CHAPTER 2

An Overview of the Financial

System
Prepared By: Madam Fauziana Bt Fauzi @ Mat Rawi (CFIS)
 Contents
• Financial System
• Financial Market
• Functions of financial markets
• Structure of financial markets
• Financial market instruments
• Financial intermediaries: Indirect Finance
• Types of Financial Intermediaries
• Structure of the Malaysian Financial System
 Introduction
• Ahmad the inventor has designed a low-cost robot that cleans the
house (even the windows), washes the car, and mows the lawn,
but he has no funds to put his wonderful invention into
production.
• Abu the widower has plenty of savings, which he and his wife
accumulated over the years.
• If Ahmad and Abu could get together so that Ahmad could be
better off: We would have cleaner house, shinier cars and more
beautiful lawns.
 WITHOUT FINANCIAL
SYSTEM

Abu - Ahmad – Inventor No productive use of

Surplus of funds Shortage of funds funds
Without financial system

Abu - saver Ahmad – Inventor

Surplus of funds Financial
Shortage of funds Invention beneficial
Does not have productive System Have a productive use to all people
use of funds of funds
Direct Finance Indirect Finance
Commercial, foreign,
Bond Market Bank Islamic, local,
merchant
Financial Financial
Market Intermediaries
Insurance AIA, Prudential,
Great Eastern,
Stock Companies
Takaful,
market
WITH FINANCIAL
Pension
SYSTEM
Funds
SOCSO, EPF
• Financial markets (bond and stock markets) and financial intermediaries (banks,
insurance companies, and pension funds) serve the basic function of getting people
like Ahmad and Abu together so that funds can move from those who have a
surplus of funds (Abu) to those who have a shortage of funds (Ahmad).

• More realistically, when Apple invents a better iPhone, it may need funds to
bring its new product to market.

• Similarly, when a local government needs to build a road or a school, it may

require more funds than local property taxes provide.

• Well-functioning financial markets and financial intermediaries are crucial to

economic health.

• To study the effects of financial markets and financial intermediaries on the

economy, we need to understand their general structure and operation.
 Functions of Financial Markets

• Financial market perform the essential economic function of channeling funds

from households, firms and governments that have saved surplus funds by
spending less than their income to those that have a shortage of funds
because they wish to spend more than their income.

• This function is shown systematically in Figure 1.

Figure 1: Flows of Funds Through the Financial System
• Those who have saved and are lending funds, the lender–savers, are at the
left,
• Those who must borrow funds to finance their spending, the borrower-
spenders, are in the right.
• The principal lender – household, business enterprises, government (particularly
state and local government), foreigners, and their governments.
• The most important borrower-spenders are businesses and the government
(particularly the federal government).
• Households and foreigners also borrow to finance their purchases of cars,
furniture, and houses.
• The arrows show that funds flow from lender-savers to borrower-spenders via
two routes.
• In direct finance, borrowers borrow funds directly from lenders in financial
markets by selling the lender’s securities (also called financial instruments),
which are claims on the borrower’s future income or assets.
• Securities are assets for the person who buys them but liabilities for the
individual or firms that sell (issues) them.
• Eg: If FORDS needs to borrow funds to pay for a new factory to
manufacture electric cars, it might borrow the funds from savers by selling
them a bond – a debt security that promises to make periodic payments for
a specified period or a stock a security that entitles the owner to a share of
the company’s profits and assets.
• Why is this channeling of funds from savers to spenders so important to the
economy?
• It is because the people who save are frequently not the same people who
have profitable investment opportunities available to them, the
entrepreneurs.
• The existence of financial markets is beneficial even if someone borrows for a
purpose other than increasing production in business.
• Say that you are recently married, have a good job, and want to buy a
house.
• You earn a good salary but because you have just started to work, you have
not saved much.
•Over time, you would have no problem saving enough to buy the house
of your dreams, but by then you would be too old to get full
enjoyment from it.
•Without financial markets, you are stuck; you cannot buy the house
and must continue to live in your tiny apartment.
•If a financial market were set up so that people who had built up
savings could lend you the funds to buy the house, you would be more
happy to pay them some interest so that you could own a home while
you are still young enough to enjoy it.
•Then over time, you would pay back your loan.
•If this loan could occur, you would be better off as would the persons
who made you the loan.
•They would now earn some interest, whereas they would not if t he
financial market did not exist.
• Now we can see why financial markets have such an important
function in the economy.
• They allow funds to move from people who lack productive investment
opportunities to people who have such opportunities.
•Financial markets are critical for producing an efficient allocation of
capital (wealth, either financial or physical), that is employed to
produce more wealth), which contributes to higher production and
efficiency for the overall economy.
• Well well-functioning financial market also directly improves the well-
being of consumers by allowing them to time their purchases better.
•They provide funds to young people to buy what they need (and will
eventually be able to afford) without forcing them to wait until they
have saved up the entire purchase price.
• Financial markets that are operating efficiently improve the economic
welfare of everyone in society.
Structure of Financial Markets
Several Categories of Financial
Markets

Primary and Exchanges and

Debt and Equity Money and Capital
Secondary Over the Counter
Markets Markets
Markets Markets
Debt and Equity Markets
• A firm or an individual can obtain funds in a financial market in
two ways:-
• Most common method - issuance of debt instrument -> bond @
mortgage (contractual agreement by the borrower to pay the
holder of the instrument fixed dollar amounts at regular intervals
(interest and principal payments) until a specified date (the
maturity date), when a final payment is made.
• The maturity of a debt instrument is the number of years (terms)
until that instrument’s expiration date.
• A debt instrument is short-term if its maturity term is less than
a year, intermediate-term if its maturity term between one and
ten years and long-term if its maturity term is ten years or
longer.
• Second method – issuance of equities -> common stock (claims to
share in the net income and the assets of a business.
• If you own one share of common stock in a company that has issued
one million shares, you are entitled to 1 one-millionth of the firm’s
net income and one-millionth of the firm’s assets.
• Equities often make periodic payments (dividends) to their holders and
are considered long-term securities because they have no maturity
date.
• Owning stock means that you own a portion of the firm and thus
have the right to vote on issues important to the firm and to elect
its directors.
• Advantage – equity holders benefit directly from any increases in the
corporation’s profitability or asset value because equities confer
ownership rights on the equity holders.
• Debt holders do not share in this benefit, because their dollar
payments are fixed.
• Disadvantages – an equity holder is a residual claimant 🡪 corporation
must pay all its debt holders before it pays its equity holders.
PRIMARY & SECONDARY
MARKETS
• Primary markets – financial market in which new issues of a
security such as a bond or a stock market are sold to initial
buyers by the corporation or government agency borrowing the
funds.
• The primary markets for securities are not well known to the
public because the selling to initial buyers often takes place behind
the closed doors.
• An important financial institutions that assists in the initial sale
of securities in the primary market is the investment bank.
• The investment bank does this by underwriting securities: It
guarantees a price for a corporation’s securities and then sells
them to the public.
• Secondary markets – financial market in which securities that have been
previously issued can be sold.
• Eg: The New York Stock Exchange and NASDAQ (National Association of
Securities Dealers Automated Quotation System), in which previously issued
stocks are traded, are the best-known examples of secondary markets,
although the bond markets in which previously issued bonds of major
corporations and the US government are bought and sold, actually have a
larger trading volume.
• Other examples of secondary markets are foreign exchange markets, future
markets, options markets.
• Securities brokers and dealers are crucial to a well-functioning secondary
markets.
• Brokers – agents of investors who match buyers with sellers of securities.
• Dealers – link buyers and sellers by buying and selling securities at stated
prices.
• When an individual buys a security in the secondary market, the person who
has sold the security receives money in exchange for the security, but the
corporation that issued the security acquires no new funds.
• A corporation acquires new funds only when its securities are first sold in the
primary market.
• Nonetheless, secondary markets serve two important functions.
• First, they make it easier and quicker to sell these financial instruments to
raise cash; that is they make the financial instruments more liquid.
• The increased liquidity of these instruments then makes them more desirable
and thus easier for the issuing firm to sell in the primary markets.
• Second, secondary markets determine the price of the security that the
issuing firm sells in the primary market.
• The investors who buy securities in the primary market will pay the issuing
corporation no more than the price they think the secondary market will set
for this security.
• The higher the security’s price in the secondary market, the higher the price
the issuing form will receive for a new security in the primary market, and
hence the greater the amount of financial capital it can raise.
•Conditions in the secondary market are therefore the most relevant to
corporations issuing securities.
Exchanges and Over-the-
counter Markets
• Secondary markets can be organized in two ways.
• One method is through exchanges, where buyers and sellers of
securities (of their agents or brokers)met in one central location to
conduct trades.
• The New York Stock Exchanges for stocks, Chicago Board of Trade
for commodities (wheat, corn, silver and other raw materials) are
examples of organized exchanges.
• The other forum for a secondary market is an over-the-counter (OTC) market, in which
dealers at different locations who have an inventory of securities stand ready to buy and
sell securities “over the counter” to anyone who comes to them and is willing to accept
their prices.
• Because OTC dealers are in contact via computers and know the prices set by one another,
the OTC market is very competitive and not different from a market with an organized
exchange.
• Many common stocks are traded OTC, although a majority of the largest corporations have
their shares traded at organized stock exchanges.
• US government bond market, with a larger trading volume than the New York Stoch
Exchange , by contrast is set up as an over-the-counter market.
• Forty or so dealers establish a “market’ in these securities by standing ready to buy and
sell US government bonds.
• Over the counter markets include those that trade other types of financial instrument,
such as negotiable certificates of deposit, federal funds and foreign exchange instruments.
Money and Capital
Markets
• Another way of distinguishing between markets is on the basis of the maturity of
the securities traded in each market.

• Money market – financial market in which only short-term debt instruments

(generally those with original maturity terms of less than one year) are traded.
• Capital market – market in which longer-term debt instruments (generally those
with original maturity terms of one year or greater) and equity instruments are
traded.
• Money market securities are usually more widely traded than longer-term securities
and so tend to be more liquid.
• Short-term securities have smaller fluctuations in prices than longer-term
securities, making them safer investments.
• As a result, corporations and banks actively use the money market to earn interest
on surplus funds that they expect to have only temporarily.
• Capital market securities, such as stocks and long-term bonds, are often held by
financial intermediaries such as insurance companies and pension funds, which have
little uncertainty about the number of funds they will have available in the future.
Financial Market
Instruments
Money market instruments

• Because of their short terms to maturity, the debt instruments traded in the money
market undergo the least price fluctuations and so are the least risky investments.
The money market has undergone great changes in the past three decades, with the amounts
of some financial instruments growing at a far more rapid rate than others.
• U.S. Treasury Bills
• These short – term debt instruments of the US government are issued in one, three and six month
maturities to finance the federal government.
• They pay a set amount at maturity and have no interest payments, but they effectively pay interest
by initially selling at a discount that is at a price lower than the set amount paid at maturity.
• US treasury bills are the most liquid of all money market instruments because they are the most
widely traded.
• They are also the safest money market instruments because there is a low probability of default, a
situation in which the party issuing the debt instrument is unable to make payments or pay off the
amount owed when the instrument matures.
• The federal government can always meet its debt obligations because it can raise taxes or issue
currency to pay off its debts.
• Treasury bills are held mainly by banks, although small amounts are held by households, corporations,
and other financial intermediaries.
Negotiable Bank Certificates of Deposit
Commercial Paper
Repurchase Agreements
Federal (Fed) Funds
• Capital Market Instruments
• Stocks
• Mortgages and Mortgage-Backed Securities
• Corporate Bonds
• U.S Government Securities
• U.S Government Agency Securities
• State and Local Government Bonds
• Consumer and Bank Commercial Loans
 Function of Financial
Intermediaries: Indirect Finance

Asymmetric Economies of
Roles of Information: Scope and
Risk Sharing
Transaction Costs Adverse Selection & Conflicts of
Moral Hazard Interest
 Transaction Costs
• Time and money spent in carrying out financial transactions.
• Major problem for people who have access funds to lend.
• Eg:
• Carl the Carpenter needs $1000 for his new tool.
• You have the cash and would like to lend him the money, but to
protect your investment, you have to hire a lawyer to write up the
loan contract that specifies how much interest Carl will pay you,
when he will make these interest payments and when he will repay
you the $1000.
• Obtaining the contract will cost you $500.
• When you figure in this transaction cost for making the loan, you realize
that you can’t earn enough from the deal (you spend $500 to make
perhaps $100) and reluctantly tell Carl that he will have to look elsewhere.
• Financial intermediaries can substantially reduce transaction costs because
they have developed expertise in lowering them and because their larger size
allows them to take advantage of economies of scale.
• Economies of scale- the reduction in transaction costs per dollar of
transaction as the size (scale) of transactions increases.
• Eg: A bank knows how to find a good lawyer to produce an airtight loan
contract, and this contract can be used over and over again in its loan
transactions, thus lowering the legal cost per transaction.
 Risk Sharing
• Financial institutions can help reduce the exposure
investor to risk – uncertainty about the returns
investors will earn on assets.
• Financial intermediaries do this through the process
known as risk sharing: they create and sell assets with
risk characteristics that people are comfortable with
and the intermediaries that use the funds they acquire
by selling these assets to purchase other assets that
may have far more risk.
• Low transaction costs allow financial intermediaries to share risk
at low cost, enabling them to earn a profit on the spread
between the returns they earn on risky assets and the
payments they make on the assets they have sold.
• This process of risk sharing is also sometimes referred to as
asset transformation because risky assets are turned into safer
assets for investors.
• Financial intermediaries also promote risk sharing by helping
individuals to diversify and thereby lower the amount of risk to
which they are exposed.
• Diversification entails investing in a collection (portfolio) of
assets whose returns do not always move together, with the
result that overall risk is lower than for individual assets.
 Asymmetric Information: Adverse
Selection and Moral Hazard
• Asymmetric Information: One party often does not know
enough about the other party to make accurate decision.
• A borrower who takes out a loan usually has better information
about the potential returns and risk associated with the
investment projects for which the funds are earmarked than
the lender does.
• Lack of information creates problems in the financial system on
two fronts: before the transaction is entered and after.
 Adverse Selection
• Problem created by asymmetric information before the
transaction occurs.
• AS in the FM occurs when the potential borrowers who are
the most likely to produce an undesirable (adverse)
outcome – the bad credit risks – are the ones who most
actively seek out a loan and are thus most likely to be
selected.
• Because AS makes it more likely that loans might be made
to bad credit risks, lenders may decide not to make any
loans even though there are good credit risks in the
marketplace.
Economies of Scope and Conflicts
of Interest
• Financial intermediaries provides multiple financial services to their
customers – offering them bank loans or selling their bonds for them.
• They can also achieve economies of scope: they can lower the cost of
information production for each service by applying one information
resource to many different services.
• A bank, for example when making a loan to a corporation can
evaluate how good a credit risk the firm is, which then helps the
bank decide whether it would be easy to sell the bonds of this
corporation to the public.
• Although economies of scope may substantially benefit financial institutions,
they also create potential costs in terms of conflicts of interest.

• A type of moral hazard, arise when a person or institution has multiple

objectives (interest), some of which conflict with each other.

• Occur when a financial institutions provides multiple services.

• The potentially competing interests of those services may lead an individual
or firm to conceal information or disseminate misleading information.

• We care about conflict of interest (COI) because a substantial reduction in

the quality of information in financial markets increases asymmetric
problems and prevents financial markets from channeling funds into the
most productive investment opportunities.
Types of Financial Intermediaries
Contractual Savings Investment
Depository Institutions
Institutions Intermediaries

Commercial Banks Life insurance Companies Finance Companies

Savings and Loan

Fire Casualty Insurance
Associations (S&Ls) and Mutual Funds
Companies
Mutual Savings Banks

Pension Funds and

Money Market Mutual
Credit Unions Government Retirement
Funds
Funds

Hedge Funds

Investment Banks
 Financial System in Malaysia
Refer to: https://www.bnm.gov.my/

Task: Students open the website of Bank Negara Malaysia and find
information about the structure of Malaysian financial system.
Write down the short notes.
The financial system can be categorized into three (3) groups, i.e. banking institutions, non-
bank financial institutions and non-bank financial intermediaries.

The Financial
System

Non-bank Non-bank
Banking
Financial Financial
Institutions
Institutions Intermediaries

Development Employees
Commercial Finance Merchant Discount
Central Bank Islamic Banks Financial Provident
Banks Companies Banks Houses
Institutions Fund
Banking institutions consist of central bank and commercial banks.
The central bank is owned and controlled by the government.
Commercial banks are owned by the private sector. They are profit-making
institutions with a charter from the government to engage in the
business of banking by accepting deposits and providing loans.
Non-bank financial institutions include finance companies, Islamic banks,
merchant banks, and discount houses.
Finance companies provide loans for the purchase of vehicles and
properties.
Finance companies provide the same services as banking institutions except
that they do not issue cheques.
 Islamic banking is conducted based on the principles of Shariáh.
As Islam prohibits riba or charged interest, Islamic banks only use the profit-
sharing concept which does not involve the paying and receiving interest.
Merchant banks do not accept deposits from the public as they only provide
support services and advice to commercial banks, in terms of financial
management and portfolio management.
Discount houses provide short-term loans in the financial market. They
receive loans with lower rates of interest from financial institutions and
supply loans to the public at a higher rate of interest to obtain profits.
Non-bank financial intermediaries include developed financial institutions and
the Employees Provident Fund.
The government sets up development financial institutions to provide loans
and financial assistance to firms and farmers, enhancing investment in the
industrial and agricultural sectors.
The Employees and employers have to contribute a certain percentage of
income to the employee’s Provident Fund for their retirement.