FIN 2024 Financial Institutions and Markets

Tutorial 1 Overview of the Financial Systems

The objective of this tutorial is to give you an overview of the financial system and what is to be discussed
in weeks to come. The answers to some of the questions here could not be found in the lecture slides or
textbook, but are meant for you to think about, especially after the lecture. Hopefully these tutorial
questions allow you to think critically and open your mind about financial institutions and markets.

Discussion Questions:
Susie has inherited MYR500,000 from her grandparents and is thinking of investing them. She is thinking if
she would be better off lending the money to her brother in his existing business, or putting them into fixed
deposits in Maybank. Susie’s brother is offering an interest of 8% p.a. for her lending and the Maybank’s 1-
year fixed deposit rate is at 3.2% p.a

a. By using what you learnt about benefits of financial intermediation, what advantages
would she have if she puts her money in a fixed deposit in Maybank rather than lending
it to her brother?
Lowering transaction costs
Susie may incur high transaction cost when she directly lends her money to her brother.
Susie or the brother may have to bear legal fees and stamp duties while setting up the
loan agreement. This is why bond issuances issue in large amounts to investors who can
invest in bulk, because in order for them to approach many small investors may incur too
much transaction cost.

Financial intermediaries make profits by reducing transactions costs, investors also save
in transaction costs that would be incurred if invested in the financial markets. Financial
intermediaries reduce transactions costs by developing expertise and taking advantage
of economies of scale.
Risk Sharing
Another benefit made possible by the FI’s low transaction costs is that they can help
reduce the exposure of investors to risk, through a process known as risk sharing. Susie
lending directly to her brother, has all her risk focused on one person, which is her
brother. Same like lending money to a corporation through bond issuances, the risk is also
focused on one entity.

Through financial intermediaries, banks borrow from many customers, and lend to many
as well. They allow depositors to share the risk of many borrowers from default.

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 Liquidity
Financial institutions such as banks provide liquidity to depositors in the same time
lending the money out to customers in a long term basis through the process of keeping
adequate reserves. Direct finance, or in this case through her brother, may not give Susie
as much liquidity as she needs.

Reduce Asymmetric Information. FIs create and sell assets with lesser risk (many) to one
party in order to buy assets with greater risk (many) from another party. This process is
referred to as asset transformation, because in a sense risky assets are turned into safer
assets for investors.

b. In your opinion, should return on investment be the final ultimatum of Susie’s decision?
You could answer this critically by thinking about the common relationship of risk and
return. If return on investment is the only factor, then everyone should put their money
in stocks. If you remember in Principles of Business Finance, stock holders are residual
owners, thus get residual returns. Higher returns come with higher risk, thus a rational
investor should not only consider return as the only factor. Further in the semester, you
will learn more about financial markets and financial intermediaries to help you in this
question even further.

Short Discussions
1. Why are financial markets important to the health of the economy? What were the financial assets
have you learnt so far in your first year of study?
What do we mean by the health of the economy?
Trade, business, income level, production, currency, buying power, government spending and
revenue, unemployment, supply and demand, GDP.
Why are the financial markets important for all those above?
Because they channel funds from those who do not have a productive use for them to those who
do, thereby resulting in higher economic efficiency. The lack of an efficient financial market
prevents the utilization of money in a more effective manner. Savers have less avenues in
saving/investing their money, businesses have less avenues in acquiring funds for their business.

You would have learnt about stocks and bonds. You have learnt about their general characteristics
on equity and debt as well as their valuations in FIN1014.
2. Some economists suspect that one of the reasons that economies in developing countries grow so
slowly is that they do not have well-developed financial markets. Does this argument make sense?
Yes, because the absence of financial markets means that funds cannot be channelled to people
who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up
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 businesses that would help the economy grow rapidly. Financial markets like the equity and bond
market accelerates economy expansion by allowing businesses to acquire funds more rapidly, thus
increasing productivity in a country.
3. Discuss the importance of direct finance and indirect finance in the financial system by explaining
their roles.
Direct Finance
Borrowers borrow directly from lenders in financial markets by selling financial instruments which
are claims on the borrower’s future income or assets. Direct finance is important to the financial
system because it allows the governments and businesses to directly access capital funding
through the public and foreign investors. Financial intermediaries such as banks may not be
sufficient because of their limitations in funding, as well as in accessing foreign investors.
Indirect Finance
Borrowers borrow indirectly from lenders via financial intermediaries (established to source both
loanable funds and loan opportunities) by issuing financial instruments which are claims on the
borrower’s future income or assets. Financial intermediaries are important to the economy
because it of the benefits they provide such as liquidity, risk sharing, transaction cost reduction
and resolving asymmetric information issues.
4. Provide an example on how a commercial bank plays a crucial role in indirect financing in a financial
system. Can you name other types of financial institution that plays a role in indirect financing?
Commercial banks are the largest and most influencial financial intermediary in the financial
system when it comes to deposit taking and lending. It is where the public and businesses keeps
savings and deposits, as well as the largest lending entity in any country. They are the main hub
that connects savers and borrowers in an economy.
Commercial banks in Malaysia such as Maybank, Public Bank, RHB Bank raise funds primarily by
issuing checkable, savings, and time deposits which are used to make commercial, consumer and
mortgage loans. They earn a profit from the difference of interest rates that they charge.
Collectively, these banks comprise the largest financial intermediary and have the most diversified
asset portfolios. Through their collection of interest income, they help distribute interest income
to the depositors in the economy, allowing savers to also earn through the prosperity of the
country.

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5. Discuss how diversification promotes risk sharing among investors in financial institutions.
Diversification in financial terms mean the holding of a variety to financial assets to reduce the risk
of a concentrated loss from a single asset. Financial intermediaries such as investment companies
help in risk sharing by providing the means for individuals and businesses to diversify their asset
holdings no matter how small or big the deposit amount is. Risk sharing occur as investors pool
their funds together in order to purchase many financial assets, therefore collectively benefiting
from diversification.
In terms of banks, depositors also benefit from diversification when banks borrow from many and
lend to many.
Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the
diversified pool to individuals. They allow depositors to share the risk of many borrowers from
default.