CHAPTER 02: Financial Intermediaries

and Financial Innovation

Financial institutions: Business

enterprises deal with financial assets
for transferring funds from one group
to another group or using funds in
their own name by issuing financial
assets are known as financial
institution.
2-1
 Functions of financial
institutions:
1. Transforming financial assets from
deficit group to surplus group through
market.
2. Exchanging of financial assets on
behalf of customers.
3. Exchanging of financial assets in their
own accounts.
4. Providing investment service to other
market participants.
2-2
Financial System of Bangladesh
1. Central Bank:
i. Nationalized commercial banks: 4
ii. Local Private commercial banks: 40
iii. Foreign commercial banks: 9
iv. Specialized banks: 4
v. Non-bank financial institutions: 33
2. Insurance companies: State owned 2, Privately owned
general insurance 45 and Privately owned life insurance
30
3. Bangladesh Securities and Exchange Commission
4. Bangladesh Micro Credit Regulatory Authority
5. Insurance Development & Regulatory Authority Bangladesh
2-3
Direct and indirect investment:

Investments made by financial intermediaries

by acquiring financial assets of other business
organizations or by sanctioning loans to others
(debtors or deficit group) by collecting funds
from others (depositors or surplus group) are
called direct investment and this investment
from the viewpoint of provider of funds are
known as indirect investment.

2-4
 Financial intermediaries:
Financial institutions act for channeling
funds against financial assets between
two parties i.e. from surplus group to
deficit group are known as financial
intermediaries.

2-5
Role of financial intermediaries:

1. Providing maturity intermediation:

Financial intermediaries play an important role by bringing
together surplus group and deficit group. Different surplus
households may have excess fund for different time period and
different deficit household may be required fund for different
time period. It may not be possible for individuals to find out
surplus household and deficit household and to match between
savings period and financing period. Financial intermediaries
can easily match between these two time periods because most
of the savers and users transact through the help of
intermediaries.
2-6
Role of financial intermediaries:

2. Reducing the cost of contracting

and information processing: Costs
incurred for writing a loan agreement between savers
and users is called contracting cost. Costs required for
collecting, processing and using relevant information
is called information processing cost. If transfer of
funds is made through the help of financial
intermediaries and information is collected by them
then there will be minimum cost because they have
expertise about these.
2-7
Role of financial intermediaries:

3. Reducing risk via diversification:

Financial intermediaries can form a large
amount of capital by collecting funds from
many savers. Since there is a large amount
of fund available for making investment,
investment can be made in portfolio form
for diversifying and minimizing risk.

2-8
Role of financial intermediaries:

4. Providing payments mechanism:

Financial intermediaries have introduced
different payment mechanisms for transferring
funds from savers to users like checks, debit
cards, credit cards and electronic fund
transfer.

2-9
Role of financial intermediaries:

5. Providing efficient micro-finance

to the poor: Financial intermediaries provide
micro-finance facilities to the poor for the following
reasons:
 Efficient provision of savings, credit and insurance
facilities can enable the poor to smoothen their
consumption, manage risks better, gradually build
assets, develop micro-enterprises, enhance income
earning capacity, and generally enjoy an improved
quality of life. 2-10
Role of financial intermediaries:

 Efficient micro-finance services can also contribute

to improvement of resource allocation, development
of financial markets and system, and ultimately
economic growth and development.
 With improved access to institutional micro-finance,
the poor can actively participate in and benefit from
development opportunities.

2-11
Overview of asset/liability
management for financial institutions
Since most of the financial institutions deal with
others money, they are always assuming liability.
They earned profit between the spread of rate
earned on investments and rate sanctioned to
savers. They are needed to be ready to make
payments any time to the supplier of funds.
Generally by the liabilities of financial institutions
we mean the amount and timing of the cash
outlays that must be made to satisfy the
contractual terms of the obligations issued.
2-12
 Nature of liabilities
1. Type-I liability: Both the amount and timing of
payment are known with certainty. For example-
Fixed deposit.
2. Type-II liability: The amount of payment is known
with certainty and the timing of payment is
unknown. For example – Life insurance policy.
3. Type-III liability: The amount of payment is
unknown and the timing of payment is known. For
example – Flexible rate certificate of deposit.
4. Type –IV liability: The amount of payment and the
timing of payment both are unknown. For example
– Property and casualty insurance.
2-13
 Liquidity concern
Since financial intermediaries/institutions deal with
other savers and depositors money, they have
obligations to make repayment upon savers and
depositors’ demand. Depositors can demand any
time for withdrawing their amount. If financial
intermediaries failure to meet up demand then they
will be defaulter. So they have to maintain a certain
amount or a certain percentage of total deposit as
liquid money for meeting depositors’ demand and
for avoiding defaultness.
2-14
 Financial innovation
The creation of a new investment vehicle such
as one may structure a derivative in a way that
has never been done before. It can increase
efficiency and profits for certain parties.
However, it often takes time for regulation
catch up to financial innovation, which can
make it risky. To add new characteristics in
financial assets and markets. Followings are
the different financial innovations:

2-15
 Financial innovation
1. Market broadening instruments- to increase the
liquidity of markets and the availability of funds by
attracting new investors and offering new
opportunities for borrowers.
2. Risk-managed instruments – to reallocate financial
risks to those who are less risk averse.
3. Arbitraging instruments and processes – to enable
investors and borrowers to take advantage of
differences in costs and returns between markets.

2-16
 Motivation for financial
innovation
1. arbitraging regulations and find loopholes in tax rules
2. introduction of financial instruments that are more
efficient for redistributing risks among market
participants.
3. increased volatility of interest rates, inflation, equity prices
and exchange rates.
4. advances in computer and telecommunication
technologies.
5. greater sophistication and educational training among
professional market participants.
6. financial intermediary competition.

2-17
 Asset securitization
To take a large amount of loan by
securing financial assets is called asset
securitization. It is the process that is
involved with the collection or pooling of
loans and the sale of securities backed
by those loans. It also means that more
than one institution may be involved in
lending capital.
2-18
 Asset securitization
Securitization is basically the process where
the company pooled its illiquid assets
together and issued a claim to a pool of
assets. When the assets are securitized, it
made the assets tradable in the financial
market. It is a process of pooling of
“homogeneous”, “financial”, “cash flow
producing”, “illiquid” assets and issuing
claims on those assets in the form of
marketable securities.
2-19
 Benefits of Asset securitization
 From originator point of view, the main benefit that
they can gain from securitization is illiquid assets are
moved “off-balance sheet” and replaced by a cash
equivalent. This process has improved the originator’s
balance sheet.
 a pool of assets has better credit characteristic. It is
achieved through diversification of credit risk,
transaction size, and geography than an individual
asset. Thus reduces the risk of holding the assets.
fixed income.
2-20
Benefits of Asset securitization

 From the investor point of view, they could

earn better yield and liquidity for their
investment in securities. Besides that, they
also can predict prepayment with better
certainty since security paid a fixed income.

2-21
Asset securitization in Islam
Islamic securitization, just like any other
dealings including day-to-day activities, must
be in line with the teachings in Quran and
Sunnah; furthermore, the sayings and
practices of companions (Sahabah), and
sayings and practices of the great peoples in
the history of Islamic teachings should also be
referred to. The teaching of Islam promotes
ethics in commercial dealings, and so, in
Islamic securitization, ethics is an important
aspect.
2-22
Asset securitization in Islam

For instance
“The Messenger of God passed by a heap of
foodstuffs. He thrust his hand into it, and his
fingers encountered dampness. He said, “What is
this, O owner of the foodstuffs?” He said, “Rain has
stricken it, O Messenger of God.” He said, “Why do
you not put it at the top of the foodstuffs, so that
the people may see it? He who deceives is not of
me.
2-23
Asset securitization in Islam

In Islamic securitization, companies, which plan to

securitize their assets, must make sure that proper
valuations of the assets are carried out, and if there
are any defects in the assets, they must be revealed
to the investors. Furthermore, to express the
importance of ethical conduct, Prophet Muhammad
said: “A trustworthy, an honest and a truthful
businessman will rise up with martyrs on the
Day of Resurrection.”(Ibn Majah)
2-24
Asset securitization in Islam
 The difference between Islamic and conventional
asset securitization is in the assets themselves. The
conventional securitization allows any assets to be
securitized, including haram assets. However, in
Islamic securitization, assets relating to riba’,
gambling and usury, and assets which are used to
manufacture and/or selling of haram goods (like
pork and liquor) are not allowed to be securitized,
and if these haram assets are securitized, Muslim
investors must refrain from investing in the related
securities.
2-25
 Sources of prohibition of
securitization of haram assets in Islam

i) In relation to assets based on riba’: “…God hath

permitted trade and forbidden usury…”
ii) In relation to gambling: “O you who believe!
Intoxicants and gambling, (dedication of) stones and
(divination by) arrows are and abomination- of Satan’s
handiwork. Eschew such (abomination) that you may
prosper. Satan’s plan is (but) to excite enmity and
hatred between you with intoxicants and gambling
and hinder you from the remembrance of Allah (swt)
and from prayer. Will you not then abstain?”
2-26
 Sources of prohibition of
securitization of haram assets in Islam

iii) In relation to manufacturing and/or selling of haram

goods: “…surely Allah and His Messenger have
prohibited the sale of wine, the flesh of dead animals,
swine and idols. Then again, just like the above
example, Muslims are prohibited from investing in
companies by buying bonds of companies, which
securitize haram goods like statues that are used for
worshipping.
iv) In relation to gharar (uncertainty): “The Messenger
of Allah (swt) forbade the sale through fraudulent
means or sale by uncertainty.” 2-27
STRUCTURES OF ISLAMIC ASSET
SECURITIZATION

i) Murabahah
ii) Al-Bai-Bithaman-Ajil (ABBA)
iii) Ijarah
i) Istisna’

2-28
 Terminologies
 Disclosure regulation: To disclose material
information to all existing and potential investors.
 Asymmetric information: Different types of
information, different level of access and different
level of possession of information to different
interested parties.
 Agency problem: Confliction of interest between
managers and investors or owners.
 Insider trading: To trade between internal parties
for taking the advantage of immediate future price
change for important decisions made.
2-29