Banking & The Financial System

Financial System in Malaysia

• Consists of:
  • Banking institutions
  • Non-banking financial institutions

Banking Institutions

• Engage in taking deposits from the public and making loans.
• Provide services like investment banking, foreign exchange, and offer safe deposit boxes.
• Heavily regulated by governments for consumer protection and to ensure stability.
• Comprises:
  • Central bank (e.g., Bank Negara Malaysia)
    • Owned and controlled by the government.
  • Commercial banks
    • Profit-making institutions chartered by the government to engage in banking.

Non-Banking Financial Institutions (NBFIs)

• Do not have a full banking license and cannot accept deposits like traditional banks.
• Play a significant role by providing various financial services and products.
• Complement banking institutions by catering to specialized financial needs.
  • Insurance companies: Offer coverage for various risks.
  • Pension funds: Provide retirement planning and investment options.
  • Mutual funds: Pool funds from multiple investors.
  • Investment banks: Help companies raise money by issuing and selling securities; advise on mergers and acquisitions; trade stocks and bonds.

The Central Bank (e.g., BANK NEGARA MALAYSIA)

• A semi-independent government authority providing financial and banking services.
• Conducts monetary policy, controls banks, and issues currency to ensure financial stability.

Central Bank Functions

• To issue currency and safeguard its external value.
  • Issues and manages currency to ensure uniformity and stability since 1967.
• Banker to the government.
  • Keeps the government’s principle bank account.
  • Receives tax and other revenue.
  • Makes payments for government expenditures.
  • Finances the federal government.
  • Gives short-term advances, manages national debt, sells bonds, and redeems treasury bills.
• Banker to the banks.
  • Keeps cash reserves of commercial banks.
  • Acts as a custodian of the country's reserves.
• Promotes monetary stability.
  • Achieves stability through control of credit and money supply.
  • Uses quantitative and qualitative measures.
  • Low inflation ensures economic stability and preserves the value of money and savings.
• Holder of the country’s stock of gold and foreign currency reserves.
  • Manages foreign exchange reserves.
  • Implements government exchange rate and balance of payment policy.
• Lender of last resort.
  • Lends to banks facing liquidity shortages during financial crises to maintain public confidence.
  • Acts as lender of last resort to the government.

Monetary Policy

• Actions by a central bank to achieve sustainable economic growth by adjusting the money supply.
• Divided into:
  1. Quantitative instruments
  2. Qualitative instruments

Quantitative Instruments

• Bank Rate
• Bank Reserve Requirement
• Funding
• Open Market Operations

Qualitative Instruments

• Selective Credit Control
• Special Directive

Open Market Operations

• Central bank purchases or sells government-issued securities to affect the money supply.
  • Purchasing bonds increases money available for lending, increasing the money supply.

Bank Reserve Requirements

• Central banks set minimum reserve amounts for commercial banks.
  • Changing the required amount influences the money supply.
  • Increasing the reserve requirement reduces money available for banks to lend, decreasing the money supply.

Bank Rate (Discount Rate)

• Central bank influences interest rates by changing the discount rate.
  • Discount rate: Interest rate charged by a central bank to banks for short-term loans.
  • Increasing the discount rate raises borrowing costs for banks, leading them to increase interest rates for customers, thus decreasing the money supply.

Funding

• Conversion of short-term loans to long-term loans.
  • Enables commercial banks to create multiple credits.

Selective Credit Control

• Restricts credit expansion for specific purposes.
  • During inflation, the banking system can control credit through hire-purchase restrictions.

Special Directive

• Instructions to commercial banks to reduce lending volume to the public.
• Influence commercial banks to restrict their lending policies.
  • e.g., requiring collateral security, guarantors.

Monetary Policy Actions

• Contractionary (Inflation)
  • Bank Rate: Rise!
  • Bank Reserve Requirement: Rise!
  • Funding: Long-term!
  • Open Market Operation: Sell!
  • Selective Credit Control: Instruct!
  • Special Directive: Reduce! Restrict!
• Expansionary (Unemployment)
  • Bank Rate: Reduce!
  • Bank Reserve Requirement: Reduce!
  • Funding: Short-term!
  • Open Market Operation: Buy!
  • Selective Credit Control: Instruct Rise!
  • Special Directive: Not Restrict!

Commercial Bank

• Owned by the private sector; a profit-making institution.
• Earns income from banking services like current and savings accounts.
• Primary profit source: loans and investments.

Commercial Bank Functions

Accepting Deposits

• Banks depend on public deposits.
• Types of deposits:
  • Current deposits: Allow cheque withdrawals.
  • Savings deposits: Easy saving and withdrawal facilities.
  • Fixed or time deposits: Provide interest at maturity.

Providing Loans and Advances

• Offer loans and advances like housing, car, business, and personal loans.
• Charge interest rates to earn profit.
• Main income source through direct loans, overdrafts, and discounting bills of exchange.

Providing Other Banking Services and Facilities

• Credit card facilities and insurance coverage.
• Facilitating foreign exchange transactions.
• Issuing bank drafts, cheques, and traveler’s cheques.
• Purchasing and selling stock exchange securities.
• Providing safe deposit boxes.
• Providing fund transfers.
• Assistance on financial matters.
• Automated Teller Machines (ATMs).

Performing Credit Creation Process

• Provide loans and investments from deposits.
• Increase money supply while making profit.

Credit Creation by Banks

• The process where a small deposit leads to a greater increase in the money supply.

Assumptions in the Process of Credit Creation

• Cash reserve ratio is fixed.
• Customers deposit money in different banks.
• Bank's assets are only in the form of cash and loans.
• Commercial banks loan out all excess reserves.
• All transactions are made by checks.
• The public keeps their money in banks in current accounts.
• No leakages exist.
• Banks have only one liability (deposits).

Limitations of Credit Creation

• Amount of cash: Credit creation power depends on the amount of cash commercial banks possess.
• Legal reserve requirement or cash reserve ratio: Banks must keep a percentage of deposits in cash as reserves.
• Banking behaviors of the people: Well-established banking behaviors ensure multiple expansion of credit creation.
• Need for collateral securities: Collateral protects lenders against borrower default.
• Availability of borrowers: Lending is limited by the availability of borrowers.
• Excess reserves: Banks may maintain excess reserves if they anticipate rising interest rates or an economic recession.
• Currency drain: Occurs when someone withdraws cash instead of depositing checks, reducing banks’ capacity to create credit.
• Business conditions: Credit creation is affected by the cyclical nature of the economy.

Credit Creation Process (Balance Sheet)

• Cash Reserve = Initial Deposit x Cash Ratio
• Initial Loan = Initial Deposit - Cash Reserve
• Money Multiplier (MM) = $1 \over Cash Ratio$
• Total Money Supply = ${1 \over Cash Ratio}$ x Initial Deposit
• Total Reserved = ${1 \over Cash Ratio}$ x Cash Reserve
• Total Credit Creation = ${1 \over Cash Ratio}$ x Initial Loan
• Cash Ratio (CR) = $Cash Reserve \over Initial Deposit$ x 100

Example:

• If the cash ratio is 10% and the initial deposit = RM10,000:
  • Cash Reserve = 10,000 x 10% = RM1,000
  • Initial Loan = 10,000 – 1,000 = RM9,000
  • Money Multiplier = $1 \over 10$= 10
  • Total Money Supply = {1 \over 10%} x 10,000 = RM100,000
  • Total Reserved = {1 \over 10%} x 1,000 = RM10,000
  • Total Credit Creation = {1 \over 10%} x 9,000 = RM90,000
• If Cash Reserve = 60,000 & Initial Deposit = 200,000:
  • Cash Ratio = ${60,000 \over 200,000 }$x 100 = 30%