.
❑ The enterprise is converted into undivided ownership of both parties.
❑ Over certain period, the equity of financier divided into equal value units, is purchased
by the client.
❑ Ultimately, client becomes the sole owner of the enterprise.
+
MOTOR VEHICLE FINANCING:
AL-IJARAH
❑ The bank will buy an asset and lease it to the customer for a fixed period.

❑ The period, lease rental and other terms are to be agreed upon both parties.
+
MOTOR VEHICLE FINANCING:
AL-IJARAH THUMMA AL-BAI
❑ The bank will buy an asset and lease it to the customer.

❑ At the end of the lease period, the customer will purchase the asset from the bank at an
agreed price with all the lease rentals previously paid constituting part of such price.
+
PERSONAL FINANCING:
BAI’ AL-INAH
❑ Selling of an asset with a mark up price on deferred payment, with the intention to sell the
same asset to the debtor with lower cash price, which is meant to settle his debt.

❑ Bargaining sale and purchase contract – without disclosing or referring to what the cost
price is.

❑ Sale of an asset, which is later repurchased at a different price, whereby the deferred price
is higher than the cash price.
+ CREDIT CARD: BAI’ AL-INAH
+ CREDIT CARD: BAI’ AL-TAWARRUQ
+
CREDIT CARD: AL-QARDHUL HASAN
(BENEVOLENT LOAN)
❑ Interest free loan given mainly for welfare purposes

❑ The borrower is only required to repay the principal amount borrowed.

❑ He may pay an extra amount as a gift (al-Hibah) at his absolute discretion, as a token of
appreciation.
+
PROJECT FINANCING: MUDHARABAH

❑ Bank provides 100% of capital

❑ Entrepreneur will manage the project without bank’s interference. However, the bank has
the right to do follow-up and supervise the project.

❑ Both parties will negotiate profits and agree on how to distribute it.

❑ Any losses will be borne by the bank

+
PROJECT FINANCING: MUSYARAKAH
(JOINT VENTURE)
❑ Bank and project initiators will both provide 100% of capital at an agreed proportion.

❑ Both parties have the right to participate and have the option to waive the right.

❑ Profits generated will be distributed as agreed.

❑ All parties will bear the loss in proportion of their share in the financing.
+
WORKING CAPITAL FINANCING:
MURABAHAH
❑ Bank appoints customer as an agent to purchase on bank’s behalf.

❑ Customer acts as an agent to purchase the goods

❑ Bank pays the supplier or reimburse the customer.

❑ Bank then sells the goods to the customer.

❑ The price (to be paid at agreed later date) will include the cost + agreed profit.
+
LETTER OF CREDIT: AL-WAKALAH

❑ The customer request the bank to open a LC

❑ Bank requires the customer to place deposits (under al-Wadiah Yad Dhamanah) – in full or
part of the price of goods to be purchased.

❑ Bank opens the LC. When LC is negotiated, the bank will pay using the earlier deposits if all
terms are complied.

❑ The trade documents will be released to the customer and the bank chrges a fee and
commission for its service rendered.
+
LETTER OF CREDIT: MUSYARAKAH
❑ The customer informs of his LC requirements and negotiates with the bank the terms of Al-
Musyarakah financing.

❑ The customer deposits his share of financing.

❑ The bank opens LC. When LC is negotiated, the bank will pay from the customer’s deposits
and bank share of financing.

❑ The trade documents will be released to the customer to take possession of the goods. The
customer will dispose them in the matter agreed upon.

❑ The bank and customer will share the profit from the ventures as stated / provided in their
agreement.
+
LETTER OF CREDIT: MURABAHAH

❑ The customer informs his LC requirements and request bank to buy goods indicating he
agrees to purchase them upon their arrival.

❑ Bank opens LC. When LC is negotiated, the bank will pay using its own funds.

❑ Bank will then resells the goods to the customer at a price (cost + profit).

❑ Settlement of the sale to the customer may be in cash or deferral (instalment) payment.
+
ISLAMIC ACCEPTED BILLS: BAI’ AL-DAYN
(DEBT TRADING)
❑ Provision of financial resources required for production, commerce and services by way of
sale / purchase of trade documents and papers.

❑ Short-term facility (maturity less than a year)

❑ Only documents evidencing debts carried out in good faith can be traded.
+
BANK GUARANTEE: AL-KAFALAH
❑ Bank will provide guarantees to its customer for certain purpose.
❑ Tender guarantee
❑ Performance guarantee
❑ Guarantee for sub-contracts
❑ Guarantee for exemption of custom duties
❑ Custom binds
❑ Credit guarantee

❑ Bank may require the customer to deposit full or certain amount for this facility

❑ A fee will be charged.

+
OTHERS: FINANCING BASED ON BAI’ AL-
SALAM
04
The four financial markets.
+
FINANCIAL MARKETS

❑ Market that channel funds from economic players that have saved surplus funds to those
that have a shortage of funds.

❑ 4 financial markets:
❑ MM/FX
❑ Capital
❑ Derivatives
❑ offshore
+
FINANCIAL MARKETS: MM/FX

❑ MM: Short-term debts are traded (< 1 year maturity).

❑ Widely traded. More liquid. Examples:

❑ Treasury bills, NCDs, Commercial paper
❑ Bankers’ acceptance, repurchase agreements

❑ FX: Deal with trading one currency for another

❑ Spot FX transaction – immediate exchange of currencies
❑ Forward FX transaction – exchange of currencies at a specified date in future and
at a specified exchange rate.
+
FINANCIAL MARKETS: CAPITAL MARKET
❑ Debts (bonds) and equity instruments are traded.

❑ Equity – provide means of raising funds by corporations by issuing stocks and shares
(primary and secondary markets)

❑ Bonds – private and public sectors can raise funds by issuing private and government debt
securities. 2 types:
❑ Government bonds (MGS, TB, etc)
❑ Corporate bonds (private debt securities)
+ FINANCIAL MARKETS: DERIVATIVES
❑ Market in which derivatives securities are traded.

❑ Instruments that derived its value from the movement of price/rate of some underlying
assets such as interest rate, foreign exchange, commodity and index.

❑ Examples:
❑ Future & forward contract
❑ Options, swaps

❑ Investors purchase or sell derivatives to

❑ Manage RISK associated with the underlying security
❑ Protect against fluctuations in value
❑ Profit from periods of inactivity or decline
+
FINANCIAL MARKETS: OFFSHORES
❑ Labuan International Offshore Financial Centre (IOFC) – formed on Oct 1, 1990.

❑ Offer wide range of offshore financial products and services such as offshore companies,
banking, leasing, insurance, fund management, investment holding, company management
services, etc.

❑ Market: More than 5000 offshore companies originating from more than 70 countries in
Labuan.

❑ Deals in currencies other than MYR.

Overview of the financial markets
• Facilitate • Facilitate
the flow of the flow of
short term long term
funds funds

Money Capital
market market

Derivative Offshore
market market

• Provide corporate &

• Allow commercial services to
buying and non-residents in the form of
offshore companies & the
selling of investment of offshore
funds
derivative
securities
 Financial Markets

Financial Markets

Futures, options,
Money market Capital market Derivatives market
swaps & forwards Offshore market
trading

Trading of short term Provides wide range

Money market
securities IPOs & shares of offshore products
Labuan
Equity markets
trading in foreign currencies

Foreign Exchange
Buy & sell foreign
Market
currencies Debt securities
Bond markets
trading
05
The risks of financial
institutions.
+ RISKS FACED BY FINANCIAL INSTITUTIONS
+ RISKS FACED BY FINANCIAL INSTITUTIONS
THE END