BFB4133 Financial Markets and Institutions Course Notes

COURSENOTES
COURSE TITLE: FINANCIAL MARKETS AND INSTITUTIONS COURSE CODE: BFB4133 PREPARED BY: PUAN LATIFAH BINTI ABDUL LATIFF
COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION
MODULE 1: OVERVIEW OF FINANCIAL SYSTEM

Learning Objectives At the end of the module, the students will be able to: 1. Explain the roles and the functions of financial markets and financial institutions in the economic system. 2. Describe financial assets and the importance of financial assets in the operations of financial system. 3. Differentiate the financial markets and the financial intermediaries. Overview of the Financial System
Product Markets
Financial Markets Producing Units Flow of funds/ savings Flow of financial services, income and financial claims Factor Markets
Consuming Units
Functions of Financial Systems and Financial Markets Savings function Liquidity function Payment function Policy function Wealth function Credit function Risk function
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Financial Assets Intangible assets of an organization, mainly comprises of claim to future cash. Owner of financial assets are investor; the entity that has agreed to make future cash payment us called the issuer of financial assets, e.g. bond issued by Government of Malaysia, Government of Malaysia is the issuer. Debt versus Equity Claim Debt instrument is a fixed dollar amount claim against a financial asset, i.e. bond. Equity claim or residual claim requires issuer to pay the holder of financial assets based on earnings, i.e. common stock. The Price of Financial Assets and Risk Basic principle: price of financial asset is equal to the present value of its expected cash flow. The degree of certainty of cash flow depends on the type of financial assets either debt instrument or equity instrument, and characteristics of the issuer. Some of the risks of financial assets are purchasing power risk or inflation risk, default risk or credit risk and foreign exchange risk. Role of Financial Assets Transfer of funds from surplus area to deficit area. Transfer of funds as a way to redistribute the unavoidable risk associated with the cash flow generated by tangible assets. Financial Markets Definition: A market where financial assets are exchanged. Role of Financial Markets Determination of the price of the traded asset through interactions between buyer and seller, i.e. determination of required rate of return. A mechanism for investors to sell financial assets. It also offers liquidity to financial assets to investors who wish to sell his financial assets before its maturity date. Reduces the transaction costs search cost and information cost. Classification of Financial Markets
Classification by nature of claims Debt Market Equity Market Classification by maturity of claims Money Market Capital Market Classification by seasoning of claims Primary Market Secondary Market Classification by immediate delivery in the future Cash or spot market Derivative Market Classification by organizational structure Auction market Over-the-counter Market Intermediated Market
Market Participants Household Business entities non financial and financial enterprise Governments Version: 01 Date: 30/03/2009
COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Supranationals (World Bank, EU, Asian Development Bank) Regulator of Financial Markets Financial Intermediaries Financial intermediaries include commercial bank, finance companies, investment companies, insurance companies and pension funds. Financial Institutions Provide the one or more of the following service: 1. Transforming financial assets acquired through the market and constituting it into a different, more preferable type of asset. 2. Exchanging financial assets on behalf of customers. 3. Exchanging financial assets for own accounts. 4. Assisting in the creation of financial assets, and selling it to other participants. 5. Providing investment advice to other market participants. 6. Managing the portfolios of other market participants. Role of Financial Intermediaries Commercial bank accepts deposits from customers, and in a way the customer agreed that the bank will act in their behalf in investing the money. The bank will be investing this deposit into different areas, which various return depending on the industry and the risk, which is called direct investment. The depositor then has made an indirect investment. The transformation involves at least four economic functions: 1. Providing maturity intermediation. 2. Reducing risk via diversification. 3. Reducing the cost of contracting and information processing. 4. Providing a payment mechanism. Exercise 1. What are the functions of financial markets? Explain with examples. 2. Explain TWO (2) financial institutions in Malaysias financial system setting, and the importance of each one to the development of the country. 3. Describe financial assets and the importance of financial assets in the operations of financial system. 4. Differentiate the financial markets and the financial intermediaries.
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MODULE 2: INTEREST RATES IN THE FINANCIAL SYSTEM

Learning Objectives At the end of the module, the students will be able to: 1. Explain what are interest rates and the functions of interest rates in the economy. 2. Differentiate between real interest rates and nominal interest rates. 3. Understand the point of arguments about interest rates from different theories in the economy. 4. Discuss different risk structure of interest rates. What is Interest Rates? An interest rate or rate of interest is the price a borrower must pay to secure scarce loanable funds for an agreed upon period, i.e. Annual rate of interest On loanable funds (In percent) Fee required by the lender = for the borrower to obtain credit x 100 Amount of credit made available to the borrower
Functions of Interest Rates in the Economy Guarantee the current savings to flow into investment to promote economic growth Provide loanable funds to be available to investment project with expected rate of returns Balance supply and demand of money in the general public Influence volume of saving and investment part of government policy The Distinction between Real and Nominal Interest Rate Nominal interest rate is an interest rate that does not take inflation factor into account. Real Interest rate is the interest rate adjusted for expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing. The Fisher Equation states that the nominal interest rate i equals the real interest rate ir plus the expected rate of inflation,
Example: a one-year loan of 5% interest, and price is expected to rise by 3% over the course of one-year, so at the end of the year, 2% is the real rate of interest, which could be spent on other goods and services. The Distinction between Interest Rates and Rates of Returns For any security, the rate of return is defined as the payments to the owner plus the change in its value, expressed as a fraction of purchase price. Example: A one-year coupon bond, coupon rate 10%, and can be redeemed upon maturity at $1,200, the one year holding period return is 30%.
e ; thus: i = ir + e
$100 + $200 = 30% $1000
The example demonstrates that the return on a bond will not necessarily equal the interest rate on that bond.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION The Liquidity Preference Theory Developed by John Maynard Keynes in 1930s. A short term theory of interest rates. The Demand for Liquidity Keynes argued that the rate of interest is really a payment for the use of a scarce resource, money. Businesses and individuals prefer to hold money, the most liquid asset. Interest rate is the price that must be paid to induce money holders to surrender perfectly liquid asset and hold risky assets. Two considerations: bonds and money. Motives for holding money: 1. Transaction motive 2. Precautionary motive 3. Speculative motive Total demand for money in the economy is the sum of transactions, precautionary and speculative. Principal determinant of transactions and precautionary demand is income, and not interest rates, these money demands are fixed at a certain level of national income. The Supply of Money The money supply is controlled, or at least regulated by Government, in which the decision concerning the size of money supply are guided by public welfare, not by the level of interest rates. Thus the supply of money is inelastic with respect of interest rates. The Equilibrium Rate of Interest in Liquidity Preference Theory In short run, the equilibrium point of interest rates is determined by total demand for and the supply of money. Above the equilibrium rate, the supply of money exceeds the quantity demanded, and some businesses, households and units of government will dispose it by purchasing bonds, thus causing the price of bonds to rise, which then push down the interest rates towards equilibrium. Below equilibrium, the quantity of money demanded exceeds the supply, then some decision makers will be selling bonds to raise cash, which then causes the bond prices to go down, and interest rates go up towards equilibrium. Liquidity preference theory explains: 1. Investors behavior and the influence of government policy in the economy and financial system. 2. Central bank influence on interest rates in the short run. Limitations of the Liquidity Preference Theory Short term approach to interest rates. Considers only supply and demand for the stock of money, whereas business, consumer and government demand for credit also affect the cost of credit.
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Rate of Interest (percent per annum)
Transaction & Precautiona ry Demand
DT Speculative Demand DT
Total Demand
K
The Loanable Funds Theory
Quantity of Money Demanded
Views the level of interest rates in financial markets as resulting from factors that affect supply and demand for goods and services. Demand for loanable funds consists of credit demands from domestic business, consumer and government, and also borrowing the domestic market by foreingers. Supply of loanable funds is from four sources: domestic savings, hoarding demand for money, money creating by the banking system, and lending in the domestic market by foreign individuals and institutions. Consumer Demand for Loanable Funds Purpose: to purchase goods and services on credit. Consumer demand for credit is relatively inelastic with respect to the rate of interest. Domestic Demand for Loanable Funds Purpose: investment. The quantity of loanable funds demanded by business increases as the interest rates falls. Government Demand for Loanable Funds Government demand does not depend significantly on the level of interest rates. Foreign Demand for Loanable Funds Huge foreign credit demand is sensitive to the spread between the domestic lending rates and interest rates in foreign market, thus it has a negative or inverse relationship. Total Demand for Loanable Funds The sum of domestic consumer, business and government credit demands plus foreign credit demands. Higher interest rates, lower total loanable funds. The Supply of Loanable Funds Loanable funds flow into the money and capital markets from four different sources: 1. Domestic savings 2. Dishoarding of excess money balances held by the public 3. Creation of money by the domestic banking system 4. Lending to domestic borrowers by foreigners
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Total Supply of Loanable Funds Include domestic and foreign savings, dishoarding of money, and new credit created by the banking system. Volume of loanable funds supplied increases as the rate of interest increases. The Equilibrium Rate of Interest in the Loanable Funds Theory Forces of supply and demand of funds are volume of lending and borrowing, and interest rates. Interest rate tends towards the equilibrium point at which supply of loanable funds equals the demand for loanable funds. If the interest rate is temporarily above equilibrium, the quantity of loanable funds supplied by domestic and foreign savers, by the banking system, and from the dishoarding of money balances (minus hoarding demand) exceeds total demand for loanable funds, the interest rates will go down, vice versa. Risk Structure of Interest Rates Two factors that cause the interest rate or yield of one security to be different from another are maturity of security and expected inflation. Other elements influencing relative interest rates are marketability, default risk, call privilege, taxation of security income and convertibility. Marketability The question of whether a market exists for assets, i.e. securities to be acquired, and how fast that the assets can be liquidated. Positively related to the size (total sales or total assets) and reputation of the institution issuing the securities and to the number of similar securities outstanding. Negative relationship between marketability and yield, where more marketable securities has a lower expected return compares to less marketable securities, other things being equal. Liquidity A liquid financial asset is readily marketable, the price tends to be stable over time and it is reversible, meaning that the holder of the asset can usually recover her funds upon resale with little risk of loss, thus the expected rate will be lower. Default Risk and Interest Rates It is a risk that the issuer will not be able to meet the payment of a particular security, e.g. bond, upon its maturity plus the expected return. The yield on a risky security is positively related to the risk of borrower default as perceived by the investor, i.e. the yield on a risky security is composed of at least two elements: Yield on Risky Security = Risk free interest rate + Default risk premium Where: Default risk premium = Promised yield on a risky security Risk free interest Rate The promised yield on a risky security is the yield to maturity that will be earned by the investor if the borrower makes all promised payments as it is due.
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The expected rate of return or yield is the weighted average of all possible yields to maturity
from a risky security. Each possible yield is weighted by the probability that it will occur. Thus if there are m possible yield from a risky security:
piyi
i =1
where: yi = ith possible yield on arisky security pi = the probability that the ith possible risky yield will be obtained. The relationship between default risk and interest rates indicated that default risk and expected return is positively related. Call Privileges Applied to bonds, which it is allowed to have call privileges. This provision of the bond contract (indenture) permits the borrower to retire all or a portion of a bond issued by buying back the security before its maturity period. When the security is being called, the borrower will be paying a call price, which equals the securities face value plus a call penalty. The size of the penalty is set in the contract/ indenture and generally varies inversely with the number of years remaining to maturity and the length of the call deferment period. In the case of a bond, minimum call penalty required is a one-year worth of coupon income. Advantages and Disadvantages of Call Privileges Advantage to the security issuer because it has greater financial flexibility and the potential for reducing future costs. In a period of declined market interest rate, it is much cheaper for the issuer to call off the security, and issuer another security at lower interest rates. To buyer, it is a disadvantage, because expected holding period of the security had been cut short. Besides, it also limits the potential increase in a securitys market price, as market price generally does not rise significantly above the call price. Therefore, callable securities are expected to yield a higher return. Taxation of Security Returns The income from securities is subject to taxation by the government. Government uses its taxing power to encourage the purchase of a certain financial assets and then redirect the flow of savings and investment toward areas of critical social needs. Convertible Securities Consists of special issues of corporate bonds or preferred stock that entitle the holder to exchange these securities for a specific number of shares of the issuing firms common stock. Frequently called hybrid securities because it offers investor the prospect of stable income in the form of interest or dividend plus capital gains on common stock once conversion occurs. Due to this additional feature, the price of convertible bonds will be higher, and it will carry a lower rate of return than a security of the same maturity and quality.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Exercises 1. What is interest rates and what are the functions of interest rates in the economy? Explain with examples. 2. Differentiate between real interest rates and nominal interest rates, and describe the implication of these rates on securities issuance both in the debt market and the capital market. 3. Analyze the arguments of both Liquidity Funds Theory and Loanable Funds Theory. Describe the key differences in its arguments. 4. Discuss THREE (3) elements of interest rates risk structure. Case Study
4 August 2008: Economics Watch: It's about time banks raised FD rates too By Anna Taing Email us your feedback at fd@bizedge.com In what must have been seen as a rather unpopular move, most banks raised their hirepurchase rates this month by as much as 100 basis points. Hire Purchase (HP) rates now range from 2.6% to 4.5%. Many had done so in anticipation of Bank Negara Malaysia raising its overnight policy rate (OPR) to at least 3.75% to cool inflation when the Committee on Monetary Policy met on July 25. Well, Bank Negara did not - it kept the OPR at 3.5%. However, this did not deter some banks from going ahead with hiking HP rates last week. They may have their justification for doing so, given that the cost of funds, particularly long-term funds, has been on an uptrend in recent months. In an inflationary environment, expectations are that long-term rates will rise. Throw in already thin margins because of intense competition and rising operational costs and the reasons seem compelling enough for banks to raise HP rates. HP loans are long term in nature, and their tenure ranges from three to seven years. HP loans for vehicles actually make up about 23% of household debts - quite a sizeable amount. What has hit a raw nerve, however, is the fact that most banks, if not all, are very quick to push lending rates higher whenever the opportunity arises. Yet when it comes to the savings and fixed deposit (FD) rates, they tend to drag their feet. The latest move to up HP rates is a case in point. Sure, expectations are for long-term funds to cost more, but in the wake of Bank Negara's decision not to raise the OPR, these tenures have eased by between 50 and 100 basis points. For example, the three-month December 2009 futures had fallen to below 4.5% last week, compared with 5.39% on June 23. The five-year swap rate has also eased, to about 4.3% to 4.5%, down by 100 basis points from a high of 5.67% on July 3. Is this a case of the banks having the cake and eating it too? For some time now, domestic savings rates have been kept relatively low. The three-month FD rate stands at between 3.1% and 3.2%, while the 12-month rate is between 3.7% and 3.75%. When Bank Negara comes into the money market to mop up excess liquidity, banks put their money (the deposits) in the central bank at OPR plus a spread, which means they get more than 3.5%. Now consider the base lending rates (BLRs) - these range from 6.25% to 6.8%. In comparison, the three-month interbank rates are currently hovering at around 3.7%. How often have we heard, in the past, the term "moral suasion"? That's what the central bank has done on numerous occasions, nudging the banks to raise FD rates. Perhaps, it is time banks were "persuaded" to raise FD rates again. It has been done before, and on more than one occasion in the 1990s, banks had to raise their FD rates to be in line with interbank rates. Higher FD rates would be a boon to Malaysians, more so when inflation is spiralling higher, hitting a 26year high of 7.7% in June and very likely moving up again in the next couple of months. Even the most conservative of projections have put this year's inflation rate, measured by the
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Consumer Price Index (CPI), at 5.1% to 5.2%. Thus, real interest rates for the three-month tenure will be a negative two percentage points. Some economists are even saying that more realistically, we can expect inflation at 6% for the whole year. If this is indeed the case, then Malaysians will have to live with negative real interest rates for some time to come, especially when the central bank has indicated its bias towards ensuring economic growth. There is a view that with crude oil prices coming off in the last week or so, inflationary pressure may ease a bit. Indeed, the more optimistic are hoping that a prolonged fall in crude oil prices will lead to a reduction in domestic petrol prices. This is, by the by, quite unlikely to happen. But really, even if it does, the noodle seller will unlikely be in a hurry to reduce the cost of a bowl of noodles, the price of which he had hiked a few months before. It is a fact of life that such price reversals are not usual, unless there is sudden oversupply or when competition becomes intense. But I digress, so back to bank lending rates. Considering that most loans are "BLR plus X rate" after the first couple of years of "BLR minus X", margins are still "reasonable". So, the question is, should banks be raising FD rates? Given that banks' operational costs are rising, and their non-interest income is being squeezed because the capital markets are in the doldrums amid a slowing economy, banks would resist raising FD rates. Unless of course, they need to attract more deposits. Interestingly, Affin Bank has launched a promotion to draw longer-term funds, offering 4.01% for 11-month deposits. Indeed, it may not be too long before FD rates are raised because banks apparently are beginning to compete for more deposits. There is already pressure for FD rates to move upwards, and about time too.
Required: 1. Describe inflationary environment. 2. HP loans are long term in nature, and their tenure ranges from three to seven years. Discuss the effect of this statement to banks financial statement, and overall efficiency of banks management. 3. When Bank Negara comes into the money market to mop up excess liquidity, banks put their money (the deposits) in the central bank at OPR plus a spread, which means they get more than 3.5%. Describe the tools used by Bank Negara to achieve the statement, and explain why the move is done in the money market rather than financial market? 4. What is moral suasion? Why is moral suasion important in maintaining financial market and institutions efficiency? Explain. 5. Some economists are even saying that more realistically, we can expect inflation at 6% for the whole year. If this is indeed the case, then Malaysians will have to live with negative real interest rates for some time to come. Explain negative real interest rates (NRIR) and the effect of NRIR on the wealth of the public. 6. What does it means by BLR plus X rate" and BLR minus X"? Discuss the importance of understanding these terms when financing. 7. In your opinion, with the current turmoil in the banking system all across the globe, will raising the FD rate induce more savings in the financial institutions? Explain your position.
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MODULE 3: CENTRAL BANK AND CONDUCTS OF MONETARY POLICY

Learning Objectives At the end of the module, the students will be able to: 1. Explain the roles of Central Bank, in the case of Malaysia, the Bank Negara Malaysia (BNM). 2. Describe the general goals of BNM. 3. Analyze how BNM uses its policy tools to achieve its goals. Overview A central bank is an agency of government that has important public policy functions in monitoring the operation of financial system and controlling the growth of its money supply. Deals with commercial banks and securities dealers in carrying out essential policy making.
Roles of Central Bank in the Economy Control of money supply Stabilizing money and capital markets Lender of last resort Maintaining and improving the payment mechanism
The Goals and Channels of Central Banking Full employment of resources Reasonable stability in the general price level for all goods and services Sustained economic growth A stable balance of payments position for the nation vis--vis the rest of the world
The Key Focus of Central Bank Monetary Policy Monetary policy regulating money and credit conditions in an effort to strengthen the economy, what target or targets does the central bank pursue in order to impact the money and capital markets and economy as a whole. Principal target is market interest rates, pushing it higher to slow borrowing and spending in the economy and lower if the economy needs to grow faster. The device use is the reserves available to the banking system in which that banks and other depository institutions create credit and cause the money supply to grow. Total supply of reserve can be changed directly by open market operation, and making loans to depository institutions through the central banks credit or discount window. If the supply of reserve is reduced relative to the demand for reserves, interest rates tend to rise as scarce funds are rationed among competing financial institutions. If the supply of reserves is expanded it leads to lower interest rates because of the increased availability of loanable funds.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION The Money Multiplier Relationship between the size of the money supply (including deposits, currency and coin, and other readily spendable funds) and the size of the total reserve base available to depository institutions. Money multiplier = Where; account RRT = required legal reserve ratio for time and saving deposit CASH and TIME = amounts of additional currency and coin and time and savings deposits the public wishes to hold for each dollar of new transaction deposit they receive EXR = quantity of excess reserves depository institutions desire to hold for precautionary purposes out of each dollar of new transaction deposits An important point to note about currency and coin is that fluctuations in the volume held by public have direct bearing on the reserves. If the public desires to hold less pocket money, the excess currency and coin typically is redeposited in transaction accounts, increasing both demand deposit and reserve. An important determinant of money supply is monetary base - the sum of legal reserves plus the amount of currency and coin held by the public. Money multiplier x Monetary base = Money supply Or; Money Supply = 1 + CASH RRD + CASH + EXR + (RRT X TIME) x Monetary Base 1 + CASH RRD + CASH + EXR + (RRT X TIME) RRD = required legal reserve ratio for transaction (demand)
Monetary base is often referred to as high powered money a change in the base, working through the money multiplier, produces a magnified change in the nations money supply.
Policy Tools
Either general credit controls which affect the entire banking and financial system, examples are the discount rate and open market operation; or selective credit controls which affect specific groups or sectors of financial system. General Credit Control o Reserve requirements general purpose is to safeguards public deposits. Any changes in reserve requirements has at least 3 effects on the financial system, i. Change in deposit multiplier (also known as coefficient expansion) affects the amount of new deposits and new loans to the banking system can create for any given injection of new reserve; also affects the size of money multiplier, influencing the rate o f increase in the money supply. If reserve requirement is increased, the deposit multiplier and the money multiplier are reduced, slowing the growth of money, deposits and loans, vice versa. ii. Affect the mix between excess and required legal reserves. If reserve requirement are reduced, a portion of what were required reserve now becomes excess reserve, thus expanding the money supply as depository institution converted the excess into loans and investments. iii. Affect interest rate higher reserve requirement caused higher interest rate, particularly in money market.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Discount Rate (DR) annual percentage interest charge levied against those institutions choosing to borrow from the Central Banks (CB) discount window (DW), which is meant to cover temporary deficiency in reserve. Borrowings from discount window increase the total reserves available to the banking system. Effects of a discount rate change: i. Cost effect: increase in DR means that it is more costly to borrow reserves from the central bank than to use some other source of funds, thus loans from the DW and the total volume of borrowed reserves will decline. ii. Substitution effect: A change in DR causes change in interest rate (IR). Increase in DR causes borrowing from CB less attractive, and banks and other borrowers will shift their borrowing from other source and causes IR to rise as well. iii. Announcement effect: DR has a psychological impact on the financial market because CBs lending rate is regarded as an indicator of monetary policy. Thus, if DR is increased borrowers will respond by reducing borrowings and curtailing its spending. The negative psychological effect is borrowers will respond to increase in DR by securing more loans from DW in order to avoid further increase in the future, which hampers the effort of slowing the growth of borrowing and spending. Open Market Operations (OMO) consists of buying and selling government and other securities by the Central Bank to affect the quantity and growth of legal reserves and ultimately general credit condition. Common financial instruments traded are bank deposits, derivative securities and central bank debts. Effects of open market on: i. Interest rates CB is a major player in OMO, so if CB buys a large quantity of government securities, demand for the security increases, which subsequently increase the security price and lower yield, in other words, lower interest rates, vice versa. ii. Reserves the principal of day-to-day effect of CB on OMO is to change the level and growth of legal reserve. If CB buys government security, banking reserves increase and expands its ability to make loans and create deposits, increasing the growth of money and credit, vice versa. iii. CB Purchases Increase reserve of depository institutions at CB rise, while institutional holdings of securities fall by the same amount. iv. CB Sales Reduce growth of reserves, deposits and loans. Selective Credit Controls o Moral Suasion by CB Officials: CBs officers encourage banks and other lending institutions to conform to the spirit of its policies. o Margin Requirement e. g. on the purchase of stocks and convertible bonds and on short sales of these securities.
Goals 1. 2. 3. 4. Controlling Inflation Full Employment Sustainable Economic Growth Equilibrium in the Balance of Payment and Protecting Monetary Value
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Exercise
1. Discuss TWO (2) goals of Bank Negara Malaysia and the roles of Bank Negara Malaysias
tools, i.e. open market operation, discount policy and reserve requirement in achieving the goals. 2. Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold. Is the statement True, False or Uncertain? Explain. 3. Discuss the tools and the targets adopted by Bank Negara Malaysia in achieving the objective of economic growth and minimizing the effect inflation. Case Study 28 July 2008: Corporate Story: Did Bank Negara make the right move? By R B Bhattacharjee & Anna Taing Email us your feedback at fd@bizedge.com YES By R B Bhattacharjee Bank Negara made the correct decision when it kept the overnight policy rate (OPR) unchanged at 3.5%, rightly explaining that the immediate concern is not inflation but how to avoid an economic slowdown and higher unemployment. If we obey the basic logic in the view that inflation occurs when too much money is chasing too few goods, prudence dictates that demand should be cooled by discouraging consumption somewhat until a more sustainable balance prevails between demand and supply. In such a situation, monetary policy should be tightened with central banks raising interest rates. The question now is whether the Malaysian economy is currently facing these problems. The answer is, it is not, and hence there is no reason to raise interest rates. Higher interest rates will undoubtedly cause a contraction, which may be needed if the country's balance of payments has been chronically in the red. This would mean, in other words, that the country has been consuming more than it produces. Clearly, this is a situation that cannot go on indefinitely without someone paying the price. This is a prescription that many economists have been suggesting to the US, which has stubbornly left its debt to balloon. Last year, its current account deficit was about 7% of its GDP. Its trade imbalance has been prolonged to such an extent that the inevitable correction is a textbook affair. However, the Malaysian situation is a far cry from such a scenario. The current account was in surplus to the tune of 16% of Gross National Product (GNP) last year. Yet, inflation has already reared its ugly head, for sure. In July it hit 7.7%, the highest in 26 years. Furthermore, analysts are predicting a further increase before the year is out. But the escalating Consumer Price Index is being fuelled by higher energy and raw material costs, not galloping demand. That is to say, we are experiencing cost-push inflation, not the demand-pull type. To tame the beast of inflation, tweaking interest rates upwards until the price of borrowing equals the demand for capital, thereby preserving the value of the currency is not the panacea for the ills facing the economy. Such a step in the current situation would spell doom for the already slowing business climate. Higher borrowing costs would deter both capital investment and consumer spending, and sure as night follows day, the economy will contract as employers cut back on jobs and defer capacity expansion, while consumers hold off purchases on fears of diminishing income and job Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION losses. The result is a living nightmare for everyone, from the small guy to the top dog. Therefore, Bank Negara Malaysia did the right thing on Friday by keeping the overnight policy rate unchanged at 3.50%. It is true that by keeping interest rates low amidst a spirally inflation rate, it results in a negative carry, meaning inflation is higher than savings rate. It affects those who depend on monthly income from their fixed deposits. But this is the social cost the nation has to pay to battle the tough times. But this is not the only course to take to weather the storm. Consider the option of pump-priming the economy. Malaysia's total debt to GDP is only 40%. The federal government deficit is a mere 3.2%. This is some way from the 5% of GDP that is considered an indicator of an economy in trouble. With a healthy current account surplus infusing the system with ample liquidity, there are ample funds to be tapped. Also, the Employees Provident Fund (EPF) is sitting on more than RM300 billion, waiting to take up more government papers. The federal government can well afford to increase its budget deficit to pump-prime the economy. If there are fears that the government should be prudent and not go back to its days of brazen spending as seen in the mid-1990s, they are unfounded. The state of the economy today is nowhere near the situation it was in prior to the 1998 crisis. In 1996, the current account was in a deficit of 5.1%. A year earlier in 1995, the deficit was 10.5%. Although the deficit was financed by foreign direct investments (FDIs), nevertheless it was a danger to the economy. When the economic crisis came in 1997/98 and the FDIs dried up, the country was in shambles. The federal government deficit was 4.2% in 1996 and went even higher in the late 1990s and early 2000. In the last three years, the deficit was steadily reduced to the present 3.2% because the global economy, just like the Malaysian economy, was growing. Although the global economic outlook is decidedly bearish today, borrowings can be comfortably increased to finance productive growth until the recessionary cycle bottoms out beyond 2009. Not only would this cushion the effect of slowing consumer demand in the US and Western Europe at this time, it can put Malaysian producers in an advantageous position to fill new orders as their traditional markets emerge from the cold embrace of these stagflationary times. That said, it must be recognised that it would be really too easy to mess up this precious chance to get the country out of its profligate rut. The powers-that-be only need to carry on with the spending spree that has allowed albatrosses like the Port Klang Free Trade Zone, the outlandish costing of the double-tracking project and the Bakun Dam imbroglio, to name a few landmark projects, to be foisted onto the public account, for the pump-priming exercise to transform into a sorry mess. Avoiding such a fate will require a level of financial discipline, which means targetting pump-priming at the right sectors and to increase productive capacity. It is such discipline and governance that keeps nations with integrity from ending up in the rubbish heap of history. NO By Anna Taing Bank Negara Malaysia should have girded its loins and nudged the overnight policy rate (OPR) higher last Friday. But it chose to keep the rate unchanged at 3.5%. It's not too late. It's a tough decision, but it can still raise the OPR next month, and at the same time, facilitate a faster appreciation of the ringgit. As things stand, the ringgit will likely take a beating when markets open on Monday, and a weaker ringgit will not help when inflation is up. Put simply, monetary policy is the key although it will not be a popular move, politically. Boosting fiscal spending to spur growth, such as pump-priming, should not be the policy of choice at this juncture. It will be popular, but it may not be the wisest move.Here is why. Clearly, Malaysia cannot afford to incur a burgeoning budget deficit, at a time when its subsidy bill, especially for fuel, is in danger of ballooning despite the fact that the government raised petrol prices by 41% and diesel by 68% in June. Note that since then, there have been some Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION flip-flops, such as a delay in implementing market driven petrol prices and plans to give subsidies to operators in the transport sector. While the price of crude oil has come down from record highs recently, the general consensus is that it is still on an upward trend. If the government does not intend to raise petrol prices further this year, it could mean that its subsidies bill will increase, not decrease. More so, when it is actually putting more items under price control, like milk and eggs. And, how much can it pump prime? In the mid-1980s, it could spend its way out of a recession because Malaysia needed a lot of infrastructure and stagflation was not a threat. The North-South Expressway was a necessity. In the late 1990s, there was the KLIA and Putrajaya. But now, Malaysia has reached saturation point there is only so much that we can build. Already, the government has increased development spending by RM30 billion to RM230 billion under the Ninth Malaysia Plan (9MP). Originally, an additional RM20 billion was to come from private financing initiative (PFI) At a time when the economy is grinding to a slowdown, it will be tough to realise PFI funding. The danger of a widening budget deficit, now at around 3.2% of gross domestic product (GDP) is that it can have severe implications for the larger economy. A prolonged and widening budget deficit will result in a downgrade of Malaysia's sovereign rating, and this will make it more expensive for the government and local corporations to raise funds. What will happen if the government needs to borrow to pump-prime the economy? Furthermore, the "overuse" of pump-priming can have negative repercussions, in that it may deter industries from striving for greater efficiency when prices are rising. It encourages them to rely on quick fixes, instead of reengineering themselves to stay competitive. It's a case of instant gratification. In the long term, this will not bode well for the country's overall competitive edge; more so when globalization has made it imperative that we move up the value chain. So, yes, the government can spend more, but only in terms of providing social safety nets for the poor and lower income groups. Now, an often cited argument is that the current inflationary pressure is cost, and not demand pushed. Raising interest rates will not do the trick in promoting price stability. In Malaysia's case, expectations are for inflation to be "temporary" because it is being caused by the one-off rise in fuel and electricity prices. Growth, therefore, should be the focus. Raising interest rates when the economy is slowing will crimp growth even more. The big question is, how temporary is temporary? In May, inflation was 3.8%, and in June, 7.7%, a 26-year high. In August, it is expected to rise to around 8%. What about secondary effects, going forward? World food prices are still astronomical, and unlikely to fall in the next one year. At home, some companies have begun to adjust wages for their staff, and there is even talk that a minimum wage will be implemented, to help the people cope with the rising cost of living. It is easy for the inflation situation to get out of hand, like in the 1970s, a time often billed as the "Great Stagflation Period" where rising oil and commodities prices raised inflation to doubledigit levels and caused a global recession. Sure, raising interest rates will crimp growth but we are not talking about a big increase of 100 basis points (bps). A gradual hike, say of 25bps, to the current OPR is practical. As long as the rate rise is not overdone, a slower growth may well be a blessing in disguise. Indeed, it is a natural way to reduce demand for goods and services, hence curb inflation. Pump-priming at this time, on the other hand, could fuel even more inflationary pressure, and what has been deemed as "temporary" could developed into a more serious problem. As the world economy found out in the 1970s and 1980s, inflation is growth's biggest enemy. Sure, raising rates will make it tougher for businesses, but at the same time, a high-cost environment will force them to be more cost efficient, which is positive over the long term. The inefficient will be competed out, which is a good thing because in a globalizing world, there is no room for mediocrity. Having said that, the best policy option in front of Bank Negara Malaysia is to allow a faster appreciation of the ringgit, as it will immediately result in cheaper imports and Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION improve the purchasing power of the people. Don't forget, many of the food and general items in shops are imported. Malaysia has the fundamentals to support a much stronger ringgit. It has a huge current account surplus estimated at around 15% of GDP, and Bank Negara's international foreign exchange reserves are at record highs. The central bank will have no choice but to nudge rates higher because global interest rates are set to rise. It's a matter of when. If Malaysian rates remain significantly lower than global rates, then investors will flee ringgit assets and put their money in higher yielding assets elsewhere, which in turn, will put pressure on the ringgit to weaken. When inflationary pressures are up, the last thing we want is a depreciating currency. And real interest rates have gone negative. Three-month fixed deposit rates are 3.7% to 3.9%, while inflation is 7.7%. In addition, some domestic banks are talking about raising certain lending rates like hire purchase to prevent thinning margins. With real interest rates already in negative territory, it means private investments will be impaired in the long term as people resort to having to spend more and save less. Inflation is like a tax. If interest rates don't rise, savings get eroded. Over time, private investments will be affected. Thus, the best way forward is to raise interest rates and allow a stronger ringgit, not fiscal pump priming.
Required: 1. Describe cost-push inflation and the demand-pull inflation type. 2. Tweaking interest rates upwards until the price of borrowing equals the demand for capital. Describe the effects of such move to the economy. 3. It is true that by keeping interest rates low amidst a spirally inflation rate, it results in a negative carry, meaning inflation is higher than savings rate. It affects those who depend on monthly income from their fixed deposits. Describe how this statement is true in nature to the pensioners that depend on their EPF. 4. Also, the Employees Provident Fund (EPF) is sitting on more than RM300 billion, waiting to take up more government papers. Explain government papers that are available in the market and risks associated in investing in these papers. 5. What is stagflationary period? 6. Explain some of the monetary policy that can be adopted by the Bank Negara to face the recession cycle of the economy. 7. A prolonged and widening budget deficit will result in a downgrade of Malaysia's sovereign rating, and this will make it more expensive for the government and local corporations to raise funds. How would this statement affect the efficiency of financial market and institutions in Malaysia? Analyze. 8. Describe the negative effects of over pump priming the economy. 9. Explain the advantages of recession/ inflationary cycle.
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MODULE 4: FINANCIAL MARKETS

Learning Objectives At the end of the module, the students will be able to: 1. Describe different types, functions and importance of financial markets to the economy. 2. Explain various instruments that are traded under different market structure, and implications to the financial markets. 3. Analyze of the overall significance of financial markets operation in the economy. Overview The financial markets are markets which facilitate the raising of funds or the investment of assets, depending on viewpoint. They also facilitate handling of various risks. The financial markets can be divided into different subtypes: Capital markets consist of: Stock markets, which facilitates equity investment and buying and selling of shares of stock. Bond markets, which provides financing through the issue of debt contracts and the buying and selling of bonds and debentures. Money markets which provides short term debt financing and investment. Derivatives markets, which provides instruments for handling of financial risks. Futures markets, which provide standardized contracts for trading assets at some forward date; see also forward market. Insurance markets, which facilitates handling of various risks. Foreign exchange markets These markets can be either primary markets or aftermarkets/ secondary markets. Money Market The money market is a general term for the markets in which banks lend to and borrow from each other, trade financial instruments such as Certificates of Deposit (CDs) or enter agreements such as Repos and Reverses. The market normally trades in maturities up to one year. It provides short to medium term liquidity in the global financial system. Derivatives of the money market include forward rate agreements (FRAs) and futures. Trading takes place between banks in the "money centres" (New York and London primarily, also Chicago, Frankfurt, Paris, Singapore, Hong Kong, Tokyo, Toronto, Sydney). Financial instruments package financial capital in readily tradeable forms - they do not exist outside the context of the financial markets. Their diversity of forms mirrors the diversity of risk that they manage. Financial Instruments can be categorized according to whether they are securities, derivatives of other instruments (see derivative securities), or so called cash securities. If they are a derivative, they can be further categorized depending on whether they are traded as standard derivatives or traded over the counter (OTC). Alternatively they can be categorized by 'asset class' depending on whether they are equity based (reflecting ownership of an asset) or debt based (reflecting a loan the investor has made Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION to the owner of an asset). If it is a debt security, it can be further categorized into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category. Combining the above methods for categorization, the main instruments can be organized into a matrix as follows:
INSTRUMENT TYPE Cash ASSET CLASS Debt (Long Term) Bond Floating rate note Standard Derivative Bond future option Bond futures</p> OTC Derivative Interest rate swap Interest rate cap & Interest rate floors Cross currency swap Exotic instruments Forward rate Foreign exchange swap options Stock Exotic instruments Foreign exchange options Foreign exchange forwards agreement
Debt (Short Term)
Deposit/loan Bill - (Capital Markets) futures CD (Certificate of deposit) CP (Commercial paper) Stock (Equity index) Foreign exchange spot Stock Equity futures
Equity Foreign Exchange
Options
Foreign exchange futures
CERTIFICATE OF DEPOSITS (CD) A certificate of deposit or CD is, in the United States, a familiar financial product, commonly offered to consumers by banks, thrift institutions, and credit unions. Such CDs are similar to savings accounts in being insuredby the FDIC for banks or by the NCUA for credit unions and thus virtually risk-free; they are "money in the bank." They are different from savings accounts in that the CD has a specific, fixed termoften three months, six months, or one to five yearsand, usually, a fixed interest rate. It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest. CD RATES In exchange for keeping the money on deposit for the agreed-on term, banks usually grant higher interest rates than they do on accounts from which money may be withdrawn on demand. For example, as of 2004 one well-known bank offers 0.40% annual interest on savings accounts from which withdrawals may be made on demand, 0.80% on a 3-month CD, and 2% on a 2-year CD. Fixed rates are common, but some banks offer CDs with various forms of variable rates. For example, in mid-2004, with interest rates expected to rise, many banks began to offer CDs with a "bump-up" feature. These allow for a single readjustment of the interest rate, at a time of the consumer's choosing, during the term of the CD. HOW CDS WORK The consumer who opens a CD may receive a bankbook or paper certificate, but as of 2004 it is common for CD to consist simply of a book entry and an item shown in the consumer's periodic bank statements; that is, there is usually no "certificate" as such. At most institutions, the CD purchaser can arrange to have the interest periodically mailed as a check or transferred into another account. This reduces total yield because there is no compounding. Commonly, banks mail a notice to the CD holder shortly before the CD matures requesting directions. The notice usually offers the choice of withdrawing the principal and accumulated interest or "rolling it over" (depositing it into a new CD). In the absence of such directions, it is common for for the bank to "roll over" the CD automatically, once again tying up the money for a period of time. A holder who actually wishes to withdraw the money must be alert for for the maturity notice, and communicate his wishes to the bank in advance of maturity. Withdrawals before maturity are usually subject to a substantial penalty, often the loss of six months' interest. These penalties ensure that it is generally not in a holder's best interest to withdraw the money before maturity.
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OTHER CDS AND CD-RELATED FINANCIAL PRODUCTS This article has described the familiar FDIC-insured or NCUA-insured CDs which are usually purchased by consumers directly from banks or credit unions. There are also "certificates of deposit" issued by various entities that do not carry insurance, and there are various CD and CD-backed products offered by investment houses and "CD brokers." These are more complicated, and the purchaser needs to research and carefully understand the terms and conditions that apply Repurchase Agreements, commonly known as Repos, are financial instruments used in the money markets. It is a transaction in which one party sells securities to another while agreeing to repurchase those securities at a future date. Several terms refer to the same transaction: "Repurchase Agreement", "Repo", "Reverse Repo", and "Resale". A Reverse is a repo seen from the point of view of the other party to the transaction. Normally, both parties view the transaction from the trader's perspective. A trader looking to borrow money is transacting a repo, while a trader looking to obtain securities is executing a reverse repo. When a customer provides money to a trader in return for securities, the transaction is often termed a repo by both parties A repo is similar to a secured loan, with the lender of money receiving securities as collateral to protect against default. The legal title to securities passes from the seller to the investor. The one providing the money is referred to as an "investor"; the provider of the collateral is the "seller". Coupons that are paid out on the securities during the life of the loan are transferred to the original owner of the security. WHY ARE REPOS TRANSACTED? For the customer, a repo is an opportunity to invest cash for a custom period of time (other investments typically involve whole numbers of months). It is a short-term and secure investment; in return for investing, the customer receives collateral. Market liquidity for repos is good and yields are competitive for investors. For the trader, repos are used to finance long positions and reduce funding costs of other speculative investments. A repo is not strictly a trade but an agreement that is entered into. In finance, a Forward Rate Agreement (FRA) is a contract under which an agreed interest rate Rk applies to an agreed principal P for an agreed period of time, say between Ts and Te. Normally the pay-off is computed without waiting out the interest period, by computing the future value of the FRA at Te, and using the actual interest rate R at Ts to discount the future value . A financial future is a futures contract on a short term interest rate (STIR). Contracts vary, but are often defined on a interest rate index such as 3-month sterling or US dollar LIBOR. They are traded across a wide range of currencies, including the G12 country currencies and many others. Some representative financial futures contracts are United States 90-day Eurodollar *(IMM) 1 mo LIBOR (IMM) Fed Funds 30 day (CBT) Europe 3 mo Euribor (LIF) 90-day Sterling LIBOR (LIF) Euro Sfr (LIF) Asia 3 mo Euroyen (TIF) 90-day Bank Bill (SFE) where IMM is the International Money Market of the Chicago Mercantile Exchange CBT is the Chicago Board of Trade LIF is the London International Financial Futures Exchange TIF is the Tokyo International Financial Futures Exchange Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION SFE is the Sydney Futures Exchange As an example, consider the definition of the International Money Market (IMM) eurodollar interest rate future, the most widely and deeply traded financial futures contract. There are four contracts per year: March, June, September, December (plus serial months) They are listed on a 10 year cycle. Other markets only extend about 2-4 years. Last Trading Day is the second London business day preceding the third Wednesday of the contract month Delivery Day is cash settlement on the third Wednesday. The minimum fluctuation (tick size) is half a basis point or 0.005%. Payment is the difference between the price paid for the contract (in ticks) multiplied by the "tick value" of the contract which is $12.50 per tick. Before the Last Trading Day the contract trades at market prices. The Final Settlement Price is the Bond (finance) price in that an increase in price corresponds to a decrease in yield). Capital Market The capital market is the market for long-term loans and equity capital. Companies and the government can raise funds for long-term investments via the capital market. The capital market includes the stock market, the bond market, and the primary market. Securities trading on organized capital markets is monitored by the government; new issues are approved by authorities of financial supervision and monitored by participating banks. Thus, organized capital markets are able to guarantee sound investment opportunities. The capital market can be contrasted with other financial markets such as the money market which deals in short term liquid assets, and futures markets which deals in commodities contracts. A stock market is a market for the trading of publicly held company stock and associated financial instruments (including stock options, convertibles and stock index futures). Traditionally such markets were open-outcry where trading occurred on the floor of an exchange. These days increasingly the markets are cyber-markets with buying and selling occurring via online real-time matching of orders placed by buyers and sellers. Many years ago, worldwide, buyers and sellers were individual investors and businessmen. These days markets have generally become "institutionalized"; that is, buyers and sellers are largely institutions whether pension funds, insurance companies, mutual funds or banks. This rise of the institutional investor has brought growing professionalism to all aspects of the markets. The movements of the prices in a market or section of a market are captured in price indices called Stock Market Indices, of which there are many, e.g., the Standard and Poors Indices and the Financial Times Indices. Such indices are usually market-capitalisation weighted. There are stock markets in most developed economies, with the world's biggest markets being in the USA, Japan, and Europe. There are global stock-market indices that, because they delineate the global universe of stock opportunities, shape the choices and distribution of funds of institutional investors. The character of markets around the world varies, for example with the majority of the shares in the Japanese market being closely held (by financial companies and industrial corporations) compared with the structures of ownership in the USA or the UK. DERIVATIVE INSTRUMENTS An option is a contract that gives an investor the right to buy or sell a security such as a stock or index at an agreed-upon price during a specified period with no obligation. A FUTURE is a contract that gives an investor the obligation to buy or sell a security at an agreed-upon price during a specified period. An option buyer who believes that the price of a stock will rise can enter a contract known as a "call" which gives him the right to buy another's stock at a date three to nine months in the future. He pays a fee to the owner of the stock and will forfeit it if he does not exercise the option. But if the stock price rises enough, he can exercise the option and buy the stock at the fixed price, and then resell it for a higher price to recover his premium and make a profit. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Someone who thinks that the price of a stock is about to fall can buy a "put" contract with someone else who agrees to buy the stock at a fixed price. He does not have to own the stock at the time the contract is made. Again, he pays a premium. But if the stock price does fall, he can buy the stock at a low price on the market and then sell it for an agreed-upon higher price. Option contracts are traded like stocks, often by people who have no intention of exercising them. Although there is a guaranteed loss of the premium when an option is not exercised, there is enormous potential profit from trading the option itself--its price rises or falls with the price of the underlying stock. Someone who has a guaranteed buyer for 10,000 shares of stock at $35 has a contract of enormous value if the price of the stock falls to $10. He may not want to invest $100,000 to fulfill the contract and earn $350,000. But someone will want to buy the contract from him for more than he paid for it. There are also two sorts of trades involving cash or stock not actually owned, short selling and margin buying. In short selling, someone sells stock that they don't actually own, hoping for the price to fall. They must eventually buy back the stock. In margin buying, someone borrows money to buy the stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks, it can be at only a certain percentage of those other stocks' value. Other rules include a prohibition of freeriding; that is, putting in an order to buy stocks without paying initially, and then selling them and using part of the proceeds to make the original payment. STOCK MARKET REGULATION Before 1929, there were few regulations governing trades. In the 1920s there were many abuses in the sale and trading of securities. State Blue Sky laws were easy to evade by making security sales across state lines. After holding hearings on the abuses Congress passed The Securities Act of 1933. It regulates the interstate sales of securities and made it illegal to sell securities into a state without complying with the state law. It requires companies which want to sell securities publicly to file a registration statement with the Securities & Exchange Commission. The registration statement provides a lot of information about the company and is a matter of public record. The SEC does not approve or disapprove the issue, but lets the statement "become effective" if it provides aufficient required detail, including risk factors. Then the company can begin selling the issue, usually through investment bankers. The next year Congress passed the Securities Exchange Act of 1934 which regulates the secondary market trading of securities. Initially it applied only to stock exchanges and listed companies as its name implies. In the late 1930s it was amended to provide regulation of the over-the-counter market also. In 1964 it was amended to apply also to companies traded in the over-the-counter market. The primary market is the financial market for the initial issue and placement of securities. Unlike in the secondary market, no organized stock exchanges are necessary. An organization that need funds contacts their investment banker who typically assembles a syndicate of securities dealers that will sell the new stock issue. Securities dealers see this as the wholesale part of their business. This process of selling the new stock issues to prospective investors in the primary market is called underwriting. The securites that they sell are called initial public offerings (IPOs). Dealers usually earn a commission that is built into the price of the security offering, that is, it is not apparent unless you read the prospectus in detail. This is contrasted with the retail part of the business, which is acting as an intermediary between buyers and sellers of securities in the secondary market. IPO is shares of a corporation to the public. It represents a primary market. The sale of stock is regulated by authorities of financial supervision and where relevant by a stock exchange. It is usually a requirement that disclosure of the financial situation and prospects of a company be made to prospective investors. In the United States, during the dot-com bubble of the late 1990s, many venture capital driven companies were started, and seeking to cash in on the bull market, quickly offered IPOs. Usually, the stock price spiraled upwards as soon as a company went public, as investors sought to get in at the ground-level of the next potential Microsoft. Initial founders could often become overnight millionaires, and due to generous stock options, employees could make a great deal of money as well. The majority of IPOs could be found on the Nasdaq stock exchange, which is laden with companies related to computer and information technology. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION This phenomenon was not limited to the U.S. In Japan, for example, a similar situation occurred. Some companies were operated in a similar way in that their only goal was to have an IPO. Some stock exchanges were set up for those companies, such as financial market, aftermarket, dot-com, reverse merger Securities are tradeable interests representing financial value. They are often represented by a certificate. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, other derivative securities, limited partnership units, and various other formal "investment instruments." Banknotes, checks, and some bills of exchange do not fall into this category. New issues of securities, including what is commonly known as an IPO, or Initial Public Offering, for new stock issues, are offered on the primary market. Securities that have already been issued may also be traded; this trading is called the aftermarket or secondary market. Secondary markets often consist of what is called an exchange to facilitate the meeting of buyers and sellers. They are often referred to as a stock exchanges, even though there are exchanges such as the Chicago Board of Options Exchange where no stocks are traded. In the United States, securities are registered with the Securities and Exchange Commission (SEC), though some may never trade on an exchange and some are exempt from registration. Dealing in securities is heavily regulated by both the federal authorities (chiefly SEC) and state authorities. In addition the industry is heavily self policed by Self Regulatory Organizations (SRO's), such as the NASD or the MSRB. Due to the difficulty of creating a general definition that covers all securities, the SEC attempts to define "securities" exhaustively (and not very precisely) as: "any note, stock, treasury stock, security future, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a "security"; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." --Section 3a item 10 of the 1934 Act. A derivatives market is any market for a derivative, that is a contract which specifies the right or obligation to receive or deliver future cash flows based on some future event such as the price of an independent security or the performance of an index. Derivatives markets can be standardized (many users trading fungible contracts, typically on an exchange) or non-standardized (where derivitives are customized for the user by a trading desk - the over-the-counter market). One derivatives market is for standardized stock options, a market where parties can buy or sell, call or put options on a secondary market. Nonstandardized derivatives instruments,such as naked warrants issued directly by financial institutions to a secondary market, also exist. A stock option is a specific type of option with a stock as the underlying instrument, (the security that the value of the option is based on). Thus it is a contract to buy (known as a "call" contract) or sell (known as a "put" contract) shares of stock, at a predetermined or calculable (from a formula in the contract) price. EXAMPLE For example I may own an option to buy a share in XYZ corp. for $100 in one months' time. If the actual stock price at the time is $105 then I would exercise (i.e. use) my option and buy a stock from whoever sold me the option for $100. I could then either keep the stock, or sell it in the open market for $105, realising a profit of $5. However, if, in one month's time, the stock price was only $95, I would not exercise my option, and if I really wanted a share in XYZ Corp, I could buy it in the open market for $95 rather than using my option to buy it for $100. Thus if I Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION have an option, I might make a profit and am certain not to make a loss. This means an option must have some positive monetary value itself. VALUATION A stock option contract's value is determined by five principal factors - the price of the stock, the strike price, the cumulative cost required to hold a position in the stock (including interest + dividends), the time to expiration, and an estimate of the future volatility of the stock price. The most general method in wide-spread use for valuing stock options is the Binomial options model, although the Black-Scholes model can give accurate answers for certain types of options. TRADING Options themselves are traded as securities on stock exchanges. Options trading, without intent to ever exercise the option, can be used as a form of leverage (business). The price of an option on a security will move more than the price of the security itself. For this reason and due to their usefulness in financial engineering, the total value of trading in options has at times, exceeded to total value of trading in stocks themselves. Efficient Market Hypothesis In finance, the efficient market hypothesis (EMH) asserts that stock prices are determined by a discounting process such that they equal the discounted value (present value) of expected future cash flows. It further states that stock prices already reflect all known information and are therefore accurate, and that the future flow of news (that will determine future stock prices) is random and unknowable (in the present). The EMH is the central part of Efficient Markets Theory (EMT). Both are based partly on notions of rational expectations. The efficient market hypothesis implies that it is not generally possible to make above-average returns in the stock market by trading (including market timing), except through luck or obtaining and trading on inside information. There are three common forms in which the efficient markets hypothesis is commonly stated - weak form efficiency, semi-strong form efficiency and strong form efficiency, each of which have different implications for how markets work. WEAK-FORM EFFICIENCY No excess returns can be earned by using investment strategies based on historical share prices or other financial data. Weak-form efficiency implies that Technical analysis will not be able to produce excess returns. To test for weak-form efficiency it is sufficient to use statistical investigations on time series data of prices. In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. The only factor that affects these prices is the introduction of previously unknown news. News is generally assumed to occur randomly, so share price changes must also therefore be random. SEMI-STRONG FORM EFFICIENCY Share prices adjust instantaneously and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that Fundamental analysis will not be able to produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient way. STRONG-FORM EFFICIENCY Share prices reflect all information and no one can earn excess returns. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. When the topic of insider trading is introduced, where an investor trades on information that is not yet publicly available, the idea of a strong-form efficient market seems impossible. Studies on the US stock market have shown that people do trade on inside information. It was also found though that others monitored the activity of those with inside information and in turn followed, having the effect of reducing any profits that could be made. Even though many fund managers have consistently beaten the market, this does not necessarily invalidate strong-form efficiency. We need to find out how many managers in fact do beat the market, how many match it, and how many underperform it. The results imply that performance relative to the market is more or less normally distributed, so that a certain percentage of managers can be expected to beat the market. Given that there are tens of thousand of fund managers worldwide, then having a few dozen star performers is perfectly consistent with statistical expectations. ARGUMENTS CONCERNING THE VALIDITY OF THE HYPOTHESIS Many observers dispute the assumption that market participants are rational, or that markets behave consistently with the efficient market hypothesis, especially in its stronger forms. Many economists, mathematicians and market practitioners cannot believe that man-made markets are strong-form efficient when there are prima facie reasons for inefficiency including the slow diffusion of information, the relatively great power of some market participants (e.g. financial institutions), and the existence of apparently sophisticated professional investors. The efficient market hypothesis was introduced in the late 1960s and the prevailing view prior to that time was that markets were inefficient. Inefficiency was commonly believed to exist e.g. in the United States and United Kingdom stock markets. However, earlier work by Kendall (1953) suggested that changes in UK stock market prices were random. Later work by Brealey and Dryden, and also by Cunningham found that there were no significant dependences in price changes suggesting that the UK stock market was weak-form efficient. Further to this evidence that the UK stock market is weak form efficient, other studies of capital markets have pointed toward them being semi strong-form efficient. Studies by Firth (1976, 1979 and 1980) in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer. Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi strong-form efficient. It may be that professional and other market participants who have discovered reliable trading rules or stratagems see no reason to divulge them to academic researchers; the academics in any case tend to be intellectually wedded to the efficient markets theory. It might be that there is an information gap between the academics who study the markets and the professionals who work in them. Within the financial markets there is knowledge of features of the markets that can be exploited e.g October 1987 where most stock exchanges crashed at the same time. It is virtually impossible to explain the scale of those market falls by reference to any news event at the time. The correct explanation seems to lie either in the mechanics of the exchanges (e.g. no safety nets to discontinue trading initiated by program sellers) or the peculiarities of human nature. It is certainly true that "behavioral psychology" approaches to stock market trading are amongst the most promising that there are (and some investment strategies seek to exploit exactly such inefficiencies). A growing field of research called Behavioral finance studies how cognitive or emotional biases, which are individual or collective, create anomalies in market prices and returns and other deviations from the EMH.
EMPLOYEE STOCK OPTIONS (ESOP) Main article at Employee stock option Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Stock options for the company's own stock are often offered to upper-level employees as part of the executive compensation package, especially by American business corporations. It is also sometimes done for non-executive employees, especially in the technology sector, in order to give all emplyees an incentive to help the company become more profitable. Because stock prices are related to corporate earning, the employees have an incentive to increase earnings, in order to make the price of the company's stock rise, and therefore increase the value of the employee's stock options. This increase in earnings can either be done in reality, or possibly by the use of creative accounting. Employee stock options differ from the options that are traded on exchanges as securities primarily in the time frame under which they can be excercised. Employee stock options typically allow an excercise timeframe of up to ten years, whereas the longest time to expiry for exchange traded options is typically 2 years. Thus employee stock options are similar to warrants. Types of Employee Stock Options Stock options granted to employees are of two forms, that differ primarily on their tax treatment. They may be either: Incentive Stock Options (ISO's) Non Qualified Stock Options Expensing of Employee Stock Options According to current GAAP, stock options granted to employees do not need to be charged as an expense on the income statement when granted. This allows a potentially large form of employee compensation to not show up as an expense in the current year, and therefore, currently overstate income. Many assert that over-reporting of income by methods such as this by American corporations was one contributing factor in the Stock Market Downturn of 2002. A call option is a financial contract between two parties, the buyer and the seller of the option. The buyer of the option has the right but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time for a certain price (the strike price). The seller assumes the corresponding obligations. "Selling" in this context is not the supplying of a physical or financial asset (the underlying instrument), rather it is the granting of the right to buy the underlying, against a fee - the option price or premium. Exact specifications may differ depending on option style. A european call option allows the holder to exercise, i.e. to buy, on the delivery date only. An american call option allows exercise at any time during the life of the option. The stock option, the option to buy stock in a particular company, is the most widely-known call. However options are traded on many other financial instruments - such as interest rates (see interest rate cap) - as well as on physical assets such as gold or crude oil. Example of a call option on a stock I buy a call on Microsoft Corp. strike price $50, exercise June 1 2005. If the share price is actually $60 on that day (the spot price) then I would exercise my option (i.e. buy the share from the counter-party). I could then sell it in the open market for $60, i.e. the option would be worth $10; my profit would be $10 minus the fee I paid for the option. If however the share price is only $40 then I would not exercise the option (if I really wanted to own such a share, I could buy it in the open market for $40, why waste $50 on it). The option would expire worthless. Thus, in any future state of the world, I am certain not to lose money on the underlying by owning the option; my loss is limited to the fee I have paid. From the above, it is clear that a call option has positive monetary value when the underlying instrument has a spot price (S) above the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a call option is Max[ (S-K) ; 0 ] or formally, <math>(S-K)^{+}<math> Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION where <math>(x)^+ =\{^{x\ if\ x\geq 0}_{0\ otherwise}<math> Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The call price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree this value initially. A put option is a financial contract between two parties, the buyer and the seller of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the seller of the option at a certain time for a certain price (the strike price). The seller assumes the corresponding obligations. Note that the seller of the option undertakes to buy the underlying! In exchange for being granted this option, the buyer pays the seller a fee. Exact specifications may differ depending on option style. A european put option allows the holder to exercise, i.e. to sell, on the delivery date only. An american put option allows exercise at any time during the life of the option. The most widely-known put option is the stock option, the option to sell stock in a particular company. However, options are traded on many other assets: financial - such as interest rates (see interest rate floor) - and physical, such as gold or crude oil. Example of a put option on a stock I enter a contract to have the option to sell a share in XYZ Corp. on June 1, 2003, for $50. If the XYZ Corp. share price is actually only $40 on that day, then I would exercise my option (i.e. sell the share from the counter-party). I could then buy another share in the open market for $40, i.e. the option would be worth $10; my profit would be $10 minus the fee I paid for the option. If, however, the share price is more than the option price, say, $60, then I would not exercise the option. If I really wanted to sell such a share, I could do so in the open market for $60, and make more profit than I would by selling through the option. My option would be worthless and I would have lost my whole investment, the fee for the option. Thus, in any future state of the world, I am certain not to lose money by owning the option; my loss is limited to the fee I have paid. This example illustrates that the put option has positive monetary value when the underlying instrument has a spot price (S) below the strike price (K). Since the option will not be exercised unless it is "in-the-money", Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The put price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree this value initially. Options: Stock option, Warrants, Foreign exchange option, Interest rate options , Bond options, Options on futures, Swaption, Interest rate cap, Interest rate floor, Exotic interest rate option, Credit default option, binary option, real option The aftermarket (also called secondary market) is the financial market for trading of already issued securities. In the secondary market, securities are sold by and transferred from one investor to another. It is therefore important that the secondary market be highly liquid and transparent. The eligibility of stocks and bonds for trading in the secondary market is regulated through financial supervisory authorities and the rules of the market place in question, which could be a stock exchange. Stock brokers see the secondary market as the retail part of their business. They are dealing with many clients and many relatively small transactions. This can be contrasted with the Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION primary market in initial public offerings which can be seen as the wholesale side of their business. The forward market describes the over the counter market in contracts for future delivery or, in physical commodities, for later shipment. Forward contracts are personalized between parties and thus are infrequently exchange traded. The forward market is a general term used to describe the informal market by which these contracts are entered and exited. Foreign Exchange Markets The foreign exchange markets are usually highly liquid particularly in the G7 currencies (USD, JPY, EUR, CHF, GBP, CAD, AUD). The main international banks continually provide the market with both bid (buy) and ask (sell) offers. The volume of trading in the foreign exchange markets exceeds that in any other market, liquidity is extremely high. In the foreign exchange markets there is little or no 'inside information'. Rate fluctuations are usually to do with world economy or the national economies so significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time. This is in contrast to the Equity Market where a stock may lose value by 5% or more, and only later do the reasons for this become apparent when a newspaper reports that forecasts for that company have been revised downward, or that a key executive has resigned (this why insider trading in stock markets can be a problem). Big foreign exchange trading centers are located in New York, Tokyo, London, Hong Kong, Singapore, Paris and Frankfurt amongst others and the foreign exchange market is open 24 hours per day throughout the week (closing worldwide Friday afternoon and reopening Sunday afternoon). If the European Market is closed the Asian Market or US will be open on the other and so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets. This enables traders to take positions anticipating the impact on the exchange rate of important news items. In the foreign exchange markets there is never a 'bear' market. Currencies are traded in pairs, every trade involves the selling of one currency and the buying of another. If some currencies are going down, others must be going up. Exchange Rates In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 120 Japanese Yen to the Dollar means that 120 is worth the same as $1. An exchange rate is also known as a foreign exchange rate, or FX rate. An exchange rate quotation is given by stating the number of units of a price currency can be bought in terms of a unit currency. For example, in a quotation that says the Euro-United States Dollar exchange rate is 1.2 dollars per euro, the price currency is the dollar and the unit currency is the euro. The usual unit currency varies by geographic location. For example, British newspapers quote exchange rates with British pounds as the unit currency. This is known as indirect or quality terms quotation and is also common in Australia and New Zealand. Quotes using a country's home currency as the unit currency are known as direct or appreciating (i.e. if the currency is becoming more valuable) then the exchange rate number increases. Conversely if the price currency is strengthening, the exchange rate number decreases and the unit currency is depreciating. In practice it is rarely possible to exchange currency at the exact rate quoted. Market makers who match together buyers and sellers will take a commission. This is achieved by quoting a bid/offer spread. For example if you are bidding to buy Japanese yen you would do so at the bid price of say, 115 per dollar, and if you were offering to sell yen you might do so at 125 yen per dollar. If a currency is free-floating its exchange rate against other countries can vary against other such currencies. In fact such exchange rates are likely to be changing almost constantly as quoted by financial markets and banks around the world. If the value of the currency is Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION "pegged" its value is maintained by the government in question at a fixed rate relative to the other currency. For example, in 2003 the Hong Kong dollar was pegged to the United States dollar. Fluctuations In Exchange Rates A market based exchange rate will change whenever the value of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency). Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the countries level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency. In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the countries level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty. For example, when Russian President Vladimir Putin dismissed his Government on Feburary 24 2004, the price of the Ruble dropped. When China announced plans for its first manned space mission the price of the Yuan jumped. Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, where options are derivatives of exchange rates.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION CASE STUDIES FOR MODULE 4: FINANCIAL MARKETS Case 1 MY SAY: THE POLITICAL STOCK MARKET By Robert J Shiller Email us your feedback at fd@bizedge.com Many economic and financial analysts complain that emerging countries' stock markets are often heavily manipulated by their governments and are more political than economic. The unstated assumption seems to be that, in contrast, some pristine force of economic nature drives stock markets in advanced countries, and that forecasting their performance is thus like forecasting the growth of trees. This description of stock markets in emerging countries is not wrong, just biased, because the same description applies to stock markets in advanced countries. Indeed, the best analysts know that forecasting the performance of any country's stock market substantially means forecasting how well the government wants stock market investors to fare in the current political environment. Consider the US stock market, by far the world's largest. The general perception is that the government leaves companies alone and that the returns from investing in the US stock market reflect the fundamental forces of a strong capitalist economy. This is one reason why the US is a magnet for portfolio investors from around the world. But the returns that make US stock markets so attractive reflect a delicate political balance. In particular, tax rates that affect stocks have varied through time as political pressures change. During World War II, for example, political support for great fortunes diminished and the government sharply increased taxes on capital gains, dividends, and high incomes in general. When WWII produced a strong recovery from the Great Depression of the 1930s, President Theodore Roosevelt and Congress slapped on an excess-profits tax to ensure that shareholders would not benefit too much. By contrast, in 1980, when there was no war but the stock market was low, US voters elected Ronald Reagan, a man many thought too right wing to be president. He asked for and got cuts in capital gains, dividend, and income taxes. Political interference in the stock market is not merely about taxes on capital gains, dividends, and income. Property taxes, excise taxes, import duties, and sales taxes all of which are paid, directly or indirectly, by corporations can have a magnified impact on corporate profits, and hence on the stock market. It is no coincidence that wherever stock markets thrive, governments take care that these taxes stop well short of destroying after-tax corporate profits.Indeed, the politics of stock markets does not stop with taxes. On the contrary, almost every activity of government has an impact on corporate profits, and in turn, on the stock market. After the 1929 stock market crash, the US government suspended much anti-trust activity, allowing companies to acquire monopoly power that would boost their value. This policy delayed the recovery from high unemployment, but even that was not enough to rein in the political forces arrayed in favour of supporting the stock market. Similarly, one of the most important things that Reagan did was to destroy much of the remaining power of America's labour unions, which compete for their share of the corporate pie. Reagan's defeat of the air traffic controllers' strike in 1981 was a watershed event for the US labour movement and for the stock market, which started its dramatic bull market in 1982. The US government has been particularly aggressive in supporting the stock market since the peak of the equities price bubble in 2000, most notably cutting interest rates repeatedly. Of course, this was publicly justified in terms of stimulating the economy, not supporting the stock market. But it is a telling sign of the US stock market's significance that one of the most important factors perceived to be weighing on the economy was declining equity prices. Indeed, the authorities' response was not limited to monetary stimulus. The US National Income and Product Accounts show that the effective rate of corporate profits tax (the percentage of profits actually paid to the government in taxes) crested at 33.7% in the first quarter of 2000 the peak of the stock market and the economy in general and fell to 20.2% in the fourth quarter of 2003, when the market was down. Much of that decline reflects explicit tax relief measures voted by Congress, as well as the perception among corporations that in the current
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION economic and political environment they can be more aggressive in tax avoidance. Moreover, after the stock market crash, the maximum tax on dividends paid on stocks was slashed from 35% to 15%, giving a substantial new advantage to long-term investors and boosting the compounding effect of reinvesting after-tax dividends. Again, this tax cut was justified in terms of stimulating the economy, which can, of course, be said of practically any measure aimed at supporting the stock market. But it is the balance of political forces that determines whether such a justification will be credible. One might say that the same variables, including hostility to high taxes and a weak labour movement, have operated in the US for the past 200 years and can thus be expected to continue operating in the future, producing high stock market returns and attracting huge inflows of foreign investment. Those who believe that investments in the US stock market will maintain the same strong growth trend for decades may well be right. But one should be clear about what one is forecasting. Essentially, one is forecasting not just economics, but politics and even the cultural values that shape economic policies and performance. Project Syndicate Robert J Shiller is Professor of Economics at Yale University, and is the author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century Discussion Questions: 1. Describe the driving force behind the booming stock market. 2. Describe the roles of the SC and the Bank Negara to maintain stock market integrity. 3. Discuss the effect of government interventions in the financial market. 4. In your opinion, does Malaysian financial market heavily manipulated by their governments and are more political than economic? Explain. Case 2 Corporate: Bond players in the dock By Ng Kar Yean Email us your feedback at fd@bizedge.com The recent spate of highly rated private debt securities (PDS) running into repayment woes have called into question the reliability of information disclosed in bond issues. Bondholders who got burnt are putting the issuers, rating agencies and trustees in the dock. Their main contention is that no prior warning was given on the adverse changes in the credit risk of PDS issuers. A case in point is the steep downgrade of ABI Malaysia Sdn Bhd's RM80 million Islamic PDS. Malaysian Rating Corp Bhd (MARC) lowered ABI's rating by a notch to "A negative" from "A flat" and placed it on watch with a negative outlook on Aug 4. PDS-rated "A" papers are considered among the best investment-grade assets and "indicate the ability to repay principal and pay interest is strong". Just 20 days later (after the downgrade from A flat to A negative), MARC downgraded ABI's rating to D, which is considered junk. "It's difficult to accept the credit profile of a company changing so abruptly in less than a month," says a market observer. ABI is involved in the manufacturing of automotive batteries. Another case is Pesaka Astana (M) Sdn Bhd, whose RM140 million Islamic PDS were downgraded to D from A+ on Sept 30, due to its failure to fulfil payment obligation. Investors say not only was there no prior warning, but MARC had also affirmed Pesaka's PDS at A+ in February. Pesaka assembles heavy-duty vehicles for agencies like the Ministry of Defence and Fire and Rescue Department. As rating agencies are seen as the body to assess and monitor PDS ratings pre- and postissuance, certain quarters opine that the surveillance mechanism currently in place is ineffective. However, not all bond investors share this sentiment. Many say the onus is on the investors themselves to monitor the financial and business health of the PDS issue. "We conduct our own credit risk assessments. We don't make investment decisions based on reports by the rating agencies alone," says a bond fund manager. Market observers say the fund manager raises a valid point. Rating reports by rating agencies are merely independent opinions on the credit risk of PDS and should not be taken at face value, they add. Nevertheless, there is still the question of the quality of surveillance by rating agencies. Version: 01 Date: 30/03/2009
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MARC chief executive officer Asri Awang says he understands the negative sentiment showed by the investors on this matter. However, he contends that the responsibility does not lie solely with the rating agencies to ensure timely and up-to-date ratings on PDS. "We form our opinion based on information made available to us by the issuers. Our hands are tied if the issuers withhold information," he tells The Edge. Asri says the issuers must change their mindset as they are borrowing money from the public. Hence, "the onus lies with the issuers to supply us with information in a timely manner", he adds. The PDS trustees must also communicate more with the rating agencies on whether the issuers are complying with the terms of PDS, says Asri, as this has bearing on the rating of the securities. On the sudden downgrade in the ratings of ABI's and Pesaka Astana's PDS, Asri says there was no default in repayment of ABI's PDS. Its parent company, Polymate Holdings Bhd, defaulted in its loan repayment, which caused a cross default on ABI's Islamic bond. The issuer did not inform MARC of the development, the rating agency claims. Hence, the downgrade on ABI's PDS only occurred after MARC had found out what had happened. Polymate announced to Bursa Malaysia that it had defaulted on its loan repayment on July 13 this year. MARC only downgraded ABI's PDS rating more than a month later. Sceptics point out that the wide time gap suggests ineffective surveillance by rating agencies. "We [MARC] will improve on our surveillance. We are also talking to the authorities on how to improve the flow of information," says Asri. On Pesaka Astana, Asri says the company had obtained a waiver from the bondholders to make a payment into the sinking fund that was due in March this year. The amount was to meet the first aggregate repayment of RM34.2 million to the bondholders in September. As the government failed to pay Pesaka Astana on time, it could not meet the payment in March. It is learnt that the company, however, assured all parties monitoring the bond that it would secure a bridging finance to fulfil its obligation of RM34.2 million. However, its attempt failed at the eleventh hour. As Pesaka Astana had informed MARC of its confidence in securing the loan, MARC did not issue any rating adjustment on the former's PDS. But the question is, why didn't MARC issue a warning since Pesaka Astana could not meet the payment in March? To this, Asri warns against premature downgrading of PDS ratings. He says if rating agencies jump the gun, it would erode the value of the paper. Discussion Questions: 1. Describe the pros and cons of using bonds as a source financing. 2. The bond market is under the purview of the financial institutions rather than financial market. The Rating Agency of Malaysia (RAM) is playing the key role in risk assessment of bond issuance. In your opinion, will this be sufficient in making bond market secure as compared to equity market? Discuss. 3. Based on your readings, has the fund managers been responsible in investing the public fund into these markets? Are you willing to take up a higher return, for more risk associated to bond market? Explain.
The materials are downloaded from www.bambooweb.com
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MODULE 5: THEORY OF FINANCIAL STRUCTURES

Learning Objectives At the end of the module, the students will be able to: 1. Explain the theories underlying the operation of financial markets and financial institutions. 2. Analyze how these theories are applicable to daily operation of both financial markets and financial institutions. 3. Analyze the effects of the theories to financial markets and financial institutions efficiency, as well the economy in general. Transaction Costs In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange. For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal. Or consider buying a banana from a store; to purchase the banana, your costs will be not only the price of the banana itself, but also the energy and effort it requires to travel from your house to the store and back, and the time waiting in line, and the effort of the paying itself; the costs above and beyond the cost of the banana are the transaction costs. When rationally evaluating a potential transaction, it is important not to neglect transaction costs that might prove significant. A number of kinds of transaction cost have come to be known by particular names: Search and information costs are costs such as those incurred in determining that the required good is available on the market, who has the lowest price, etc.. Bargaining costs are the costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract, etc.. Policing and enforcement costs are the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action (often through the legal system) if this turns out not to be the case. The term "transaction cost", frequently thought to have been coined by Ronald Coase, who used it to develop a theoretical framework for predicting when certain economic tasks would be performed by firms, and when they would be performed on the market, is actually absent from his early work up to the 1970s. The term can instead be traced back to the monetary economics literature of the 1950s, and does not appear to have been consciously 'coined' by any particular individual. Arguably, transaction cost reasoning became most widely known through Oliver E. Williamson's 'Transaction Cost Economics'. These days, Transaction Cost Economics is used to explain a number of different behaviors. Often this involves considering as "transactions" not only the obvious cases of buying and selling, but also day-to-day emotional interactions, informal gift exchanges, etc. Asymmetric Information In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. (It has also been called asymmetrical information and markets with asymmetrical information). Typically it is the seller that knows more about the product than the buyer, however, it is possible for the reverse to be true -- for the buyer to know more than the seller. Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, stockbrokers, real estate agents, and life insurance transactions. Version: 01 Date: 30/03/2009
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This situation was first described by Kenneth J. Arrow in a seminal article on health care in 1963 entitled "Uncertainty and the Welfare Economics of Medical Care," in the American Economic Review. George Akerlof later used the term asymmetric information in his 1970 work The Market for Lemons. He also noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. It is even possible for the market to decay to the point of non-existence. Because of information asymmetry, unscrupulous sellers can "spoof" items (like software or computer games) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item. Adverse selection or anti-selection It was originally used in insurance to describe a situation where the people who take out insurance are more likely to make a claim than the population of people used by the insurer to set their rates. For example, when setting rates for a life insurance contract, a life insurer may look at death rates among people of a certain age in a certain area. Now suppose that there are two groups among the population, smokers and non smokers, and the insurer can't tell which is which so they each pay the same premiums. Non smokers know that they are less likely to die than average and that they are cross subsidizing smokers, so will be reluctant to insure themselves, while smokers will have a higher likelihood of claiming so will be more likely to buy insurance. The insurance company ends up with people with higher average mortality rates than allowed for when setting premiums. Asymmetric Information Problem Relationship to Adverse Selection In the usual case, a key condition for there to be adverse selection is an asymmetry of information - people buying insurance know whether they are smokers or not, whereas the insurance company doesn't. If the insurance company knew who smokes and who doesn't, it could set rates differently for each group and there would be no adverse selection. However, other conditions may produce adverse selection even when there is no asymmetry of information. For example, some states require health insurance providers to insure all who apply at the same cost. In this case, there may not be an actual asymmetry of information, the insurance company may know who is or isn't a smoker, but the insurer not being allowed to act on that information, there is a "virtual" asymmetry of information. The Lemon Problem The concept of adverse selection has been generalized by economists into markets other than insurance, where similar asymmetries of information may exist. For example, George Akerlof developed the model of the "market for lemons." People buying used cars do not know whether they are "lemons" (bad cars) or "cherries" (good ones). The sellers, on the other hand, have this knowledge. At any given price, the sellers will be more likely to sell lemons than cherries, keeping the good cars for themselves. Thus, the buyers will learn to presume that all or most used cars are lemons. This depresses the price of used cars, so that even more of the cherries are held off the market. The "price mechanism" fails to keep the lemons off the market, even in a competitive market. Instead, they dominate the market. Guarantees are needed. Moral Hazard In law and economics, moral hazard is the name given to the risk that one party to a contract can change their behavior to the detriment of the other party once the contract has been concluded. The most well known examples of moral hazard come from insurance. Fire insurance gives people an incentive to commit arson, especially if they are operating a failing business and decide that they'd rather have the cash from the insurance proceeds on the buildings than the buildings themselves. Many, perhaps most, police investigations of arson are the result of leads from suspicious insurance adjusters. More generally, fire insurance may encourage sloppy fire prevention. For example, the expectation that federal government Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION disaster aid will come seems to encourage the residents of Malibu, California, to let bushes and trees grow near their houses, raising the risk of fire. Moral hazard appears in other insurance-related areas as well: automobile insurance makes it safer for people to have accidents that cause injuries or property damage. Because of these hazards, actuaries are careful to avoid insuring any property for more than it is worth, or even for its replacement cost, and almost always require that there be a deductible, an initial up-front sum which the insured must pay out of his or her own pocket. They may also impose conditions, such as the ownership of fire extinguishers (in the case of fire insurance). Moral hazard also appears in politics, for example, as it regards anti-poverty transfer programs and similar programs. The Central Bank's rescue of the creditors of a country suffering from a financial crisis (such as Mexican "Tequila Crisis" of 1994-5) encourages the creditors to make such risky loans again in the future. The existence of unemployment insurance encourages people not to look for work; most such programs thus require that the unemployed prove that they are seeking jobs. Because some people will evade the intent of the rules by submitting sham applications for jobs they are unlikely to get, more bureaucratic restrictions are imposed. It has been argued, especially by political conservatives, that welfare payments to unwed mothers encourage the birth of children born out of wedlock. It could be argued along the same lines that military spending increases the risk of war. Free Riders Issue In the analyses of economics and political science, free riders are actors who take more than their fair share of the benefits or do not shoulder their fair share of the costs of their use of a resource, involvement in a project, etc. The free rider problem is the question of how to prevent free riding from taking place, or at least limit its effects. Because the notion of "fairness" is highly subjective, free riding is usually only considered to be an economic "problem" when it leads to the non-production or under-production of a public good, and thus to Pareto inefficiency, or when it leads to the excessive use of a common property resource. The usual example of a free rider problem is National Defense: no person can be excluded from being defended by a nation's military and thus free riders may develop who refuse or avoid paying for being defended, but are still as well guarded as everyone else in the nation. Therefore, it is usual for the government to avoid relying on volunteer donations, using taxes and/or conscription instead. The Principal Agent Problem/ The Agency Problem The principal-agent problem in economics refers to the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. Suppose that principal Adam hires agent Eve to manage his business. Adam's lack of information about how Eve does her job allows her to shirk work, embezzle, or to violate the contract in some other way. She may also interpret the contract in a way that is different from the way Adam does. Thus, Adam may not get what he "bargained for," so his enterprise may not be as profitable as hoped. Since the contract is not self-enforcing (and it is too expensive to have the government enforce each and every contract), Adam must find some way to ensure that Eve does her job. This can involve monitoring (supervising) her or requiring her to post a bond that she surrenders if she violates the contract. (Thus hired contractors are often "bonded.") Eve can be motivated to cooperate with the contract by offering her a share of profit income. Alternatively, if Eve knows that she will suffer a cost from losing her job, the fear of not being rehired (or of being fired) can motivate her to act according to the contract. Finally, Eve may not want to break the contract if her goals are identical to Adam's. Most of these solutions to the principalagent problem are incomplete. The principal-agent problem is found in most employer/employee relationships, for example, when stockholders hire top executives of corporations. Many interpret the extremely high salaries of chief executive officers of U.S. corporations in these terms.
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5 May 2008: My Say: The end of banks?

By Xavier Vives Are banks doomed as a result of the current financial crisis? The securitisation of mortgages originally was seen as a triumph because it shifted risk to financial markets, while taking deposits and making and monitoring loans the purview of traditional banks was regarded as narrow and old-fashioned. By contrast, modern banks would seek finance mainly in the interbank market and securitize their loan portfolios. In theory, such banks should be immune to runs, because the interbank market is supposed to be extremely efficient, and risk would be shifted to investors willing to bear it. Deposits would be replaced by mutual funds, which, as we know, are also immune to runs, and the risk of structured investment vehicles (SIVs) would be assessed accurately by rating agencies. All this financial engineering would avoid the obsolete capital requirements that burden banks' operation. The current crisis killed off this optimistic scenario. The interbank market has almost collapsed, because banks do not trust each other in the same way that we tend not to trust an eager seller of a second-hand car. This is a textbook market failure. The origin of the problem is uncertainty about banks' exposure to sub-prime mortgages, the risks of which have been carelessly assessed by rating agencies due to conflicts of interest. Northern Rock in the UK has been a victim of this modern banking strategy, as has Bear Stearns in the US. Others may follow soon. Moreover, institutions that thought they had transferred risk to the market realized that the demise of sponsored SIVs would damage their reputation irreversibly. This implied that they had to rescue these SIVs. Alas, they failed to set aside enough capital for this unforeseen contingency, and external investors, such as the sovereign wealth funds of China, Singapore, and the Middle East, have had to come to the rescue. Finally, mutual funds are at risk as well, because their supposedly safe investments may sour and the insurance that backs them now appears shaky. The sub-prime contamination of money market funds would prove disastrous, with consequences far beyond what we have seen up to now. The supposed transfer of risk would turn out to have been a mirage. Are banks, markets, or regulators to blame? The answer may indicate what future awaits banks. Some regulators were irresponsible for not anticipating the rational profit-maximizing behavior of institutions with a limited liability charter and of executives effectively protected from failure. After all, what should banks do when, instead of keeping sub-prime mortgages on their books, monitoring their performance, and incurring capital requirements, they can securitize them advantageously (because the rating agencies have a stake in the business), avoid capital requirements, and profit from investors' inexperience with such products. Indeed, even if things turned ugly and banks' equity suffered, executives knew that their own generous bonuses and pension packages most likely would not. Given this, regulators should have thought twice before permitting off-balance sheet operations without any further provision. The fundamental question today is, who monitors opaque loans, whether of the sub-prime or any other variety? Traditionally, the answer was banks; in the securitized world, it remains a question. So, is there an alternative to the old-fashioned monitoring of loans by banks? Perhaps if those securitized packages had been properly rated, the originating institution would be obliged to retain a share to signal to the market that risk was being controlled. And, clearly, the idea that capital requirements were not needed for banks' off-balance sheet activities (because the banks were not bearing the risk), was simply wrong. Appropriate regulation including regulation of rating agencies would most likely make traditional banks popular again. A reconsideration of banks' limited liability charter would go even further in restoring credibility. The principle is simple: when your own money is at stake, you tend to be careful. But when you can play with other people's money and expect a very high reward for success and no punishment for failure, the incentives for irresponsible risk-taking become enormous. Project Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Syndicate, Xavier Vives is professor of economics and finance at IESE Business School, Barcelona, Spain
Required: 1. And, clearly, the idea that capital requirements were not needed for banks' off-balance sheet activities (because the banks were not bearing the risk), was simply wrong. Explain TWO (2) types of off-balance sheet activities, why is it said to be not bearing any risk on banks? [10 marks] 2. Identify scenario mentioned in the article in regards to: a. Agency problem b. Lemon problem [10 marks] 2. The interbank market has almost collapsed, because banks do not trust each other in the same way that we tend not to trust an eager seller of a second-hand car. Discuss the issue of moral hazard that may be implicated by the statement, and the effect of the statement to the overall efficiency of financial markets and financial institutions. [10 marks] [Total: 30 marks]
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MODULE 6: THE BANKING FIRM AND BANK MANAGEMENT

Overview The essential function of a bank is to provide services related to the storing of value and the extending credit. The evolution of banking dates back to the earliest writing, and continues in the present where a bank is a financial institution that provides banking and other financial services. Currently the term bank is generally understood an institution that holds a banking license. Banking licenses are granted by financial supervision authorities and provide rights to conduct the most fundamental banking services such as accepting deposits and making loans. There are also financial institutions that provide certain banking services without meeting the legal definition of a bank, a so called non-bank. Banks are a subset of the financial services industry. The word bank is derived from the Italian banca, which is derived from German and means bench. The terms bankrupt and "broke" are similarly derived from banca rotta, which refers to an out of business bank, having its bench physically broken. Money lenders in Northern Italy originally did business in open areas, or big open rooms, with each lender working from his own bench or table. Typically, a bank generates profits from transaction fees on financial services or the interest spread on resources it holds in trust for clients while paying them interest on the asset. SERVICES TYPICALLY OFFERED BY BANKS Although the type of services offered by a bank depends upon the type of bank and the country, services provided usually include: Directly take deposits from the general public and issue checking and savings accounts Lend out money to companies and individuals (see moneylender) Cash checks Facilitate money transactions such as wire transfers and cashiers checks Issue credit cards, ATM, and debit cards online banking Storage of valuables, particularly in a safe deposit box
TYPES OF BANKS There are several different types of banks including: Central banks usually control monetary policy and may be the lender of last resort in the event of a crisis. They are often charged with controlling the money supply, including printing paper money. Examples of central banks are the European Central Bank and the US Federal Reserve Bank.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Investment banks underwrite stock and bond issues and advise on mergers. Examples of investment banks are Goldman Sachs of the USA or Nomura Securities of Japan. Merchant banks were traditionally banks which engaged in trade financing. The modern definition, however, refers to banks which provides capital to firms in the form of shares rather than loans. Unlike Venture capital firms, they tend not to invest in new companies. Private banks manage the assets of the very rich. An example of a private bank is the Union Bank of Switzerland. Savings banks write mortgages exclusively. Offshore banks are banks located in jurisdictions with low taxation and regulation, such as Switzerland or the Channel Islands. Many offshore banks are essentially private banks. Commercial banks primarily lend to businesses (corporate banking) Retail banks primarily lend to individuals. An example of a retail bank is Washington Mutual of the USA. Universal banks engage in several of these activities. For example, Citigroup, a large American bank, is involved in commercial and retail lending; it owns a merchant bank (Citicorp Merchant Bank Limited) and an investment bank (Salomon Smith Barney); it operates a private bank (Citigroup Private Bank); finally, its subsidiaries in tax-havens offer offshore banking services to customers in other countries.
BANKS ARE PRONE TO CRISIS The traditional bank has an inherent tendency to crisis. This is because the bank borrows short term and lends leveraged long term. The sum of deposits and the bank's capital will never equal more than a modest percentage of the loans the bank has outstanding. Even if liquidity is not a concern, if there is no run on the bank, banks can simply choose a bad portfolio of loans, and lose more money than they have. The US Savings and Loan Crisis in the late 1980s and early 1990s is such an incident.
ROLE IN THE MONEY SUPPLY A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or issuing financial instruments in the money market or a securities market. The bank then lends out most of these funds to borrowers. However, it would not be prudent for a bank to lend out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits. Bank reserves are typically kept in the form of a deposit with a central bank. This behavior is called fractional-reserve banking and it is a central issue of monetary policy. Some governments (or their central banks) restrict the proportion of a bank's balance sheet that can be lent out, and use this as a tool for controlling the money supply. Even where the reserve ratio is not controlled by the government, a minimum figure will still be set by regulatory authorities as part of banking supervision. REGULATION Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION The combination of the instability of banks as well as their important facilitating role in the economy led to banking being thoroughly regulated. The amount of capital a bank is required to hold is a function of the amount and quality of its assets. Major Banks are subject to the Basel Capital Accord promulgated by the Bank for International Settlements. In Malaysia, banks are regulated through Banking and Financial Institution Act 1989 (BAFIA). In addition, banks are usually required to purchase deposit insurance to make sure smaller investors are not wiped out in the event of a bank failure. Another reason banks are thoroughly regulated is that ultimately, no government can allow the banking system to fail. There is almost always a lender of last resortin the event of a liquidity crisis (where short term obligations exceed short term assets) some element of government will step in to lend banks enough money to avoid bankruptcy.
HOW BANKS ARE VIEWED Banks have a long history of being characterized as heartless, rapacious creditors, hounding honest folk down on their luck for the last dime. In United States history, the National Bank was a major political issue during the presidency of Andrew Jackson. Jackson fought against the bank as a symbol of greed and profit-mongering, antithetical to the democratic ideals of the United States. PROFITABILITY Large banks in the United States are some of the most profitable corporations, especially relative to the small market shares they have. This amount is even higher if one counts the credit divisions of companies like Ford, which are responsible for a large proportion of those company's profits. For example, the largest bank, Citigroup, which for the past 3 years has made more profit then any other company in the world, has only a 5 percent market share. Now if Citigroup were to be as dominant in its industry as a Home Depot, Starbucks, or Wal Mart in their respective industries, with a 30 percent market share, it would make more money than the top ten non-banking US industries combined. In the past 10 years in the United States, banks have taken many measures to ensure that they remain profitable while responding to ever-changing market conditions. First, this includes the Gramm-Leach-Bliley Act, which allows banks again to merge with investment and insurance houses. Merging banking, investment, and insurance functions allows traditional banks to respond to increasing consumer demands for "one stop shopping" by enabling the crossing selling of products (which, the banks hope, will also increase profitability). Second, they have moved toward risk based pricing on loans, which means charging higher interest rates for those people who they deem more risky to default on loans. This dramatically helps to offset the losses from bad loans, lowers the price of loans to those who have better credit histories, and extends credit products to high risk customers who would have been denied credit under the previous system. Third, they have sought to increase the methods of payment processing available to the general public and business clients. These products include debit cards, prepaid cards, smart-cards, and credit cards. These products make it easier for consumers to conveniently make transactions and smooth their consumption over time (in some countries with under-developed financial systems, it is still common to deal strictly in cash, including carrying suitcases filled with cash to purchase a home). However, with convenience there is also increased risk that consumers will mis-manage their financial resources and accumulate excessive debt. Banks make money from card products through interest payments and fees charged to consumers and companies that accept the cards. The banks' main obstacles to increasing profits are existing regulatory burdens, new government regulation, and increasing competition from non-traditional financial institutions. FIAT MONEY
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Fiat money or fiat currency (usually paper money) is a type of currency whose only value is that a government made a fiat (i.e. decreed) that the money is a legal method of exchange. Unlike commodity money or representative money it is not based in another commodity such as gold or silver and is not covered by a special reserve. Fiat money holds its value so long as holders of the currency feel that they can find an exchange partner for it at some later time. Fiat money, by definition, does not have any intrinsic value, nor is it backed by anything other than the confidence holders have in the economy which is covered by the government which decrees it to have value. Its value lies solely in the expectation of later use. Most currencies in the world as of 2004 are fiat monies. However, the situation with major currencies, such as the euro, the United States dollar and the Swiss franc is more complex. What exactly is a "fiat" currency is a matter of some debate, with a spectrum of opinion that runs from hard money advocates which declare that anything other than a one to one currency basis is "fiat money", to a range of economic theories which hold that market dynamics enforce fiscal discipline. In general, ultra-conservatives define fiat money stringently, and an opposition to fiat money is coupled with an opposition to fractional reserve banking and governments having a central bank. Advocates of "debt-free money" argue, in contrast, that money which requires the issuing of central bank debt is burden on the public. In essence, just as there is a school of thought which opposes any money which is not linked to specific, countable, and measurable reserves, there is a school of thought which denies the value of any encumberance on the government's ability to issue notes at all. Historically, specie based money generally gold and silver was the unit of account that governments would accept as "legal tender", and was struck into coins which were the "circulating medium". That is the government would accept it as payment, and would enforce others accepting gold and silver coin at fixed rates. Notes backed directly by currency became used by private banks and holders of specie, which were used as "drafts" to move or lend money. This system of drafts has never completely disappeared, and there are today high tech equivalents of it that use fax machines in place of bank notes. However, such hard currencies were frequently in short supply, leading to alternate currencies based on a promise to pay, such as "notes of credit", "bank notes" or stock in companies. Such money becomes fiat money when the central government backs, or requires others to back, such notes as legal tender without the promise to redeem in specie. Examples include stock in government monopolies and military script issued to soldiers. The general term "paper money" was used to cover such fiat money during the 18th and early 19th century, and its tendency to inflate led to hardened political opposition to any use of paper, even if backed by promise to pay, because such promises were easy to break, and hard to hold accountable. In the 18th century, there was an increasing demand for international trade, which made monetary standards based on more than one kind of specie less and less stable, as individuals would take advantage of government determined exchange rates to buy silver where it was cheap, and then redeem it for gold where it was overvalued. This lead to the gradual adoption of the gold standard among industrialized nations, while exact dates are often hard to fix, Britain's adoption of the gold sovereign in 1816 begins their move to a gold standard, and 1844 is generally dated as the establishment of the practical gold standard in the United Kingdom. Previously silver had been the standard against which gold was measured, because Europe had had an influx of silver from mines in Germany and silver looted from the Inca and Aztec empires. The word "dollar" comes from the name "Thaler" for a silver coin from the mines near the town of that name in Bohemia. These mines were the first significant discovery of silver in Europe since antiquity. The first historical example of fiat money was in China. Chinese governments would produce "notes of credit" which were valued as tender for limited periods of time, in order to prevent inflation. The Song dynasty (10th through 13th centuries), however, created unlimited legal tender paper money, good throughout their empire, as a way of centralizing financial control, and preventing external trade. This money, however, was only as stable as the mandarinate that enforced it, and only as safe as the rigidity and integrity of the people who created it. Since it was both easy to counterfeit, and communication was slow, the Song experiment with paper
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION money collapsed, as individuals preferred doing business through bank drafts, or checks, which were backed with gold. The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries. Often nations would have dual currencies, with paper trading at some discount to specie backed money. Examples include the "Continental" issued by the US Congress before the constitution, paper versus gold ducats in Napoleanic era Vienna (where paper often traded at 100:1 against gold) and South Sea Bubble of John Law which produced bank notes not backed by sufficient reserves. The abuse of paper money issued by banks led most industrialized nations to either outlaw private currency, or strictly regulate its printing, such as the National Banking Act of 1862. Each cycle of inflation and panic would leave citizens vowing never to allow inflation again, until the next round of bone-crushing deflation caused business failure and squeezed borrowers who had to pay back in much harder money than they had borrowed. A good example being the abolition of the "Bank of the United States" by Andrew Jackson, where he declared paper money backed by the government "unconstitutional". The two temptations to the creation of inflationary currencies, and to allow reserves to drop from one to one, to the expected rate of redemption of gold repeatedly hobbled economic stability. It was World War I which was the collision between specie currency and fiat money. By this point most nations had a legalized government monopoly on legal tender, and, in theory, government's promised to redeem notes in gold or silver on demand. However, the costs of the war, plus the massive expansion afterward made, in effect, every currency fiat money, since there was no reason for a government not to print as much money as it felt it could back with some fraction of its reserves. Since there was no direct penalty for doing so, governments were not responsible for the economic consequences of "running the printing presses", the 20th century found itself facing a new economic terror: hyperinflation. The economic crisis that attempts to reassert hard money brought on created a new kind of currency: asset based money. This money combined aspects of fiat currency, in that there was limited convertability, fractional reserve banking and a unit of account set by the government, with commodity based money, in that there were limits to the amount of money that could be put into circulation. However, many nations failed to create the legal checks and balances, and continued to suffer inflationary booms and deflationary busts as a result. One recent example was the Argentine bust which followed the unravelling of the "currency board". Instead of being linked to gold, the peso was linked to the dollar, which served as the hard money basis. When economic crisis hit, dollar reserves fled the country, causing the monetary basis to collapse. The root cause was overprinting of pesos beyond available dollar reserves, a pattern as old as fiat money itself. The asset based money of the 1930's however, did not last long in practice by itself, and was linked to a gold reserve system by the Bretton Woods Agreement. The value of the United States dollar was pegged to 1/35 troy ounce (889 milligrams) of gold (the "gold standard") and other currencies were pegged to the U.S. dollar. The US promised to redeem dollars, in gold, to other central banks. Trade imbalances were corrected by gold reserve exchanges, or by loans from the International Monetary Fund. In the late 1960's the US again began allowing more dollars into international circulation than it could directly back with gold, the "reserve trap" was held in check by import quotas and other restrictions. However, by 1969, the ratio of gold reserves to dollars outstanding had grown rapidly. First import controls were lifted, which created a gold flight. President Nixon unpegged the U.S. dollar from gold on August 15, 1971. Global capitalism, wherein a currency is widely traded as a commodity in itself, is more likely to rely on credit money which can reflect both (commodity) supplies and protections of supplies (by states military fiats). It is not held stable by any one state but rather by tension between states, as investment migrates from currency to currency in an open "money market". As long as there Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION is a feedback mechanism, where by states that attempt to inflate their currency suffer a corresponding drop in international buying power, and an internal feedback mechanism by which the government is liable for economic failures that stem from fiscal or monetary irresponsibilty, the money system does not take on the characteristics of a fiat money system. However, to proponents of hard money, such mechanisms are not to be trusted, and all money not directly based on specie redeemable on demand is "fiat money". This regime of asset based money, or credit based money, in which banks create currency as intermediaries and governments, in turn, back the banking system, produces a different series of problems. In no small part because it is not immediately easy to differentiate sound currencies from unsound ones, and it is possible to convert credit based money into fiat money by a legal act or regulation. The question of confidence dominates credit based money, the confidence that a particular central bank or government will not act in a manner contrary to its national interest by allowing the money supply to rise or fall too much. Part of the system of confidence includes holding of reserves to be able to support a currency if attacked, and the issuing of debt to regulate the supply of currency. Both Marxist economics and green economists view the evolution from fiat-centric to credit-centric regimes as fundamental to global capitalism, as direct imperialism and colonialism is replaced by more local intermediaries, and relations between rich and poor are defined more by debt. Some of these, e.g., in the anti-globalization movement, or advocates of communism, characterize the shift as shallow and insincere. These argue that the imperial or colonial power (e.g. the United States or United Kingdom) retains the full control of the military power, especially naval power critical to control of commodity trade, and delegate only local enforcement to their former colonies (now their "allies"). They also argue that the credit regime is biased very heavily towards nation-states avowing capitalism, i.e. accepting policy from the International Monetary Fund and clearing its currency via the Bank for International Settlements, and, more recently, belonging to the World Trade Organization. These, they argue, simply extend the pre-existing military fiat and its unfair advantages from colonialism, e.g. the "law of first price" setting commodity prices artificially low. Neo-classical economists respond that no nation must belong to any of these organizations, and that states such as Cuba and North Korea retain a strict military fiat and retain their own absolute control of currency, especially "hard currency", easily traded for goods on the Western markets. They point to the difficult economic position of these nations as evidence of the futility of maintaining fiat money regimes in a world run by mutual credit capitalism. To which critics respond, that position has been amplified by isolation, sanctions and boycott, and these nations have suffered "collateral damage"; due to their affiliation with the Soviet Union during the Cold War. This argument, however, is quite unconvincing to classical economists, who reply that isolated economies are practicing not only fiat banking, but also protectionism practices which protect incompetent local competitors from competent global competitors. The relation of fiat money, usury, debt interest, and commodity money is complex and must usually be established in a political economy as a whole. Competing national economies and their relative advantages and stabilities are reflected on global currency markets. There are moves to make the Bank for International Settlements (BIS) employ credit ratings for nation-states to render them equivalent to corporations or landowners for the purpose of required reserves. This would "hardwire the credit culture" in the words of Andrew Crocket, head of the Bank. It would also render it difficult or impossible to truly distinguish fiat money from credit money, as both would then rely on the hegemony of global capitalism and the nation-states that practice it. In effect, all "hard currency" would rise and fall based on the agreements behind the BIS itself.
CASE STUDY FOR MODULE 6: BANKING FIRM AND BANK MANAGEMENT FRBSF Economic Letter
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION 2001-37; December 21, 2001 Financial Modernization and Banking Theories What's different about banks? Implications for financial modernization Conclusion References
Financial innovation has greatly changed the business of banking. Instead of just accepting deposits and making loans the old-fashioned way, banks nowadays are increasingly active in lending without putting loans on their balance sheets, through either securitization of their asset portfolio or outright loan sales. Banks also are shifting from interest-based revenues towards fee-based activities, including lines of credit and many types of credit guarantees. The 1999 Gramm-Leach-Bliley Financial Modernization Act further legalizes the integration among commercial banks, securities firms, and insurance companies under the financial holding company (FHC) organizational structure, allowing banks to diversify into other nonbank activities. So far (as of 12/7/01), 591 financial organizations have elected to become FHCs, though only a few firms are active in the full spectrum of financial services. While it is difficult to predict how the financial services sector in general, and the banking industry in particular, will evolve over time, financial regulators and policymakers are keenly interested in the course of financial modernization. As we look to the future of the financial services industry, it may be useful to revisit the roots of banking. Banking theories provide us with insights into why banks exist in the economy. If these theories are correct, banks exist because they perform certain special functions that no other financial services firms can replicate. Thus, no matter what course financial modernization takes in the future, we can count on certain defining characteristics in banking to be preserved. This Economic Letter looks at financial modernization through the lens of existing banking theories. First, I review some wellknown banking theories in the finance literature. Then, I discuss the implications of these theories for financial innovation and financial integration.
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What's different about banks? Economists have been asking the question "what's different about banks" for ages. In his famous article, Corrigan (1982) argued that banks are special because: (1) they provide transaction services and administer the nation's payments system; (2) they provide backup liquidity to the economy; and (3) they are transmitters of monetary policy. Due to their special function in the economy, the government set up a safety net to protect the banking system, in the forms of deposit insurance and access to the Fed's discount window borrowing. Based on this argument, what makes banks special spans both the asset side and the liability side of the bank's balance sheet: banks make loans in the course of providing liquidity, and they accept demand deposits in providing transaction services? Since only commercial banks have the unrestricted power to make commercial loans and accept demand deposits, it is their banking power that defines banks' specialness. Thus, banks are special not because of the government safety net, but, rather, the safety net is in place because banks perform special functions in the economy. One can go deeper into the specialness of banks and ask a more fundamental question: Why do banks make loans and provide deposit services? For decades, banking researchers have studied the question of why banks exist and have made considerable progress in developing banking theories to explain banks' central role in the economy. Although many of us may take the existence of banks for granted, in a "perfect" world, where savers can channel their surplus funds to borrowers without friction, financial intermediaries like banks are not needed. As a corollary, banks' existence must be motivated by certain economic frictions, so that banks, as financial intermediaries, can provide some "value added" from transferring funds from savers to borrowers and providing liquidity. An important value added provided by banks, according to several theories, is dealing with the information problems in lending and the incentive problems caused by the moral hazard behavior of borrowers. Because a lender must evaluate a borrower's creditworthiness, banks' investments in information technology allow them to achieve scale economies in information production, making them more efficient information producers than individual investors. Delegating the loan monitoring function to banks avoids the redundancy of monitoring by numerous individual depositors. Banks are credible monitors because their returns are more predictable due to the diversification effect of making a large number of loans (Diamond 1984). With credibility, banks can gather deposits at relatively low cost. While information production represents a key function performed by banks, banks by no means have monopoly access to information production technology. Other nonbank lenders, such as finance companies, also engage in information production and loan monitoring. Moreover, nonbank lenders could enjoy certain advantages over banks because they are not subject to banking regulations. However, empirical evidence suggests that there is something "special" about bank loans. Specifically, research has found that bank loan approvals represent positive economic signals that can lift the borrowing firms' stock prices, while loan approval by nonbank lenders does not have the same economic effect (for example, see James 1987). Since loan making by itself does not seem to make banks special, banking theorists also have focused on the role of liquidity provision in conjunction with loan making to explain the unique economic function performed by banks. Calomiris and Kahn (1991), Flannery (1994), and Diamond and Rajan (2001) showed that the fragile capital structure in banks and, hence, their vulnerability to deposit runs serve important economic functions. Deposit runs represent a powerful disciplining device that limits banks' incentives for risk-taking and misallocation of resources. This provides some degree of quality assurance in banks' loan portfolios. Because nonbank lenders that cannot issue demand deposits do not have the "benefits" of a fragile capital structure, they are less credible in their loan portfolio quality commitment. This may explain why a loan approval by nonbank lenders does not carry the same "good news" weight as does a loan approval by banks.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Implications for financial modernization If the roots of banking are in loan making and liquidity provision, how will financial innovations and financial integration shape banking's future? Regarding financial innovations, the most noticeable trend in the loan making process is the movement towards securitization and feebased activities. Securitization means packaging bank loans into securities for resale, which permits banks to move those loans off their balance sheets. According to theory, good securitization candidates are less information-intensive assets, such as mortgages and credit card receivables, but not the more information-intensive assets, which include most business loans. Thus, this self-selection of loans for securitization leaves the bank's balance sheet with a high concentration of information-intensive loans. This may make the bank less flexible in dealing with liquidity shocks. Because the fragile capital structure calls for banks to invest in relatively low-risk assets that can be liquidated to meet depositors' withdrawal demand, this implies that there is a limit to how extensively securitized assets can be shifted outside of the banking system. The same is true for fee-based activities, where banks do not make loans but provide credit lines, credit enhancements, or credit guarantees. Banks can provide these fee-based services because of their credibility, which stems from their commitment to low-risk assets as dictated by their fragile capital structure. Although banks can leverage their reputation capital, they can do so only up to a limit. To stay credible, banks need a core of low-risk assets on their books that are funded by demand deposits, and the scale of these core activities must be proportional to the overall organization. Regarding financial integration, the driver seems to be linking activities in which banks can share expertise and operating systems, as well as the potential for providing one-stop-shopping for financial services to individual customers. Consider first securities underwriting. Both securities underwriting and loan making involve pricing financial assets. In loan making, a bank underwrites a loan and then funds it by putting it on its book. In securities underwriting, a bank underwrites a security but quickly turns around and resells it to the public. Securities underwriting involves information production, an expertise that banks already have in making loans. Further, information produced during credit underwriting is potentially reusable for securities underwriting. Thus, banks already have the know-how and infrastructure to engage in securities activities and would seem likely to realize a degree of scope economies by engaging in these activities. On the other hand, securities firms that diversify into commercial banking also must engage in deposit-taking and payments service activities, which are integral to banking but have very little overlap with their existing dealing and underwriting activities. Except for securities brokerage firms, which already have established retail networks that can be readily used for gathering deposits, the required investment in retail deposit taking can be quite substantial. This may be one factor explaining why, so far, we observe relatively more financial integration originating from the banking side, especially those with a strong retail franchise, than from the securities side. Next consider insurance. Its commonality with banking appears to be limited, because the two businesses are fundamentally different. Still, both share expertise in credit management and loan monitoring, whether it is a bank's loan portfolio or an insurance company's investment portfolio. In addition, both insurance products and banking services are retail activities targeted towards individual consumers. Thus, the ability to engage in cross-marketing seems to be an important force behind the integration of insurance and banking. For both securities and insurance activities, the direction of integration is complicated by the government safety net and the regulation and supervision under which banks operate due to their special role in the economy. Banks, which already bear the cost of banking regulation and supervision, may not face appreciably more regulatory burden as the result of becoming an FHC and diversifying into nonbank activities. In contrast, nonbanks entering commercial banking must subject the entire organization to umbrella supervision by a banking regulator. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION The regulatory burden of being an FHC may deter nonbanks from integrating with banks. This also may explain why a number of nonbank financial institutions have decided to enter banking through the so-called nonbank-bank or thrift options, rather than through integrating with a fullfledged commercial bank. Conclusion An objective way of looking into the future of the financial services industry is to appeal to banking theories. As the intermediary channeling funds from savers to borrowers, banks engage in information production when making loans and commit themselves not to take excessive risks by having a fragile capital structure consisting of demand deposits. Thus, regardless of how financial modernization progresses, these core activities that define banks are expected to be preserved, suggesting that there may be a limit to the transformation of banks' balance sheets through financial innovations. Furthermore, to the extent that certain characteristics are unique to banks, such as gathering demand deposits in the course of providing payments services, banks may have some comparative advantage in financial integration over securities firms or insurance companies. This may be further accentuated by the disparity in supervision and regulation between banking organizations and nonbank financial firms. Simon Kwan Research Advisor
References Calomiris, C.W., and C.M. Kahn. 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements." American Economic Review 81(3) pp. 497-513. Corrigan, E.G. 1982. "Are Banks Special?" Annual Report. Federal Reserve Bank of Minneapolis, pp. 2-24. Diamond, D.W. 1984. "Financial Intermediation and Delegated Monitoring." Review of Economic Studies 51, pp. 393-414. Diamond, D.W., and R.G. Rajan. 2001. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking." Journal of Political Economy 109(2) pp. 287-327. Flannery, M.J. 1994. "Debt Maturity Structure and the Deadweight Cost of Leverage: Optimally Financing Banking Firms." American Economic Review 84(1) pp. 320-331. James, C.M. 1987. "Some Evidence on the Uniqueness of Bank Loans." Journal of Financial Economics 19, pp. 217-235.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Discussion Questions: 1. Define Banking Firm, and describe its difference from other financial institutions. 5 marks 2. Discuss the importance of banking firms in the economic system of a country. 10 marks 3. If the roots of banking are in loan making and liquidity provision, how will financial innovations and financial integration shape banking future? Based on the statement: a. Describe some of the financial innovations that Malaysias banking system had adapted over the last few years. 7.5 marks b. In your opinion, has the financial integration helped in revamping the banking system in Malaysia, and how so? 7.5 marks 2. Malaysia is in the midst of establishing itself as the Islamic Financial hub in at least the Asian region. How would this affect our economy as a whole, and the financial system in particular? What about the common people? Will this bring any good? Explain your position. 10 marks [Total: 40 marks]
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MODULE 7: INSURANCE AND UNIT TRUST

Learning Objectives At the end of the module, the students will be able to: 1. Explain the theories underlying the operation of financial markets and financial institutions. 2. Analyze how these theories are applicable to daily operation of both financial markets and financial institutions. 3. Analyze the effects of the theories to financial markets and financial institutions efficiency, as well the economy in general.
Overview In insurance, the insured makes payments called "premiums" to an insurer, and in return is able to claim a payment from the insurer if the insured suffers a defined type of loss. This relationship is usually drawn up in a formal legal contract. In one classic example of insurance, a ship-owner insures a ship and receives payment if the ship is damaged or destroyed. This example is one of the earliest uses and developments of concepts like insurance. Interestingly, ships are now more often insured through risk pooling and spreading organizations such as Lloyd's of London because the loss of a large ship going down is too great for one insurer to accept. In the case of annuities, such as a pension, similar concepts apply, but in some sense in the reverse. When applied to annuities, the terms risk and loss are somewhat different from traditional insurance as they concern the chances of living beyond life expectancy and the need for income during the period between annuitization and death. Insurance attempts to quantify risk by pooling together a large number of risks. This makes use of the law of large numbers. As applied to insurance, this means that the greater the number of similar risks, the greater accuracy with which insurers can estimate the overall risk. For example, many individual people purchase health insurance policies and they each pay a small monthly or yearly premium to an insurance company. When a policyholder gets ill, the insurance company provides money to cover medical treatment. For some individuals the insurance benefits may total far more money than they have ever paid into the insurance policy. Others may never make a claim. When averaged out over all of the people buying policies, value of the claims even out. Insurance companies set their premiums based on their calculated payouts. They plan to take in more money (in premiums and in profit from the float, see below) than they pay out in the end to cover expenses. For-profit insurance companies set their rates to make a profit rather than to break even. Insurance companies also earn investment profits, because they have the use of the premium money from the time they receive it until the time they need it to pay claims. This money is called the float. When the investments of float are successful, they may earn large profits, even if the insurance company pays out in claims every penny received as premiums. In fact, most insurance companies pay out more money than they receive in premiums. The excess amount that they pay to policyholders is the cost of float. An insurance company will profit if they invest the money at a greater return than their cost of float. An insurance contract or policy will set out in detail the exact circumstances under which a benefit payment will be made and the amount of the premiums.
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HISTORY OF INSURANCE Insurance has been an institution of human society for thousands of years, having been practiced by Babylonian traders as long ago as the 2nd millennium BCE. Eventually it was given legal mention in the Code of Hammurabi, and practiced by early Mediterranean sailing merchants. The Greeks and Romans had "benevolent societies" which acted to care for the families and funeral expenses of members upon death. Guilds in the middle ages served a similar purpose. Insurance became much more sophisticated in post-Renaissance Europe, and specialized varieties developed. In America, Benjamin Franklin helped to popularize and make standard the practice of insurance, particularly against fire. The 19th century saw a rise in the government regulation of insurance, and the 20th century saw further specialization and, in the United States, a bit of deregulation that allowed other financial institutions, such as banks, to offer insurance. The ever-increasing ability of science to predict catastrophes of any measure or variety continues to affect the way insurance is conducted.
TYPES OF INSURANCE There are a number of different types of insurance: Automobile insurance, also known as auto insurance, car insurance and in the UK as motor insurance, is probably the most common form of insurance and may cover both legal liability claims against the driver and loss of or damage to the vehicle itself. Property insurance provides protection against risks to property, such as fire, theft or weather damage. This includes specialized forms of insurance such as fire insurance, flood insurance, earthquake insurance, home insurance or boiler insurance. Casualty insurance insures against accidents, not necessarily tied to any specific piece of property. Liability insurance covers legal claims against the insured. For example, a doctor may purchase insurance to cover any legal claims against him if he were to make a mistake in treating a patient. Financial loss insurance protects individuals and companies against various financial risks. For example, a business might purchase cover to protect it from loss of sales if a fire in a factory prevented it from carrying out its business for a time. Insurance might also cover failure of a creditor to pay money it owes to the insured. Fidelity bonds and surety bonds are included in this category. Title insurance provides a guarantee on research done on public records affecting title to real property, usually in conjunction with a search done at the time of a real estate transaction, such as a sale, or a mortgage. Health insurance covers medical bills incurred because of sickness or accidents. Life insurance provides a benefit to a decedent's family or other designated beneficiary, usually to make up for their loss of his or her income. Annuities provide a stream of payments and are generally classified as insurance because they are issued by insurance companies and regulated as insurance. Annuities and pensions that pay a benefit for life are sometimes regarded Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION as insurance against the possibility that a retiree will outlive his or her financial resources. In that sense, they are the opposite of life insurance. Credit insurance pays some or all of a loan back when certain things happen to the borrower like unemployment, disability, or death. Terrorism insurance Political risk insurance can be taken out by businesses with operations in countries in which there is a risk that revolution or other political conditions will result in a loss A single policy may cover risks in one or more of the above categories. For example, car insurance would typically cover both property risk (covering the risk of theft or damage to the car) and liability risk (covering legal claims from say, causing an accident). A homeowner's insurance policy in the US typically includes property insurance covering damage to the home and the owner's belongings, liability insurance covering certain legal claims against the owner, and even a small amount of health insurance for medical expenses of guests who are injured on the owner's property. Potential sources of risk that may give rise to claims are known as perils. Examples of perils might be fire, theft, earthquake, hurricane and many other potential risks. An insurance policy will set out in details which perils are covered by the policy and which are not.
TYPES OF INSURANCE COMPANIES Insurance companies may be classified as Life insurance companies, who sell life insurance, annuities and pensions products. Non-life or general insurance companies, who sell other types of insurance. In most countries, life and non-life insurers are subject to different regulations, tax and accounting rules. The main reason for the distinction between the two types of company is that life business is very long term in nature - coverage for life assurance or a pension can cover risks over many decades. By contrast, non-life insurance cover usually covers shorter periods, such as one year. Companies may sell both life and non life insurance, in which case they are sometimes known as composite insurance companies. Insurance companies are also often classified as either mutual or stock companies. This is more of a traditional distinction as true mutual companies are becoming rare. Mutual companies are owned by the policyholders, while stockholders, (who may or may not own policies) own stock insurance companies. Reinsurance companies sell insurance cover to other insurance companies. This helps insurance companies to spread their risks, and protects them from very large losses. The reinsurance market is dominated by a few very large companies, with huge reserves. LIFE INSURANCE AND SAVING As well as paying out a sum of money on death, many life insurance contracts also pay out a sum of money after a given time (in which case it is known as an endowment policy), and may
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION also pay out a cash value if the policy is cancelled early. In many countries, such as the US and the UK, tax law provides that the interest on this cash value is not taxable under certain strict circumstances. This leads to widespread use of life insurance as a tax-efficient method of saving as well as protection in the event of early death. Wealthy individuals buy life insurance policies as a means for avoiding income taxes and estate taxes. If the tax benefit exceeds the fees charged by the insurance company for maintaining the policy, then the policy serves as a life insurance tax shelter. There is much controversy surrounding this practice, and the financial industry is deeply divided about whether or not these practices work as advertised. CRITICISMS OF THE INSURANCE INDUSTRY Lack of knowledge of policyholders Insurance policies can be complex and some policyholders may not understand all the fees included in a policy. As a result, people could buy policies at unfavorable terms. In response to these issues, governments often make detailed regulations that set down minimum standards for policies and govern how they may be advertised and sold. Redlining Location is one of the variables used to set rates. Insurers are also starting to use credit "scores", occupation, marital status, and education level to set rates. Many consider these practices to be "unfair" and even racist. An interesting refutation to this is that the job of an insurance underwriter is to properly categorize a given risk as to the likelihood that the loss will occur. Any factor that causes a greater likelihood of loss should in theory, be charged a higher rate. This is a basic principle of insurance and must be followed for insurance companies or groups to operate properly, even for non-profit groups. Thus, discrimination of potential insureds by legitimate factors is central to insurance. Therefore the only thing that can be considered legitimately "unfair" are practices that discriminate against a given group without actual factors that show that the group is a higher risk. Health insurance Health insurance is one of the most controversial forms of insurance because of the conflict between the need for the insurance company to remain solvent versus the need of its customers to remain healthy, which many view as a basic human right. This conflict exists in a liberal healthcare system because of the unpredictability of how patients respond to medical treatment. Suppose a large number of customers of a particular insurance company were to contract a rare disease costing 100 million dollars to fight for each patient. The insurance company would be faced with the choice of either charging all its future customers astronomical premiums (thus losing customers and going out of business), paying all claims without complaint (thus going out of business) or fighting the customers in an attempt to deny the costly treatment (thus outraging patients and their families, and becoming a target for lawsuits and legislation). Many countries have made the societal choice to avoid this important conflict by nationalizing the health industry so that doctors, nurses, and other medical workers become state employees, all funded by taxes; or setting up a national health insurance plan that all citizens pay into with tax payments, and which pays private doctors for health care. These national health care systems also have their problems. Many countries have citizen groups which protest bureaucracy and cost-cutting measures that unduly delay medical treatment.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION In the United States, health insurance is made more complicated by Federal Medicare/Medicaid programs, which have had the unintended consequence of determining the price of medical procedures. Many suspect that these prices are set independently of medical necessity or actual cost. A physician who refuses to accept a Medicare/Medicaid payment will be banned from accepting any such payments for a number of years, regardless of the reason for rejecting the payment or the amount offered. In either case, this means that private insurers have little incentive to pay more than the government does. TAKAFUL Tomorrow's Takaful Products By Ikram Shakir Contemporary Western products are considered "unIslamic" as they contravene many of the Islamic principles. For instance, it is considered gambling to lose an insurance premium to an insurance company if the insured event does not take place (and gambling is prohibited by Islam) and the investment of the policyholders' funds may not be based on Riba. Takafol is the Islamic alternative to contemporary insurance. Islamic insurance products have existed, in one shape or another, for several years but the real impetus came during the early 1980s when such products appeared in Western Europe mainly due to the efforts of Dar Al-Mall Al-Islami, one of the biggest Islamic financial institutions in the world, through its Takafol subsidiaries. Business conditions for Islamic financial institutions were very favourable at the time and Takafol products were well received by the ethnic Muslim community living in Western European countries. The first generation of emigrant Muslims to Western Europe had established themselves successfully. The prejudices and discriminations of the host communities were coming to surface, Muslims were facing a crisis of identity and this created a chain reaction. These social problems were expressed through the establishment of a number of mosques and Halal meat and Islamic food shops throughout Western Europe. Simultaneously, non-interest bearing bank deposits and Islamic savings funds became more popular within Muslim communities. The prevailing social and economic environment in Western Europe gave an encouraging start to Takafol operations in Western Europe. The early types of Takafol products were unit-linked savings plans where the benefits of the policy were notionally linked to the value of the underlying assets in the internal funds of the Takafol company. Those products were, in general, complying with Islamic sharia principles regarding the type of investment and risk. In particular, the following principles were observed in the product design: Riba-free investments No deception (i.e. transparent and clear definition of benefits and charges) No profit to the Takafol company from favour able mortality experience Based on solidarity principles rather than probabilities (principles of gambling)
In order to comply with the above rules, the Takafol policyholders' funds were invested in short term assets without any fixed interest or guarantee of capital and the mortality risk was shared on a solidarity basis so that any loss or profit due to mortality was shared between the policyholders. However, the Takafol savings products only offered a small death cover, which limited their appeal to prospective customers. It was expected that other Islamic insurance products would be made available to cater for a variety of insurance needs amongst the Muslim community, such as term assurance, mortgage protection or old age annuities, but the process of introducing new Takafol products has been very slow and, to some extent, non existent. In order to be successful and profitable, it is imperative for a Takafol company to offer a wide range of products and Takafol should not remain to be seen as a very narrowly based product Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION operation. The Muslim communities in Western Europe have very high expectations from Islamic institutions in offering a complete Islamic system for their daily financial and insurance needs. However, until recently, only a part of this Islamic financial system was offered. Just imagine how difficult it would be to explain to a prospective policyholder that he should take out a Takafol savings plan for savings purposes but should rely upon the Western insurance industry for other insurance needs. It is therefore imperative to design and market Islamic products, which can meet wider insurance needs of the Muslim community. WHAT ARE THE LIKELY PRODUCTS FOR TOMORROW? The Western insurance products have evolved over the last 2 centuries to meet the social and economic needs of the population. As Muslims in Europe are living in the Western social and financial environment, they have similar social and financial problems and their insurance needs are therefore very similar. In order to identify which products may have a wider appeal for Muslims in future in Western Europe, it may be helpful to first identify the factors which affect the insurance market. Some of the primary factors are as follows: Changes in legislation Budgetary constraints Political Uncertainty Ageing population Longevity Changes in social habits Competition Available Investment Distribution Risks Involved
The most important factors affecting the insurance industry are perhaps the ageing population, due to the baby boom/baby bust cycle in the 1950s and 1960s, and longevity due to the improvement in health care and economic living conditions. Other key factors are political and fiscal: the EU Member States are facing State budgetary deficit and constraint due to the introduction of the single European currency and the increasing cost of pensions and health care. This suggests that insurance products for which there will be a higher demand in future are likely to be old age pension, annuity, medical care and long term care products. Pension and Annuity Products We are all very familiar with the three pillars of the Western pension system: State pension schemes. Occupational pension schemes, and Personal savings.
In the EU Member States, the State is by far the biggest provider of retirement benefits. However, the system is now being questioned. Studies indicate that a male joining the State scheme at normal age and retiring at normal retirement age will receive on average 62% of his contributions, which may not be considered as a good investment. In addition, the current system is based on "pay-as-you-go", which means that .the State collects contributions form the working population and pays it out to pensioners.
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This system works as long as there are more contributors than pensioners but it will come under tremendous pressure as the number of pensioners grows. It is a well-known fact that the population in Western Europe and North America is ageing, i.e. that the ratio of older people to younger people is constantly increasing. Clearly, as a result of the excellent health service provided by the State, people are living longer than ever before (on average life expectancy has increased by 4 years over the last twenty years). However, this is not the only cause of ageing. The other cause is to be found in the sudden increase of fertility rates between 1950 and 1960 (a phenomenon known as the baby boom) and the subsequent drop in those rates (the baby bust). The graph below illustrates fertility rates in Western Europe from the twenties to the eightiesIt can be seen that there was a sharp rise in fertility rates after World War II, followed by a sudden drop in the late 1960s. Some people call this phenomenon a time bomb, but it can be better described as a tidal wave because a time bomb explodes only once whereas this phenomenon has recurrent long-Iasting consequences. As the baby boomers aged it created temporary demand for age-specific products but as the baby boomers were replaced by the baby busters, these areas of temporary high demand immediately contracted. In the 1950s, there was a high demand for kindergartens and schools, which had to close down later on for lack of attendance. In the late 1960s, the demand was in the higher education sector, which was followed by a recession with the consequence that many teachers were made redundant and many schools were closed. In the 1980s it was housing, appliances and commercial office space. In the year 2020, the demand will probably be in the medical, pharmaceutical and old care houses sector. What will happen when baby boomers reach retirement age? Baby-boomers, who were trying to save the world in the 60s, will find it very hard to save their State retirement income. It is expected that by the year 2020, in Europe, there will be only two workers contributing to the State scheme for every pensioner.
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Ratio of pensioners to contributing workers 1960 2020 (projected
With the State schemes being "pay-as-you-go", it becomes obvious that the State pension system will face serious financial challenges by the year 2020. There will be a systematic reduction in benefits with an increase in contributions and one can expect that the demand for personal pension products and occupational pension schemes will therefore grow dramatically. This will be equally applicable to the Muslims living in Western countries. There will be a real opportunity for Takafol companies and they should be ready to offer private pension plans to their niche market. In particular, life annuities will be in higher demand, where Takafol companies will be required to cover the longevity and investment risks. However, Takafol companies should bear in mind that, due to the increase in life expectancy, the mortality of pensioners has shown remarkable improvements in recent years and the actual mortality improvements are much higher than the projected improvements used in the pricing of annuity products. An analysis carried out recently shows, in particular, that the improvement in male rates and in the annuity amounts is significant and clearly warrants a health warning. Consideration should therefore be given to those factors when designing pension and annuity contracts. Long Term Care Products Due to old age, or as a result of an accident or disease, some people lose some of their mobility and need special assistance to carry out daily activities. In the worst cases, 24-hour assistance may be required. The average length of such assistance normally varies between 6 to 12 years but it can be longer in certain circumstances. In the past, the family used to provide such assistance. However, because of the changing family structure (single parent families, divorces, working women, etc.), it appears that the family is no longer in a position to do so and, therefore, some external assistance is required. This can be quite expensive and, as State pension benefits and disability benefits are usually insufficient, extra cover could be provided through Takafol policies. The current estimate is that about 25% of retired people will require some long-term care at one time or another, which offers big potentials to Takafol companies. Benefits normally cover the cost of any external assistance required to carry out such activities as feeding, bathing, dressing, transferring to and from bed or chair, going to the toilet, etc. The target market for long term care products could be the middle-income group and the distribution could be through Islamic banks, occupational pension schemes and normal Takafol distribution channels. Medical Care Products Modern medicine and health care in the European Union has helped to improve the life expectancy but it has not improved the health and quality of life at older ages. In a recent research carried out in the USA, it was found that on average 77% of all health care expenses occur during the last six months of our life. As a result of the ageing population, one can expect that the demand in the medical care sector will become higher. However, as a result of budgetary constraints, EU States may not be able Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION to finance medical care expenses and there is a risk that the benefits paid out by the sickness fund may be reduced in future. This is already happening in some countries where hospitals are being closed, the availability of hospital beds is being restricted for people above a certain age, and medical subscription charges are being increased. This indicates that private individuals have to find extra cover from the private industry .As a result, the demand for medical care products is likely to increase and Takafol companies should be ready to provide such products to the Muslim communities. Takafol companies could, for example, offer the following covers: Ordinary medical care (where normal medical expenses are paid on an indemnity basis) Major medical expenses (where fixed lump sum benefits are provided in respect of defined medical procedures) Critical illness products (where the risk of diseases such as heart attack, stroke and cancer is covered) Total health care products (where critical illness, medical care, life cover and long term care covers are provided under a single cover).
The word "Takafor' may portray the real meaning of risk sharing on a solidarity basis in the Arabic language, but it is not commonly used and understood by the Muslim community living in Western Europe. It is already difficult for a Takafol salesman to convince somebody that he should take a Takafol policy and having to explain what Takafol is, adds even more difficulties in the selling process. It would perhaps be better to use "Islamic insurance". This method was successfully used by the Islamic banking industry and a similar process could be employed by the Islamic insurance industry. One of the main difficulties probably experienced by Islamic financial institutions is to design products, which can meet the insurance needs of the Muslim community living in Western Europe without contravening the basic Islamic (sharia) principles. When designing a new product, considerations should be given not only to its adequacy, but also to its competitiveness. For that purpose, both the investment strategies and the product charging structure need to be carefully defined. For example, it should be noted that funds invested in short-term assets usually provide lower returns than those invested in longer term assets -since the liabilities of a Takafol company towards its policyholders are longer term by nature, it is considered prudent to invest the policyholders' funds in long term assets. As regards the charges, the use of single mortality rates puts some people at a disadvantage, which may reduce the product attractiveness to some prospective policyholders. Takafol should devise systems under which it should be possible to invest in longer-term assets and to use different mortality rates without contravening sharia principles. Takafol managers are well aware of the insurance needs of their customers but may not be well experienced in the interpretation and application of sharia principles, whereas Sharia experts (religious leaders) may not fully comprehend the commercial requirements of a Takafol company. Therefore, there is a need to educate both sides into the other discipline and to maintain a continuous dialogue between them so as to find pragmatic business solutions under which the Takafol products are acceptable on sharia principles but offer competitive terms to the Muslim community for their insurance needs. Institutions like DMI and the Islamic Institute for Banking and Insurance are already doing an excellent job in the development and promotion of Islamic financial systems. They should try to accelerate this process further by providing a forum where Takafol managers and sharia experts could communicate with each other. According to some estimates, there are over 6 million Muslims living in Western European countries. That offers a very substantial market size to Islamic financial institutions. The Western insurance industry is facing problems in identifying its market and is going through a phase of consolidation and repositioning. With a defined market in Europe, Takafol companies
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION do not face this problem. They potentially have a very prosperous future ahead of them, provided they can offer efficient Takafol solutions to the Muslim communities.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION MODULE 8: SECURITIES FIRMS Investment Banks Intermediaries that help corporations raise funds. Also plays vital role as deal makers in the merger and acquisition area, as intermediaries in the buying and selling of companies and as private brokers to the very wealthy. The companies earn its income from fees charges to clients rather than from commissions on stock trades. Functions: o Underwriting stocks and bonds consultation on when is the issuance should be made, and the price to be issued at. filing documents with Securities and Exchange Commission (SEC) called Registration Statement, in which a portion of the statement will be reproduced and made available to investors known as prospectus. Underwriting: At a pre-specified time and date, the issuer will sell all of the stocks or bonds issuance to the investment banking (IB) at an agreed price, e.g. $10 per share. Then, the issuance will be made available to the public at a greater price, e.g. $12, and the spread is the banks profit. To reduce risk of the issuance may not be saleable, some investment bank underwrite issues under syndicate, in which that each bank participating in the syndicate will purchased some portion of the issuance. The longer the banks hold the securities before reselling it, the higher the risk that a negative price change will cause losses, so bank speeds the sale to solicit offer to buy the securities from investors prior to the date of ownership by investment banker. Issuance need to be fully subscribed, but it could be undersubscribed, or oversubscribed. Best Effort Agreement is an alternative to underwriting. The investment banker sells the securities on a commission basis with no guarantee regarding the price the issuing firm will receive. Advantage is no risk of security mispricing, and no time consuming task of establishing the market value of security. If the security fails to sell, the placement can be cancelled. Private Placement is when the issuance was sold to only a group of investors. No SECs registration statement is required. Investment bankers role is mostly consultation. o Equity Sales The sale of companies and corporate division. Steps in equity sales: 1. Seller determines the business worth. IB provides a detailed analysis of the current market worth of similar company in the same industry. IB also makes discreet inquiry of who would be interested, and prepares confidential memorandum containing detailed information to prospective buyers. 2. Prospective buyer will issue letter of intent, which contains the intention to acquire the company and the terms. IB provides negotiation service as well as analyzing other offers. 3. Due diligence period of 20 40 days, and buyers need to verify the accuracy of information in confidential memorandum. 4. Definitive Agreement will then be issued containing all terms and conditions of the sales, and turn into legally binding contract. Mergers and Acquisition A merger is when two firms combine to form one new company, and an acquisition is when another company acquires the other through ownership of stocks. If the other company does not agree to the acquisition, it is known as hostile takeover. IB provides consultation to firms that intent to merge or acquire another firm.
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Securities Brokers and Dealers Conduct trading inn secondary market. Brokers are pure middlemen who act as agents for investors in the purchase and sale of securities, and it functions to match buyers and sellers and be paid brokerage commissions. Dealers link buyers and sellers by standing ready to buy and sell securities at a given price. They hold inventory of the security, and make money from the spread of bid and ask price. Known as market makers because it stands ready to buy. Brokerage Services (BS) o Securities orders deals with three primary types of transactions: market order, limit order and short sell. Market order is when a customer instructed its broker to purchase a security at a current market price. Limit order specify the maximum acceptable price for buy order and minimum acceptable price for sell order. Short sell is carried out when the investor does not own a particular stock and still be able to sell it or buy it in the future by borrowing the stock from brokerage house. o Other orders include safekeeping service, margin credit. o Types of BS are full service broker and discount broker. Investment banks assist corporations in raising funds in the public markets (both equity and debt). They may sometimes be confused with brokerages, which are firms which assist people in choosing and buying stocks, bonds, and mutual funds. (Of course, it is possible for a brokerage and an investment bank to share common ownership, and most of the largest brokerage companies also do investment banking.) [Top] THE TOOLS OF INVESTMENT BANKING Investment banks can invest money on stock markets or use advanced products called derivatives. Investment banks can also invest money directly into companies, projects, etc., either as direct investments for which they carry the full risk (known as private equity, venture capital, or merchant banking), or as loans with collaterals to reduce risks. Combinations of derivatives and loans also exist, such as mezzanines. [Top] THE MAIN ACTIVITIES AND UNITS Investment banks will typically be concerned with several business units, including Corporate Finance (concerned with managing the finances of corporations, including mergers, acquisitions and disposals), often called the Investment Banking Division of the firm; Research (concerned with investigating, valuing, and making recommendations to clients--both individual investors and larger entities such as hedge funds and mutual funds--regarding shares and corporate and government bonds); and Equities or Sales and Trading (concerned with buying and selling shares both on behalf of the bank's clients and sometimes also for the bank itself). Management of the bank's own capital, or Proprietary Trading, is often one of the biggest sources of profit; for example the banks may arbitrage in huge scale if they see a suitable opportunity and/or they may structure their books so that they profit from a fall of bond yields (a rise of bond prices). [Top]
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION POSSIBLE CONFLICTS OF INTEREST Because potential conflicts of interest may arise between different parts of a bank, the authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall which prohibits communication between Investment Banking on one side and Research and Equities on the other. These are some of the conflicts of interest involved in investment banking: The fact that most stock research companies (companies which are supposed to do research on a business and tell investors to buy or sell a company) are owned by investment banks can create a large conflict of interest. Historically, many investment banks seeking to be allowed to underwrite a companies IPO or debt offering have said to that company that they would tell their research division to rate that company a buy, in order to convince them to do a deal. Most observers allege that during the bull market of the 90's this would occour with almost every deal. The companies would choose the investment bank who had a large research division which would rate them a "buy", because that would likely increase the stock price of the company, which would increase the amount of money made by the companies CEO's since they were primarily paid by stock options, meaning they make more money the higher the stock price goes. The fact that many investment banks also own retail brokerages, can cause a conflict of interest. Besides the research division rating the stock a buy, the Investment bank may tell its brokers to try and convince their customers to buy the stock as well. This would occur not only as a thing to clinch the deal, but may also occour when the company might be performing badly and the Investment Bank might have a large supply of stock in its inventory. The investment bank can instruct the retail stock brokers to tell clients to buy the stock, so that the investment bank can get the poor performing stock off its hands.
NATIONAL AND INTERNATIONAL PUBLIC INVESTMENT BANKING In the United States, the Glass-Steagall Act prohibited banks from offering both commercial and investment services. The Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act in 1999. In part this was due to the tendency of the U.S. Congress to act itself as an investment bank: Lester Thurow claimed in the 1980s that it served exactly this function, advancing specific industrial policy and agricultural policy by direct grants or subsidies, loan guarantees, and exemption from regulations, taxes or other government-controlled expenses that would otherwise apply. This fusion of the banking and oversight role with fiscal policy was thought to be undesirably political, but inevitable if the US had no large investment banks. Various international development organizations, either global (such as The World Bank), or regional (such as the European Investment Bank, nor to be confused with the European Central Bank), and also various central banks, are considered by most economists to be investment banks, as they can bolster or create currency for specific projects. Banking overlaps with monetary policy at this largest scale.
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CASE FOR MODULE 7 & 8: INSURANCE AND UNIT TRUST CASE 1: REMOVING BARRIERS TO UNIT TRUST INVESTMENTS By P Gunasegaram A subject that should hold the attention of anyone interested in capital market development is the increase in market swings post-Asian financial crisis 1997. While this may be partly a reflection of increased risk, it is also caused by the sudden shifts of money in and out of the market by foreign funds. As foreign fund managers have large funds at their disposal, a small proportion of these funds moving in and out of emerging markets is enough to induce wild gyrations of the market. The situation is often made worse by local investors moving in tandem with the foreign players to avoid being left behind, holding losses. For a relatively small market like ours, it may be necessary to consider long-term measures to reduce the dependence of the market on foreign funds. This move could take two paths the more drastic step is to put a curb on excessive inflow of foreign portfolio capital and the other, more palatable measure is to reduce the dependence on foreign funds by channeling more local savings into the stock market.
The latter is to some extent being done by getting institutions such as the Employees Provident Fund into the market, which, as a broad strategy, is to be applauded but leaves a lot to be desired in terms of specific investment objectives. What is lacking is professionalism and expertise. For a broader effect, more savings can be moved into the market via unit trusts which basically make direct investments in the market and elsewhere and issue units to those who contribute to the fund. Unit trusts or mutual funds have been credited as one of the key factors in distributing ownership of companies in the US, making the common man a beneficiary of the rise in stock markets there. In Malaysia, retail investment in the market is still undertaken directly by the individual investors who are often ill-informed, have little or no research resources, rely heavily on rumors and tips, and typically have a very short-term horizon. A retail investor is almost a speculator. To make the transition and get more individual and small investors to invest in unit trusts, some major changes need to take place first. There is the process of education and explaining to investors how they can benefit from unit trust investments. Unit trust practitioners, at a recent capital markets conference, called raucously for tax and other incentives for investing in unit trusts, which we admit, will help stir interest in unit trusts. But they appear to have left out some other important considerations. The major one is a 5.0 to 10 per cent upfront fee for investing in unit trusts. Add a 2.0 per cent management fee and the unit trust will have to give a return of better than up to 12 per cent in the first year for a positive return to the unit holder. How many fund managers can perform that well? The front-loaded fee also makes it difficult for a person to exit a poorly performing unit trust as he will have to pay the fee again to invest in another unit trust. This perpetuates inefficiency by forcing people to keep their money in unit trusts that are not performing. Under such circumstances, public skepticism is well-justified. Perhaps the unit trust industry should take the first step forward and commit itself to unwinding the front-end fee in stages, say in three years and cutting the management fee to 1.0 per cent a year. That will be closer to the norm in the developed markets. Then, it should address itself to improving professional standards. It must make clear to the public that return is related to risk. An index fund should benchmark itself against the index it is supposed to replicate. A small market capital fund concentrates on smaller companies that are riskier and therefore the benchmark comparison cannot be the KL Composite Index, for instance. Perhaps an index of smaller companies could be created for comparison purposes. Is the local unit trust fund industry doing enough to promote professional standards among its practitioners? Is there a code of conduct? Does it set guidelines on how to set up benchmarks to measure performance? Does it construct some of these benchmarks itself? Until such time as the industry takes these measures, even tax breaks are not going to
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION encourage more people to buy unit trusts. Huge front-loaded fees and a lack of professionalism are bound to be major impediments to investing in unit trusts. ISSUES: RESCUING UNIT TRUST HOLDERS By C S Tan Johor will be seen as trying very hard to restore the value of investment units in its state unit trust funds. After failing to get a favorable reply from the federal government for a RM1.9-billion rescue package, Johor decided to take the bull by the horns. The state has announced its intention to inject RM400 million to lift prices in its two unit trust funds. Will the plan get off the ground? It probably will, even if it sounds improbable - this may be the first time in the world that unit trust holders are bailed out. Johor's Menteri Besar Datuk Abdul Ghani Othman told the press last week that a formal announcement will be made after the state Treasury approves the plan. The injection of value into the funds will be made by the state government and its investment arm, Johor Corp Bhd, he said. At first glance, the rescue package seems to be beyond the means of even the state. After all, a RM400-million bailout amounts to more than half of the annual state budget of about RM600 million. Where would the state and Johor Corp find the money for this? Johor Corp itself was last reported to be restructuring billions of ringgit of its debts. On a closer reading of Ghani's comments, it appears he has a workable solution. His plan is for unit holders to cash out 10 per cent of their investments by the end of the year and, hopefully, another 10 per cent next year. That suggests the rescue package is not a full and immediate payment. Ghani indicated a recovery to par value for only 20 per cent of investments. It is not understood whether he plans to provide relief for the rest of the unit holders' investments but it is clear payment will be staggered from year to year. Other states, which have similar problems with their unit trusts, will be watching Johor. The state's financial predicament stems from its two unit trusts - Amanah Saham Johor which was launched in 1992 and Dana Johor, launched in 1995. Both were offered mainly to bumiputeras at RM1 par, but the value of Amanah Saham Johor has since plummeted to 19.5 sen a unit and Dana Johor's units fell to 14.5 sen each as at last Wednesday. A total of 800 million units were initially offered in these two funds. It would cost more than RM660 million to bring the value of all these units back to RM1 par. It would therefore cost about RM66 million to restore 10 per cent of the fund to its par value, a sum the state might be able to swallow painfully. Looking at these numbers and the sum of RM400 million mentioned by Ghani, it appears the state might not be looking at a bailout for all the units.
Even at a ballpark figure of RM66 million for this year's part of the rescue package, it's a burden for the state. The state budget will carry a deficit of RM10 million this year. There is no surplus state revenue to cover the bailout. It would have to come from a larger budget deficit. It has been envisaged that asset-rich Johor Corp will help with this support plan. While the corporation grapples with its huge debt, its vast oil palm plantations in Johor are probably yielding ample cash flow. It might be able to assist in the bailout. Even as the unit holders are delighted, there will be other quarters that will criticize the whole scheme. There are other investors, in Johor and elsewhere, who have also lost heavily in their investments in unit trusts and shares. There is no rescue package for them. There are political considerations in the Johor state unit trusts. The unit holders are mainly bumiputeras, many of whom are said to be Umno members, who were encouraged to participate in the unit trusts. No doubt, the state government wants to be seen as lending a helping hand now.
Supporters would say the relief offered is part of the on-going costs of the New Economic Policy and its subsequent versions. Critics argue, on the other hand, that the money could be better used in other ways to raise the economic potential of bumiputeras in the state. The money could be used for education or in loans for those in business who have some experience and a track record. Further, a rescue scheme for the unit trust could foster a culture of dependence on the state and bailouts. Instead, the unit holders should have been taught how to assess risks in unit trusts. As Prime Minister Datuk Seri Dr Mahathir Mohamad put it in reference to Johor's Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION appeal for a rescue package, there is no guarantee profits will be made. The only guaranteed return is from bank deposits, he said. Capital is always a scarce commodity and there are many demands on it; it's needed not only for development but also to meet the demands from the community for health and social welfare causes. The state has to be more effective in its employment of capital. The need for the bailout scheme arises from the poor management of funds in the state unit trusts. The management cannot lay the blame on the regional financial crisis. Most of the private sector unit trusts have already managed to recoup most of their losses. The management of the state funds has to accept responsibility for the severe erosion of value in the unit trusts. This sad episode is a reminder of the unproductive outcomes that usually result from state intervention in business. The state should stay focused on providing public amenities, and leave business to the private sector. REQUIRED: 1. 2. 3. 4. Abstract the case. Describe the advantages and disadvantages of unit trusts. Explain the types of unit trusts discussed in the articles. What are some of the financial structures, e.g. lemon problem, asymmetric information issues in relation to unit trusts industry? Describe based on the case. 5. The articles mentioned, For a relatively small market like ours, it may be necessary to consider long-term measures to reduce the dependence of the market on foreign funds. In your opinion, why is it very important for Malaysia to be less dependence of foreign funds? What are some of the measures that need to be taken to reduce the dependency? Discuss. 6. Based on the information you gathered from the articles, will investing in unit trusts be something that you want to get into? Explain your position.
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CASE 2 COVER STORY: HOW AMBANK BANKS ON INSURANCE fd@bizedge.com Elena Tan, a middle management executive at a large listed company, finds it a hassle to renew her car insurance policy and road tax every year, as she would have to take time off from her usually busy schedule. But no longer. And here is why. Tan bought a new car two years ago, and took a five-year loan with the Ambank group, which also has in its stable, its insurance arm, AmAssurance Bhd. The loan officer packaged the loan with motor insurance, and since then, the bank has been doing the renewal of both road tax and insurance for her for a small fee. Tan is an example of how consumers have begun to benefit from the growing convergence between banking and insurance activities, which explains why bancassurance has begun to take off in a big way. And consumers are not the only beneficiaries. Insurance companies, too, are seeing bigger contributions from bancassurance. Take Ambank. It was among the first few banks that implemented bancassurance in the 1990s, and today, this channel's contribution in terms of new premiums to AmAssurance has been around 33% in the last three years. Ng Lian Lu, chief executive officer at AmAssurance, says that in terms of distribution channel, bancassurance business has also been consistently registering growth rates of about 30% for the past three years. Star performers were motor and housing loans. "We expect bancassurance to contribute 35% to our total business in the region, which is significant to us," she says. Perhaps, the story for AmAssurance could have been very different today if Fortis International, a major financial services and insurance group in Europe, had entered the AmBank Group post the 1997/1998 financial crisis. At that time, Fortis was believed to have considered taking a 15% stake in AMMB Holdings, but the deal did not materialize. Today, Fortis is partnering Maybank's insurance operations via a 30% stake in Mayban Fortis. AmAssurance, on the other hand, recently found a new potential partner in Insurance Australia Group (IAG) Ltd, one of the largest general insurance groups in Australia, which is also listed on the Australia Stock Exchange. AmAssurance is one of the larger bank-backed composite insurance companies, with total assets of RM1.61 billion and shareholders' funds of RM143 million. IAG has assets totalling A$17.1 billion and shareholders' funds of A$4.4 billion. IAG, it was announced three weeks ago, plans to take a 30% stake in AmAssurance. Details of the partnership have yet to be finalized, but the alliance is aimed at enhancing operations of AmAssurance by leveraging on the combined skill base of IAG and the former, according to a statement by AMMB Holdings on the proposed acquisition. AmAssurance, unlike Mayban-Fortis, has a strong agency force which is expected to contribute some 40% to its overall business. It has 5,696 life insurance agents and 2,721 general insurance agents. Ng says AmAssurance has identified four channels of distribution, and all are expected to play equally important roles in bringing in new business. Ng believes that the agency force of bank-owned insurance companies will not be replaced by any other channels (such as bancassurance) in the near future as there is still demand for the services provided. "Both are unique channels of distribution in terms of sales culture, offerings and techniques. People buy through bancassurance because of their relationship with the bank. People buy through agents because of their relationship with agents. Hence, they cater to very different sectors of customers," she explains. Still, Ng appears to be more a tad cautious when it comes to bancassurance's prospects. One of the reasons it did not quite take off in a big way, she says, is because Malaysians generally have the view that banks play a role of savings and lending institutions. "Hence, the insurance products sold in the banking hall are short term, savings and investment in nature with a small element of insurance protection. As a result, many insurance companies experience high lapses or surrender of bancassurance business, because there are many other savings or investment opportunities available for consumers to choose from," she explains. Banks, she adds, are also treading their entry into bancassurance cautiously; as it requires commitment in providing adequate training and having in place a compensation structure for the sales staff. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION COVER STORY: BRAVE NEW WORLD by Anna Taing In 1994, a year after bancassurance was introduced in Malaysia; its share of new premiums in the life insurance market was just under 2%. In 2004, a decade later, the share had leapfrogged to 48%, nearly half the new premium market! The statistics get more impressive. The top performing financial executive selling bancassurance products at a leading local bank can bring in new premiums equivalent to that of a whole agency force of some insurance companies. And, we are talking about a business that is still in its infancy in Malaysia. What this means is that there is enormous potential still untapped. And some Malaysian banks are scrambling to get a piece of the action. So, what is bancassurance? Loosely defined, it means usage of a bank's distributive network to sell insurance products but in practice, it can be more complex and involves a great deal of investment and planning. Bancassurance is the result of the growing convergence of banking and insurance services; it is a global trend that started in the 1980s, sweeping first across Europe, and the US before making its way to Asia. The winds of change were globalization, deregulation, liberalization, heightened competition and technological advancement. The global financial landscape saw the concept of universal banking or a one-stop financial supermarket taking root in the 1990s. It was also a period when capital markets grew very quickly in both depth and width, and financial institutions had to look beyond traditional activities to grow their bottom line as markets opened up, competition heated up and margins got squeezed. New growth frontier For many financial institutions, insurance was seen as the new frontier of growth, given the synergy and its great potential, as the lines separating the two sectors began to blur. On the flip side, insurance companies saw the opportunity to tap an alternative distribution channel that had the capacity to reach far and wide. In Malaysia, for example, the penetration rate of banking services is around 98% of the population aged between 18 and 64, according to Bank Negara Malaysia. With close to 2,300 bank branches throughout the country, banks' ability to mine their customer database provides a significant market potential for insurers. This potential, according to the central bank, is further enhanced by the fact that less than 8% of Malaysians who use banking ser-vices are estimated to have relationships with their banks that include insurance products and services. Dr Jens Lottner, managing director at McKinsey & Co in Singapore, says the next level for banks to go into is insurance. Malaysia, he explains, is not saturated as a market in insurance it is halfway between the markets of Singapore, Taiwan (which has a high penetration rate) and other Southeast Asian countries such as the Philippines and Indonesia. Malaysia's penetration rate at present is 38%. "There are still additional sources of growth ... it may not be easy but you need to have more sophisticated products," he says. He notes that a survey conducted by McKinsey last year concluded that banks have enormous potential to tap their customer base in terms of nontraditional financial services and products, such as insurance. It found that, generally, Malaysian consumers are loyal to their banks, preferring to use one financial institution for their needs. To a question on cross-selling, for example, 59% of respondents in the survey said they prefer to deal with one institution for all their financial needs, while 36% said they prefer to buy life insurance from a bank. Bancassurance can be done through various ways, such as a physical merger between banks and insurance companies, strategic alliances, joint ventures and distribution agreements. The result of this growing convergence is a proliferation of mergers and acquisitions as well as strategic alliances and distribution tie-ups among banks and insurance companies across the globe. Still, bancassurance has proved to be more successful in Europe than in the US. In Europe, some 60% of the life insurance business is transacted by banks, according to various research reports. In the US, the merger between Citigroup and Travelers and the subsequent divestment of the latter is cited often as an example of failure of convergence in banking and insurance. According to Deloitte Consulting, Travelers and Citigroup created a conglomerate rather than an integrated financial services organization. "This is not a real bancassurance model," it says, pointing out that acquisitions
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION are best used to reach new markets or distribution channels, but is a more complex brand management challenge. Bancassurance gets second wind Consider some of the major developments that have occurred since 2000 in Malaysia. In 2001, Fortis International, one of Europe's largest financial services companies, entered a partnership with the insurance unit of the Malayan Banking group. It turned out to be a very successful partnership. Affin Holdings Bhd entered the fray when it recently acquired Tahan Insurance. A few months ago, Southern Bank Bhd (SBB) proudly declared that it had outbid bigger names in the region for a major stake in Singapore's Asia General Holdings. More recently, Maybank said it is acquiring MNI Holdings, a composite insurance company, a move which will propel it into the big league of insurance players. And just last month, AmAssurance announced tie-up plans with Insurance Australia Group Ltd (IAG), the largest general insurer in Australia. IAG is listed on the Australian Stock Exchange. Public Bank, meanwhile, has made no secret of the fact that it is looking to buy an insurance outfit. It was one of the bidders for Asia Life, a unit of Asia General but it lost out to SBB. Industry players believe that what has evolved thus far is just the beginning for Malaysia at least even though bancassurance made its debut as early as 1993. Real integrated bancasssurance did not quite take off in a big way in Malaysia in the last decade, for various reasons. These are: Domestic banks, roiled by the 1997-1998 financial crisis, spent the ensuing years focused on cleaning up their balance sheets and on consolidation. The period of intense restructuring tapered off around 2000-2001, after which banks began to focus again on growth and expansion. "Many banks have been going through their own industry consolidation ... in addition; we are still going through the after-effects of the 1997 financial crisis. Many banks therefore have had other priorities during that period," explains Zulkify Sulaiman, chief executive officer at Mayban Fortis Holdings. Furthermore, retail banking was never a big focus for many banks in the 1990s it was the corporate sector which took centre stage, an industry observer says. Even today, there are still banks that do not have insurance units, including Public Bank and Alliance Bank. RHB Capital has an insurance arm, but it does not have life insurance business, a segment identified as having the strongest growth potential. However, this does not mean that banks without insurance subsidiaries are not involved in some form of bancassurance. They are increasingly involved in distribution agreements with insurance companies, be they local or foreign. There are, according to Bank Negara, three predominant bancassurance models in Malaysia: Referral arrangements where the insurer is placed on the panel of a bank for provision of certain products to bank's customers; Distribution agreements where the bank agrees, for a fee, to promote insurance products; and, Integrated services, where there is an integration of front and back-end operations between a bank and insurer to deliver banking and insurance products. Underlying such a model is usually an equity relationship between the bank and insurance company.
At present, some 96% of all bancassurance arrangements in Malaysia are focused on the distributive agreement model. Be that as it may, the integrated services model is beginning to draw more interest, the central bank notes in the latest Annual Insurance Report. McKinsey's Lottner says that by bringing the big entities (banks and insurance company) together, it can lead to the creation of additional value via integrated offerings such as mortgages and home insurance, hire-purchase and motor insurance and so on. In contrast, standalone insurance companies can just offer mono-line products. Furthermore, products can also be structured to tap the wealth management segment of the market, a direction that SBB is heading, once its acquisition of Asia General Holdings is completed. Exciting times ahead
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Expectations are that, going forward, the growing convergence as well as the play of market forces will drive financial institutions to undergo more mergers, takeovers and strategic alliances. There will also be rising foreign interest in this part of the world, given that Asia has been touted as the world's fastest growing market for the insurance industry. According to a report by Swiss Re, emerging markets will be the new frontier for insurance where life premiums are expected to grow from US$188 billion (RM710 billion) this year to US$450 billion by 2014. Industry players say they expect more exciting times ahead for bancassurance activities. Mayban Fortis' Zulkifi, for one, believes that bancassurance will take off from here. He notes: "I believe competitors are catching up with us. Almost all local banking groups now own or are in the process of acquiring their own insurance operators, and more and more independent insurers, particularly international insurers, are pursuing distribution relationships with commercial banks." Meor Amri Meor Ayob, analyst at Rating Agency Malaysia (RAM), agrees. He notes that now that the economy has recovered and balance sheets repaired, banks have begun to focus on growth again, and an area that is being looked at in a big way is bancassurance. "In the next couple of years, we can expect to see a lot more bancassurance products come onstream," he says. Indeed, the growth in bancassurance's market share in the last two years has been quite phenomenal. According to Bank Negara's Annual Insurance Report, bancassurance managed to capture 48% of new life premiums written in the industry in 2004, against 38% in 2003. In general insurance, the share is lower at 7% of industry's gross premiums. Maybank, for one, has reaped a rich harvest from its success in bancassurance. In the last decade, Maybank has managed to build its insurance business from almost nothing to being one of the top 10 players in the local industry via bancassurance. The compound annual growth rate (CAGR) for Mayban-Fortis Holdings is around 28%. Malaysian Assurance Alliance (MAA) Bhd, a leading standalone insurance company, too, has shown that bancassurance has begun to contribute significantly to its new premiums. Its bancassurance unit, which was set up about five years ago, is chalking up high growth rates, in terms of new premiums, of around 50% last year, according to Alzafry Mohd Zaliff Mohamed Adahan, executive vice-president, finance and group insurance, at MAA Assurance. This compares to an overall premium growth rate of 30% for the company. Catalysts of change The main catalyst of this change, according to industry players, is Bank Negara, which is the regulator of both the banking and insurance industry. "For example, the Financial Sector Master Plan, which maps out the growth path for both sectors in 10 years, facilitates greater convergence," says an industry player. Against this backdrop, banks and insurance companies, according to an industry observer, are now cognizant of the advantages to be gained. According to Deloitte Consulting, convergence between banking and insurance will gain momentum because of two main factors: A shift of bank deposits into retirement investments; and, Investment funds are growing more rapidly than bank deposits, thus causing banks to diversify into an adjacent growth area.
Banks will also derive many benefits from such convergence, according to Deloitte in response to queries from The Edge. These include an increased share of the customer's wallet, protection of customer relationship, cross-selling opportunities; reduced cost of sale compared to life agents, additional source of profits, and it is a low-risk diversification. What is more, the long-term nature of life insurance translates into income stability and sustained profitability. Indeed, banks that have adopted bancassurance are optimistic about the prospects going forward. Standard Chartered Bank (Stanchart), which is the first foreign bank in Malaysia to implement bancassurance, is upbeat about prospects. "Bancassurance is rated top three in revenue growth potential for the Standard Chartered Group in Asia-Pacific... it has fared well, with a revenue growth of US$63 million in 2004. We aspire to grow to over US$100 million or a growth rate of 51% by end of the year," says the bank's general manager (wealth Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION management), Ronnie Lim. In Malaysia, Lim says, the bancassurance business is expected to contribute some 20% to Stanchart's revenue. "We envisage a 50% growth on our year-on-year growth for this channel through our new strategies and products in the coming years," he adds. Indeed, Lim is emphatic about the importance of bancassurance to Stanchart. "It is one of the three core areas of wealth management wealth protection," he explains. He adds: "The insurance industry in Malaysia has a relatively low penetration rate. With a takeup rate of 30%, we see a huge potential for growth in bancassurance, especially since the bank [Stanchart] has an even lower penetration rate in insurance." Huge potential Be that as it may, practitioners say bancassurance is still in an infancy stage in Malaysia. MAA's Zaliff, for one, believes that banks have not fully tapped opportunities in bancassurance. "We have not talked about general insurance, about cross-selling insurance products to corporates, small and medium-scale enterprises and so on," he says. Zaliff's view is that standalone insurance companies can also tap other channels of distribution, such as post offices, for example. MAA currently carries out its bancassurance via several financial institutions, which include Bank Simpanan Nasional and Malaysia Building Society Bhd. Zaliff says the segments with good potential are health and takaful (Islamic insurance). SBB, for one, recently signed a memorandum of understanding to form an alliance with Bahrain-based Takaful International. The alliance will apply for a Takaful licence, not just to tap the local market but also the region's. "There is plenty of opportunity to grow bancassurance further, especially in terms of cross-selling insurance products to the bank's wide customer base." Stanchart's Lim agrees. He expects more tie-ups, noting that a few banks have even gone into buying insurance companies. RAM, in a report on banking convergence, says bancassurance is one of the most significant developments in the global financial services sector over the past decade and is the next step forward. "Banks and insurers are converging to form one-stop financial services centres via the complete integration of their existing distribution channels, with customers at the centre," it says. "Convergence makes a lot of sense," says Gan Kim Khoon, head of research at AmResearch. "It makes sense for banks to own an insurance unit they tap each other's big customer base, create cross-selling opportunities for banks vice versa," he says. Which may well explain why SBB, which has tied up with AIG to distribute the latter's products, is willing to cough up more than RM2 billion for a stake in Asia General Holdings. How SBB will integrate Asia General into the banking group remains to be seen. While there is no one definition or right model on bancassurance, an industry player says the question to ask is: Where does it make sense to integrate? And this will mean looking from the perspective of the customers right across to other processes, such as risks and management. In the SBB-Asia General case, it is understood the inclination at this point is towards the noninclusive model, which means that there will be no physical merger between SBB and Asia General. It is also likely that SBB will keep the Asia General "brand", as it is an established name in the region.
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Regulatory measures to enable bancassurance Stanchart's Lim says the current regulatory environment is conducive to bancassurance. "It is conducive as it requires transparency in all commissions, charges and expenses for each bancassurance product sold. This enables all banks to play on a level field... it further encourages us to think out of the box to be more creative in our product and service proposition," he says. Regulatory measures put in place over the last few years include: A more flexible commission structure for the sale of life insurance products through bancassurance; For new life products offered after December 2004 with a savings component, insurers will be required to reflect any savings from lower distribution costs arising from bancassurance arrangements in lower premiums or better benefits to consumers; Insurers are required to spread payment of commissions meaningfully over a minimum period of up to 10 years for annual premium life policies. This avoids high front-loaded commissions in the first few years of the policies, which provides incentives for banks to service their customers effectively after close of sale; and, Banks are required to disclose charges borne by customers so that they can make comparisons with other savings alternatives.
Driving consolidation Given that banks like Maybank have begun to acquire insurance companies, a question raised is whether they will eventually be the key drivers of the insurance industry's consolidation. The industry, as it is now, is still fragmented, despite the central bank's push for consolidation in the last decade or so. Views are mixed on this. AmResearch's Gan, for example, does not believe that banks will play a major role in the industry's consolidation. "I don't see consolidation in the insurance industry being led by banks. Maybank is acquiring MNI because it needs the scale, now they are very small," he says. Banking groups which already own insurance units which are of a good size will not see the need to go on an acquisition trail. Be that as it may, there is still potential for M&As because there are still some banking groups that do not have insurance arms, Gan observes. RAM's Meor Amri, though, does not rule out banks being the driver of consolidation in the insurance industry, as one way for banks to grow their insurance business is through acquisition. But he stresses two factors the capacity to pay (acquisition will not be cheap) and the push to do so. Ng Lian Lu, who heads AmAssurance in the AmBank Group, says a bank-led consolidation is already happening now. In response to queries from The Edge, he says: "It is happening now, and the bank-led consolidation is a result of consumer demands for complete financial solutions under one roof. There are a few anchor banks in Malaysia without an insurance licence," she says. Ng sees benefits from such consolidation. "It is believed that insurance companies that operate under a banking group will be more cost-effective, because of the concept of shared common services such as human resource services, audit and others," she explains. The financial services landscape is changing, and fast. In the coming months, this tempo can be expected to quicken, as barriers tumble and competition heats up. Local financial institutions will have no choice but march to the beat to remain in the game. It will be a brave new world for financial institutions, going forward.
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PERSONAL FINANCE: ROLE OF LIFE INSURANCE IN ESTATE PLANNING By Ong Eu Jin My spouse and I had a good friend who truly had it all. Armed with a master's degree from Oxford, this young man worked in an international firm with a remuneration package most of us would die for. He belonged to the jet set, had a multitude of friends, spent his vacations skiing in the Swiss Alps, shopped in New York or just relaxed in his Sydney home. If there was anyone who lived life to the fullest, it was him. In 2004, he was diagnosed with cancer and doctors gave him six months to live. After going through a series of expensive treatments, his last words to us before he passed on were: "I'm glad it is finally over. At least, I don't have to suffer anymore." Although it was tragic, his family and he were fortunate, in a way. Money was never an issue for them, unlike for most people. The target clients of most insurance agents and financial planners are naturally the wealthy. After all, the more expensive the policy, the higher the commission. The irony is that those who need insurance the most are the not so rich, who can only afford to pay low premiums. In 2003, some 21,464 Malaysians were diagnosed with cancer in Peninsular Malaysia alone. According to the National Cancer Registry, the crude rate for males and females for that year was 97.4 and 127 per 100,000 of the population respectively. According to Bank Negara's Insurance Annual Report 2005, some 10,142,994 life insurance policies were in force, with a total sum insured of about RM645 billion and annual premiums amounting to RM12.3 billion. In the same period, RM778 million was paid out as death and disability benefits. Life insurance is essential not only for critical illnesses but also for estate planning. The latter is not only about choosing who your beneficiaries are in a will. It is also important that you ensure there are sufficient funds and liquidity to pay off debts and expenses as well as sustain family members and dependents. Sufficient funding is needed for: The estate (which comprises the assets and liabilities of the deceased and is represented by the personal representative); and Family members and other dependents.
The estate is distinct from the deceased's family members. Most people name their family members as nominees of their life insurance policies. In such a case, the insurance proceeds would be paid to the family members. However, if the estate has insufficient funds to pay expenses and debts, the personal representative may be forced to liquidate some of the assets of the estate notwithstanding that it was the deceased's intention to leave them as a legacy to his loved ones under his will. In other words, the family members may have sufficient funds but the estate may not. In this regard, life insurance proceeds can fund the estate for the purpose of paying: Funeral and testamentary expenses, including probate and administration costs, lawyer's fees and so on; Medical expenses which may have been incurred prior to death; Any outstanding debts, including loans relating to motor vehicles and credit cards; and Outstanding taxes.
Life insurance proceeds are increasingly becoming the source of funding for middle-income families that create education trusts for their children and maintenance trusts for their dependents. The advantage of having insurance-funded trusts is that you are not required to set aside any cash during your lifetime. Insurance also plays an important role in the estate planning of business owners by: Funding the acquisition of the business interests of an outgoing partner under a buysell agreement; Providing family members who will not be inheriting any shares in the business with alternative inheritance or financial gifts; Softening the impact on business finances resulting from the loss of a key employee;
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Ensuring that the estate has sufficient funds to settle any loans taken for working capital or to fund the acquisition of shares in the business during his lifetime; and Ensuring that the estate of a business owner has sufficient funds to pay personal debts, outstanding taxes, estate administration costs and other expenses. Insufficient funds can sometimes leave the family with no other option but to sell the business.
At times, insurance proceeds may be insufficient to cover the living expenses of family members, perhaps because the policy owner was underinsured or the insured-cum-policy owner suffered disability and most of the proceeds were used up during his lifetime. In this regard, it is important to understand the terms of the policy you own. In addition, it is not uncommon for the family's breadwinner to have the most coverage and the non-working spouse to be underinsured. If the latter is struck down by critical illness, the family will be faced with the dreadful choice of liquidating their assets to pay the medical bills (which may amount to hundreds of thousands) or giving up on the treatment. Insurance is important because both living and dying is expensive. Many of us may be under the misguided impression that we are richer than we truly are. It is frightening when you realize that once your bank loans and other liabilities have been taken into account, your net assets are not as much as you presume. It is not uncommon to underestimate the amount of funding one's estate and family members require. You may have purchased insurance for, say, RM500,000 when the amount needed is probably RM1 million or more. To ensure that sufficient funding is in place to meet the financial needs of your family and yourself, you may need to ascertain the value of your net assets (that is, assets minus liabilities) and have in place a mechanism to fund the shortfall. A financial wealth assessment by qualified financial planners may be helpful. This process includes gathering information from you, analysis and feedback from the financial planners.
REQUIRED: 1. Describe the differences between bancassurance and conventional insurance. 2. Explain the types of insurance discussed in the articles. 3. What are some of the financial structures, e.g. lemon problem, asymmetric information issues in relation to insurance industry? Describe based on the case. 4. Bancassurance and insurance provider provides the same products and services fundamentally. Is there a need for the elimination of the conventional insurance? What are some of the obstacles faced by the bancassurance provider in embarking into bancassurance business? Discuss. 5. Based on the information you gathered from the articles, which of the services appeal to you more and why? Explain your position.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION RISK MANAGEMENT IN FINANCIAL INSTITUTIONS Financial institutions are subjected to many risks either internally or externally, and this title discusses management approach of some of the risks.
Managing Credit Risk FIs are very vulnerable to credit risk, in which in order for FI to earn high profit, it must manage its credit efficiently, thus minimizing its credit risk. Credit risk is related directly to adverse selection and moral hazard issue. The principle of managing credit risk: o Screening Adverse selection issue Effective screening through collection of reliable information from prospective borrowers
Prospectiv e Borrower Loan Applicatio n Form Credit Score Officers Judgme nt References and Employmen t
Monitoring Moral hazard issue To reduce moral hazard, FI managers must adhere to the principle of managing credit risk of writing provisions (restrictive covenants) into loan contracts that prevent borrowers from engaging in overly risky activities. Long-term Customer Relationship FI prefers to make loan to long term customer who has an account with them. The balances in the account indicate the liquidity of potential borrower, as well as payment made in the case of loan was previously granted to the customer. Reduce information collection cost and monitoring cost, and usually this customer will be offered lower interest rates. Loan Commitment A banks commitment (for a specified future period of time) to provide a firm with loans up to a given amount at a fixed interest rate or more commonly at a rate tied to some market interest rate. Advantage for firm is that it has a source of credit when firm needs it, and for bank is that the loan commitment promotes a long term relationship, which reduces screening and monitoring cost. Collateral Collateral is property promised to the lender as compensation if the borrower default, lessens the consequences of both adverse selection and moral hazard. Loans with collateral requirements are called secured loans.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION o Compensating Balance A form of collateral, in which a firm receiving loan is required to keep a minimum amount of funds in a checking account at the bank. Aside from that, CB helps increase the likelihood that the loan will be paid off, thus minimizes adverse selection and moral hazard. Credit Rationing Lenders refuse to make loan even though borrower is willing to pay the stated or higher IR. Two forms: FI refuse to make loan at all or FI loan out only a fraction of the required amount.
Managing Interest Rate Risk IR risk is associated with the riskiness of earning and returns due to fluctuation in IR. Bank manager decides which assets and liabilities are rate sensitive that is, which have IR that will be reset within the year. If a FI has more rate sensitive liabilities than assets, a rise in interest rates will reduce the net interest margin (NIM) and income, and a decline in IR will raise the NIM and income. Management of IR risk: o Income Gap Analysis Amount of rate sensitive liabilities is subtracted from the amount of rate sensitive assets. o Duration Gap Analysis Examines the sensitivity of the market value of FIs net worth to changes in IR.
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Case for Module 9: Risk Management and Financial Institutions FRBSF Economic Letter, 2003-03; February 14, 2003 How Financial Firms Manage Risk Common risk categories Common risk management techniques Financial risks of commercial banking Financial risks of securities activities Financial risks of insurance activities Conclusion References
Financial Notes: This series supersedes Western Banking. It appears on an occasional basis and is prepared under the auspices of the Financial and Regional Research Section of the FRBSF's Economic Research Department. Regional Banking Tables will continue to be updated online quarterly. Over the past several years, there has been a steady march toward financial integration across product lines among larger financial firms. The trend is in part due to the increasing globalization of financial markets, the development of new financial instruments, and advances in information technology. In the United States, the Gramm-Leach-Bliley Act of 1999 permits financial firms to engage in banking, securities exchange, and insurance under a new charter type that creates financial holding companies (FHCs). The Federal Reserve is the primary supervisor for FHCs, and it had granted 640 FHC charters to top-tier holding companies as of January 24, 2003. The attraction to firms of offering an array of financial services can stem from the potential advantages of cross-selling several products to customers or from the similarity in underlying expertise and information systems used. However, from a supervisory perspective, it is important to recognize that different financial activities typically give rise to different types of underlying risks. This Economic Letter outlines these risks and the differing risk management techniques commonly used for banking, securities, and insurance activities. Common risk categories Financial firms face four common risks: market risk, credit risk, funding risk, and operational risk. Market risk refers to the possibility of incurring large losses from adverse changes in financial asset prices, such as stock prices or interest rates. Standard risk management involves the use of statistical models to forecast the probabilities and magnitudes of large adverse price changes. These so-called "value-at-risk" models are used to set capital against potential losses. In practice, while models provide a convenient methodology for quantifying market risks, there are limitations to their ability to predict the magnitude of potential losses. To address these limitations, firms also use stress tests that examine the impact of large hypothetical market movements on their portfolio values. Credit risk is the risk that a firm's borrowers will not repay their debt obligations in full when they are due. The traditional method for managing credit risk is to establish credit limits at the level of the individual borrower, industry sector, and geographic area. Such limits are generally based on internal credit ratings. Quantitative models are increasingly used to measure and manage credit risks (see Lopez, 2001, for further discussion). Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Funding (or liquidity) risk is the risk that a firm cannot obtain the funds necessary to meet its financial obligations, for example short-term loan commitments. Three common techniques for mitigating funding risk are diversifying over funding sources, holding liquid assets, and establishing contingency plans, such as backup lines of credit. Generally, firms set funding goals as benchmarks to measure their current funding levels, and take mitigating actions when they are below certain thresholds. Finally, operational risk is the risk of monetary loss resulting from inadequate or failed internal processes, people, and systems or from external events (see Lopez, 2002, for a more complete discussion). Although operational risk management is a rapidly developing field, standard risk mitigation techniques have not yet been developed. Common risk management techniques A key element of financial risk management is deciding which risks to bear and to what degree. Indeed, a financial firm's value-added is often its willingness to take on specific risks. Correspondingly, risk management involves determining what risks a firm's financial activities generate and avoiding unprofitable risk positions. Other important components are deciding how best to bear the desired risks and what actions are needed to mitigate undesired risks by shifting them to third parties. Financial firms protect themselves from risk by setting aside funds to cover losses. Broadly speaking, these funds are known as provisions and capital. Provisions are funds set aside to cover expected (or average) losses, and capital refers to funds set aside to cover unexpected (or extraordinary) losses. Capital takes several forms on the balance sheets of financial firms, but typically it includes such items as shareholder equity. The reliance on provisions and capital varies among financial firms engaging in banking, securities, and insurance activities due to differences in their underlying risks. Since financial firms have similar general goals regarding risk bearing, some of their risk management techniques are similar. For example, all firms have procedures to ensure that independent risk assessments are conducted and that controls are in place to limit the amount of risk individual business units take. In addition, hedgingi.e., paying third parties to take on some of the risk exposureis common to all types of financial activities. Market risk is the easiest to hedge, because of the wide variety of exchange-traded and over-the-counter derivatives available. Increasingly, credit risk is hedged using credit derivatives, which are overthe-counter derivatives for which payments are based on borrower credit quality. Finally, certain risk exposures arising from insurance activities can be hedged using the reinsurance market. At the same time, important differences in risk management techniques exist. As noted in the 2001 report by the Joint Forum consisting of international bank, securities, and insurance supervisors, financial firms tend to invest more in developing risk management techniques for the risks that are dominant in their primary business lines. The report also found that risk management still is conducted mainly on the basis of specific business lines. The following sections highlight the key differences in risk management techniques across financial activities. Financial risks of commercial banking A defining characteristic of commercial banking is extending credit to borrowers of all types. Hence, commercial banks' main risks are the credit risk arising from their lending activities and the funding risk related to the structure of their balance sheets. Banks hold loan loss provisions to cover expected losses, but capital to cover unexpected credit accounts for a larger share of the balance sheet. Banks are required to hold minimum levels of regulatory capital, and bank regulators in most countries adhere to the 1998 Basel Capital Accord. As mentioned, credit risk management is placing greater emphasis on producing detailed quantitative estimates of credit risk. These measures are used to form better estimates of the amount of provisions and capital necessary at the portfolio level and to price and trade individual credits; in addition, they would be used for regulatory capital purposes under proposed changes to the Basel Capital Accord. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Commercial banks are particularly vulnerable to funding risk because they finance illiquid longer-term lending commitments with short-term liabilities, such as deposits. Broadly speaking, funding risk management consists of an assessment of potential demands for liquidity during a stressful period relative to the potential sources of liquidity. To avoid a shortfall, banks seek to expand the size and number of available sources, for example, the interbank market. In the United States, banks also have access to the Federal Reserve discount window. Financial risks of securities activities Securities firms engage in various financial activities, but key among these are serving as brokers between two parties in transfers of financial securities and as dealers and underwriters of these securities. The degree to which individual securities firms engage in these activities varies widely. In general, a large share of securities firms' assets are fully collateralized receivables arising from securities borrowed and reverse repurchase transactions with other market participants. Another asset category is securities they own, including positions related to derivative transactions. The main risk arising from securities activities is the market risk associated with proprietary holdings and collateral obtained or provided for specific transactions. Securities firms generally do not maintain significant provisions because their assets and liabilities can be valued accurately on a mark-to-market basis. Hence, hedging techniques and capital play dominant roles in risk management for securities firms. With respect to credit risk, securities activities generate fewer credit exposures than commercial bank lending. With fully secured transactions, securities firms mitigate their credit risk exposures by monitoring them with respect to the value of the collateral received. For partially secured or unsecured transactions, such as funds owed by counterparties in derivative transactions, they mitigate credit risk by increasing or imposing collateral requirements when the creditworthiness of the counterparty deteriorates. In addition, with frequent trading counterparties, securities firms enter into agreements, such as master netting and collateral arrangements that aggregate and manage individual transactions exposures. Securities firms have significant exposure to funding risk because a majority of their assets are financed by short-term borrowing from wholesale sources, such as banks. The liquidation of their asset portfolios is viewed as a source of funding only as a last resort. Accordingly, the primary liquidity risk facing securities firms is the risk that sources of funding will become unavailable, thereby forcing a firm to wind down its operations. To mitigate this risk, securities firms hold liquid securities and attempt to diversify their funding sources. Financial risks of insurance activities Insurance activities are broadly divided into life and non-life insurance, and firms specializing in either category face different risks. Specifically, these two types of activities require firms to hold different technical provisions, by virtue of both prudent business practices and regulatory mandates. For life insurance companies, technical provisions typically are the greater part of their liabilitiesabout 80%, according to the Joint Forum reportand they reflect the amount set aside to pay potential claims on the policies underwritten by the firms; capital is a relatively small percentage. Thus, the dominant risk arising from life insurance activities is whether their technical provisions are adequate, as measured using actuarial techniques. While term-life insurance policies are based solely on providing death benefits, whole-life insurance policies typically permit their holders to invest in specific assets and even to borrow against the value of the policies. Hence, life insurance companies also face market and credit risks. For a non-life insurance company, technical provisions make up about 60% of liabilities, which is less than observed for life insurance companies. The different balance between provisions and capital for non-life insurance companies reflects the greater uncertainty of non-life claims. The need for an additional buffer for risk over and above provisions accounts for the larger relative share of capital in non-life insurance companies' balance sheets.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Regarding funding risk, insurance activities are different from other financial activities because they are prefunded by premiums; for this reason, insurance companies do not rely heavily on short-term market funding. Life insurance companies have more than 90% of their assets in the investment portfolio held to support their liabilities. Hence, whether the investment portfolio generates sufficient returns to support the necessary provisions is a major financial risk. Investment risks include the potential loss in the value of investments made and therefore include both market and credit risk. These investment risks traditionally have been managed using standard asset-liability management techniques, such as imposing constraints on the type and size of investments and balancing maturity mismatches between investments and liabilities. Conclusion Several factors have contributed to the convergence of the financial service sectors. Yet, significant differences in their core business activities and risk-management techniques remain. There are also important differences in the regulatory capital frameworks, reflecting differences in the underlying businesses. As firms become active participants in new markets and take on new types of financial risks, it is important that appropriate policies and procedures be put into place to measure and manage these risks. However, risk management still is conducted on the basis of specific business lines. Hence, the challenge for risk managers is to aggregate different financial risks across the firm accurately. At present, there are significant practical and conceptual difficulties associated with these calculations. Because of differing time horizons and the difficulty of precisely measuring correlations across financial risks, many firms calculate the amount of economic capital separately for each risk type and aggregate. Clearly, simple summation is too conservative, since it ignores any possible diversification. Much further research is necessary to determine the best methods for firm-wide risk management for FHCs. Jose A. Lopez, Economist References [URL accessed February 2003.] The Joint Forum. 2001. "Risk Management Practices and Regulatory Capital: Cross-Sectoral Comparison." http://www.bis.org/publ/joint04.pdf Lopez, J.A. 2001. "Modeling Credit Risk for Commercial Loans." FRBSF Economic Letter 200112 (April 27). http://www.frbsf.org/publications/economics/letter/2001/el2001-12.html Lopez, J.A. 2002. "What Is Operational Risk?" FRBSF Economic Letter 2002-02 (January 25). http://www.frbsf.org/publications/economics/letter/2002/el2002-02.html
Discussion Questions: 1. Based on the common risk categories; If you are a banker that had just approved a housing loan of RM 400,000, for a tenure of 30 years, how would each of the risk category affecting lending. 10 marks 2. Describe some of the measures that you should be taking prior to approving the loan to better manage the risk. 10 marks 3. Discuss the risks associated to: a. Commercial banking b. Securities activities Version: 01 Date: 30/03/2009
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10 marks 2. In Malaysias financial system, Bank Negara had implemented the CCRIS or Central Credit Information System, a database which recorded credit history of Malaysian of legal age. How would you think that this system helps in managing risk in financial institutions, and will it really work? Discuss your opinion. 10 marks [Total: 40 marks]
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION MODULE 8: SECURITIES FIRMS Investment Banks Intermediaries that help corporations raise funds. Also plays vital role as deal makers in the merger and acquisition area, as intermediaries in the buying and selling of companies and as private brokers to the very wealthy. The companies earn its income from fees charges to clients rather than from commissions on stock trades. Functions: o Underwriting stocks and bonds consultation on when is the issuance should be made, and the price to be issued at. filing documents with Securities and Exchange Commission (SEC) called Registration Statement, in which a portion of the statement will be reproduced and made available to investors known as prospectus. Underwriting: At a pre-specified time and date, the issuer will sell all of the stocks or bonds issuance to the investment banking (IB) at an agreed price, e.g. $10 per share. Then, the issuance will be made available to the public at a greater price, e.g. $12, and the spread is the banks profit. To reduce risk of the issuance may not be saleable, some investment bank underwrite issues under syndicate, in which that each bank participating in the syndicate will purchased some portion of the issuance. The longer the banks hold the securities before reselling it, the higher the risk that a negative price change will cause losses, so bank speeds the sale to solicit offer to buy the securities from investors prior to the date of ownership by investment banker. Issuance need to be fully subscribed, but it could be undersubscribed, or oversubscribed. Best Effort Agreement is an alternative to underwriting. The investment banker sells the securities on a commission basis with no guarantee regarding the price the issuing firm will receive. Advantage is no risk of security mispricing, and no time consuming task of establishing the market value of security. If the security fails to sell, the placement can be cancelled. Private Placement is when the issuance was sold to only a group of investors. No SECs registration statement is required. Investment bankers role is mostly consultation. o Equity Sales The sale of companies and corporate division. Steps in equity sales: 5. Seller determines the business worth. IB provides a detailed analysis of the current market worth of similar company in the same industry. IB also makes discreet inquiry of who would be interested, and prepares confidential memorandum containing detailed information to prospective buyers. 6. Prospective buyer will issue letter of intent, which contains the intention to acquire the company and the terms. IB provides negotiation service as well as analyzing other offers. 7. Due diligence period of 20 40 days, and buyers need to verify the accuracy of information in confidential memorandum. 8. Definitive Agreement will then be issued containing all terms and conditions of the sales, and turn into legally binding contract. Mergers and Acquisition A merger is when two firms combine to form one new company, and an acquisition is when another company acquires the other through ownership of stocks. If the other company does not agree to the acquisition, it is known as hostile takeover. IB provides consultation to firms that intent to merge or acquire another firm.
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Securities Brokers and Dealers Conduct trading inn secondary market. Brokers are pure middlemen who act as agents for investors in the purchase and sale of securities, and it functions to match buyers and sellers and be paid brokerage commissions. Dealers link buyers and sellers by standing ready to buy and sell securities at a given price. They hold inventory of the security, and make money from the spread of bid and ask price. Known as market makers because it stands ready to buy. Brokerage Services (BS) o Securities orders deals with three primary types of transactions: market order, limit order and short sell. Market order is when a customer instructed its broker to purchase a security at a current market price. Limit order specify the maximum acceptable price for buy order and minimum acceptable price for sell order. Short sell is carried out when the investor does not own a particular stock and still be able to sell it or buy it in the future by borrowing the stock from brokerage house. o Other orders include safekeeping service, margin credit. o Types of BS are full service broker and discount broker. Investment banks assist corporations in raising funds in the public markets (both equity and debt). They may sometimes be confused with brokerages, which are firms which assist people in choosing and buying stocks, bonds, and mutual funds. (Of course, it is possible for a brokerage and an investment bank to share common ownership, and most of the largest brokerage companies also do investment banking.) [Top] THE TOOLS OF INVESTMENT BANKING Investment banks can invest money on stock markets or use advanced products called derivatives. Investment banks can also invest money directly into companies, projects, etc., either as direct investments for which they carry the full risk (known as private equity, venture capital, or merchant banking), or as loans with collaterals to reduce risks. Combinations of derivatives and loans also exist, such as mezzanines. [Top] THE MAIN ACTIVITIES AND UNITS Investment banks will typically be concerned with several business units, including Corporate Finance (concerned with managing the finances of corporations, including mergers, acquisitions and disposals), often called the Investment Banking Division of the firm; Research (concerned with investigating, valuing, and making recommendations to clients--both individual investors and larger entities such as hedge funds and mutual funds--regarding shares and corporate and government bonds); and Equities or Sales and Trading (concerned with buying and selling shares both on behalf of the bank's clients and sometimes also for the bank itself). Management of the bank's own capital, or Proprietary Trading, is often one of the biggest sources of profit; for example the banks may arbitrage in huge scale if they see a suitable opportunity and/or they may structure their books so that they profit from a fall of bond yields (a rise of bond prices). [Top]
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION POSSIBLE CONFLICTS OF INTEREST Because potential conflicts of interest may arise between different parts of a bank, the authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall which prohibits communication between Investment Banking on one side and Research and Equities on the other. These are some of the conflicts of interest involved in investment banking: The fact that most stock research companies (companies which are supposed to do research on a business and tell investors to buy or sell a company) are owned by investment banks can create a large conflict of interest. Historically, many investment banks seeking to be allowed to underwrite a companies IPO or debt offering have said to that company that they would tell their research division to rate that company a buy, in order to convince them to do a deal. Most observers allege that during the bull market of the 90's this would occour with almost every deal. The companies would choose the investment bank who had a large research division which would rate them a "buy", because that would likely increase the stock price of the company, which would increase the amount of money made by the companies CEO's since they were primarily paid by stock options, meaning they make more money the higher the stock price goes. The fact that many investment banks also own retail brokerages, can cause a conflict of interest. Besides the research division rating the stock a buy, the Investment bank may tell its brokers to try and convince their customers to buy the stock as well. This would occur not only as a thing to clinch the deal, but may also occour when the company might be performing badly and the Investment Bank might have a large supply of stock in its inventory. The investment bank can instruct the retail stock brokers to tell clients to buy the stock, so that the investment bank can get the poor performing stock off its hands.
NATIONAL AND INTERNATIONAL PUBLIC INVESTMENT BANKING In the United States, the Glass-Steagall Act prohibited banks from offering both commercial and investment services. The Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act in 1999. In part this was due to the tendency of the U.S. Congress to act itself as an investment bank: Lester Thurow claimed in the 1980s that it served exactly this function, advancing specific industrial policy and agricultural policy by direct grants or subsidies, loan guarantees, and exemption from regulations, taxes or other government-controlled expenses that would otherwise apply. This fusion of the banking and oversight role with fiscal policy was thought to be undesirably political, but inevitable if the US had no large investment banks. Various international development organizations, either global (such as The World Bank), or regional (such as the European Investment Bank, nor to be confused with the European Central Bank), and also various central banks, are considered by most economists to be investment banks, as they can bolster or create currency for specific projects. Banking overlaps with monetary policy at this largest scale.
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CASE FOR MODULE 7 & 8: INSURANCE AND UNIT TRUST CASE 1: REMOVING BARRIERS TO UNIT TRUST INVESTMENTS By P Gunasegaram A subject that should hold the attention of anyone interested in capital market development is the increase in market swings post-Asian financial crisis 1997. While this may be partly a reflection of increased risk, it is also caused by the sudden shifts of money in and out of the market by foreign funds. As foreign fund managers have large funds at their disposal, a small proportion of these funds moving in and out of emerging markets is enough to induce wild gyrations of the market. The situation is often made worse by local investors moving in tandem with the foreign players to avoid being left behind, holding losses. For a relatively small market like ours, it may be necessary to consider long-term measures to reduce the dependence of the market on foreign funds. This move could take two paths the more drastic step is to put a curb on excessive inflow of foreign portfolio capital and the other, more palatable measure is to reduce the dependence on foreign funds by channeling more local savings into the stock market.
The latter is to some extent being done by getting institutions such as the Employees Provident Fund into the market, which, as a broad strategy, is to be applauded but leaves a lot to be desired in terms of specific investment objectives. What is lacking is professionalism and expertise. For a broader effect, more savings can be moved into the market via unit trusts which basically make direct investments in the market and elsewhere and issue units to those who contribute to the fund. Unit trusts or mutual funds have been credited as one of the key factors in distributing ownership of companies in the US, making the common man a beneficiary of the rise in stock markets there. In Malaysia, retail investment in the market is still undertaken directly by the individual investors who are often ill-informed, have little or no research resources, rely heavily on rumors and tips, and typically have a very short-term horizon. A retail investor is almost a speculator. To make the transition and get more individual and small investors to invest in unit trusts, some major changes need to take place first. There is the process of education and explaining to investors how they can benefit from unit trust investments. Unit trust practitioners, at a recent capital markets conference, called raucously for tax and other incentives for investing in unit trusts, which we admit, will help stir interest in unit trusts. But they appear to have left out some other important considerations. The major one is a 5.0 to 10 per cent upfront fee for investing in unit trusts. Add a 2.0 per cent management fee and the unit trust will have to give a return of better than up to 12 per cent in the first year for a positive return to the unit holder. How many fund managers can perform that well? The front-loaded fee also makes it difficult for a person to exit a poorly performing unit trust as he will have to pay the fee again to invest in another unit trust. This perpetuates inefficiency by forcing people to keep their money in unit trusts that are not performing. Under such circumstances, public skepticism is well-justified. Perhaps the unit trust industry should take the first step forward and commit itself to unwinding the front-end fee in stages, say in three years and cutting the management fee to 1.0 per cent a year. That will be closer to the norm in the developed markets. Then, it should address itself to improving professional standards. It must make clear to the public that return is related to risk. An index fund should benchmark itself against the index it is supposed to replicate. A small market capital fund concentrates on smaller companies that are riskier and therefore the benchmark comparison cannot be the KL Composite Index, for instance. Perhaps an index of smaller companies could be created for comparison purposes. Is the local unit trust fund industry doing enough to promote professional standards among its practitioners? Is there a code of conduct? Does it set guidelines on how to set up benchmarks to measure performance? Does it construct some of these benchmarks itself? Until such time as the industry takes these measures, even tax breaks are not going to
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION encourage more people to buy unit trusts. Huge front-loaded fees and a lack of professionalism are bound to be major impediments to investing in unit trusts. ISSUES: RESCUING UNIT TRUST HOLDERS By C S Tan Johor will be seen as trying very hard to restore the value of investment units in its state unit trust funds. After failing to get a favorable reply from the federal government for a RM1.9-billion rescue package, Johor decided to take the bull by the horns. The state has announced its intention to inject RM400 million to lift prices in its two unit trust funds. Will the plan get off the ground? It probably will, even if it sounds improbable - this may be the first time in the world that unit trust holders are bailed out. Johor's Menteri Besar Datuk Abdul Ghani Othman told the press last week that a formal announcement will be made after the state Treasury approves the plan. The injection of value into the funds will be made by the state government and its investment arm, Johor Corp Bhd, he said. At first glance, the rescue package seems to be beyond the means of even the state. After all, a RM400-million bailout amounts to more than half of the annual state budget of about RM600 million. Where would the state and Johor Corp find the money for this? Johor Corp itself was last reported to be restructuring billions of ringgit of its debts. On a closer reading of Ghani's comments, it appears he has a workable solution. His plan is for unit holders to cash out 10 per cent of their investments by the end of the year and, hopefully, another 10 per cent next year. That suggests the rescue package is not a full and immediate payment. Ghani indicated a recovery to par value for only 20 per cent of investments. It is not understood whether he plans to provide relief for the rest of the unit holders' investments but it is clear payment will be staggered from year to year. Other states, which have similar problems with their unit trusts, will be watching Johor. The state's financial predicament stems from its two unit trusts - Amanah Saham Johor which was launched in 1992 and Dana Johor, launched in 1995. Both were offered mainly to bumiputeras at RM1 par, but the value of Amanah Saham Johor has since plummeted to 19.5 sen a unit and Dana Johor's units fell to 14.5 sen each as at last Wednesday. A total of 800 million units were initially offered in these two funds. It would cost more than RM660 million to bring the value of all these units back to RM1 par. It would therefore cost about RM66 million to restore 10 per cent of the fund to its par value, a sum the state might be able to swallow painfully. Looking at these numbers and the sum of RM400 million mentioned by Ghani, it appears the state might not be looking at a bailout for all the units.
Even at a ballpark figure of RM66 million for this year's part of the rescue package, it's a burden for the state. The state budget will carry a deficit of RM10 million this year. There is no surplus state revenue to cover the bailout. It would have to come from a larger budget deficit. It has been envisaged that asset-rich Johor Corp will help with this support plan. While the corporation grapples with its huge debt, its vast oil palm plantations in Johor are probably yielding ample cash flow. It might be able to assist in the bailout. Even as the unit holders are delighted, there will be other quarters that will criticize the whole scheme. There are other investors, in Johor and elsewhere, who have also lost heavily in their investments in unit trusts and shares. There is no rescue package for them. There are political considerations in the Johor state unit trusts. The unit holders are mainly bumiputeras, many of whom are said to be Umno members, who were encouraged to participate in the unit trusts. No doubt, the state government wants to be seen as lending a helping hand now.
Supporters would say the relief offered is part of the on-going costs of the New Economic Policy and its subsequent versions. Critics argue, on the other hand, that the money could be better used in other ways to raise the economic potential of bumiputeras in the state. The money could be used for education or in loans for those in business who have some experience and a track record. Further, a rescue scheme for the unit trust could foster a culture of dependence on the state and bailouts. Instead, the unit holders should have been taught how to assess risks in unit trusts. As Prime Minister Datuk Seri Dr Mahathir Mohamad put it in reference to Johor's Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION appeal for a rescue package, there is no guarantee profits will be made. The only guaranteed return is from bank deposits, he said. Capital is always a scarce commodity and there are many demands on it; it's needed not only for development but also to meet the demands from the community for health and social welfare causes. The state has to be more effective in its employment of capital. The need for the bailout scheme arises from the poor management of funds in the state unit trusts. The management cannot lay the blame on the regional financial crisis. Most of the private sector unit trusts have already managed to recoup most of their losses. The management of the state funds has to accept responsibility for the severe erosion of value in the unit trusts. This sad episode is a reminder of the unproductive outcomes that usually result from state intervention in business. The state should stay focused on providing public amenities, and leave business to the private sector. REQUIRED: 7. 8. 9. 10. Abstract the case. Describe the advantages and disadvantages of unit trusts. Explain the types of unit trusts discussed in the articles. What are some of the financial structures, e.g. lemon problem, asymmetric information issues in relation to unit trusts industry? Describe based on the case. 11. The articles mentioned, For a relatively small market like ours, it may be necessary to consider long-term measures to reduce the dependence of the market on foreign funds. In your opinion, why is it very important for Malaysia to be less dependence of foreign funds? What are some of the measures that need to be taken to reduce the dependency? Discuss. 12. Based on the information you gathered from the articles, will investing in unit trusts be something that you want to get into? Explain your position.
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CASE 2 COVER STORY: HOW AMBANK BANKS ON INSURANCE fd@bizedge.com Elena Tan, a middle management executive at a large listed company, finds it a hassle to renew her car insurance policy and road tax every year, as she would have to take time off from her usually busy schedule. But no longer. And here is why. Tan bought a new car two years ago, and took a five-year loan with the Ambank group, which also has in its stable, its insurance arm, AmAssurance Bhd. The loan officer packaged the loan with motor insurance, and since then, the bank has been doing the renewal of both road tax and insurance for her for a small fee. Tan is an example of how consumers have begun to benefit from the growing convergence between banking and insurance activities, which explains why bancassurance has begun to take off in a big way. And consumers are not the only beneficiaries. Insurance companies, too, are seeing bigger contributions from bancassurance. Take Ambank. It was among the first few banks that implemented bancassurance in the 1990s, and today, this channel's contribution in terms of new premiums to AmAssurance has been around 33% in the last three years. Ng Lian Lu, chief executive officer at AmAssurance, says that in terms of distribution channel, bancassurance business has also been consistently registering growth rates of about 30% for the past three years. Star performers were motor and housing loans. "We expect bancassurance to contribute 35% to our total business in the region, which is significant to us," she says. Perhaps, the story for AmAssurance could have been very different today if Fortis International, a major financial services and insurance group in Europe, had entered the AmBank Group post the 1997/1998 financial crisis. At that time, Fortis was believed to have considered taking a 15% stake in AMMB Holdings, but the deal did not materialize. Today, Fortis is partnering Maybank's insurance operations via a 30% stake in Mayban Fortis. AmAssurance, on the other hand, recently found a new potential partner in Insurance Australia Group (IAG) Ltd, one of the largest general insurance groups in Australia, which is also listed on the Australia Stock Exchange. AmAssurance is one of the larger bank-backed composite insurance companies, with total assets of RM1.61 billion and shareholders' funds of RM143 million. IAG has assets totalling A$17.1 billion and shareholders' funds of A$4.4 billion. IAG, it was announced three weeks ago, plans to take a 30% stake in AmAssurance. Details of the partnership have yet to be finalized, but the alliance is aimed at enhancing operations of AmAssurance by leveraging on the combined skill base of IAG and the former, according to a statement by AMMB Holdings on the proposed acquisition. AmAssurance, unlike Mayban-Fortis, has a strong agency force which is expected to contribute some 40% to its overall business. It has 5,696 life insurance agents and 2,721 general insurance agents. Ng says AmAssurance has identified four channels of distribution, and all are expected to play equally important roles in bringing in new business. Ng believes that the agency force of bank-owned insurance companies will not be replaced by any other channels (such as bancassurance) in the near future as there is still demand for the services provided. "Both are unique channels of distribution in terms of sales culture, offerings and techniques. People buy through bancassurance because of their relationship with the bank. People buy through agents because of their relationship with agents. Hence, they cater to very different sectors of customers," she explains. Still, Ng appears to be more a tad cautious when it comes to bancassurance's prospects. One of the reasons it did not quite take off in a big way, she says, is because Malaysians generally have the view that banks play a role of savings and lending institutions. "Hence, the insurance products sold in the banking hall are short term, savings and investment in nature with a small element of insurance protection. As a result, many insurance companies experience high lapses or surrender of bancassurance business, because there are many other savings or investment opportunities available for consumers to choose from," she explains. Banks, she adds, are also treading their entry into bancassurance cautiously; as it requires commitment in providing adequate training and having in place a compensation structure for the sales staff. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION COVER STORY: BRAVE NEW WORLD by Anna Taing In 1994, a year after bancassurance was introduced in Malaysia; its share of new premiums in the life insurance market was just under 2%. In 2004, a decade later, the share had leapfrogged to 48%, nearly half the new premium market! The statistics get more impressive. The top performing financial executive selling bancassurance products at a leading local bank can bring in new premiums equivalent to that of a whole agency force of some insurance companies. And, we are talking about a business that is still in its infancy in Malaysia. What this means is that there is enormous potential still untapped. And some Malaysian banks are scrambling to get a piece of the action. So, what is bancassurance? Loosely defined, it means usage of a bank's distributive network to sell insurance products but in practice, it can be more complex and involves a great deal of investment and planning. Bancassurance is the result of the growing convergence of banking and insurance services; it is a global trend that started in the 1980s, sweeping first across Europe, and the US before making its way to Asia. The winds of change were globalization, deregulation, liberalization, heightened competition and technological advancement. The global financial landscape saw the concept of universal banking or a one-stop financial supermarket taking root in the 1990s. It was also a period when capital markets grew very quickly in both depth and width, and financial institutions had to look beyond traditional activities to grow their bottom line as markets opened up, competition heated up and margins got squeezed. New growth frontier For many financial institutions, insurance was seen as the new frontier of growth, given the synergy and its great potential, as the lines separating the two sectors began to blur. On the flip side, insurance companies saw the opportunity to tap an alternative distribution channel that had the capacity to reach far and wide. In Malaysia, for example, the penetration rate of banking services is around 98% of the population aged between 18 and 64, according to Bank Negara Malaysia. With close to 2,300 bank branches throughout the country, banks' ability to mine their customer database provides a significant market potential for insurers. This potential, according to the central bank, is further enhanced by the fact that less than 8% of Malaysians who use banking ser-vices are estimated to have relationships with their banks that include insurance products and services. Dr Jens Lottner, managing director at McKinsey & Co in Singapore, says the next level for banks to go into is insurance. Malaysia, he explains, is not saturated as a market in insurance it is halfway between the markets of Singapore, Taiwan (which has a high penetration rate) and other Southeast Asian countries such as the Philippines and Indonesia. Malaysia's penetration rate at present is 38%. "There are still additional sources of growth ... it may not be easy but you need to have more sophisticated products," he says. He notes that a survey conducted by McKinsey last year concluded that banks have enormous potential to tap their customer base in terms of nontraditional financial services and products, such as insurance. It found that, generally, Malaysian consumers are loyal to their banks, preferring to use one financial institution for their needs. To a question on cross-selling, for example, 59% of respondents in the survey said they prefer to deal with one institution for all their financial needs, while 36% said they prefer to buy life insurance from a bank. Bancassurance can be done through various ways, such as a physical merger between banks and insurance companies, strategic alliances, joint ventures and distribution agreements. The result of this growing convergence is a proliferation of mergers and acquisitions as well as strategic alliances and distribution tie-ups among banks and insurance companies across the globe. Still, bancassurance has proved to be more successful in Europe than in the US. In Europe, some 60% of the life insurance business is transacted by banks, according to various research reports. In the US, the merger between Citigroup and Travelers and the subsequent divestment of the latter is cited often as an example of failure of convergence in banking and insurance. According to Deloitte Consulting, Travelers and Citigroup created a conglomerate rather than an integrated financial services organization. "This is not a real bancassurance model," it says, pointing out that acquisitions
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION are best used to reach new markets or distribution channels, but is a more complex brand management challenge. Bancassurance gets second wind Consider some of the major developments that have occurred since 2000 in Malaysia. In 2001, Fortis International, one of Europe's largest financial services companies, entered a partnership with the insurance unit of the Malayan Banking group. It turned out to be a very successful partnership. Affin Holdings Bhd entered the fray when it recently acquired Tahan Insurance. A few months ago, Southern Bank Bhd (SBB) proudly declared that it had outbid bigger names in the region for a major stake in Singapore's Asia General Holdings. More recently, Maybank said it is acquiring MNI Holdings, a composite insurance company, a move which will propel it into the big league of insurance players. And just last month, AmAssurance announced tie-up plans with Insurance Australia Group Ltd (IAG), the largest general insurer in Australia. IAG is listed on the Australian Stock Exchange. Public Bank, meanwhile, has made no secret of the fact that it is looking to buy an insurance outfit. It was one of the bidders for Asia Life, a unit of Asia General but it lost out to SBB. Industry players believe that what has evolved thus far is just the beginning for Malaysia at least even though bancassurance made its debut as early as 1993. Real integrated bancasssurance did not quite take off in a big way in Malaysia in the last decade, for various reasons. These are: Domestic banks, roiled by the 1997-1998 financial crisis, spent the ensuing years focused on cleaning up their balance sheets and on consolidation. The period of intense restructuring tapered off around 2000-2001, after which banks began to focus again on growth and expansion. "Many banks have been going through their own industry consolidation ... in addition; we are still going through the after-effects of the 1997 financial crisis. Many banks therefore have had other priorities during that period," explains Zulkify Sulaiman, chief executive officer at Mayban Fortis Holdings. Furthermore, retail banking was never a big focus for many banks in the 1990s it was the corporate sector which took centre stage, an industry observer says. Even today, there are still banks that do not have insurance units, including Public Bank and Alliance Bank. RHB Capital has an insurance arm, but it does not have life insurance business, a segment identified as having the strongest growth potential. However, this does not mean that banks without insurance subsidiaries are not involved in some form of bancassurance. They are increasingly involved in distribution agreements with insurance companies, be they local or foreign. There are, according to Bank Negara, three predominant bancassurance models in Malaysia: Referral arrangements where the insurer is placed on the panel of a bank for provision of certain products to bank's customers; Distribution agreements where the bank agrees, for a fee, to promote insurance products; and, Integrated services, where there is an integration of front and back-end operations between a bank and insurer to deliver banking and insurance products. Underlying such a model is usually an equity relationship between the bank and insurance company.
At present, some 96% of all bancassurance arrangements in Malaysia are focused on the distributive agreement model. Be that as it may, the integrated services model is beginning to draw more interest, the central bank notes in the latest Annual Insurance Report. McKinsey's Lottner says that by bringing the big entities (banks and insurance company) together, it can lead to the creation of additional value via integrated offerings such as mortgages and home insurance, hire-purchase and motor insurance and so on. In contrast, standalone insurance companies can just offer mono-line products. Furthermore, products can also be structured to tap the wealth management segment of the market, a direction that SBB is heading, once its acquisition of Asia General Holdings is completed. Exciting times ahead
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Expectations are that, going forward, the growing convergence as well as the play of market forces will drive financial institutions to undergo more mergers, takeovers and strategic alliances. There will also be rising foreign interest in this part of the world, given that Asia has been touted as the world's fastest growing market for the insurance industry. According to a report by Swiss Re, emerging markets will be the new frontier for insurance where life premiums are expected to grow from US$188 billion (RM710 billion) this year to US$450 billion by 2014. Industry players say they expect more exciting times ahead for bancassurance activities. Mayban Fortis' Zulkifi, for one, believes that bancassurance will take off from here. He notes: "I believe competitors are catching up with us. Almost all local banking groups now own or are in the process of acquiring their own insurance operators, and more and more independent insurers, particularly international insurers, are pursuing distribution relationships with commercial banks." Meor Amri Meor Ayob, analyst at Rating Agency Malaysia (RAM), agrees. He notes that now that the economy has recovered and balance sheets repaired, banks have begun to focus on growth again, and an area that is being looked at in a big way is bancassurance. "In the next couple of years, we can expect to see a lot more bancassurance products come onstream," he says. Indeed, the growth in bancassurance's market share in the last two years has been quite phenomenal. According to Bank Negara's Annual Insurance Report, bancassurance managed to capture 48% of new life premiums written in the industry in 2004, against 38% in 2003. In general insurance, the share is lower at 7% of industry's gross premiums. Maybank, for one, has reaped a rich harvest from its success in bancassurance. In the last decade, Maybank has managed to build its insurance business from almost nothing to being one of the top 10 players in the local industry via bancassurance. The compound annual growth rate (CAGR) for Mayban-Fortis Holdings is around 28%. Malaysian Assurance Alliance (MAA) Bhd, a leading standalone insurance company, too, has shown that bancassurance has begun to contribute significantly to its new premiums. Its bancassurance unit, which was set up about five years ago, is chalking up high growth rates, in terms of new premiums, of around 50% last year, according to Alzafry Mohd Zaliff Mohamed Adahan, executive vice-president, finance and group insurance, at MAA Assurance. This compares to an overall premium growth rate of 30% for the company. Catalysts of change The main catalyst of this change, according to industry players, is Bank Negara, which is the regulator of both the banking and insurance industry. "For example, the Financial Sector Master Plan, which maps out the growth path for both sectors in 10 years, facilitates greater convergence," says an industry player. Against this backdrop, banks and insurance companies, according to an industry observer, are now cognizant of the advantages to be gained. According to Deloitte Consulting, convergence between banking and insurance will gain momentum because of two main factors: A shift of bank deposits into retirement investments; and, Investment funds are growing more rapidly than bank deposits, thus causing banks to diversify into an adjacent growth area.
Banks will also derive many benefits from such convergence, according to Deloitte in response to queries from The Edge. These include an increased share of the customer's wallet, protection of customer relationship, cross-selling opportunities; reduced cost of sale compared to life agents, additional source of profits, and it is a low-risk diversification. What is more, the long-term nature of life insurance translates into income stability and sustained profitability. Indeed, banks that have adopted bancassurance are optimistic about the prospects going forward. Standard Chartered Bank (Stanchart), which is the first foreign bank in Malaysia to implement bancassurance, is upbeat about prospects. "Bancassurance is rated top three in revenue growth potential for the Standard Chartered Group in Asia-Pacific... it has fared well, with a revenue growth of US$63 million in 2004. We aspire to grow to over US$100 million or a growth rate of 51% by end of the year," says the bank's general manager (wealth Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION management), Ronnie Lim. In Malaysia, Lim says, the bancassurance business is expected to contribute some 20% to Stanchart's revenue. "We envisage a 50% growth on our year-on-year growth for this channel through our new strategies and products in the coming years," he adds. Indeed, Lim is emphatic about the importance of bancassurance to Stanchart. "It is one of the three core areas of wealth management wealth protection," he explains. He adds: "The insurance industry in Malaysia has a relatively low penetration rate. With a takeup rate of 30%, we see a huge potential for growth in bancassurance, especially since the bank [Stanchart] has an even lower penetration rate in insurance." Huge potential Be that as it may, practitioners say bancassurance is still in an infancy stage in Malaysia. MAA's Zaliff, for one, believes that banks have not fully tapped opportunities in bancassurance. "We have not talked about general insurance, about cross-selling insurance products to corporates, small and medium-scale enterprises and so on," he says. Zaliff's view is that standalone insurance companies can also tap other channels of distribution, such as post offices, for example. MAA currently carries out its bancassurance via several financial institutions, which include Bank Simpanan Nasional and Malaysia Building Society Bhd. Zaliff says the segments with good potential are health and takaful (Islamic insurance). SBB, for one, recently signed a memorandum of understanding to form an alliance with Bahrain-based Takaful International. The alliance will apply for a Takaful licence, not just to tap the local market but also the region's. "There is plenty of opportunity to grow bancassurance further, especially in terms of cross-selling insurance products to the bank's wide customer base." Stanchart's Lim agrees. He expects more tie-ups, noting that a few banks have even gone into buying insurance companies. RAM, in a report on banking convergence, says bancassurance is one of the most significant developments in the global financial services sector over the past decade and is the next step forward. "Banks and insurers are converging to form one-stop financial services centres via the complete integration of their existing distribution channels, with customers at the centre," it says. "Convergence makes a lot of sense," says Gan Kim Khoon, head of research at AmResearch. "It makes sense for banks to own an insurance unit they tap each other's big customer base, create cross-selling opportunities for banks vice versa," he says. Which may well explain why SBB, which has tied up with AIG to distribute the latter's products, is willing to cough up more than RM2 billion for a stake in Asia General Holdings. How SBB will integrate Asia General into the banking group remains to be seen. While there is no one definition or right model on bancassurance, an industry player says the question to ask is: Where does it make sense to integrate? And this will mean looking from the perspective of the customers right across to other processes, such as risks and management. In the SBB-Asia General case, it is understood the inclination at this point is towards the noninclusive model, which means that there will be no physical merger between SBB and Asia General. It is also likely that SBB will keep the Asia General "brand", as it is an established name in the region.
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Regulatory measures to enable bancassurance Stanchart's Lim says the current regulatory environment is conducive to bancassurance. "It is conducive as it requires transparency in all commissions, charges and expenses for each bancassurance product sold. This enables all banks to play on a level field... it further encourages us to think out of the box to be more creative in our product and service proposition," he says. Regulatory measures put in place over the last few years include: A more flexible commission structure for the sale of life insurance products through bancassurance; For new life products offered after December 2004 with a savings component, insurers will be required to reflect any savings from lower distribution costs arising from bancassurance arrangements in lower premiums or better benefits to consumers; Insurers are required to spread payment of commissions meaningfully over a minimum period of up to 10 years for annual premium life policies. This avoids high front-loaded commissions in the first few years of the policies, which provides incentives for banks to service their customers effectively after close of sale; and, Banks are required to disclose charges borne by customers so that they can make comparisons with other savings alternatives.
Driving consolidation Given that banks like Maybank have begun to acquire insurance companies, a question raised is whether they will eventually be the key drivers of the insurance industry's consolidation. The industry, as it is now, is still fragmented, despite the central bank's push for consolidation in the last decade or so. Views are mixed on this. AmResearch's Gan, for example, does not believe that banks will play a major role in the industry's consolidation. "I don't see consolidation in the insurance industry being led by banks. Maybank is acquiring MNI because it needs the scale, now they are very small," he says. Banking groups which already own insurance units which are of a good size will not see the need to go on an acquisition trail. Be that as it may, there is still potential for M&As because there are still some banking groups that do not have insurance arms, Gan observes. RAM's Meor Amri, though, does not rule out banks being the driver of consolidation in the insurance industry, as one way for banks to grow their insurance business is through acquisition. But he stresses two factors the capacity to pay (acquisition will not be cheap) and the push to do so. Ng Lian Lu, who heads AmAssurance in the AmBank Group, says a bank-led consolidation is already happening now. In response to queries from The Edge, he says: "It is happening now, and the bank-led consolidation is a result of consumer demands for complete financial solutions under one roof. There are a few anchor banks in Malaysia without an insurance licence," she says. Ng sees benefits from such consolidation. "It is believed that insurance companies that operate under a banking group will be more cost-effective, because of the concept of shared common services such as human resource services, audit and others," she explains. The financial services landscape is changing, and fast. In the coming months, this tempo can be expected to quicken, as barriers tumble and competition heats up. Local financial institutions will have no choice but march to the beat to remain in the game. It will be a brave new world for financial institutions, going forward.
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PERSONAL FINANCE: ROLE OF LIFE INSURANCE IN ESTATE PLANNING By Ong Eu Jin My spouse and I had a good friend who truly had it all. Armed with a master's degree from Oxford, this young man worked in an international firm with a remuneration package most of us would die for. He belonged to the jet set, had a multitude of friends, spent his vacations skiing in the Swiss Alps, shopped in New York or just relaxed in his Sydney home. If there was anyone who lived life to the fullest, it was him. In 2004, he was diagnosed with cancer and doctors gave him six months to live. After going through a series of expensive treatments, his last words to us before he passed on were: "I'm glad it is finally over. At least, I don't have to suffer anymore." Although it was tragic, his family and he were fortunate, in a way. Money was never an issue for them, unlike for most people. The target clients of most insurance agents and financial planners are naturally the wealthy. After all, the more expensive the policy, the higher the commission. The irony is that those who need insurance the most are the not so rich, who can only afford to pay low premiums. In 2003, some 21,464 Malaysians were diagnosed with cancer in Peninsular Malaysia alone. According to the National Cancer Registry, the crude rate for males and females for that year was 97.4 and 127 per 100,000 of the population respectively. According to Bank Negara's Insurance Annual Report 2005, some 10,142,994 life insurance policies were in force, with a total sum insured of about RM645 billion and annual premiums amounting to RM12.3 billion. In the same period, RM778 million was paid out as death and disability benefits. Life insurance is essential not only for critical illnesses but also for estate planning. The latter is not only about choosing who your beneficiaries are in a will. It is also important that you ensure there are sufficient funds and liquidity to pay off debts and expenses as well as sustain family members and dependents. Sufficient funding is needed for: The estate (which comprises the assets and liabilities of the deceased and is represented by the personal representative); and Family members and other dependents.
The estate is distinct from the deceased's family members. Most people name their family members as nominees of their life insurance policies. In such a case, the insurance proceeds would be paid to the family members. However, if the estate has insufficient funds to pay expenses and debts, the personal representative may be forced to liquidate some of the assets of the estate notwithstanding that it was the deceased's intention to leave them as a legacy to his loved ones under his will. In other words, the family members may have sufficient funds but the estate may not. In this regard, life insurance proceeds can fund the estate for the purpose of paying: Funeral and testamentary expenses, including probate and administration costs, lawyer's fees and so on; Medical expenses which may have been incurred prior to death; Any outstanding debts, including loans relating to motor vehicles and credit cards; and Outstanding taxes.
Life insurance proceeds are increasingly becoming the source of funding for middle-income families that create education trusts for their children and maintenance trusts for their dependents. The advantage of having insurance-funded trusts is that you are not required to set aside any cash during your lifetime. Insurance also plays an important role in the estate planning of business owners by: Funding the acquisition of the business interests of an outgoing partner under a buysell agreement; Providing family members who will not be inheriting any shares in the business with alternative inheritance or financial gifts; Softening the impact on business finances resulting from the loss of a key employee;
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Ensuring that the estate has sufficient funds to settle any loans taken for working capital or to fund the acquisition of shares in the business during his lifetime; and Ensuring that the estate of a business owner has sufficient funds to pay personal debts, outstanding taxes, estate administration costs and other expenses. Insufficient funds can sometimes leave the family with no other option but to sell the business.
At times, insurance proceeds may be insufficient to cover the living expenses of family members, perhaps because the policy owner was underinsured or the insured-cum-policy owner suffered disability and most of the proceeds were used up during his lifetime. In this regard, it is important to understand the terms of the policy you own. In addition, it is not uncommon for the family's breadwinner to have the most coverage and the non-working spouse to be underinsured. If the latter is struck down by critical illness, the family will be faced with the dreadful choice of liquidating their assets to pay the medical bills (which may amount to hundreds of thousands) or giving up on the treatment. Insurance is important because both living and dying is expensive. Many of us may be under the misguided impression that we are richer than we truly are. It is frightening when you realize that once your bank loans and other liabilities have been taken into account, your net assets are not as much as you presume. It is not uncommon to underestimate the amount of funding one's estate and family members require. You may have purchased insurance for, say, RM500,000 when the amount needed is probably RM1 million or more. To ensure that sufficient funding is in place to meet the financial needs of your family and yourself, you may need to ascertain the value of your net assets (that is, assets minus liabilities) and have in place a mechanism to fund the shortfall. A financial wealth assessment by qualified financial planners may be helpful. This process includes gathering information from you, analysis and feedback from the financial planners.
REQUIRED: 6. Describe the differences between bancassurance and conventional insurance. 7. Explain the types of insurance discussed in the articles. 8. What are some of the financial structures, e.g. lemon problem, asymmetric information issues in relation to insurance industry? Describe based on the case. 9. Bancassurance and insurance provider provides the same products and services fundamentally. Is there a need for the elimination of the conventional insurance? What are some of the obstacles faced by the bancassurance provider in embarking into bancassurance business? Discuss. 10. Based on the information you gathered from the articles, which of the services appeal to you more and why? Explain your position.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION RISK MANAGEMENT IN FINANCIAL INSTITUTIONS Financial institutions are subjected to many risks either internally or externally, and this title discusses management approach of some of the risks.
Managing Credit Risk FIs are very vulnerable to credit risk, in which in order for FI to earn high profit, it must manage its credit efficiently, thus minimizing its credit risk. Credit risk is related directly to adverse selection and moral hazard issue. The principle of managing credit risk: o Screening Adverse selection issue Effective screening through collection of reliable information from prospective borrowers
Prospectiv e Borrower Loan Applicatio n Form Credit Score Officers Judgme nt References and Employmen t
Monitoring Moral hazard issue To reduce moral hazard, FI managers must adhere to the principle of managing credit risk of writing provisions (restrictive covenants) into loan contracts that prevent borrowers from engaging in overly risky activities. Long-term Customer Relationship FI prefers to make loan to long term customer who has an account with them. The balances in the account indicate the liquidity of potential borrower, as well as payment made in the case of loan was previously granted to the customer. Reduce information collection cost and monitoring cost, and usually this customer will be offered lower interest rates. Loan Commitment A banks commitment (for a specified future period of time) to provide a firm with loans up to a given amount at a fixed interest rate or more commonly at a rate tied to some market interest rate. Advantage for firm is that it has a source of credit when firm needs it, and for bank is that the loan commitment promotes a long term relationship, which reduces screening and monitoring cost. Collateral Collateral is property promised to the lender as compensation if the borrower default, lessens the consequences of both adverse selection and moral hazard. Loans with collateral requirements are called secured loans.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION o Compensating Balance A form of collateral, in which a firm receiving loan is required to keep a minimum amount of funds in a checking account at the bank. Aside from that, CB helps increase the likelihood that the loan will be paid off, thus minimizes adverse selection and moral hazard. Credit Rationing Lenders refuse to make loan even though borrower is willing to pay the stated or higher IR. Two forms: FI refuse to make loan at all or FI loan out only a fraction of the required amount.
Managing Interest Rate Risk IR risk is associated with the riskiness of earning and returns due to fluctuation in IR. Bank manager decides which assets and liabilities are rate sensitive that is, which have IR that will be reset within the year. If a FI has more rate sensitive liabilities than assets, a rise in interest rates will reduce the net interest margin (NIM) and income, and a decline in IR will raise the NIM and income. Management of IR risk: o Income Gap Analysis Amount of rate sensitive liabilities is subtracted from the amount of rate sensitive assets. o Duration Gap Analysis Examines the sensitivity of the market value of FIs net worth to changes in IR.
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Case for Module 9: Risk Management and Financial Institutions FRBSF Economic Letter, 2003-03; February 14, 2003 How Financial Firms Manage Risk Common risk categories Common risk management techniques Financial risks of commercial banking Financial risks of securities activities Financial risks of insurance activities Conclusion References
Financial Notes: This series supersedes Western Banking. It appears on an occasional basis and is prepared under the auspices of the Financial and Regional Research Section of the FRBSF's Economic Research Department. Regional Banking Tables will continue to be updated online quarterly. Over the past several years, there has been a steady march toward financial integration across product lines among larger financial firms. The trend is in part due to the increasing globalization of financial markets, the development of new financial instruments, and advances in information technology. In the United States, the Gramm-Leach-Bliley Act of 1999 permits financial firms to engage in banking, securities exchange, and insurance under a new charter type that creates financial holding companies (FHCs). The Federal Reserve is the primary supervisor for FHCs, and it had granted 640 FHC charters to top-tier holding companies as of January 24, 2003. The attraction to firms of offering an array of financial services can stem from the potential advantages of cross-selling several products to customers or from the similarity in underlying expertise and information systems used. However, from a supervisory perspective, it is important to recognize that different financial activities typically give rise to different types of underlying risks. This Economic Letter outlines these risks and the differing risk management techniques commonly used for banking, securities, and insurance activities. Common risk categories Financial firms face four common risks: market risk, credit risk, funding risk, and operational risk. Market risk refers to the possibility of incurring large losses from adverse changes in financial asset prices, such as stock prices or interest rates. Standard risk management involves the use of statistical models to forecast the probabilities and magnitudes of large adverse price changes. These so-called "value-at-risk" models are used to set capital against potential losses. In practice, while models provide a convenient methodology for quantifying market risks, there are limitations to their ability to predict the magnitude of potential losses. To address these limitations, firms also use stress tests that examine the impact of large hypothetical market movements on their portfolio values. Credit risk is the risk that a firm's borrowers will not repay their debt obligations in full when they are due. The traditional method for managing credit risk is to establish credit limits at the level of the individual borrower, industry sector, and geographic area. Such limits are generally based on internal credit ratings. Quantitative models are increasingly used to measure and manage credit risks (see Lopez, 2001, for further discussion). Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Funding (or liquidity) risk is the risk that a firm cannot obtain the funds necessary to meet its financial obligations, for example short-term loan commitments. Three common techniques for mitigating funding risk are diversifying over funding sources, holding liquid assets, and establishing contingency plans, such as backup lines of credit. Generally, firms set funding goals as benchmarks to measure their current funding levels, and take mitigating actions when they are below certain thresholds. Finally, operational risk is the risk of monetary loss resulting from inadequate or failed internal processes, people, and systems or from external events (see Lopez, 2002, for a more complete discussion). Although operational risk management is a rapidly developing field, standard risk mitigation techniques have not yet been developed. Common risk management techniques A key element of financial risk management is deciding which risks to bear and to what degree. Indeed, a financial firm's value-added is often its willingness to take on specific risks. Correspondingly, risk management involves determining what risks a firm's financial activities generate and avoiding unprofitable risk positions. Other important components are deciding how best to bear the desired risks and what actions are needed to mitigate undesired risks by shifting them to third parties. Financial firms protect themselves from risk by setting aside funds to cover losses. Broadly speaking, these funds are known as provisions and capital. Provisions are funds set aside to cover expected (or average) losses, and capital refers to funds set aside to cover unexpected (or extraordinary) losses. Capital takes several forms on the balance sheets of financial firms, but typically it includes such items as shareholder equity. The reliance on provisions and capital varies among financial firms engaging in banking, securities, and insurance activities due to differences in their underlying risks. Since financial firms have similar general goals regarding risk bearing, some of their risk management techniques are similar. For example, all firms have procedures to ensure that independent risk assessments are conducted and that controls are in place to limit the amount of risk individual business units take. In addition, hedgingi.e., paying third parties to take on some of the risk exposureis common to all types of financial activities. Market risk is the easiest to hedge, because of the wide variety of exchange-traded and over-the-counter derivatives available. Increasingly, credit risk is hedged using credit derivatives, which are overthe-counter derivatives for which payments are based on borrower credit quality. Finally, certain risk exposures arising from insurance activities can be hedged using the reinsurance market. At the same time, important differences in risk management techniques exist. As noted in the 2001 report by the Joint Forum consisting of international bank, securities, and insurance supervisors, financial firms tend to invest more in developing risk management techniques for the risks that are dominant in their primary business lines. The report also found that risk management still is conducted mainly on the basis of specific business lines. The following sections highlight the key differences in risk management techniques across financial activities. Financial risks of commercial banking A defining characteristic of commercial banking is extending credit to borrowers of all types. Hence, commercial banks' main risks are the credit risk arising from their lending activities and the funding risk related to the structure of their balance sheets. Banks hold loan loss provisions to cover expected losses, but capital to cover unexpected credit accounts for a larger share of the balance sheet. Banks are required to hold minimum levels of regulatory capital, and bank regulators in most countries adhere to the 1998 Basel Capital Accord. As mentioned, credit risk management is placing greater emphasis on producing detailed quantitative estimates of credit risk. These measures are used to form better estimates of the amount of provisions and capital necessary at the portfolio level and to price and trade individual credits; in addition, they would be used for regulatory capital purposes under proposed changes to the Basel Capital Accord. Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Commercial banks are particularly vulnerable to funding risk because they finance illiquid longer-term lending commitments with short-term liabilities, such as deposits. Broadly speaking, funding risk management consists of an assessment of potential demands for liquidity during a stressful period relative to the potential sources of liquidity. To avoid a shortfall, banks seek to expand the size and number of available sources, for example, the interbank market. In the United States, banks also have access to the Federal Reserve discount window. Financial risks of securities activities Securities firms engage in various financial activities, but key among these are serving as brokers between two parties in transfers of financial securities and as dealers and underwriters of these securities. The degree to which individual securities firms engage in these activities varies widely. In general, a large share of securities firms' assets are fully collateralized receivables arising from securities borrowed and reverse repurchase transactions with other market participants. Another asset category is securities they own, including positions related to derivative transactions. The main risk arising from securities activities is the market risk associated with proprietary holdings and collateral obtained or provided for specific transactions. Securities firms generally do not maintain significant provisions because their assets and liabilities can be valued accurately on a mark-to-market basis. Hence, hedging techniques and capital play dominant roles in risk management for securities firms. With respect to credit risk, securities activities generate fewer credit exposures than commercial bank lending. With fully secured transactions, securities firms mitigate their credit risk exposures by monitoring them with respect to the value of the collateral received. For partially secured or unsecured transactions, such as funds owed by counterparties in derivative transactions, they mitigate credit risk by increasing or imposing collateral requirements when the creditworthiness of the counterparty deteriorates. In addition, with frequent trading counterparties, securities firms enter into agreements, such as master netting and collateral arrangements that aggregate and manage individual transactions exposures. Securities firms have significant exposure to funding risk because a majority of their assets are financed by short-term borrowing from wholesale sources, such as banks. The liquidation of their asset portfolios is viewed as a source of funding only as a last resort. Accordingly, the primary liquidity risk facing securities firms is the risk that sources of funding will become unavailable, thereby forcing a firm to wind down its operations. To mitigate this risk, securities firms hold liquid securities and attempt to diversify their funding sources. Financial risks of insurance activities Insurance activities are broadly divided into life and non-life insurance, and firms specializing in either category face different risks. Specifically, these two types of activities require firms to hold different technical provisions, by virtue of both prudent business practices and regulatory mandates. For life insurance companies, technical provisions typically are the greater part of their liabilitiesabout 80%, according to the Joint Forum reportand they reflect the amount set aside to pay potential claims on the policies underwritten by the firms; capital is a relatively small percentage. Thus, the dominant risk arising from life insurance activities is whether their technical provisions are adequate, as measured using actuarial techniques. While term-life insurance policies are based solely on providing death benefits, whole-life insurance policies typically permit their holders to invest in specific assets and even to borrow against the value of the policies. Hence, life insurance companies also face market and credit risks. For a non-life insurance company, technical provisions make up about 60% of liabilities, which is less than observed for life insurance companies. The different balance between provisions and capital for non-life insurance companies reflects the greater uncertainty of non-life claims. The need for an additional buffer for risk over and above provisions accounts for the larger relative share of capital in non-life insurance companies' balance sheets.
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION Regarding funding risk, insurance activities are different from other financial activities because they are prefunded by premiums; for this reason, insurance companies do not rely heavily on short-term market funding. Life insurance companies have more than 90% of their assets in the investment portfolio held to support their liabilities. Hence, whether the investment portfolio generates sufficient returns to support the necessary provisions is a major financial risk. Investment risks include the potential loss in the value of investments made and therefore include both market and credit risk. These investment risks traditionally have been managed using standard asset-liability management techniques, such as imposing constraints on the type and size of investments and balancing maturity mismatches between investments and liabilities. Conclusion Several factors have contributed to the convergence of the financial service sectors. Yet, significant differences in their core business activities and risk-management techniques remain. There are also important differences in the regulatory capital frameworks, reflecting differences in the underlying businesses. As firms become active participants in new markets and take on new types of financial risks, it is important that appropriate policies and procedures be put into place to measure and manage these risks. However, risk management still is conducted on the basis of specific business lines. Hence, the challenge for risk managers is to aggregate different financial risks across the firm accurately. At present, there are significant practical and conceptual difficulties associated with these calculations. Because of differing time horizons and the difficulty of precisely measuring correlations across financial risks, many firms calculate the amount of economic capital separately for each risk type and aggregate. Clearly, simple summation is too conservative, since it ignores any possible diversification. Much further research is necessary to determine the best methods for firm-wide risk management for FHCs. Jose A. Lopez, Economist References [URL accessed February 2003.] The Joint Forum. 2001. "Risk Management Practices and Regulatory Capital: Cross-Sectoral Comparison." http://www.bis.org/publ/joint04.pdf Lopez, J.A. 2001. "Modeling Credit Risk for Commercial Loans." FRBSF Economic Letter 200112 (April 27). http://www.frbsf.org/publications/economics/letter/2001/el2001-12.html Lopez, J.A. 2002. "What Is Operational Risk?" FRBSF Economic Letter 2002-02 (January 25). http://www.frbsf.org/publications/economics/letter/2002/el2002-02.html
Discussion Questions: 3. Based on the common risk categories; If you are a banker that had just approved a housing loan of RM 400,000, for a tenure of 30 years, how would each of the risk category affecting lending. 10 marks 4. Describe some of the measures that you should be taking prior to approving the loan to better manage the risk. 10 marks 5. Discuss the risks associated to: a. Commercial banking b. Securities activities Version: 01 Date: 30/03/2009
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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION c. Insurance activities
10 marks 6. In Malaysias financial system, Bank Negara had implemented the CCRIS or Central Credit Information System, a database which recorded credit history of Malaysian of legal age. How would you think that this system helps in managing risk in financial institutions, and will it really work? Discuss your opinion. 10 marks [Total: 40 marks]
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BFB4133 Financial Markets and Institutions Course Notes

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COURSE: BFB4133: FINANCIAL MARKETS AND INSTITUTIONS FACULTY: BUSINESS ADMINISTRATION

MODULE 1: OVERVIEW OF FINANCIAL SYSTEM

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MODULE 2: INTEREST RATES IN THE FINANCIAL SYSTEM

$100 + $200 = 30% $1000

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Rate of Interest (percent per annum)

Transaction & Precautiona ry Demand

Quantity of Money Demanded

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MODULE 3: CENTRAL BANK AND CONDUCTS OF MONETARY POLICY

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MODULE 4: FINANCIAL MARKETS

Debt (Short Term)

Equity Foreign Exchange

Foreign exchange futures

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The materials are downloaded from www.bambooweb.com

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MODULE 5: THEORY OF FINANCIAL STRUCTURES

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5 May 2008: My Say: The end of banks?

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MODULE 6: THE BANKING FIRM AND BANK MANAGEMENT

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MODULE 7: INSURANCE AND UNIT TRUST

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