financial system latest

Fauziah Hanim Tafri, PhD Centre for Actuarial Studies

Faculty of Computer and Mathematical Sciences Universiti Teknologi MARA

11 March 2014

11 March 2014 Fauziah Hanim Tafri 2

Areas to be Covered Overview of Financial Assets Overview of the Valuation of Financial Assets Overview of Financial Markets and Financial Institutions Structure of Financial system Functions of the Financial system and Financial markets Global Financial Markets Types of Financial Markets Market Participants Economic Functions of Financial Institutions Forces affecting the Financial System of the Future


Overview of Financial Assets An asset is any possession that has value in an exchange Tangible Assets

Real or tangible assets are those expected to provide benefits based on their fundamental qualities-e.g. buildings, land, or machinery

Intangible Assets Represent legal claims to some future benefits. Their value bears no relation to the form, physical or

otherwise, in which the claim are recorded.


Asset Classes Major asset classes 1. Traditional asset classes Common stocks

Further subdivided according to the market capitalization (the total market value of the common stock outstanding i.e. The no of shares x the market value of each share)

Bonds Cash equivalents 2. Non traditional asset classes Real estate commodities Hedge funds Private equities Currencies


Properties of Financial Assets The attractiveness of a financial asset depend on the desirable properties of the asset Moneyness Divisibility and Denomination Reversibility Term to maturity Liquidity Convertibility Currency Cash Flow and Return Predictability Complexity Tax status


Reversibility Refers to the cost of investing in a financial asset and

then getting out of it and back into cash again. Eg deposit in a bank, financial assets traded in an

organized market or market makers Most relevant cost is the bid ask spread or the bid-offer

spread ie, the difference between the price at which the market maker is willing to sell an asset and the price at which a market maker is willing to buy the asset.

The spread depends on the the types of financial assets and the amount of risk that the market maker assumes, and the thickness of the market.


Liquidity No definite definition of liquidity and illiquidity One definition

How much sellers stand to lose if they wish to sell immediately against engaging in a costly and time consuming search.


Convertibility Convertible into other financial assets Conversion can take place within the same asset

class E.g. bond converted into another type of bond

Conversion can also spans classes E.g. preferred stock convertible into common stock

Timing, cost and conditions are clearly spelled out in the legal documents at the time of issuance


Overview of Valuation of a Financial Asset

Valuation is the process of determining the fair value or the price of the financial asset

Fundamental principle is that: The value of any financial asset is the present value of

the cash flow expected Process

Determine the cash flow Find the present value

Is the task that simple?


Overview of Valuation of a Financial Asset

Estimate the cash flow

(cash flow=interest, principal repayment, dividends, expected sale price of asset)

Determine the appropriate interest rate for discounting the cash flow

•Minimum interest rate-rate on govt. treasury bills

•Plus premium required for perceived risk

Value of financial asset=Present value of expected cash flow


Problems that may be encountered In estimating the cash flow (the cash that is expected to be

received each period from investing in a particular financial asset) there is no certainty

For debt instruments The issuer might default Provision included in most debt instruments grant the issuer the

right to change how the borrowed funds are repaid The interest rate that the issuer pays can change over the time the

borrowed funds are outstanding For common stock

Uncertainty in the timing and amount of the dividend payment


Role of Financial Assets Two principal economic functions

Financial assets transfer funds from those parties who have surplus funds to invest to those who need funds to invest in tangible assets

Financial assets transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by the tangible assets among those seeking and those providing the funds


The Economic Functions of Financial Institutions

Without financial institutions, transactions between borrowers and lenders are difficult to arrange. They need to incur significant cost, time to search for information

Helps to reduce transactions, search, monitoring and information costs

Helps to reduce risk management cost and provide risk management services-risk between two parties is great

Allow investors to diversify their risks and hold portfolios of financial assets by creating ways of indirect financing.


Search cost FI provide ways to identify entities with excess funds and

those needing funds, eliminating the need for individual lenders and borrowers to find one another

Portfolio transaction cost FI issue secondary securities in forms attractive to

lenders and then repackage the funds they obtain in forms attractive to borrowers

Eg banks and mutual funds


Monitoring Costs When two parties agree to transfer funds, either through direct or indirect

investment, the arrangement is usually formalized by a financial contract

Financial contracts are often characterized by asymmetric information i.e. the contracting parties are not equally and fully informed about each other.

Asymmetric information give rise to monitoring costs-the ongoing expenses incurred by investors to gather information so they can intervene if borrowers’ financial situation changes.

FI provides economies of scale in monitoring by employing appraisers, financial analyst, and other specialist to investigate large number of claims on a full time basis.

The reduction of monitoring costs is the most important reason for the

existence of financial intermediaries


Risk Management Costs To reduce the risk that are inherent in a single financial claim

against a party, investors need to hold a variety of financial assets

Investors can reduce the risks by holding shares in mutual funds and secondary securities

Insurance companies-pool premiums from thousands of individuals and businesses –invest in securities – provide income to fund for the liabilities of contingent claims

Banks provide letters of credit that guarantee the payment by other parties-helps to facilitate trade transactions between different parties since the risk associated with the default of either party is eliminated.


Market Participants Entities in the financial market can both raise funds

(debt or equity) by issuing financial obligations and invest in financial assets.

Financial intermediaries Non Financial organizations Regulators


Types of Financial Intermediaries/Financial Institutions

Depository Institutions Financial institutions that take deposits and make loans

Non Depository Institutions Insurance companies Pension funds

Designed to collect funds from employers and sometimes employees and to repay those funds, along with the investment returns after the employees have retired or become disabled

Investment companies Mutual funds- collect funds from small investors, pool the funds and

invest in a variety of financial instruments Money market mutual funds

Securities firms Assist customers with purchasing and selling stocks, bonds and other

financial assets.


Nature of Liabilities

Depends on the amount and timing of the cash outlays that must be made to satisfy the contractual terms of the obligations issued

Liability type

Amount of cash outlay

Timing of cash outlay example

Type I Known Known Depository institutions, insurance companies

Type II Known Uncertain Life insurance co.

Type III Uncertain Known Depository institutions issuing floating rate CDs with a stated maturity

Type IV uncertain uncertain Insurance co. and pension funds

Introduction to the Financial System The financial system is …

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• the collection of markets, institutions, laws, regulations, and techniques

• through which bonds, stocks, and other securities are traded and priced, interest rates are determined, and financial services are produced and delivered around the world.

Tasks of a Financial System

The primary task of the financial system is … to move scarce loanable funds from those who save to those who borrow to buy goods and services and

to make investments in new equipment and facilities,

so that the global economy can grow and the standard of living can increase.


Circular Flow of Income, Payments, and Production in the Global Economic System


Producing units (mainly business firms

and governments) Consuming units

(mainly households)

Financial System Financial System

The Role of Markets in the Global Economic System

Most economies around the world rely principally upon markets to carry out the complex task of allocating scarce resources.

Market is an institution through which buyers and sellers meet to exchange goods, services, and productive resources

The marketplace is dynamic. It determines what goods and services will be produced and in what quantities through their prices.

Markets also distribute income by rewarding superior producers with increased profits, higher wages, and other economic benefits.


Types of Markets There are essentially three types of markets within the global economic system. The factor markets allocate factors of production (land,

labor, skills, capital) and distribute income (wages, rent) to the owners of productive resources.

Consuming units use most of their income from factor markets to purchase goods and services in the product markets.

The financial markets channel savings to those individuals and institutions needing more funds for spending than are provided by their current incomes.


Types of Markets


Producing units (mainly business

firms and governments)

Consuming units (mainly households)

Flow of funds (savings)

Flow of financial services, income, and

financial claims

Financial markets

Product markets

Factor markets

The Financial Markets and the Financial System: Channel for Savings and Investment The financial markets enable the exchange of current

consumption for future consumption and the transformation of savings into investment so that production, employment, and income can grow, and living standards can improve.

The suppliers of funds to the financial system expect not only to recover their original funds but also to earn additional income as a reward for waiting and assuming risk.


The Global Financial System


Flow of financial services, incomes, and

financial claims

Demanders of funds (mainly business

firms and governments)

Flow of loanable funds (savings) Suppliers of

funds (mainly

households)

Functions Performed by the Global Financial System and the Financial Markets Savings function. The global system of financial

markets and institutions provides a conduit for the public’s savings.

Wealth function. The financial instruments sold in the money and capital markets provide an excellent way to store wealth.

Liquidity function. Financial markets provide liquidity for savers who hold financial instruments but are in need of immediately available funds.


Functions Performed by the Global Financial System and the Financial Markets

Credit function. Global financial markets furnish credit to finance consumption and investment spending.

Payments function. The global financial system provides a mechanism for making payments for goods and services, in the form of currency, checking accounts, debit cards, credit cards, digital cash, etc.


Functions Performed by the Global Financial System and the Financial Markets Risk protection function. The financial markets

offer protection against life, health, property, and income risks, by permitting individuals and institutions to engage in both risk-sharing and risk spreading to achieve risk reduction.

Policy function. The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation or financial system disruption.


Functions Performed by the Global Financial System and the Financial Markets The financial services that are most widely sought by

the public include: Payments services Thrift services Insurance services Credit services Hedging services Agency services



Financial Markets and Financial Institutions Financial markets- market for financial assets Financial markets

Are markets where surplus spending units (SSUs) can lend their funds directly to deficit spending units (DSUs)

This is called direct finance e.g. the market for corporate bonds

Financial Institutions Firms that provide financial services to SSUs and DSUs Most important FIs are the financial intermediaries the linkage is indirect

Types of Financial Markets Within the Global Financial System The money market is for short-term (one year or less)

loans, while the capital market finances long-term investments by businesses, governments, and households.

In particular, governments borrow from commercial banks in the money market, while in the capital market, insurance companies, mutual funds, security dealers, and pension funds supply the funds for businesses.


Types of Financial Markets Within the Global Financial System The money market may be subdivided into

Treasury bills, certificates of deposit (CDs), bankers’ acceptances, commercial paper, federal funds and Eurocurrencies.

The capital market may be subdivided into mortgage loans, tax-exempt (municipal) bonds, consumer loans, Eurobonds and Euronotes, corporate stock, and corporate notes and bonds.


Types of Financial Markets Within the Global Financial System In open markets, financial instruments are sold to

the highest bidder, and they can be traded as often as is desirable before they mature.

In negotiated markets, the instruments are sold to one or a few buyers under private contract.

Financial capital is raised when new securities are sold in the primary markets. Security trading in the secondary markets then provides liquidity for the investors.


Types of Financial Markets Within the Global Financial System In the spot market, assets are traded for immediate

delivery (usually within one or two business days). A futures or forward market is designed to trade

contracts calling for the future delivery of financial instruments.

Options markets enable contracts that grant the right to buy or sell certain securities at specific prices within a certain time to be traded.



Classification of Financial markets Types of claims

Debt market (claim is for fixed amount) Equity market (residual claim)

Maturity of claims Money market (short term financial assets) Capital market (longer maturity financial assets)

Whether the financial claims are newly issued Primary markets Secondary markets

Organizational structure Auction markets OTC market Intermediate markets


Classification of Financial markets by type of claim

Fixed Dollar Amount Claim Residual or Equity Claim

Debt Instrument Preferred Stock Common Stock Preferred Stock

Common Stock Market Debt Market

Equity or Stock Market Fixed Income market


Classification of Financial markets by maturity of claim

Debt Instruments Common Stock and Preferred Stock

Maturity of 1 year or less

Capital Market

Maturity greater than 1 year

Money market


Globalization of financial markets Institutionalization of financial markets

Shifting roles of investors- institutional investors becoming more dominant in the market

Emerging markets Countries that have economies that are in transition but

have started to implement political, economics, and financial reforms in order to participate in the global capital market

Investors are exposed to political risk and unstable value of the currency- high price volatility

Rely on foreign investors for capital


Classification of Global Financial Markets

Internal market

(also called national market)

External Market

(also called international market, offshore market or

Euromarket)

Domestic Market Foreign Market


Derivative Markets

The existence of derivative instruments is the key reason why investors can more effectively implement investment decisions to achieve their financial goals and issuers can more effectively raise funds on more satisfactory terms

Key role of the derivative instruments in global financial market: To provide the end users with opportunities to better

manage their financial risks associated with their business transactions

the instruments allow the end users to unbundle risks and allocate them to the investors most willing and able to assume them.

Factors Tying All Financial Markets Together

Credit, the common commodity. The shifting of borrowers among markets helps to weld the financial system together and to balance the costs of credit in the different markets.

Speculation and arbitrage. Speculators who gamble on their market forecasts and arbitrageurs who watch for profitable arbitrage opportunities help to level out prices and maintain price consistency among the markets.


Factors Tying All Financial Markets Together (cont..) Perfect and efficient markets. There is some

research evidence suggesting that financial markets are closely tied to one another due to their near perfection and efficiency.

Financial markets in the real world. In the real world however, market imperfection and information asymmetry exist.



The Structure of the Financial System

An important part of any modern economy is its financial structure, the combination of its financial markets and institutions

These two parts of any financial systems allow a highly complex, specialized economy to function ia a decentralized manner

The financial structure brings borrowers and lenders together and foster economic efficiency and a better use of society’s resources, which in general results in a higher capital stock for the economy as a whole and a better standard of living for its inhabitants


Financial Structure

Financial Markets

Savers/lenders:

Households, firms, government

Investors/borrowers:

Households, firms, government

Financial Intermediation

11 March 2014 Fauziah Hanim Tafri

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Financial system

Financial Institutions Financial markets

Banking system 1. BNM

2. Banking Institutions

3. others

Non Bank Financial Intermediaries

1. EPF

2. Insurance Co

3. Development Finance Banks

4. Savings Institutions

5. Others

• Unit trust

• LUTH

• Cagamas Berhad

• CGC

• Leasing co

• Venture capital co

Money market

Capital Market

Derivatives market

Offshore market


What happen if there is no financial system?

Firms, institutions and household would be forced to operate as self-contained economies

They could not save without deploying their resources somewhere

They could not invest without saving for their current output.

The Dynamic Financial System The global financial system is rapidly changing. In particular, the trend towards the global

integration of financial systems has been aided by the gradual deregulation of financial institutions and services as well as the increasing harmonization of their regulations.

The results have been increasingly intense competition, many new financial services, increased risk, a movement from financial intermediation to financial markets and a wave of mergers among financial institutions.


Institutional Structure The institutional structure of firms differ from country to country and over time Reasons for the variation: Firstly, government have had major impact on the nature,

size and scope of institutions in their financial sector Through legislation and regulation, various government

agents have shaped the nature scope of allowable activities for each type of financial institutions.

With different political forces from country to country, it is no surprise, then, that the structure of financial institutions differ across countries

11 March 2014 50 Fauziah Hanim Tafri

Institutional Structure (cont..) Secondly, institutions themselves are adaptive entities They change shape and form subject to the limits imposed

upon them by regulation They seek competitive advantage and maximise the profit

they can access servicing customers needs Adapt to financial needs and also to the level of economic

development of the country. In short, the financial structure is unique to that country

and its current situation and constantly changing to adapt to new environment it faces and the evolving demands of its customers.


Relative Size and Importance of Major Financial Institutions

Total Financial Assets Held by U.S. Financial Institutions ($ billions at year-end) 1970 1980 1990 2000 2004Q1 Financial intermediaries: Commercial banks $489 $1,248 $3,340 $6,488 $8,044 S&L assoc. and savings banks 252 794 1,358 1,219 1,557 Life insurance companies 201 464 1,357 3,204 3,849 Private pension funds 110 413 1,629 4,587 4,260 Investment co. (mutual funds) 47 64 602 4,457 4,890 State & local gov’t pension funds60 198 820 2,290 2,303 Finance companies 63 199 611 1,138 1,401 Property-casualty insurance co. 50 174 534 872 1,069 Money market funds –– 74 498 1,812 1,972 Credit unions 18 72 202 441 635 Mortgage companies –– 16 49 36 32 Real estate investment trusts 4 6 13 62 133 Other financial institutions: Security brokers and dealers 16 36 262 1,221 1,725


Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts

Forces Affecting the Financial System of the Future


Financial Services Firm Structures Subsidiary Model


Banking or Other Controlling Firm

Securities Subsidiary

Insurance Subsidiary

Other Financial-

Service Subsidiaries

Financial Services Regulation Functional Regulator Model


Holding Company Regulator

Holding Company or Parent Firm

Securities Firm

Insurance Company Bank

Securities Regulator

Insurance Regulator

Bank Regulator

Legislations Legislation has been established to co-ordinate and manage the operations of

financial institutions and financial service providers in Malaysia. Among other goals, these regulatory mechanisms are aimed at preventing fraud and the protection of consumers’ rights.

Securities Commission Act 1993 Securities Commission (Amendment) Act Capital Markets and Services Act 2007

Capital Markets and Services Act 2007 CMSA Regulations 2007 Capital Markets and Services (Price Stabilization Mechanism) Regulations

2008 (Date Issued: 11 January 2008) Policies and Guidelines on Issue/Offer of Securities (Date Issued: 1 April

2003)(Revised Edition: 1 May 2003) Capital Markets and Services (Amendment of Schedule 8)

Order 2008 (Effective: 1 August 2008)


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Insurance companies Insurance Act 1996 Takaful Act 1984

Banks Banking and Financial Institutions Act 1989 Development Financial Institutions Act 2002 Payment Systems Act 2003 (Act 627) Anti Money Laundering Act 2001 (Act 613)

Money Lenders Pawn Brokers Money Changers Investors Stock Brokers Bond Market Discount houses Unit Trust


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Labuan Offshore Financial Service Authority (LOFSA) The International Offshore Financial Centre (IOFC) was established to

monitor activities and the operations of Labuan offshore financial services.

It also operates its own business including offshore banks, offshore insurance, offshore trust companies, fund management, offshore leasing, offshore factoring, offshore company, and money broking.

legislations pertaining to IOFC: Labuan Offshore Financial Service Authority 1996 Labuan Offshore Business Activities Tax Act 1990 Offshore Companies Act 1990 Offshore Banking Act 1990 Offshore Insurance Act 1990 Offshore Trust Companies Act 1990 Labuan Offshore Trust Act 1996 Labuan Offshore Limited Partnership Act 1997 Labuan Offshore Securities Industry Act 1998 Money-laundering Act 2001


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Financial Innovation Definition of innovation according to product and process Product innovation

The introduction of new product or service that does not currently exist in the market

E.g. new derivative instruments, Process innovation

One in which an existing product can be produced or service provided more efficiently than that of the current existing product or service

E.g. new trading strategies Definition according to the functional approach

The function of the innovation in the financial market Eg as suggested by Bank for International Settlements

Price risk –transferring mechanism Credit-risk transferring instruments Liquidity generating innovation Credit generating instrument


Why is financial innovation necessary? The essence of innovation is the introduction of more efficient financial

instruments for redistributing risks among market participants It is necessary due to : Increased volatility of interest rates, inflation, equity prices, and

exchanges rates There is a need to protect against unfavourable market conditions

Advances in computer and telecommunication technologies Greater sophistication and educational training among professional

market participants Financial intermediary competition Incentives to get around existing regulation and tax laws Changing global patterns of financial wealth


Changing role of financial institutions in the technological age

With the advent of technology and the internet, information has become more accessible to firms and individuals, reducing the role of financial intermediaries as monitors and information providers

FIs role in maturity intermediation has increased -loans have been pooled and packaged into securities sold to investors -mutual funds have grown as investors save for retirement-investors are

going for long term investments Increased in advisory roles- give advice to small and medium sizes

businesses for fee income

Expanding the use of technology by FIs has increased the risks associated with technological failures- regulators now require banks to set up risk management systems for electronic fund transfers and disaster management plans in the event of technological breakdowns

Pension Funds Around the World Germany

Public Pension System Aging Population Pension Reform Private Pension Funds

Malaysia Public Pension Scheme Social Security EPF Private Pension Funds

Japan Public and Corporate

Pension Program Aging Population Defined Benefit Plan Defined Contribution

Plan

Is Malaysia an aging population?


Pension Funds (e.g.)


Important Financial Instruments for Global Financial Institutions


The Scope of International Banking Activities The facilities operated by multinational banking

corporations include: international departments in their home offices full-service branch offices in foreign markets shell branches on offshore islands representative offices Edge Act and Agreement corporations international banking facilities (IBFs) agency offices


The Future of International Banking A persistent problem in international banking is the

preservation of public confidence in the banking system.

Essentially, this means protecting the major multinationals against failure. International Lending and Supervision Act (1983) Basel I Agreement (1988) (11 countries) Basel II Accord (2008)


The Future of International Banking Deregulation: There is a growing trend toward relying more on the

private marketplace and less on government rule-making in order to regulate global banking.

At the same time, regulatory cooperation and harmonization of banking regulations across nations is necessary to ensure a minimum level of public scrutiny.

Basel II: Revised International capital framework Revised as of November 15, 2005 The Basel Committee on Banking Supervision has today issued an updated version of International Convergence of Capital Measurement and Capital Standards: A Revised Framework, commonly known as Basel II, as well as an updated version of the Amendment to the Capital Accord to incorporate market risks. Solely as a matter of convenience to readers, these updated versions incorporate the Basel Committee's 18 July 2005 paper, The application of Basel II to trading activities and the treatment of double default effects .


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