The process in Financial intermediation in the banking sector

The financial intermediation is defined as the process which had been carried out by the financial intermediaries as the middleman between the borrower (spender) and lender (saver) to smooth the flow of fund. The financial intermediation called as the process of using the indirect finance in the financial system, which the primary route to transfer funds from lender to borrower. Those savers who have the surplus money will deposits their fund in the financial institution, which will lends those funds to borrowers such as business firms, households, government or foreigners who shortage of fund. Financial intermediary are those financial institution such as commercial bank, finance company, merchant bank, Islamic bank and Brokerage Company. The financial intermediary help to transfer the funds between the lender and borrower in the ways of borrow money from the lender-saver and then using this money to make loan to borrower-spender. For example, the financial institution acquires funds through public by issuing liabilities such as time deposits and saving accounts. After that, the bank might use that fund to acquire an asset by making loan to the people needed fund for investment or buying that company bond in the financial market. As a result, with the help of financial intermediary, the money successfully transfers from public to the borrower.

Financial intermediaries play an important role in the financial system because they help to facilitate the risk transfer and in dealing with the increasingly complex of financial instruments and markets. The financial intermediary’s role is to transform the assets which are less desirable by a large portion of public in to assets that are more preferable by the public. This transforming have serve four economic function which are providing maturity intermediation, reduction of risk by diversification, reducing the contracting and information processing costs and to provide a efficient payment mechanism. Besides, many subsequent authors also have stressed about the role of transaction cost in the financial intermediaries. Due to the financial intermediaries are very specializing in information processing, they have create the well-functioning financial institutions that has greatly reduced the transaction and information for customer. They can achieve the economy of balance through specialization; this is because they are handling very large number of transaction so they are able to minimize the fixed costs by ward off the same production of information faced by borrower and lender. In addition, Petersen and Rajan (1994) stated that financial intermediaries develop specialist or expert people in evaluating prospective borrowers and investments projects. Other than that, they can also exploit customer information and reuse that information over time and again. As a result, there are more funds are made available for investments. For example, the fixed cost of assets evaluation mean that the financial intermediaries have an advantage over an individual because they allow the costs to be shared. Faulkender and Petersen (2003) mentioned that the information acquisition cost maybe still can lower down by establish a long-run relationship between the borrower and financial intermediaries. Furthermore, financial intermediation has gain confidence and trust from the public by protect their assets with providing efficient service to help them manage their assets. This is because the financial intermediaries help them channel funds more efficiently to productive investments through funding pooling, better identification and monitoring of profitable investments and risk diversification. Diversification allows allocating assets and bearing risks more efficiently. Those investments are protected against from unconscientiously borrowers by the institution’s qualified loan officers and well-trained investment analysts seek good investment opportunities and screen prospective securities so as to obtain the best yield available for the risk level that suits the investor’s preferences. Thus, the financial intermediaries are vital part for our economic system and in order to maintain the flow of money in the economy.

Diamond and Dybvig (1983) show that how the financial intermediaries can improve the risk sharing and thus improve the economy welfare. The financial intermediary’s help to diversify the risk of the lenders (savers) by help them to investigate their savings across different sector of business. They have the ability to get the important information that concern about the borrowers’ financial position compare to those in direct finance route which lender directly lends their money to borrowers in financial market without any information about the borrowers. Financial intermediaries can have the borrowers’ such important information is because they already have a history of exercising discretion with this type of information, and help to reduce unreliable information concerning the borrowers. This will help to solve the problems create by asymmetric information which are adverse selection and moral hazards. Financial intermediaries help them to screen risk, monitor risk and evaluate risk. It is more efficient for financial institution to screen the investment opportunity and risk on behalf of individuals compare to an individual to screen its. Since the institution has all the important information available about the lenders and borrowers, it helps to reduce the information costs for analyzing their data and save their time. Thus, individual can enjoy other services provided by the financial institution which can enable them to deposit and withdrawal funds without negotiation whereas the borrowers can avoid having a deal with individual investors. It concludes that it helps those individual not only save their time and money, and also offer low risk investment opportunity to them. If there is no the financial intermediaries, the lenders-savers and borrowers-spenders have to pay higher transaction and information costs and the facing the problem create by the asymmetric information such as adverse selection problem and moral hazards problems. Hirshleifer and Riley (1979) said that adverse selection problems arise before the transaction occurs. Usually those people who agreeable to pay higher interest rate will be worse risk and thus the lenders are more likely had make a loan to high risk borrowers This problem only occurs on the borrowers but not the lenders. However, the moral hazard problem occurs after the transaction which it arise just as the borrowers involve in the chance of their loan will being repaid back to the lenders. It also will happen when the borrowers is taking too much risk as the costs incur more than the benefit that gains by borrowers. Therefore, it will discourage the individual savers from lending money to those borrowers who have such investment opportunity and affected the whole economic development in the country.

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Amina (2009) show that financial intermediaries also provide maturity flexibility service to individuals by creating financial claims with wide range of maturities so as to balance the maturity of different instruments so as to reduce the gap between assets and liabilities. As if there are no financial intermediaries, individual savers have to purchase the securities of borrowers it will lead them to have many uncertain risks such as the conflicting of the maturity needs of lender and borrower. For example, most lenders would like to lend money at short maturity, however normally the borrower will attempt to borrow for a longer maturity. It would make difficult for the borrower to match their larger loan amount with the small amounts of individual savings which are desired by the lenders then it will make the borrowing more difficult. In addition, financial intermediaries perform an important function as maturity intermediation to make sure investment from lenders and money borrowing for borrowers flawless. In the existence of financial intermediary, individual’s income tax differentials are mitigated which it help to transfer tax deductions from low to high income tax payers and to provide tax free services in place of taxable interest. For example, the income invested in and earned by pension funds is not taxed until retirement when the rates are generally lower than before the retirement. Beside, commercial bank also rewards depositors with free service, which are non taxable, rather than pay interest, which is taxable. The depositors will receive nontaxable benefits such as checking accounts, traveler’s checks and low rate loan in return for the use of the money.

In conclusion, the existence of financial intermediary played a very important role in the economic development of the country. In this modern world, it would not have been so efficient, aggressive and progressive without the financial intermediation. Financial intermediaries provide a convenient and safe place where lenders can safely invest excess money and borrowers can easily borrow fund with the low cost and low risk.

Question 2: Compare money and capital markets and identify the major issuers of securities in the different markets and the difference among the various types of securities within and between each of the markets. Within your discussion of the money markets include a consideration of the role of the Federal Reserve System (Fed) and the banking system as they interact through required reserve maintenance and monetary policy actions by the Fed. Consider in your analysis the types and significance of the links between the money and capital markets via the term structure of interest rates, issuers of debt and equity, or the characteristics of these securities.

There were two group of markets can be found in financial market. They were the capital market and the money market. Although they both come from financial market but they consist of differences.

In capital market, we will found the stocks and bond market but in general it is the market for securities where long term funds can be raised by companies or government. To raise the funds, a person needs to purchase a price-set bond in order to borrow their money to the government or business for period of time and this will gain higher return as promised. The government or company paid the lenders through interest that accrues from the borrowings. Another way for the government or company to raise the fund is through the stock market. By using this method, they will sell shares of their stock which is the ownership of the company to the public or companies. Dividends will be paid to the shareholders as agreed by the company as the return on their investment. There were two markets in the capital market: Primary market and secondary market. New issues are distributed to the investor in the primary market and the secondary market is the place where trade securities.

In money market, it is about the global financial market. The money market is the place where borrowing and lending in a short-term period. Short-term liquid funding also will be provided to the global financial system. The period of the borrowing of money by the company in a money market has an average of thirteen months. There are few common types of things that being used in the money market such as bankers’ acceptance, certificates of deposits, commercial paper and repurchase agreements. Normally the money market consists of banks’ borrowing and lending but money market also will involve by financial companies. A large amounts of asset where issued by the finance companies to fund themselves which is secured by the promise of eligible assets into an asset backed commercial paper conduit.

The difference between the two markets is that capital market is for long term investment. They were selling stocks and bonds to borrow money from investors to operate their company. In money markets, it is the short term borrowing or lending market. The banks borrow and lend between themselves and it is usually paid back within thirteen months. The differences can be seen through the ways the two markets used for borrowing or lending transaction. In capital market, primary and secondary markets are interrelated. Securities emerge in primary market while other dealings take place in secondary market. However, there was no sub-division in money market. In efficient money market, secondary market does take place too. In capital market, the financial instrument that being used are debentures, shares, public sector bonds and units of mutual funds. On the other hand, money market uses different financial instruments such as Treasury bill, call money, commercial papers, and certificate of deposits.

There were several characteristic of the securities in the money market. They are rapid maturity, safety, liquidity funds of securities of the money market. Short-term capital requirements of the business and government can be solve by issuing money market securities.

The maturity of the securities is between three months and matured within one year. Federal funds and repurchase agreements are the money market instruments that examine the maturity of the securities. The credit ratings that surpass the other investment grade debt instruments make money market securities the safest investments available. (Jim Orrill, 2010) “The SEC helps ensure this safety by mandating that at least 95% of a money market fund’s securities must be ones that have earned the highest rating of at least two of the five major credit rating institutions”.

Federal Reserve System is often referred as Fed is the central bank of the United States. In Malaysia, Bank Negara Malaysia or BNM is our central bank. Although central bank may differ in terms of structure and modus but they have common responsibility which is to maintain the monetary and financial stability. Sometimes, they are responsible for developing the financial infrastructure and participating in the overall development of nation.

Bank Negara Malaysia is responsible to maintain the monetary stability. Preserved the value of the ringgit is the best way to ensure the price stability. This can maintain the inflation of the country low and stable. By maintaining the inflation at low and stable condition will not diminished the purchasing power of ringgit. When the inflation rate is high, people will tend to consider about their purchasing power. When this happened, demand for real assets like properties and houses will be higher because they were thought to be more “inflation-proof”. Interest of people will be less on investment in the productive capacity of the economy. The interest of holding saving in the financial system will be lesser as they expect that their saving’s value will be diminished. Fixed income earners will feel their ability to purchase goods and services become less.

Bank Negara Malaysia influences the level of interest rates to conduct its monetary policy. Interest rates are the rate that the borrowers of the loan have to pay and the depositors earn on their deposits. To encourage people to save more, interest rate will be given at a high rate. When the economic is weak, funds will be injected into the banking system to reduce the interest rates. Economic activity will be stimulated by the increasing consumption and investment. (Elgilani Eltahir Elshareif, 2010) “Short term and long term interest rates of fixed securities is important for the transmission mechanism of monetary policy”.

Usually the short-term rates will be influence by central bank, while the basis of investors’ expectations of future real interest rates and inflation affect long-term rates. The future real interest rates will affect the domestic investment and production. The real sector of the economy will affect by the term structure transmits monetary policy. In the open economy system, the structure will affect international capital flows and hence exchange rate.

Required reserve is referring to the amount that the banking institution place with the BNM in compliance with the Statutory Reserve Requirement. Cash in vault of the banking institution and the demand deposits with BNM are considered as excess reserves. Demand and time deposits placed by the financial corporations are deposits of the private sector.

Money market securities are extremely liquid can be converted into cash quickly. As the principles of these debts are repaid very rapidly thus the liquidity of the investment was gained. These securities give the optimum way to the public to invest in the money market securities by trading in large denominations. The money market securities are a wholesale market of short term debt instruments.

Question 3: Are the following statements consistent or inconsistent? Explain your answer and discuss how equilibrium is achieved between the futures and cash markets.

Answer: Yes, the statement “equilibrium is achieved between the futures and cash markets” is consistent. An equilibrium relationship can be exists between cash and futures markets.

In order to explain how equilibrium is achieved between the futures and cash markets, we first need to take a look on the meaning of future and cash markets and understand how they functions in the commodity market, then we proceed with the basic relationship that arises between both markets. Lastly, we will explain how arbitrage and the law of supply and demand lead the future price to the equilibrium level.

The futures market is a place where participants can trade for future contract. A future contract is a contract that involves two parties to buy or sell a specified asset on a specified future date at a price agreed today. While the cash market is a market in which the buyer makes an immediate payment for physical commodities that equal to the current market price, which also called the spot price. The purchaser of a future contract which represent as a long position holder undertakes to receive the delivery of the commodity on future and want to pay it for a low price as possible, while the seller of a futures contract which represent as a short position holder promises to deliver the commodity on future and want to receive a high payment as possible.

Long Position

Short Position

Hedger

Secure a current price to protect against future rising

Secure a current price to protect against future declining price

Speculator

Secure a current price in anticipation of rising prices

Secure a current price in anticipation of declining prices

As above mentioned, the traders in the future market basically classified into two categories: hedgers and speculators. Hedgers can be farmers, dealer, foresters and oil drillers. They have the preexistence risk that connected with a commodity and they enter the market to reduce that risk. Thus, intended to protect against the price risks, they on purpose trade in the futures market to secure the future price of a commodity and sell it later in the cash market. Unlike hedger, speculators aim to profit from the vary price change that hedgers are protecting themselves against. They do not intend to minimize the risk but rather to get benefits from the intrinsically risky nature of the commodity market.

For example, we assume a farmer bears the risk at the planting time associated with the uncertain harvest price his wheat will worth on the later 6 months. To avoid this risk he may enter the future market and sell a future contract. For instance, if the current market price for wheat is $10 per ton and he expected to produce 1000 tons of wheat in the next six months, he could lock the price at $10 per ton and selling a 1000 tons wheat future contract. In this manner, the farmer intends to establish a price today that will be harvested in the futures. At the end of the 6 months, the price of wheat in the cash market is actually $9 per ton, so the farmer benefit from the future contact and escapes the lower price. However, if the prices of wheat in cash market were $11 per ton, then the speculator would benefit from the future contact instead of the farmer.

Since the future prices are fluctuate based on unpredictable circumstance, the gap between future price and spot price might be huge, hence, people calling the basis as referring to the difference between the cash price and future price of a contract. When a future contract near to its maturity date, the future price and spot price will move close to each other and finally become the same at expiration. Which means the basis must be zero at the maturity of the future contract.

From Fig 4.3, we can see that as the delivery month of a future contract is neared, the futures price centralize to the spot price of the asset, and at the delivery period, future price equals to the spot price. So, as time passes, the basis narrows approach maturity of the contract. This behavior of the basis over time is known as convergence, this can be easily explained by arbitrage and the law of supply and demand.

For example, suppose that future price is much higher than the spot price as time goes near to the contract’s month of delivery. In this condition, traders will catch the arbitrage opportunity of shorting futures contracts, buying more underlying asset and then making delivery. Due to this, the future price will tend to fall, and suppose that future price is much lower than the spot price. Again, there will be arbitrage opportunity, traders are more willing to acquire short contract and cause more long future contract in the market. Thus, the futures price will tend to arise. In this manner, whether the future price is lower or higher to the spot price, at the expiration, both will be equal.

In terms of supply and demand, the effect of arbitrage attracts traders to shorting futures contract and creates an increase the supply of contracts to market so makes the future price fall. Inversely, buying the underlying asset causes the demand of assets increase; as a result the future spot price will increase as well.

In conclusion, we know that no matter how the future price is difference to the cash price, at the maturity, the basic must be zero, which means that the future price and cash price are equal. Therefore, we can say equilibrium is achieved between the futures and cash markets.

Question 5: If banking were to be based on interest-free transactions, how would it work in practice? Do we really need Islamic banks? Is Islamic banking viable? How does Islamic banking fare and conventional banking differ? How many Islamic banks are working at present and where?

The Interest-free transactions of Banks’ Practice

Islamic banks are the financial institutions that operate base on Shariah principles. Islamic scholars commend trade-oriented banking in place of traditional interest-bearing credit oriented banking. The major vehicle of interest-free banking is a two-tier mudarabah, which is a business contract negotiated on the basis of profit-sharing ratios between two profits-seeking parties, A and B. Parties A provide funds to party B, party B independently manages the business according to the agreed terms. From the banking point of view, it is an advance agreement on a ratio in which realized business profits are to be shared.

The basis of two-tier mudarabah is one mudarabah between the surplus economic units (depositors) and financial institution in order to replace interest-bearing contracts between savers and banks; and another mudarabah between the financial institutions and the deficit economic units in order to replace interest-bearing contracts between banks and ultimate users of funds. So, banks can negotiate deposits and advances on the basis of profit-sharing ratios. In effect, interest-bearing loans are replaced by profit-seeking investments and qard hasanah (loans on zero interest). Interest-free financial institution can efficiently perform all types of intermediation after eliminating interest from the system and the replacement of interest rates by profit-sharing ratios has profound macroeconomic consequences for unemployment, inflation, stability, growth, and income distribution.

The Needs of Islamic Banks’ With Conventional Bank

Many Islamic banks use the facilities of conventional banks for treasury management, foreign exchange, portfolio services and investment banking. Major multinational conventional banks have the critical mass to provide specialist service while Islamic banks are usually too small in size to take on such services themselves. Outsourcing makes sense for organizations when the benefits of internalization are outweighed by the administrative costs of trying to extend their functions into new areas where demand is limited. As most Islamic banks are located in the Muslim world, where most of the demand is for core banking services rather than for highly specialized finance, it is a potential management distraction to widen the facilities on offer excessively. This could actually result in deterioration in the quality of the basic level of deposit and funding services.

Islamic Bank is Viable

Islamic banking and finance are emerging as viable alternatives to conventional interest-based banking and financing. The long run goal of BNM is to construct an Islamic banking system operates same as the conventional banking system. However, an Islamic banking system requires three important elements to qualify as a viable system, such as a large number of players, various types of instruments and money market in Islamic world. In addition, the socio-economic values in Islam must be reflected in an Islamic banking system.

BNM spreads the virtues of Islamic banking to distribute Islamic banking on countrywide with a lot of players and able to reach all Malaysians by achieving the above objective. Islamic financial products and services are being in their existing infrastructure and branches. It was seen as the most successful way to increase the number of financial institutions offering Islamic banking services efficiently. On 4 March 1993, BNM introduced an idea is known as Interest-free Banking Scheme (Skim Perbankan Tanpa Faedah). There are many Islamic banking services that provided by the banks using a range of Islamic concepts such as Mudarabah, Musyarakah, Murabahah, Ijarah and others.

Mudarabah (Profit-sharing)

A capital provider and another party to allow the entrepreneur to carry out business projects based on a profit sharing ratio under an agreement. However, the capital provider of the funds needs to bear all losses.

Musyarakah (Joint Venture)

The sharing of profits will be distributed base on predetermined ratio for a partnership or joint venture of a particular business. Both parties will bear the losses base on equity participation.

Murabahah (Cost Plus)

Sales agreement is applicable on the condition that the sale of goods at a price, other costs and the profit margin are agreed to by both parties.

Ijarah (Leasing)

A lesser (owner) leases property to a lessee at an agreed rental against a fixed charge.

Islamic Banking versus Conventional Banking

The difference between Islamic Banking and Conventional Banking which is conventional banking eliminates the risk while Islamic banks take the risk when involve in any transaction. In addition, conventional banks do not bear the liability only get the benefit from customers when involve in transaction with customers in form of interest. On the other hand, Islamic banks bear all the liability in transaction with consumer because in getting out any benefit without taking its liability is illegal in Islamic principles.

In retail deposit services include the provision of current accounts and low-risk investment accounts base on mudarabah with clients sharing in any bank profits. Conventional banks provide similar deposit services at retail level and allow overdrafts on current accounts, which often incur both fixed-rate charges and interest. Islamic banks cannot offer overdraft facilities on current accounts. However, depositors who get temporary financial difficulties due to events beyond their control such as illness may receive interest-free loans. Conventional banks offer savings rather than investment accounts, the major attraction of such accounts being the interest paid to depositors. This often increases as the minimum notice period for withdrawals lengthens, with accounts which for example require three months’ notice for withdrawals paying more interest than those requiring one months’ notice. Some Islamic banks apply similar stepped returns with their investment accounts, with a higher proportionate profit share as the period of notice for withdrawals increases.

Moreover, conventional bank concern on money as a medium of exchange, valuable and interest on capital is charging on time value basis. Islamic banks focus on the real asset but money is just a medium of exchange goods & services for earning profit. In conventional banks, Government gets the loans easily from BNM through Money Market without any capital development expenses. In Islamic banks, Government cannot obtain loans without capital development expenditure.

Lastly, debts financing in conventional banks has the benefit of leverage for a project because interest expense is deductible expense form taxable profits. This leads to maximize the tax burden over salaried persons. So, the saving and disposable income is affected badly and decrease in the real GDP. In Islamic banks, Mudarabah and Musharakah provide extra tax to Federal Government and minimize the tax burden over salaried persons. Hence, the savings and disposable income is rise and increase in the real GDP.

List of Other Financial Institutions Offer Islamic Financial Products and Services

According to the General Council for Islamic Banks and Financial Institutions, there are currently 275 institutions worldwide that follow Islamic banking and financing principles, collectively managing in excess of $200 billion. These institutions are spread throughout 53 countries, including Europe and the United States. Twenty institutions now offer a variety of Islamic financial services in the United States. The Islamic banks are not the only banking institutions drawn in Islamic banking but Islamic banking services were introduced by other financial institutions via the Islamic Banking Scheme. In Malaysia, there are separate Islamic legislation and banking regulations in financial systems. The Islamic Banking Act (IBA) was established to provide BNM with the authorizations of supervising and regulating the Islamic banks.

On 1 July 1983, Bank Islam Malaysia Berhad (BIMB) was the first Islamic bank established and was operated base on Shariah principles. After few years, BIMB expanded rapidly and was being listed on the Main Board of the Kuala Lumpur Stock Exchange (KLSE). After that, BNM allowed the existing financial institutions to offer Islamic banking services through “Skim Perbankan Tanpa Faedah”. The Islamic Interbank Money Market (IIMM) was established to link the financial institutions and their instruments. The National Shariah Advisory Council on Islamic Banking and Takaful (NSAC) was established as the highest Shariah authority on takaful in Malaysia.

On 1 October 1999, Bank Muamalat Malaysia Berhad (BMMB) was established. The establishment of BMMB was the result of the joining between Bank Bumiputra Malaysia Berhad (BBMB) and Bank of Commerce Berhad (BOCB).

Islamic Banks

1. Bank Islam Malaysia Berhad (BIMB)

2. Bank Muamalat Malaysia Berhad (BMMB)

Commercial Banks

1. Alliance Bank Berhad 8. Malayan Banking Berhad

2. AFFIN Bank Berhad 9. AmBank Berhad

3. OCBC Bank (Malaysia) Berhad 10. Public Bank Berhad

4. Citibank Berhad 11. RHB Bank Berhad

5. EON Bank B