BBBM4103 Bank Management PDF

BBBM4103
BANK
MANAGEMENT
Shamsudin Ismail
Copyright © Open University Malaysia (OUM)

Project Directors: Prof Dato’ Dr Mansor Fadzil
Prof Dr Wardah Mohamad
Open University Malaysia
Module Writer: Shamsudin Ismail

Universiti Putra Malaysia
Moderator: Assoc Prof Dr Shamsubaridah Ramlee

Universiti Kebangsaan Malaysia
Developed by: Centre for Instructional Design and Technology

Open University Malaysia
Printed by: Meteor Doc. Sdn. Bhd.

Lot 47-48, Jalan SR 1/9, Seksyen 9,
Jalan Serdang Raya, Taman Serdang Raya,
43300 Seri Kembangan, Selangor Darul Ehsan
First Edition, August 2007

Second Edition, December 2013 (rs)
Copyright © Open University Malaysia (OUM), December 2013, BBBM4103
All rights reserved. No part of this work may be reproduced in any form or by any means
without the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide xi-xvi
Topic 1 Structure of Financial System in Malaysia 1

1.1 Financial System in Malaysia 2
1.2 Banking System 4
1.2.1 Bank Negara Malaysia 5
1.2.2 Commercial Banks 9
1.2.3 Islamic Banks 15
1.2.4 Investment Bank 15
1.2.5 Labuan Offshore Banks 17
1.3 Non-bank Financial Intermediary System 19
1.3.1 Institutions of Development Finance 21
1.3.2 Savings Institutions 22
1.3.3 Provident Funds, Pension Funds
and Insurance Companies 23
1.3.4 Other Non-bank Financial Institutions 28
1.4 Financial Markets 32
1.4.1 Money Market 32
1.4.2 Capital Market 37
Summary 40
Key Terms 40
Topic 2 Banking and Financial Institutions Act (BAFIA) 1989 41

2.1 Banking and Financial Institutions Act (BAFIA), 1989 42
2.2 New Provisions Under BAFIA, 1989 43
2.2.1 Licensing and Regulation 43
2.2.2 Management of Licensed Institutions 45
2.2.3 Ownership and Control of Licensed
Financial Institutions 45
2.2.4 Supervision and Control of Licensed
Financial Institutions 46
2.2.5 Power to Investigate, Search and Seize 48
2.2.6 Power and Duties of Auditors 48
2.2.7 Deposits Taking and Definition of Deposits 49
2.2.8 Secrecy 50
2.2.9 Electronic Funds Transfer 51
2.2.10 Penalty 51

iv X TABLE OF CONTENTS
2.3 The Effect of BAFIA, 1989 on the Management of

Commercial Banks 52
Summary 54
Key Terms 54
Topic 3 Branch Banking 55

3.1 Branch Banking 55
3.1.1 Advantages of Branch Banking 56
3.1.2 Disadvantages of Branch Banking 57
3.2 Problems of Branch Banking Management in Malaysia 58
3.2.1 Operational Problems 58
3.2.2 Staff Problems 61
3.2.3 Relationship Problems between Head Office
and Branches 63
3.2.4 Problems Pertaining to Business Promotion 66
3.2.5 Problems Pertaining to BranchesÊ Performance 67
Summary 73
Key Terms 73
Topic 4 Islamic Banking 74

4.1 History of the Development of Islamic Banking 75
4.2 Definition of Islamic Banking 76
4.3 The Differences between Conventional Banking and
Islamic Banking 80
4.4 Islamic Principles in Islamic Banking 82
4.5 Islamic Banking Products and Services 88
4.6 Latest Measures to Develop Islamic Banking 91
Summary 92
Key Terms 93
Topic 5 Asset Management 94

5.1 BankÊs Financial Statements 95
5.1.1 BankÊs Balance Sheet 95
5.1.2 BankÊs Income Statement 103
5.2 Asset Management 107
5.2.1 Elements of Asset Liquidity 108
5.2.2 Liquidity-profitability Dilemma 109
5.3 Fund Pool Method 109
5.3.1 Disadvantages of Fund Pool Method 111
5.4 Asset Allocation Method 112
5.5 Management Science Method 115
5.6 The Functions of Bank Liquidity 117
5.7 Bank Liquidity Theory 119

TABLE OF CONTENTS W v
5.8 Liquidity Measurement 120

5.8.1 Disadvantages of Loan-to-Deposit Ratio 121
5.9 Estimating Credit Requirement 123
Summary 126
Key Terms 127
Topic 6 BankÊs Liability Management 128

6.1 BankÊs Liability Management 128
6.2 Types and Characteristics of Bank Liabilities 129
6.3 Deposits 129
6.4 Factors Influencing BankÊs Deposit Level 135
6.4.1 Competitive Interest Rates 136
6.4.2 Staff and Other Physical Aspects of the Bank 137
6.4.3 Services Offered by the Banks 138
6.4.4 Key Strengths and Policies 138
6.4.5 Economic Activity Level 139
6.4.6 Location 139
6.4.7 Early Establishment Effect 139
Summary 140
Key Terms 140
Topic 7 Asset and Liability Management 141

7.1 BankÊs Asset and Liability Management 142
7.2 Fund Gap Management 143
7.2.1 Types of BankÊs Asset and Liability Management 143
7.2.2 Fund Gap Management in Different Interest
Rate Scenarios 146
7.2.3 Summary of Operation Action in Fund
Gap Management 150
Summary 150
Key Terms 151
Topic 8 BankÊs Capital Management 152

8.1 Definition of BankÊs Capital 153
8.1.1 Characteristics of BankÊs Capital 154
8.2 Functions of BankÊs Capital 157
8.3 BankÊs Capital and Bankruptcy Risk (Capital Risk) 160
8.4 The Effects of Capital Requirement on Bank Operations 163
Summary 165
Key Terns 165

vi X TABLE OF CONTENTS
Topic 9 Capital Adequacy 166

9.1 The Concept of Capital Adequacy 167
9.1.1 Capital Adequacy and BankÊs Security 168
9.2 Structure of Bank Capital 171
9.3 Capital Adequacy Measurement Methods 172
9.3.1 Capital Ratios 173
9.3.2 Capital Adequacy Ratios 175
9.3.3 Qualitative Measurement 182
9.4 Capital Adequacy and Bank Stability 184
Summary 187
Key Terns 188
Topic 10 Lending Policy 189

10.1 The Importance of Lending Activities 190
10.2 The Process of Lending 191
10.3 The Princples of Lending 192
10.3.1 Principle of Purpose 193
10.3.2 Principle of Payment 194
10.3.3 Principle of Protection 195
10.4 Documented Lending Policy 196
10.5 Factors Influencing Lending Policy 200
Summary 202
Key Terns 203
Topic 11 Credit Analysis 204

11.1 The Purposes of Credit Analysis 205
11.2 Credit Analysis Process 205
11.3 5C Credit Analysis Model 206
11.4 Scope of Credit Analysis 211
11.5 Ources of Credit Information 211
11.6 Evaluation of Financial Statements 214
11.7 Ratio Analysis 216
11.7.1 Liquidity Ratios 217
11.7.2 Asset Management Ratios 218
11.7.3 Financial Leverage Ratios 220
11.7.4 Profitability Ratios 221
11.8 Application of the 5C Credit Analysis Model 222
Summary 230
Key Terns 231

TABLE OF CONTENTS W vii
Topic 12 Pricing Policy 232

12.1 Pricing Policy 233
12.2 History of Pricing Policy Development 234
12.3 The Components of Base Lending Rate (BLR) 239
12.4 The Factors Influencing Pricing Policy 242
Summary 245
References 246
Topic 13 Collateral Policy 247

13.1 Why is Collateral Necessary? 248
13.2 Types of Collateral 249
13.3 Collateral Selection Criteria 252
13.4 Unsecured Loans 253
13.5 Loan to Collateral Ratio 254
Summary 255
Key Terns 256
Topic 14 Non-Performing Loan (NPL) Management 257

14.1 Definition of Non-performing Loan (NPL) 258
14.2 5Cs of Bad Credit 258
14.3 The Sources of Non-performing Loans (NPLs) 260
14.4 Detecting Non-performing Loans (NPLs) 261
14.5 Prevention of Non-performing Loans (NPLs) 266
14.6 Roles of Danaharta 269
14.7 Roles of Danamodal 270
14.8 Roles of Corporate Debt Restructuring Committee (CDRC) 272
14.9 The Effects of NPL on Commercial BankÊs Management 274
Summary 275
Key Terms 276
Answers 277

viii X TABLE OF CONTENTS

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COURSE GUIDE W xi
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBBM4103 Bank Management is one of the courses offered by the Faculty of
Business and Management, Open University Malaysia (OUM). This course is
worth three credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This is an elective course for students undergoing Bachelor of Business
Administration specialising in Finance.
As an open distance learner, you should be acquainted with learning

independently and be able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm that you have the
course material, know the course requirements and understand how the course is
conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

xii  COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussions 3
Study the module 60
Attend 3 to 5 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS 120
COURSE OUTCOMES
By the end of this course, you should be able to:
1. Discuss the effect of the Banking and Financial Institutions Act (BAFIA),
1989 on the operation and management of banks;
2. Explain in detail the factors influencing the legislation of important banking
policies such as pricing policy, lending policy, security policy and
investment policy;
3. Apply suitable techniques and methods to solve the financing and
investment problems of commercial banks;
4. Evaluate loan applications through credit analysis; and
5. Identify sources of non-performing loans and examine loan portfolio
problem.

COURSE GUIDE W xiii
COURSE SYNOPSIS
The course is divided into 14 topics. The synopsis for each topic is presented
below:
Topic 1 explains in detail the financial system in Malaysia and the roles played
by each of its components.
Topic 2 discusses the Banking and Financial Institutions Act (BAFIA), 1989,
which regulates the operation and management of commercial banks in
Malaysia.
Topic 3 discusses the advantages and disadvantages of branch banking as well as

branch banking management.
Topic 4 discusses Islamic banking from the aspect of dual banking, the
differences between Islamic banking and conventional banking as well as the
principles and products of Islamic banking.
Topic 5 discusses the three main methods used by banks when making
investment decisions, i.e. Savings Fund Method, Assets Provision Method and
Management Science Method.
Topic 6 discusses banksÊ main sources of funds and the strategies to acquire or
purchase the funds.
Topic 7 explains how gap analysis and futures method are used in managing
banksÊ assets and liabilities.
Topic 8 discusses banksÊ capital management by looking at the types and

elements of banksÊ capital, the roles of banksÊ capital and the special provisions
under BAFIA, 1989 on the requirement for banksÊ capital.
Topic 9 discusses adequacy of capital and the measurement for capital adequacy.
Topic 10 talks about lending policy of commercial banks and covers topics such
as lending process, principles of lending, basic elements of lending and factors
influencing lending policy.
Topic 11 focuses on commercial banksÊ credit analysis. Main topics in this

chapter are: framework of the 5C credit analysis, scope of credit analysis, sources
of credit information and ratio analysis.

xiv X COURSE GUIDE
Topic 12 explains commercial banksÊ pricing policy by exploring the historical

development of the pricing policy of commercial banks in Malaysia. Base
Lending Rate (BLR) is the focus of this topic.
Topic 13 discusses commercial banksÊ security policy through topics such as

types of security, rational for the requirement of security, security selection
criteria and lending,security ratio.
Topic 14 covers matters related to non-performing loans (NPL) such as the

sources of NPL, detection of NPL and prevention of NPL.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one sub-section or a few sub-
sections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
Activity: Like Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you to
solve questions, explore short case studies, or conduct an observation or research.
It may even require you to evaluate a given scenario. When you come across an
Activity, you should try to reflect on what you have gathered from the module and
apply it to real situations. You should, at the same time, engage yourself in higher
order thinking where you might be required to analyse, synthesise and evaluate
instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should

COURSE GUIDE W xv
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful

textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Learners of this course are required to pass the BBPB2103 Human Resource
Management course.
ASSESSMENT METHOD
Please refer to myVLE.
REFERENCES
Donald, R. F., Benton, E. G., & James, W. K. (2004). Commercial banking: The
management of risk (3rd ed.). South-Western College Publishing.
Peter, S. R. (2001). Commercial bank management (5th ed.). Boston: McGraw-

Hill. Shamsudin Ismail. (2002). Pengurusan bank perdagangan di Malaysia,
Jilid 1. Kuala Lumpur: Dewan Bahasa dan Pustaka.
Shamsudin Ismail. (2002). Pengurusan bank perdagangan di Malaysia, Jilid 2.

Kuala Lumpur: Dewan Bahasa dan Pustaka.
Shamsudin Ismail. (1989). A survey of commercial bank lending practices in

Malaysia, Siri Monograf No. 1. Kuala Lumpur: Institut Bank-Bank Malaysia
(IBBM).

xvi X COURSE GUIDE
Shamsudin Ismail, & Ee Kow Keang. (1991). A survey of local bank branch
management practices in Malaysia, Siri Monograf No. 2. Kuala Lumpur:
Institut Bank-Bank Malaysia (IBBM).
TAN SRI DR ABDULLAH SANUSI (TSDAS)

DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for the
use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books24x7, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.

Topic X Structure
1 of Financial
System in
Malaysia
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1." Explain the role of the banking system, non-bank financial
intermediary system and financial markets in MalaysiaÊs financial
system structure;
2." Identify various institutions in the banking system, non-bank
financial intermediary system and financial markets;
3." Discuss the roles and functions of commercial banks in detail ; and
4." Differentiate various types of financial instruments available in
the financial markets.
X" INTRODUCTION
Changes in the economic environment and the rapid advancement of technology
in the past decade have a tangible effect on the development of the financial
system at both domestic and global levels. Due to the changes in the global
financial industry, the financial system in Malaysia, especially the banking
industry, was forced to become more efficient and competitive. Financial Sector
Masterplan 2001 was outlined to form a strong, competitive and dynamic
financial system of best practices of a group of steady, far-sighted, technology-
oriented domestic financial institutions which would support and contribute
towards the economic growth of Malaysia. To achieve the objectives, the group
must also be ready to face the challenges posed by liberalisation and
globalisation of the financial industry.

2 X TOPIC 1 STRUCTURE OF FINANCIAL SYSTEM IN MALAYSIA
1.1 FINANCIAL SYSTEM IN MALAYSIA

The financial system acts as a mechanism that transfers fund from the party with
excess fund to the party that needs the fund. In general, a financial system
facilitates financial transactions that generate economic growth. MalaysiaÊs
financial system structure is divided into three parts, i.e. banking system, non-
bank financial intermediary system and financial markets (refer to Figure 1.1).
Financial Institutions Financial Markets

Banking System Money Market and Foreign Exchange
•" Bank Negara Malaysia •" Money Market
•" Banking Institutions •" Foreign Exchange Market
−" Commercial Banks
−" Finance Companies Capital Markets
−" Merchant Banks •" Equity Market
−" Islamic Banks •" Bond Market
•" Others
−" Discount Houses Derivative Market
−" Representative Offices of Foreign Off-shore Market
Banks •" Labuan Off-shore
−" Labuan Off-Shore Banks •" Foreign Finance Authority
Non-bank Financial Intermediaries
•" Employee Provident Fund and
Pension Fund
•" Insurance Companies
•" Including Takaful
•" Development Finance Institutions
•" Savings Institutions
−" Bank Simpanan Nasional
−" Co-operative Associations
−" Unit Trusts
−" Lembaga Tabung Haji
−" Housing Credit Institutions
−" Cagamas Berhad
−" Credit Guarantee Corporation
−" Leasing Companies
−" Factoring Companies
−" Venture Capital Companies
Figure 1.1: Financial System in Malaysia

Source: Bank Negara Malaysia and Financial System in Malaysia (2000)

TOPIC 1 STRUCTURE OF FINANCIAL SYSTEM IN MALAYSIA W 3
The structure of the Malaysian financial system is presented in Figure 1.1. During
the 1990s, the financial system was broadened with the introduction of the
Labuan International Offshore Financial Centre (IFOC) in 1990, an integrated
offshore centre that provided a wide range of offshore products. In addition, the
period also saw the introduction of the financial derivatives markets in 1995. In
terms of structure, the institutions can broadly be divided into the banking
system and the non-bank financial intermediaries.
Banking System
The banking system consists of BNM, the banking institutions and other financial
institutions, namely investment bank, the representative offices of foreign banks
and offshore banks in the International Offshore Financial Centre in Labuan.
BNM, as the central bank, is at the apex of the banking system, with exception of
the offshore banks operating in the Labuan IOFC which comes under the
purview of the Labuan Offshore Financial Services Authority (LOFSA). The
banking system is the largest component of the financial system.
The non-bank financial intermediaries (NBFIs) comprise five groups of

institutions, namely the provident and pension funds, insurance companies
(including takaful), the development finance institutions, the savings institutions,
and a group of other non-bank financial intermediaries. The NBFIs are
supervised by various Government departments and agencies. In addition, with
the enactment of the Banking and Financial Institutions Act 1989 (BAFIA),
companies involved in scheduled businesses such as leasing, factoring, building
credit, development finance and credit token businesses are required to register
and submit periodic returns to BNM for monitoring purposes.
Financial Markets
The financial markets in Malaysia comprise the money and foreign exchange
markets, capital markets, the derivatives markets and the offshore market.
The money market is an avenue for the channeling of short-term funds with
maturities typical;;y nor exceeding 12-month. It provides a ready source of funds
for market participants facing temporary shortfalls in funding, while at the same
time, providing short-term investment outlets for those with temporary surplus
funds.
The foreign market is the market for the trading of foreign currencies against
other foreign currencies. Dealings in the foreign exchange market can be
undertaken in the spot market as well as the forward and swap markets.

Capital markets are markets for raising long term funds and comprise the equity
and bond markets. The equity market provides the avenue for corporations to
raise funds by issuing stocks and shares. The bond market is the market through
which both the private and public sectors can raise funds, by issuing private debt
securities (PDS) and government securities respectively.
The derivatives markets are for trading instruments that provide contingent
claims on underlying assets, and whose values depend on the price of the
underlying assets or securities. The main use of derivatives is to hedge against
volatility in the price of the underlying assets, although it is possible to use
derivatives to speculate for capital gains.
The offshore market is a new addition to the financial landscape of Malaysia,

with the establishment of the Labuan International Offshore Financial Centre
(Labuan IOFC) in October 1990. The Labuan IOFC is aimed at enhancing the
attractiveness of Malaysia as a regional financial centre, as well as to promote the
economic development of Labuan and its vicinity.
Each component plays the respective roles for the well-being and stability of the
financial system.
In the evolution of MalaysiaÊs financial system, various financial intermediaries

have been formed and many types of financial instruments have been introduced
to facilitate the flow of funds between savings and investments. These financial
intermediaries and financial instruments have to be controlled in order to ensure
orderly economic growth.
1.2 BANKING SYSTEM
SELF-CHECK 1.1
Most of our financial matters involve transactions with banks. For
example, we borrow from banks to finance house and car purchases.
Banks provide other services such as deposits and withdrawal of
money. What do you understand of the banking system?

A banking system is one of the financial system intermediaries linking

financial institutions and individuals with excess funds, and financial
institutions and individuals with shortage of funds. In Malaysia, Bank
Negara Malaysia (BNM) regulates and controls banking institutions
comprising commercial banks, finance companies and merchant banks in
general.
Figure 1.2 shows an overview of the banking system in Malaysia.
Figure 1.2: Banking system in Malaysia
1.2.1 Bank Negara Malaysia

The Central Bank of Malaysia or Bank Negara Malaysia (BNM) was established
on 26 January 1959 under the Central Bank Ordinance 1958. The main objectives
of the establishment of BNM are to:
•" Supply currency, act as custodian of banksÊ reserves and control the value of
Malaysian currency;
•" Act as the governmentÊs banker and financial adviser;
•" Ensure financial stability and strong financial structure;
•" Act as commercial banksÊ banker; and
•" Control and influence the countryÊs credit situation to ensure a stable
economic growth rate.

(a)" Supply Currency, Act as Custodian of BanksÊ Reserve and Control the
Value of Malaysian Currency
BNM is the sole issuer and supplier of Malaysian money. It started issuing
its own money on 12 June 1967. The currency unit issued by BNM is Ringgit
Malaysia, which consists of 100 sen.
BNM is also responsible for the safe-keeping of reserves in order to protect

the Ringgit Malaysia currency. To safeguard the external value of Ringgit
Malaysia, external reserves amounting to as much as 80.59% of money
issued are allowed to be reserved by BNM, as provided under Section 29 of
the Central Bank Ordinance 1958. In 1998, BNM fixed the Ringgit exchange
rate at RM3.80 for every USD1.00, as a result of the economic crisis and
speculative attack against Ringgit Malaysia.
(b)" Act as GovernmentÊs Banker and Financial Adviser

BNM is the banker, financial agent, and financial adviser of the
government. As the governmentÊs financial agent, BNM has the
responsibility to represent the government in the civil loan programme and
manage the governmentÊs civil debts.
(c)" Ensure Financial Stability and Strong Financial Structure

As the party responsible for the countryÊs finances, BNM has the duty to
encourage financial stability and strong financial structure, and to influence
the credit situation in order to achieve overall economic objectives. BNM
has to ensure that the supply of money and credit are sufficiently elastic to
meet the needs of domestic economy without straining the available
resources. BNM controls the supply of money and credit in commercial
banks through financial control instruments such as statutory reserve
requirement, minimum liquidity requirement, open-market operation
and discount operation.
(d)" Act as Commercial BanksÊ Banker

As the banker of commercial banks, BNM has the responsibility to
encourage sturdy financial structure in the banking system. BNM does its
best to encourage and to preserve banking services and other services for
the public, and to achieve high banking and professional standards. BNM is
also given the mandate to issue licences for banks, examine financial
institutions and be the ultimate financier.

(e)" Control and Influence the CountryÊs Credit Situation to Ensure Stable
Economic Growth Rate
Controlling the supply of money and credit in the ountry is one of the key
roles of BNM. To achieve this goal, BNM controls the countryÊs finances
through various instruments. Among them are:
•" Statutory reserve requirement;
•" Minimum liquidity requirement;
•" Open-market operation;
•" Discount operation;
•" Interest rate control;
•" Credit control and lending guidelines; and
•" Moral persuasion.
(i)" Statutory Reserve Requirement

A portion of every Ringgit of deposit collected by banking institutions
is required to be deposited at BNM. Currently around, 3.5% of all
deposits collected by each bank must be deposited at BNM as
statutory reserves without interest payment as a measure to safeguard
the interest of the depositors.
As a financial control tool, BNM will increase the statutory reserve

ratio if contractionary monetary policy is practised and decrease the
ratio if inflationary monetary policy is implemented. When BNM
increases the statutory reserve ratio, commercial banks must keep
more reserves at BNM. This will reduce the banksÊ capacity to lend to
their customers and consequently, reduce the supply of money in the
countryÊs economy. Conversely, if BNM decreases the statutory
reserve ratio, the supply of money in the countryÊs economy will
increase as the banksÊ capacity to lend increases.
(ii)" Minimum Liquidity Requirement

Under section 38(1), Banking and Financial Institutions Act (BAFIA),
1989, banking institutions are required to comply with the minimum
liquidity ratio so as to ensure that there is always sufficient liquid to
meet deposit withdrawals. Currently, banking institutions are
required to keep 15% of all deposits collected in the form of liquid
assets, which include cash, balance with BNM, call money, treasury
bills, Cagamas bonds and other government securities. Like statutory
reserve requirement, minimum liquidity requirement is also a
financial control tool.
(iii)" Open-market Operation

Open-market Operation (OMO) involves the buying and selling of
government securities in the open market by the central bank with the
objective of directly influencing the supply of money in the economic
system. When BNM decides to buy government securities (for
example, Treasury Bills), it practises inflationary monetary policy as it
effectively injects money into the banking system. If BNM sells
government securities, it is considered practising contractionary
monetary policy as money is withdrawn from the banking system.
(iv)" Discount Operation

Commercial banks can borrow funds from BNM through discount
window at the central bank. Money supply will increase when
commercial banks use such loan facility. BNMÊs role is to control the
interest rate or discount rate on this loan facility. BNM can reduce the
discount rate in order to encourage borrowing by banks.
(v)" Interest Rate Control

BNM can influence banksÊ availability as well as cost of credit by
controlling bank loan interest rates and deposit interest rates. Changes
in interest rates can encourage and discourage the suppliers of fund
(banksÊ depositors) and the users of fund (banksÊ borrowers). Initially,
BNM had the absolute power to determine deposit interest rates and
bank loan interest rates. However, BNM subsequently allowed market
force to determine loan interest rates through the Base Lending Rate
(BLR) concept.
The use of BLR has its setback, and most importantly, in determining
the suitable cost of fund. At present, cost of fund (the biggest
component in BLR) is determined by BNMÊs intervention rate. If there
is excess liquidity in the banking system, BNM reduces the liquidity
by increasing interest rate. As a result, the cost of borrowing increases
and the level of borrowing from commercial banks decreases.
(vi)" Credit Control and Lending Guidelines

Apart from the above, BNM also controls money supply in the
economy through credit control and lending guidelines as well. For
example, previously, hire-purchase financing grew out of control to
the extent that BNM became very concerned about the matter. Such
activity was the source of excess liquidity in the banking system and
contributed to the increase in inflation rate in the economic system.
Taking cautious measures, BNM issued directives to restrain the hire-
purchase activity by imposing stringent terms and conditions for hire-

purchase such as shorter loan period and increased percentage for

advance deposit.
BNM has the power to set guidelines for specific economic sectors too.
For example, BNM has resolved that agricultural loans, small and
medium industries (SMI) loans and housing loans are priority sector
loans accorded with special privileges in terms of cost of borrowing
and availability of fund.
(vii) Moral Persuasion

Moral persuasion refers to the influence by BNM or its governor on
commercial banks to implement a proposed policy. For example,
when there was high level of lending to the construction and real
estate sector, BNM advised banks to limit their lending to the sector to
30% of the total approved loans. At present, such technique is no
longer effective and BNM has to issue written directives with legal
impact.
ACTIVITY 1.1
What would happen to the countryÊs financial system if Bank Negara

Malaysia (BNM) did not exist or there were more than one central
bank?
1.2.2 Commercial Banks
EXERCISE 1.1
1." Discuss the ways used by Bank Negara Malaysia (BNM) to control
the supply of money in the Malaysian financial system.
2." Bank Negara Malaysia (BNM) intends to practise tighter monetary
policy to overcome inflation problem in our economy. What can
BNM do to achieve such an objective?

Section 2, BAFIA 1989 defines a commercial bank as an entity that carries out
banking businesses which in turn are defined as:
(a)" Businesses that involve the following:

(i)" Accepting deposits for current accounts, deposit accounts, savings
accounts and other similar accounts;
(ii)" Making payment to or collecting cheques written by or paid by the
customers; and
(iii)" Providing financing through:
•" Lending;
•" Leasing;
•" Factoring;
•" Purchase of bills of exchange, promissory notes, deposit
certificates, debentures or other tradeable instruments; and
•" Acceptance of or guarantee for an individualÊs liabilities.
(b)" Other businesses as permitted by the central bank and approved by the
Ministry of Finance.
Commercial banks are the largest group of financial institutions in
Malaysia. At the end of 2001, 74.2% of total deposits and 40.9% of total
assets in MalaysiaÊs financial system were held by commercial banks, and
71% of loans offered by the system were from commercial banks. At the end
of 2000, commercial banks held 70.7% of total deposits and 41.3% of total
assets, and offered 75.8% of total loans and advances.
Commercial banking system is the principal axis of a financial system.

Failure of a commercial bank will have an impact on the commercial
banking system, the financial system and the entire economic system of the
country.
Table 1.1 shows the list of commercial banks in Malaysia. There are 27
commercial banks, out of which 8 are locally owned and the remaining 19
are foreign owned.

Table 1.1: Commercial Banks in Malaysia
No. Name Ownership

1. Affin Bank Berhad L
2. Alliance Bank Malaysia Berhad L
3. AmBank (M) Berhad L
4. BNP Paribas Malaysia Berhad F
5. Bangkok Bank Berhad F
6. Bank of America Malaysia Berhad F
7. Bank of China (Malaysia) Berhad F
8. Bank of Tokyo-Mitsubishi UFJ (Malaysia) Berhad F
9. CIMB Bank Berhad L
10. Citibank Berhad F
11. Deutsche Bank (Malaysia) Berhad F
12. HSBC Bank Malaysia Berhad F
13. Hong Leong Bank Berhad L
14. India International Bank (Malaysia) Berhad F
15. Industrial and Commercial Bank of China (Malaysia) Berhad F
16. J.P. Morgan Chase Bank Berhad F
17. Malayan Banking Berhad L
18. Mizuho Corporate Bank (Malaysia) Berhad F
19. National Bank of Abu Dhabi Malaysia Berhad F
20. OCBC Bank (Malaysia) Berhad F
21. Public Bank Berhad L
22. RHB Bank Berhad L
23. Standard Charted Bank Malaysia Berhad F
24. Sumitimi Mitsui Banking Corporation Malaysia Berhad F
25. The Bank of Nova Scotia Berhad F
26. The Royal Bank of Scotland Berhad F
27. United Overseas Bank (Malaysia) Bhd. F
Source: http://www.bnm.gov.my

The roles and importance of commercial banks to the economy can be

understood from the following main functions of commercial banks:
•" Creating money;
•" Providing payment mechanism;
•" Collect savings;
•" Providing credit; and
•" Financing international trades.
(a)" Creating Money

One of the key functions of commercial banks is their capability to create
and eliminate money through lending and investment activities with the
co-operation of the central bank.
How does a commercial bank create money? At the end of 1993, there was
RM14.6 billion of money and RM28 billion of current deposits in the
country. How could the current deposits be more than the money in
circulation?
This happens because commercial banks create money in the form of

deposits. Every bank creates deposits and a portion of the new deposits can
be refinanced to create more deposits. This process continues until the new
deposits are a few times more than the original amount. Please refer to
Example 1.1 for illustration.
Example 1.1
(a)" Bank X gives Mr. A an overdraft of RM200 to purchase a radio. Mr. A

pays the radio vendor by cheque.
(b)" When the radio vendor deposits the cheque into his current account in
Bank Y, a new deposit of RM200 is created.

Bank Y keeps 20% of the deposits in its reserves and lends the balance
totalling RM160 (i.e. 80% x RM200) to Mr. B to purchase office
furniture. Mr. B pays the furniture vendor by cheque.
Bank Y
Deposits RM200 Reserves RM40
Loans RM160
(c)" When the furniture vendor deposits the cheque into his current
account in Bank Z, a new deposit of RM160 is created.
Subsequently Bank Z keeps 20% of the deposits in its reserves and

lends the balance totalling RM128 (i.e. 80% x RM160) to Mr. C to
purchase car spare parts. Mr. C pays by cheque.
When the car spare part vendor deposits the cheque into his current
account in a bank, new deposits of RM128 are created.
Bank Z
Deposits RM16 Reserves RM32
Loans RM128
(d) The creation process (b to c) continues and will only cease if the car
spare parts vendor spends or hides away all RM128 earned from the
sale.
From the above example, the creation process continues and will only stop
if the car spare part vendor spends or hides away all RM128 earned from
the sale. If the creation process takes place continuously, the original
overdraft of RM200 can create deposits amounting to RM1,000. How do we
get this sum? Please refer to Example 1.2.
Example 1.2
Radio Vendor Ês Deposits = RM200

Furniture Vendor Ês Deposits = RM200 x (80/100)
= RM200 x (80/100)1
= RM160
Spare Part Vendor Ês Deposits = RM200 x (80/100) x (80/100)

= RM200 x (80/100)2
= RM128

If the creation process continues (until the final round of deposits is close to
zero), the fractional exponent will increase. Mathematically, the total
amount of created deposits can be calculated by using the following
formula:
⎡1⎤
Total deposit = p ⎢ ⎥
⎣r⎦
Where:
P = Original value of deposits

r = Ratio of cash needed by the bank
(You do not have to know how the formula is obtained, but you need to
know the logic of how the formula is obtained.)
Based on Example 1.1, the amount of money created by banks is:
⎡1⎤
Total deposit = P ⎢ ⎥
⎣r⎦
⎡1 ⎤
= 200 ⎢ 20 ⎥
⎢ 100 ⎥
⎣ ⎦
= 200 ( 5 )
= 1, 000
Commercial banksÊ capability to create credit is very important to a

countryÊs economy because such capability helps build an elastic credit
system for economic progress. Without bankÊs credit, business are unable to
grow and operate smoothly.
(b)" Providing Payment Mechanism

One of the important functions of commercial banks is the provision of a
mechanism to pay or move funds. This function has become increasingly
important as the usage of cheques and credit cards increases from time to
time. All the cheques in our country are cleared through banking system
using computer technology that speeds up cheque clearance process,
reduces clearing cost and improves clearing accuracy.
(c)" Collecting Savings

Commercial banks provide services which are very important to all
economic sectors by making available the facility to collect savings that can

be used for economic and social purposes. Depositors are paid interest on
their savings at commercial banks. The collected funds are then lent to
traders and consumers. In other words, commercial banks are important
financial intermediaries for our countryÊs economy.
(d)" Providing Credit

Another key function of commercial banks is its provision of credit to
qualified customers. Bank credit helps elevate output level, further expand
investment capital and improve the living standard of the society. Bank
credit is important to finance agricultural, trade and industrial activities.
Without sufficient bank credit, economic activities will be stunted.
(e)" Financing International Trades

Basically international trades and domestic trades are similar. Nevertheless,
there are a few differences that made it necessary for banks to offer
international banking services. Such differences exist as financial systems
and economies differ across the various countries. In addition, difficulty in
securing payment guarantee makes the special services provided by
commercial banks crucial. Commercial banks provide financing for import
and export activities through various trade finance facilities.
1.2.3 Islamic Banks

Islamic banks are commercial banks operating in accordance with Islamic law or
Syariah Islam which forbids the element of interest or usury. At present, there are
two Islamic banks in Malaysia, i.e. Bank Islam Malaysia Berhad (BIMB) and Bank
Muamalat Malaysia Berhad (BMMB). BIMB was the first Islamic bank that
operated under Islamic Bank Act, 1983, followed by Bank Muamalat Malaysia
Berhad (BMMB) which was established in 2001. These two banks offer products
and services similar to those offered by ordinary commercial banks except that
they follow the syariah law. Financial products and services following the Islamic
principles will be discussed in detail in Topic 4.
1.2.4 Investment Bank

The establishment of investment banks, in line with the recommendation of the
Financial Sector Masterplan, aims to strengthen the capacity and capabilities of
domestic banking groups through internal rationalisation so that they can contribute
to the economic transformation process and better face the challenges of liberalisation
and globalisation. Following the successful rationalisation of the commercial banks
and finance companies within the banking groups, the model is now extended to the
merchant banks, discount houses and stockbroking companies within the banking

groups to achieve greater efficiency and effectiveness. With enhanced capacity, the
new investment banks would also play a greater role in developing a more dynamic
and efficient domestic capital market.
The framework for the investment bank has been developed by Bank Negara
Malaysia (BNM) and the Securities Commission (SC) based on the following
principles:-
•" Enhancing the scope of activities for the merged entity;
•" Enhancing capacity for growth and business expansion through industry
wide rationalisation; and
•" Minimising unnecessary regulatory burden that may arise from the dual
regulatory regime.
The Guidelines on Investment Banks (the Guidelines) are therefore issued jointly
by BNM and the SC pursuant to Section 126 of the Banking and Financial
Institutions Act 1989 (BAFIA) and Section 158 of the Securities Commission Act
1993 (SCA). It sets out the requirements and processes for the setting up of the
investment bank and the regulatory framework within which the investment
bank would operate.
The setting up of investment banks would require the existing merchant banks,
stockbroking companies, which has complied with the Framework on
Consolidation of Stockbroking Companies that was issued by the SC on 21 April
2000, and discount houses within the same banking groups to be merged before
the new entities are transformed into investment banks. While the consolidation
may involve entities conducting futures business within the banking group,
flexibility would be allowed for investment banks to retain such entities as
separate subsidiaries.
Stand-alone discount houses (that are not part of any banking group) would be
required to merge with another discount house to become a merchant bank.
These institutions will then be transformed into investment banks, upon their
merger with a stock broking company which has complied with the SC
Framework on Consolidation of Stock broking Companies.
Investment banks will continue to be able to conduct activities based on the types
of licences the investment bank entity held prior to the rationalisation. In
addition, investment banks will also be allowed to undertake fund management
and unit trust businesses in line with securities laws and guidelines issued by the
SC. Such businesses will be prescribed as additional businesses under merchant
banking business under Section 2 of BAFIA. Table1.2 shows a list of investment
banks in Malaysia.
Table 1.2: Investment Banks in Malaysia
Investment Banks
No. Name Ownership
1. Affin Investment Bank Berhad L
2. Allience Investment Bank Berhad L
3. AmInvestment Bank Berhad L
4. CIMB Investment Bank Berhad L
5. ECM Libra Investment Bank Berhad L
6. Hong Leong Investment Bank Berhad L
7. HwangDBS Investment Bank Berhad L
8. KAF Investment Bank Berhad L
9. Kenanga Investment Bank Berhad L
10. MIDF Amanah Investment Bank Berhad L
11. MIMB Investment Bank Berhad L
12. Maybank Investment Bank Berhad L
13. OSK Investment Bank Berhad L
14. Public Investment Bank Berhad L
15. RHB Investment Bank berhad L
Source: http://www.bnm.gov.my (2013)
1.2.5 Labuan Offshore Banks

On 1 October 1990, International Offshore Financial Centre (IOFC) was set up in
Labuan to enable local as well as international companies and investors to carry
out investment and financial activities at international level. These activities
include those related to banking, financing, corporate restructuring, insurance
and credit. Offshore banks are commercial banks set up at Labuan IOFC under
the Offshore Banking Act 1990. Financial activities at IOFC are conducted in
foreign currencies except for Ringgit Malaysia.
For example, offshore banks in Labuan are allowed to provide loans quoted in
any foreign currency such as US Dollar, but they are not permitted to offer loans
quoted in Ringgit Malaysia.

Banking services and facilities offered by offshore banks are as follows:

(a)" Open deposit accounts in the form of Multiple Currency Account (MCA) or
in any major currency (except for Ringgit Malaysia) for Malaysians and
foreigners.
(b)" Open current accounts for customers but no cheques will be issued.
Payments and funds transfers are done via written instructions.
(c)" Offer trade finance facilities such as Letters of Credit, BankersÊ Acceptances
or (BA), and trust receipts. All facilities are in foreign currencies.
(d)" Prepare remittances for international payments and receipts and allow
customers to buy and sell foreign currencies in spot exchange market,
forward market or through SWAPs. SWAP means exchange, i.e. a foreign
currency can be bought through SWAP agreement by which a foreign
currency can be exchanged with another foreign currency to reduce foreign
exchange risk or speculation activities.
(e)" Provide various types of offshore loans and financing facilities such as term
loans and revolving credits. Offshore banks also provide advisory services
related to acquisitions and restructuring of companies.
Representative Offices Of Foreign Bank

Foreign institutions intending to establish representative offices in Malaysia must
obtain the prior written approval from Bank Negara Malaysia (or „the Bank‰).
The representative offices of foreign institutions are not required to pay any fees
to Bank Negara Malaysia for the establishment of the representative offices. The
prior written consent of the Minister of Finance is required for the representative
offices to use the word „bank‰ or its equivalent or any other name prohibited
under Section 15 of the Banking and Financial Institutions Act 1989 (BAFIA), in
their names.
„Foreign institution‰ as defined under Section 2 of the BAFIA means a person,

not being a licensed institution or a scheduled institution, which carries on any
business outside Malaysia, which corresponds, or is similar to the business of a
licensed institution or scheduled institution such as banking business, investment
bank, money broking business, building credit business, development finance
business, factoring business and leasing business. The establishment and
maintenance of representative offices in Malaysia by foreign institutions are
subject to the relevant provisions of PART III of the BAFIA.
Please refer to page ....... for list of licensed insurance companies and takaful
operators in Malaysia.

ACTIVITY 1.2
The Banking system in Malaysia consists of various types of financial

institutions playing their respective and important roles in MalaysiaÊs
financial system.
Based on your comprehension and research at the myOUM Digital

Library, complete the following table:
Type of Institution Role/Importance

Bank Negara Malaysia
Commercial Banks
Islamic Banks
Instruments Bonds
Offshore Banks
1.3 NON-BANK FINANCIAL INTERMEDIARY

SYSTEM
ACTIVITY 1.3
We have talked about the financial system and the banking system.
What do you understand about the non-bank financial intermediary
system, based on your comprehension and experience in banking and
financial matters?

Like banking, financial institutions, non-bank financial intermediaries also

play the role of matching the parties with excess funds with the parties with
shortage of funds.
The difference being the banking system is directly under BNMÊs regulation,
while non-banking financial intermediary system is under the direct control
of various government departments and agencies and indirectly under BNM
through periodic reporting.
Financial institutions in the non-bank financial intermediary system are divided

into four groups, as shown in Figure 1.3.
Figure 1.3: Non-bank financial intermediary system
Generally, financial institutions in the non-bank financial intermediary system

are controlled by various government departments and agencies. For example,
Bank Simpanan Nasional (savings institution) is under the control of the Ministry
of Finance, Malaysian Industrial Development Finance Berhad (MIDF) is under
the Ministry of Plantation Industries and Commodities, and deposit taking
cooperatives under the Ministry of Entrepreneurial and Cooperative
Development. BAFIA 1989 provides that financial institutions in the non-bank
financial intermediary system shall also be controlled by Bank Negara Malaysia
indirectly through periodic reporting.

1.3.1 Institutions of Development Finance

Institutions of development finance have the specific purpose of providing
medium and long term capital, as well as mobilising savings, economic activities
and expertise with an aim to promote investment in the industrial and
agricultural sectors. The role is executed by way of financial assistance, equity
participation and acting as guarantor for borrowers.
These institutions also help to identify new projects, make available additional
financial assistance and provide technical and management advice. The role of
institutions of development finance complements the services offered by commercial
banks and finance companies. Institutions of development finance in Malaysia are:
(a)" DFIs Prescribed Under Development Financial Institutions Act 2002

(i) Bank Pembangunan Malaysia Berhad
(ii) Bank Perusahaan Kecil & Sederhana Malaysia Berhad (SME Bank)
(iii) Export – Import Bank of Malaysia Berhad (EXIM Bank)
(iv) Bank Kerjasama Rakyat Malaysia Berhad
(v) Bank Simpanan Nasional
(vi) Bank Pertanian Malaysia Berhad (Agrobank)
(b)" Other DFIs (not prescribed under Development FinancialInstitutions Act 2002)
(i) Malaysian Industrial Development Finance Berhad
(ii) Credit Guarantee Corporation Berhad
(iii) Lembaga Tabung Haji
(iv) Sabah develooment Bank Berhad
(v) Sabah Credit Corporation
(vi) Borneo Dvelopment Corp.
(vii) Borneo Dvelopment Corp. (Sarawak) Sdn. Bhd.
Institutions of development finance are expected to play a bigger role in

financing and development as a result of the government policy aiming to make
Malaysia an industrial country by 2020. However, institutions of development
finance face intense challenge from other financial institutions which are more
development-oriented.

Commercial banks, finance companies and merchant banks have begun to

replace institutions of development finance in the financing of lower risk but
more profitable business development ventures. New ventures of higher risk are
financed by development banks. Nevertheless, the government is expected to
provide the necessary incentives to improve the efficiency and effectives of the
institutions of development finance in order to intensify industrial development
in the country.
1.3.2 Savings Institutions

Even though commercial banks and finance companies are the two biggest
groups of deposit collecting institutions in Malaysia, there exists other savings
institutions which promote and mobilise savings of the middle and lower income
groups, especially those from the rural areas. These savings institutions depend
mostly on the network of branches and other offices as well as large potential
customer base to collect huge amount of savings. Savings institutions in Malaysia
are:
•" Bank Simpanan Nasional (BSN)
•" Co-operative societies
(a)" Bank Simpanan Nasional

Bank Simpanan Nasional (BSN), established through reorganisation of the
post office system, is the main savings institution in Malaysia. BSN was set
up mainly to promote the savings habit. The establishment of BSN was a
strategy to build up personal savings to finance the countryÊs economic
development programmes. It functioned as a civil debt holder. However,
this function has weakened over time due to declining rate of deposits
growth at BSN and competition from commercial banks and finance
companies.
Savings deposited at BSN are guaranteed by the government. BSN uses

post office network, mobile vans and branches to provide services to
customers at places lacking in the services of commercial banks and finance
companies.
(b)" Co-operative Societies

In Malaysia, a co-operative society is defined under Co-operative Societies
Ordinance 1948 as:

ÂA society that aims to improve its membersÊ interests through co-

operative principles.Ê
In general, co-operative societies are not actual financial intermediaries.

Many co-operative societies in Malaysia provide financial intermediary
services. For example, they accumulate savings/funds through share
investments and deposits and channel the funds in the form of loans to
members. Credit co-operatives, like Bank Rakyat, mobilise large quantity of
funds not only from its members, but from the public too, to finance the
bankÊs lending operation.
ACTIVITY 1.4
Are savings institutions still needed since commercial banks and finance
companies also collect deposits in addition to providing other banking
services?
1.3.3 Provident Funds, Pension Funds and Insurance

Companies
Provident funds, pension funds and insurance companies form the biggest group
of non-bank financial intermediaries. They mobilise financial resources from
their members in the form of contributions, pensions and insurance premiums to
retirement schemes and insurance schemes. Contractual and long term savings
are stable financial sources for institutions making long term investments.
(a)" Provident and Pension Funds

Provident and pension funds are financial intermediaries that collect funds
from workers and provide funds during a worker Ês old age. Every worker
is required to contribute a portion of their respective salaries to the funds.
Employers also contribute to the funds for their workers. Some companies
also provide additional pension funds for their retired workers. These
funds are aimed to help meet the workersÊ cost of living during retirement.
Examples of provident and pension funds in Malaysia are:

•" Kumpulan Wang Simpanan Pekerja (KWSP);
•" Kumpulan Wang Simpanan Guru-Guru (KWSG);

•" Tabung Angkatan Tentera; and

•" Pertubuhan Keselamatan Sosial (PERKESO).
(b)" Insurance Companies

Insurance funds are funds collected in the form of insurance premiums
paid by insurance policy holders for protection against calamities such as
loss of working capability, illness, fire, accident and theft.
In Malaysia, there are two types of insurance businesses, i.e. life insurance
and general insurance.
•" Life insurance is for the protection against risks related to death, loss of
working capability and major illness.
•" General insurance covers non-life insurance, i.e. losses as a result of fire,
accident or theft.
Occasionally, insurance companies are unable to sell insurance against

certain risks when the risk is too high for them to bear. It is not uncommon
for an insurance company to share its high risk businesses with other
insurance companies known as reinsurer companies.
Islamic insurance business was introduced on 24 November 1984 by

Syarikat Takaful Malaysia Sdn. Bhd. This company offers Takaful Keluarga
(Life) and Takaful Am (General). Islamic insurance is insurance business
conducted in accordance with Islamic principles.
Insurance and Takaful

Developments in the financial market and increasing competition have
spurred greater innovation within the insurance and takaful industry with
a wider diversity of products and services being made available to
consumers. At the same time, trends towards financial convergence have
significantly broadened the market segments in which insurers and takaful
operators compete.
Against these developments, the regulatory framework for insurance and

takaful products has been reviewed to further enhance consumer protection
while according greater flexibility for insurers and takaful operators to
respond to changing market conditions, both in managing risks and
enhancing their competitiveness.

The revised regulatory framework set out in these Guidelines for the
introduction of new products aims to:
(i)" Improve the time-to-market for insurance companies and takaful
operators to introduce new products, or to effect changes to existing
products;
(ii)" Promote sound risk management practices in managing and
controlling product risk by ensuring the appropriate assessment and
mitigation of risk during the product development and marketing
stages; and
(iii)" Further strengthen the duty of care owed to consumers in ensuring
that products developed and marketed are appropriate to the needs,
resources and financial capability of targeted consumer segments.
With the increased flexibility provided to insurance companies and takaful

operators under these Guidelines, greater responsibility is placed on the
board and senior management to ensure that product risks are well
managed, and the needs and rights of consumers are respected. These
responsibilities will continue to be reinforced by the Bank through its
supervisory reviews and enforcement actions taken to protect consumers
and promote sound risk management practices.
Licensed insurane companies and Takaful Operators in Malaysia include:
Insurance and Takaful Companies
(a)" Life and General Business

•" American International Assurance Bhd
•" Etiqa Insurance Berhad
•" ING Insurance Berhad
•" MCIS Zurich Insurance Berhad
•" Prudential Assurance Malaysia Berhad
•" Zurich Insurance Malaysia Berhad
(b)" Life Business Only

•" AXA Affin Life Insurance Berhad
•" Allianz Life Insurance Malaysia Berhad
•" AmLife Insurance Berhad
•" CIMB Aviva Assurance Berhad
•" Great Eastern Life Assurance (Malaysia) Berhad
•" Hong Leong Assurance Berhad
•" Manulife Insurance Berhad

•" Tokio Marine Life Insurance Malaysia Bhd

•" Uni.Asia Life Assurance BerhadL
(c)" General Business

•" ACE Jerneh Insurance Berhad
•" AIG Malaysia Insurance Berhad
•" AXA Affin General Insurance Berhad
•" Allianz General Insurance Company (Malaysia) Berhad
•" AmG Insurance Berhad
•" Berjaya Sompo Insurance Berhad
•" Danajamin Nasional Berhad
•" Kurnia Insurans (Malaysia) Berhad
•" Lonpac Insurance Berhad
•" MSIG Insurance (Malaysia) Bhd
•" Multi-Purpose Insurans Berhad
•" Overseas Assurance Corporation (Malaysia) Berhad
•" Pacific & Orient Insurance Co. Berhad
•" Pacific Insurance Berhad,
•" Progressive Insurance Berhad
•" QBE Insurance (Malaysia) Berhad
•" RHB Insurance Berhad
•" Tokio Marine Insurans (Malaysia) Berhad
•" Tune Insurance Malaysia Berhad
•" Uni.Asia General Insurance Berhad
(d)" Life and General Reinsurance Business

•" Hannover Rueckversicherungs AG
•" ife Reinsurance Business
•" Malaysian Life Reinsurance Group Berhad
(e)" General Reinsurance Business

•" Asia Capital Reinsurance Malaysia Sdn. Bhd.
•" Malaysian Reinsurance Berhad
•" Munchener Ruckversicherungs-Gesellschaft
•" Swiss Reinsurance Company
•" Toa Reinsurance Company Ltd., The


(f)" Takaful Operators

•" AIA AFG Takaful Bhd.
•" AmFamily Takaful Berhad
•" CIMB Aviva Takaful Berhad
•" Etiqa Takaful Berhad
•" Great Eastern Takaful Sdn Bhd
•" HSBC Amanah Takaful (Malaysia) Sdn Bhd
•" Hong Leong MSIG Takaful Berhad
•" ING PUBLIC Takaful Ehsan Berhad
•" MAA Takaful Berhad
•" Prudential BSN Takaful Berhad
•" Syarikat Takaful Malaysia Berhad
•" Takaful Ikhlas Sdn. Bhd.
(g)" Retakaful Operators

•" ACR Retakaful Berhad
•" MNRB Retakaful Berhad
•" Munchener Ruckversicherungs-Gesellschaft (Munich Re Retakaful)
•" Swiss Reinsurance Company Ltd. (Swiss Re Retakaful)
On 1 April 1988, the duty to supervise insurance companies was transferred from
the Treasury to BNM. Following that, the Governor of BNM assumed the role of
Director General of Insurance with effect from 1 May 1988.
Provident funds, pension funds and insurance companies play two important
roles in the economy of Malaysia. Firstly, they provide financial protection
measures during retirement or in the event of death or disability. i.e. they
provide financial assistance when the membersÊ normal stream of income
deteriorates or ceases. Secondly, they move and re-channel long term savings
into private as well as public sectors to finance long term investments.

1.3.4 Other Non-bank Financial Institutions

The following are other non-bank financial institutions:
(a)" Unit Trust Companies

Unit trust companies act as financial intermediaries for small investors
wishing to own shares in various portfolios of companies. Unit trust
ownership provides the investors with advantages in terms of diversity,
choices and professional investment management. Generally unit trust
involves three parties, professional trust fund manager, trustee and unit
holder. In Malaysia, the trustee for all unit trusts is the Public Trustee of
Malaysia.
Unit trust companies are a new phenomenon in our country when

compared to the United Kingdom. The first unit trust company in Malaysia,
Amanah Saham Malaya Berhad, was established in 1959 while the first unit
trust company in the United Kingdom was established in the 19th century,
i.e. in 1868. As at the end of 1980, there were five unit trust companies
managing 21 unit trust funds in Malaysia. Until 1980, the size of unit trust
fund in Malaysia was considered small as compared to the funds at other
financial institutions. The launch of the Amanah Saham Nasional Scheme
(ASN) in April 1981 stimulated the unit trust industry and in January 1990,
the Amanah Saham Bumiputera Scheme (ASB) was founded. These two
unit trust schemes have triggered the expansion of unit trust fund
impressively.
Unit trust in Malaysia is governed by the Trustee Act 1949 (Amendment

1978), Section 84-97 of the Companies Act 1965, the Securities Industry Act
1983 and Trust Deeds. Prior to 1978, unit trust investment was controlled by
terms and conditions imposed by the Trustee Act 1949 and Trustee
Investments Act 1965. These two acts were reviewed and combined in 1978
to produce the Trustee Act 1949 (amendment 1978). The operation of unit
trust companies is monitored by the Securities Commission.
(b)" Housing Credit Institutions

Housing credit institutions provide housing loans. The government
encourages house ownership by Malaysians, and ensures that the public,
especially those with low income, have the opportunity to have their own
houses. The government focuses its effort on providing low cost housing
while the housing credit needs of middle and high income groups are
catered to by commercial banks, finance companies, housing cooperatives
and two housing credit institutions, i.e. Malaysia Building Society Berhad
(MBSB) and Borneo Housing Mortgage Finance Berhad. Besides this, the

government has set up a Housing Loan Division in the Treasury

Department to provide low credit cost for housing (interest rate at 4% per
annum) for government employees.
The government, through BNM, requests that financial institutions to play

an active role in providing suitably priced financing for the purchases of
residential properties. Financing purchases of residential properties is one
of the important sectors for commercial banks in Malaysia. BNM issues
guidelines related to provision of housing loans every year.
(c) Leasing Companies and Factoring Companies
(i)" Leasing
The Leasing industry started in 1874 with the incorporation of the first
leasing company, followed by factoring industry in 1981.
Leasing is an agreement between an asset owner (lessor) and a lessee

by which the lessor agrees to let the lessee have the use of the asset
and in return the lessee pays rent to the lessor by instalments. At the
end of the lease agreement, the asset concerned is still owned by the
lessor and the lessor can give the lessee the option to purchase the
asset.
The Leasing industry grew rapidly in the 1980s. However, there were
a few constraints, including high capital requirement and domestic
tax structure that retarded the growth of the industry.
(ii)" Factoring
In factoring, a company „sells‰ or surrenders the rights to its accounts
receivable to a factoring company, and in return the factoring
company advances a percentage of the value of the accounts to the
company. The percentage usually ranges from 70% to 80%. Factoring
companies also provide management and administration services
related to accounts receivable. The main income of factoring
companies comes from factoring commission earned from the
management of accounts receivable, and discount or discounting
interest earned from advances paid to customers.
As in leasing, factoring is a relatively new industry in Malaysia but

has expanded rapidly. Nonetheless, there are a few obstacles that
impede the growth of this industry:

•" Many small and medium businesses are still uncertain about the
use of factoring in their businesses for lack of knowledge in
factoring and its benefits.
•" Factoring companies require high capital.
•" Negative perception – it is widely assumed that companies using
factoring are companies that are facing financial problems.
(c)" Venture Capital Companies

The incorporation of the first venture company in Malaysia, i.e. Malaysian
Ventures Berhad, marked the beginning of the usage of this type of capital
in the domestic business world. Venture capital involves financing of high-
risk investments or assets which are normally not financed by banking
institutions. This kind of financing usually focuses on high technology
fields such as biotechnology and robot industry. Venture capital companies
also finance new products and businesses such as those in the shipping
industry. The main problem faced by venture capital companies is to
determine how much risk they can take and whether the returns
corresponds to the risk they take. This sector also faces capital related
problems and most of the existing venture capital companies are associate
companies of financial institutions capable of providing such huge capital.
(d)" Lembaga Urusan dan Tabung Haji (LUTH)

LUTH was established in August 1969 to promote and to coordinate
activities related to the fulfilment of religious obligations by Muslims.
Apart from organising the pilgrimage to the Holy Land in Mecca, LUTH
also manages funds which largely comprise long term savings of
prospective Muslims intending to perform the pilgrimage.

Test your comprehension by answering the questions below.
EXERCISE 1.2
1. Compare the differences and similarities between each of the

following pairs in terms of their roles in MalaysiaÊs financial system.
Bank Bank Comparison
CIMB Bank Berhad Bank Kerjasama Rakyat
Malayan Banking Berhad Bank Pertanian Malaysia
(Maybank)
RHB Bank Berhad Public Bank Berhad
Malayan Banking Berhad Mayban Finance Berhad
(Maybank)
AmBank (M) Berhad Bank Simpanan Nasional
(BSN)
Agro Bank Malaysia Bank Simpanan
Nasional (BSN)
Bank Pembangunan Bank Industri Malaysia
Malaysia Berhad Berhad
Bank Islam Malaysia CIMB Bank Berhad
Berhad
Kurnia Insurance Kumpulan Wang
Simpanan Pekerja
(KWSP)
Malaysian Industrial Bank Pembangunan

Development Finance Malaysia Berhad
MCIS Insurance Public Bank Berhad
BBMB Factoring Berhad BBMB Leasing Berhad
Showa Leasing (Malaysia) Public Leasing and
Baerhad Factoring Berhad
2. Why are commercial banks important to the financial system of a

country?

1.4 FINANCIAL MARKETS

You have studied two components of MalaysiaÊs financial system, i.e. banking and
non-banking financial intermediaries. The third dimension in MalaysiaÊs financial
system is financial markets. Financial markets can be divided into two, i.e.:
•" Money market and foreign exchange market; and
•" Capital market.
Maturity period of the traded securities is the key characteristics that distinguish
between the money market and foreign exchange market from the capital market:
•" Money and foreign exchange market involve short term financial
instruments, i.e. those with maturity of less than one year.
•" Capital market involves long term financial instruments, i.e. those with
maturity of more than one year.
1.4.1 Money Market
Money market involves the trading of short term financial instruments

quoted in Ringgit Malaysia (RM).
Money market is the trading ground between banks and those with short term
money. Transactions in this market involve discount houses, money brokers,
commercial banks, finance companies and merchant banks. Money market is
more used by financial institutions than individuals.
The operation in money market consists of three categories, i.e.:

(a)" Placement of time deposit or fixed deposit;
(b)" Provision of (commercial) financing; and
(c)" Buying and selling of money market financial papers.
Listed below are the money market related topics which will be discussed
further:
(a)" Financial instruments in money market;
(b)" Money markets in Malaysia; and
(c)" Foreign exchange market.

(a)" Financial Instruments in the Money Market;

(i)" Treasury Bills
Treasury Bills are government debts with maturity of 91, 182 or 364
days (3, 6 or 12 months). They are issued by BNM in its capacity as the
debt manager Ês agent of the country. Funds collected are used to
finance annual (current) operating expenditure of the government.
(ii)" Government Investment Certificates
In July 1983, Government Investment Certificates (GIC), a non-interest
bearing instrument, were introduced to enable Bank Islam Malaysia
and other institutions to invest their liquid funds in the Islamic way.
GICs are used by Islamic institutions to fulfil the statutory reserve
requirement and minimum liquidity requirement imposed by BNM,
and to invest their temporary excess funds.
(iii)" Bank Negara Bills
BNM Bills were introduced in February 1993. They are similar to
Treasury Bills.
(iv)" Cagamas Bonds
Cagamas Bonds are bonds issued by the national mortgage company,
Cagamas Berhad, to finance the purchase of commercial banksÊ
housing loans. They were introduced in October 1987. These bonds
with mortgage backing are issued via auctions through major dealers
system.
(v)" BankersÊ Acceptances
Together with Negotiable Certificates of Deposit (NCD), BankersÊ
Acceptances or BAs were introduced in May 1979. A Banker Ês
Acceptance is a bill of exchange issued on the obligations of and
acceptance by a commercial bank or merchant bank. BAs are usually
used by importers, exporters, buyers or suppliers who need financing.
(vi)" Negotiable Certificates of Deposit
Negotiable Certificates of Deposits (NCD) are deposit receipts
lodged in commercial banks by customers. NCDs were introduced to
overcome the weakness of normal deposits, i.e. the imposition of
penalty for withdrawal of deposit before maturity. NCD holders can
withdraw the NCD deposit at any time without the penalty of
discounting the NCD concerned. Therefore, NCDs do not bear any
depositor Ês name. The NCD issuer pays the principal and interest
amount to the holder at maturity.

(vii)" Floating Rate Negotiable Certificates of Deposit

Floating Rate Negotiable Certificates of Deposit (FRNCD) are similar
to NCDs, except that the interest rates of FRNCDs are adjusted every
3 or 6 months based on the Kuala Lumpur Inter-Bank Offered Rates
(KLIBOR). Introduced in June 1988, FRNCDs have the advantage to
minimise the interest rate risk of investors.
(b)" Money Markets in Malaysia

Money market instruments are transacted in the primary market as well as
secondary market. Probably many of us do not know what primary market
and secondary market is. In the following sections, we will discuss further
on primary market and secondary market for deposits.
(i)" Primary Market for Deposits
Primary market for deposits is where deposits are lodged by

depositors in financial institutions such as commercial banks,
finance companies, merchant banks and discount houses. These
deposits are then channelled as loans to borrowers.
The participants in primary market consist of the original suppliers of

funds and the end users:
•" Original suppliers of funds comprise of individuals,
enterprises, plantation houses, international trading companies,
provident funds, pension funds and other trust funds, public
authorities and government departments who deposit temporary
excess funds at commercial banks, finance companies, merchant
banks, discount houses, and other deposits taking financial
institutions.
•" End users are borrowers comprising individuals, companies
and government.
Commercial banks have exclusive rights to accept temporary short

term funds in non-interest bearing current accounts. Apart from
Negotiable Certificates of Deposit (NCD), commercial banks are
allowed to accept savings account deposits and fixed deposits from
the customers. As a competitive strategy, commercial banks offer
multi-tiered interest rates which award higher interest rates to higher
deposit amounts. Commercial banks can collect deposits of various
tenures, i.e. 1 month, 3 months or any tenure in the multiple of 3
months subject to a maximum of 60 months. For 1-month deposit, the

minimum deposit amount required is RM5,000. For 3 months and

above, the minimum deposit required is between RM500 and
RM1,000.
Just like commercial banks, finance companies can also accept fixed
deposits and savings deposits. Initially finance companies were
allowed to collect fixed deposits of 3-month tenure only. However,
effective October 1991, finance companies are allowed to accept fixed
deposits of 1-month tenure too.
Merchant banks can accept fixed deposits from commercial banks,

finance companies and other institutions as stipulated by BNM, such
as MIDF, Bank Pertanian Malaysia, Bank Rakyat, Bank Simpanan
Nasional and insurancecompanies. Initially, a minimum deposit
amount of RM250,000 was required from financial institutions and
RM1,000,000 from other organisations, for deposits of no less than 1-
month tenure. However, with effect from October 991, merchant
banks are allowed to collect fixed deposits at a minimum sum of
RM200,000 from any of the mentioned institutions.
Discount houses are allowed to accept deposits of less than 1-month

tenure from the public, banks and other financial institutions.
Minimum deposit amount accepted by discount houses is RM50,000.
Most of the deposits held by discount houses consist of call money
and overnight deposits. Call money is deposit that can be withdrawn
on demand on condition that the request for withdrawal is received
before 11.30 a.m. on the day of withdrawal. Overnight money is
deposit kept for one day only but allowed to be rolled over with or
without the negotiated interest rate.
(ii)" Secondary Market for Deposit
Secondary market for deposit is where financial institutions trade

deposits or financial instruments among themselves.
Secondary market for short term deposits involve inter-bank trading

of short term deposits among commercial banks, finance companies,
merchant banks and discount houses. Inter-bank money market
transactions involve small branches of foreign banks and local banks
without large deposit base. It is the most active money market and the
traded instrument is cash deposits collected by the banks. Inter- bank
money market is often used by banks to accommodate the
requirement for short term funds which in turn is triggered by the

requirement to:
•" Accommodate financing needs of customers; and
•" Fulfil the statutory reserve requirement and minimum liquidity
requirement.
(iii)" Treasury Bills Market

Treasury Bills market becomes important when Treasury Bills and
other government securities become one of the liquid assets required
by the minimum liquidity requirement. The expansion of the
domestic money market has been promoted by way of encouraging
commercial banks and other financial institutions to invest in
Treasury Bills.
Companies and local authorities also purchase short term Treasury

Bills, other short term government securities and other money market
papers through repurchase agreements or REPOS. REPOS is an
agreement between financial institutions by which one party agrees to
sell a money market paper at market price and also to repurchase the
same paper at a future date at a specified price deemed attractive
enough to the buyer/investor. REPOS provides the investors (buyers)
the opportunity to lend their funds for short term and is secured by
money market papers. At the same time, REPOS provides the sellers
(financial institutions) the opportunity to refinance their investment in
money market papers with short term funds.
(c)" Foreign Exchange Market
This market involves trading of short term financial instruments

quoted in foreign currencies.
Only commercial banks are allowed to conduct foreign currency businesses.

The transactions take place either among themselves directly or through
money brokers and foreign exchange brokers.
Who are the buyers and sellers of foreign currencies? Buyers of foreign
currencies are those who want to purchase goods, services or financial
assets that have to be paid in foreign currencies. The sellers of foreign
currencies are those who own foreign currencies and want to convert them
to local currency. Obviously, the emergence of foreign currency market was
encouraged by international trades.
Financial instruments used in foreign currency exchange market include

foreign currencies, bank drafts, telegraphic transfers and bills of exchange.
BankersÊ Acceptances (BA) in foreign currency are also often used in this
market There are two markets in foreign exchange market, i.e. spot
exchange market and forward market. Spot exchange market involves
immediate delivery of foreign currencies. In forward market, foreign
currencies are bought and sold for future delivery.
1.4.2 Capital Market

Capital market is divided into primary market and secondary market. Primary
market involves buying and selling of new securities. If a company wants to
finance its expansion with equities, it sells new shares in the primary capital
market.
Secondary market involves buying and selling of existing securities. For example,
if Mr. Johan wants to buy RHB Berhad shares, he can do it at Bursa Malaysia.
Capital market in Malaysia helps the countryÊs economic development process

by mobilising long term funds to finance public development and private
investment initiatives. Capital market also encourages the development of
private enterprises by providing access to funds required for investment and
corporate expansion activities.
Financial instruments in capital market have maturity periods of more than one
year. These instruments are usually less liquid because of their long maturity.
However, the existence of secondary market enables these instruments to become
more liquid through trading in such market. Capital market instruments are
issued by both government and private sectors. The Federal government issues
bonds of maturity ranging from 2 to 21 years, while private firms issue debt
instruments such as bonds and debentures and equity instruments such as
shares.
ACTIVITY 1.5
Visit Bank Negara MalaysiaÊs website at www.bnm.gov.my, find the

information on the financial system in Malaysia and then outline the
system. What would happen to our countryÊs financial system if one of
the intermediary systems failed to function?

EXERCISE 1.3
1. Who can match the needs of the groups with surplus of funds with
the groups that need funds?
2. Elaborate on the compositions of the banking system and non-bank

financial system.
3. Bank Negara Malaysia (BNM) wants to practise tighter monetary

policy to overcome inflation problem in the countryÊs economy.
What can BNM do to achieve the said objective?
4. Which of the following is NOT a commercial bank?

A." Affin Bank Berhad
B." Bank Muamalat Malaysia Berhad
C." Alliance Bank Berhad
D." All of the above are commercial banks
E." B&C
5. Which of the following is a savings institution?

A." Bank Rakyat
B." Malayan Banking Berhad
C." Sime Bank
D." Hong Leong Finance
E." All of the above are savings institutions
6. Which of the following is NOT a function of Bank Negara Malaysia?

A." Issue licences for the establishment of banking institutions.
B." Issue licences for the establishment of financial institutions.
C." Issue licences for the establishment of commercial banks.
D." Issue licences for the establishment of Islamic banks.
E." All of the above are Bank Negara MalaysiaÊs functions.

7. The following are the differences between commercial banks and

finance companies, EXCEPT:
A." Commercial banks are permitted to handle savings accounts, but
finance companies are not permitted to do so.
B." Commercial banks form the biggest group of financial
institutions in the financial system in Malaysia.
C." Finance companies focus their attention on hire-purchase
activities.
D." Only commercial banks are permitted to carry out off-balance
sheet activities.
E." All of the above are differences between commercial banks and
finance companies.
8. Merchant banks are permitted to carry out the following activities,

EXCEPT:
A." Provide hire-purchase facility
B." Provide leasing facility
C." Provide corporate finance consultation
D." Manage investment portfolios of individuals
E." A&B
9. Capital market involves the following market(s):

A." Equity market
B." Bond market
C." Foreign Exchange market
D." A&B
E." A, B & C
10. Money market and foreign exchange market differ in terms of:
A." Money market involves cash while foreign exchange market
involves financial instruments.
B." Main participants of foreign exchange market are commercial
banks while money market involves all banking institutions
C." Unlike money market, foreign exchange market is exposed to
foreign exchange risk.
D." A & B E. B & C

11. Bank Negara Malaysia (BNM) has decided to sell Malaysian

Government Security (MGS) to commercial banks as part of its Open
Market operation (OMO). This means:
A." BNM practises inflationary monetary policy.
B." It will reduce the business costs of commercial banks.
C." Commercial banks will be more meticulous in credit analysis.
D." Commercial banksÊ investment in marketable securities will
deteriorate.
•" Transfer of funds from those with excess funds to others who need funds is
coordinated by financial intermediaries in MalaysiaÊs financial system.
•" Financial intermediaries consist of banking system, non-bank financial

intermediaries and other institutions in the financial market. All of them
operate in the two key financial markets, i.e. money market and foreign
exchange market, and capital market.
•" Bank Negara Malaysia is the central bank that regulates the activities of
financial intermediaries directly as well as indirectly in accordance with the
specific acts and guidelines in order to uphold the security and stability of the
countryÊs financial system.
Discount houses Money market

Factoring company Statutory reserve requirement
Leasing company
"

Topic X Banking and
2 Financial
Institutions Act
(BAFIA) 1989
LEARNING OUTCOMES
1." Explain the importance of a new banking act, BAFIA, 1989;
2." Discuss the new provisions under BAFIA, 1989; and
3." Identify the effect of BAFIA, 1989 on the management of
commercial banks.
X" INTRODUCTION
On 29 July 1999, Bank Negara Malaysia (BNM) announced the mergers of local
banks. The announcement triggered various reactions from different parties. The
supporting parties were of the opinion that BNMÊs action was appropriate in this
era of globalisation, while the objectors were concerned that the mergers would
result in large scale dismissal of bank employees.
The banking industry is very influential to the economy and financial system of
the country. After the economic recession in the late 1980s, a number of financial
control measures were introduced by the government. The stringent rules were
written into the Banking and Financial Institutions Act (BAFIA), 1989, which
replaced the Banking Act, 1973 and the Finance Companies Act, 1969. The new
act combined most of the provisions already existing in the two old acts.
Nevertheless, BAFIA, 1989 introduced new laws on several matters.

42 X TOPIC 2 BANKING AND FINANCIAL INSTITUTIONS ACT (BAFIA) 1989
2.1 BANKING AND FINANCIAL INSTITUTIONS

ACT (BAFIA), 1989
BAFIA, 1989 was introduced to provide an integrated regulation system for the
financial system in Malaysia and to modernise and coordinate laws related to
banking and other financial institutions.
Due to rapid growth and stiff competition in the banking system, there were no
longer clear lines between the businesses of commercial banks, finance
companies and merchant banks. Even though these three groups of institutions
were regulated separately by Bank Negara Malaysia (BNM) in accordance with
the old acts (Banking Act, 1973 and Finance Companies Act, 1969) which have
since been repealed, the control over the three groups became more and more
joint over time. Presently, BAFIA, 1989 enables BNM to supervise and control all
financial institutions, including those controlled by way of administration, under
one regime.
BAFIA, 1989 was introduced also because of the financial crisis related to co-
operative societies and problems associated with illegal deposits taking by
institutions. The lack of power of BNM to act swiftly and effectively to resolve
the issues became apparent when it was confronted with the above mentioned
problems. Now BAFIA, 1989 provides that BNM has the power to investigate
and prosecute immediately in the event of any illegal activity.
The financial system in Malaysia has changed dramatically with the rapid
development of ancillary financial institutions such as institutions of
development finance, dedicated credit institutions, credit firms and co-operatives
(especially deposits taking co-operatives.) Although their operation is small
compared to that of commercial banks and finance companies, the combined
operation of these institutions has important implication on the monetary policy
and financial stability of the country.
Get rich schemes or deposit taking cooperatives have proven to give a bad
impression towards the operation of financial institutions and weaken the faith
of the public towards the strength of the financial structure as a whole. BAFIA,
1989 enables BNM to oversee, supervise and control activities as well as the
operation of financial institutions to safeguard the stability of the nation financial
structure.

TOPIC 2 BANKING AND FINANCIAL INSTITUTIONS ACT (BAFIA) 1989 W 43
SELF-CHECK 2.1
Before the implementation of BAFIA, 1989, commercial banks in

Malaysia were controlled under the Banking Act, 1973 and finance
companies under the Finance Companies Act, 1969. Why was BAFIA,
1989 introduced while the two Acts were already in effect?
2.2 NEW PROVISIONS UNDER BAFIA, 1989

BAFIA, 1989 was introduced to spell out and update various matters which were
deemed ambiguous. The matters, relating to the management of commercial
banks and other banking institutions, include the following:
•" Licensing and regulation;
•" Management of licensed institutions;
•" Ownership and control of licensed financial institutions;
•" Supervision and control of licensed financial institutions;
•" Power to investigate, search and seize;
•" Power and duties of auditors;
•" Deposits taking and definition of deposits;
•" Secrecy;
•" Electronic funds transfer ; and
•" Penalty.
The new Act has included new provisions to cover the loopholes found in the old
banking acts in relation to the matters listed above. It also takes into account the
current development in and around the banking industry.
2.2.1 Licensing and Regulation

BAFIA, 1989 provides new laws for the licensing and regulation of financial
institutions carrying out banking, finance company, merchant banking, discount
house and money broking businesses. It came into effect on 1 October 1989 and
required all local commercial banks, local finance companies and local merchant
banks to replace their old licences with the new ones before the end of March
1990, i.e. six months from 1 October 1989.

Old licences for foreign banks were valid for five years only. Any foreign bank
applying for the new licence must first be incorporated as a new company in
Malaysia. This means all the foreign banks that had been operating as Malaysian
branches of foreign banks would have to convert themselves into subsidiaries
incorporated in Malaysia in order to continue operating in the country. This is
mandatory as BAFIA, 1989 permits issuing of licences to public companies
incorporated in Malaysia only.
All applicants of new licences under BAFIA, 1989 must fulfil the minimum
criteria in addition to the requirements stated in the old banking acts. Briefly, the
minimum criteria are as follows:
(a)" Every person who is, or is to be, a director, controller or manager of a
financial institution must be a qualified and proper person to hold the
particular position;
(b)" At least two individuals must effectively direct the business of a financial
institution;
(c)" The board of directors must include such number (if any) of directors
without executive responsibility as BNM considers appropriate;
(d)" The financial institution must conduct its business in a prudent manner;
and
(e)" The shareholding structure of the financial institution must be in
accordance with the economic policy of Malaysia.
The licence may be revoked for reasons stated in Section 7, BAFIA, 1989. They
include:
(a)" Failure to fulfil the minimum criteria;
(b)" The breach of any condition imposed under the licence;
(c)" In any situation whereby, the interests of the depositors, customers or
creditors are in any way threatened;
(d)" The appointment of receiver or manager of the financial institution; and
(e)" The financial institution has insufficient assets to meet its liabilities.
EXERCISE 2.1
Explain in detail the new provisions in BAFIA, 1989 concerning

licensing of banking institutions.

2.2.2 Management of Licensed Institutions

No person is allowed to accept an appointment or be elected as a director of a
licensed institution unless he has, prior to such acceptance, obtained the written
consent of BNM to accept the same.
However, the following individuals are disqualified from being a director,

manager, secretary, or any officer concerned in the management of a licensed
financial institution:
(a)" A person who is a bankrupt;
(b)" A person who has been guilty of a criminal offence punishable by
imprisonment for one year or more;
(c)" A person who has been proven guilty of any offence under BAFIA, 1989;
(d)" A person who has been imposed with any order of detention, supervision,
restricted residence, banishment or deportation; or
(e)" A person who has been a director of, or directly concerned in the
management of, any corporation which is being or has been wound up by a
court.
Every licensed financial institution must appoint an individual as the chief

executive officer of the institution and such individual must be a resident in
Malaysia during the period of his appointment. After the implementation date of
BAFIA, 1989, every licensed financial institution must seek and obtain BNMÊs
written approval before appointing a chief executive officer.
2.2.3 Ownership and Control of Licensed Financial

Institutions
BAFIA, 1989 places restrictions on the ownership of financial institutions to
ensure that shareholdings in financial institutions are adequately spread out and
that the controlling power in any one financial institution does not lie with a few
individuals only.
Any person who wishes to acquire 5% or more shares of any financial institution
must obtain prior written approval of the Minister of Finance. The aggregate of
5% shares include shares of that institution which are already held by the person
and by persons acting in concert with him. The same applies to disposal of
shares; i.e., any person who wishes to dispose 5% or more shares of any financial
institution must obtain prior written approval of the Minister of Finance.

An individual are not allowed to hold more than 10% shares of a licensed
financial institution, while as corporations, cannot hold more than 20% shares.
The corporation is deemed as an individual if 75% or more of the corporation
shares are held by an individual.
The above restrictions do not apply to acquisitions, disposals or shareholdings

before the implementation date of BAFIA, 1989. The restrictions are taken into
account when determining whether any of the post-implementation date
acquisitions, disposals and shareholdings is prohibited.
ACTIVITY 2.1
BAFIA, 1989 does not allow the controlling power in any one financial
institution to rest with just a few individuals. How does this restriction
help the financial institution concerned, the shareholders and the
customers in their financial activities?
2.2.4 Supervision and Control of Licensed Financial

Institutions
Under BAFIA, 1989, BNM has the responsibility to, from time to time and
without any prior notice, examine the books or other documents, accounts and
transactions of each licensed financial institution. Any licensed financial
institution which considers itself to be insolvent, or is likely to become unable to
meet all or any of its obligations, or, that it is about to suspend payment to any
extent, must immediately inform BNM of that fact.
If a licensed financial institution does any of the following:

(a)" Carry on its business in a manner detrimental to the interests of its
depositors, creditors, or the general public;
(b)" Is insolvent or is unable to meet all or any of its obligations; or
(c)" Has breached any provision of BAFIA, 1989 or any condition of its licence.
BNM may exercise any one or more of the following powers:

(a)" Ordering the financial institution to take any steps or any action which
BNM considers necessary;
(b)" Prohibiting the financial institution from extending any further credit
facility;

(c)" Terminating from office any officers of the financial institution;

(d)" Terminating from office any directors of the licensed financial institution;
(e)" Appointing any person or persons as a director or directors of the licensed
financial institution; and
(f)" Appointing a person to advise the financial institution in relation to the
proper conduct of its business.
With the approval of the Ministry of Finance, BNM may also:

(a)" Grant loans to that financial institution against the security of that
institutionÊs own shares;
(b)" Purchase any shares of that financial institution for the purpose of
controlling the business of that institution; or
(c)" Grant loans to another licensed financial institution to purchase any shares,
assets and liabilities of the financial institution facing problems.
In respect of a licensed local financial institution, on the recommendation of

BNM, the Minister of Finance may:
(a)" Confer powers to BNM to assume control of the whole of the property,
business and affairs of the licensed financial institution facing problems; or
(b)" Authorise BNM to make an application to the High Court to appoint a
receiver or manager to manage the whole of the business, affairs and
property of the licensed financial institution, and to present a petition to the
High Court for the winding up of the financial institution if it is a local
financial institution.
If the Minister of Finance considers it is to be in the interest of the depositors, he

may, on the recommendation of BNM:
(a)" Prohibit the institution from carrying on its licensed business or from doing
or performing any act or function connected with its licensed business;
(b)" Authorise BNM to apply to the High Court for a stay order for a period not
exceeding six months on all actions and proceedings by or against the
financial institution; and
(c)" Suspend the licence granted to the financial institution.

2.2.5 Power to Investigate, Search and Seize

Commercial crimes in the banking and financial industry increased
tremendously to the extent that the BNMÊs power to investigate and search prior
to BAFIA, 1989 was proven to be inadequate for curbing these white collar
crimes. Today, BAFIA, 1989 provides to the investigating officers of BNM the
power to enter, search, seize, detain and examine suspected individuals and their
partner.
Investigating officers may supply the acquired information to the police or any
other public officer. The power conferred on an investigating officer may be used
against any person suspected to have committed an offence under BAFIA, 1989
or any of its by-laws. The rationale for this extended power is to enable BNM to
collect all the necessary evidence in order to prosecute any person committing an
offence under the provisions of BAFIA, 1989.
Test your comprehension level by answering the questions below.
EXERCISE 2.2
1." According to BAFIA, 1989, who is eligible to manage a commercial

bank in Malaysia?
2." „BAFIA, 1989 gives absolute power to BNM with regard to the
management of our countryÊs financial system‰. Provide your opinion.
2.2.6 Power and Duties of Auditors

Section 40 of BAFIA, 1989 has increased the power and duties of the auditors of
licensed financial institutions. An auditor has the responsibility to report to BNM
if in the course of his duties he has discovered any of the following:
(a)" There has been a breach of any provision of BAFIA, 1989 or an offence
under any other law has been committed by the financial institution;
(b)" Losses have been incurred by the financial institution which reduced its
capital funds by more than 50%;
(c)" Any irregularity which jeopardises the interests of depositors or creditors of
the financial institution;
(d)" Any other serious irregularity; or

(e)" The auditor is unable to confirm that the claims of depositors or creditors
are covered by the assets of the financial institution.
The auditor is given power to obtain all information from the relevant officers in
the financial institution for auditing purposes.
ACTIVITY 2.2
BAFIA, 1989 grants power to the auditors of licensed financial
institutions to report any contravention of BAFIA, 1989 to BNM. Does
this not cause any conflict since the auditors are paid by the financial
institution? Discuss.
2.2.7 Deposits Taking and Definition of Deposits

The provisions on deposits taking under BAFIA, 1989 have two objectives, i.e.
development objective and control objective. Development objective aims to
promote the growth and innovation of bond market and commercial paper
market by relaxing the definition of deposits.
The controlling objective aims to supervise deposits taking activities in an

adequate manner in order to obliterate illegal deposits taking activities. Under
Section 25 of BAFIA, 1989 prohibit any individuals to carry out deposits taking
business except under and in accordance with a valid licence granted by the
Ministry of Finance to carry out banking, finance company, merchant banking or
discount house business. Besides this, Section 26 of BAFIA, 1989 prohibit any
individuals, without the written consent of BNM, to enter into any agreement to
accept any deposit from any person in Malaysia or outside Malaysia.
BAFIA, 1989 defines deposit as a sum of money received or paid on terms under
which it will be repaid in the form of money or moneyÊs worth, with or without
interest or at a premium or discount. Any activity with deposits taking elements
are regarded as deposits taking regardless whether the transaction is described as
a loan, an advance, an investment, a saving, a sale or a sale and repurchase.
BAFIA, 1989 provides the list of activities that are not regarded as deposits taking
activities as follows:
(a)" Money paid by way of an advance or a part payment under a contract for
the sale, hire or other provision of property or services;
(b)" Money paid by way of deposit for the performance of a contract;

(c)" Money paid in the circumstances specified in the First Schedule of BAFIA, 1989,
including money paid by an individual to any of the specific institutions
such as the Government of Malaysia, BNM or a local authority; or
(d)" Money paid to any person by any of the specific persons such as the
Government of Malaysia, a statutory body, or the individuals related or
associate company.
2.2.8 Secrecy
SELF-CHECK 2.2
What do you understand about secrecy in banking?
The relationship between a bank and any of its customers is considered highly
confidential to the extent that there are provisions in terms of secrecy provisions
in the banking act to protect such a relationship. When a customer applies or
obtains a credit facility from a bank, he expects the bank not to disclose that
matter to anyone. In order to harbour such confidential information, the banking
act prohibits the bank from disclosing the information to anyone, except with the
consent of the customer concerned. A relationship is formed between a bank and
a customer when, among others, the customer keeps his money in the bank or
when the customer buys bonds from the bank.
The law on secrecy has been made clear and extended to all licensed financial
institutions under BAFIA, 1989. Section 99 of the said act permits disclosure of
information under the following circumstances:
(a)" The customer has given permission in writing to disclose the information;
(b)" The customer is declared bankrupt;
(c)" In court cases which involves the financial institution and the customer; and
(d)" The information that is only related to the credit facility granted by a
branch of a licensed foreign bank and the information is required by the
head office overseas.
The above disclosure is permitted by federal law to be made to a police officer

investigating an offence. The disclosure by the financial institution to the police
officer must be limited to the accounts and affairs of the person suspected of the
offence.

BNM also permits the relevant supervisory authorities of a foreign country to

examine the books, accounts and transactions of a foreign bank or a foreign
bankÊs representative office in Malaysia.
ACTIVITY 2.3
Mr and Mrs Chong have a joint account in Bank Bumirakyat since 1970.
Consent of both parties or of Mr Chong must be obtained to effect any
transaction in relation to that account. Mr and Mrs Chong divorced two
months ago. Subsequently Mrs Chong came to see a bank officer and
made an inquiry on the account balance. Can the bank officer reveal the
account balance without Mr ChongÊs consent, with reference to the
provisions under BAFIA, 1989 on secrecy? Why?
2.2.9 Electronic Funds Transfer

Provisions have been made in BAFIA, 1989 for the supervision and control of any
proposed electronic funds transfer system or any existing system in Malaysia.
According to Section 119, BAFIA, 1989, no individual is allowed to operate any
electronic funds transfer system unless he has revealed to BNM the operation
scheme in relation to the duties and liabilities of all parties involved in the
electronic funds transfer system. This enables BNM to coordinate and supervise
the development of modern electronic funds transfer system in Malaysia.
2.2.10 Penalty
In general, the quantum of penalties imposed under BAFIA, 1989 have been
increased to ensure that the penalty imposed corresponds to the offence
committed. The maximum fine is RM10 million and the maximum imprisonment
term is 10 years.
Examples of penalties imposed for failure to comply with the provisions of

BAFIA, 1989 are listed in Table 2.1.

Table 2.1: Examples of Penalties
Offence Section Imprisonment Fines Daily Fines

Carrying out Section 4 (a) 10 years RM10 million RM100
banking thousand
businesses
without a valid
licence
Failure to Section 16 - RM5 thousand RM5 hundred
display sign
board „licensed
bank‰
Advertising to Section 27 3 years RM3 million -
solicit deposits
(except licensed
banks)
Fail to appoint Section 40(1) - RM1 million RM1 thousand
an auditor
Section 106 of BAFIA, 1989 provides that where any offence against any
provision of BAFIA, 1989 has been committed by any financial institution, any
person who at the time of the commission of the offence was a director, officer, or
controller, of the financial institution is considered guilty of that offence unless
he can prove that the offence was committed without his knowledge or consent
and that he had exercised all necessary care and diligence to prevent the
commission of the offence.
Controller means a person who has an interest in more than 50% of the shares of
the institution. According to Section 121, BAFIA, 1989, the director, officer and
controller of the licensed financial institution are liable to indemnify the
institution in full for the loss or damage in any form resulting from the offence
committed. Nevertheless, the director, officer and controller can avoid such
penalty if the offence was committed without his consent and he had exercised
all necessary care and diligence to prevent the commission of the offence.
2.3 THE EFFECT OF BAFIA, 1989 ON THE

MANAGEMENT OF COMMERCIAL BANKS
In general, BAFIA, 1989, by way of holding the management and the boards of
directors responsible, forces the management of commercial banks to be more
disciplined, professional and transparent in order to ensure prudent
management and integrity of their respective banks.

SELF-CHECK 2.3
After knowing why BAFIA, 1989 was implemented, and about its
provisions.What effect did BAFIA 1989 have on the management of
commercial banks?
BAFIA, 1989 holds the members of the board of directors and the bank officers
accountable for any offence committed by the bank unless they can prove that
the offence was committed without their consent and that they exercised all
necessary care and diligence to prevent the commission of the offence. They are
also liable to indemnify the institution for the loss or damage in any form
resulting from the offence committed.
The provisions of BAFIA, 1989 make the members of the board of directors and
the bank officers more cautious and alert in their respective duties because they
will be subject to severe penalties in the event that their duties are neglected or
not carried out competently.
BAFIA, 1989 also ensures that the appointed key officers are of high calibre and
experienced by requiring banks to obtain BNMÊs written consent before making
any key appointment. Although this condition is cumbersome, it ensures that
each commercial bank is managed by a truly qualified individuals. This filtration
process eliminates influential individuals from holding any post in financial
institutions.
Test your understanding by answering the questions below:
EXERCISE 2.3
1." Why does BAFIA, 1989 impose harsh penalties for offences
committed under this new act?
2." Bank Untung Selalu Berhad is found to have breached one of the
provisions in BAFIA, 1989 regarding the bankÊs liquidity. Why is
the bank officer held responsible by BAFIA, 1989?
3." Can BAFIA, 1989 withstand the new challenges in the banking
industry in future?

•" The Banking and Financial Institutions Act (BAFIA), 1989 came into effect on
1 October 1989. It was legislated to provide new and comprehensive laws for
the licensing and regulation of financial institutions carrying out banking,
finance company, merchant banking, discount house and money broking
businesses, and for the regulation of financial institutions carrying out other
financial businesses.
•" Rapid development and stiff competition in the banking system and the
financial crisis of the deposits taking co-operatives (DTC), were the main
rationale for the legislation of these new laws.
•" There were harsh criticisms against BAFIA, 1989, but in reality the banking
system in Malaysia was in need of a new banking act to solve the
development and competition problems in a more swiftly and effectively
manner.
•" BAFIA, 1989 is able to help Bank Negara Malaysia (BNM) control and
supervise the participants in the banking industry in a more organised and
comprehensive manner for the stability and robustness of the countryÊs
financial system.
•" It also directly, promotes more discipline, professionalism and sense of

responsibility among the members of the boards of directors and the
management of commercial banks by imposing harsh penalties in the event
of negligence in the management of any commercial bank.
•" This new banking act is expected to open a new horizon for increased sense
of responsibility and accountability in the management of commercial banks.
Electronic fund transfer Secrecy
"

Topic X Branch Banking
3
LEARNING OUTCOMES
1." Discuss the advantages and disadvantages of the branch banking
system;
2." Describe the problems faced by the branch managers of commercial
banks; and
3." Explain the steps that can be used to solve problems related to the
management of commercial bank branches.
X" INTRODUCTION
The special characteristic of the financial system in Malaysia is the network of
branches all over the country. The branch network system is the most convenient
and efficient way to expand banking businesses and services because each
branch operates as a profit centre. Nevertheless, there are certain unique
problems faced in the management of branches.
3.1 BRANCH BANKING
Branch banking means the businesses of a bank are carried out by branch
offices which offer banking services such as deposit taking and lending.
Banks establish their branches all over the country to maximise their respective
market shares in banking. The basic characteristic of branch banking is that the
branch operations are controlled by head offices and each branch is regarded as a
profit centre. Each branch is regarded as a profit centre instead of a cost centre
because each of them has the ability to produce revenue through lending and
investment activities.

56 X TOPIC 3 BRANCH BANKING
3.1.1 Advantages of Branch Banking

Branch banking in Malaysia is believed to have many advantages, either from the
banksÊ point of view or that of the customers. These advantages include:
(a)" Reduce the Population Per Branch Ratio

Branch banking reduces the population per branch ratio. Therefore, the
more branches a bank has means the more capability it has to provide
banking services to the public.
(b)" Use the BanksÊ Resources More Effectively

If branch banking was not permitted, a bank would have to open new banks to
penetrate new markets. This would involve enormous and overlapping
resources. With branch network, a bank can expand into new markets through
more effective use of financial, operation and human resources.
(c)" Diversify the Assets and Deposits of Banks

By having customer base and geographic diversification, a bank is able to
have a mixed portfolio of loans and mixed portfolio of deposits. Such
diversification of assets and deposits can reduce the bankÊs risk. For
example, a bank with many branches can spread out its credit risk by
procuring customers of different professions, needs etc compared to a bank
that has to focus on certain specific groups of customers only due to its
limitation in the number of branches and locations of its operation.
(d)" Mobilise Funds More Effectively

There are branches which can attract more deposits than giving out loans,
and there are branches which receive more loan applications than their
deposits base can cover. By having branch banking, the branch network can
overcome this problem by moving the excess deposits from one branch to a
branch with deposit deficiency. Insufficiency in branch network will result
in opportunity cost, i.e. loss of customers due to failure to meet the needs
for loans which in turn results in deficiency of deposits.
(e)" Provide Better Services

With adequate branch network, customers need not change bank or
open a new account in another bank upon changing job or moving house.
Moreover, customers need not worry when working outside their areas as
banking activities can be conducted anywhere.
(f)" Provide Competitive Edge

A bank with many branches has a competitive edge over those with fewer
because bank branches are profit generating centres for banks.

TOPIC 3 BRANCH BANKING W 57
Furthermore, the robustness of a bank is associated with the size of its

branch network. This is evident from the fact that the majority of the large
commercial banks in Malaysia have large branch networks.
3.1.2 Disadvantages of Branch Banking

The fundamental feature of branch banking is that the operations of branches are
controlled by the head office. There are many differences in terms of power given
to branch managers. These differences can cause various problems in the
management of branch banking. The imbalance in power between the bank
officers at head office and those at branches also contributes to management
problems. The excellence and quality of banking services offered to customers
depends on the solution to these problems.
ACTIVITY 3.1
You surely have accounts with certain banks but often conduct your
transactions at the branches. Speaking from your own experience, what are
the advantages/disadvantages of the branches you have transacted with?
EXERCISE 3.1
1." Why are the branches of commercials banks treated as profit

centres instead of cost centres?
2." Bank Perdana Berhad has opened a branch in a rural area. This
branch only collects deposits and does not provide loans. Is this
branch considered a profit centre or cost centre?
3." What advantages does a bank with a large branch network have
over a bank without a branch network?
4." In general local commercial banks have more branches compared to
foreign commercial branch became BNM limits the number of new
branches of foreign commercial bank. However, there are foreign
commercial banks which show better performance than local banks.
Does this mean that the number of branches is not a key
determinant of the profitability of a bank?

3.2 PROBLEMS OF BRANCH BANKING

MANAGEMENT IN MALAYSIA
Branch banking operations are controlled by head office. Therefore there are
often management problems between head office and branches. Problems
concerning branch banking management in Malaysia are:
•" Operational problems;
•" Staff problems;
•" Relationship problems between head office and branches;
•" Problems pertaining to business promotion; and
•" Problems pertaining to branchesÊ performance.
3.2.1 Operational Problems

Three main operational problems faced by the management of branch banking are:
(a)" Staff-related problems;
(b)" Computer-related problems; and
(c)" Customer-related problems.
Table 3.1 shows the types of operation problems frequently faced by bank branches.
Table 3.1: Types of Operational Problems Faced by Bank Branches
Type of Problems Frequency Percentage (%)

Staff related problems 81 36.8
Computer related problems 69 31.4
Customer related problems 49 22.3
Limited authority of branches 48 21.8
Operation procedures 41 18.6
Too many reports 24 10.9
Space constraint 13 5.9
Lack of facilities 9 4.1
Law related problems 6 2.7
Others 23 10.5
Source: Shamsudin Ismail and Ee Kow Keang (1991) pg. 43

(a)" Staff-related Problems

Generally, staff-related problems affect staff morale which in turn
influences the banksÊ quality of service delivered to customers. Indirectly,
they affect the bankÊs profitability. Among the staff-related problems
that cause operational problems include the following:
(i)" Leave
Problems pertaining to annual leave often occur, especially during
main festive seasons and when the staff take medical leave or
emergency leave simultaneously. This affects the branch operation
because when the staff are on leave (especially long leave), the branch
will be short of staff to perform the daily tasks.
(ii)" Staff Shortage
Staff shortage often happens during lunch time, pay days, before and
after long holidays, and when staff are on medical, annual leave or
maternity leave. When there is a shortage of manpower, other
employees are required to take over the duties of the absent
employees. The additional work load affects the performance of the
replacement workers and hence jeopardises the quality of service
delivered to customers.
(iii)" Quality of Staff
Staff sent by head office to branches are not experienced or adequately
trained. Besides that, the branchÊs staff are weak in
communication and supervision skills.
(b)" Computer-related Problems

(i)" Computer Breakdown and Downtime
Computer breakdown and downtime disrupt daily operations. When
such problem takes place, daily tasks will have to be carried out
manually and updates will have to be done later on. Should there be
any major breakdown, the staff will have to complete the daily tasks
on the next day, usually in great haste. This may jeopardise the
quality of work as there will probably be mistakes made under the
circumstances. Staff morale too will be affected.
The situation gets more complicated if the breakdown takes place

during peak time. Counter clerks become the target of angry and
impatient customers waiting for the restoration of normal operations.
Furthermore, as a result of over-dependence on computers,

occasionally branch staff forget the manual process related control
measures that they have to follow during computer breakdown.

(ii)" Dissatisfaction with Electronic Data Processing (EDP) Department

Branch staff are of the opinion that the Electronic Data Processing
(EDP) Department at the head office is considered as not adequately
knowledgeable in terms of products, systems, and banking
procedures. EDP often stipulates new operation procedures without
taking into consideration the practical operation requirements and
problems.
(c)" Customer-related Problems

Customer-related problems revolve around customersÊ dissatisfaction
with the banking services provided by the branch. What makes customers
dissatisfied? Firstly, customers always complain about the slow service
during lunch time, pay days and festive seasons. Secondly, customers are
not satisfied as their requests or appeals for exemption from the bankÊs
guidelines, rules and conditions get rejected by the management.
ACTIVITY 3.2
You are a branch manager of a local bank. Explain in detail how you will
handle the following operation problems:
Problems Suggestion
All your branch staff are Malays. Hari Raya Puasa is
imminent and all the employees wish to go on long
leave. However, Hari Raya Puasa is expected to fall
during midweek and the bank will allow two public
holidays only. Who will be allowed to go on long leave?
Your branch has just started the dayÊs business and
many customers are thronging to get banking services.
Suddenly the computer system breaks down and the
customers and staff are complaining as this problem
happens frequently. What should you do?
Encik Bahari is a long standing customer of your branch.
He applied for a housing loan recently and your head
office approved the loan at an interest rate of BLR + 2%.
Encik Bahari requests for your goodwill as the branch
manager to reduce the interest rate to BLR + 1%. You are
unable to do it as it is against the rules of the Institute of
Banks in Malaysia and Bank Negara Malaysia. How will
you explain to Encik Bahari?

3.2.2 Staff Problems

Three main staff problems concerning the management of branch banking are:
(a)" Absenteeism;
(b)" Motivation; and
(c)" Inexperienced staff.
Table 3.2 lists the types of staff problems often faced by branches.
Table 3.2: Types of Staff Problems Faced by Branches
Type of Problems Frequency Percentage (%)

Absenteeism 50 22.9
Motivation 49 22.5
Inexperienced staff 35 16.1
Attitude 34 15.6
Discipline 28 12.8
Staff shortage 27 12.4
Staffing 22 10.1
Excessive overtime 20 9.2
Lack of skills in marketing and management 20 9.2
Conflict between officers and clerks 18 8.3
Low productivity 13 6.0
Leave 12 5.5
Problems related to employees union 10 4.6
Dissatisfaction with remuneration system 9 4.1
Personal problems 8 3.7
Staff relationship 5 2.3

(a)" Absenteeism
Absenteeism means absence from work for reasons including medical
leave, participation in sports and participation in workers associationÊs
meetings. If absenteeism happens frequently, it will disrupt the operations
of the branch and affect the employees who have to take over the absent
employeesÊ work.
(b)" Motivation
Four factors that may dampen staffÊs motivation are:
(i)" Lack of opportunity for self development and career advancement;
(ii)" Lack of intrinsic and non-intrinsic reward;
(iii)" Ambiguous policies and guidelines;
(iv)" Be reprimanded in public.
(c)" Inexperienced Staff

Most of the staff sent to branches are not experienced or properly trained.
ACTIVITY 3.3
You are a branch manager of a local bank. What is your approach to the
following motivation problems?
Problems Suggestion
Cik Rosni has served your branch for a long time. She
arrives for work at 9.00 a.m. sharp and leaves work at
5.00 p.m. sharp. She does only what she is asked to do.
Cik Rosni does not work overtime even though there is
a lot of work that has to be completed. Does Cik Rosni
have any motivation problem?
Mr Ragunathan is your assistant branch manager. He is
usually a hard working employee. However, since his
application for promotion was turned down, he
appears to be less interested in his work. What action
would you take?
Mr Koh is a credit officer at your branch. He does not
like to source for customers. His philosophy is, „If the
customers want financing, they should come to the
bank. Why should a well look for buckets?‰ Why does
he have this opinion? What should you do?

3.2.3 Relationship Problems between Head Office

and Branches
Relationship problems between head office and branches are attributable to the
following sources of conflict:
•" Sharing of resources;
•" Different goals;
•" Interdependent work activities;
•" Differences in value and perception; and
•" Communication problems.
(a)" Sharing of Resources

Limited resources in a bank have to be shared by head office and
branchesin accordance with priorities set by the bank management. As a
result, some branches are given resources more or less than their
requirement. Conflictspertaining to resources include:
(i)" Head office rejects loan applications by branch customers as the bank
does not have sufficient funds for the loans.
(ii)" Staff shortage problem.
(b)" Different Goals

Although head office and branches belong to the same organisation, they
have different goals in certain activities. For example, operation procedures
in the operation manual are too stringent and over emphasise on the
control aspect. This reflects the conflict in objectives between branch
managers and head office staff responsible for internal control.
The responsibilities of a branch manager are to manage the branch and to

generate profits in a reasonably controlled environment. However, the
internal control staff at head office want a comprehensive control system.
Such conflict is inevitable when branches are regarded as profit centres
while head office is a service centre.
The problem exists because of differences in the degree of emphasis on the

same objectives. For example, branches have to submit too many reports in
accordance with deadlines stipulated by head office. Branches feel that the
time given to complete and submit the reports is too short. While branches
are of the opinion that their daily tasks should be given priority but
reporting is the first agenda on head officeÊs list of responsibilities.

(c)" Interdependent Work Activities

The structure of the branch network system requires interdependence
between branches and head office. For example, head office depends on
branches in preparing the bankÊs financial reports, and branches depend on
head office for funding.
Problems occur when a unit in an organisation is not able to perform its

duties as a result of non-performance or non-completion of work by
another unit. In view of that, there would be problems between a branch
and head office if the branch fails to submit reports by the stipulated
deadlines, or, if the head office fails to approve loan applications by the
stipulated deadlines.
(d)" Differences in Value and Perception

Differences in attitude, value and perception between head office staff and
branch staff contribute to conflicts within a bank. The level of conflict
depends on the degree of differences in value and perception – the more the
differences, the bigger the conflict.
Conflicts can arise from the differences in the perception on balance of

power between head office and branches. Head office is perceived to be
more powerful than branches. Imbalance in power is often the cause of
continuous conflicts between head office and branches.
(e)" Communication Problems

Unclear communication can result in conflicts between groups. Factors
jeopardising the communication between head office and branches are:
(i)" Slow responses;
(ii)" Competence level of the officers concerned;
(iii)" Communication methods;
(iv)" The person to be contacted; and
(v)" Conflicting policies and procedures.
SELF-CHECK 3.1
How can the communication problems between head office and
branches be solved?

Table 3.3 lists some measures that can help solve the communication problems
between head office and branches.
Table 3.3: Measures to Solve Communication Problems betweenHead Office

and Branches
Percentage
Measure Frequency
(%)
More frequent meetings/dialogues/discussions 62 29.5
Have better understanding of the work at 38 18.5
branches
More interaction between head office staff and 31 14.8
branch staff
Head office staff must have branch level working 29 13.8
experience
Head office staff to be on attachment to branches 26 12.4
Understand each other Ês roles and limitations 13 6.2
Better communication channels 12 5.7
Prompt responses to branchesÊ queries or 12 5.7
problems
Head office staff should be friendlier, more 10 4.8
courteous and more diplomatic
Discuss with branches before making any major 8 3.8
changes that have impact on branches
Reduce ad hoc requests for information which 5 2.4
can be obtained from any other head office
departments
We can conclude from Table 3.3 that the best step towards solving the
relationship problems between head office and branches is through better and
more frequent interaction between the two parties. This includes having
meetings/dialogues/ discussions more frequently between the two parties to not
only discuss ways to improve the operation aspect of branch management but
also to solve any relationship problems.
Apart from that, head office staff should be more empathetic towards work
problems at branches. This can be achieved through having work experience at
branches or through relevant training programmes.

Interaction between head office staff and branch staff can also be enhanced
through official or even social meetings.
3.2.4 Problems Pertaining to Business Promotion

Table 3.4 lists the problem faced by branch managers in promoting banksÊ
businesses.
Table 3.4: Main Problems Faced by Branches in Relation to Business Promotion
Problems Frequency Percentage (%)

Manpower shortage 104 47.5
Competition 63 28.8
Non-competitive products 55 25.1
Overly stringent policies and rules 34 15.5
Inadequate authority to use discretion to 29 13.2
approve
Delayed approvals by head office 27 12.3
Lack of support from head office 20 9.1
Lack of banking facilities 19 8.7
Small market 15 6.8
Location 15 6.8
Lack of quality customers 12 5.5
CustomersÊ attitude 10 4.6
BankÊs image 8 3.7
Economic condition 6 2.7
Size of the bank 3 1.4
(a)" Manpower Shortage

Shortage of manpower to implement the promotion correctly is the key
problem in business promotion. For example, branches lack in officers,
especially those who have the relevant skills and are experienced in
sales and marketing, to promote loans. Branches are of the opinion that
branch staff should be given training in sales and marketing and business
promotion.

(b)" Competition
Stiff competition from other commercial banks and finance companies is
the second biggest problem in business promotion. Branch managers have
to compete not only with the branches of other banks but also with the
branches of their own banks too.
(c)" ProductÊs Ability to Compete

The third biggest problem in business promotion lies in whether the
products are able to compete. Branches are of the opinion that their banksÊ
products are not competitive in terms of pricing and interest rates
compared to those offered by other banks. Other factors that can affect a
productÊs ability to compete are:
(i)" Excessively stringent terms and conditions;
(ii)" Excessively long time taken for processing loan applications; and
(iii)" Rigid rules set by head office.
(d)" Policies and Rules

Strict policies and rules are identified as the fourth problem in business
promotion as they fail to attract customers. Branches have the opinion that
evaluation on loan applications is too rigid to promote the development of
loan portfolios of branches. Besides, the branchesÊ promotion efforts are
constrained by the lending policies set by head office which restrict the
types of businesses that can be sourced by the branches.
3.2.5 Problems Pertaining to Branches’ Performance

Essentially, performance of a branch involves evaluation or measurement of the
effectiveness of that branchÊs organisation. Therefore the main objective of
evaluating the performance of branches is to assess the actual performance in
comparison with the budgeted performance.
(a)" Evaluation Criteria

Quantitative criteria as well as qualitative criteria are used in the evaluation
of branchesÊ performance. Table 3.5 lists the criteria used.

Table 3.5: Evaluation Criteria of BranchesÊ Performance
Criterion Frequency Percentage (%)

Financial performance 158 72.8
Loans and advances 100 46.1
Deposits 94 43.3
Actual performance versus budget 77 35.5
General management of branch 37 17.1
Internal control/audit reports 22 10.1
Non-performing loans 18 8.3
Quality of customer service 17 7.8
Reporting 12 5.5
Compliance with procedures and guidelines
12 5.5
set by head office
Priority sector financing 7 3.2
Size of bank/branch 6 2.8
Number of staff 6 2.8
Comments/complaints from head office/other
5 2.3
departments
Table 3.5 shows that the effectiveness of an organisation can be evaluated based
on various criteria because no one single standard can provide a complete
evaluation of the effectiveness of an organisation.
(b)" Performance Measurement

As in the case of effectiveness, the performance of a branch cannot be
measured with just one standard of measurement. Table 3.6 shows 26
performance measurements which can be used to evaluate efficiency,
profitability, productivity and service quality in the sequence of
importance.
Based on the table, the performance ratio that is of the utmost importance is
the total loans to total deposits ratio. This ratio has the highest score, in line
with the efficient organisation concept which links output with input. In the
banking industry, the main input is deposits while loans is the main output.

The ratio with the next highest score is the operating expenses to operating
income ratio. This ratio is also known as cost efficiency ratio. It measures
the organisationÊs capability to minimise its operating expenses.
The ratio of profit just as the ratio of net profit compared to the amount of
loans is also used to help branches financial performance.
Three performance measurements have the lowest scores because of their

ambiguity or irrelevance. For example, the measurement by the number of
operation mistakes is a negative performance measurement.
Table 3.6: Performance Measurements of a Branch
Performance Measurement Mean Score
Total loans/total deposits 4.024
Operating expenses/operating income 3.899
Net profit/total revenue 3.871
Net profit/operating income 3.824
Amount of non-performing loans 3.762
Net profit/total assets 3.762
Net profit/total deposits 3.572
Net interest earned/total deposits 3.569
Total loans and advances/total assets 3.522
Net profit/number of employees 3.476
Number of non-performing loans 3.459
Interest earned/deposits 3.398
Operating expenses/number of employees 3.345
Net interest earned/total assets 3.289
EmployeesÊ salaries and benefits/operating expenses 3.201
Interest earned/total assets 3.139

Total interest expense/operating expenses 3.112
Business loans/total assets 3.082
Net interest earned/total number of employees 3.076
Total loans/total number of employees 3.043
Number of complaints from customers 3.038
Interest earned/total number of employees 3.033
Maintenance of work place 3.043
Number of operation weaknesses/damages (such as cash 2.995

shortage, wrong posting)
Personal loans/total assets 2.633
Accommodation expenditure/operating expenses 2.585
ACTIVITY 3.4
An evaluation on the performance of a branch is indeed an evaluation
on the performance of the branch manager. If a branch is found to be
weak as a whole, then the branch manager Ês management is ineffective,
therefore, the branch manager should be replaced. What is your view
on this?
Test your understanding by answering the questions below:
EXERCISE 3.2
1. Puan Zakiah is a branch manager of Bank Perdana Berhad. She

has taken the following actions in relation to the relationship
problems between head office staff and her branch staff. Do you
agree with her actions? Explain your answers in detail with the
appropriate reasons.

(a)" Accounts Department staff from head office reprimanded Puan

ZakiahÊs accounts staff for late submission of the banksÊ
coordination reports. Puan Zakiah contacted the Chief
Accountant of the bank and requested that accounts staff from
head office be sent to her branch to solve the manpower shortage
problem there.
(b)" Mrs Loo is a long standing customer of Puan ZakiahÊs branch.
Mrs LooÊs application for loan, which was supported by Puan
Zakiah, was rejected by the Credit Committee at head office
recently. Puan Zakiah advised Mr. Loo to appeal to the CEO
directly.
(c)" The internal auditor recommended that Puan ZakiahÊs branch
maintain the staff attendance register in a more meticulous and
organised manner. Puan Zakiah did not agree to the
recommendation and threw the staff attendance register into a
wastepaper basket.
2. Below are actions taken by Encik Suhaimi, a branch manager of Bank

Besar Berhad, to solve the problems pertaining to business promotion.
Evaluate Encik SuhaimiÊs actions in handling the problems:
(a)" Bank Besar Berhad has launched a new product. Encik Suhaimi
feels that the promotion by head office was not effective enough,
therefore he carries out additional promotions.
(b)" There are ten Bank Besar Berhad branches located in the same
area as Encik SuhaimiÊs branch. The branches sometimes
compete among themselves for business. Encik Suhaimi has
suggested to the Area Manager to solve such inter-branch rivalry
by giving business opportunities to the biggest branch (Encik
SuhaimiÊs branch is the biggest branch in the business area
concerned).
Encik SuhaimiÊs rationale being, customers should be given the
best and comprehensive range of services which can only be
found at the biggest branch.
(c)" Encik SuhaimiÊs branch is not permitted by head office to offer
agricultural loans. In the event of any agricultural loan
application, Encik Suhaimi would suggest to the applicant to
apply to the branches of other banks in the same area.

3. You are the Senior Manager of Bank BerjayaÊs Branch Banking

Department at head office. Your bank has 50 branches throughout the
country.
(a)" How do you assess the performance of your branches?
(b)" What are the assessment criteria that you will select?
(c)" What are the assessment measurements used by you?
(d)" State the main problems you face in assessing the business
performance.
4. What is the cause of friction between the head office and branches of a
commercial bank?
A." Differences in work objectives
B." Interdependence of work activities
C." Differences in salary scale
D." All of the above
E." A&B
5. Which is not an advantage of branch banking?

A." Branch banking usually can increase the population per branch
ratio.
B." Banks can use the financial resources more effectively.
C." Branch banking can help to diversify banksÊ assets.
D." Branch banking provides job opportunities.
E." A&D
6. Based on the study by Shamsudin Ismail and Ee Kow Keang (1991),

the main source of staff related problems is:
A." Lack of discipline
B." Motivation level of branch staff
C." Weak human resource management
D." A&B

•" Bank branches are profit centres of commercial banks in Malaysia.

•" Top management has to be sensitive to branch management problems, which
•" affect a bankÊs overall profitability and growth.
•" Bank branches are no longer just the place to collect deposits and provide
loans.
•" To ensure branchesÊ success as profit centres, more effort and attention
should be given in handling the problems identified in the study by
Shamsudin Ismail and Ee Kow Keang.
Branch banking Quantitative criteria

Competitive edge Qualitative criteria
"

Topic X Islamic Banking
4
LEARNING OUTCOMES
1." Explain the development of Islamic banking in Malaysia;
2." Discuss the concept of dual banking;
3." Differentiate between Islamic banking and conventional banking; and
4. Compare the similarities and differences between Al-Mudharabah
products and Al-Musyarakah products.
X" INTRODUCTION
The development of Islamic banking in Malaysia is often related to the revival of
Islam and the aspiration of Muslims to live all aspects of their lives, including
that related to banking activities, in accordance with the teachings of Islam.
According to the International Association of Islamic Banks, basically an Islamic
bank is one that implements new banking concepts based on Syariah rules in
finance as well as other businesses. The functions of Islamic banks should reflect
Islamic principles in real life.
The concept of Islamic banking is different from that of conventional banking.

From IslamÊs point of view, conventional banking means a banking system with
interest element. Islamic banking is a sub-system of Islamic economies and is
considered to have the capability to overcome the weaknesses of the Capitalist
system and Marxist system.
Capitalist system gives the individual freedom to conduct businesses, own

capital, and own the means of production. Conversely, in Marxist system, the
means of production are controlled by the country so that all the benefits of joint
effort are enjoyed by society in a just and equitable manner. The Islamic
economic system also acknowledges individualsÊ rights to own their respective

TOPIC 4 ISLAMIC BANKING W 75
yields. Besides, the Islamic economic system emphasises on the necessity to

cooperate and protect the less capable members of the society.
4.1 HISTORY OF THE DEVELOPMENT OF

ISLAMIC BANKING
Islamic banking activities in Malaysia began as a result of the pressure from
Muslims to conduct their living, including banking activities, in accordance with
the Islamic principles. In September 1963, Perbadanan Wang Simpanan Bakal-
Bakal Haji (PWSBH) was set up as a savings institution for Muslims. PWSBH
symbolises the infancy stage of Islamic banking in Malaysia. In 1969, PWSBH
merged with Pejabat Urusan Haji to form Lembaga Urusan dan Tabung Haji
(presently known as Lembaga Tabung Haji).
The pressure mounted when the Islamic Development Bank of Jeddah and
Islamic Bank of Dubai were established in 1974 and 1975 respectively. On 30th
June 1980, the National Steering Committee on Islamic Banking was set up. The
committee submitted its report to the government on 5th July and the Islamic
Banking Act was enacted at the end of 1982. The Islamic Banking Act, 1983 came
into effect on 7th April 1983. The Act provides Bank Negara Malaysia (BNM)
with powers to supervise and regulate Islamic banks.
In addition, the Government Investments Act, 1983 was enacted to confer power
to the government of Malaysia to issue Government Investment Certificates
specially for investment management and liquidity management of Islamic
Banks. GICs are government bonds issued in accordance with Islamic principles.
Malaysia is believed to be the first country in the world to issue Islamic
government bonds.
On 1st July 1983, the first Islamic Bank, i.e. Bank Islam Malaysia Berhad (BIMB)
was incorporated. On 4th March 1993, BNM introduced a scheme known as
"Skim Perbankan Tanpa Faedah" (Interest-free Banking Scheme) or SPTF.
Through this scheme, financial institutions in Malaysia can implement the
Islamic banking system on a parallel basis with the conventional banking system.
This concept is known as dual concept (will be discussed in the subsequent
sections). On 4th January 1994, the Islamic inter-bank money market was
introduced.
BNM established the National Syariah Advisory Council on Islamic Banking and
Takaful (NSAC) on 1st May 1997 to provide advisory service to BNM on the
aspects of Syariah in the operation of institutions offering Islamic banking. On 1st
October 1999, a second Islamic bank, namely Bank Muamalat was established.

76 X TOPIC 4 ISLAMIC BANKING
ACTIVITY 4.1
Create a time chart to mark the development of Islamic banking,
including the main events that contributed to the development. Based on
the development history, how do you predict Islamic banking to be in
the next five to 10 years?
4.2 DEFINITION OF ISLAMIC BANKING
ACTIVITY 4.2
We often hear about Islamic Banking. Can you explain the meaning of
Islamic Banking?
Islamic banking is banking activities conducted based on the Syariah principles

known as Fiqh Al-Muamalat (Islamic rules for business transaction). Islamic
banking does not allow payment or receipt of interest but encourages profit
sharing. Institutions offering Islamic banking must separate the funds and
activities related to Islamic banking from those for conventional banking.
Under Islamic Banking Act, 1983, Islamic Bank is defined as:
A company which carries out Islamic banking business and holds a valid licence.
The same Act provides definition for Islamic Banking too.
Islamic banking business means banking business with aims and operations
that do not involve any element which is not approved in Islam.
All banks offering Islamic banking services must display the Islamic banking
logo as shown in Figure 4.1.
Figure 4.1: A logo of Islamic Banking

Dual Banking Concept

The long-term objective of BNM is to create an Islamic banking system operating
on a parallel basis with the conventional banking system. This is called dual
banking system. To achieve the long-term objective for Islamic banking, BNM
has formulated three strategies namely:
•" To have a large number of participants;
•" To have a broad variety of instruments; and
•" To have an Islamic inter-bank money market.
(a)" To Have a Large Number of Participants

To increase the number of financial institutions offering Islamic banking
services, BNM had three options:
(i)" Setting up new Islamic banks;
(ii)" Allowing existing financial institutions to offer Islamic banking
services; or
(iii)" Allowing the existing financial institutions to offer Islamic banking
services using their existing infrastructure and branches.
Setting up new Islamic banks would requirement a huge investment

and many skilled staff immediately. If financial institutions were allowed to
offer Islamic banking services without depending on their existing
resources, that would also require huge investment in terms of procuring
skilled manpower and opening new branches. As estimated by the banking
industry, a cost of RM500,000 would be required to open a new branch. In
view of the cost and human resource factors, BNM decided to allow the
existing financial institutions to offer Islamic banking services using their
existing infrastructure and branches.
The third option was executed with the establishment of Interest free
Branching Scheme (SPTF) on 4th March 1993 through the pilot project
involving Malayan Banking Berhad (MBB), Bank Bumiputra Malaysia
(BBMB) and United Malayan Banking Corporation (UMBC). All
commercial banks, finance companies and merchant banks are qualified to
participate in SPTF.
The second phase of the SPTF project, which involved 10 other financial
institutions, was launched on 21st August 1993. At the end of 1997, there
were 24 commercial banks, 22 finance companies and 5 merchant banks
taking part in SPTF. SPTF has been renamed as Skim Perbankan Islam (SPI)

or Islamic Banking Scheme to reflect the suitable status and prestige of

Islamic banking in Malaysia.
There were 36 financial institutions offering Islamic banking services by

May 2003. Table 4.1 lists the financial institutions concerned.
Table 4.1: Financial Institutions Offering Islamic Banking Services
No. Name of Institution Type of Institution

1. Bank Islam Malaysia Berhad Islamic bank
2. Bank Muamalat Malaysia Berhad Islamic bank
3. Affin Bank Berhad Commercial bank
4. Alliance Bank Berhad Commercial bank
5. AmBank Berhad Commercial bank
6. Citibank Berhad Commercial bank
7. EON Bank Berhad Commercial bank
8. Hong Leong Bank Berhad Commercial bank
9. HSBC Bank (M) Berhad Commercial bank
10. Malayan Banking Berhad Commercial bank
11. OCBC Bank (Malaysia) Berhad Commercial bank
12. Public Bank Berhad Commercial bank
13. RHB Bank Berhad Commercial bank
14. Southern Bank Berhad Commercial bank
15. Standard Chartered Bank Malaysia Berhad Commercial bank
16. AFFIN-ACF Finance Berhad Finance company
17. AmFinance Berhad Finance company
18. EON Finance Berhad Finance company
19. Hong Leong Finance Berhad Finance company
20. Kewangan Bersatu Berhad Finance company
21. Mayban Finance Berhad Finance company
Source: BNM Web Site (http://www.bnm.gov.my) (May, 2003)

(b)" To Have a Broad Variety of Instruments

During the 10 years (1983–1993) prior to the establishment of SPTF, many
Islamic financial instruments were introduced through Bank Islam
Malaysia Berhad (BIMB). 21 Islamic banking products were introduced in
1993. We will discuss the Islamic Banking products in Section 4.5.
(c)" To Have an Islamic Inter-bank Money Market

Islamic inter-bank money market was launched on 3 January, 1994 as an
intermediary between financial instruments and financial institutions. This
market consists of three components:
•" Inter-bank trading of Islamic financial instruments;
•" Islamic inter-bank investments; and
•" Islamic inter-bank cheque clearing system.
Malaysia is the first country in the world to set up Islamic money market.
Besides, Malaysia is also the first country in the world to implement dual
banking system and a complete Islamic banking system. This achievement
is attributed to BNMÊs success in executing all three strategies for Islamic
banking.
ACTIVITY 4.3
Most commercial banks in Malaysia offer Islamic banking besides

conventional banking. How do these banks carry out two banking
systems simultaneously and how does BNM help them implement the
dual system?
You can obtain additional information on the implementation of dual

banking on BNMÊs web site at http://www.bnm.gov.my

4.3 THE DIFFERENCES BETWEEN

CONVENTIONAL BANKING AND ISLAMIC
BANKING
We can differentiate Islamic banking from conventional banking by using the
following criteria:
•" Basis of operation;
•" Basis of earnings;
•" Certainty on returns;
•" Relationship between bank and customers; and
•" Objectives.
(a)" Basis of Operation

Conventional banking is based on interest or riba, which is prohibited by
Islam. Riba is an addition to or an excess of the original capital. Three main
elements in riba related transactions are:
(i)" Riba is an addition to or excess of the original capital or (loan)
principal.
(ii)" Riba is predetermined based on the tenure. Riba is considered pre-
determined because the interest rate and the payment are fixed
before any business takes place. This means the banksÊ income can be
determined before any banking business is conducted. This is
contrary to Islamic banking which predetermines sharing ratio only.
Income is only determined after the banking business is conducted.
(iii)" Riba is a condition of the transaction. As stated in verse 175, Surah Al-
Baqarah in the Al-Quran, an addition to the capital is legitimate if it is
resulted from a business transaction based on Syariah principles; an
addition to the capital is illegitimate if it is attributed to interest. The
operation of Islamic banking is based on just and equitable concept.
(b)" Basis of Earnings

Earnings in conventional banking means the difference between interest
received and interest paid. In Islamic banking, earnings are derived from
the profits of the projects undertaken by customers.
(c)" Certainty on Returns

Interest rates in conventional banking are determined based on floating
interest rates, which take into account interest rate fluctuations. The returns

in Islamic banking are not certain because only the profit/loss sharing ratio
is predetermined. This means that in conventional banking, a customer will
have to pay the interest even though his business suffers from losses. In
Islamic banking, the provider of capital and the customer share the losses
based on the profit/loss sharing ratio pre-agreed upon.
(d)" Relationship between Bank and Customer

In conventional banking, banks are the creditors while the borrowers are
the debtors. In Islamic banking, a partner-buyer-seller relationship exists
between the two parties.
The important aspect of this relationship is the balance of power between

the two parties. In conventional banking, banks are the dominant party in
the relationship and therefore they can dictate any terms and conditions as
they wish. Many lawyers have the opinion that loan agreements are indeed
biased towards the banks. In Islamic banking, customers and banks have
equal opportunity to specify the terms and conditions or to change the
terms and conditions based on their respective needs.
(e)" Objectives
The conventional banking emphasises on profits only but Islamic banking
emphasises on profits as well as social welfare. Although conventional
banking practises corporate social responsibility, the practice is more for the
image of the banks. Islamic banking emphasises on the society as it is part
of Syariah requirements which form the basis of Islamic banking.
SELF-CHECK 4.1
Based on your understanding of Islamic banking concept and your

experience in dealing with banks offering conventional banking and
Islamic banking service, what differentiates conventional banking from
Islamic banking?

4.4 ISLAMIC PRINCIPLES IN ISLAMIC BANKING

Islamic banking is implemented based on Syariah principles. There are various
Syariah principles used in the diverse range of Islamic banking products. The
principles concerned are:
•" Al-Wadiah principle (savings);
•" Al-Mudharabah principle (profit sharing);
•" Al-Musyarakah principle (joint venture);
•" Al-Murabahah principle (cost plus);
•" Al-BaiÊBithaman Ajil principle (deferred payment sale or instalment
payment sale);
•" Al-Ijarah principle (leasing/renting);
•" Al-Takjiri principle (leasing/renting that ends with ownership);
•" Al-Kafalah principle (guarantee);
•" Qard al Hasan principle (benevolent loan); and
•" Al-Ujr (fee).
(a)" Al-Wadiah Principle (Savings)

Al-Wadiah is a contract between the owner and the custodian of the goods.
The custodian has the responsibility to prevent the goods from theft, loss or
damage.
Al-Wadiah current deposit and Al-Wadiah savings deposit are Islamic

banking products that follow the Al-Wadiah concept. Banks are given the
trust by the depositors to keep the deposits properly and safely.
Depositors/ customers have the right to withdraw their deposits at any
time and the banks must be prepared to return the deposits when
demanded.
It is at the banksÊ discretion to pay dividend on any deposit. The depositors

do not require any other reward from the bank as they receive the benefit
from the bank in terms of deposit safekeeping service. Nevertheless, banks
usually pay dividends as a result of intense competition in the banking
world these days.
What benefit does a bank get for safekeeping its customersÊ deposits?
Customers allow the bank to use their deposits and that represents trust

from the customers. Therefore, banks have the responsibility to invest the
deposits wisely.
(b)" Al-Mudharabah Principle (Profit Sharing)

Al-Mudharabah involves a contract between two parties, i.e. a capital
owner and an entrepreneur. The capital owner provides a sum of money to
enable the entrepreneur to carry out business projects. Profits from the
project are to be shared based on pre-agreed profit sharing ratio.
In the context of Islamic banking, a depositor (capital owner) deposits a

sum of deposits with the bank (entrepreneur) with an objective to share the
profits derived from investing the fund. Profits are shared based on pre-
agreed ratio.
Islamic banking products based on Al-Mudharabah principles are:

•"Al-Mudharabah general investment account (GIA);
•"Al-Mudharabah special investment account (SIA); and
•"Al-Mudharabah project finance.
(i)" Al-Mudharabah General Investment Account (GIA)

Al-Mudharabah General Investment Account (GIA) depositors may
receive returns on their deposits which are used or invested by the
banks. The returns are in the form of profit sharing based on pre-
agreed ratio.
For example, sharing ratio of 70% : 30% means the depositor is

entitled to 70% of the profits, and the bank 30%. All GIA depositors
are entitled to one standard rate of return as all GIA deposits are
pooled together and invested by the bank at its discretion.
Investment losses are borne by all the depositors. This does not mean
that the bank does not have to bear any of the losses. Losses incurred
are recorded in the bankÊs books and accounts and this certainly
tarnishes the bankÊs integrity and trust worthiness, not to mention the
negative consequences to the share price of the bank, if its shares are
listed on the stock exchange.
(ii)" Al-Mudharabah Special Investment Account (SIA)

Like General Investment Accounts (GIA), Special Investment
Accounts (SIA) are also for savings or fixed deposits. However, there
are differences between the two types of accounts in some aspects.

•" Most SIA depositors are institutional investors while GIA

depositors are retail customers. This may be due to the much
higher minimum investment amounts required for SIA compared
to GIA.
•" SIA depositors are allowed to decide which or what projects that
they want their funds to be invested in, while GIA depositors give
the banks absolute discretion in investment decisions. This
happens because SIA deposits are not placed into a common pool
like in the case of GIA deposits.
•" Unlike GIA deposits which provide a standard rate of return for
all depositors, the rates of return on SIA deposits differ from one
depositor to another. This is because SIA depositors decide
individually on the investment projects they wish to take part in.
•" SIA depositors are allowed to negotiate on the profit sharing ratio.
This is not the case for GIA depositors. However, just like GIA
depositors, SIA depositors have to bear any losses incurred.
In conventional banking, the equivalence of GIA and SIA is fixed

deposit account. The difference between conventional fixed deposit
and GIA/SIA is basically the difference between conventional
banking and Islamic banking.
(iii)" Al-Mudharabah Project Finance

Project finance is a frequently used banking product by entrepreneurs
to finance their projects. Al-Mudharabah project finance is similar to
Al-Mudharabah investment account, except for one difference – in Al-
Mudharabah project finance, the bank is the capital provider and the
entrepreneur is the bankÊs customer.
In Al-Mudharabah project finance, profits from the project are shared

based on pre-agreed profit sharing ratio, while the losses are borne by
the bank. However, this does not mean the customer does not bear
any losses. Indeed the losses are reflected in the customer Ês books and
accounts and this can jeopardise the customer Ês integrity as an
entrepreneur.
The equivalence of this product in conventional banking is term loan

or industrial loan. Again, the difference between conventional bank
loan and Al-Mudharabah project finance is basically the difference
between conventional banking and Islamic banking.

(c)" Al-Musyarakah Principle (Joint Venture)

Al-Musyarakah principle refers to a joint venture for a specific business.
Both the lender and borrower finance the business jointly, and the lender
participates in the management activities. The profit sharing ratio does not
necessarily follow the equity participation ratio. However, in the event of
losses, both parties will share the losses on the basis of their equity
participation.
Al-Musyarakah project finance and Al-Musyarakah trade finance are

banking products based on Al-Musyarakah principle.
(i)" Al-Musyarakah Project Finance

In Al-Musyarakah project finance, the bank and the entrepreneur
(bankÊs customer) contribute capital towards the cost of a specific
project. Both parties have the right to participate in the management
of the project. However, such rights can be waived. Profits from the
project are shared by both parties based on pre-agreed ratio, but not
necessarily based on equity participation. Nevertheless, losses from
the project are shared based on equity participation.
The equivalence of Al-Musyarakah project finance in conventional

banking is term loan or industrial loan.
(ii)" Al-Musyarakah Trade Finance

In conventional banking, a bank customer importing goods from
overseas may use Letter of Credit (L/C) facility to finance the imports.
In Islamic banking, a customer may use Al-Musyarakah trade
financing product. Through Al-Musyarakah trade finance, the bank
and the customer tie a partnership to import goods. The bank issues a
Letter of Credit to pay for the imports, while the customer deposits a
sum of money with the bank based on his share of the cost of imports.
After the goods are sold by the customer, profits earned will be
shared between the bank and the customer.
The significant difference between Al-Musyarakah project finance and

Al-Mudharabah project finance is in the capital contribution. In the
former, both parties contribute the required capital while in the latter,
the required capital is contributed by one party only. The obvious
similarity between the two financing methods is in the sharing of
profits and losses.

ACTIVITY 4.4
P L/C facility offered by conventional banking is almost the same as Al-

Musyarakah trade finance product offered by Islamic banking. Visit
BNM web site http://www.bnm.gov.my as well as the web sites of
banks offering Islamic banking and conventional banking, and identify
the differences between the two systems.
(d)" Al-Murabahah Principle (Cost Plus)

Al-Murabahah principle involves the sale of goods at a price calculated as
follows:
SELLING PRICE = COST OF GOODS + PROFIT MARGIN
The lender buys goods desired by the customer and then sells the goods to
the customer at a higher price, after taking into account the cost of the
goods and profit margin. The terms and conditions must be mutually
agreed by both parties.
Loans involving sale and purchase agreement and Al-Murabahah trade

finance are Islamic banking products based on Al-Murabahah principle.
Al-Musyarakah trade finance requires the importer to contribute a sum of

capital to finance the imports, but Al-Murabahah trade finance does not
impose the same requirement. Therefore, Al-Murabahah finance does not
involve profit sharing on the sale of goods. The importer is merely required
to repay the Letter of Credit amount plus commission on the maturity date.
(e)" Al-BaiÊBithaman Ajil (Deferred Payment Sale or Instalment Payment Sale)

Al-BaiÊBithaman Ajil (BBA) principle is a fragment of Al-Murabahah
principle. BBA refers to the sale of goods on a deferred payment or
instalment payment basis, compared to Al-Murabahah which requires
full payment at once. In BBA, the tenure and method of payment must be
mutually agreed by both parties.
Islamic banking products based on BBA concept are:

(i)" BBA asset financing;
(ii)" BBA hire-purchase; and
(iii)" BBA share financing.

Islamic banking customers may purchase their houses or any other fixed
assets through BBA financing. In BBA financing, the bank purchases the
asset desired by the customer and resells the same to the customer. In
return, the customer pays the bank the pre-agreed installment payments.
Consumer goods such as electrical appliances, business equipments and

vehicles can also be purchased through BBA. After the customer decides on
the desired goods, the bank buys and resells the goods to the customer. The
customer then pays the bank by installment payments, whether on a
monthly basis, quarterly basis, half-yearly basis or yearly basis.
(f)" Al-Ijarah Principle (Leasing/Renting)

Based on the Al-Ijarah principle, the bank buys the asset chosen by the
customer. The bank then leases the asset to the customer, and the customer
will pay lease rental to the bank by installment payments based on
mutually agreed terms and conditions.
Al-Ijarah principle is similar to BBA hire-purchase in terms of repayment by

installments, but they differ in terms of asset ownership. Conventional
banking product equivalent to Al-Ijarah leasing is the ordinary leasing
product used to finance purchases of fixed assets.
(g)" Al-Takjiri Principle (Leasing/Renting that Ends with Ownership)

Al-Takjiri principle is a fragment of Al-Ijarah principle. Lease contract
under Al-Takjiri gives the customer the option to own the asset at the end
of the lease tenure, and the rentals or lease payments already settled by the
customer are taken into consideration in determining the selling price.
Al-Takjiri principle is similar to BBA hire-purchase contract, except that

asset ownership is automatically transferred under BBA hire-purchase. In
conventional leasing, the ownership of the asset usually remains with the
lessor at the end of the lease. Nevertheless, there are ordinary leases which
give the lessees an opportunity to own the asset concerned through option
to purchase.
(h)" Al-Kafalah Principle (Guarantee)

Al-Kafalah principle involves guarantee by a bank to bear the liability of its
customer. Al-Kafalah bank guarantee is similar to bank guarantee in
conventional banking. For example, an entrepreneur planning to operate a
petrol station may be required to obtain bank guarantee from his bank. To
enjoy such a facility, the customer must place a deposit as collateral.
Ordinary bank guarantee is this productÊs equivalence in conventional
banking.

(i)" Qard al Hasan Principle (Benevolent Loan)

Based on this principle, the borrower is only required to repay the principal
amount borrowed. Nevertheless, he may pay an extra amount at his
absolute discretion as a token of appreciation. For example, Malaysia
Investment Certificate (MIC) is a benevolent loan to the government of
Malaysia. MIC holders do not expect any returns because dividends are
paid at the governmentÊs absolute discretion.
(j)" Al-Ujr (Fee)

Al-Ujr refers to commissions or fees charged for services.
EXERCISE 4.1
1. Discuss the similarities and differences between Al-Mudharabah

trade finance and Al-Musyarakah trade finance.
2. Discuss the similarities and differences between Al-Murabahah
Letter of Credit and Al-Musyarakah Letter of Credit.
4.5 ISLAMIC BANKING PRODUCTS AND

SERVICES
Products and services offered by Islamic banking are based on Syariah principles
discussed earlier. There are five different categories of Islamic banking products
and services:
•" Savings or deposits;
•" Retail finance services;
•" Credit card services;
•" Trade finance; and
•" Banking services.

(a)" Savings or Deposits

Product/Service Syariah Principle
Savings account-i •" Wadiah (savings)
•" Mudharabah (profit sharing)
Current account-i •" Wadiah (savings)
•" Mudharabah (profit sharing)
General investment account-i Mudharabah (profit sharing)
Special investment account-i Mudharabah (profit sharing)
Specific investment account-i Mudharabah (profit sharing)
Negotiable Debt Certificate-i BaiÊBithaman Ajil (deferred payment sale
or installment payment sale)
Negotiable Deposit Instrument-i Mudharabah (profit sharing)
(b)" Retail Finance Services

Home/house financing-i BaiÊBithaman Ajil (deferred payment sale
Land financing-i BaiÊBithaman Ajil (deferred payment sale
Hire purchase agency-i Al-Ijarah Thumma al BaiÊ (leasing)
Cash line facility-i •" BaiÊBithaman Ajil (deferred payment
sale or installment payment sale)
•" Murabahah (cost plus)
Share financing-i •" BaiÊBithaman Ajil (deferred payment

sale or instalment payment sale)
•" Musyarakah (joint venture)
Unit trust financing-i •" BaiÊBithaman Ajil (deferred payment


Umrah & visitation financing-i •" BaiÊBithaman Ajil (deferred payment

Working capital financing-i Murabahah (fixed price plus)
(c)" Credit Card Services

Credit card-i Bai' al-Inah (sell and repurchase agreement)
(d)" Trade Finance

Accepted bills-i Murabahah (fixed price plus)
Letter of Credit-i •" Murabahah (fixed price plus)
(e)" Banking Services

Stock brokerage service Ujr (fee)
Telegraphic Transfer Ujr (fee)
Traveller Ês Cheque Ujr (fee)
Demand Draft Ujr (fee)
Cashier Ês Order Ujr (fee)
Standing Instruction Ujr (fee)
ATM service Ujr (fee)
Tele-banking Ujr (fee)

ACTIVITY 4.5
There are equivalences of Islamic banking products and services in
conventional banking. What are the similarities and differences between
the two groups?
You can obtain additional information on products and services offered

by conventional banking as well as Islamic banking by visiting the web
sites of commercial banks and Islamic banks, through the hyperlinks at
BNM web site (http://www.bnm.gov.my).
4.6 LATEST MEASURES TO DEVELOP ISLAMIC

BANKING
Detailed below are the latest measures implemented by Bank Negara Malaysia to
develop Islamic banking in Malaysia:
Date Measure
1 Dec 1998 Financial institutions participating in Skim Perbankan Tanpa
Faedah (SPTF) or Interest-free Banking Scheme were allowed to
use the term „Islamic banking‰ in their banking operations,
businesses and correspondences.
This was implemented to avoid confusion over the term

„interest-free banking‰ among Islamic banking customers, since
the term could mislead the customers to believe that banks were
offering loans without charging any interest or any other
charges.
8 Dec 1998 Bank Negara Malaysia (BNM) introduced guidelines on Islamic
negotiable instruments equivalent to Negotiable Instruments of
Deposits (NIDs) used in conventional banking.
The guidelines brought in two Islamic deposits products, i.e.

Negotiable Islamic Debt Certificate (NIDC) and Negotiable
Islamic Deposit (NID).
Both of these measures enhanced the deposit taking opportunity

of Bank Islam and Skim Perbankan Islam (SPI) institutions, and
further developed the Islamic money market in tandem with the
increase in liquid and negotiable instruments.

2 Jan 1999 Banking institutions participating in Skim Perbankan Islam (SPI)

or Islamic Banking Scheme, which replaced SPTF, were required
to elevate the status of Islamic Banking Unit to Islamic Banking
Department. The new status came with broader scope and more
responsibilities. The head of Islamic Banking Unit at each
participating bank was upgraded to be Assistant General
Manager.
Feb 1999 Discount houses were permitted to participate in SPI. Three
discount houses joined the scheme by Feb 1999.
2 Jan 2001 Minimum Islamic banking funds were increased as follow:
Commercial banks - increased from RM5 million to RM20
million Finance companies - increased from RM5 million to
RM10 million Merchant banks - increased from RM3 million
to RM6 million
2001 A second Islamic Bank, Bank Bumi-Muamalat Malaysia Berhad
was established following the merger between Bank Bumiputra
Malaysia and Bank of Commerce Berhad.
EXERCISE 4.2
Compare the similarities and differences between Islamic banking
system and conventional banking system.
•" Islamic banking in Malaysia began with the incorporation of the first Islamic
bank in 1983.
•" Islamic banking activities were intensified ten years later with the launch of
Skim Perbankan Tanpa Faedah (SPTF) or Interest-Free Banking Scheme,
which was subsequently replaced by Skim Perbankan Islam (SPI) or Islamic
Banking Scheme.
•" The banking industry now practices a dual banking system, the first in the
world. In the dual banking system, Islamic banking operates on a parallel
basis with conventional banking.
•" The government always takes the necessary steps to heighten the
development of Islamic banking in Malaysia in view of the huge potential for
Islamic banking in the country as well as in the region.

•" Even though Islamic banking products seems similar to conventional

banking products, they are different in terms of receipt and payment of
interest.
•" Interest is prohibited in Islamic banking. In view of that, Islamic banking

practices the profit sharing concept.
Certainly on returns Negotiable Islamic Debt Certificate

Dual banking concep

Topic X Asset
5 Management
LEARNING OUTCOMES
1." Apply the fund pool method, asset allocation method and
management science method in solving the liquidity-profitability
(LP) dilemma;
2." Compare the similarities and differences among the fund pool
method, asset allocation method and management science method;
3." Discuss the functions and roles of bank liquidity in commercial bank
management;
4." Identify the similarities and differences among the bank liquidity
theories; and
5." Estimate the liquidity requirement of a commercial bank.
X" INTRODUCTION
The main problem in bank asset management is how to distribute bank funds
(which are limited) among the different categories of assets so as to maximise
profits. As different assets have different levels of liquidity and profitability,
banks are faced with the liquidity-profitability or LP dilemma. LP dilemma spells
that if a bank emphasises on liquidity, profitability will be sacrificed. That means,
in reducing liquidity risk, a bank is forced to reduce profitability. Conversely, if a
bank focuses on profitability, it has to do so at the expense of liquidity. In other
words, a bank must bear higher liquidity risk in order to increase its returns.
This topic will discuss asset management methods used by banks to manage
their asset utilisation in order to maximise shareholdersÊ returns.

TOPIC 5 ASSET MANAGEMENT W 95
5.1 BANK’S FINANCIAL STATEMENTS

Before we begin the discussion on asset management, we need to understand
bankÊs financial statements, i.e. balance sheet and income statement.
Like other business organisations, commercial banks must prepare the main
financial statements, i.e. balance sheet and income statement or profit & loss
statement. However, financial statements of commercial banks are significantly
different from the financial statements of other firms because of the differences
between their businesses. This can be seen clearly when we study the details of
the balance sheets and income statements of commercial banks.
SELF-CHECK 5.1
You have learned about three types of financial statements in the

Financial Management course. What are these financial statements
(other than cash flow statement)? Do all banking institutions have the
same financial statements?
5.1.1 Bank’s Balance Sheet

Like the balance sheets of other firms, every bank balance sheet has three main
components i.e. assets, liabilities and ownersÊ equity. Nevertheless, the sub
components of bank asset, liability and ownersÊ equity are significantly different
from those found in other firmsÊ balance sheets.

96 X TOPIC 5 ASSET MANAGEMENT
Table 5.1: BankÊs Balance Sheet
Bank Gemilang Berhad

Balance Sheet
as at 31 December 2002
Current Assets (RM Million)

Cash and short term funds 90
Securities purchased under resale agreements 700
Deposits and placements with banks and other financial institutions 860
Securities held-for-trading 1,300
Investment securities 4,100
Loans, advances and financing 40
Other assets 15
Investment in subsidiary companies 2
Investment in associated companies 3
Fixed assets 25
Total assets 7,275
Liabilities and Equity

Deposits from customers 5,175
Deposits and placements of banks and other financial institutions 600
Obligations on securities sold under repurchase agreements 170
Bills and acceptances payable 200
Other liabilities 90
Bonds and bank notes 100
Subordinated loans 90
Total liabilities 6,425
Share capital 800
Reserves 50
Total liabilities and shareholdersÊ equity 7,275
Commitments and contingencies 1,255
Further explanation on the sub-components of bank asset, liability and equity is

as follows:
(a)" Assets
(i)" Cash and Short Term Funds

Cash and short term funds consist of cash and balances at other banks
or financial institutions. Like other firms, banks keep cash for daily
operations. Commercial banks require cash to fulfil customersÊ

deposit withdrawals. Balances at other banks and financial

institutions are to facilitate clearance of cheques.
(ii)" Securities Purchased Under Resale Agreements

When a bank invests in a repurchase agreement (REPOS)
suchinvestment is recorded as „securities purchased under resale
greements‰. It represents short term investment of commercial banks
for the purpose of bank liquidity. However, when a bank issues or
sells any REPOS, it represents an obligation that has to be recorded in
the liability section.
(iii)" Deposits and Placements with Banks and Other Financial Institutions
Deposits of more than one-month maturity placed with other
commercial banks, finance companies and other financial institutions
are recorded as „deposits and placements with banks and other
financial institutions‰. These deposits are also kept for bank liquidity.
However, deposits of no more than one-month maturity are recorded
as „cash and short term funds‰.
(iv)" Trading Securities

These are marketable securities purchased or acquired for resale in a
short term. Examples of these money market instruments are:
•" Malaysian government treasury bills;
•" Malaysian government securities;
•" Government investment certificates;
•" Bank Negara Malaysia bills;
•" Cagamas bonds;
•" Negotiable instruments of deposit;
•" BankersÊ acceptances; and
•" Private debt securities.
(v)" Investment Securities

Investment securities are securities purchased or acquired and held
for capital growth. Investment securities are also acquired to meet the
minimum liquidity requirement imposed by Bank Negara Malaysia.
Examples of investment securities are money market instruments
such as trading securities. Besides, securities with no fixed price such
as shares and private debt securities are also categorised as
investment securities.

(vi)" Loans, Advances and Financing

Loans, advances and financing represent the largest category of
assets of any commercial bank since the provision of credit facilities is
commercial banksÊ main activity. In turn, interest earned from lending
or financing represents the major source of income for any of these
banks. Loans, advances and financing are believed to be the least
liquid assets because it is difficult to recall the loans instantly while
repayments are often by installments. In accordance with one of the
investment principles, i.e. the higher the required returns, the higher
the risk, so loans, advances and financing are the highest risk assets of
banks.
The following are the types of loans offered by commercial banks:

•" Overdrafts;
•" Term loans;
•" Fixed rate loans;
•" Variable rate loans;
•" Credit card receivables;
•" Bills receivable;
•" Trust receipts;
•" Claims on customer under acceptance credits;
•" Staff loans; and
•" Other loans.
Loans and advances can be categorised based on economic sectors as

follows:
•" Agriculture;
•" Mining;
•" Quarry;
•" Manufacturing;
•" Real estate;
•" Construction;
•" Housing;
•" Trading;

•" Finance and insurance; and

•" Application credit.
(vii)" Other Assets

Other assets include debtors, deposits and repayments as well as
foreclosed properties.
(viii)"Statutory Deposits with Bank Negara Malaysia

These are deposits placed with Bank Negara Malaysia pursuant to
Section 37 (1)(c) of the Bank Negara Malaysia Ordinance 1958 which
requires commercial banks to place non-interest bearing statutory
reserve with Bank Negara Malaysia to safeguard the welfare of the
depositors. The amount of statutory reserve placed by a bank
represents a percentage of the bankÊs total eligible liabilities.
(ix)" Investment in Subsidiary Companies

A company is a subsidiary company if the commercial bank:
•" Has control over the composition of its board of directors; or
•" Has control over more than 50% of its voting rights; or
•" Hold more than 50% of the companyÊs issued ordinary share
capital.
(x)" Investment in Associated Companies

A company is an associated company if the commercial bank:
•" Owns between 20% and 50% of its long term equity interests; and
•" Has extensive influence through participation in the management
of the company.
(xi)" Fixed Assets

Fixed assets are long term assets needed by banks to carry out their
banking businesses. Examples of fixed assets are:
•" Freehold land;
•" Leasehold land;
•" Buildings on freehold land;
•" Buildings on leasehold land;
•" Office equipment and furniture;
•" Computer equipment and software;

•" Motor vehicles; and

•" Other leased assets
•" Office equipment and furniture;
•" Computer equipment and software; and
•" Motor vehicles.
(b)" Liabilities
(i)" Deposits from Customers

Deposits from customers consist of:
•" Demand deposits or current accounts;
•" Savings accounts;
•" Fixed deposits;
•" Negotiable instruments of deposit; and
•" Other deposits.
The structure of maturity periods of fixed deposits and negotiable

instruments of deposit are as follows:
•" Not more than 6 months;
•" More than 6 months but not more than one year;
•" More than one year but not more than three years;
•" More than three years but not more than 5 years; and
•" More than five years.
(ii)" Deposits and Placements of Banks and Other Financial Institutions

These are deposits and savings placed by licensed commercial banks,
licensed finance companies and other financial institutions.
(iii)" Obligations on Securities Sold under Repurchase Agreements

When a bank issues or sells REPOS, the liabilities are recorded as
„obligations on securities sold under repurchase agreements‰. These
obligations are short term debts owed to the REPOS investors or
buyers concerned.

(iv)" Bills and Acceptances Payable

Bills and acceptances payable refer to outstanding exchange bills and
bankersÊ acceptances.
(v)" Other Liabilities

Other liabilities include:
•" Proposed dividends;
•" Taxes;
•" Deferred taxes;
•" Obligations under finance lease; and
•" Other liabilities.
(vi)" Bonds and Bank Notes

Bonds and bank notes are long term debts obtained through issuance
of bond securities and bank notes. These long term debts may be
charged fixed or floating interest rates. Bonds consist of convertible
bonds and redeemable bonds.
(vii)" Subordinated Loans

Subordinated loans are unsecured loans obtained by banks to finance
their banking activities. These debts are given lower priority than other
debts. This means that should a bank be liquidated, subordinated loans
will be repaid only after other liabilities are settled.
(c)" OwnersÊ Equity
(i)" Share Capital

Share capital of banks usually consists of ordinary shares.
Nevertheless, some banks issue preference shares too. Ordinary
shares but not preference shares give the holders the rights of
ownership of the company. A banks issues preference shares when it
needs fresh funds and at the same time it wants the ownership rights
of the bank to remain in the hands of the existing ordinary
shareholders.
"
(ii)" Reserves
Bank reserves usually consist of:
•" Share premium;
•" Statutory reserve; and
•" Retained profits.

Share premium represents the excess of issue price over nominal

value of the shares concerned. Ordinary shares usually have a
nominal value or par value of RM1.00. When a bank issues new
shares, the issue price is always higher than the nominal value.
Therefore, if the ordinary shares are sold at RM3.00 each, the share
premium amounts to RM2.00, i.e. issue price (RM3.00) – par nominal
value (RM1.00).
Statutory reserve is the reserve kept in pursuant to Section 36 of

BAFIA, 1989 and it cannot be distributed for cash dividends.
Retained profits are profits that is not distributed for cash dividends and
are to be carried forward to the following year. A bankÊs retained profits
represent an amount accumulated since the establishment of the bank.
(d)" Commitments and Contingencies

Banks make various commitments and bear the liabilities of the
contingencies concerned in their ordinary conduct of businesses. For
example, a bank customer intending to open a petrol station may request a
bank to issue a bank guarantee as required by the oil company. Essentially,
when a bank issues the bank guarantee, it provides guarantee to the oil
company that it will bear the customer Ês liability that may arise in future.
At that juncture, the bank only admits that it will bear a contingent liability,
while no actual business transactions has yet taken place. Therefore such a
transaction is not recorded in the bankÊs balance sheet. It is regarded as an
off-balance sheet item. Even though no liability has arisen, there is a
potential liability and the bank is exposed to such risk. In view of that, such
information ought to be recorded as an item in the bankÊs financial report.
Examples of other off-balance sheet items are:

•" Short-term self-liquidating trade-related contingencies;
•" Housing loans sold directly and indirectly to Cagamas Berhad;
•" Obligations under underwriting agreement;
•" Foreign exchange related contracts; and
•" Interest rate related contracts.

ACTIVITY 5.1
Obtain the balance sheets of at least three commercial banks in
Malaysia and identify the components therein. Make comparisons
among the three balance sheets, including how they are reported, and
summarise your findings.
Balance sheets of commercial banks in Malaysia can be obtained from

the web sites of the respective banks. These web sites are accessible
through the hyperlinks at BNM website site at
http://www.bnm.gov.my.
5.1.2 Bank’s Income Statement

Table 5.2 is a sample of a commercial bankÊs income statement.
Table 5.2: BankÊs Income Statement
Bank Gemilang Berhad

Income Statement
For the year ended 31 December 2008
(RM Million)
Interest income 400
Interest expense 200
Net interest income 200
Allowance for losses on loans, advances and financing 100
100
Non-interest income 40
Net income 155
Overhead expenses 2
Profit before taxation 3
Tax 25
Net Profit after tax
Transfer to statutory reserve 5,175
Net profit after transfer to statutory reserve 600
Retained profit brought forward 170
Distributable profit 200
Proposed dividend 90
Retained profit carried forward 100
Earnings per share (sen) RM3.80

Further explanation on the income statement items is as follows:
(a)" Interest Income

Interest income is income derived from the following assets:
(i)" Loans, advances and financing;
(ii)" Call money and deposit placements at other financial institutions;
(iii)" Securities held-for-trading; and
(iv)" Investment securities.
Interest income is recognised on accrual basis. Interest income from

housing loans and term loans is recognised based on the balance tenure, be
it monthly or annually. When an account is classified as non-performing,
the recognition of its interest income is suspended until cash in obtained.
An account is non-performing when repayments on loans including
overdrafts are past due by six months or more. An account pertaining to
commercial bills, bankersÊ acceptances or trust receipts is deemed non-
performing after the maturity date of the facility.
(b)" Interest Expense

Interest expense is the interest paid to the various sources of finance such as:
(i)" Deposits from customers;
(ii)" Deposits and placements of banks and other financial institutions; and
(iii)" Subordinated term loans.
(c)" Net Interest Income

Net interest income is the difference between interest income and interest
expense. It shows how far the interest income derived from assets can meet
the interest expense obligations due to the various sources of finance.
(d)" Allowance for Losses on Loans, Advances and Financing

This amount represents allowance made for bad and doubtful debts, as well
as bad debts written off to absorb the expected losses from the loans
concerned. This allowance can be in the form of specific allowance or
general allowance.
Specific allowance is made up for doubtful debts which have been

individually and specifically identified as bad debts or doubtful debts.
General allowance, based on a percentage of the loan portfolio, is made to
allow for probable losses not identifiable specifically.

Banks classify a loan as bad debts after taking into consideration the value
of the collateral and after determining that the loan has no prospect for
collection. Allowance for losses on loans, advances and financing is a
measurement of credit risk borne by banks in their effort to procure interest
income.
(e)" Non-interest Income

Non-interest income consists of fee income, investment income and other
income.
Examples of fee income are:

(i)" Commission;
(ii)" Service charge and service fee;
(iii)" Guarantee fee; and
(iv)" Underwriting fee.
Examples of investment income are:

(i)" Net profit on held-for-trading securities;
(ii)" Gain on disposal of investment securities;
(iii)" Dividend income from trading securities;
(iv)" Dividend income from investment securities; and
(v)" Dividend income from subsidiary companies.
Sources of other income include:

(i)" Foreign exchange gain;
(ii)" Rental income;
(iii)" Gain on disposal of fixed assets; and
(iv)" Gain on disposal of foreclosed properties.
(f)" Net Income

Net income refers to the total net income after the allowance for bad debts
and doubtful debts.

(g)" Overhead Expenses

Bank overhead expenses consist of:
(i)" Personnel costs;
(ii)" Establishment costs;
(iii)" Marketing expenses;
(iv)" Administration expenses; and
(v)" General expenses.
Commercial banks in Malaysia are required to report the following

expenses:
(i)" DirectorsÊ remuneration;
(ii)" Premises rental;
(iii)" Equipment rental;
(iv)" Lease rental;
(v)" AuditorsÊ remuneration;
(vi)" Depreciation of fixed assets;
(vii)" Loss on disposal of fixed assets; and
(viii)" Professional fee paid to the firmÊs directors.
(h)" Profit Before Taxation

This represents profit procured by the bank before taking into account taxes
payable.
(i)" Tax
Tax refers to Malaysian corporate tax payable by banks for the relevant year
based on profit before taxation. It covers foreign taxes payable and takes
into account the double taxation relief.
(j)" Transfer to Statutory Reserve

This item shows the amount transferred from the profit and loss account to
the statutory reserve account. This transfer is necessary in compliance with
the statutory reserve requirement.
(k)" Net Profit After Transfer to Statutory Reserve

This amount represents the net profit of a bank after the provision for
statutory reserve.

(l)" Retained Profit Brought Forward

This is the amount of retained profit accumulated procured in the previous
years.
(m)" Distributable Profit

This is the profit amount that can be distributed to the shareholders. It
represents the total of retained profit for the current year (after provision
for statutory reserve) and that of the previous years. It is owned by the
shareholders and can be distributed as dividend to the shareholders.
(n)" Proposed Dividend

It is the amount of dividend after tax for shareholders, as proposed by the
board of directors.
(o)" Retained Profit Carried Forward

This represents distributable profit net of proposed dividend. It becomes nil
if a dividend amounting to 100% of the distributable profit is proposed.
(p)" Earnings per Share (Sen)

This is additional information reported in income statements. Earnings per
share of a bank are derived from dividing the net income after taxation by
the number of ordinary shares in issue.
ACTIVITY 5.2
Obtain the income statements of at least three commercial banks.

Compare the components in the statements and explain how the banks
report the components.
These income statements can be obtained from the web sites of the
respective banks, which are accessible through the hyperlinks at BNM
website site at http://www.bnm.gov.my.
5.2 ASSET MANAGEMENT

After discussing the components in the bank balance sheet and income
statement, we will proceed to discuss asset management.
Asset management of a bank signifies how the bank invests its assets/funds to
maximise its shareholdersÊ wealth. As the liquidity and profitability differ from

one asset to another, banks must take into consideration the liquidity-
profitability (LP) dilemma.
5.2.1 Elements of Asset Liquidity
SELF-CHECK 5.2
Liquidity is not a new concept in accounting. What do you understand
about asset liquidity, based on your knowledge of liquidity concept?
An asset is considered liquid if it can be turned into cash without heavy losses.
For example, if the market price of an asset is RM100 and if it can be sold at
RM95, the asset is considered liquid. A liquid asset is one that can be sold easily
and has a ready and stable market for it too.
In asset management, liquidity of bank assets can be lined up in a continuum

beginning with cash as the most liquid asset and loans and advances as the least
liquid assets.
Cash is considered the most liquid asset as it can be used to repay debts or to
invest instantly. Government securities are the second most liquid assets as they
can be sold without heavy losses since there is not much difference between the
buying and selling prices. Besides, they have a ready and stable market.
Marketable securities are considered the third most liquid asset because there is a
ready market for these instruments. However, their buying and selling prices are
not as stable as that of government securities. Other investments are also
considered liquid assets because they can be converted into cash. Nonetheless,
these assets have different degrees of liquidity among them. Their degrees of
liquidity depend upon how easily they can be turned into cash while avoiding
ability heavy losses at the same time.
Fixed assets of banks are deemed more liquid than loans and advances because
fixed assets can be sold at any time, amid the probability of heavy losses upon
conversion. On the contrary, loans and advances cannot be recalled arbitrarily
because of the pre-agreed repayment terms as specified in the loan agreements
must be adhered to. Furthermore, the problems associated with non-performing
loans also contribute to loans and advances being the least liquid bank assets.

5.2.2 Liquidity-Profitability Dilemma

Liquidity-profitability (LP) dilemma exists because the degrees of liquidity and
profitability are different across different assets. Besides, the LP dilemma is
attributed to conflicting goals among shareholders, depositors and the
controlling party.
Shareholders expect high returns on the financial leverage provided by

depositorsÊ funds. Depositors desire maximum liquidity so that they can
withdraw their deposits at any time. The controlling party (i.e. BNM) requires
satisfactory bank liquidity to safeguard depositorsÊ welfare and bank security. At
the same time, BNM expects reasonable returns for the benefit of the
shareholders, depositors and banks.
To overcome LP dilemma, we ought to find a method that can strike a balance

between risk and return, liquidity and profitability. There are three methods that
can be used to overcome the LP dilemma. They are:
(a)" Fund pool method;
(b)" Asset allocation method (exchange fund method); and
(c)" Linear programming method (management science method).
5.3 FUND POOL METHOD

In fund pool method, funds from all sources are pooled together to create a single
source of funds. Subsequently, the funds are distributed to the various
predetermined categories of assets based on their degrees of importance.
In order to understand the fund pool method, please refer to Example 5.1.

Example 5.1
Corporate Planning Department of Bank Gemilang Berhad has estimated
the bankÊs sources of fund for year 2008, as shown below:
RM (MILLION)
Current deposits 200
Savings deposits 100
Fixed deposits 100
Repurchase agreements 50
NCDs 50
Debentures 100
Total 600
The Asset and Liability Committee of Bank Gemilang Berhad has been requested
to allocate funds for the bankÊs using the fund pool method.
Step 1:
Gather all funds totalling RM600 million into one single pool.
Step 2:
Provide fund for the main reserve. The main reserve consists of cash, statutory
reserve, balances at other financial institutions and cash-in-transit. Based on the
assumption that Bank Gemilang has excess reserve base of 20% and that the
statutory reserve imposed by the central Bank is 10%, the provision for main
reserve is 180 million (30% × RM600 million).
Step 3:
Provide fund for secondary reserve. Bank assets included in secondary reserve
are usually money market securities such as treasury bills, Malaysian
government securities (MGS), bankersÊ acceptances (BAs), negotiable certificates
of deposit (NCDs) and repurchase agreements (REPOS).
Besides having the ability to meet the expected liquidity requirement, assets in
secondary reserve can be used to meet contingent obligations.
The provision for secondary reserve is 20%, i.e. RM120 million. That means a
total RM300 million (50%) has been provided for bank liquidity specifically.

Step 4:
Only after liquidity has been sufficiently provided for can the fund be allocated
to meet the credit requirement of customers. The fund pool method does not
offer any specific guidelines regarding the composition of loan portfolio.
Nevertheless, in general, this method suggests that credit distribution should
reflect the prevailing economic forces. This method does not consider loan
portfolio as a liquidity source.
By assuming that the provision for loan portfolio is 30% and it is distributed to
the economic sectors based on market demand and Bank GemilangÊs practice and
experience, the composition of the loan portfolio of Bank Gemilang is as follows:
Sector Amount (RM Million) %

Agriculture 18 10
Manufacturing 90 50
Real estate 36 20
Service 36 20
180 100
Step 5:
Investment in long term securities and fixed assets can be made only after
allocation of funds to loan portfolios. Investment in long term securities such as
shares and bonds contributes to additional income as well as liquidity of the
bank. Investment in fixed assets is necessary for the day-to-day operations of the
bank. The bank cannot function efficiently and effectively without any premises,
equipment and vehicles. In a distressed situation, the bank can sell the fixed
assets to improve its liquidity.
The remaining RM120 million can be allocated between long term securities and
fixed assets. For example, RM50 million may be invested in equity and bond
securities and RM70 million in fixed asserts.
5.3.1 Disadvantages of Fund Pool Method

(a)" This method over-emphasises on liquidity at the expense of profitability. In
Example 5.1, 50% of the funds are allocated for liquidity compared to 30%
for loan portfolio.
(b)" This method does not provide any specific basis for purpose of estimating
liquidity standards. It only provides general guidelines.

(c)" This method does not take into consideration the volatility of deposit
accounts. As we all know, the degree of stability differs from one type of
deposit to another, and this needs to be monitored to facilitate smooth asset
management of any bank.
(d)" This method does not recognise loan portfolio as a source of liquidity even
though loan portfolio produces continuous cash flow in the form of
principal repayment and interest income from customers.
(e)" This method fails to appreciate the fact that long term security of a bank
depends on its ability to generate sufficient income. Liquidity which is
limited to liquid assets only does not warrant the overall security of any
bank.
(f)" This method does not take into account the mutually interactive role that
both assets and liabilities play in providing seasonal liquidity and revolving
liquidity. By providing liquidity in the form of liquid assets, this method
can jeopardise profitability because some liquid assets either produce
minimal returns or do not generate any income at all.
5.4 ASSET ALLOCATION METHOD

Asset allocation method is created to overcome some disadvantages of the fund
pool method. Changes in and around the banking industry have also encouraged
the use of this method in bank asset management. For example, banks are forced
to utilise deposits more efficiently and effectively as a result of competition from
non-bank financial institutions in terms of deposit acquisition.
Changes and innovation pertaining to the sources of funds have also encouraged
banks to use funds in a more profitable ways. Among the financial product
innovations are negotiable certificates of deposit, REPOS, Eurodollar and floating
rate negotiable certificates of deposit. Besides, the volatility and the increase in
interest rates have forced banks to be more organised and effective in planning
the asset management.
Specifically, asset allocation method treats each source of fund individually in

view of the different degrees of volatility among them. For example, as current
deposits have higher volatility than fixed deposits, a higher allocation percentage
is assigned for liquidity from current deposits compared to fixed deposits. For
that reason, LP decisions are made individually and separately for each source of
fund. In other words, each source of fund is treated as a mini bank or a profit

centre. To illustrate the mechanism of this method more clearly, we will use the
same example used in explaining the fund pool method earlier.
To recall, Bank Gemilang BerhadÊs sources of fund are as follow:
RM (Million)
Current deposits 200
Savings deposits 100
Fixed deposits 100
Repurchase agreements 50
NCDs 50
Debentures 100
Total 600
(a)" Current Deposits

As current deposits have high turnover, most of these deposits will be
allocated for main reserve and secondary reserve. In this case, we allocate
60% (RM120 million) for main reserve and 40% (RM80 million) for
secondary reserve. No allocation is made for loan portfolio because of the
high volatility of these deposits.
(b)" Savings Deposits

As savings deposits are more stable than current deposits, most of the
savings deposits may be allocated for loan portfolio. For example, 80%
(RM80 million) is used as allocation for loan portfolio, 10% (RM10 million)
for secondary reserve and 10% (RM10 million) for main reserve.
(c)" Fixed Deposits

Among all deposits, fixed deposits have the lowest volatility. Therefore, a
large portion of fixed deposits can be allocated for loan portfolio. For
example, 80% (RM80 million) is allocated for loan portfolio and the
remaining RM20 million for long term securities and fixed assets.
(d)" Repurchase Agreements and NCDs

The total fund from these sources amounting to RM100 million can be
invested in loan portfolio for purpose of short term financing. These two
short term financial instruments were created to borrow short term funds
from investors.
(e)" Debentures
These long term debt securities do not need statutory reserve. As these
debts can only be redeemed after a long period of time, the funds from this

source should be invested in long term assets such as long term financing,
long term investments and fixed assets. In this example, the bank allocates
30% (RM30 million) for loan portfolio, 30% (RM30 million) for investment
in long term securities and 40% (RM40 million) for fixed asserts.
Asset allocation method follows one of the principles of finance, i.e. short
term assets should be financed by short term financing sources while long
term assets by long term financing sources. This principle of finance is more
widely known as matching principle.
By comparing the fund pool method and asset allocation method (refer to
Table 5.3), we can see the differences between the two methods.
Table 5.3: Comparison between Fund Pool Method and Asset Allocation Method
Fund Pool Method Asset Allocation Method

(RM Million) (RM Million)
Main reserve 180 130
Secondary reserve 120 90
Loan portfolio 180 290
Long term securities 50 40
Fixed assets 70 50
Total 600 600
It is visible from Table 5.3 that the fund pool method is more liquidity-oriented
while the asset allocation method is more profitability-oriented. This is evident
by our examples in which the fund pool method has allocated more funds for
liquidity purposes compared to the asset allocation method that has allocated
more funds for loan portfolio. Asset allocation method shifts the focus of
portfolio management from liquidity to profitability by reducing the holding of
liquidity reserve and increasing the allocation for loans and advances.
Disadvantages of Asset Allocation Method
The disadvantages of asset allocation method are as follows:

(a)" This method may overestimate the liquidity of deposit accounts. We have
to take into consideration the actual volatility of deposits. For example, not
all current deposits have one same degree of volatility. Besides, at times
when customers have to keep minimum balances in their accounts, the
balances can indeed be channeled to loan portfolio.

(b)" This method does not recognise loan portfolio as a source of liquidity.
(c)" Just like the fund pool method, this method does not provide specific
guidelines on the allocation of funds among different categories of bank
assets.
(d)" This method assumes that asset management decisions and liability
management decisions are made separately.
ACTIVITY 5.3
We have discussed two methods of asset provision, i.e. fund pool
method and asset allocation method. Which method would you use if
you were given the responsibility to manage Bank Gemilang? Why?
Compare your answer with your friends. Discuss the reasons for their
respective decisions.
5.5 MANAGEMENT SCIENCE METHOD

LP dilemma can also be overcome through scientific approach, i.e. by using
management science devices such as linear programming. Management science
approach is able to provide more accurate answers to LP dilemma. Linear
programming is a mathematical procedure to choose variable values for purpose
of maximising (or minimising) an objective, subject to certain restrictions. In this
particular context, linear programming helps to determine the required balance
sheet quantity set in order to maximise bank profitability subject to restrictions in
terms of liquidity and other fixed rules.
Please refer to Example 5.2 in order to understand the management science

method.
Example 5.2
Bank Orang Kita Bhd. has funds totalling RM25 million which can be invested in
loan assets (x1) and secondary reserve (x2). The funds are made up of current
deposits and fixed deposits. The rate of return on loans is estimated at 12% while
short term securities 8%. Let us assume that the bank income is net income after
deducting the cost of deposits. The management of bank Orang Kita has
stipulated the bankÊs liquidity standard, i.e. RM2 in short term securities for
every RM10 investment in fixed assets.

Based on the above data, we can formulate the case mathematically as follows:
z = 0.12 x1 + 0.08 x2
Subject to,
x1 + x2"≤ RM25 million
x2"≥ 0.25x1
x1"≥ 0
x2 ≥ 0
z represents the bankÊs objective, i.e. maximise the returns on investment in loans
and investment in money market securities. The achievement of z is subject to
three constraints:
•" The maximum investment in loan portfolio (x1) and short term securities (x2)
is RM25 million.
•" The minimum investment in long term securities is fixed at 25% of the
investment in loan portfolio.
•" The investment in x1 and x2 must have positive values.
By using quadratic equations, the optimum portfolio is as follows:

x1 = RM20 million
x2 = RM5 million
z = RM2.8 million
This means, by investing RM20 million in loan portfolio and RM5 million in short
term securities, Bank Orang Kita Berhad will make a maximum profit of RM2.8
million.
z = 0.12(20) + 0.08(5)
= RM2.4 + RM0.4
= RM2.8 million
One main advantage of the linear programming model is its ability to show how
the optimum portfolio changes, when one or more constraints are changed. LetÊs
say the bank fund has increased by RM5 million, i.e. the total fund is RM30
million now.
What should the maximum interest rate be in order to generate the additional
RM5 million from the fixed deposits? Let us also assume that the liquidity ratio is
15% of the total assets, i.e. x2 > 0.18x1

The new solution is as follows:

x1 = RM25.5 million
x2 = RM4.5 million
z = RM3.42 million
The new solution increases the profit by RM620,000 or RM0.124 for every RM100
of fixed deposits. Based on that, the bank should pay a maximum interest rate of
12.4% in order to generate the additional deposits. Example 4.2 is bound by one
objective only, i.e. to maximise the returns on investment in loans and money
market securities. However, linear programming method is able to provide
solutions even to cases where there are multiple and contradictory objectives.
This can be done with multi objective linear programming. Management science
approach is more efficient and quicker than other methods because it uses
computer technology that is able to provide multiple solutions within a short
time.
Test your understanding by answering the following questions.
EXERCISE 5.1
1. Why does LP dilemma exist in the asset management of banks?

2. Compare the similarities and differences between fund pool
method and asset allocation method.
5.6 THE FUNCTIONS OF BANK LIQUIDITY
SELF-CHECK 5.3
In the earlier part of this topic, we already discussed LP dilemma and

how banks use the adequate asset management methods to help them
maximise their liquidity and profitability.
What is your understanding of the functions of bank liquidity, based on

your knowledge of liquidity?

There are five factors that explain why banks must have adequate liquidity:
•" Confidence factor
•" Relationship factor
•" Forced sale factor
•" Risk premium factor
•" Last chance factor
(a)" Confidence Factor

A bank with adequate liquidity gives an indication to the financial market
and general public that it is strong and secure. That means it is able to repay
its debts and meet all its liabilities. Liquidity becomes even more important
when the bank envisages aggressive liability management. The general
public will have more trust in a bank that has adequate liquidity. In the
event of massive and panic withdrawal of deposits by customers, the bank
management will be able to convince the customers and general public that
the bank has sufficient liquidity to meet the demand for deposit
withdrawals and all other claims.
(b)" Relationship Factor

Banks are responsible to get instant liquidity for the benefit of depositors
and borrowers. It is not possible for a bank to forge a good relationship
with its customers if it is unable to meet the demand for deposit
withdrawals and loans satisfactorily. Inadequate liquidity can cause a bank
to lose its customers, and in turn reduce its capability to compete.
(c)" Forced Sale Factor

Without sufficient liquidity, a bank may be forced to sell its assets at a loss
in order to provide the required liquidity. This may happen when a bank is
confronted with liquidity crisis, as a result of poor liquidity planning.
Selling assets in haste with the objective of overcoming the crisis always
results in losses as it is impossible for the bank to obtain any good or
reasonable prices under the circumstances.
(d)" Risk Premium Factor

Banks with high credit integrity are charged low default risk premium by
the money market and capital market. Liquidity is one of the determinants
of credit integrity. Banks with high risk premium are forced to pay higher
costs in order to procure funds from the financial market. High cost of fund
jeopardises a bankÊs profitability and ability to compete. Therefore, the
bank management ought to manage the liquidity of their respective banks
adequately so as to keep the default premium at the optimum level.
(e)" Last Chance Factor

Commercial banks have the opportunity to borrow short term from the
Central Bank (i.e. Bank Negara Malaysia) through the discount window
when they are faced with temporary financial difficulty. This facility is
made available by Bank Negara Malaysia to safeguard the interest of the
countryÊs financial system because the entire financial system will be in
jeopardy should any bank fail. This facility is not to be used frequently
otherwise Bank Negara Malaysia will investigate the bank concerned to
ensure that it is not faced with long term liquidity problem.
Should the general public, money market and capital market find out that a
bank often uses the discount window, they will lose confidence in the bank
concerned. Besides that, the money market and capital market will impose
high default risk premium on the bank. To avoid using this „last chance‰,
banks should practise efficient and effective liquidity management.
5.7 BANK LIQUIDITY THEORY

In bank liquidity management, there are four liquidity theories which describe
the definition of liquidity and the strategies that should be used to ensure
liquidity adequacy. These theories are:
(a)" Commercial financing theory;
(b)" Shiftability theory;
(c)" Expected income theory; and
(d)" Liability management theory.
These theories are also known as lending theories because the strategies
concerned involve lending practices and policies.
(a)" Commercial Financing Theory

According to the commercial financing theory, a bank is considered liquid
if its loan portfolio consists of short term financing only. Liquidity is vital to
fulfill unexpected deposit withdrawals. The liquidity strategy is to approve
self-liquidating short term financing such as share financing. In this
strategy, the maturity date of financing coincides with the maturity of
deposits because the deposits concerned represent the source of fund or
liquidity.

(b)" Shiftability Theory

The shiftability theory was pioneered by H. G. Moulton in 1918. This theory
recommends that banks invest part of their funds in loan portfolio and
securities that have secondary markets. When liquidity need arises, the said
assets can be sold at the market concerned. This theory prolongs the
average maturity period of loan portfolios and promotes the growth of
government security market.
(c)" Expected Income Theory

In 1949, Herbert Prochnov suggested that bank liquidity can be acquired
through loan repayments. According to this theory, loan repayments (and
liquidity requirement at the same time) should be matched with the
expected loan income. This theory acknowledges that loan portfolio is a
source of bank liquidity. As a reminder, the fund pool method and asset
allocation method do not consider loan portfolio as a source of bank
liquidity. Directly, this theory pioneers the amortised loan concept too.
(d)" Liability Management Theory

According to the liability management theory, banks can fulfill
liquidity requirement by borrowing from the money market and capital
market. This means the sources of income are not limited to deposits, loan
portfolio and financial market instruments but also include short term and
medium term borrowings from the financial market as well. This theory
encourages the development of financial instruments such as BNDs,
REPOS, commercial papers and Eurodollar. Borrowed funds acquired for
the purpose of bank liquidity are sometimes called purchased funds.
5.8 LIQUIDITY MEASUREMENT
It is not easy to measure bank liquidity because there is no one single specific
standard that is recognised as the measure of bank liquidity. Nevertheless loan-
to-deposit ratio is used widely to measure bank liquidity. It measures how far a
bank uses its sources of funds to meet customersÊ credit needs. This means the
higher the ratio, the less capable the bank is to provide more loans. In other
words, as the ratio increases, bank liquidity decreases. A bank will become more
selective in lending if the ratio increases, since rising ratio means diminishing
resources for lending activities.

In general, loan interest rates increase in tandem with the increase in loan- to-
deposit ratio, since the demand for credit exceeds the supply under the
circumstances. Besides, this ratio has a psychological impact on the bank
management. When the ratio increases, the management feels that they are
forced to slow down lending activities as a result of declining bank liquidity.
Banks that practice aggressive loan portfolio approach will feel hindered from
carrying on their credit activities. This may affect the motivation to achieve
targets.
Please refer to Example 5.3 in order to understand the liquidity concept better.
Example 5.3
Bank AÊs loan-to-deposit ratio is 80% and Bank BÊs 60%. Which bank has better
liquidity?
According to the definition of loan-to-deposit ratio, Bank B is more liquid than

Bank A because Bank B has a higher capacity to provide more loans, compared to
Bank A (40% : 20%). Nevertheless, this ratio has some weaknesses that deter its
use as the measure of bank liquidity.
If bank C has a loan-to-deposit ratio of 100%, that means Bank C has used all its
deposits for lending purposes. Does that also mean Bank C is not able to provide
any more loans? We know that the sources of funds are not limited to deposits
only. Banks can „purchase‰ funds at the money market to meet their liquidity
and lending needs. Therefore, a more than 100% loan- to-deposit ratio does not
necessarily indicate that the bank concerned is no longer able to provide any
additional financing.
5.8.1 Disadvantages of Loan-to-Deposit Ratio

The following are the disadvantages of loan-todeposit ratio:
(a)" Loan-to-deposit ratio does not show the maturity or quality of loan
portfolio. Even though this ratio is based on loan figures, we are unable to
determine from it, the composition of the loan portfolio, i.e. we do not
know if they are short term or long term loans, if the sectors involved are
productive or speculative, and how damaging the bad debts and doubtful
debts are.
(b)" Compared to banks providing loans for productive purposes, banks that
provide loans more for speculative purposes are more likely to face
liquidity problem.

(c)" This ratio does not provide any truth about bank liquidity needs. For
example, Bank XÊs loan-to-deposit ratio is 80% and Bank YÊs 60%. Does this
mean that Bank Y is more liquid than Bank X? In other words, does it mean
that Bank X has more liquidity needs than Bank Y? If liquidity is measured
based on the loan-to-deposit ratio, Bank Y has higher liquidity than Bank X.
However, if the loan compositions of the two banks reveasl that Bank Y has
more non-performing loans than Bank X, Bank X is considered more liquid
than Bank Y.
(d)" This ratio does not provide any information on other assets of a bank other
than its loan portfolio. For example, Bank P and Bank Q have similar loan-
to-deposit ratio. Does it mean that both banks have the same level of
liquidity? Based on the interpretation of this ratio, Bank P and Bank Q have
the same level of liquidity. Nonetheless, if we have the opportunity to
investigate the asset composition of both banks, we may find that indeed
one of the banks has higher liquidity because it has more liquid assets as
compared to the other.
Even though the loan-to-deposit ratio has several weaknesses, this ratio is
popular as a measure of bank liquidity as it can be calculated and understood
easily. Usually, bankers do not rely solely on this ratio as an indicator of bank
liquidity. This ratio is used as a preliminary indicator only. There are other ratios
that can be used as measures of bank liquidity, such as:
(a)" Cast Assets

Total Assets
(b)" Cast Assets - Reserve + Government Securities

Total Deposits
(c)" Cast Assets + Government Securities

Total Deposits
(d)" Cast Assets - Statutory Reserve + Marketable Government Securities of

Less than One-year Maturity
Total Deposits
These ratios are more accurate than the loan-to-deposit ratio because they take
into account the liquid assets and they show how far total deposits are used to
invest in liquid assets.

These ratios have their constraints as they do not take into account the banksÊ
capability to borrow for the purpose of bank liquidity. Besides, these ratios do
not recognise loan repayments as a source of bank liquidity.
EXERCISE 2.5
1. Explain five reasons why commercial banks need liquidity.
2. What do deposit liquidity and financing liquidity mean
respectively?
3. Compare the similarities and differences among the bank liquidity
theories.
5.9 ESTIMATING CREDIT REQUIREMENT

We have already discussed the functions and theories of liquidity. We will now
look at how to calculate bank liquidity requirement by using a simple example.
LetÊs assume that Bank Perdana Berhad has estimated its deposit and loan levels.
Table 5.4: Deposit and Loan Estimates of Bank Perdana Berhad

Bank Perdana Berhad
Deposit and Loan Estimates for the Period from January 2008 to December 2008
Total Deposits Total Loans

Month
December 2007 (actual) 593 351
January 587 356
February 589 359
March 586 356
April 591 365
May 606 357
June 620 345
July 615 330
August 616 341
September 655 341
October 635 361
November 638 375
December 643 386

In order to estimate the liquidity requirement of Bank Perdana Berhad, we will

prepare a statement that looks like a cash flow statement. We will be able to
detect from that statement when the bank has surplus liquidity and when it is in
deficit of liquidity. Changes in the bank liquidity are due to changes in deposits,
loans, investments, and statutory reserve. The computation of Bank Perdana
BerhadÊs liquidity requirement is shown in Table 5.5.
Table 5.5: Liquidity Statement of Bank Perdana Berhad

Liquidity Statement of Bank Perdana Berhad
for the Period Ending 31 December 2008
Change in
Total Change in Total Change Surplus
Statutory
Deposits Deposits Loans in Loans Deficit
Month Reserve
(RM (RM (RM (RM (RM
(RM
Million) Million) Million) Million) Million)
Million)
Dec 593 - - 351 - -
Jan 587 (6.0) (0.6) 356 5.0 (10.4)
Feb 589 2.0 0.2 359 3.0 (1.2)
Mar 586 (3.0) (0.3) 356 (3.0) 0.3
Apr 591 5.0 0.5 365 9.0 (4.5)
May 606 15.0 1.5 357 (8.0) 21.1
Jun 620 14.0 1.4 345 (12.0) 24.6
Jul 615 (5.0) (0.5) 330 (15.0) 10.5
Aug 616 1.0 0.1 341 11.0 (10.5)
Sep 655 39.0 3.9 341 0.0 35.1
Oct 635 (20.0) (2.0) 361 20.0 (38.0)
Nov 638 3.0 0.3 375 14.0 (11.3)
Dec 643 5.0 0.5 386 11.0 (6.5)
The explanation for Table 5.5 is as follows:
(a)" Estimates on Deposits and Loans

The monthly estimates on deposits and loans may be made based on
information in relation to the countryÊs economic development and factors
influencing the domestic market. Besides, the bank can also study the
requirements of its main customers. Monetary policy of the country on
liquidity represents a main input to the forecast of bank liquidity.

(b)" Changes in Deposits and Loans Affect Bank Liquidity

Decline in deposits means outflow of funds and reduces bank liquidity at
once. In Table 5.5, decreases in deposits are shown in parentheses. For
example, deposits declines from RM593 million in December 2007 to RM587
million in January 2008. That represents a decrease of RM6 million for
January 2008. Otherwise, increase in deposits means inflow of funds and
increases bank liquidity. For example, the deposits at Bank Perdana Berhad
are expected to increase by RM150 million in May 2008.
The statutory reserve amount to be deposited at the Central Bank is also

affected by any increase or decrease in deposits. Increase in deposits
increases the statutory reserve amount and that means outflow of bank
funds. Increases in statutory reserve are not shown in the parentheses in
Table 5.5 even though they are outflows of bank funds. For example, the
increase in deposits by RM5 million in April 2008 resulted in the increase in
statutory reserve by RM0.5 million. As a reminder, statutory reserve is a
liquid asset of banks.
Decrease in loans means inflow of cash and that increases bank liquidity
simultaneously. Loan repayments decrease the amount of total loans. For
example, Bank Perdana Berhad is expected to experience a decrease in
loans by RM15 million in July 2008. In Table 5.5, decreases in loans are
shown in parentheses but they are indeed inflows of funds. On the
contrary, increases in loans are outflows of funds that decrease bank
liquidity. For example, the loan base of Bank Perdana Berhad is expected to
increase to RM375 million in November 2008 from RM361 million in
October 2008.
(c)" Surplus Deficit of Liquidity

When the changes in deposits, statutory reserve and loans are combined,
we will find an important figure that shows whether Bank Perdana Berhad
will experience a shortage of liquidity or otherwise. We ought to be
cautious to avoid being confused by the parentheses in Table 5.5. For
statutory reserve and loans, although the parentheses indicate decreases,
they are indeed inflows of funds.
(d)" ManagementÊs Action

What should the bank management do in the event of any decrease or
increase in bank liquidity? During the period from May to July 2008, the
bank will experience surplus in liquidity. The management may use the
excess liquidity to reduce their borrowings or may accumulate their
statutory reserve by buying money market securities, or both. During the
final quarter of the year, Bank Perdana is expected to experience deficit in

liquidity shortage. The management may ease the situation by using

purchased funds or exhausting its secondary reserve or both.
EXERCISE 5.3
Bank Perdana Berhad has made the following estimates on deposits and
loans:
Total Deposits Total Loans

Month
March 586 356
April 591 365
May 606 357
June 620 345
July 615 330
August 616 341
September 655 341
(a)" Determine the liquidity requirement of Bank Perdana Berhad for

each month, i.e. from April to September.
(b)" How will Bank Perdana Berhad overcome its liquidity problem
each month?
(c)" What are the disadvantages of using the loan comparison method
to determine the liquidity requirement of a bank?
(d)" Both Bank Perdana Berhad and Bank Premia Berhad have the
same loan-to-deposit ratio. Does it mean that they have the same
level of liquidity?
•" The problems in bank asset management revolve around the liquidity-
profitability dilemma which can be resolved by using various asset allocation
methods.
•" These methods range from being liquidity-oriented to profitability-oriented.

•" All these methods take into consideration bank liquidity because without
adequate liquidity, banks will lose the trust of the general public, especially
that of the depositors and borrowers.
•" Bank liquidity management has become more difficult due to the many
uncertain factors influencing deposit withdrawals by depositors and future
loan takers.
Bonds Equity
Contingencies
"

Topic X BankÊs Liability
6 Management
LEARNING OUTCOMES
1." Discuss the types and characteristics of bank liabilities; and
2. Evaluate the factors influencing the deposit levels of banks.
X" INTRODUCTION
Initially, commercial banks focused their attention more on asset management,
which was generally linked to investment decisions. After a while, they were
forced to shift their focus to liability management, i.e. financing decisions. This
shift in direction was driven by the various aspects of development affecting the
banking industry, for example, increased demand for loans, shortage of deposit
funds and emergence of other financial intermediaries.
6.1 BANK’S LIABILITY MANAGEMENT

In general, liability management of a commercial bank involves acquiring funds
from depositors and other fund providers in the financial market, and
determining the suitable mix of funds for the bank after taking into account the
costs of the various sources of funds and their expected rates of return.
Specifically a bankÊs liability management involves the bankÊs borrowing

activities in the financial market in order to get bankÊs liquidity.

TOPIC 6 BANK’S LIABILITY MANAGEMENT W 129
6.2 TYPES AND CHARACTERISTICS OF BANK

LIABILITIES
SELF-CHECK 6.1
In Topic 5, we discussed about the bank balance sheet and its main
components, i.e. assets, liabilities and ownersÊ equity. What are bank
liabilities made up of?
As discussed in Topic 5, bank liabilities consist of:

•" Deposits from customers;
•" Deposits and placements of banks and other financial institutions;
•" Obligations on securities sold under repurchase agreements;
•" Bills and acceptances payable;
•" Bonds and bank notes;
•" Subordinated term loans; and
•" Other liabilities.
Deposits constitute the largest component of the main liability structure in

liability management. We will have further discussion in this topic on the
features of bank deposits and factors influencing the level of bank deposits.
6.3 DEPOSITS
Bank deposits consist of:
• Current accounts
• Savings accounts
• Fixed deposit accounts
• Negotiable Certificates of Deposit (NCDs)
• Repurchase Agreement
(a)" Current Accounts

Current accounts enable account holders to issue cheques for payment
purposes. Only commercial banks are allowed to offer current account

130 X TOPIC 6 BANK’S LIABILITY MANAGEMENT
facility to customers. Current accounts are also used by commercial banks

to offer overdraft facility to their customers. Many businesses require the
convenience of current account to facilitate payments. Current accounts are
regarded as „working‰ accounts and is used mainly for keeping cash or
cheques and for making payments.
It is stipulated by the relevant laws that opening of any new current

account is subject to recommendation from an existing account holder or
from an eligible bank employee.
Current accounts are non-interest bearing accounts. In view of that,

commercial banks enjoy „cheap‰ funds from these accounts. This indeed
provides a competitive edge to commercial banks since other banking
institutions are prohibited from offering current account facility to
customers.
ACTIVITY 6.1
We often read or hear from the media about fraud and forgery cases
involving cheques. How do such incidents happen? What can current
account holders and banks do to avoid the occurance of these incidents?
What is Bank Negara Malaysia (BNM)Ês role in handling this problem?
Present your answers in short notes.
Information on fraud and forgery cases involving cheque can be

obtained from commercial banks which are accessible through the
hyperlinks at BNM website, and BNM customer information web site at
http://www.bankinginfo.com.my
(b)" Savings Accounts

Savings accounts are deposit accounts. Deposits and withdrawals are
donevia passbooks or automated teller machine (ATM) cards. Some banks
require new applicants for savings accounts to obtain third partyÊs
recommendation, as practised for current accounts. This new measure was
introduced because there had been many fraudulent cases involving saving
accounts.
Savings account interest rates are fixed and at the discretion of each bank.
Most banks tend to offer competitive rates because savings accounts are
more stable compared to current accounts.

(c)" Fixed Deposit Accounts

To enjoy higher interest rates than that offered by savings accounts, a
depositor may opt for fixed deposits. Banks offer fixed deposits of various
maturity tenures and interest rates. There are 1-month, 3-month, 6-month,
9-month, 12-month, 15-month, 18–month, 21-month, 24-month, 36-month,
48-month and 60-month fixed deposits. For fixed deposits with maturity
tenure of not more than 15 months, the same prevailing rates are applicable
to the respective tenures and are paid to all the customers concerned.
For example, if a bank offers an interest rate of 5% to Cik Ruhaida for her
9-month deposits, the same bank must offer this same interest rate to all of
its other customers with 9-month deposits. Customers may negotiate the
interest rates with their respective banks for deposits with more than 15-
month maturity tenure.
Compared to current deposits and savings deposits, fixed deposits are the
most stable source of funds for financing and investment purposes. In view
of that, banks often implement new marketing strategies to attract fixed
deposit customers. In any case, penalty charges related to premature
withdrawals remain as the one main shortcoming of fixed deposits.
ACTIVITY 6.2
You are a small-time entrepreneur who opened a sundry shop in your

residential area recently. Since your residential area is new and no
supermarkets have been set up yet, your shop was well received by
customers and has made a profit of RM10,000 in the first three months
of operation.
You would like to save the money and earn interest on your savings.
However, your business may require additional capital to keep up
with the patronage of your customers. Would you keep your money as
current deposits, savings deposits or fixed deposits, based on your
understanding of these three types of deposits? Why? Record your
answers in short notes.
In order to make a wise decision, you may get information on the

deposits concerned at the web sites of various banks through the
hyperlinks at http://www.bnm.com.my.

(d)" Negotiable Certificates of Deposit (NCDs)

Bank Negara Malaysia introduced Negotiable Certificate of Deposit (NCD)
and Banker Ês Acceptance (BA) in May 1979. BAs are financing instrument
used to facilitate trades, while NCDs are instruments used to amalgamate
savings of the general public. NCDs are believed to be able to overcome the
shortcomings of fixed deposits because they can be traded through
discounting process.
Several vital developments have taken place in the NCD market since the
introduction of the instrument. Floating Rate Negotiable Certificate of
deposit was introduced in July 1998, followed by zero-coupon NCD in
February 1993.
Today, Negotiable Instruments of Deposits (NID) that can be issued by

banking institutions and traded in the Malaysian money market consists of
the following financial instruments:
(i)" Short-term Negotiable Certificates of Deposit
(ii)" Long-term Negotiable Certificates of Deposit
(iii)" Floating rate Negotiable Certificates of Deposit
(iv)" Zero-coupon Negotiable Certificates of Deposit
NIDs are instruments in bearer form, i.e. the owner Ês name is not written
on the NID concerned. This is to facilitate the transfer of certificates from
the depositors to third parties. NID certificates are kept by accredited
custodians for security reasons.
The appeal of NIDs as investment instruments is attributable to their

liquidity and marketability. Nevertheless, their rates of return are relatively
low, in line with risk-return trade off. Commercial banks and other banking
institutions are permitted to issue NIDs with minimum and maximum
values of RM50,000 and RM10 million respectively.
NIDs can be traded via three different means:

(i)" Absolute sale and purchase, i.e. the ownership of an NID is
transferred from the seller to the buyer without the involvement of
any third party. This means the buyer can make no claims against the
seller should there be any problems related to the NID concerned.
Nevertheless, the buyer can seek recourse from the issuing banking
institution;

(ii)" Purchase and redemption transaction which must be completed by

the maturity date of the NID as specified by the issuing institution;
and
(iii)" Repurchase agreement.
The explanation on the different types of NID financial instruments are as

follows:
(i)" Short-term Negotiable Certificates of Deposit

A Short-term Negotiable Certificate of Deposits (SNCD) certifies that:
•" a sum in Ringgit Malaysia has been deposited with a commercial
bank or merchant bank or finance company that issued the
certificate („issuing institution‰); and
•" the money will be returned to the certificate holder upon the
surrender of the certificate through the accredited custodian, i.e. a
commercial bank or any banking institution appointed by Bank
Negara Malaysia to act as the third party responsible for
safekeeping of the certificate.
The maturity period of Short-term Negotiable Certificate of Deposits

range from a minimum of 90 days to a maximum of 364 days. Interest
is paid by the issuing institution at the specified coupon rate on
maturity date. On maturity date, the accredited custodian collects on
behalf of the SNCD holder the coupon interest and the original
deposited amount.
(ii)" Long-term Negotiable Certificates of Deposit

A Long-term Negotiable Certificate of Deposits (LNCD) also certifies
that a sum in Ringgit Malaysia has been deposited with the issuing
institution and that the money will be returned to the certificate
holder upon the surrender of the certificate through the accredited
custodian.
LNCDs can be issued for a minimum maturity period of 12 calendar

months, subjected to a maximum maturity period of 60 calendar
months. Interest is paid every 6 months, with the exception of interest
payments that may have to be made before the expiry of 6 months.
For example, interest payments on a 15-month LNCD issued on 19
February 1995 should be made on 10 May 1995, 10 November 1995
and 10 May 1996 respectively.

(iii)" Floating Rate Negotiable Certificate of Deposits

Like other NCDs, a Floating Rate Negotiable Certificate of Deposit
(FRNCD) also certifies that a sum in Ringgit Malaysia has been
deposited with the issuing institution and that the money will be
returned to the certificate holder upon the surrender of the certificate
through the accredited custodian.
The maturity periods of FRNCDs range from a minimum of 12

months to a maximum of 60 months. FRNCDs are unique in the sense
that they bear interest rates that vary with the specified reference
rates. Interest payments are made every 3 months or 6 months at the
coupon or interest rates that are adjusted based on the Kuala Lumpur
Interbank Offer Rates.
(iv)" Zero-Coupon Negotiable Certificate of Deposits

The maturity periods of Zero-Coupon Negotiable Certificate of
Deposits (ZNCDs) ranges from a minimum of 3 months to a
maximum of 60 months. ZNCDs do not pay interest. At maturity, the
accredited custodian, acting on behalf of the ZNCD holder, surrenders
the certificate concerned to the issuing institution in exchange for the
full remind or face value of the certificate.
(e)" Repurchase Agreement

Repurchase Agreement (REPOS) constitutes a form of short-term secured
loans. REPOS were introduced by Bank Negara Malaysia in 1979. They
provide alternatives for banks to collect excess funds from various
companies by selling or issuing financial instruments or securities
especially bankersÊ acceptances (BA) and Malaysian government securities
or Marketable Government Securities (MGS) through REPOS.
Prior to 1989, REPOS were regarded as a more economical and flexible

source of finance for commercial banks in comparison with deposits. The
reason being, REPOS were not subject to statutory reserve and minimum
liquidity requirements for they were treated as off-balance sheet items.
However, with effect from 1 January 1989, REPOS must be reported in
balance sheet and is subjected to statutory reserve requirement and
minimum liquidity the requirement. Notwithstanding that, REPOS remain
a popular source of financing for commercial banks

EXERCISE 6.1
1." Define liability management in general as well as in a specific
manner.
2." Discuss the similarities and differences between current account
and savings account, and between savings account and fixed
deposit account.
3." Why did commercial banks shift their focus from asset
management to liability management?
6.4 FACTORS INFLUENCING BANK’S DEPOSIT

LEVEL
SELF-CHECK 6.2
In our country, there are various types of financial institutions offering

deposit service. Among them are commercial banks, Islamic banks and
savings institutions.
As a customer, what are the factors influencing your choice of a suitable

deposit institution?
In order to increase the deposit level, banks should give thorough consideration
in the following factors:
(a)" Competitive interest rates;
(b)" Staff and other physical aspects of the bank;
(c)" Services offered by the bank;
(d)" Key strengths and policies;
(e)" Economic activity level;
(f)" Location; and
(g)" Early establishment effect.

6.4.1 Competitive Interest Rates
SELF-CHECK 6.3
How do interest rates influence your choice of financial institution for
your deposits and how does interest rate influence the deposit level of a
bank?
To the depositors, interest rates is the main appeal factor. Banks that wish to
acquire more deposits may achieve the objective by increasing their interest rates.
Banks should offer interest rates which are competitive but not excessively high.
While high interest rates can attract depositors, they can also discourage
customers from obtaining loans since loan interest rates have to be increased in
line with the increase in the deposit interest rates.
In the banking industry in Malaysia, BNM permits commercial banks to

determine their deposit interest rates individually. At the same time, BNM
monitors the interest rates constantly so as to protect the interest of the general
public.
The general public often feel that it is more profitable to place their deposits with
finance companies compared to commercial banks because finance companies
offer higher interest rates than commercial banks. However, it is often forgotten
that in line with the higher interest rates for deposits, loan interest rates imposed
by finance companies are inevitably higher than that imposed by commercial
banks.
Today, commercial banks offer competitive interest rates in the form of tiered
interest rates. With tiered interest rates, the applicable interest rate increases with
the deposit amount. Table 6.1 illustrates how tiered interest rate structure
functions.
Table 6.1: Tiered Interest Rates
Deposits Amount Interest Rate (%)

Up to RM4,999 5.0
RM5,000-RM9,999 5.5
RM10,000-RM14,999 6.0
RM15,000-RM20,000 6.5

6.4.2 Staff and Other Physical Aspects of the Bank

Some bank customers choose their banks based on the physical aspects of banks
including the quality of bank staff. Physical aspects of banks comprise:
• Bank size;
• Customer waiting area;
• Numbers of automatic teller machines (ATMs);
• Car park facility; and
• Quality of the bank staff.
(a)" BankÊs Size

Some customers do not like to deal with small or medium-sized banks
because the products and services offered by these banks tend to be limited.
On the other hand, there are customers who prefer small or medium-sized
banks because they feel that small or medium-sized banks are friendlier
compared to larger banks.
(b)" Customer Waiting Area

The customer waiting area may also influence a personÊs choice of bank.
When waiting for banking services, customers expect a place that allows
them to wait comfortably. Because of that, commercial banks always
endeavour to ensure the comfort of customers who are waiting. Initiatives
taken include the provision of automatic queue system, more comfortable
chairs and even soothing music to help customers relax. Besides this, some
banks even provide more spacious and exclusive waiting rooms for their
key customers and corporate customers.
(c)" Numbers of Automated Teller Machines (ATMs)

During the infancy stage of ATM, banks with ATMs were preferred by new
customers. Today, all banks have their own ATMs and the number of ATM
is longer a determinant. This is because the application of information
technology in banking has opened up the door for customers to use the
ATMs of other banks in addition to the ATMs of their respective banks. For
example, the Malaysian Electronic Payment Platform (MEPS) and the
GREAT system, which are owned by a consortium of commercial banks,
allow the holders of ATM cards issued by any consortium member to
withdraw cash from any of the ATMS of any of the consortium members.
(d)" Car Park Facility

Car park facility is another factor influencing customersÊ choice of bank. To
alleviate the car park shortage problem, banks such as Standard Chartered
(M) Berhad, Southern Bank Berhad and OUB (M) Berhad have resorted to
providing drive-through facility for customersÊ convenience.
(e)" Quality of the Bank Staff

Staff quality refers to the friendliness, politeness and efficiency of staff
when dealing with customers. Such quality is vital to the patronage of
customers. According to the annual reports of commercial banks, most
banks have spent huge sums of money in providing customer service
training for staff.
6.4.3 Services Offered by the Banks

CustomersÊ deposit decisions are influenced by the line-up of financial services
offered by banks. Product uniqueness is vital to a bankÊs success in procuring
new customers. Now, there are 3-in-1 shampoo products, there are also 2-in-1
and even 3-in-1 financial products. For example, current account and savings
account are combined and marketed as one account by some banks. A numbers
of banks even merge all three deposit accounts, i.e. current account, savings
account and fixed deposit account, into one account.
The desire to fulfill all the financial service needs of customers has triggered the
financial supermarket concept. Every bank strives to attract customers by
promoting the uniqueness of their respective products. All banking institutions
offer essentially the same banking products, but each of them endeavour to
distinguish their products through marketing initiatives and strategies.
6.4.4 Key Strengths and Policies

A bank that has its own set of key strengths and policies which are in harmony
with customer needs is more likely to attract deposits successfully compared to
the one without. For example, small and medium businesses are more likely to
place their deposits with a bank that has the policy to support the financial needs
of small and medium industries (SMI) as opposed to one that is without such
policy.
Technology advancement of a bank to fulfill customer demand is a strength

considered important by deposit customers. Besides, show of empathy is also
vital for customer loyalty.

ACTIVITY 6.3
Nowadays, there are various innovations in banking services in terms

of product, bank image, banking hall layout and staff image. What are
the innovations that have been implemented by banks? How do these
innovations influence bank deposit level directly and indirectly?
Discuss.
6.4.5 Economic Activity Level

It is easier to procure deposits from customers during economic expansion as
opposed to economic contraction. During economic expansion, customers place
deposits with banks even when interest rates are low. During economic
recession, banks have to raise interest rates in order to attract deposit placements.
These situations are not unusual since banks have to give due consideration to
the relationship between loan interest rates and deposit interest rates.
One of the main factor in the determination of loan interest rate and advance is
the interest rate paid to the depositors. Therefore economic condition plays an
important role in obtaining bank deposits.
6.4.6 Location
Before the emergence of sophisticated banking technology, location was a factor
influencing customersÊ choice of bank. Most people chose banks which were
close to their homes or places of work. That was one of the reasons why banks
flocked to set up branches in housing areas.
General public do not open bank accounts at branches situated in town centres
unless they work in the area. This is because they want to avoid traffic congestion
and shortage of car-parking facility. While todayÊs banking technology enables
customers to conduct their banking transactions from home, shopping complexes
and offices, location is still a main factor because there are still customers who
prefer the friendlier and more personal banking experience. Hence, bank location
is an important factor.
6.4.7 Early Establishment Effect

Most of the largest banks in our country are also the oldest ones. This shows that
these banks have the capability to procure more customers and business.

Experience and reputation are the main factor in this context. New customers
choose the more established banks as they are confident of these banksÊ proven
service efficiency. Besides, customers feel more secure depositing their savings
with banks which have long been in operation as opposed to the newer banks.
EXERCISE 6.2
You are tasked with planning a campaign to increase the deposit level
of your bank branch. Describe how you will implement this campaign.
•" The main sources of funds for commercial banks are deposits, which include
negotiable instruments of deposits (NID) and repurchase agreements
(REPOS).
•" In this era of globalisation and information technology, competition among

banks gets more and more intense and the task of procuring customersÊ funds
or deposits is also increasingly difficult.
•" In order to compete against other financial institutions in the pursuit of

deposits, commercial banks must seriously weigh all factors that can
influence the deposit level of banks.
Current account Negotiable instruments of deposits

Fixed deposits account Repurchase agreement
Liability management Savings account
"

Topic X Asset and
7 Liability
Management
LEARNING OUTCOMES
1." Explain the importance of asset and liability management in banks;
2." Identify the different categories of assets and liabilities for the purpose
of fund gap management; and
3." Apply the fund gap management methods in different interest rates
scenarios.
X" INTRODUCTION
Asset and liability management is a new concept in bank management.
Previously, asset management and liability management of a bank were carried
out on a separate basis. During the period from the end of World War II to the
end of the 1960s, the management of financial institutions focused on asset
management only because banks were able to procure deposit funds easily and
also the interest rates were rather stable. Banks focused more on making
investment decisions pertaining to the available funds then.
Management of financial institutions was eventually compelled to put more

focus on liability management due to the many changes that took place after the
1960s. When the growth rate of the demand for loans began to exceed the growth
rate of deposits, banks had to seek alternative sources of fund to finance the
increasing demand for loans. Banks were forced to borrow from the money
market through innovative financial instruments such as negotiable certificates of
deposit, floating rate negotiable certificates of deposit and notes payable. As most
of these financial instruments are short-term instruments, banks were also
exposed to financial crisis when these funds became scarce. Such financial crisis
could cause any bank to collapse, as experienced by Continental Illinois Bank in
the USA in 1984.
142 X TOPIC 7 ASSET AND LIABILITY MANAGEMENT
Liability management became popular in the 1970s when many banks began to
reduce their liquid assets and depend more on borrowed funds or funds
purchased from the financial market. Due to the instability in interest rate, the
emergence of financial problems and the increasing number of bank failures in
the 1980s, most banks decided not to depend solely on liability management.
Today, bank assets and liabilities are no longer managed separately but
simultaneously.
7.1 BANK’S ASSET AND LIABILITY

MANAGEMENT
SELF-CHECK 7.1
In Topic 5 and 6, we have discussed asset management which involved
investment decisions and liability management which involved
financing decisions.
How does a bank combine its asset and liability management? What
will happen if bank assets are managed independently of bank
liabilities?
We already know that asset management of a bank involves investment

decisions regarding the allocation of funds among several categories of assets
while liability management involves financing decisions in terms of procuring
funds from depositors and other fund providers in the financial market and
determining the adequate mix of funds for the bank. The management must take
into consideration the cost and rate of return of each source of fund when
determining the right mix of funds.
Even though asset management and liability management involves different

decisions, the techniques engaged in asset management and liability
management lead to the same objectives, which is to:
(a)" Ensure bank liquidity;
(b)" Ensure that all demands for deposit withdrawals can be fulfilled;
(c)" Ensure sufficiency of funds to fulfill loan applications; and
(d)" Maintain the net interest margin and profitability of the bank.

TOPIC 7 ASSET AND LIABILITY MANAGEMENT W 143
When interest rates were unstable during the 1980s, asset management and
liability management were combined to facilitate effective management of profit
margin through gap management. We will have more in-depth discussion on this
topic in the following sections.
7.2 FUND GAP MANAGEMENT
Fund gap management means managing the interest rates of bank assets and
liabilities in consideration of the maturity features of the same assets and
liabilities. Fund gap indicates total variable rate assets financed by fixed rate
liabilities.
There are two types of fund gap, i.e. positive fund gap and negative fund gap.
Positive fund gap exists when variable rate assets are financed by fixed rate
liabilities, while negative fund gap emerges when fixed rate assets are financed
by variable rate liabilities. Positive fund gap is necessary to stabilise net interest
margin.
The management of various assets and liabilities that can influence fund gap will
be discussed in the following section.
7.2.1 Types of Bank’s Asset and Liability Management

There are three types of bank asset and liability management, i.e.:
•" Matching rate asset and liability;
•" Variable rate asset and liability; and
•" Fixed rate asset and liability.
(a)" Matching Rate Asset and Liability

In matching rate asset and liability management, interest rates receivable
from acquired assets exceeded the interest rates payable on the liabilities.
Acquired assets are loan assets and/or investment assets. Payable

interest rates refer to interest rates payable to the depositors or on other
liabilities that involve interest payments.

Below is an example of matching rate asset and liability:
A loan or advance with three-year tenure is financed by a deposit with two-

year tenure. Although the tenure of the asset differs from the tenure of the
liability (3 years versus 2 years), the three-year loan can be financed by
another two-year deposit.
(b)" Variable Rate Asset and Liability

Variable rate asset and liability management involves the bankÊs assets and
liabilities with variable interest rates. This type of assets and liabilities
usually have short maturity period and their interest rates change
according to the prevailing situations.
Examples of variable rate assets are:

(i)" Repurchase agreements (REPOS);
(ii)" Short-term loans and investments; and
(iii)" Variable rate term loans.
Examples of variable rate liabilities are:

(i)" Short-term deposits;
(ii)" REPOS;
(iii)" Negotiable certificates of deposit; and
(iv)" Short-term financing.
If variable rate assets are matched against the variable rate liabilities, the net
profit margin can be maintained. Net profit margin is defined as the net
rate of return on acquired assets and can be calculated as follows:
Interest received – Interest paid

Net Profit Margin =
Acquired assets
Where:
Interest received = Interest received from loans, advances and
investments.
Interest paid = Interest paid to depositors or paid on other liabilities
that involve interest payment.
Acquired assets = Loan assets and/or investment assets.

(c)" Fixed Rate Asset and Liability

Fixed rate asset and liability management involves the bank assets and
liabilities with fixed interest rates and with longer maturity periods.
Examples of fixed rate assets are:

(i)" Mortgages;
(ii)" Fixed rate term loans;
(iii)" Fixed rate installment loans;
(iv)" Leased assets; and
(v)" Long-term investments.
Examples of fixed rate liabilities are:

(i)" Long-term debts;
(ii)" Long-term deposits;
(iii)" Minimum balances in current accounts and savings accounts; and
(iv)" Capital funds.
If fixed rate assets are matched against fixed rate liabilities, the net profit
margin will change gradually over time as the value of fixed rate assets and
fixed rate liabilities change concurrently over time.
ACTIVITY 7.1
Obtain articles on the development of asset and liability management of

banks in Malaysia from the 1960s to year 2000 from the digital collection
in OUM Digital Library at http://www.oum.edu.my (you will have to
log in and click on the Digital Library icon in order to access the digital
collection).
Based on the articles, describe the trend of asset and liability

management in Malaysia. You can obtain additional information on
asset and liability management of the banks in Malaysia from BNM web
site at http://bnm.gov.my or the web sites of the respective banks,
which are accessible through the hyperlinks at BNM web site.

EXERCISE 7.1
1." Why must bank asset management and bank liability management
be performed simultaneously? Does this not inconvenience the
management team of any bank?
2." What are the similarities and differences between asset
management decisions and liability management decisions of
banks?
3." By using appropriate examples, discuss the factors that may affect
net profit margin.
7.2.2 Fund Gap Management in Different Interest

Rate Scenarios
There are four fund gap management methods, based on different interest rate
scenarios:
•" Rising interest rates;
•" Highest level of interest rates;
•" Declining interest rates; and
•" Lowest levels of interest rates.
Below is the explanation on the management methods:
(a)" Rising Interest Rates

When interest rates are rising, we have to enlarge the fund gap, i.e. banks
should have more variable rate assets which are financed by liabilities with
fixed and low interest rates.
When interest rates are rising, it is difficult for banks to procure long-term
funds at low rates. Therefore, they should make adjustments by shifting
funds to short-term investments and shifting from fixed rate loans to
variable rate term loans. By doing this, banks can enjoy higher returns from
rising interest rates.
Example 7.1 is to help you understand how the gap management works
when interest rates are rising.

Example 7.1
ABC Bank has the following assets and liabilities:
RM Average Interest Rate (%)

Assets
Variable rate assets 10,000 10
Fixed rate assets 6,000 12
Non-acquired assets 1,000
Total assets 17,000

Variable rate liabilities 5,000 4
Fixed rate liabilities 6,000 6
Equity 6,000
Total Liabilities and Equity 17,000
Net Interest Income = (10,000 × 10%) + (6,000"×"12%) – (5,000"× 4%) –(6,000"× 6%)
= RM1,160
Net Interest Margin = 1,160

(10,000 + 6,000)
= 7.3%
Fund Gap = Variable rate assets – Fixed rate liabilities

= 10,000 – 6,000
= 4,000
Now, let us assume that the interest rates have increased by 1%. That means the
interest rate of variable rate assets becomes 11% and the interest rate of variable
rate liabilities 5%. The interest rates of fixed rate assets and fixed rate liabilities
do not change.
In fund gap management, when interest rates are rising, banks should seize the
opportunity to enlarge the fund gaps by increasing their investment in short-
term assets and variable rate loans. Besides this, banks are also encouraged to
acquire long-term liabilities with low interest rates.

LetÊs say ABC bank makes an additional investment of RM5,000 in variable rate
assets, and acquires variable funds totalling RM5,000. What is the effect of such
action?
RM Average Interest Rate (%)

Assets
Variable rate assets 15,000 11
Fixed rate assets 6,000 12
Non-acquired assets 1,000
Total assets 22,000

Variable rate liabilities 10,000 5
Fixed rate liabilities 6,000 6
Equity 6,000
Net Interest Income = (15,000"× 11%) +(6,000"× 12%) – (10,000"× 4%)–(6,000"× 6%)
= RM1,610
Net Interest Margin = 1,160

(15,000 + 6,00)
= 7.7%
Fund Gap = Variable rate assets – Fixed rate liabilities

= 15,000 – 6,000
= 9,000
Such action produces more net income and higher interest margin. That shows
interest rate risk can be managed by expanding fund gap.
Interest rate risk refers to the change in the next interest income of a bank as a
result of changing interest rates. For example, letÊs just say a bank grants a loan at
a fixed interest rate of 10% per annum and the loan is financed by a short-term
deposit bearing an interest rate of 6% per annum. This means the bankÊs net
interest income is 4% per annum. What will happen if interest rates rise by 1%?
The bankÊs net interest income will decrease to 3% because the interest income
will remain at 10% while the interest expenses will increase to 7%.

(b)" Highest Level of Interest Rates

Fund gap is at its widest when interest rates is at peak. This means that
before the interest rates decline, banks should move their funds to long
term securities and fixed rate loans in order to attain the highest interest
rates. Besides, banks should shorten the maturity periods of their liabilities
in order to enjoy low cost of funds.
(c)" Declining Interest Rates

When interest rates are declining, banks should narrow their fund gaps by
reducing variable rate assets which are financed by fixed rate liabilities.
This action is the reverse of that taken when interest rates are rising.
(d)" Lower Levels of Interest Rates

Fund gap is at its narrowest when interest rates are at the lowest levels. During
this time, the necessary asset and liability management measures are:
(i)" Extend the maturity periods of liabilities in order to enjoy the low
interest rates;
(ii)" Shorten the maturity periods of investments;
(iii)" Limit fixed rate loans;
(iv)" Encourage variable rate loans; and
(v)" Procure short-term debts, if necessary.
ACTIVITY 7.2
By using Example 7.1, apply fund gap management in three other

different scenarios of interest rates, i.e. peak interest rates, declining
interest rates and rock-bottom levels interest rates. Make brief notes on
your findings. You may also attach your examples for future reference.

7.2.3 Summary of Operation Action in Fund Gap

Management
(a)" Fund gap must be maintained at all times.
(b)" Adjust fund gap size in accordance with the prevailing situation, i.e.:
(i)" Widen the fund gap when interest rates are rising;
(ii)" Fund gap is at its widest when interest rates are at their peak;
(iii)" Narrow the fund gap when interest rates are declining; and
(iv)" Fund gap is at its narrowest when interest rates are at rock-bottom
levels.
EXERCISE 7.2
Explain how fund gap management can overcome the interest rate
risks.
•" The main challenge of asset and liability management of banks is interest rate risk.
•" Interest rate risk can affect the performance of any commercial bank.
•" One of the techniques used to manage this risk is through fund gap
management which involves matching the interest rates and maturity periods
of bank assets against the interest rates and maturity periods of bank
liabilities in different interest rate environments.
•" Fund gap management technique is effective only when the bank
management is able to accurately forecast the movement of interest rates, be
it rising, peaking, declining or reducing to rock-bottom levels.
•" Fund gap management technique can at least motivate the management of
commercial banks to quantitatively take into account the impact of interest
rates changes on bank values.

Asset management Liability management

Fund gap management
"

Topic X BankÊs Capital
8 Management
LEARNING OUTCOMES
1." Define bankÊs capital;
2." Identify the different types of bankÊs capital;
3." Explain the characteristics of bankÊs capital;
4." Discuss the functions of bankÊs capital; and
5." Examine the effects of capital requirement on a bankÊs operations.
X" INTRODUCTION
Bank management and the regulatory body are different in their views on bank
capital management. Since a bankÊs security is closely linked to the capital of the
bank, the regulatory body stipulates various rules such as capital diversification
to ensure the security of deposits as well as bank stability. On the other hand, the
bank management is inclined to maximise the use of capital to achieve maximum
asset returns.
In general, the importance of bankÊs capital is linked to its role in bank

operations, bank protection and bank supervision. Many people are of the view
that the main roles of bank capital are to reduce risk by acting as „loss absorber‰,
to facilitate access to financial market for purpose of overcoming liquidity
problems, and to limit growth and risk taking.
A huge capital base can reduce risks by absorbing income volatility, limiting
growth opportunities and reducing the probability of failure. However, a huge
capital base may also reduce the rate of return for shareholders. Therefore, risk-
return trade off is involved in decision making regarding the adequate amount of
capital.
TOPIC 8 BANK’S CAPITAL MANAGEMENT W 153
8.1 DEFINITION OF BANK’S CAPITAL
SELF-CHECK 8.1
We know in accounting that capital is an owner Ês contribution
towards the business, i.e. assets and liabilities. Does bank capital have
the same definition?
The concept of capital in banking is different from the concept of capital in

accounting.
BankÊs capital is defined as asset minus liabilities and minus certain types of
debts and reserves stipulated by the regulatory body. Debts and reserves are
included in bankÊs capital in order to ensure capital adequacy of banks.
For the purpose of computing bank capital adequacy, the regulatory body
defines bank capital under two categories, i.e.:
•" Basic capital or core capital or Tier 1 capital; and
•" Additional capital or secondary capital or Tier 2 capital.
Figure 8.1 shows the different types of bankÊs capital under Tier 1 and Tier 2 capital.
Figure 8.1: Types of bank capital

154 X TOPIC 8 BANK’S CAPITAL MANAGEMENT
In general, bankÊs capital must be fully paid up and with the bank at all times.
BankÊs capital must be readily obtainable and able to absorb losses. Besides,
bankÊs capital is not necessarily a fixed charge on income.
8.1.1 Characteristics of Bank’s Capital

Further explanation on the features of bankÊs capital are as follows:
(a)" Ordinary Shares

Ordinary shares are securities that symbolise ownership in a bank. The
more ordinary shares an investor has, the larger his share of ownership in a
bank.
Ordinary shares are favoured by the regulatory body as the main source of
external funds. They form a fixed source of funds with no maturity dates.
Ordinary shares have perpetual life span, as long as the bank concerned
remains in operation. As dividend payments are not mandatory, ordinary
shares are free of fixed payments that can deteriorate bank income and
value. Besides, all losses are deductible from equity. For these reasons,
ordinary shares give better protection to banks than debts do.
While ordinary shares are favoured by the banking regulatory body, banks
find a weakness in ordinary shares; dividends are non tax deductible.
Besides, dividend payments reduce the amount of profit after tax.
Furthermore, the cost involved in the issuance of ordinary shares is
significantly higher than the cost of issuing any other sources of capital. In a
slow and depressed market, issuance of ordinary shares is indeed not a
suitable option to be used to raise capital. Volatility of share prices is
another negative feature of ordinary shares. New ordinary shares also
dilute the earnings of existing shareholders and reduce their ownership.
(b)" Preference Shares

Preference shares are sometimes called hybrid securities because they have
the features of both ordinary shares and debt. Therefore, preference shares
are said to have the advantages and disadvantages of both ordinary shares
and debts. Like ordinary shares, dividend payments made on preference
shares are not tax deductible.
Preference shares have a preferential position over ordinary shares, with

regard to the payment of dividends and the division of assets. Preference
shares are similar to debts/bonds to the extent that debts/bonds receive
interest at a fixed rate for a fixed tenure, and preference shareholders get a
fixed rate of dividends for a fixed period of time. The difference between
them being, the interest on debts/bonds must be paid on specific dates,

while the dividends on preference shares may be deferred and accrued
until the company is able to pay.
Unlike the dividends on ordinary shares, preference share dividends which

are not paid can be carried forward for as long as the bank is in operation.
Preference shares are bank capital that can avoid the dilution of income and
ownership of banks because dividends are payable at fixed rates and
preference share holders do not have the rights of ownership.
(c)" Unappropriated Profit

Unappropriated profit is the accumulated net earnings of any transfer to
fund reserves. Unappropriated profit decreases when the dividend
payments exceeds the yearÊs net profit, and/or when the bank reports net
loss for the year.
For example, if a bank makes a net profit of RM100 million for the year and
pays dividends of RM10 million, unappropriated profit will increase by
RM90 million barring any transfer to reserves. Conversely, if a bank reports
a net loss of RM50 million, itÊs unappropriated profit will be reduced by
RM50 million.
(d)" Capital Reserves

A part of fund reserves that banks are required to keep. It is for the purpose
of revaluation of bank assets.
(e)" Contingency Reserves

Contingency reserves are for contingencies such as legal actions and
payments of undeclared dividend.
(f)" Loan Loss Reserves

Loan loss reserves are used to absorb losses arising from non-repayment of
loans and are gathered through the provision for loan losses in the income
statement.
(g)" Debentures
Debentures are unsecured long-term debts or bonds. The issuer of a
debenture must pay interest at a fixed rate and at a stipulated time. Failure
to meet payment may result in the debenture issuer being liquidated.

While debentures provide financial leverage to shareholders, shareholders

are exposed to greater financial risk as debts increase. This is because the
exposure to fixed financial cost such as interest increases with the level of
debts.
(h)" Convertible Securities

Convertible securities refer to the bonds which are convertible to ordinary
shares at a fixed price and a fixed conversion ratio stipulated by the issuing
company. They are also regarded as hybrid securities because they have the
characteristics of debts as well as equities. Compared to equity securities
and debt securities, convertible securities are a cheaper source of fund for
banks.
Investors are usually interested in convertible securities because these

securities can be converted to ordinary shares when the time is right, i.e.
when the share price increases and exceeds the conversion price. Like other
bonds, convertible securities involve fixed interest and principal payments.
Failure to meet the payments may expose the issuer to liquidation risk.
Sometimes the issuance of convertible securities involves setting up funds
to redeem the securities. This increases the liquidity pressure on the issuing
bank since a sum of reserve must be kept for the purpose
ACTIVITY 8.1
Obtain the balance sheets of at least three commercial banks from their
annual reports or newspaper.
Identify the following from the balance sheets:

• The types of capital owned by these banks; and
• The percentage of each type of capital.
Which type of capital is most used by the banks based on your analysis?
Annual reports of commercial banks can be obtained from the web sites
of the banks. Visit BNM web site at http://www.bnm.gov.my and click
on the hyperlink to access the web sites of commercial banks.

EXERCISE 8.1
From the banksÊ point of view, discuss the advantages and

disadvantages of the following sources of capital:
"
No. Type of Capital Advantage Disadvantage
1. Ordinary shares
2. Bonds
3. Convertible securities
4. Preference shares
"
8.2 FUNCTIONS OF BANK’S CAPITAL
SELF-CHECK 8.2
For manufacturing businesses like Nestle, PROTON and PETRONAS,

the main function of capital is to finance assets and business operations.
Do you think bank capitalÊs main function is to finance bank assets and
operations, based on your understanding of the definition and the types
of bank capital?
Bank capital has three main functions, i.e.:

• Operational function;
• Protection function; and
• Supervision function.
(a)" Operational Function

Banks need fixed assets such as land and buildings, computer equipment
and vehicles to carry on their banking businesses. These fixed assets are
usually financed with long-term funds in line with the life span of the
assets.

Long-term funds of banks consist of shareholders funds and long-term

debts. Banks often issue new shares or make rights issues for development
and growth purposes including purchases of fixed assets.
BankÊs capital is also a measurement used by Bank Negara Malaysia when

assessing a bankÊs application to open any new branch. Banks need
adequate level of capital to sustain their branches.
(b)" Protection Function

The protection function can be categorised as:
•" Loss absorber of a bank; and
•" Assurance to the general public on the bankÊs capability.
(i)" Loss Absorber of a Bank

A lot of people are of the view that the most important function of
bank capital is to safeguard depositorsÊ money. Hence banks must
always have sufficient funds to fulfill deposit withdrawals, even when
they are incurring losses. For that reason, bankÊs capital plays the role
of loss absorber so that banks can continue to operate and generate
profits.
Regardless of bank capitalÊs role as loss absorber, continuous losses

will eventually affect the wellbeing of bank capital; the bank
concerned may faced with liquidity problem to accommodate deposit
withdrawals or loan applications by customers.
It should be noted that there are organisations that make profits but
face liquidity problem and conversely, there are organisations that
incur losses but do not have any liquidity problem. For example, a
bank that incurs losses does not necessarily face any liquidity problem
because the problem is prevented with the statutory reserve and
minimum liquidity provisions. Nonetheless, banks should continue to
increase their capital even when they incur losses so that they can
carry on to operate and to generate income to meet the customersÊ
needs.
(ii)" Assurance to the General Public on the BankÊs Capability

Apart from being a loss absorber, bankÊs capital provides assurance to
the general public that banks are capable to continue operating even
when incurring losses.

The confidence of the general public is very important to any bank.

When the confidence in a bank is shaken by any situation or incident,
the bank will certainly face the bank run crisis, i.e. mass deposit
withdrawals.
Example 8.1 shows how the general public lost its confidence in a bank and how
that led to a bank run.
Example 8.1
International Bank of Asia in Hong Kong experienced a bank run on
Monday, 10 November 1997. Account holders were queuing up outside the
bank branches to withdraw their savings.
The Chief Executive of Hong Kong Special Administrative Region, Tung

Chee Hwa has given assurance that all banks in Hong Kong are stable and
strong. Hong Kong Monetary Board has issued a statement saying that it has
confidence in International Bank of Asia Ltd. (IBA). The board of directors of
IBA has dismissed news on IBAÊs financial difficulty as rumours and has
stated that IBA is able to pay all its obligations.
Source: New Straits Times, 12 November 1997.
ACTIVITY 8.2
Visit BNM web site at http://www.bnm.gov.my and the digital library

of Open University Malaysia at http://www.oum.edu.my to find
information on local banks which were incurring losses (from 1980 to
2002) but were still operating as normal.
Why were these banks able to continue their operations while incurring
losses? Record your findings in short notes.
(c)" Supervision Function

The regulatory body of banks in Malaysia is Bank Negara Malaysia (BNM),
i.e. the Central Bank of our country. One of the important rules imposed by
BNM on all the commercial banks in Malaysia is the capital adequacy
requirement which is measured with Capital Adequacy Ratio (CAR).
CAR is defined as the ratio of a bankÊs capital to its risk-weighted assets, i.e.
CAR = capital/total risk-weighted assets. A bank is deemed to have
adequate capital if its CAR is at least 8%. This means if a bankÊs CAR is less

than 8%, the bank must increase its capital until the CAR is 8%. Failure to
comply with the minimum CAR requirement will lead to severe penalty
under BAFIA, 1989.
Example 8.2 illustrates how BNM used the supervision function of CAR to
require Sime Bank (Sime Bank merged with RHB Bank on 30 June 1999) to
increase its capital to an adequate level.
Example 8.2
Sime Bank recorded a loss before tax of RM1.57 billion for the 6-month
period ending 31 December 1997. The losses reduced Sime BankÊs capital
level to RM698 million and RWCR to 2.9%.
The minimum level of RWCR was 8%. Therefore Sime Bank was required to
increase its capital by a minimum of RM1.2 billion in order to achieve
adequate capital level.
Source: BNM press release (http://www.bnm.gov.my) on 3 March 1998
EXERCISE 8.2
Bank capital is said to have three main functions. How do these three
functions work on a parallel basis with other bank functions?
8.3 BANK’S CAPITAL AND BANKRUPTCY RISK

(CAPITAL RISK)
SELF-CHECK 8.3
What do you think is the connection between bankÊs capital and
bankruptcy risk, based on your understanding of the definition and
functions of bank capital discussed earlier?
How does bankÊs capital help prevent bankruptcy? A bank is still able to carry on
its banking business even when it is incurring losses so long as it has sufficient
capital to accommodate the losses. However, should the bank fail to
accommodate its losses, it will face bankruptcy risk, i.e. the potential of not being
able to repay its debts or the potential of its liabilities exceeding its assets.

It is probably difficult for us to understand how an insufficiency of capital to

accommodate losses can result in bankruptcy risk. Example 8.3 is to help you
understand the relationship between capital adequacy and bankruptcy risk.
Example 8.3
ABC BankÊs balance sheet as at 30 June 2008 was as follows:
ABC Bank
Balance Sheet
as at 30 June 2008
Assets: RM Liabilities and Equity: RM
(Million) (Million)
Cash 10 Deposits 60
Short-term securities 20 Long-term debts 10
Loans and advances 100 Capital 30
Fixed assets 10 Retained earnings 40
Total Assets 140 Total Liabilities and Equity 140
On 30 September, ABC Bank incurred losses totalling RM30 million as a result of

bad debts. ABC BankÊs balance sheet changed to as follows:
ABC Bank
Balance Sheet
as at 30 September 2008
(Million) (Million)
Cash 10 Deposits 60
Fixed assets 10 Retained earnings 10
The RM30 million losses due to bad debts caused the loan assets of ABC Bank to
decrease to RM70 million (i.e. RM100 million – RM30 million). The retained
earnings also decreased by RM30 million, i.e. from RM40 million to RM10

million. This is because when there are bad debts, banks debit the profit and
credit the loans and advances.
Although ABC Bank incurred huge losses, i.e. RM30 million, it was still able to
continue its operation, because the equity or bank capital was sufficient to
accommodate the losses. Besides, there were sufficient bank assets (RM110
million) to cover the bank liabilities totalling RM70 million.
We now observe what would happen to ABC BankÊs balance sheet if it had
incurred bad debt losses totalling RM80 million on 30 September 2008.
ABC Bank
Balance Sheet
as at 30 September 2008
(Million) (Million)
Cash 10 Deposits 60
Loans and advances 20 Capital (10)
Fixed assets 10 Retained earnings -
If ABC bank had incurred RM80 million of bad debt losses, it would have to
cease operation or face a bankruptcy risk. The bank liabilities totalling RM70
million would now exceed the bank assets totalling RM60 million. The RM80
million losses would reduce ABC BankÊs loan assets to RM20 million because the
bank had to credit loans and advances and debit profit when the losses occurred.
The profit of RM40 million would not be sufficient to absorb the losses. Therefore
the bank would have to debit capital by RM40 million to absorb the remaining
losses. The entire bank equity would be consumed by the losses until there was
negative bank capital.
In order to prevent the bank from being liquidated, fresh capital would have to
be injected into the bank to increase the capital to a safe level. For example, if a
fresh capital of RM20 million was deposited into ABC BankÊs account on
1 October 2008, the BankÊs balance sheet would change to:

ABC Bank
Balance Sheet
as at 1 October 2008
(Million) (Million)
Cash 30 Deposits 60
Fixed assets 10 Retained earnings -
With an additional capital of RM20 million, the total assets would increase by
RM20 million in the form of cash to RM80 million. This would enable the bank
assets to cover the total liabilities of RM70 million. The additional capital would
also return the bank capital to the positive region. These two factors would
enable the bank to continue its operation.
8.4 THE EFFECTS OF CAPITAL REQUIREMENT

ON BANK OPERATIONS
As the regulatory body of banks strives to increase bank capital to safeguard the
welfare of the banking system, it also imposes restrictions on the operation
policies of banks in a direct manner. Most of the larger banks are able to raise
external capital through capital market but smaller banks are only able to use
internal funds as their main source of capital. Internal funds are in the form of
retained earnings. They are usually limited because the management has to also
take into account shareholdersÊ return in the form of dividends. For that reason,
statutory requirement on minimum capital can indeed hinder the growth of
banks.
Whenever a bank increases its assets, it has to also increase its capital to comply
with the capital requirement stipulated by the regulatory body. In fact every
bank has to limit the growth of assets to a certain percentage of retained earnings
plus fresh external capital.
The minimum capital requirement forced the banks to use external capital in the
form of debts. For example, a bank that is unable to issue ordinary shares will be
forced to use debts if it wants to expand its business. Even though debt securities
are regarded as capital, debts increase the financial risk of banks and the risk

exposure of shareholders. Hence the change in capital requirement will trigger a

change in the capital structure of a bank.
Another effect of bankÊs capital requirement is, banks which are unable to
procure additional capital will tend to invest in low risk assets. This indeed
affects the interest of the shareholders. On the contrary, banks that have the
ability to secure huge sums of additional capital may invest in high risk assets in
order to procure large sums of income to justify their large investments. Hence
capital requirement influences the asset investment structure of banks.
The minimum capital requirement influences the pricing policies of banks as

well. Costly additional capital increases bank product prices which have to be
borne by the bank customers eventually.
ACTIVITY 8.3
Summarise the advantages and disadvantages of minimum capital
requirement.
You are encouraged to visit the web site of banks in Malaysia through
the hyperlinks at BNM web site at http://www.bnm.gov.my to obtain
additional information on minimum capital requirement and its effect
on the bank operations.
EXERCISE 8.3
Test your comprehension level by answering the questions below:
1. Discuss five incidents that can trigger a bank run.
2. Based on the bank run case concerning International Bank of Asia

(IBA) Ltd in Hong Kong on 10 November 1997, answer the
following questions:
(a) What caused the bank run at International Bank of Asia Ltd?
(b) Why did the Hong Kong leader, the Hong Kong Monetary
Board and the board of directors make their respective
statements?

(c) How would you handle the bank run if you were the manager
of an IBA branch?
(d) State an example of bank run in Malaysia recently and explain
why it happened.
•" The importance of bank capital rests with its roles in the operations,
protection and supervision of banks.
•" The main role of bank capital is to reduce bank risk by acting as the
„cushion‰ or „absorber‰ for potential losses, by providing access to financial
market to overcome liquidity problem, and by limiting growth and risk-
taking.
•" A huge capital base is able to reduce risk by absorbing income volatility,
controlling growth and reducing the probability of failure.
•" A huge capital base may also reduce shareholdersÊ returns.
•" The decision on the amount of required capital indeed involves a trade off
between risk and return.
Capital reserves Loan loss reserves

Core capital Ordinary shares
Convertible securities Preferences shares
Contingency reserves Secondary capital
Debenture
"

Topic X Capital
9 Adequacy
LEARNING OUTCOMES
1." Explain the relationship between the concept of capital adequacy and
the liquidation risk of banks;
2." Discuss the relationship between capital adequacy and bank stability;
3." Measure capital adequacy quantitatively and qualitatively; and
4." Evaluate capital adequacy level of banks.
X" INTRODUCTION
One of the critical issues in todayÊs commercial bank management involves
issuing and sustaining adequate capital. This is because many people are of the
view that capital inadequacy is the main contributing factor to bank failure and
closure. Many commercial banks in the USA and European countries have been
forced into liquidation due to their lack of capital to accommodate their losses.
Furthermore, the financial crisis in our country during 1997–1998 has proven
clearly that our banking industry is indeed very much exposed to the risk of
capital inadequacy. Capital adequacy protects banks from liquidation, and it also
protects bank management teams. It ensures that every bank has sufficient
capital to carry on their operations.
Capital adequacy can be measured quantitatively as well as qualitatively with

several methods. Important issues pertaining to capital adequacy, such as the
concept of capital adequacy, capital adequacy measurement methods and bank
stability will be discussed in this topic.

TOPIC 9 CAPITAL ADEQUACY W 167
9.1 THE CONCEPT OF CAPITAL ADEQUACY
ACTIVITY 9.1
What do you think the concept of capital adequacy is about, based on

your understanding of capital management discussed in Topic 8?
Essentially, capital adequacy is defined as:
Any level of capital that allows a bank to absorb or accommodate any losses
and at the same time equips the bank with sufficient funds to sustain and
carry on its businesses as a continuing entity.
The key question in capital adequacy management is, „How much capital does a
bank need?‰ In general, a bank must have enough capital to:
(a)" Balance the interests of depositors, creditors, shareholders and borrowers.
(b)" Protect depositors and creditors from losses.
(c)" Maintain general publicÊs confidence in the stability of the bank.
(d)" Provide funds for lending purposes.
In view of the above, the bank management must analyse the trade off between
risk and return in determining the desired level of capital. If a bankÊs capital level
is too high, it may have lower risk at the expense of profit. On the contrary, if a
bank has low level of capital, its profit may increase and so may its risks
exposure.
The regulatory body of banks (BNM) and the management teams of banks have
different views on capital adequacy. The banking regulatory body expects banks
to have more capital for the following reasons:
(a) Firstly, in BNMÊs opinion, a large capital base can ensure the security and
stability of the countryÊs financial system. As it is generally known,
commercial banks form the largest component of any financial system.
Failure of any commercial bank will certainly distress the financial system.

168 X TOPIC 9 CAPITAL ADEQUACY
(b) Secondly, a large capital base can safeguard the bank itself, since the bank
can use its capital to absorb losses while carrying on its business. In other
words, a large capital base can reduce the probability of bank failure. The
failure of the banking system will definitely affect the stability of the
financial system and subsequently the economy of the country.
(c) Thirdly, a large capital base can increase bank liquidity for the purpose of
fulfilling the needs of depositors as well as borrowers. Large capital base
can help gain confidence from the general public in a bankÊs financial
stability.
Otherwise, the management teams of banks favour smaller capital base for
the benefits of leverage. The smaller the equity base of a bank, the more
financial leverage and the bigger potential of equity multiplication it has.
Financial leverage can translate an average Return On Assets (ROA) to a

high return on equity. However, the management must remember that
while the concept of financial leverage can increase profits, it can also
increase financial losses.
9.1.1 Capital Adequacy and Bank’s Security
ACTIVITY 9.2
How does capital adequacy influence bankÊs security? Construct your

answer based on your understanding of the previous topic, i.e. the
concept of capital adequacy.
What does bankÊs security mean? Who is protected when the bankÊs security is
intact and who bears the losses when a bank is not secure? In general, when we
talk about bankÊs security, reference is made to:
The endeavours to protect the interests of the banking regulatory body, the
depositors and the borrowers specifically, and the interests of the general
public.

One of the endeavours is to ensure that banks have adequate capital. Capital
adequacy and bankÊs security can be explained from four perspectives:
• Regulatory body of banks
• Depositors
• Borrowers
• General public
(a)" Regulatory Body of Banks

To the regulatory body or Bank Negara Malaysia, capital adequacy is vital
to ensure the stability of the banking system specifically, and of the
financial system generally. Failure of any bank due to capital inadequacy
will affect the banking system drastically. We already learned about how a
bankÊs failure had resulted in a bank run that could cripple the entire
banking system.
Without a good banking system, a countryÊs economic system will be

jeopardised as businesses cannot be carried on without a proper payment
and credit mechanism. In view of that, the regulatory body imposes various
rules and laws to ensure that all commercial banks under its regulation
have adequate capital.
(b)" Depositors
To the depositors, the safety of their deposits is of the utmost importance.
Banks must remember that depositors are entitled to withdraw their
deposits at any time. Therefore banks must always have sufficient capital to
meet the withdrawal demands.
Should a depositor Ês withdrawal demand be not fulfilled by a bank for

whatever reason, such negative news will spread very quickly and will
most probably affect the bank. The bankÊs failure to handle the negative
news may even result in its liquidation. In view of that, capital adequacy is
critical in assuring the depositors that their deposits are safe and protected.
(c)" Borrowers
Borrowers are also concerned about bank security since only secure and
stable banks are able to provide loans. During the financial crisis in 1997–
1998, commercial banks in Malaysia either reduced or froze their lending
activities for bankÊs security and stability reasons. As non-performing loans
continued to increase, many banks had to incur huge losses and their bank
capital also deteriorated accordingly. Banks began to worry about
increasing potential losses and liquidation risk.

Reducing or stopping lending activities completely was one of the

measures adopted by banks in their quest to reduce losses and risk, since
loans formed the main cause of losses during that period. However,
borrowers became the victims of such strategy. As a result Bank Negara
Malaysia interfered in the situation by setting up Danaharta and
Danamodal to ensure that borrowers could continue to obtain loans from
commercial banks, and in turn ensure that our economic system would not
be jeopardised by the slow-down or halt in lending activities by banks.
ACTIVITY 9.3
Visit the web site of Danamodal at http://skali.bnm.gov.my/danamodal
and the web site of Danaharta at http://www.danaharta.com.my to obtain
information on how Danamodal and Danaharta help banking institutions
restructure their capital.
What actions do Danamodal and Danaharta take to help the banking

institutions? Record your findings in short notes. Also work out how
these actions influence capital adequacy of banks.
(d) General Public

To the general public, bankÊs security is a vital factor in their dealings with
commercial banks. Through Bank Negara Malaysia, the government always
reminds the public of its commitment to the stability of the banking system,
financial system and economic system by means of implementing just and
appropriate monetary and fiscal policies. The general public are always
reminded of the importance of safeguarding the welfare of the banking
system. The general publicÊs desire for efficient and secure banking services
can only be fulfilled if the wellbeing of the banking system is intact.
ACTIVITY 9.4
The banking regulatory body, depositors, borrowers and public have
different views on capital adequacy and bankÊs security. How do capital
adequacy and bank security form links among the regulatory body,
depositors, borrowers and public? Sketch a simple mind-map to show
the relationships.

EXERCISE 9.1
Explain the relationship between bankÊs security and capital
adequacy.
9.2 STRUCTURE OF BANK CAPITAL

Before any further discussion on the methods of measuring capital adequacy, we
have to understand the structure of bank capital first. The capital structure of
banks is different from the capital structure of non-bank institutions. Table 9.1
shows the comparison between the balance sheet of banks and the balance sheet
of non-bank institutions.
Table 9.1: Comparison between the Balance Sheet of Banks and the Balance Sheet of Non-
bank Institutions
Non-bank Institutions Banks
Assets % Assets %
Cash 4 Cash 8
Accounts receivable 26 Short-term securities 17
Inventory 30 Short-term loans 50
Total current assets 60 Total current assets 75
Long-term securities 5
Long-term loans 18
Fixed assets 40 Total fixed assets 2
Total assets 100 Total assets 100
Liabilities Liabilities
Accounts payable 20 Short-term deposits 60
Short-term notes payable 10 Short-term debts 20
Total current liabilities 30 Total current liabilities 80
Long-term debts 30 Long-term debts 12
ShareholderÊs equity 40 ShareholderÊs equity 8
Total liabilities and equity 100 Total liabilities and equity 100

Below is the summary of the comparison between the balance sheet of banks and
the balance sheet of non-bank institutions:
(a) ShareholdersÊ equity of banks is 8% while shareholdersÊ equity of non-bank

institutions is 40%. This shows that in comparison with non-bank
institutions, banks have significantly lower capability to absorb losses. How
does this happen while one of the functions of bank capital is to absorb
losses? This is due to the fact that banks depend more on customer deposits
to finance their operations, hence lower capital component. On the other
hand, non- bank institutions depend more on long-term capital as their
main source of finance.
(b) Compared to non-banks, banks have higher percentage in assets (75% :

60%). This shows that banks have higher liquidity level than non-bank
institutions. Bank liquidity serves the purpose of fulfilling claims arising
from short-term liabilities, especially deposit withdrawals which can
happen at any time. Claims against non-bank institutions are of periodic
nature, i.e. the payment amounts and dates are pre-determined.
(c) Current assets and fixed assets of non-bank institutions are split at a ratio of
60% : 40% and financed by debts and equity at 60% : 40% split. Debts of
non-bank institutions consist of current liabilities and long-term debts, each
of which constitutes 30% of the total liabilities and equity. On the other
hand, banks have 75% of their assets in the form of current assets compared
to only 25% in long-term assets. 92% of the assets are financed by debts, i.e.
80% by short-term liabilities and 12% by long-term liabilities. The
remaining 8% of assets are financed by equity. It is evident from the
composition of assets, liabilities and equity that banks have a higher level of
financial leverage compared to non-bank institutions. This means that
banks maximise their usage of capital to generate higher return on assets in
order to maximise shareholdersÊ wealth.
9.3 CAPITAL ADEQUACY MEASUREMENT

METHODS
Up to this stage, we only know that banks need to have sufficient capital so that
they can bear the losses incurred by them. We also know, in a generic manner,
that bank capital must have the capability to protect the interests of shareholders,
depositors and creditors. However, we still do not know specifically how much
capital, in quantitative terms, is considered adequate for a bank.

The following section illustrates the quantitative as well as qualitative methods

used in the evaluation of capital adequacy.
Capital adequacy can be measured by using the methods shown in Figure 9.1.
Figure 9.1: Capital adequacy measurement methods
9.3.1 Capital Ratios

The four capital ratios frequently used in measuring capital adequacy of banks are:
•" Capital to total deposits ratio
•" Capital to total assets ratio
•" Capital to risk weighted assets ratio
•" Capital to loans ratio
These ratios represent the conventional methods in assessing how far a bank can
bear its losses while still having sufficient capital to ensure the safety of
customersÊ deposits. As the minimum required values of these ratios are not
available unknown in Malaysia, we will use the minimum requirements in the
USA as benchmarks.

(a)" Capital to Total Deposits Ratio

In the USA, a capital to total deposits ratio of 10% is said to be sufficient to
protect depositors. The ratio means that every USD10 of deposits is
protected by every USD1 of capital. The ratio gives depositors the
assurance that their banks have sufficient capital to protect their deposits.
However, this ratio has its weakness; it does not take into account the fact
that deposits alone do not have any risk apart from their volatility. Besides,
all deposit-associated risks are indeed originated from risky loans and
investments. In view of that, this ratio would be more accurate if it also
incorporated the investment in assets.
(b)" Capital to Total Assets Ratio

In the USA, a bank is considered to have adequate capital if its capital to
total assets ratio is no less than 7%. This means that customersÊ deposits are
safe so long as every USD100 of investment in assets is financed by at least
USD7 of capital. This ratio, as well as the capital to total deposits ratio, take
no account of the structure of assets. As we all know, different assets have
different risk levels. For example, cash assets do not have any risk whereas
loan assets have the highest risk amongst all bank assets. For that reason,
capital ratio that is based on risk weighted assets reflects a more accurate
picture of capital adequacy than those two ratios. Since they can be easily
understood and applied, the capital to total deposits ratio and capital to
total assets ratio are used as simple tests for capital adequacy.
(c)" Capital to Risk Weighted Assets Ratio

Capital to risk weighted assets ratio is sometimes known as risk weighted
assets ratio. Risk weighted assets mean net total assets of liquid assets
comprising cash, bank balances and government securities. In Malaysia, a
capital to risk weighted assets ratio of 8% is considered adequate to protect
depositors. It means that every RM1 of investment in risk weighted assets
must be financed by at least RM0.08 of capital. Before the implementation
of BAFIA, finance companies in Malaysia were allowed a risk weighted
assets ratio of 15 times the amount of shareholdersÊ funds. In other words, if
a finance company had a capital base of RM20 million, it was allowed to
invest up to RM300 million in risk weighted assets. Another interpretation
to this is, if we wanted to invest RM300 million in risk weighted assets, we
would need to have a capital of at least RM20 million to protect such
investment.
(d)" Capital to Loans Ratio

Lending activities provide the main source of income for banks. Amongst
all bank assets, loans and advances have the highest risk and such risk is
called credit risk. Bank losses are usually attributed to this group of assets.

Credit risk is not visible in the capital to risk weighted assets ratio because
besides loan assets, other assets of lower levels of risk are included in the
ratio. Capital to loans ratio is to overcome such shortcoming by focusing on
loans and advances. In the USA, any bank with a gross loan base exceeding
seven times its capital account will be subject to scrutiny. For example, if a
bank has a gross loan base of RM1,400 million, it must ensure that it has a
capital base of at least RM200 million.
9.3.2 Capital Adequacy Ratios

Before the introduction of risk weighted capital adequacy ratio (RWCR), the
minimum capital adequacy ratio (CAR) was introduced in September 1981 and
implemented in January 1982 by Bank Negara Malaysia. This ratio is derived
from the following formula:
Free capital
Minimum capital adequacy ratio =
Total assets
„Free‰ capital consists of shareholdersÊ funds net of investment in long-term

assets. The minimum ratios stipulated by BNM are 4% for local banks and 6% for
foreign banks.
Minimum capital adequacy ratio does not take account of the risk structure of
assets. Therefore, RWCR was introduced to overcome such shortcoming; RWCR
recognises that assets can have different levels of risk and therefore uses risk-
weighted assets, also known as risk weighted credit exposures in its calculation.
RWCR can be derived from the following formula:
Capital
RWCR =
Total risk weighted assets
While the total risk weighted assets is:
Balance items"× (Off-balance sheet

(Total risk weighted assets) = items"× Credit conversion factor) ×
Risk weighting

RWCR ratio classify bankÊs asset into five categories as follows:
(a)" 0% Category
Bank assets in this category have either minimal or zero credit risk. Cash
and Malaysian government securities (MGS) fall into this category. Cash
itself does have any credit risk whereas MGS do not carry any default risk
since the repayments are guaranteed by the government.
(b)" 10% Category

Investment in money market instruments and investment in Cagamas
bonds are part of this category. Since money market instruments such as
bankersÊ acceptances, negotiable certificates of deposit (NCDs) and floating
rate negotiable certificates of deposit (FRNCDs) are usually highly liquid,
their credit risks are low. Cagamas bonds have low risk weighting because
they are guaranteed by the government.
(c)" 20% Category

Loans guaranteed by financial institutions carry 20% risk weighting. These
loan assets are not assigned high risk weighting because they are
guaranteed by third parties, i.e. financial institutions.
(d)" 50% Category

Housing loans are assigned 50% risk weighting even though the houses
concerned are used as the collateral securities. This is because the values of
these collateral securities are subject to economic situations.
(e)" 100% Category

Other loans and advances, and all other bank assets fall into this category.
RWCR takes account the off-balance sheet items by converting them to credit
equivalent amounts with credit conversion factor. Bank guarantee is an example
of off-balance sheet items. When a bank guarantee is issued, the nominal value of
the guarantee is not recognised in the accounting books of the issuing banks since
there has been no advances or loans involved. Nevertheless, the bank may have a
payment obligation in future, depending on whether the guarantee is enforced.
This means the off-balance sheet items such as bank guarantees also carry credit
risk which must be taken into consideration in the calculation of RWCR.
Off-balance sheet items or off-balance sheet credit exposures are weighted

according to their risk levels after they are converted to their respective credit
equivalent amounts. Credit conversion factor has four values, i.e. 0%, 20%, 50%
and 100%.

(a)" 0% Risk Weightage

Formal standby credit facilities and formal credit facilities with a maturity
period of not more than 1 year or which can be unconditionally cancelled at
any time are subject to 0% credit conversion factor. Facilities with an
original maturity of more than one year are subject to 50% credit conversion
factor.
(b)" 20% Risk Weightage

This is applicable to short-term self-liquidating trade related contingencies
such as letters of credit and shipping guarantees.
(c)" 50% Risk Weightage

Trade related contingencies not influenced by the integrity of the counter
party, such as performance bonds, warranties and standby letters of credit
which aretransaction-related are subject to 50% credit conversion factor.
(d)" 100% Risk Weightage

This is applicable to:
(i)" Direct credit substitutes such as guarantees, acceptances and letters of
credit for financial guarantees.
(ii)" Asset sales with recourse, i.e. the credit risk is still borne by the selling
institution.
Now let us see how RWCR is calculated.
Example 9.1
LetÊs just assume that Bank Y, a commercial bank, has the following asset and
financial details:
Balance Sheet Items RM Million Risk Weightage
BNM Statutory reserve 30 0%

Malaysian government securities (MGS)
50 0%
and treasury bills
Placements with discount houses 40 10%
Amounts owed by banking institutions 60 20%
Housing loans secured by first charge on
100 50%
residential property
Loans and advances provided to commercial
480 100%
customers

Amount Credit Risk

Off-balance Sheet Items (RM Conversion
Million) Factor Weightage
Housing loans sold to Cagamas with recourse 60 100% 50%
Performance bonds for commercial customers 20 50% 100%

Letters of credit for commercial customers 70 20% 100%
Capital RM Million
Paid-up ordinary shares 20
Share premium 4
Retained earnings 16
Subordinated term loan 10
Revaluation reserve 4
General provision for bad debts and doubtful debts 6
Calculation of credit equivalents
Nominal Credit Credit

Off-balance Sheet Items Amount Conversion Equivalent
(RM Million) Factor Amount
Housing loans sold to Cagamas 60 100% 60

with recourse
Perf rmance bonds for 20 50% 10
commercial customers 20% 14
Letters of credit for commercial 70 20% 14
customers

Calculation of Risk Weighted Assets or Credit Exposures
Risk Risk
Exposure Credit
Amount + = Total ×" = Weighted
Type Equivalent Weighting asset
Statutory reserve 30 + 0 = 30 ×" 0% = -
MGS and treasury 50 + 0 = 50 ×" 0% = -
bills
Placements with 40 + 0 = 40 ×" 10% = 4
discount houses
Amounts owed 60 + 0 = 60 ×" 20% = 12
by banking
institutions
Housing loans 100 + 60 = 160 ×" 50% = 80
Claims against 480 + 24 = 504 ×" 100% = 504
non-bank private
sector
Total 600
Capital fund
RCWR =
Total weighted assets
RM60 million
=
RM600 million
= 10%
A 10.2% RWCR shows that Bank Y has fulfilled the capital adequacy requirement
since the minimum ratio imposed by BNM is 8%.
Another useful ratio is the core capital ratio which compares the core capital with
the total risk weighted assets. The core capital ratio of Y Bank is 6.67%, calculated
as follow:
RM20 million + RM4 million + RM16 million

Core capital ratio = = 6.67%
RM600 million
BankÊs YÊs core capital ratio is considered adequate since the minimum ratio
stipulated by BNM is 4%.

The new capital adequacy ratio, i.e. the risk weighted capital adequacy ratio
(RWCR) was introduced for the following reasons:
(a)" The shortcoming of the old method used in the measurement of capital
adequacy. The old capital adequacy ratio introduced by BNM does not take
into account the risk portfolios of assets.
(b)" The old ratio also takes no account of the potential risks of off-balance sheet
items.
(c)" As financial activities undertaken by other financial institutions have
become increasingly indistinguishable from that undertaken by commercial
banks, we need a standard measurement that is applicable to all major
financial institutions consisting of commercial banks, finance companies
and merchant banks.
The main weakness of capital adequacy ratio (CAR) is, it takes account of credit
risk only. In reality, every bank is exposed to five primary risks:
(a)" Credit risk
(b)" Liquidity risk
(c)" Interest rate risk
(d)" Operational risk
(e)" Capital risk or bankruptcy risk
(a)" Credit Risk

Credit risk means the potential loss in net income and the market value of
equity due to a customer Ês non-payment or late payment of loan principal
or interest or both. Loans and advances have the highest credit risk. Credit
risk is assessed with credit analysis. We will discuss credit analysis in
Section 3 of Topic 11. Credit risk is measured with the following ratios:
(i) Non-performing loans
Total loans
(ii) Provision for bad debts

Total loans
(b)" Liquidity Risk

Liquidity risk is risk to net income or capital arising from a bankÊs inability
to procure funds by selling assets or borrowing without incurring
unacceptable losses. The highest level of liquidity risk arises from the
failure to forecast loan applications and deposit withdrawals accompanied

by failure to access new funding sources. Liquidity risk can be measured

with the following ratios:
(i) Purchased (Borrowed) funds
Total assets
(ii) Short-term securities
Total deposits
(iii) Total Net Borowings
Total assets
(iv) Cash and Malaysian government securities
Total assets
(c)" Interest Rate Risk

Interest rate risk is the potential loss in a bankÊs net income and the market
value of its equity resulting from any change in the market interest rates.
Banks have to compare the sensitivity of their interest income to the
changes in the rates of return of their assets, with the sensitivity of their
income expenses to the changes in the interest rates of their liabilities. For
example, an increase in interest rate will increase interest expenses, and if
the increase in interest income falls short of the increase in interest
expenses, the net interest income will decline, and so will the value of the
bank.
Interest rate risk can be measured with the following ratio:

Interest-sensitive assets
Interest-sensitive liabilities
A bank with a ratio of less than 1 is exposed to losses should the interest
rates decline.
(d)" Operational Risk

Operation risk is the risk to a bankÊs net income and the market value of its
equity arising from changes in operating expenditure. These changes may
be related to:
(i)" Direct costs;
(ii)" Staff error;
(iii)" Fraud by customers; and
(iv)" Technology.

Risk to net income can be measured by the standard deviation of net

income after tax and the standard deviation of the returns on assets and
equity.
Market risk refers to the impact of interest rates on the net asset portfolio. It
can be measured by the following ratios:
(i) Book value of assets
Market value of assets
(ii) Variable rate liabilities
Variable rate loans
(iii) Variable rate loans
Variable rate liabilities
(e)" Capital Risk or Bankruptcy Risk

Capital risk or bankruptcy risk is the potential that a change to a bankÊs
capital that may disrupt the capital adequacy level and the security of the
bank subsequently. Capital adequacy and bankruptcy risk or bankÊs security
were already discussed in-depth earlier.
ACTIVITY 9.5
What would happen to the countryÊs financial system if Bank Negara
Malaysia (BNM) did not exist or there were more than one central bank?
In order to arrive at your decision, list all the methods as well as their
significance and disadvantages respectively.
9.3.3 Qualitative Measurement
SELF-CHECK 9.1
In the previous topic, we used various quantitative methods to
measure capital adequacy of banks. Are those methods sufficient to
determine if a bank has adequate capital? Do internal and external
environment factors have any impact on capital adequacy of banks?
Qualitative measurement is used in the assessment of bankÊs capital adequacy

because the minimum capital adequacy ratio takes no account of the non-

quantitative internal and external aspects of banks. Various aspects that can be
used as qualitative measurement are as follows:
•" Quality of bankÊs management;
•" Quality of bankÊs assets;
•" BankÊs earnings history;
•" Quality of bank ownership;
•" Accommodation cost ;
•" Quality of operation procedures;
•" Volatility of deposits; and
•" Local market conditions.
(a)" Quality of BankÊs Management

Quality of management refers to the qualification and experience of the top
management of a bank. Market and investorsÊ confidence in the capital
adequacy of a bank increases with the level of qualification and experience
of the bankÊs management team. It is generally assumed that there is a
positive correlation between the quality of bank management and bank
security, because may people have the opinion that a bank will be run
properly if it has a responsible management team.
(b)" Quality of BankÊs Assets

Specifically, quality of bank assets refers to the quality of the loan portfolio
of a bank. This can be measured by the level of non-performing loans
(NPLs). Higher loan portfolio quality means lower percentage of NPLs, and
that translates into higher confidence level in the bankÊs capital adequacy.
As we all know, high NPL level can reduce or deteriorate bank capital.
Deterioration in bank capital will certainly affect bank capital adequacy.
(c)" BankÊs Earnings History

One of the key components of bankÊs capital is the accumulated retained
earnings which consist of net income after tax accumulated year after year.
The growth rates of a bankÊs retained earnings reflect the quality of bank
income. The higher the growth rates are, the more confidence the market
and the investors have in the capital adequacy of the bank.
(d)" Quality of Bank Ownership

When some commercial banks in Malaysia experienced capital inadequacy
during the financial crisis in 1997–1998, we had to depend on Danamodal to
restore the capital adequacy of these banks because most shareholders

refused to inject fresh capital into the troubled banks. This is a clear
evidence of how the quality of bank ownership can influence capital
adequacy of banks.
(e)" Accommodation Cost

A bank without its own premises will have to rent it in order to carry on its
banking businesses. This means the bank has to incur huge amount of cost
on rental and building administration, especially if the bank has branches.
This expenditure can jeopardise the profitability and hence the capital level
of the bank.
(f)" Quality of Operation Procedures

A bank can run its operations smoothly and efficiently if it has proper
procedures in place to monitor and ensure the effectiveness of its goal-
achieving actions. Inaccurate and disorganised procedures can affect the
operations and profitability of a bank, and will in turn jeopardise the capital
adequacy of the bank.
(g)" Volatility of Deposits

Deposits represent the main source of funds for lending activities. At the
same time, loans represent the main source of bank profits. If the
availability of deposits is not stable, the loan portfolio will be affected. That
means the volatility of deposits can indeed jeopardise capital adequacy,
through the deterioration in loan portfolio.
(h)" Local Market Conditions

Borrowing from the money market or capital market is one of the ways to
overcome capital inadequacy problem. Should the market conditions not
favour funding for such purpose, banks will lose this main remedy for
capital inadequacy. However, if the market is ever ready to provide
funding, bank security can be assured since the capital inadequacy problem
will not be prolonged and banks can always carry on their banking
businesses smoothly.
9.4 CAPITAL ADEQUACY AND BANK STABILITY

The key question pertaining to capital adequacy is the relationship between
capital adequacy and bank stability since both terms are often treated as
interchangeable. Example 9.2 is to help you differentiate them.

Example 9.2
The balance sheets of Bank M and Bank N are as follows:
Bank M
Balance Sheet (RM Million)
Assets RM Liabilities and Net Values RM

Cash 60 Current deposits 120
Treasury bills 120 Savings deposits 100
Long-term investments 120 Fixed deposits 140
Loans and advances 140 Negotiable certificates
of deposit (NCDs) 30
REPOS 30
Equity 20
Bank N
Balance Sheet (RM Million)
Assets RM Liabilities and Net Values RM

Cash 40 Current deposits 320
Treasury bills 20 Savings deposits 10
Long-term investments 100 Fixed deposits 10
Loans and advances 290 Negotiable certificates
of deposit (NCDs) 50
REPOS 10
Equity 40
Which bank has better capital adequacy level, based on the balance sheets of
Bank M and Bank N?

Answer:
Bank N has better capital adequacy than bank M because:
• Bank N has more capital than Bank M.
• Capital ratios of Bank N are beter than the capital ratios of Bank M.
Capital Ratio Bank M Bank N

Capital/Total assets 4.5% 9.1%
Capital/Total deposits 5.0% 10.0%
Capital/Total loans 14.3% 14.3%
Therefore, can we also conclude that Bank N is more stable than Bank M? Before
we provide the answer, we should first look at the asset and liability structures of
the two banks.
Asset structure
From the aspect of asset structure, Bank M has more liquid assets compared to
Bank N. Bank M has cash and treasury bills totalling RM180 million while Bank
N has a total of RM60 million only.
Therefore, it can be concluded that Bank M is more liquid than Bank N. Besides,
Bank N has higher exposure to bad debts since it has more loans and advances
than Bank M. If the average rate of bad debts of the banking industry is 10%,
Bank N will have more bad debts compared to Bank M.
Nevertheless, we have to take into consideration that BankÊs N rate of bad debts
may be lower than BankÊs M. There is not enough information for us to
determine the loan portfolio quality of these banks.
Liability structure
From the aspect of liabilities, the deposits at Bank N are considered less stable
than that at Bank M because Bank N has more current deposits than Bank M.
Besides, Bank M has a more balanced composition of deposits.
In view of the above, we can conclude that the asset and liability structures of
Bank N have higher risk than that of Bank M. With additional information, we
may be able to conclude that Bank M is more stable than Bank N.
Based on the above example, we can conclude that capital adequacy is different
from bank stability. Capital adequacy is just a part of bank stability. In other
words, capital adequacy is a subset of bank stability. Bank stability reflects a
bankÊs strengths in terms of capital, assets and liabilities.
ACTIVITY 9.6
Obtain the balance sheets of at least two local banks from their annual
reports or newspaper. Calculate the following ratios, based on the
available information:
•" Capital to total deposits ratio
•" Capital to total assets ratio
•" Capital to risk weighted assets ratio
•" Capital to loans ratio
Which bank has better capital adequacy, based on the ratios? Which
bank has better capital adequacy if you also incorporate qualitative
measurement into the assessment?
EXERCISE 9.2
1. What is the difference between the old CAR and the new CAR?
2. What is the relationship between bank security and bank stability?
3. Explain the relationship between capital adequacy and bank
stability.
•" The concept of capital adequacy is a vital concept in bank management

because this concept is closely linked to the concept of bankÊs security and
bankÂs stability.
•" Commercial banks must have adequate capital to assure the regulatory body,
depositors, borrowers and general public of the banksÊ security.
•" Commercial banks need to have adequate capital because capital adequacy is
one of the key determinants of bank stability. At the same time, bank security
is closely related to bank stability since a secure bank is a stable bank.
•" The management of each bank must always strive to have adequate bank
capital in order to protect the interests of the regulatory body, depositors,
borrowers and general public.

Asset ratio Deposit ratio

Capital adequacy Loan ratio
Credit risk
"

Topic X Lending
10 Policy
LEARNING OUTCOMES
1." List the importance of lending activities;
2." Explain lending process in detail;
3." Describe the three main principles in lending;
4." Identify the relevant elements of lending policy; and
5." Examine the factors influencing lending policy.
X" INTRODUCTION
Lending is one of the key activities of any commercial bank. Loan assets
constitute a large portion of banks assets while interest income derived from
customer loans makes up a large part of bank income. Since lending is a key
activity, every bank must have its own clear, accurate and documented lending
policy.
Lending policy of a bank should make reference to a set of comprehensive

criteria so that they can provide guidelines for new as well as existing credit
officers. When formulating lending policy, all internal and external factors that
may influence the lending policy must be accounted for. Last but not least,
lending policy must be aligned to the three main principles in lending, i.e. the
principles of purpose, payment and protection.

190 X TOPIC 10 LENDING POLICY
10.1 THE IMPORTANCE OF LENDING

ACTIVITIES
ACTIVITY 10.1
Most of us have borrowed from a banking institution, or even a non-
bank institution before. What would happen to you, the society and the
country if these financial institutions did not provide such facility?
The importance of lending activities of banks can be viewed from several angles:
Firstly, lending activities represent one key contributor to the achievement of

banking objectives. They fulfill the valid credit needs of the society. A loan that
satisfies „valid credit needs‰ means a loan with a purpose that is both legal and
relevant to the society. For example:
(i)" Lending to serve the purpose of smuggling drug or other illegal goods
cannot be considered to be fulfilling „valid credit needs‰.
(ii)" Provide agricultural lending in non-agricultural area or granting a loan to
send someone to the moon is not considered as fulfilling „valid credit
needs‰.
Commercial banks must provide loans or credit facilities to their respective local
communities for the economic growth and stability of these communities.
Secondly, loans are important intermediaries that shape and maintain the
relationship between a bank and its deposit customers. Customers are more
attracted to banks that provide loans to their deposit customers.
Usually, banks are more willing to provide loans to their existing deposit account
holders instead of new customers. When granting a loan to a new loan customer
without any deposit account, a bank will usually request that the customer open
a deposit account with the bank first.
Thirdly, the return of loans is higher than any other investments of a bank. This
is in consistent with risk-return trade off, as loans are the riskiest bank assets.
Such high risk is attributed to credit risk and liquidity risk.

TOPIC 10 LENDING POLICY W 191
10.2 THE PROCESS OF LENDING

Before we discuss the main principles in lending, let us look at the lending
process first. Figure 10.1 illustrates the lending process of banks in general.
Figure 10.1: Lending process of banks
Lending activities begin with a written loan application, i.e. the applicant
completes the application form supplied by the bank. The application is then sent
to the credit department for credit analysis to determine the applicantÊs credit-
worthiness. After the credit analysis is done, the credit department will put
forward a proposal to the management for the final decision.
In Malaysia, the credit process involves two levels, i.e. branch level and area level
or head office level. The power to approve loans at branch level rests with the
branch managers. A branch managerÊs power to approve loan applications is
subject to the size of the branch. For example, a branch manger may be granted
the power to approve any loan applications not exceeding RM50,000 per loan.
Any loan exceeding RM50,000 will be sent to the area office or the credit
department at head office after preliminary credit analysis is performed at the
branch. The area or head office will then conduct a detailed analysis and make
the final decision on the loan application.

ACTIVITY 10.2
Most of us have the experience of applying for a car loan, housing loan
or education loan from a financial institution. What process took place
when you made your application? Outline the process that you have
experienced and compare it with the one discussed earlier. What
conclusion can you draw from the comparison?
If you have not applied for any loan from any financial institution so
far, obtain the information on loan application process from your
friends who have experienced loan application before.
10.3 THE PRINCPLES OF LENDING

A bank lends to a customer based on the credit information of the customer and
his business. Unfortunately banks are always faced with the problem of
asymmetric information since banks always have less knowledge than the
customers of the customersÊ future performance.
Loan applications usually provide information that shows low credit risk and
conceal information that proves their high credit risk. The problem of
asymmetric information is more common when dealing with small-scale
businesses compared to large-scale businesses because public information on
small-scale businesses is very limited.
Asymmetric information can cause two problems in lending, i.e. adverse

selection and moral hazard.
(a)" Adverse Selection

Adverse selection comes into play before any loan is granted. It involves a
bankÊs knowledge, or the lack of it, of the businesses of its loan applicants.
Due to incomplete information and knowledge, a bank may make incorrect
credit decisions at this stage and suffer from losses subsequently. For
example, if, for lack of the relevant knowledge, a bank procures low quality
customers and ends up charging high interest rates, the bank may risk
turning away high quality borrowers and may also have to deal with large
numbers of non-performing loans.

(b)" Moral Hazard

Moral hazard happens after a loan is granted. It is attributed to the change
in attitude and behaviour of a borrower after the loan is granted. Again,
banks may be ignorant of those changes. For example, without the bankÊs
knowledge, a borrowerÊs appetite for risk may have increased from
moderate to high after he obtained the loan. Changes like this spell
potential problems for the bank.
In order to make sound and founded loan decisions, bank officers should
use the three main principles in lending, i.e. the principle of purpose, the
principle of payment and the principle of protection.
10.3.1 Principle of Purpose

Loans are used for various purposes. Loans can be used, amongst others, as
working capital, for purchase of a fixed asset and for investment in securities.
Credit officers of a bank must ensure that the purposes of loans are consistent
with the lending policy of the bank in order to avoid confusion and other
problems among customers. Loans without any real and concrete purpose are
bound to be problematic.
„If I manage to get the loan, I will use it to expand my

business through franchise. I am certain that I will be able
to repay the RM600 loan in six months...‰
A lot of people are of the opinion that there is a close relationship between the
purpose of a loan and its repayment; if we do not know the true purpose of a
loan, we tend to be unclear about its repayment too. Conversely, if the purpose of
a loan can be identified clearly, so can the source of repayment. For example, if a
loan is for the purchase of raw material for a business, the proceeds from the
eventual sale of goods will be identified as the source of loan repayment.

The purpose of loans becomes even more important when bank credit is difficult
to obtain. For example, during the financial crisis in 1997–1998, commercial banks
in Malaysia decelerated the growth rate of credit because of the pressure from
Bank Negara Malaysia which required them, and other financial institutions, to
give lending priority to manufacturing and agricultural sectors. Non-productive
lending such as lending to the real estate sector was halted, and loans for the
purchase of real estate shares were not to be granted. In such situation, the
purpose of loans became crucial as banks wanted to ensure that the loans would
not have high risk and the potential of becoming non-performing loans (NPL)
like non-productive loans and speculative loans.
How do we know the purpose of a loan? The purpose of a loan is usually stated
in the loan application form. The real purpose can usually be discovered by
interviewing the applicant and through credit analysis on the application. The
credit officer must have the ability to uncover from the applicant the real purpose
of the loan by asking specific and relevant questions.
10.3.2 Principle of Payment

Loan repayment is likened to the blood flow in our bodies. Just imagine if the
blood flow stops because of any reason that is beyond our control. To ensure
uninterrupted repayments from customers, a bank must set systematic and
realistic repayment schedules for its customers. When repayment becomes a
problem, the credit officer may have to review the borrower and revise the
repayment schedule in order to protect the interest of the bank.
A sound loan should be collectible via the disposal of the borrowerÊs asset or
from the income stream or business profits of the borrower and not from forced
sale of any of the collateral. Disposal of borrowerÊs asset means the sale of asset
purchased with the bank loan concerned. For example, if a loan was granted to
finance the purchase of stocks, the borrower should use the proceeds from the
eventual sales of these stocks as loan repayments.
If repayment is by installments, the installment amount and the date of final

payment must be determined at the time the loan is approved. Repayment
schedule must be set so that the repayment process can be monitored and
repayment problems, if any, can be detected and resolved without undue delay.

10.3.3 Principle of Protection

A bank must protect its own interest when approving loans since the credit-
worthiness of any borrower may change in future. Due to uncertainties, a
borrower who is credit-worthy when the loan is approved may become a credit-
unworthy customer subsequently. Negative factors that emerge in the future
may affect a borrowerÊs loan repayment capacity. A bank can protect its interest
by requiring its customers to provide collateral for their loans. Collateral only
acts as the second line of defence for purpose of loan protection. The first line of
defence is cash flow from the borrowerÊs business or project.
BanksÊ interest can also be protected by positive as well as negative terms and
conditions in the loan agreements. Positive terms and conditions include periodic
submission by the borrower of the relevant audited financial statements,
maintenance of financial ratios and notification to bank by the borrower of any
internal or external development that may affect the borrowerÊs position.
Negative terms and conditions include restriction on dividend payment,
prohibition in selling or leasing any asset of the borrower without the bankÊs
permission, and restriction on the borrowerÊs operation capacity. These terms
and conditions are to ensure that the borrowerÊs liquidity will remain intact for
loan repayment purpose.
Banks must observe all three principles in lending when making credit decisions.
Should any of the three principles be neglected or violated, the resultant credit
decision may be incorrect. For example, a bank may neglect the principle of
payment on the basis that the collateral offered by the borrower is sufficiently
attractive and that the purpose of the loan is consistent with the bankÊs lending
policy. The credit decision made based on two principles only is likely to lead to
non-performing loan problem because the repayment of the loan should not be
dependent on disposal of collateral.
ACTIVITY 10.3
Encik Ali, a petty trader, comes to your bank to apply for a loan to
expand his business. How will you use the principle of purpose,
principle of payment and principle of protection to evaluate Encik AliÊs
loan application? Outline a simple mind map to show the relationships
among the three principles.

EXERCISE 10.1
1." What is the relationship between the principle of purpose and the
principle of payment in ensuring the soundness of a bankÊs credit
decisions?
2." Why is it important for a credit officer to consider all the three
main principles in lending simultaneously?
10.4 DOCUMENTED LENDING POLICY

A bankÊs lending policy usually symbolises the bankÊs lending philosophy and
concept. It encompasses the standards, guidelines and restrictions that guide the
process of making credit decisions. Lending policy should be documented as it is
an official guide for all credit officers. Lending policy of a bank is even more
important to the new credit officers still adapting to a new environment.
Documented lending policies are required for the following purposes:

•" Setting directions including that pertaining to bank fund utilisation;
•" Controlling the composition and size of loan portfolio; and
•" Determining which or what loans should be granted.
Documented lending policy can also be used to evaluate the performance of

credit officers or loan officers. For example, the competence of a loan officer can
be measured by the officer Ês compliance with the lending policies.
A bank without any documented lending policy is faced with two dangers:
•" Decision making pertaining to loans tend to be done by a certain cluster only.
This will hold up the decision making process and hinder the development of
loan officers; and
•" It will result in non-standardised loan philosophies and practices, cause
confusion and inconsistent and erratic credit decisions forthwith.
According to Behrens (1985), the following elements must be incorporated into

any comprehensive lending policy:
•" The objectives of lending;
•" Authority lines;
•" Credit criteria;
•" Procedures and controls;

•" Staff loans;
•" Criteria for handling non-performing loans (NPL);
•" Criteria for auctions;
•" Compliance procedures; and
•" Procedures on periodic review of credit policy.
(a)" The Objectives of Lending

Most lending institutions have the following lending objectives:
(i)" Growth: Of assets, loans and capital.
(ii)" Profitability: Expressed in Ringgit, or in percentage as the return on
equity or return on assets.
(iii)" Quality of portfolio: Keep non-performing loans (NPLs) and losses at
a certain ratio; limit loan concentration.
(iv)" Customer service: Guidelines on effective and efficient customer
service.
(v)" Social service: Guidelines on corporate social responsibilities and
involvement in the society.
(vi)" Compliance of rules: All lending institutions are required by the
regulatory body to incorporate compliance policy into their general
policy statements.
(b)" Authority Lines

(i)" Endorse the responsibilities of the board of directors.
(ii)" Establish the authorities and functions of the loan committee or
discount committee,
(iii)" Establish the tasks and responsibilities of the chief executive officer
and loan supervision officer.
(iv)" Determine the tasks and responsibilities of loan officers.
(v)" Determine the lending authorities of each of the loan officers by
taking into account their respective ranks, experience in lending, past
performance and assignments.

(c)" Credit Criteria

(i)" Determine the types of loans that are permitted and the types not
permitted. Non permitted loans may include loans for illegal or
speculative activities, loans granted on subordinate basis and backed
by subordinate collateral, loans secured by restricted shares and loans
related to brokered deposits.
(ii)" Define credit factors that have to be considered when making credit
decisions.
(iii)" Determine the criteria for unsecured loans.
(iv)" List all acceptable types of collateral and the margins of finance based
on each type of collateral.
(v)" Ascertain the types of deposit relationship required from borrowers.
(vi)" Construct guidelines on acceptable maturity tenures based on loan
types and objectives.
(vii)" Determine the extent of credit investigation for each type of loan
application.
(viii)"Set the criteria for loan renewal or extension.
(ix)" Define the bankÊs stance on lending deemed outside the bankÊs
ordinary course of business.
(d)" Procedures and Controls

(i)" Detail all the information and documentation required to be kept in
credit files, and the frequency of updating this information.
(ii)" Define the standards for loan supervision including the frequency of
visit to borrowerÊs business premises, the frequency of credit file
review and the monitoring of repayments.
(iii)" Set the procedures for the reporting of potential problems to the
management.
(e)" Staff Loans

(i)" No special treatment for internal people.
(ii)" Ascertain the procedures for approving this type of loans.
(iii)" Determine the credit limits and other terms and conditions.

(f)" Criteria for Handling Non-performing Loans (NPL)

(i)" Determine who should be responsible for the handling of non-
performing loans (NPL).
(ii)" Set the guidelines for legal action proceedings.
(iii)" Define the procedures for periodic status reporting to the
management.
(g) Criteria for Auctions

(i)" Identify situations that may warrant foreclosure or auction action.
(ii)" Establish accounting procedures for auctions.
(iii)" Define guidelines and procedures for follow-up and collection of
auction proceeds.
(h) Procedures for Rules Compliance

(i)" Intention statements on compliance of laws and rules must be made
known to staff and customers.
(ii)" Establish guidelines for staff training.
(i) Procedures on Periodic Review of Credit Policy

(i) Annual review may be sufficient.
ACTIVITY 10.4
ABC Bank is reviewing its documented lending policy. As an

experienced credit officer, you are assigned to review the policy and
make the necessary recommendations to the bank. What are the main
components that must be incorporated in the documented lending
policy of ABC Bank?
You may use the elements of documented lending policies suggested

by Behrens (1985) as a guide. For additional input, you may make
enquiries with the credit officers of the local commercial banks by
visiting the web sites of these banks through the hyperlinks at BNM
web site at http:// www.bnm.gov.my.

10.5 FACTORS INFLUENCING LENDING POLICY

In order to stay in the race against competition, banks must take into account the
following factors when formulating a complete set of documented lending
policy:
•" Capital position;
•" Risk and profitability of each type of loan;
•" Stability of deposits;
•" Economic situation;
•" Bank staffÊs capability and experience;
•" Monetary and fiscal policies of the country; and
•" Local credit requirement.
(a)" Capital Position
SELF-CHECK 10.1
How do you think capital influences the lending policy of a bank?

"
We have learned about the important role of bank capital; bank capital
absorbs losses incurred by banks to ensure bank security and to safeguard
the welfare of depositors. We have also discussed how capital adequacy
ratio (CAR) influences the risk level of a bank.
A bank with high capital ratios, especially the CAR, can afford to bear
higher risk by providing loans with longer maturity tenures and also by
providing loans to non-conventional sectors. We must stress here that
capital is a criterion for opening any new branches. In the branch banking
system in Malaysia, the more the branches, the more loans can be granted.
Moreover, the capital level of a bank is a determinant of the total amount
and types of loans the bank can offer.
(b)" Risk and Profitability of Each Type of Loan

Each type of loan has its unique profile of risk and profitability. In general,
the higher the risk, the higher the expected return. Therefore, the loan
portfolio of a bank is vastly dependent upon the bankÊs mission statement.

If a bank opts for a conservative approach in its strategic management, then

its loan portfolio will have a conservative risk and profitability profile.
(c)" Stability of Deposits

Deposits are the main source of finance for customer loans and advances.
Therefore, deposit stability has significant impact on lending policy. A
bankÊs lending activities will be in jeopardy if it has unstable deposit base.
We must remember one important point, i.e. deposits are usually short-
term while loans are long-term. For that reason, an unsteady supply of
deposits can indeed disrupt lending activities and in turn impair bank
profitability. Deposit stability becomes even more important when it is
difficult to forecast or estimate the demand for loans.
(d)" Economic Situation

Loan portfolio is very sensitive to the local economic situation, i.e. the
economic situation of the area where the bank is situated. Usually, the
countryÊs economic situation can be used as a guide to forecast local
economic situation. Lending policy of a bank is usually tighter during
economic recession and more liberal during economic expansion.
(e)" Bank StaffÊs Capability and Experience

A lot of people have accepted the fact that the most valuable asset of any
organisation is the staff. We can find the acknowledgment of this fact by the
board of directors and Chief Executive Officers (CEOs) of several banks in
their annual reports.
StaffÊs capability and experience determine a bankÊs competitive edge. For

example, if a bank wants to be the leader in high technology loans, the banks
must have staff members who have the experience and skills related to the
high technology field; otherwise the bank will end up with vast number of
non-performing loans (NPL). That means the focus as well as diversification
of loan portfolio are limited by the capability and experience of bank staff.
(f)" Monetary and Fiscal Policies of the Country

The government implements monetary policy or financial policy and fiscal
policy that promote an environment for growth. If the government
practises expansionary monetary policy and fiscal policy, banks may put in
place more liberal lending policy.
For example, a reduction in statutory reserve will enable banks to have

more funds for loan purposes. Otherwise, if the government practises

contractionary monetary policy, banks will have to slow down their

respective credit growth and be more selective in their lending activities.
(g)" Local Credit Requirement

Bank management must consider the credit needs of their respective local
communities when defining their loan portfolios. This is because the
existence of a bank depends on whether the bank is able to fulfill the needs
of its local society.
A bank that does not provide agricultural loans or provides minimal

agricultural loans must not operate in any agricultural area. We often heard
complaints about banks not providing loans for one or the other sector.
These complaints may evolve into strong grounds for challenging the roles
and existence of the banks in the respective local communities.
EXERCISE 10.2
1." What role does lending policy play towards effective lending
activities?
2." Discuss three external factors and two internal factors that can
influence the lending policy of a commercial bank. Rank the
factors based on their degrees of significance and support your
answer with reasons.
•" Credit or loan decisions depend on the three main principles in lending, i.e.
the principle of purpose, principle of payment and principle of protection.
•" All three principles must be considered simultaneously.
•" Clear, accurate and documented lending policy is also crucial for accurate
credit decisions.
•" In order to develop effective lending policy, banks must consider all relevant
factors comprehensively.

Adverse selection Moral hazard
"

Topic X Credit
11 Analysis
LEARNING OUTCOMES
1." Explain the credit analysis process in detail;
2." Apply the 5C credit analysis model to make accurate and sound credit
decisions;
3." Evaluate the sources of credit information; and
4. Apply ratio analysis to evaluate companies financial performance.
X" INTRODUCTION
Credit analysis is the most important activity in the lending process of any
commercial bank. This activity involves a network of tasks which are based on a
theoretical model to ascertain the credit standing of loan applicants. This model
is commonly known as 5C credit analysis model.
At the end of a credit analysis process, a credit decision proposal will be

presented to the bank management for final decision. The extent or depth of a
credit analysis depends on several important factors that can influence the
conditions of any loan application.
The validity or credibility of a credit decision is very much dependent on the

credibility of the credit analysis which in turn is subject to the credibility of the
credit information obtained. In general, credit analysis is greatly influenced by
ratio analysis because of the availability of financial information. Besides, the
results of ratio analysis are more objective and comprehensible.

TOPIC 11 CREDIT ANALYSIS W 205
11.1 THE PURPOSES OF CREDIT ANALYSIS
SELF-CHECK 11.1
In Topic 10, we already discussed the two problems related to

asymmetric information, i.e. adverse selection and moral hazard. What
is the connection between these problems and credit analysis?
Credit analysis is the most important step in the lending process. It determines
the credit standing of a potential borrower, be it an individual or a corporate
borrower. Banks provide loans based on the credit information of the borrowers
as well as their businesses. However the issue of asymmetric information often
arise because borrowers certainly have more information than banks on their
future performance.
As discussed in Topic 10, adverse selection exists before a loan is granted. It

refers to incomplete information given to banks before the loan is approved,
which affects banksÊ judgement regarding the quality of prospective borrowers.
Moral hazard emerges after a loan is granted. It is related to the change in
borrowersÊ attitudes and behaviours after they have procured their loans, which
banks may not be aware of due to incomplete information they possess.
In view of the above, credit analysis is practised to determine the repayment

capacity of prospective borrowers and their attitude towards loan repayment.
There is a difference between a borrower who is able to repay but does not want to,
and a borrower who is unable to repay but wishes to. All banks desire borrowers
with not only repayment capacity but also posses the sense of responsibility
towards loan repayment. In short, credit analysis is a process to investigate all
factors influencing the probability of loan repayment by a borrower.
11.2 CREDIT ANALYSIS PROCESS

As shown in Figure 11.1, credit analysis process is based on the three principles
in lending, i.e. the principle of purpose, principle of payment and principle of
protection. All three principles have been discussed in details in Topic 10.

206 X TOPIC 11 CREDIT ANALYSIS
Figure 11.1: Credit analysis process
The 5C model is used in credit analysis to determine credit risk, i.e. the risk
related to non-repayment of loan. To carry out effective 5C analysis, the credit
officer must have access to accurate and reliable credit information. Interviews,
bank records, credit bureau and visits to the business premises concerned are
among the sources of information that can be used.
Credit information obtained will be processed by using various measurement

tools such as ratio analysis, cash budgets, pro forma financial statements and
evaluation of financial statement items. Credit analysis process ends with a
proposed loan decision.
11.3 5C CREDIT ANALYSIS MODEL

The credit analysis model is based on 5 elements known as the 5 Cs of credit, i.e.:
• Character;
• Capacity;
• Collateral;
• Conditions; and
• Capital.

(a)" Character
ACTIVITY 11.1
Simon is 25 years old and single. Richard, 42, has been a textile
He sells fruits at the night market entrepreneur for 17 years. He has 3
and has 2 employees. company branches and 20
employees.
As an experienced credit officer of ABC Bank, you are assigned to

evaluate the character of each loan applicant. What is your evaluation
on Simon and Richard? How do you make the evaluation?
Do you think you can evaluate accurately, based on the above scenarios
and available information? What if you were given additional information
such as the applicantsÊ financial records?
Evaluation on a loan applicantÊs character is indeed a very subjective

process as the mere purpose is to assess the applicantÊs willingness to make
loan repayment. Willingness to repay loan refers to the borrower Ês sense of
responsibility towards fulfilling the loan agreement. How do we measure
such sense of responsibility? This is where the character evaluation
becomes complicated because attitudes such as honesty, integrity, sincerity,
sense of commitment and motivation, which are all deemed applicable to
measuring a borrowerÊs willingness to pay the loan, are abstract by nature;
they are defined and weighed differently from one individual to another.
Even though it is difficult to measure the willingness to repay a loan, banks

have other means or indications to base their decisions on. Amongst them

are historical credit records of the borrower and character reference by a

third- party.
In the case of a corporate borrower, character evaluation is done with

reference to the quality of the top management, ownership and corporate
image of the company. The quality of top management can be determined
by studying its members from the aspects of qualification, work experience
and self- achievement.
Ownership of the company is also an important factor. For example, the

credit risk may be lower if the management of the company is run by the
owner(s). Besides, local owners are deemed to have more willingness and
desire to make loan repayment than foreign owners. Undeniably, a
company with a good corporate image, good standing and good reputation
in the society is deemed to have good character.
The character of a company can also be evaluated based on measures and

actions taken by its management. For example, if the management has
made debt repayment even during economic recession, it shows that the
management is committed to fulfilling its responsibility as a borrower.
Besides, a companyÊs conservative approach in financial management
symbolises the companyÊs sense of responsibility towards third parties.
Another aspect of character evaluation is related to the prospective

borrowersÊ sense of commitment and motivation towards their respective
businesses. Does the prospective borrower really know the business? Does
the prospective borrower have any alternative plan, in case the original
plan fails? These details must be investigated since loan repayment is very
much dependent on the business income of the prospective borrower
concerned.
(b)" Capacity
When we evaluate a prospective borrowerÊs capacity, we evaluate his
capacity from the aspects of law as well as finance. The credit officer must
determine if a prospective borrower has the legal capacity to borrow.
Failure to do so will expose the bank to risk of no recourse. That means, if
the borrower has no legal capacity, the eventual contract between the bank
and borrower will be either void able or void for incapacity. In other words,
the bank will not have the option to take any legal action against the
borrower in the event of non-repayment of loan.
The determinants of legal capacity to borrow vary across the different

categories of borrowers. For example, in the case of individuals, minors

(usually below the age of 18) have no legal capacity to borrow. Therefore,
credit officers have to be mindful of the age of the respective loan
applicants when performing credit analysis.
For partnership concerns, the partners are usually entitled to mortgage the
assets of their respective partnership concerns. Nevertheless, to accurately
ascertain each partnerÊs legal capacity to borrow, banks must study the
relevant partnership agreements. In many cases, the partners are indeed not
conferred similar powers by the partnership agreements. Loans to any
partnership are usually subject to the terms stating that all partners
involved are jointly and severally responsible for the loans granted.
Banks may use more stringent rules and methods when assessing foreign
companies (i.e. companies that have less than 51% local ownership). This is
because foreign companies tend to have higher risk than local companies.
Evaluation of the financial capacity of a prospective borrower involves

determining the personÊs capacity to repay the loan. The main method used
for this purpose involves cash flow projection and ratio analysis based on
the prospective borrowerÊs financial statements. Banks also require the
income tax statements of prospective borrowers for purpose of confirming
their income sources. Other sources of information used include income
and expenditure statements, asset and liability statements and reports from
credit agencies.
(c)" Collateral
Collateral means any asset pledged by a borrower to secure a loan. It is the credit
officerÊs responsibility to assess and ascertain if the proposed collateral is
acceptable or otherwise. Among the commonly used collateral are:
(i)" Charges on real estate, shares and insurance policies;
(ii)" Third party guarantees;
(iii)" Fixed and floating charges; and
(iv)" Assignments of rights to debts and stocks.
The to protect the interest of banks, credit officers must assess the details of
collateral involved. Usually, credit officers need to know the age, condition
and specialisation level of the borrows assets. The loan to collateral ratio of
each loan application must also be determined. It must be stressed that
even though collateral can reduce the credit risk of banks, banks are more
concerned about or interested in loan repayment sourced from the income
of borrowers.

(d)" Conditions
When we evaluate a prospective borrowerÊs capacity to borrow, we actually
need to evaluate the economic conditions that may affect the borrower Ês
capacity to repay the loan. The analysis on economic conditions is to
forecast the exposure of the borrower Ês business to economic changes and
interest rate changes.
The best example for now, is the economic recession that hit the country in
mid 1997 as a result of the financial crisis in the region. Such crisis had
caused many companies to close down. In view of that, banks must study
the effect various factors such as competition, technology, product demand,
location, industry related matters and distribution methods have on the
prospective borrowersÊ capacity to repay their loans.
(e)" Capital
We need to know the financial worth of a prospective borrower through his
net worth because net worth symbolises the success and commitment of the
person. The higher the capital contributed by a prospective borrower, the
more committed the person is to the company, and also the more willing he
is to repay the loan.
High net worth represents the success level of a borrower because net
worth encompasses accumulated retained earnings. The higher the net
worth of a borrowerÊs company, the higher is the loan repayment capacity
of the borrower. Besides, the credit officer involved must assess the
working capital requirement of the borrowerÊs company to ascertain if there
is any excess or shortage of working capital.
Usually credit will not be granted to a business corporation unless the

capital contribution has already been made by the owner(s).

SELF-CHECK 11.2
What will happen to a loan if one of the 5C elements is not evaluated by
the bank? Complete the following table:
Element Not Evaluated Effect on Credit Analysis
Character
Capacity
Collateral
Conditions
Capital
11.4 SCOPE OF CREDIT ANALYSIS

To what extent does a credit officer or loan officer have to conduct credit
investigation? The scope of credit evaluation depends on the size and maturity
period of the loan, the track record of the company, the collateral involved and
the past relationship between the applicant and the bank. This implies that the
bigger the size and the longer the maturity period of the loan, the wider the
investigation scope is. Nevertheless, it does not mean that no credit analysis is
required if the value of the collateral exceeds the loan amount. Credit
investigation must be carried out regardless of the value of the collateral.
11.5 SOURCES OF CREDIT INFORMATION

The commonly used main sources of credit information are loan applicant
interviews, bank records, examinations of the business premises concerned,
financial statements, credit bureau and bank references.
(a)" Loan Applicant Interviews

The objective of the interview between the credit officer and the loan
applicant is to collect information on the character and intention of the
applicant. During the interview, the credit officer also has the opportunity
to evaluate the applicant in terms of commitment and motivation.
Investigative questions must be asked in order to acquire information not
found in the loan application form. Through the interview, the credit officer

should be able to judge whether the applicant is genuinely skilful and

knowledgeable in the business for which the loan is applied for.
The quality of information obtained from an interview is subjected to the

credit officerÊs skills in relationship building, interview and listening.
Without these skills, the credit officer will most probably fail to determine
the real objective of the loan applicant since the loan applicant may give
only information deemed favourable for his application.
(b)" Bank Records

Banks records provide credit information such as loan repayment records,
current account and savings account balances and the conduct of overdraft
account. As credit information contained in bank records is factual, it is
deemed highly reliable.
(c)" Examination of ApplicantÊs Business Premises

Various types of important information can be obtained during the visit to
the business premises of the applicant; the credit officer has the opportunity
to verify the existence of the company, the structure of the company, the
skilfulness of the operation staff, and the details of the companyÊs operating
assets and fixed assets. Such visit is crucial as it helps to prevent the bank
from fraud.
There have been many cases of bank fraud involving borrowers whom do
not have business premises. In reality the visit should be made without any
prior notification to the company or loan applicant. In other words, the
credit officer should make surprise visits in order to see the real situation of
the company.
(d)" Financial Statements

Almost all loan applicants are required to submit their financial statements
for evaluation of their financial standing. Financial statements required are
the income statements, balance sheets and cash flow statements. It is
customary for banks to ask for the financial statements for the past three or
five years so that they can perform trend analysis.
The financial information contained in the financial statements provides

credit officers with the opportunity to make quantitative judgement on the
applicantsÊ capacity to repay their loans. Credit information stated in the
financial statements prepared in compliance with the rules and policies of
accounting bodies are reliable since they are based on the true and fair view
concept. Therefore, credit information obtained from the audited financial

statements is certainly more reliable than that obtained from unaudited

financial statements.
Use of financial statement information is subjected to the assumption that

whatever has happened in the past will continue its occurrence in future.
A credit officer must be able to make his own assumptions in the analysis
because of potential changes in future. For that reason credit officers should
not rely on the given financial statements completely; they should make
necessary adjustments based on assumptions they deem relevant.
For firms or individuals who have just started their businesses and
therefore do not have any financial statement, banks will have to depend on
the forecast of future cash flow in their evaluation. However, the credit
officers must bear in mind that the cash flow data is merely based on
forecast.
(e)" Credit Bureau

In October 2001, a borrower database known as Central Credit Record
Information System (CCRIS) was set up by the Credit Bureau of Bank
Negara Malaysia (BNM). CCRIS enables financial institutions to acquire
information on their prospective borrowers for the purpose of loan
application evaluation.
While CCRIS facilitates the loan evaluation process of financial institutions,

there have been many complaints regarding customer confidentiality which
is protected by BAFIA, 1989. In view of that, BNM has made several law
related changes to protect the rights and interests of bank customers.
Apart from the Credit Bureau of BNM, there is Rating Agency Malaysia
(RAM) that conducts credit rating for large companies.
ACTIVITY 11.2
Visit the web sites of the Credit Bureau of BNM at http://

creditbureau:bnm.gov.my and RAM at http://www.ram.com.my to
obtain additional information on how credit officers use these agencies
to help them evaluate loan applicants.

(f) Inter-Bank References

Confirmation from other banks regarding a loan applicantÊs credit standing
is a common banking practice. However, this practice is less helpful for
credit evaluation because banks provide only general information to one
another. Besides, banks routinely attach to their replies a disclaimer clause
stating that they are not responsible for the information they provided.
Why do banks not share any specific information in their possession? The
reason being, banks are subjected to BAFIA, 1989 which has provisions for
information secrecy.
EXERCISE 11.1
1." Why do bankers have to perform credit analysis?
2." How does a bank officer or credit officer evaluate the character
element for the purpose of credit analysis?
3." How does a credit officer evaluate the conditions element for the
purpose of evaluating the credit standing of a loan applicant?
4." Why is the capacity element important in credit analysis?
11.6 EVALUATION OF FINANCIAL

STATEMENTS
The objective of financial statement analysis is to determine the accuracy and
validity of the information contained in the financial statement in tandem with
the effort to ascertain the credit risk of the loan applicant. The credit officer must
have at least some knowledge of the applicantÊs business in order to evaluate the
applicantÊs financial statements effectively. Financial statement evaluation
involves the following:
•" Asset evaluation;
•" Liability and net worth evaluation;
•" Income statement evaluation; and
•" Statement of Changes in Financial Position evaluation.

(a)" Asset Evaluation

One of the biggest asset components in a companyÊs balance sheet is
accounts receivable or debtors. The sizes, the ages and the sources of these
accounts must be examined because huge investment in these accounts is
likely to result in high amount of bad debts.
Accounts receivable aging schedule can be used to determine the amount of

doubtful debts and bad debts. The credit officer involved must ascertain
whether the accounts receivable of the loan applicant consist of genuine
trade debtors only, or they include internal debtors i.e. the staff and
management of the company. Besides, it must also be determined if the
accounts receivable have been factored or assigned to someone else.
Inventories or stocks should also be studied from the aspects of age,

liquidity and product stability. The types and maturity periods of fixed
assets should be examined to determine which fixed asset can be used as
collateral for the loan concerned. Banks take account of tangible assets only.
Therefore intangible assets are not evaluated.
Asset evaluation is indeed an analysis to determine the efficiency and

effectiveness of asset management of a company. Efficiency in asset
management can ensure continuity of the companyÊs operation.
(b)" Liability and Net Worth Evaluation

The credit officer must ascertain the status of each creditor in the balance
sheet of the applicant in order to safeguard the bankÊs interest in the event
that the loan is approved. Status of creditor can be categorised as secured
creditors, preferential creditors and general creditors.
The amount and maturity periods of long-term and short-term debts must
be taken into account in determining the financial risk of the applicant
company. OwnersÊ equity capital is very important to banks, to the extent
that it is one of the 5C criteria in the evaluation of credit applications. As
mentioned before, ownersÊ capital contribution reflects the ownersÊ
commitment and success. Besides, investigation should be expanded to
include contingent liabilities and other liabilities as they can affect the
companyÊs loan repayment capacity.
(c)" Income Statement Evaluation

Income statement information shows the stability and profitability levels of
the company. Analysis of this information will also reveal the effectiveness
of the companyÊs credit policy, operation policy and debt utilisation policy.

For example, by examining the sales information, we will be able to find out
if credit sales constitute a large portion of sales. If they do, we should
review the accounts receivable aging to ensure that the company is not
exposed to huge amount of doubtful debts and bad debts.
Careful examination of expenditure information will reveal to what extent

the company management is able to control the operation, administration,
marketing and financial expenses. Additional analysis of income statement
can be performed by relating each expenditure detail with sales detail. This
analysis will show the sensitivity of each expenditure detail to change in
sales.
(d)" Statement of Changes in Financial Position Evaluation

Statement of changes in financial positions indeed reflects the change in the
liquidity of the company for a certain period. This statement is sometimes
called cash flow statement or fund flow statement.
This statement is important in order to evaluate the effectiveness of the

companyÊs operation policy and financial policy in handling company
liquidity. The credit officer should examine the sources and uses of funds in
this statement in order to determine if there is a balance between the
financing policy and investment policy of the company.
11.7 RATIO ANALYSIS

The purpose of ratio analysis is to study the financial performance and position
of a company. Credit officers of banks use ratio analysis to determine if the
financial performance and position of a prospective borrower show sufficient
loan repayment capacity. For this purpose, credit officers use trend analysis to
find out if the financial performance and position have improved or deteriorated
or remained unchanged over a period of time. Trend analysis requires financial
statements for a few consecutive years such as five years.
Usually, there are four groups of financial ratios used in ratio analysis. These
ratios are:
• Liquidity ratios;
• Asset management ratios;
• Financial leverage ratios; and
• Profitability ratios.

Ratio analysis is more meaningful if the ratios of the company concerned are
compared with the industry average.
11.7.1 Liquidity Ratios

There are two ratios which are commonly used to measure the liquidity of a
company, i.e. current ratio and acid test ratio.
(a)" Current Ratio

Current ratio is used to measure a companyÊs ability to meet its short-term
obligations. It can be derived from the following formula:
Current asset
Current ratio =
Current liabilities
A current ratio of 2 is considered sufficient because that means every RM1

of current liabilities are protected by RM2 of current assets. Current ratio
that is significantly higher than industry average shows that there is too
much investment in current assets. This is indeed a loss to the company as
its capital is „buried‰ in current assets instead of generating more income
on its own.
(b)" Acid Test Ratio

Acid test ratio is used to measure the ability of a company to cover its short-
term obligations from its „quick‰ assets only (i.e. it ignores inventories or
stocks). This ratio does not take inventories into account because they are
not easily convertible to cash. Acid test ratio can be derived from the
following formula:
(Current asset – Inventories)

Acid test ratio =
Current liabilities
An acid test ratio or a quick ratio of 1 is considered ideal because that means
every RM1 of liabilities is protected by RM1 of „quick‰ assets.

11.7.2 Asset Management Ratios

There are four main financial ratios that can be used to measure the effectiveness
of the asset management policy of a company, i.e. average collection period ratio,
inventory turnover ratio, fixed asset turnover ratio and total asset turnover ratio.
(a)" Average Collection Period Ratio

Average collection period ratio is used to examine the effectiveness of the
credit policy of a company by comparing the average collection period with
the companyÊs credit terms. If the average collection period exceeds the
credit terms given to customers, it means the accounts receivable are not
collected according to the collection schedule, and this implies a weak
credit policy.
Average collection period can be calculated as follows:
Accounts receivable
Average collection period ratio = × 365 days
Annual credit sales
While we desire a shorter average collection period, a very short collection

period is not necessarily favourable, rather it may indicate a very restrictive
credit and collection policy which may curtail sales. On the other hand, an
excessively longer than average collection period will attract doubtful debts
and bad debts.
(b)" Inventory Turnover Ratio

Inventory turnover ratio is used to measure the effectiveness of the
inventory management policy of a company by comparing sales with
average inventory. It can be derived from the following formula:
Sales
Inventory turnover ratio =
Average inventory
High ratio means inventories are quickly swiftly turned into sales, and
implies better inventory management. However, credit analysts must watch
out for any ratio that is too high or too low.

If a companyÊs inventory turnover ratio is significantly higher than the

industry average, it means the company keeps too little inventory. Low
inventory-holding cost indeed implies high inventory-ordering cost and
loss of customers for the companyÊs inability to fulfill their requirements.
Otherwise, if a company has very low inventory turnover ratio, it means
the company is holding a lot of inventories, hence high inventory-holding
cost. The cost of holding a lot of inventories includes the cost of damaged or
obsolete stock and the storage cost.
(c)" Fixed Asset Turnover Ratio

Fixed asset turnover ratio measures the ability of a companyÊs management
in using fixed assets to generate sales. The more effective the fixed asset
management, the higher the ratio is. This ratio can be calculated as follows:
Sales
Fixed asset turnover ratio =
Fixed assets
Low ratio symbolises that the management failed to utilise fixed assets
productively to generate sales.
(d)" Total Asset Turnover Ratio

This ratio can be used to measure the ability of a companyÊs management in
using all of the companyÊs assets to generate sales. The more effective the
asset management, the higher the ratio is. This ratio can be derived from the
following formula:
Revenue
Total assets turnover ratio =
Total assets
By comparing the fixed asset turnover ratio and the total asset turnover
ratio, we will be able to determine whether there is weakness in the fixed
asset management or the current asset management.

11.7.3 Financial Leverage Ratios

The financial leverage ratios are often used by banks to evaluate the credit
capacity of their customers. Financial leverage rates the degree to which a
customerÊs business activities are financed by debts. Debt ratio is regularly used
to measure the financial leverage of companies.
If a company has a financial leverage ratio of 60%, it means 60% of the companyÊs
assets are financed by debts and the remaining 40% by equity. The higher the
debt ratio, the higher the financial leverage, and the higher the financial risk of
the company since there are more claims on the assets by external parties than
the shareholders. For that reason, banks are more inclined to provide loans to
companies with low financial leverage.
Among the financial leverage ratios, debt ratio is used to measure the extent to
which a companyÊs assets are financed by debts, and fixed-charge coverage ratio
is used to measure the companyÊs capacity to repay debts.
(a)" Debt Ratio

Debt ratio shows the level of debts being used by a company. The higher
the level of debts, the higher the ratio and the higher the financial risk of the
company, and vice versa.
Usually, the maximum debt ratio allowed is 50%. Debt ratio can be derived
from the following formula:
Total debts
Debit ratio =
Total assets
Banks prefer customers with low debt ratio since the lower the debt ratio,
the lower the debt repayment risk.
(b)" Fixed-charge Coverage Ratio

The fixed-charge coverage ratio is used to measure a companyÊs capacity to
pay fixed charges such as loan interest and lease payments. The higher the
fixed-charge coverage ratio, the higher the companyÊs capacity is to pay
fixed charges. The ratio is calculated as follows:

Net income
Fixed-change coverage ratio =
Fixed changes
The weakness of this ratio is that, it only reflects the capacity to pay loan
interest, i.e. it takes no account of loan principals. This means that the ratio
does not show a companyÊs capacity to repay debts in totality.
11.7.4 Profitability Ratios

This group of ratios measure the ability of a company to generate profit for every
RM1 of sales revenue and investment in assets. The commonly used ratios are
return on assets (ROA) ratio and return on equity (ROE) ratio.
(a)" Return on Assets (ROA) Ratio

The return on assets (ROA) ratio measures the profit of a company
attributable to its investment in assets. The higher the ROA ratio, the higher
the companyÊs ability is to generate return by using its assets, and vice
versa. This ratio can be derived from the following formula:
After tax earnings

ROA =
Total assets
(b)" Return on Equity (ROE) Ratio

This ratio shows the profit of a company attributable to the amount
invested by the shareholders, i.e. it measures the returns generated for
shareholders. The higher the returns is for shareholders, the higher the
ratio, and vice versa. This ratio can be calculated as follows:
After tax earnings

ROE =
Shareholder's equity

If a companyÊs ROE is higher than its ROA, it means the company is

enjoying the positive effect of financial leverage. On the contrary, if the
ROE is lower than the ROA, the company appears to be experiencing the
negative effect of financial leverage. However, if both ROA and ROE are
equal, we may conclude that the company does not use any debt to finance
its assets, or that the company does not experience any effect of financial
leverage.
(c)" Net Profit Margin

Net profit margin measures the profit of a company generated by every
RM1 of sales. The more profit generated by every RM1 of sales, the higher
the ratio will be. This ratio can be calculated as follows:
After tax earnings

Net profit margin =
Sales
ACTIVITY 11.3
Ratio analysis involves four main groups of ratios, i.e. liquidity ratios,
asset management ratios, financial leverage ratios and profitability ratios.
How do these ratios help banks evaluate their loan applications? Outline
the relationship between credit analysis and ratio analysis.
11.8 APPLICATION OF THE 5C CREDIT

ANALYSIS MODEL
Example 11.1 illustrates how 5C credit analysis model is used to make credit
decisions.
Example 11.1
Puan Farizah, the finance manager of Syarikat Cemerlang Berhad has submitted
the companyÊs loan application to you in your capacity as the loan manager of
Bank Perdana Berhad. She has enclosed the companyÊs financial statements for
year 2001.

The main business activities of Syarikat Cemerlang Berhad is manufacturing

furniture for domestic as well as overseas customers. On average, the company
exports 25% of its furniture products to European and ASEAN countries. Besides,
that the company sells home decoration supplies, DIY equipment and various
types of lawn mowers which represents 10% of the companyÊs business activities.
The main shareholder of Syarikat Cemerlang is Encik Cemerlang, who is also the
managing director of the company. He holds 55% of the company shares. Other
shareholders are his wife (10%) and child (5%).
The company has been incorporated thirty (30) years ago by Encik CemerlangÊs
father. The company was handled by En. Cemerlang after his father passed away
ten years ago. Encik Cemerlang is a certified accountant and according to his staff
is hardworking person.
Syarikat Cemerlang has not borrowed from your bank before but holds a current
account and a fixed deposit account at your bank. You have been informed by
Puan Farizah that the company wishes to borrow from your bank because it is
dissatisfied with the treatment and facility provided by its other bank which is
indeed the closest rival of your bank. Puan Farizah has also advised that the
purpose of the loan applied for is to increase the working capital of the company.

Shown below are the financial statements of Syarikat Cemerlang Berhad:
Syarikat Cemerlang Berhad

Balance Sheet
as at 31 December 2008
RM
(Million)
Current Assets: 500

Cash 16,000
Inventories 45,500
Total Currents Assets 62,000
Fixed Assets:
Land 26,000
Buildings and equipment 100,000
Less: depreciation (38,000)
Total Assets 150,000
Current Liabilities:
Accounts payable 22,000
Bank loans 47,000
Total Current Liabilities 69,000
Long-term debts 22,950

Ordinary shares 31,500
Retained earnings 26,550

Syarikat Cemerlang Berhad

Income Statement
for the Year Ending 31 December 2008
RM Million RM Million
Sales 160,000
Cost of goods sold 96,000
Gross margin 64,000
Operating expenses:
Fixed cash expenditure 21,000
Variable cash expenditure 16,000
Depreciation 10,000
Total operating expenses 47,000
Earnings before interest and tax 17,000
Interest expense 6,100
Earnings before tax 10,900
Income tax 5,450
Net Income 5,450
You are required to make the credit decision on the loan application of Syarikat
Cemerlang Berhad based on 5C credit analysis model.
The Result of Credit Analysis:
(a)" Character
Since the loan applicant is a company, we will try to evaluate the character
of the company by making reference to the character of the owner, Encik
Cemerlang. As Encik Cemerlang is the majority shareholder as well as the
managing director of the company, we have to examine his experience and
proficiency to ensure that the company will continue to be in operation.
Since Encik Cemerlang is an accountant, he is deemed to have the

qualification to operate the company well. In terms of experience, Encik
Cemerlang has been in the business world for the past 10 years, i.e. since
the demise of his father. Probably he was already exposed to the family
company since he was even younger.
Encik CemerlangÊs commitment to the company can be measured by his

majority shareholding, i.e. 55%. Besides, the staff of Syarikat Cemerlang
have also confirmed how hard working Encik Cemerlang is. All of this

information provides definite assurance that Encik Cemerlang is committed

and feels responsible for his business.
The character of the company can also be analysed by studying other

peopleÊs opinion of the company. Does this company have integrity and
good image? Is the company a corporate citizen with the sense of
responsibility and empathy? Can the company play a sensible and suitable
role in the industry?
The character of the company can only be assessed based on its top
managementÊs capability in terms of qualification, experience and
efficiency. Thorough examination using various sources of information
such as annual reports of the company, industry reports, reports from
business magazines and the reputation of the individuals needs to be
carried out.
Syarikat Cemerlang is new to your bank in terms of loans. However it is not

a new customer in terms of deposits. There are deposit records of the
company that may help in the analysis. Nevertheless, we have to
investigate why Syarikat Cemerlang wants to switch from the rival bank
suddenly. This information can be obtained from the rival bank concerned
or the company itself.
(b)" Capacity
We have to investigate whether the finance manager of Syarikat Cemerlang
has the legal power and authority to make the loan application on behalf of
the company. This can be done by checking the memorandum and articles
of association of the company. To ascertain the companyÊs capacity to repay
loan, methods or documents that can be used are ratio analysis, cash flow
statement and pro forma statement.
In this case, we will use ratio analysis only because we do not have enough
information to use any other methods. We have to prepare the cash flow
statement, or alternatively, request Puan Farizah to prepare the statement
in order for us to determine the amount of loan required and also to study
the source of loan payment. The pro forma statement is useful for the
purpose of assessing the effect of the proposed loan on the companyÊs
financial position and performance in future. Pro forma statement is the
forecast of the companyÊs financial statements.
Ratio analysis is becomes effective if the financial statements for a few

consecutive financial periods, ideally 5 years, are available for trend
analysis. Therefore we need to request for the same from Puan Farizah. To

enhance the credibility of our analysis, we have to ensure that these

financial statements have been audited.
Based on the limited information provided by the company, the following

ratio analysis can be conducted:
Table 11.1: Financial Ratios of Syarikat Cemerlang Berhad for the Years 2008, 2007
and Industry Average
Type of Ratio 2008 2007 Average

Current ratio 0.90 1.84 1.80
Quick ratio 0.24 0.78 0.70
Average collection period 36.5 days 36.5 days 37 days
Inventory turnover 2.11 2.59 2.50
Debt ratio 0.61 0.50 0.58
Times interest earned 2.79 4.0 3.8
Gross profit margin 40% 40% 38%
Operating profit margin 10.6% 9.6% 10%
Asset turnover 1.07 1.11 1.14
Fixed asset turnover 1.82 2.02 1.40
ROA 3.6% 4.0% 4.0%
ROE 9.4% 8.0% 9.5%
With reference to Table 11.1, the summary on the financial performance and
financial position of Syarikat Cemerlang is as follows:
Ratio Analysis:
•" With an average collection period of 36.5 days, the management of
accounts receivable has been consistent and on par with the industry
average. The analysis will be more meaningful if the information on the
credit period is also available.
•" Based on the inventory turnover ratio, the companyÊs inventory
management appears to have deteriorated from the previous year.
Besides, the companyÊs performance is worse than the industry average.
•" The companyÊs fixed asset management is better than the industry
average but has deteriorated from the previous year.

•" Based on the total asset turnover ratio, it appears that the companyÊs
performance in total asset management is worse than the previous
yearÊs and the industry average (total asset turnover has deteriorated).
One of the main causes of this performance weakness is the
deterioration in inventory management.
•" The profitability performance of the company can be evaluated with the
return on assets (ROA) and return on equity (ROE) ratios. In
comparison with the previous year Ês result, the companyÊs ROA has
declined. Besides it is below industry average.
The companyÊs ROE has improved and is very close to the industry
average. Since its ROE is higher than ROA, it shows that Syarikat
Cemerlang has successfully increased the shareholdersÊ wealth through
financial leverage. The decline in ROA indicates that the companyÊs
profitability performance as opposed to operation performance is more
dependent on financial leverage.
•" In terms of financial position, the companyÊs liquidity is worse than the
position in the previous year. It is also below the industry average. This
is evident from the current ratio and quick ratio.
The quick ratio has deteriorated significantly due to the weakness in
inventory management which has resulted in a large quantity of
inventories being held by the company. In terms of debt capacity, the
companyÊs capacity to pay loan interest has reduced, as measured by
the times interest earned (TIE) ratio.
The deterioration is attributed to the increased utilisation of loans, as
shown by the current ratio, and the decline in income generating
capacity. The financial risk of Syarikat Cemerlang has increased, as
evidenced from the increase in debt ratio from 50% to 61%.
(c) Collateral
Assets that can be used as collateral consist of current assets such as
accounts receivable and inventories, and fixed assets. Encik Cemerlang and
other shareholders can also provide personal guarantee as collateral. We
have to determine the value of the collateral, and then calculate the loan to
collateral ratio by comparing the value of the collateral with the amount of
loan applied for. This is to ensure that the ratio is in line with the
benchmark set by the bank. Furthermore, we have to thoroughly assess the
important features of the collateral in order to safeguard the bankÊs interest.

(d) Conditions
We have to determine if the furniture business is seasonal business because
the volatility in cash flow may affect the companyÊs capacity to repay debts.
As furniture represents the main products of the company, we have to

focus on the factors that can affect the demand for these products. Besides,
we have to study the effect of regional as well as global economy since
some of the companyÊs products are exported to European and ASEAN
countries.
For example, export sales may be affected by any drastic change in the
foreign exchange rates. We should also investigate if the company takes any
measure to protect itself against those risks.
(e) Capital
It is difficult to perform capital analysis since we do not have any
comparative figures. Nevertheless, we should investigate if the capital of
the company has increased because that will provide an indication on the
financial performance of the company. Besides, we should review the
companyÊs working capital position from year to year. By making reference
to the deterioration in the current ratio and quick ratio, the capital position
is expected to have deteriorated too.
Credit Decision:
From the above analysis which is equipped with limited information but based
on 5C credit analysis model, it appears that we are unable to approve the loan
application. Reasons being, the companyÊs capacity to repay the loan looks very
doubtful; deteriorated liquidity, deteriorated profitability and growing financial
risk are the negative indicators of the companyÊs capacity to repay its debts.
ACTIVITY 11.4
Visit the web site of one of the financial institutions to find out how the
institution concerned conducts credit analysis. Compare the process
with what we have discussed. You may take notes of any information
that has not been discussed here.

EXERCISE 11.2
1. What are evaluated in the collateral element in credit analysis?
2. What is shown by the capital of a loan applicant for purposes of
credit analysis?
•" One of the most important activities in the lending process is credit analysis
which evaluates the credit integrity of loan applicants by using the 5 Cs of
credit. If the credit analysis is not effective, the bank involved will face the
problem of non-performing loans (NPL) and that will certainly jeopardise the
profitability and liquidity of the bank.
•" Banks must ensure that their credit and loans divisions are fundamentally
strong and have sufficient capable staff to conduct accurate evaluation on
loan applications.
•" Despite the fact that NPL can be caused by factors beyond the control of a
bank, the credit and loans division, backed by strong credit analysis, should
have the capability to detect or monitor problems that may be faced by any
borrower in future.
•" The 5Cs of credit can be used as the basis for credit analysis because they take
into account both internal and external factors.
•" Internal factors include the character of the loan applicant, the loan
applicantÊs capacity to repay debts, the collateral that can be used and the
capital owned. External factors include economic conditions that may affect
the applicantÊs debt repayment capacity.
•" It must be remembered that 5C credit analysis involves subjective as well as

quantitative analysis which must only be conducted by trained and
experienced credit or loan officers in order to arrive at strong and sound
credit decisions.

Credit bureau Collateral

Credit decision Ratio analysis
"

Topic X Pricing
12 Policy
LEARNING OUTCOMES
1." Explain the history of pricing policy development in Malaysian
banking industry in Malaysia;
2." Identify components of base lending rate (BLR);
3." Calculate base lending rate (BLR); and
4. Discuss factors influencing pricing policy.
X" INTRODUCTION
We often read from newspapers about banksÊ interest rates being increased or
decreased in keeping with the prevailing situations. Do you know why this
happens? Before we answer this question, first we should know and understand
how the interest rate is derived. In this topic, we will be exposed to pricing
policy, i.e. interest rate pricing policy.
Each commercial bank needs to have its own competitive pricing policy in order
to ensure its survival and growth. The pricing policies of commercial banks in
Malaysia are not fully controlled by the banks themselves. The pricing policies of
these banks are indeed subject to the rules and controls of Bank Negara Malaysia
(BNM). The history of pricing policy development of the banking industry shows
how Bank Negara Malaysia (BNM) has relaxed the rules and controls little by
little over time. BNM returned to play its key role in this aspect by imposing new
rules when there was instability in the banking industry.

TOPIC 12 PRICING POLICY W 233
12.1 PRICING POLICY
SELF-CHECK 12.1
As a bank customer in Malaysia, have you thought of how financial

institutions determine their interest rates on loans such as car loans,
housing loans and industrial loans? Do these institutions use certain
formulas or does BNM determine the interest rates for these loans?
Pricing policy involves determining the interest rates a bank will charge its
customers for using the loans offered by the bank. It is the sole factor that
determines the profitability of any commercial bank. Indirectly, interest rates
offered to deposit customers play a part in the pricing policy formulation process
of commercial banks.
In general, the average interest rate imposed by commercial banks is derived

from the following equation:
K=I+P+C+H+M
Where:
K = Loan interest rates
I = Deposit interest rates
P = Administration cost pertaining to processing of loan applications
C = Compensation factor
H = Provision for bad debts
M = Profit margin
Compensation factor means adjustments made to take account of loss of income

borne by a commercial bank due to the following reasons:
•" Interest rates on priority sector loans are usually lower than the interest rates
paid on customersÊ deposits.
•" Holding low returns public sector financial instruments such as treasury bills
and government securities in fulfillment of liquidity reserve requirement.
•" Non-interest bearing deposits placed with BNM to fulfill the statutory reserve
requirement (SRR).

234 X TOPIC 12 PRICING POLICY
12.2 HISTORY OF PRICING POLICY

DEVELOPMENT
Today, all bank customers are charged interest based on the base lending rate
(BLR) concept. Before we discuss how BLR is calculated, first we have to learn
about the development history of the pricing policy of commercial banks in
Malaysia, especially BNMÊs role as the leader. This will help us understand the
evolution of pricing methods used by the banks. The evolution of pricing policy
can be classified into four stages as shown in Figure 12.1.
Figure 12.1: Evolution of pricing policy
(a)" Administered Interest Rates Regime

In the 1960s, i.e. after Malaysia had achieved independence, the banking
system in the country was still influenced by the British. During that time,
banks in Malaysia used prime rate as the determinant of loan policy. Under
such a system, the interest rates of the leading banks would be the interest
rates of other banks too.
To reduce the influence of the British, BNM built a regime of interest rates
based on domestic situations. Under such regime, BNM set the lowest rate
of interest permissible for bank loans and the highest rate of interest
permissible for deposits, with the cooperation of the Association of Banks in
Malaysia (ABM). In October 1966, the prime loan rate used in the British
system was replaced by the following rates:
(i) Prime Loan Rate

The lowest rate of interest on bank loans offered to borrowers with the
best credit standing.
(ii) Preferential Rate

Preferential rate is the special interest rate offered to public sector
such as government agencies and departments, borrowing from
commercial banks.

This special interest rate is lower than any ordinary interest rate
charged to other customers. This special interest is usually 50 basis
points lower than the prime rate. If the prime rate was 8%, the
preferential rate would be 7.5%.
(iii) Priority Sector Lending Rate

Priority sector loans such as housing loans and loans provided to the
small and medium industry were charged lower interest rates than
the interest rates charged on ordinary loans.
(b)" Market-driven Interest Rates Regime

In the early 1970s, the administered interest rates regime was replaced by
the market-driven interest rates regime. With effect from 23 October 1978,
commercial banks were permitted to set their own interest rates by making
reference to the interest rates set by three leading banks, i.e. Bank
Bumiputera Malaysia Berhad (BBMB), Malayan Banking Berhad (MBB) and
Chartered Bank (now known as Standard Chartered).
(c)" Base Lending Rate (BLR) Regime

After the market-driven interest rates regime, there was further evolution of
pricing policy in 1981, 1983, 1984-1985 and 1987.
(i)" 1981
In the late 1981, base lending rate (BLR) was introduced to replace the
prime loan rate. From then on, the loan interest rates of commercial
banks were pegged to BLR. In other words, the interest rate on a loan
could vary in accordance with BLR movement.
For example, on 1 October, Simon obtained a housing loan and was

charged a loan interest rate of BLR + 1%. BLR was 5% at that time and
therefore the interest rate applicable to SimonÊs loan was 6%. On 17
December, BNM increased the BLR to 6%. Due to that, the interest
rate imposed on SimonÊs loan was increased to 7% (i.e. 6% + 1%).
(ii)" 1983
On 1 November 1983, each bank was required to calculate their own
BLRs based on the cost of funds after taking account the statutory
reserve cost, liquidity requirement cost and overhead cost. The
maximum interest rate a bank was allowed to impose on its customers
was the sum of its declared BLR plus their target profit margin. Banks
were given the discretion to set their respective profit margins.

(iii)" 1984 -1985

During the economic recession in 1984 and 1985, BNM resumed
control over BLR due to commercial banksÊ reluctance to resolve the
worsening interest rate disparity – the gap between loan interest rates
and deposit interest rates was increasingly wider.
(iv)" 1987
With effect from 1st September 1987, commercial banks were required
to set their BLRs at 50 basis points higher than the BLRs of the two
leading banks. For example, if the BLR of Malayan Banking Berhad
was 5%, the BLR of other banks would be 5.5% (i.e. 5% + 0.5%).
Maximum interest rate that a bank was allowed to charge its
customers was equivalent to the sum of its BLR and its maximum risk
premium. Under this system, risk premium, which measured credit
risk of customers, ranged from 1% to 4%.
Risk premium charged varied from customer to customer, subjected

to their respective credit integrity. For example, if the BLR of a bank
was 6%, the interest rate of housing loans offered by the bank could
be at 6% + 1%, i.e. 7% since the houses concerned would be used as
collateral. Other consumer loans could be charged at higher interest
rates, even as high as 6% + 4%, i.e. 10% due to their high risk nature.
BLR was introduced because of the ambiguity of prime loan rate, i.e. the
components of prime loan rate were not defined or specific. On the
contrary, it was clear that BLR-based interest rates comprised the following
components:
•" Cost of funds;
•" Statutory reserve cost;
•" Cost of liquid asset requirement
•" Overhead cost; and
•" Profit margin.

ACTIVITY 12.1
You have obtained a RM90,000 housing loan to purchase a house. The loan
tenure is 25 years and the interest rate is at BLR + 1%. At the time the loan
was approved, the BLR was 6% and the monthly repayment is RM637.
What is the effect on your loan if the BLR change? Will your monthly
payment increases with any increase in BLR, and vice versa?
Does your financial institution inform you of any change in BLR and its
effect on your loan? You can find out from any credit officer of your
financial institution the information regarding the impact on your loan
as a result of BLR movement.
(d)" New BLR Regime

Since the liberalisation of loan interest rates, BNM had made several
changes to the formula of BLR to enhance the responsiveness of the lending
rates of banks towards the monetary policy of the country. After the
changes made in the 1980s, further changes were introduced in the 1990s,
which marked another phase of the pricing policy evolution. 1991, 1995 and
1998 were the years that saw this further evolution of pricing policy.
(i)" 1991
On 1 February 1991, BNM released its control over BLR and the
regime of market-oriented interest rates was re-introduced. The new
BLR was implemented because the BLR introduced in 1983 failed to
define the cost components specific.
Commercial banks were no longer required to peg their respective

BLRs to the BLRs of the leading banks; they were allowed to set their
BLRs based on a standard formula:
BLR = Cost of financing + Staff cost + Overhead cost +

Nominal profit margin (0.25)%
(ii)" 1995
With effect from November 1995, BNM set the formula for
commercial banksÊ BLR for each month based on the previous
monthÊs average 3-month interbank rate. For example, BLR for the
month of April would depend on the interbank rate for March.

Interbank rate is the interest rate that the banks charge one another for
loans transacted in the interbank market. For the purpose of BLR
calculation under this phase of evolution, the Kuala Lumpur
Interbank Offered Rate (KLIBOR) was used as the interbank rate.
Previous month's KLIBOR× 0.8%

BLR = + 2.5%
1 - SRR%
Where:
0.8 = Adjustment for zero-interest current account balances
2.5% = Administrative cost borne by bank, and nominal
profit margin
1 – SRR% = Effect of SRR, i.e. statutory reserve requirement, i.e. a
deposit placed with BNM (without interest) to
safeguard the welfare of bank customers (depositors).
Example 12.1: Calculation of BLR

LetÊs say the 3-month interbank rate was 5% and the SRR rate 3%, therefore the
commercial banksÊ BLR would be:
5% × 0.8
BLR = + 2.5%
1 - 3%
= 4.12% + 2.5%
= 6.62%
(iii)" 1998
In September 1998, BNM replaced the previous monthÊs average
KLIBOR with the prevailing BNM 3-month intervention rate as the
base rate for BLR calculation. Intervention rate is a rate fixed by BNM
to represent the cost of funds of banks. BNM set the intervention rate
as it was not satisfied with the way commercial banks determined
their cost of funds.

The BLR was calculated by:
BNM 3-month intervention × 0.8%

BLR = + 2.5%
1 - SRR%
Following this prevailing rule, the maximum interest rate banks were
allowed to charge their customers was BLR plus a risk premium not
exceeding 2.5%. Risk premium was reduced from 4% to 2.5% in order
to reduce the cost of doing business in Malaysia following the
financial crisis in 1997-1998. Lower BLR would encourage borrowing
and hence enable the financially affected businesses to continue their
operation. Ultimately, this would help the country achieve economic
recovery and stability.
ACTIVITY 12.2
Draw up a time line to mark the evolution of pricing policy. What were
the important events that took place during the different phases of
pricing policy evolution? Did those events influence the pricing policy of
banks? Make some notes on your findings.
12.3 THE COMPONENTS OF BASE LENDING

RATE (BLR)
Base lending rate (BLR) has the element of cost plus pricing, i.e. banks are
allowed to collect from customers the cost of lending plus a profit margin.
Usually, an interest rate at BLR rate is only quoted to the best customers of a
bank. Best customers mean customers with the highest level of credit integrity.
Normally only 20% of total loans are quoted at BLR rate. Other customers are
charged the interest rates at BLR + 1% to 4%, depending on their credit integrity
levels and the types of loan involved.
The components of BLR can be seen in the following formula:
BLR = Cost of funds + Staff cost + Overhead cost + 0.25% Profit margin

Where
(a) Cost of funds = Interest expenditure MINUS interest income from

liquid assets.
The formula used to calculate the cost of funds
expressed in percentage value is as follow:
Cost of funds (%) = Interest paid – Interest received
Funds available for financing
Interest paid = Interest paid by a bank to the depositors.
Interest received = Interest received by a bank from investment in
securities.
Funds available = Current deposits
for financing (+) Savings deposits
(+) Fixed deposits
(+) KLIBOR (Kuala Lumpur Interbank Offer Rate)
deposits
(+) SWAP
(+) Interbank deposits
(+) Head office funds (Long-term loans)
(-) Statutory reserve and liquid assets
(b) Staff cost is total staff cost (including bonus payments) MINUS the staff cost
related to non-lending activities. The formula used to compute staff cost
expressed in percentage value is as follow:
Total staff cost related to lending activities

Staff cost (%) =
(c) Overhead cost is defined as total overhead cost (excluding loan losses)
MINUS overhead cost not related to lending activities. The formula used to
compute overhead cost expressed in percentage value is as follow:
Total overhead cost related to lending activities

Overhead cost =

Example 12.2 is to help you understand the calculation of BLR.
Example 12.2: Calculation of BLR

The following is the financial information of Bank Perdana Berhad:
RM (million)
Funds available for financing 250
Cost of funds 8
Overhead cost 4
Staff cost 4
What is the BLR of Bank Perdana Berhad?
8
Cost of funds =
250
= 3.2%
4
Staff cost =
250
= 1.6%
4
Overhead cost =
250
= 1.6%
BLR = 3.2% + 1.6% + 0.25%

= 6.65%
4
Staff cost =
250
= 1.6%
Bank Perdana Berhad is allowed to charge its customers loan interest rates
ranging from 7.65% (BLR + 1%) to 10.65% (BLR + 4%). This is not applicable to its
best customers who may be charged the rate of BLR only.

There is some controversy over BLR components, specifically the exclusion of

loan losses from overhead cost. Some parties are of the opinion that loan losses
should be provided for in the calculation of BLR since it is a part of the cost of
carrying on banking businesses, which are high risk by nature. They feel that the
new BLR is disadvantageous to all concerned except for the borrowers.
At the same time, there are opposite parties who are in favour of the new BLR.
They have the opinion that the banks should be responsible for their own
weaknesses in making credit decisions. There are a lot of views that the flaws of
risky borrowers should not be borne by the sound borrowers. They also
emphasised that borrowers must not be burdened with the weaknesses of the
bank management. Notwithstanding that, we have to be aware of the fact that
weak bank management is not the only cause of non-performing loans and bad
loans. The weaknesses of borrowersÊ management and the economic situation,
which is beyond anyoneÊs control, also contribute to the existence and the growth
in non-performing loans and bad loans.
12.4 THE FACTORS INFLUENCING PRICING

POLICY
ACTIVITY 12.3
Through the development history of pricing policy, we can see that BNM
plays an important role in the pricing of loan interest rates charged by
commercial banks in Malaysia. Based on your understanding of the evolution
of pricing policy in Malaysia, what do you think are the other factors that can
influence the pricing policy of commercial banks in Malaysia?
While commercial banks are required to follow the stipulated BNM rules
regarding to the formulation of pricing policy, the pricing policy of banks can
indeed be influenced by other factors. These factors are:
•" Rates of return of alternative investments;
•" Bank–borrower relationship;
•" Cost of funds;
•" Maturity tenure of loan;
•" Risk level;
•" Cost of issuing and administering loan; and
•" Competition.

(a)" Rates of Return of Alternative Investments

All banks have various short-term and long-term investments apart from
the loan assets. The conditions in the money market and capital market
influences the extent a bank is willing to invest in loans and advances.
Among all bank assets, loans and advances are believed to generate the
highest returns for banks. In line with the portfolio theory, loans and
advances are also the highest risk assets. Therefore, changes in the money
market and capital market play an important role in loan pricing. For
example, if a higher rate of return is expected from a bankÊs alternative
investments, the bank management will have to reconsider or review the
bankÊs lending rates.
(b)" Bank-borrower Relationship

The track record of a customer also influences loan pricing. A bank will
quote different loan rates between its existing customers and new
customers. There are differences in the loan rates among the existing
customers too, depending on their track records.
(c)" Cost of Funds

Deposits form the main source of funds of any bank. The cost of acquiring
deposits is referred to as cost of funds. As the cost varies from one type of
deposits to the other, a bank has to work out the weighted average cost as
its actual cost of funds.
A bankÊs ability to compete is very much dependent on its ability to keep its
cost of funds low. To achieve this, the bank has to analyse its deposit base
systematically and consider factors such as level of deposit required for
each category. Such analysis should also take into account the statutory
reserve requirement and minimum liquidity requirement which can cause a
direct impact to the cost of funds.
Cost of funds is the largest component in any bankÊs lending rates. In view
of that, banks should strive to minimise this cost.
(d)" Maturity Tenure of Loan

In line with risk-return trade off, the longer the maturity tenure of a loan, the
higher is its risk, and therefore the higher is the return. The longer the fund is
held in an investment (loan), the higher the risk borne by the bank because of
higher exposure to future uncertainties including the financial position of the
borrower. Therefore, banks need to be rewarded with higher returns for their
willingness to take higher risk. Fixed interest rates as opposed to variable or
floating interest rates expose banks to higher risk too.

Variable or floating interest rates vary with the market interest rate. If the
market rate increases, so will the variable interest rate, and vice versa.
Loans with short maturity tenures are generally charged lower interest
rates than loans with long maturity tenures because shorter term means
lower risk.
(e)" Risk Level

Some loans have higher risk than others. For example, consumer loans are
considered riskier than commercial loans. Therefore, consumer loans are
charged higher interest rates.
(f)" Cost of Issuing and Administering Loan

The cost of issuing and administering loans depends on the following:
(i) Scope of credit investigation required;
(ii) Cost of acquiring and putting collateral in order; and
(iii) Expenditure pertaining to collection of loan repayment.
The top management of a bank has to determine the overhead expenditure

for the credit department to facilitate evaluation on the effectiveness and
profitability of the bankÊs lending function.
(g)" Competition
ACTIVITY 12.4
In our country, there are various financial institutions competing
against one another to acquire customers. How does such competition
influence the prices of a bankÊs products?
There is intense competition in the banking industry. Commercial banks are

not only competing among themselves in terms of pricing, each of them has
to compete with all other financial institutions in the banking system as
well as non-bank financial system too.

EXERCISE 12.1
1. What will happen to a bank if its pricing policy is not properly
formulated?
2. Discuss the components of base lending rate (BLR) by providing

appropriate examples.
3. Bank Perdana Berhad is about to approve the following loans

applications:
•" Application by a lawyer for a loan to purchase a house.
•" Application by an entrepreneur for a loan to buy consumer
goods.
•" Application by the state government for a loan to build a
bridge. What interest rates should Bank Perdana Berhad
impose on each of the above loans if its BLR is 6%?
ACTIVITY 12.5
Visit the web sites of the financial institutions in Malaysia and make
comparison on their lending interest rates based on loan categories.
What conclusion can you draw from your comparison? You can access
the web sites of these institutions through the hyperlinks at BNM web
site at http://www.bnm.gov.my.
•" The pricing policy of the banking industry is influenced by the rules and
formulas set by the central bank, Bank Negara Malaysia.
•" Banks enjoy a certain extent of flexibility by having control over their own
operating cost.
•" Each bank is free to set their own BLR but the components of BLR are
controlled by Bank Negara Malaysia.
•" Pricing policy is critical to any bank as it determines a bankÊs profitability and
continuity.
•" Pricing policy of banks is influenced by several other factors.

Base lending rate Prime loan rate

Preferential rate
"

Topic X Collateral
13 Policy
LEARNING OUTCOMES
1." Explain the rationale for collateral requirement in lending;
2." Identify the types of collateral required by commercial banks;
3." Discuss the collateral selection criteria; and
4. Apply loan to collateral ratio in credit decisions.
X" INTRODUCTION
Collateral is the third principle of lending, after the principle of purpose and the
principle of payment. In general, collateral means asset(s) pledged by a borrower
to secure a loan. Not all assets are acceptable as collateral. Banks have their own
collateral policy which specifies the types of assets that can be accepted as
collateral.
The key issue pertaining to collateral policy is regarding the real function of
collateral, i.e. why collateral is needed in lending. This issue surfaces because
many bank customers have failed to get a loan due to lack of adequate collateral.
The Credit Guarantee Corporation (CGC) was set up simply because small
businesses were having difficulty obtaining loans from commercial banks and
financial institutions due to lack of or absence of collateral.

248 X TOPIC 13 COLLATERAL POLICY
13.1 WHY IS COLLATERAL NECESSARY?
ACTIVITY 13.1
As a customer of the banking industry in Malaysia, have you ever

considered how financial institutions determine the interest rates
imposed on loans such as car loan and housing loan? Do these
institutions use some specific formulas or BNM determines all the
interest rates?
Commercial banks in Malaysia appear to be collateral-oriented to the extent

many people have the opinion that it is impossible to get a loan without any
collateral. Some people are of the view that a loan is safe so long as the purpose
of the loan is solid and the schedule and the source of repayment are satisfactory.
J. P. Morgan, a well known banker in the USA said:
„A true banker is one that provides loans without sufficient

collateral. Anyone can be a lender if loans are fully
secured.‰
Many people have negative impression of the collateral policy of banks because
they do not fully understand the functions of banks. Banks are indeed trustees
for their customersÊ deposits which are used as the sources of loans. As trustees,
banks have the responsibility to ensure the security of their customersÊ deposits.
In view of that, banks should not provide loans based on the principle of purpose
and the principle of payment only for uncertainties in various aspects can affect
borrowersÊ capacity to repay their respective loans in future.
The actual function of collateral is to reduce the credit risk of a loan. Nonetheless,
collateral cannot be regarded as a substitute for the credit integrity of a borrower.
Loans officers should not make credit decisions based on mere comparison
between the value of the collateral and the amount of the loan. Collateral must be
regarded as the last line of defence that safeguards a loan from future
uncertainties. To emphasise, collateral policy is needed to protect the interest of
depositors.

TOPIC 13 COLLATERAL POLICY W 249
13.2 TYPES OF COLLATERAL

Figure 13.1 illustrates a loan application situation.
„Mr. David, there are some minor problems regarding your business loan. The
types of collateral proposed by you do not fit the bankÊs requirement on
collateral. Office supplies and equipment such as stationery, tables, chairs and
computers are not acceptable as collateral‰.
Figure 13.1: Loan application situation
Types of assets acceptable to banks as collateral are:

•" Buildings and equipment;
•" Mortgages on land, buildings and equipment;
•" Assignment of inventories and accounts receivable;
•" Assignment of insurance policy;
•" Assignment of priority rights in subsidiary company; and
•" Personal guarantees.
(a)" Buildings and Equipment

Buildings and equipment are often accepted as collateral because these
assets can be sold in the event that the borrower fails to make loan
repayment. The sales proceeds are used specifically to settle the
outstanding balance of the loan.

(b)" Mortgages on Land, Buildings and Equipment

Mortgages on land, buildings and equipment are often accepted as
collateral because the assets concerned can be sold should the borrower fail
to make loan repayment. The sales proceeds are used specifically to settle
the outstanding balance of the loan.
(c)" Assignment of Inventories and Accounts Receivable

A borrower may assign to a bank the rights to the inventories and accounts
receivable as collateral for a loan. This type of collateral is usually used for
working capital financing.
Accounts receivable are usually favoured over inventories because the true
values of the former are more stable; the true values of inventories vary
according to the quality, type and location of the inventories. Even though
accounts receivable and inventories can be accepted as collateral, credit
officers should evaluate the following before making any credit decision:
•" How many percent of the accounts receivables used as collateral is
expected to turn into bad debts?
•" Has the validity of the accounts receivable concerned been confirmed
directly with the purporsed debtors?
•" Have the average collection period, accounts receivable turnover and
accounts receivable aging been compared with the industry average,
previous yearsÊ figures and the companyÊs credit terms?
•" Do one or two big accounts constitute the bulk of the portfolio of
accounts receivable?
•" Does the loan applicant collect deposits from trade customers on
condition that customer orders will be delivered in future?
(d)" Assignment of Insurance Policy

Commercial banks are usually reluctant to accept assignment of insurance
policies as collateral because of the unique problems associated with this
type of collateral. For example, a loan secured by a life insurance policy is
exposed to the following problems:
•" Can a third party make any claim on the policy should the policy holder
commit suicide?
•" Is the consent from the policy beneficiary required?
•" Can the rights to the insurance policy concerned be assigned?

•" Are the options pertaining to insurance settlement satisfactory?

•" Are they any special provisions or documentation involved?
Usually, assignment of insurance policy is accepted as a protection for the

loan in the event of death of the borrower, or as collateral if the policy has
cash value. Banks habitually request their housing loan customers to
purchase life insurance as protection for the loans in the event of death, in
addition to mortgages on the properties concerned. Should a borrower die
before his housing loan is fully settled, the insurance company will pay the
bank the outstanding loan amount and the ownership right to the property
will be given to the estate of the borrower.
(e)" Assignment of Priority Rights in Subsidiary Company

Assignment of priority rights in subsidiary company contains problems
associated with determining the value of the collateral, and monitoring and
controlling of the collateral.
(f)" Personal Guarantees

Collateral in the form of a personal guarantee has the following problems:
•" The credit officer must conduct credit analysis on the guarantor as if the
guarantor is borrowing from the bank. This increases the work load of
the credit department.
•" The image and reputation of the guarantor may influence the
judgement of the credit officer to the extent that the necessary credit
analysis is neglected.
•" As one same person may act as the guarantor for many loans or
borrowers, banks are subjected to reduced claims on the asserts of the
guarantor in the event of default by the borrowers.
•" More often than not, guarantors do not view their guarantees seriously
even though their responsibilities are as heavy as the borrowersÊ. It is
highly likely that a guarantor will express his displeasure towards the
bank if he is called upon as a result of default by the borrower.
Guarantors tend to claim that banks should make the demands against
the borrowers instead of guarantors. It is indeed wrong for the
guarantors to have such opinion which is attributable to their ignorance
of the fact that their responsibilities are as heavy as the borrowersÊ.

ACTIVITY 13.2
Visit the web sites of commercial banks through the hyperlinks at BNM web
site at http://www.bnm.gov.my and find out what types of collateral are
accepted by these banks. Compare the findings of your research with what
has been discussed here. What conclusion can you draw?
13.3 COLLATERAL SELECTION CRITERIA

In general, banks accept collateral that has character that is liquid, stable in value,
marketable and can be easily evaluated. These characteristics are important as
they can influence a bankÊs position when the bank has to dispose the collateral.
(a)" Liquidity
An asset is considered liquid if it can be disposed off or sold at no huge
losses to the seller. For example, if an asset has a market value of
RM100,000 and can be sold at RM90,000, it is considered more liquid than a
similar asset that can be sold at RM80,000.
The liquidity level of an asset is closely related to the marketability of the

asset, i.e. the greater the marketability, the higher the liquidity. Banks prefer
assets with high liquidity in order to avoid losses should they have to sell
the assets as a result of default in loan repayment by the borrowers.
(b)" The Stability of Value

Banks prefer collateral with stable values because any sudden changes in
values can affect a bankÊs position when they have to sell the collateral.
This also explains why most banks are reluctant to accept share certificates
as collateral; shares cannot ensure adequate protection for banks since their
prices may change unpredictably and drastically. LetÊs picture the
following scenario as an example:
Four months ago, a customer obtained a loan amounting to RM100,000 and

secured 20,000 shares which were worth RM160,000 at that time. The price
of the shares has dropped from RM8.00 per share to RM4.00 per share since.
That means the collateral value is now at RM80,000 only, which is
insufficient to protect the loan. To ensure full protection, the bank has to
request the customer to top up the value of the collateral. In the event that
the customer is unable to fulfill such request, the bank will have to bear the
losses.

(c)" Marketability
Marketability of collateral is subject to the condition of the collateral. Banks
want collateral that is in good condition in case they have to sell the same.
For example, collateral in the form of a poorly maintained building is likely
to have low marketability. Banks want collateral with high marketability for
easy disposal in the event of default in loan repayment by borrowers. The
marketability factor also implies that ready market or demand for the
collateral concerned is a requirement too. In other words, banks require
collateral which they can sell easily in the shortest of time and without
incurring losses.
(d)" Easy to Evaluate

Banks want collateral that can be easily evaluated. For example, evaluation
on an art collection is complex compared to the evaluation on an office or a
factory. This characteristic of collateral is important to banks because an
asset that can be easily evaluated is usually an asset that can be sold easily.
This characteristic helps protect a bankÊs position and interests in the event
that disposal of the collateral becomes necessary.
ACTIVITY 13.3
We have already discussed lending practice and policy in Topic 10. The
three principles in lending, i.e. the principle of purpose, principle of
payment and principle of protection were among the issues discussed.
Explain the relationship between the collateral selection criteria and the
three principles based on your understanding of the said principles and
of collateral.
13.4 UNSECURED LOANS

In reality, unsecured loans do not exist. The so called unsecured loans are indeed
loans which are secured by personal guarantees. We have learned that personal
guarantees are accepted by banks as collateral for loans.
If a bank intends to approve an unsecured loan, it must first ensure that the
following requirements are fulfilled:
•" The bank has very strong confidence in the character of the prospective
borrower;
•" The prospective borrower must have strong balance sheets and must show
proof of financial strengths;

•" The prospective borrowerÊs capacity to repay debts must be more than
adequate;
•" The prospective borrower should have good track records with banks; and
•" The prospective borrower should borrow from one source only.
ACTIVITY 13.4
You should by now be aware of the importance of collateral and why

financial institutions require collateral. How do you think banks prevent
default in unsecured loans (but secured by personal guarantees)? Base
your answer on your understanding of collateral and your experience as
a borrower or guarantor of a bank loan.
Based on your understanding of the principles in lending as well as of

credit analysis, what measures do you think banks should take? You
may visit the web sites of commercial banks for additional information.
13.5 LOAN TO COLLATERAL RATIO

The loan to collateral ratio indicates the value of collateral required to protect a
loan or the amount of loan that can be granted based on the value of the
collateral offered.
For example, a 60% loan to collateral ratio means that for every RM60 of loan
granted, a RM100 worth of collateral is required. In other words, a prospective
borrower requesting for a RM60,000 loan should provide RM100,000 worth of
collateral, or, if a prospective borrower has RM100,000 worth of collateral, his
maximum loan entitlement is RM60,000.
The norm for the loan to collateral ratio ranges from 60% to 70%. This shows the
prudent approach taken by banks pertaining to secured lending. No banks are
able to practise lending at 100% loan to collateral ratio.

EXERCISE 13.1
1." Discuss why collateral is required for a loan even though the
purpose of the loan and the loan repayment capacity of the
borrower are adequate.
2." State the relevant collateral for the following types of loan:
Type of Loan Collateral
Term loan to finance construction of a factory
Working capital loan

Loan for the purchase of furniture and other
equipment
Loan for the purchase of shares
Loan to finance corporate takeover
Personal loan
Housing loan
Education loan
3." Why is the marketability criterion regarded by some banks as the

most important criterion in collateral selection?
•" A sound loan is one that is repaid through self-liquidating of the borrower Ês
assets, or from the borrower Ês income or profits.
•" A sound loan is not one that has to be collected through forced sale of the
corresponding collateral.
•" The actual role of collateral is to protect a bank against the uncertainty in a
borrower Ês future repayment capacity.

•" To banks, collateral is the last resort, not a main source of loan repayment.
•" Lending policy which over-emphasises on collateral as a lending criterion

will cause problems for certain economic sectors such as the small and
medium industries and new businesses that cannot afford to offer collateral.
Collateral policy Types of collateral

Collateral ratio Unsecured loan

Topic X Non-
14 Performing
Loan (NPL)
Management
LEARNING OUTCOMES
1." Define non-performing loan (NPL);
2." Apply „poor 5C credit analysis model‰ to explain the NPL problem;
3." Identify the sources and signs of NPL;
4." Discuss the requirements in preventing NPL;
5." Explain the roles played by Danaharta, Danamodal and the Corporate
Debt Restructuring Committee (CDRC) in solving the NPL problem; and
6. Examine the effects of NPL on commercial banks management.
X" INTRODUCTION
The main activities of commercial banks are lending activities. These activities
involve high credit risk as there is a potential of non-repayment by borrowers. In
the event that a borrower fails to make repayment or is unable to repay his loan,
the loan will become a non-performing loan (NPL).
When our country was hit by the economic crisis in 1997–1998, the financial
performance and position of most of the commercial banks were affected because
many loans became NPLs. The NPL problem became increasingly critical to the
extent that Bank Negara Malaysia had to set up Danaharta, Danamodal and the
Corporate Debt Restructuring Committee (CDRC) to solve the problem.

258 X TOPIC 14 NON-PERFORMING LOAN (NPL) MANAGEMENT
14.1 DEFINITION OF NON-PERFORMING

LOAN (NPL)
SELF-CHECK 14.1
Most of us have heard of the terms „bad debt‰ and „non-performing

loan‰. Are they the same?
Most of us probably share the opinion that NPL and bad debt are the same. This
opinion is indeed untrue; non-performing loan is a loan that is in default or close
to being in default but there is still a possibility of collection. A bad debt is a loan
that can no longer be collected from the borrower and will be written off from the
books of accounts. An NPL that can no longer be collected will become a bad
debt.
In 1988, Bank Negara Malaysia (BNM) defined a NPL as a loan from which
interest has not been paid for at least 12 months (six months for hire-purchase
loans). BNM changed the definition in 1997 by shortening the period to three
months. The definition was changed once more in 1998, and the period was
lengthened to six months.
Upon the classification of a loan as NPL, the loan interest will be accrued and not
be credited as income. In other words, the interest will be suspended. Besides, the
total amount of NPLs will be deducted from the Provision for Loan Losses. As a
result, the profits of the bank will reduce and so will bank equity.
14.2 5Cs OF BAD CREDIT
SELF-CHECK 14.2
In Topic 11, we have already discussed the 5C credit analysis model.
What does 5C credit analysis mean and what is its relationship with
NPL?
5C credit analysis is an analysis tool used to determine the debt repayment risk
or credit risk. The 5Cs refer to capacity, conditions, capital, character and
collateral. By essence, the 5C credit analysis model can be called a good 5C credit
analysis model because anyone making credit decisions based on this model is
likely to make good credit decisions.

TOPIC 14 NON-PERFORMING LOAN (NPL) MANAGEMENT W 259
If there is a good 5C credit analysis model, there must be a poor 5C credit

analysis model too. Poor 5C credit analysis model was introduced by Sam
Golden and Harry M. Walker (1993). Poor 5C credit analysis refers to:
•" Complacency;
•" Carelessness;
•" Communication;
•" Contingency; and
•" Competition.
According to Golden and Walker (1993), if a credit analysis is performed based

on bad 5C credit analysis model, the resultant loan may become a non-
performing loan (NPL).
(a)" Complacency
Golden and Walker have pointed out that a bankerÊs complacency in the
customerÊs history of repayment records will attract NPL problem.
According to them, such complacency is caused by over-dependence on
collateral, over-emphasis on past performance and over-confidence in the
future.
(b)" Carelessness
Carelessness of a banker in handling loan agreement or loan documentation
can contribute to non-performing loans (NPL). Examples given by Golden
and Walker include incomplete loan documentation, poor management of
credit files and lack of adequate terms to protect the bankÊs interest.
(c)" Communication
Poor communication between loan officers on the objectives and quality of
loans can lead to NPL problem. Unclear communication also causes
confusion among loan officers.
(d)" Contingency
Golden and Walker suggests that banks should evaluate future repayment
capacity of each borrower based on the worst case scenario. Banks need to
conduct this analysis in order to reduce credit risk.
(e)" Competition
Credit decisions made with an objective to compete with rival banks will
result in the approval of low quality loans. Pressure on the sales
department will increase the incidents of NPL too.

14.3 THE SOURCES OF NON-PERFORMING

LOANS (NPLS)
NPL happens when a borrower does not make loan repayment either because he
refuses to make repayment or he is unable to make repayment for whatever
reasons. Refusal as well as inability to repay loans is closely related to economic
conditions.
The willingness and the ability to repay loan are higher during good economic
condition than during economic recession. The inability to repay loans may be
attributed to poor business management of the borrower. Inexperience and
inefficiency are often cited as the causes of business failure.
The 1987 annual report of Bank Negara Malaysia on NPL revealed that most
NPLs have been caused by prolonged economic recession. Weaknesses of
borrowers and lenders or financial institutions had also contributed to NPLs.
Table 14.1 shows the weaknesses of borrowers and lending institutions which
contribute to NPLs.
Table 14.1: Weaknesses of Borrowers and Lending Institutions which Contribute to NPLs
Borrower Lending Institution

Overly optimistic forecast made during Poor evaluation of projects
good economic condition
Errors in calculation of costs Inadequate evaluation of collateral
Cash flow problems Poor credit documentation
Over-trade Poor monitoring of loans
Fraud Weaknesses in collection of loans
According to Pace and Simpson (1997), the sources of NPLs or problematic loans
are as follows:
(a)" Inadequate analysis of the capability of borrowerÊs management;
(b)" Inadequate analysis of financial statements;
(c)" Weaknesses in the examination and audit of marginal loans;
(d)" Over-emphasis on the bank profitability and growth; and
(e)" Overly liberal credit policy in relation to loans granted to the friends of any
of the directors or the chief executive officer.

ACTIVITY 14.1
How can a bank use the information pertaining to credit analysis, bad 5C
credit analysis model and the causes of non-performing loans to prevent
a loan from becoming a non-performing loan?
You are encouraged to visit the web sites of local banks through the
hyperlinks at BNM web site at http://www.bnm.gov.my and obtain
additional information on how these banks use credit analysis and bad
5C credit analysis model to prevent non-performing loans.
Make comparison between your own answer and the information

available on the webs sites of local banks. What conclusion can you make
based on the comparison?
EXERCISE 14.1
1." What does „non-performing loan‰ mean?
2." Is NPL the same as bad loan or bad debt?
3." What are the main differences between 5Cs of good credit and 5Cs
of bad credit?
4." How does the „complacency‰ element of 5Cs of bad credit cause
non-performing loans?
14.4 DETECTING NON-PERFORMING LOANS

(NPLS)
Non-performing loans (NPLs) do not happen overnight. There are usually signs
indicating the deterioration in the credit quality of a loan.
Groves (1992) classifies the signs of NPL into five categories, i.e.:
•" Signs from financial statements;
•" Signs from borrower Ês conduct of loan or conduct of account;
•" Signs from borrower Ês business;
•" Signs from borrower Ês behaviour; and
•" Signs from the macro economy.
(a)" Signs from Financial Statements

Analysis of financial statements is the main tool that can be used by credit
officers to detect deterioration in a borrowerÊs financial position. In the
presence of deteriorating financial ratios, the credit officer in-charge should
conduct more in-depth assessment on the status of the loan concerned to
ensure there is and will be no NPL problem.
In the course of financial analysis, the credit officer should determine if

there is any trend in assets, liabilities, ownersÊ equity, expenditure or
income:
(i)" Current Assets

•" Deterioration in cash position.
•" Deterioration in debt collection.
•" Sharp increase in accounts receivable either in absolute terms or
expressed as a percentage of total assets.
•" Increase in inventory level either in absolute terms or expressed as
a percentage of total assets.
•" Deterioration in inventory turnover which reflects weaknesses of
purchasing policy and slow movement of inventories.
•" Deterioration in the current ratio.
(ii)" Fixed Assets

•" Declining expenditure on fixed assets. This shows that the funds
needed for the purchase of fixed assets have been used for other
purposes. That means the company will have to pay more for new
fixed assets in future when the prices are higher. This will cause a
huge amount of cash outflow.
•" Increasing expenditure on fixed assets. This may become serious if
other assets have to be sacrificed or forgone.
•" Revaluation of fixed assets; this is necessary if its purpose is to
show more realistic values. It is not necessary if the purpose is to
convince bank to grant additional loans.
•" Lien on one or more assets.
•" Large amount of intangible assets.

(iii)" Liabilities
•" Out of line increase in current liabilities.
•" Increase in long-term liabilities.
•" Rising loan to equity ratio, even more alarming when this is
accompanied by low current ratio.
(iv)" Expenditures and Earnings

•" Big gap between gross sales and net sales.
•" Increasing proportion of costs.
•" Increase in sales but decrease in profits.
•" Increasing bad debt losses.
(b)" Signs from Borrower Ês Conduct of Loan or Conduct of Account

Examples of situations indicating that a loan may become an NPL:
(i)" Decline in the account balance, and overdraft account.
(ii)" Unexpected credit usage trend.
(iii)" Request for exemption from pre-agreed repayment programme.
(iv)" Delayed payment of loan principal and interest.
(v)" Excessively optimistic budgets.
(c)" Signs from BorrowerÊs Business

Credit officers should have the ability to detect and monitor the following
situations which signal that a loan may turn into an NPL:
(i)" Deteriorating relationship between the borrower and his suppliers.
(ii)" Borrower shows speculative behaviour and the desire to take
unnecessary risk.
(iii)" Excessively low pricing for the purpose of showing the achievement
of break-even point.
(iv)" Loss of any product line, franchise licence, distribution rights or main
source of supply.
(v)" Loss of any key customer.
(vi)" Discontinuation of key product.
(vii)" Slow reaction to market or economic recession.

(viii)"No clear management succession plan.

(ix)" Speculative inventory purchases.
(d)" Signs from BorrowerÊs Behaviour

The following matters which are directly related to the borrower are some
other signs of a potential non-performing loan:
(i)" Family problems.
(ii)" Serious illness.
(iii)" Not answering calls from credit officer.
(iv)" Non-disclosure of significant incidents related to the borrower Ês
business such as workersÊ strike.
(v)" Launch of new product that is outside the ordinary course of the
borrower Ês business.
(vi)" Increasing number of credit enquiries from external parties.
(e)" Signs from the Macro Economy

In general the businesses of borrowers are not spared from the domestic
economic conditions or any changes in the countryÊs economy. In view of
that, credit officers should evaluate the effect of economic changes on the
loan repayment capacity of each borrower. Even though most firms follow
the same business rhythm and cycle, some firms are more sensitive than
others to domestic economic changes. Evaluation should be made to gauge
the extent of impact on each borrowerÊs business vis-à-vis the different
levels of economic deterioration.

According to Robert Benbow (1985), the following are the warning signs of
NPL:
•" Hurried loan application or anxious loan applicant.
•" Borrower who depends heavily on a specific type of support and is likely
to be affected by any disruption to such support.
•" Lending to wealthy people or celebrities whose assets and liabilities
cannot be easily identified or detected.
•" Borrower who is unclear of the purpose of the loan.
•" Borrower who wants a more liberal repayment programme which falls
short of the expected cash flow shown to bank.
•" Borrower who does not own any important part of the business
concerned and who seems to be acting in the capacity as a broker only.
•" Change of accounting method and auditor.
As soon as the signs of NPL are identified, suitable measures must be taken to
prevent NPL problem.
ACTIVITY 14.2
Choose at least one listed company on the Kuala Lumpur Stock

Exchange. Based on the signs of NPL identified by Groves (1992),
analyse the company from the following perspectives:
•" Signs from financial statements;
•" Signs from borrower Ês conduct of loan or conduct of account;
•" Signs from borrower Ês business;
•" Signs from borrower Ês behaviour; and
•" Signs from the macro economy.
What conclusion can you make based on your analysis?

EXERCISE 14.2
Explain how the following incidents can be signs of NPL:

(a)" Deterioration in the companyÊs current ratio;
(b)" Liened assets;
(c)" Increasing debt ratio;
(d)" Overly optimistic budgets;
(e)" Loss of key customer; and
(f)" Borrower is suffering from serious illness.
14.5 PREVENTION OF NON-PERFORMING

LOANS (NPLS)
„If you borrow RM10 thousand from a bank, you will have sleepless nights.
However, if you borrow RM10 million, the bank will have sleepless nights.‰
Think about the above statement for a moment.
Upon detection of any troubled loan account in a bank, the bank should take the
necessary measures to prevent the account from turning into an NPL account.
Bank Negara Malaysia (BNM) feels that the effort to prevent NPL has to begin by
resolving the corporate failure problems. That means seeing and understanding
the problems through the borrowersÊ eyes. BNM has proposed measures such as
debt restructuring, reduced interest rates and revamp of corporate management.
For example, the government set up the RM500 million Corporate Recovery
Fund to help Bumiputera companies which were severely affected by the
recession in 1984–1985. Such fund was administered by Malaysian Industrial
Development Finance (MIDF) with the help of corporate recovery experts who
performed viability study on the companies concerned.
From the lendersÊ point of view, NPL problem can be prevented so long as the
loan portfolios are managed by competent credit officers. What skills should
these credit officers have?

Morsman (1986) believes that a credit officer should have the following strengths
in order to protect his loan portfolio from NPL problem:
•" Competence in corporate analysis;
•" Ability to evaluate loan applications;
•" Possession of at least minimum knowledge and experience;
•" Interpersonal relationship skills; and
•" Desirable character traits.
(a)" Competence in Corporate Analysis

The credit officer should be capable and trained in the analysis of the
following aspects of any business:
(i)" Character, capacity and depth of management;
(ii)" The companyÊs standing in the industry and market;
(iii)" Business environment and business climate; and
(iv)" Financial statement analysis.
(b)" Ability to Evaluate Loan Applications

The credit officer should have the capability to conduct effective evaluation
on the loan application related matters:
(i)" Purpose of loan;
(ii)" Loan repayment;
(iii)" Secondary source of loan repayment;
(iv)" Monitoring needs; and
(v)" Compliance with loan policy.
(c)" Possession of at Least Minimum Knowledge and Experience

A credit officer should have the following qualifications and skills to help
him make sound credit evaluation:
(i)" Academic qualification;
(ii)" Technical skills;
(iii)" Knowledge of bank value; and
(iv)" Experience.

(d)" Interpersonal Relationship Skills

Since a credit officer often has to interact with people, he should equip
himself with the following interpersonal skills to facilitate the performance
of his duties:
(i)" Communication skills;
(ii)" Interview skills;
(iii)" Listening skills;
(iv)" Skills in delivering bad news;
(v)" Sales and marketing skills; and
(vi)" Time management skills.
(e)" Desirable Character Traits

Credit officers should possess the following character traits:
(i)" Courageous;
(ii)" Considerate;
(iii)" Consistent; and
(iv)" Ability to prioritise.
Abraham Wax (1987) uses the acronym DRIPS to explain NPL. Table 14.2 shows
what DRIPS stands for.
Table 14.2: DRIPS
DRIPS Explanation
D Documentation The most important part of sound lending practice is
related to accurate and organised loan documentation.
Loan documentation should be complete and clear
to enable resolution of problems that may arise in
future. Every loan issued must be in compliance with
the clauses stated in the loan documents. Without
accurate and complete loan documentation, a bank is
exposed to loan related losses.
R Remember Each loan officer should have the ability to remember
every transaction, every new loan application and
every renewal of loan application. This can be done by
keeping records of the loan officer Ês own perception
of each case as it happens.

I Information/Investigation Before approving a loan, the loan officer should visit

the business premises of the loan applicant to verify
the existence of the company and its operation. Every
loan officer should monitor all internal and external
factors that may affect the loan repayment capacity
of their customers. Besides, loan officers should be
sensitive to market and commercial situations that
may have an impact on their borrowers.
P Position During negotiation, the loan officer needs to be
aware of his customerÊs state of affairs.
Customers are usually in their best manners before
their loans are granted; this is the time the
necessary information or documents required
from customers are most accessible to loan officers.
S Speed Loan officers should inform the Legal Department of
their banks without any delay the moment they begin
to have doubts in any of the loan accounts. Delay in
doing so will result in more NPLs.
ACTIVITY 14.3
Simon is a fruits importer. He often uses bank guarantees to finance his
business activities. He has been dealing with ABC Bank for 20 years and
maintains good credit records in general.
Simon obtained a 3-year loan facility amounting to RM200,000 from ABC

Bank three years ago, and he repaid the loan promptly during the first
year. However, Simon has been late in repaying the loan since three
months ago, and sometimes the delay was as long as three weeks.
What measures should you take, in your capacity as the credit officer
assigned to monitor this account? Will this account become an NPL
account? If yes, how will it happen?
14.6 ROLES OF DANAHARTA

Pengurusan Danaharta Nasional Berhad (Danaharta) was set up on 20 Jun 1998
to take over non-performing loans (NPLs) from banking institutions to enable the
later to continue their lending activities and to facilitate the recovery process of
the countryÊs economy.

Banking institutions with NPL rate exceeding 10% were required to sell their
NPLs to Danaharta. Besides, institutions that needed additional injection of
capital were also required to sell their NPLs to Danaharta. DanahartaÊs task was
to manage these NPLs and to maximise their recovery values. Danaharta also
had the responsibility to revive and restructure the NPL accounts concerned.
Refer to the press release extracted from the web site of Danaharta to find out
about the de elopment of the NPLs it has taken over.
„As at 31 December 2002, Danaharta had reviewed and identified the

appropriate recovery strategy for its entire NPL portfolio (total adjusted loan
rights acquired value of RM52.52 billion). Of which Danaharta expects to
recover a total recovery amount of RM30.19 billion. The expected average
recovery rate (excluding defaulted loans) is thus approximately 57%.
DatoÊ Abdul Hamidy Hafiz, Managing Director of Danaharta, said,

„Although Danaharta has identified the recovery strategy for each loan in its
portfolio, the agencyÊs task is not completed yet. Until its closure in 2005,
DanahartaÊs operations will be focused on implementing the recovery
strategies identified for the remaining NPLs, collecting recovery and
converting all non-cash recovery into cash.‰
Source: Press Release of Danaharta at http://www.danaharta.com.my
14.7 ROLES OF DANAMODAL

Danamodal Nasional Berhad (Danamodal) was set up on 10 August 1998 as a
wholly-owned subsidiary of Bank Negara Malaysia (BNM) charged with the
responsibility to recapitalise banking institutions. Banks which were
experiencing high NPLs found their capital eroding to a dangerous level.
Danamodal injected fresh capital in the forms of ordinary shares, Irredeemable
Non-cumulative Convertible Preference Shares (INCPS) or subordinated loans.
Being a strategic shareholder, Danamodal was also involved in the restructuring
of the banking institutions concerned by facilitating the unification and
rationalisation process.
Table 14.3 shows the measures taken by Danamodal to recapitalise financial

institutions in Malaysia.

Table 14.3: Measures Implemented by Danamodal
Date Event
August – September Danamodal identified 14 financial institutions likely to be in
1998 need of recapitalisation. They were:
•" RHB Bank/Sime Bank
•" Arab-Malaysian Bank Berhad
•" Arab-Malaysian Finance Berhad
•" BSN Commercial Bank (M) Berhad
•" Oriental Bank Berhad (Group)
•" Sabah Bank Berhad
•" United Merchant Finance Berhad
•" Perdana Merchant Bankers Berhad
•" Utama Merchant Bankers Berhad
•" Perwira Affin Bank
•" Bank of Commerce Berhad
•" Bank Bumiputera Malaysia Berhad
•" MBF Finance Berhad
October 1998 – •" Danamodal recapitalised 9 banking institutions by using
December 1998 funds totalling RM4,550 million. These institutions were:
•" RHB Bank/Sime Bank
•" Arab-Malaysian Bank Berhad
•" Arab-Malaysian Finance Berhad
•" Arab-Malaysian Merchant Bank Berhad
•" BSN Commercial Bank (M) Berhad
•" Oriental Bank Berhad (Group)
•" Sabah Bank Berhad
•" United Merchant Finance Berhad
•" Perdana Merchant Bankers Berhad
•" 4 banking institutions opted to turn to financial markets to
solve their capital shortage problem:
−" Bank Bumiputera Malaysia Berhad
−" Utama Merchant Bankers Berhad
−" Perwira Affin Bank
−" Bank of Commerce Berhad
MBF Finance Berhad was referred to Bank Negara Malaysia
January – March •" Entered into Subscription Agreements with:

1999
−" Arab-Malaysian Group and BSN Commercial Bank on
5/2/1999
−" Sabah Bank (RM122million) on 12/2/1999
−" Oriental Bank (700 million) and United Merchant
Finance (RM317 million) on 30/3/99
•" Capital requirement evaluation on Perdana Merchant
Bankers was to be finalised immediately. Injection of
additional capital:
−" RM550 million into Oriental Bank Berhad
−" RM210 million into BSN Commercial Bank
•" United Merchant Finance returned RM483 million
•" Sabah Bank returned RM18 million
•" Arab-Malaysian Merchant Bank returned RM200 million
•" BNM took over the management of MBF Finance on
4/1/99. Danamodal injected RM1.6 billion of capital into
MBF on 11/3/99, and held 70% controlling interest.
Subscription agreement was signed on 12/3/99.
•" Shareholders of United Merchant injected RM120 million
of capital into MBF Finance.
Source: http://skali.bnm.gov.my/danamodal)
14.8 ROLES OF CORPORATE DEBT

RESTRUCTURING COMMITTEE (CDRC)
Corporate Debt Restructuring Committee (CDRC) was set up in July 1998 to
provide avenues for borrowers and creditors to resolve their debt problems so
that their businesses could continue to be in operation.
This committee acted as the middle man by introducing and implementing the
necessary frameworks to facilitate corporate debt restructuring of borrowers. The
founding of this committee was prompted by the increasing number of court
cases between creditors and debtors over the debtorsÊ failure to make payment of
debts; many creditors decided to take legal action against their debtors including
large corporations and other companies except banks. CDRC was of the opinion
that these court cases would not be beneficial to either party since they would
take a long time to finalise. At the same time, those large corporations involved
were unable to carry on their business activities. Such scenario was detrimental
to the countryÊs economic recovery.

According to the status and statistics obtained from BNM website in June 2003,
as at 30 June 2001, 75 applications totalling RM47.4 billion were received by
CDRC. Out of which, the debts of 37 companies, which amounted to
RM28.5billion, were successfully resolved by CDRC. The majority of the 37
structured companies were main board listed companies and investment holding
companies. 21 applications were withdrawn/rejected for lack of viability, nine
applications were transferred to Danaharta and 8 applications were pending
decisions. Refer to table 14.4 for detailed information on the status and statistics
of CDRC for the period from September 1998 to June 2001.
Table 14.4: Status and Statistics of CDRC

Resolved with
Withdrawn/ Tranfered to Completed Cases
Assistance of
Applications Total Debts Rejected Cases Danaharta Cases Outstanding
Danaharta
Quarter Received (RM mil) (Accumulative) (Accumulative) (Accumulative) (Accumulative)
(Accumulative)
(Accumulative) (Accumulative)
Amount Amount Amount Amount Amount
No. No. No. No. No.
(RM mil) (RM mil) (RM mil) (RM mil) (RM mil)
3/1998 20 5,350.20 - - - - - - - - 20 5,350.20
4/1998 36 11,028.15 - - - - 2 344.5 - - 34 10,683.65
1/1999 52 26,018.52 4 849.85 - - 4 1,153.30 - - 44 24,015.37
2/1999 62 33,039.64 8 2,053.05 - - 10 10,249.40 2 954.30 42 19,782.37
3/1999 63 35,024.65 14 3,259.35 - - 11 11,234.89 2 954.30 36 19,576.11
4/1999 66 35,652.77 15 3,504.35 8 2,764.7 13 11,778.29 2 954.30 28 16,651.13
1/2000 68 36,519.20 13 2,760.45 10 32,98.44 17 13,106.84 2 954.30 26 16,399.17
2/2000 71 39,643.01 16 3,822.63 9 18,13.54 23 17,392.49 2 954.30 21 15,660.05
3/2000 75 45,938.82 18 4,072.57 9 18,13.54 28 23,085.17 2 954.30 18 16,013.24
4/2000 75 47,209.75 21 7,825.89 9 18,13.54 31 25,476.92 2 954.30 12 11,139.10
1/2002 75 47,209.75 21 7,825.89 9 18,13.54 33 25,816.82 2 954.30 10 10,799.20
2/2001 75 47,378.75 21 7,825.89 9 18,13.54 33 27,576.92 2 954.30 8 9,208.10
Source: http://www.bnm.gov.my

ACTIVITY 14.4
ABC Bank is facing critical non-performing loan problem to the extent

that its capital is in jeopardy. Which institution can help ABC Bank and
what measures should be taken by ABC Bank and the institution
concerned?
Visit DanahartaÊs web site at http://www.danaharta/com.my,

DanamodalÊs web site at http://skali.bnm.gov.my/danamodal and
CDRCÊs web site at http://www.bnm.gov.my/index.php?ch=31 to
acquire information on how these institutions helped financial
institutions resolve their NPL problem.
14.9 THE EFFECTS OF NPL ON COMMERCIAL

BANK’S MANAGEMENT
NPL problem is a threat to the continuity of any bank. When a bank fails to
collect loan repayments as scheduled, the bankÊs cash flow will be affected. If its
NPL problem persists, the bank will experience liquidity problem and will fail to
fulfill the demand for deposit withdrawals sooner or later. NPL is the main cause
of banks failure in the United States of America two decades ago.
NPLs also affects bank profitability. When an NPL loan becomes uncollectible,
the entire loan amount will be wiped out from the books of accounts of the bank
as bad debt losses, which will deteriorate the bankÊs profitability. Provision for
doubtful debts must be made in relation to any account classified as NPL. This
further reduces bank profitability. Besides, NPLs consume the financial resources
and strength of banks.
Furthermore, NPLs have negative psychological impact, which includes loss of

self-confidence, demoralisation and disappointment, on the loan officers of
banks. After all, the NPLs concerned are indeed loans which the officers have
approved after much detailed analysis and due consideration.

Think for a moment.
Mark Twain had said „A banker is a fellow who lends you his
umbrella when the sun is shining and wants it back the minute
it begins to rain.‰
ACTIVITY 14.3
1." What skills and knowledge should a loan officer or credit officer
have in order to prevent or reduce the NPL problem?
2." What is the difference between Danaharta and Danamodal in terms
of solving NPL problem in MalaysiaÊs banking industry?
3." What effect do NPLs have on commercial bankÊs management?
•" The most effective way to manage non-performing loans (NPLs) of a bank is
to ground them from entering the books and records of the bank right at the
beginning of the lending cycle.
•" This can be done by following the 3Ps lending principle: purpose – determine
how the loan will be used, payment – identify the primary source of
repayment, protection – identify the secondary source of repayment.
•" A loan that is good initially can still turn into an NPL for reasons beyond
anyoneÊs control.
•" Loan portfolios must be monitored closely by authorised and experienced

loan officers in order to detect the warning signs of NPL as early as possible.
•" Management of NPLs requires the involvement of loan officers who are
diligent and knowledgeable in the businesses of the customers.

Bad credit DRIPS

Debt restructuring Non performing loans

" ANSWERS W"" 277
" "
"
Answers
TOPIC 1: STRUCTURE OF FINANCIAL SYSTEM IN
MALAYSIA
Exercise 1.1
1." BNM controls the supply of money in the financial system of the country by
influencing the availability of money and the cost of money with the
following methods:
•" Statutory reserve requirement
•" Minimum liquidity requirement
•" Open-market operation
•" Discount operation
•" Interest rate control
•" Credit control
•" Lending guidelines
•" Moral persuasion
2." BNM may increase statutory reserve requirement, increase minimum

liquidity requirement, sell government securities in open-market operation,
decrease discount operation by increasing discount rates, increase interest
rates, issue stringent lending guidelines, and/or negotiate with members of
the banking system to reduce lending activities.
Exercise 1.2
1." The differences and similarities between each of the following pairs are as
follows:
Bank Bank Comparison

CIMB Bank Berhad Bank Kerjasama CIMB is a commercial bank while Bank
Rakyat Rakyat is a co-operative.

278 X" ANSWERS"
Malayan Banking Agro Bank Maybank is a commercial bank while

Berhad (Maybank) Bank Agro is a development financial
institution.
RHB Bank Berhad Public Bank RHB Bank and Public Bank are
Berhad commercial banks.
Malayan Banking Mayban Maybank is a commercial bank while
Berhad (Maybank Finance Berhad Mayban Finance is a finance company.
They are both members of the banking
system in Malaysia.
AmBank Berhad Bank Arab Malaysian Merchant Bank Berhad is a
Simpanan merchant bank while BSN Commercial
Nasional Bank Berhad is a commercial bank. They
(BSN) are both members of the banking system in
Malaysia.
Agro Bank Bank Simpanan Bank Pertanian Malaysia is a
Malaysia Nasional (BSN) development financial institution while
Bank Simpanan Nasional is a savings
institution. They are both members of the
non-bank system.
Bank Bank Industri Both Bank Pembangunan Malaysia
Pembangunan Malaysia Berhad and Bank Industri Malaysia
Malaysia Berhad Berhad Berhad are development financial
institutions.
Bank Islam CIMB Bank Both Bank Islam Malaysia Berhad and
Malaysia Berhad Berhad Southern Bank Berhad are commercial
banks, but Bank Islam Malaysia is
regulated by the Islamic Banking Act 1983
while Southern Bank is regulated by
BAFIA, 1989.
Kurnia Insurance Kumpulan Wang Talasco Insurance is an insurance
Simpanan company while KWSP is a provident fund
Pekerja (KWSP) and pension fund institution. They are
both members of the non- bank system.
Malaysian Bank MIDF and Bank Pembangunan are both
Industrial Penbangunan development financial institutions.
Development Malaysia
Finance Berhad
MCIS Insurance Public Finance MCIS is an insurance company while
Berhad Public Finance is a finance company.
MCIS is part of the non-bank system
while Public Finance is a member of
the banking system.
" Copyright © Open University Malaysia (OUM)

ANSWERS W 279
BBMB Factoring BBMB Leasing BBMB Factoring Berhad is a factoring

Berhad Berhad company while BBMB Leasing is a
leasing company. They are both members
of the non-bank system.
Showa Public Leasing Showa Leasing is a leasing company
Leasing(Malaysia) and Factoring while Public Leasing and Factoring Sdn.
Berhad Sdn. Bhd. Bhd. can be either a leasing company or a
factoring company. Both are members of
the non-bank system.
2." Commercial banks are vital to the banking system of the country because
commercial banks have the capability to create money and are responsible
for the payment mechanism through their role in implementing the cheque
payment system with current accounts. Commercial banks also form the
biggest group of financial institutions in terms of assets, deposits, loans and
advances. Besides, commercial banks are the only banking institutions
allowed to conduct foreign currency businesses.
Exercise 1.3
1." A financial system is able to match the unit/group having excesses with the
unit/group having deficits.
2." The banking system consists of Bank Negara Malaysia (BNM), Islamic
banks, commercial banks, finance companies, merchant banks, discount
houses, representative offices of foreign banks and offshore banks.
Financial intermediaries in the non-bank financial system are development
financial institutions, provident and pension funds, insurance companies
including insurance companies in Labuan, and other financial institutions
such as housing credit companies, unit trust companies, leasing companies
and factoring companies.
3." BNM may increase statutory reserve requirement, increase minimum

liquidity requirement, sell government securities in open-market operation,
decrease discount operation by increasing discount rates, increase interest
rates, issue stringent lending guidelines, and/or negotiate with members of
the banking system to reduce lending activities.
4." D
5." A

280 X" ANSWERS"
6." B
7." A
8." A
9." C
10." E
11." C
TOPIC 2 BANKING AND FINANCIAL INTITUTIONS

ACT (BAFIA), 1989
Exercise 2.1
1. The new provisions in BAFIA, 1989 deal with licensing of banking
institutions. With effect from 1 October 1989, all local commercial banks,
local finance companies and local merchant banks were required to replace
their old licences with the new ones before the end of March 1990, i.e. six
months from 1 October 1989.
Old licences for foreign banks were valid for five years only. Any foreign
bank applying for the new licence must first incorporate a new company in
Malaysia.

ANSWERS W 281
All applicants of new licences under BAFIA, 1989 must fulfill the minimum
criteria in addition to the requirements stated in the old banking acts.
Briefly, the minimum criteria are as follows:
•" Every person who is, or is to be, a director, controller or manager of the
financial institution must be a qualified and proper person to hold the
particular position which he holds or is to hold.
•" At least two individuals must effectively direct the business of a
financial institution.
•" The board of directors include such number (if any) of directors without
executive responsibility as BNM considers appropriate.
•" The financial institution must conduct its business in a prudent
manner.
•" The shareholding structure of the financial institution must be in
accordance with the economic policy of Malaysia.
A licence may be revoked for reasons stated in Section 7, BAFIA, 1989. They
include:
•" Failure to fulfil the minimum criteria.
•" The breach of any condition imposed under the licence.
•" In any situation whereby the interests of the depositors, customers or
creditors are in any way threatened.
•" The appointment of a receiver or manager of the financial institution.
•" The financial institution has insufficient assets to meet its liabilities.
Exercise 2.2
1." In actual fact BAFIA, 1989 does not confer absolute power to Bank Negara
Malaysia in the management of the countryÊs financial system. All the
powers conferred by the old act still remain. BAFIA, 1989 was introduced to
spell out and update various matters considered to be legislative
weaknesses that inhibited BNMÊs capability to control and supervise the
financial system more effectively.
2." As required by BAFIA, 1989, every person who is, or is to be, a director,
controller or manager of the financial institution is a qualified and proper
person to hold the particular position which he holds or is to hold.

282 X" ANSWERS"
Exercise 2.3
1." BAFIA, 1989 imposes harsh penalties on offences committed under this
new act as these offences can have great negative impact on the general
public. The act is determined to inject more discipline into the conduct of
the financial sector.
2." BAFIA holds the bank officers accountable for any offence committed by
the bank because they are liable to comply and execute all rules and
regulations pertaining to the operations of the bank. Nevertheless, they can
avoid being prosecuted if they can prove that they have exercised all
necessary care and diligence in complying with the rules and regulations
and the offence was attributed to factors beyond their control.
3." In the new millennium, BAFIA, 1989 may have to be revamped once again
to handle new challenges in and around the banking industry, especially in
relation to banking businesses involving the use of information technology.
TOPIC 3 BRANCH BANKING
Exercise 3.1
1." Commercial bank branches are considered profit centres and not cost
centres because bank branches are capable of producing profits through
lending and investment activities.
2." The Bank Perdana Berhad branch is still considered a profit centre because
deposits collected by the branch are channelled to the head office to finance
lending businesses.
3." A bank with a wide network of branches has the following advantages over
a bank without a branch network:
•" Better services for the general public
•" More effective use of the bankÊs resources
•" Broader diversification of assets and deposits
•" More effective mobilisation of funds
•" Better services for existing customers
•" Better competitive edge

ANSWERS W 283
4." The more branches a bank has, the better the opportunity to produce
profits. The larger banks in our country are the ones making the most
profits, and they are also the ones with the widest network of branches.
Exercise 3.2
1." (a) That was not a wise move as it would not help to solve the problem.
Puan Zakiah should have supported her request for additional staff
from head office with concrete reasons.
(b) It was an appropriate action since Puan Zakiah was not able to help
the customer.
(c) Such action was inappropriate because the staff attendance register is
an official record of any bank.
2." (a) This is an innovative move which should be encouraged among

branch managers.
(b) The said action or proposal is incorrect as customers should be given
the opportunity to make their decisions respectively.
(c) Although such action provides the competitors with opportunities, it
enhances the bankÊs image by showing that the bank is attentive to
the customersÊ needs, as opposed to being interested in acquiring
profits only.
3." (a) Evaluation of branchesÊ performance can be done by comparing

actual performance with estimated performance.
(b) Evaluation criteria as set out in Table 3.5.
(c) Performance measurements as set out in Table 3.6.
(d) Non-acceptance of evaluation criteria and measurements by the
person being appraised is the main problem in business performance
evaluation.
4." E
5." A
6." A

284 X" ANSWERS"
TOPIC 4 ISLAMIC BANKING
Exercise 4.1
1." The similarities and differences between Al-Mudharabah trade finance and
Al-Musyarakah trade finance are:
Al-Mudharabah Al-Musyarakah
Similarities Both involve profit sharing based on mutually agreed ratio.
Both involve detailed credit analysis before any financing is granted.
Differences •" Capital is contributed by •" Capital is contributed by
banks only. banks and their customers.
•" Banks are not involved in the •" Banks have the right to be
affairs of their customersÊ involved in the affairs of their
businesses. customersÊ businesses.
•" Losses are borne by banks •" Both parties bear the losses
only." based on equity participation.
2." The similarities and differences between Al-Murabahah letter of credit and
Al-Musyarakah letter of credit are:
Al-Murabahah Al-Musyarakah
Similarities Both provide credit facility to importers to finance imports.
Differences •" Importers are not required •" Importers are required to
to contribute capital in the contribute capital in the
form of deposits. form of deposits.
•" Banks do not have any •" Banks and importers share
share in the profits derived the profits derived from
from the sales of the the sales of the imports.
imports.
•" Losses are borne by both
•" Losses are borne by banks parties based on equity
only." participation."

ANSWERS W 285
Exercise 4.2
1. Comparison between Islamic banking system and conventional banking
system:
Islamic Banking System Conventional Banking System

Non-riba based income. Riba based income.
Profit sharing. Banks receive interest paid by
t
Relationships between banks and customers Creditor–debtor like relationships,
are that between business partners. biased
Main objectives are to make profits and take Main objective is to make profits for
care of public welfare. shareholders.
TOPIC 5 ASSET MANAGEMENT
Exercise 5.1
1." LP dilemma in asset management is the dilemma to choose between
liquidity and profitability. If a bank focuses on investment in liquid assets,
it will have to sacrifice its profitability because liquid assets generate low
rates of return. Conversely, if a bank emphasises on profitability in its asset
investments, it will have to forgo liquidity since assets with high rates of
return are usually less liquid.
This dilemma exists in asset management because of differences in interests

among the groups involved, i.e. shareholders, depositors and Bank Negara
Malaysia. Shareholders desire high rates of return while depositors want
asset liquidity so that they will face no difficulty in withdrawing their
deposits at any time. At the same time, Bank Negara Malaysia or the central
bank requires banks to uphold both profitability and liquidity for the
security of the banking system.
2." The similarities between fund pool method and asset allocation method are:
•" Both methods allocate funds among the same asset categories.
•" Both methods do not provide specific guidelines on allocation of funds.
They provide general guidelines only.
•" Both methods do not recognise loan portfolio as a source of liquidity.

286 X" ANSWERS"
•" Both methods have similar sources of funds.

•" Both methods fail to appreciate the fact that long-term security of a
bank depends on its ability to generate sufficient income.
•" Both methods do not take into account the fact that asset management
and liability management are indeed mutually interactive.
The differences between fund pool method and asset allocation method are:
•" Fund pool method gathers all sources of capital into a single pool of
fund while the asset allocation method considers each source of fund as
a stand-alone profit centre.
•" Fund pool method is liquidity-oriented while asset allocation method is
profitability-oriented.
Exercise 5.2
1." Five reasons why any commercial bank needs bank liquidity:
•" To build financial marketÊs confidence in the bank so that the bank will
be able to obtain financing in future.
•" To gain the trust of depositors and borrowers and develop long-term
relationships with them.
•" To avoid selling valuable assets to fulfill the liquidity needs of
depositors or borrowers.
•" To pay low risk premium for financing.
•" To enable the bank to use the financing facility offered by Bank Negara
Malaysia.
2." Deposit liquidity means liquidity that is able to fulfill depositorsÊ

withdrawal demands at any time.
Loan liquidity means liquidity that is able to fulfill the loan needs of eligible
borrowers.
3." The similarities of bank liquidity theories are:

• All theories link the bank liquidity concept with the lending policies of a
bank. For example, commercial financing theory declares that a bank is
considered liquid if its loan portfolio consists of short-term loans. Shift
ability theory stresses that in order to ensure bank liquidity, a bank

ANSWERS W 287
should invest part of their funds in loan portfolio and securities that
have secondary market. Expected income theory advocates that loan
repayments should be matched with the expected income of the
borrower. According to liability management theory, banks can fulfill
liquidity requirement by borrowing from the financial market.
• Commercial financing theory and shift ability theory describe bank
liquidity based on stock concept, i.e. the liquidity of a bank is backed by
its liquid assets.
• Expected income theory and liability management theory uses a flow
concept, i.e. the liquidity of a bank is indeed supported by its cash flow.
The differences among bank liquidity theories:

• Expected income theory recognises loan portfolio as a source of bank
liquidity, but the other three theories do not.
• Liability management theory recognises external sources as liquidity
sources, but the other three theories do not.
Exercise 5.3
1. (a) Change Change
SRR Surplus/
Month Deposit in Loan in
(10%) Deficit
Deposit Loan
March 586 - - 356 - -
April 591 5 0.5 365 9 (4.5)
May 606 15 1.5 356 (9) 22.5
June 620 14 1.4 345 (11) 23.6
July 615 (5) (0.5) 330 (15) 10.5
August 616 1 0.1 341 11 (10.1)
September 655 39 3.9 341 0 35.1
(b) (1) Borrow to overcome cash deficit.

(2) Read just deposit and loan estimates.
(c) The disadvantages of the loan comparison method are:

•" It is dependent on the accuracy of the estimates.
•" It does not takes any account of other sources of cash flow.

288 X" ANSWERS"
(d) Even though both banks have the same loan-to-deposit ratio, they
may not have similar liquidity level.
TOPIC 6 BANK’S LIABILITY MANAGEMENT
Exercise 6.1
1." Specifically, liability management means a bankÊs activities of sourcing
funds from the financial market by way of borrowing from other banking
institutions with the objective to fulfill the bankÊs liquidity needs.
Generally, liability management refers to a bankÊs activities of acquiring
funds from depositors or other fund providers in the financial market, and
determining the adequate mix of funds by weighing the cost and the rate of
return of each source of funds.
2." The similarities between current accounts and savings accounts are as
follows:
•" Both types of accounts are for customers to keep their deposits.
•" Both types of accounts are offered by commercial banks.
•" Both types of accounts allow customers to make withdrawal at any
time.
The differences between current accounts and savings accounts are as follows:
•" Savings accounts provide returns in the form of interest to the
customers, but current accounts do not provide any returns.
•" Only commercial banks are allowed to offer current account facility.
•" The terms relating to the opening of savings accounts are more relaxed
than that related to the opening of current accounts.
•" Withdrawals from current accounts are done via cheques while
withdrawals from savings accounts are done via passbooks. However,
both types of accounts allow withdrawals via ATM.
The similarities between savings accounts and fixed deposit accounts are as
follows:
• Both types of accounts are for customers to keep their deposits.
• Both types of accounts provide customers returns in the form of
interest.

ANSWERS W 289
The differences between savings accounts and fixed deposit accounts are as
follows:
• The interest rates on fixed deposits are different from the interest rates
on savings deposits.
• Savings deposits can be withdrawn at any time. On the contrary, fixed
deposits except NCDs can only be withdrawn on maturity of the
respective deposits.
• Withdrawals from savings accounts are done via passbooks whereas
withdrawals from fixed deposit accounts are done via the presentation
of the relevant fixed deposit certificates.
• Fixed deposits have various maturity tenures but savings accounts have
no maturity dates.
3." Banks shifted their focus from asset management to liability management
for several reasons. Firstly, banks were facing shortage of funds as the
demand for loans was growing at a faster rate than the supply of
deposits. Secondly, banks were forced to look for alternative sources of
funds due to shortage of deposit funds. Thirdly, the emergence of
innovative financial instruments such as NCD, FRNCD and REPOS
presented enough motivation factors for banks to focus on solving
financing problems. Fourthly, unstable interest rates made the task of
acquiring funds even more complex. Fifthly, banks were losing depositors
due to strong competition from other financial intermediaries.
Exercise 6.2
A campaign to increase deposits must take into account all factors influencing
customersÊ deposit decisions. The next step involves working out how to use
these factors to attract customers. For example, if deposit interest rates are
important to customers, then it is only wise to work out how to use this factor to
attract customers.
TOPIC 7 ASSET AND LIABILITY MANAGEMENT
Exercise 7.1
1." Bank asset management and liability management decisions must be made
simultaneously to ensure that both types of financial decisions are in
agreement with each other. Making these two types of decisions on a

290 X" ANSWERS"
separate basis will lead to problems relating to allocation of funds. For

example, if the asset management team of a bank makes investment
decisions without any knowledge of the sources of finance, the investments
may end up requiring more funds than what is readily available. That
means additional funding will have to be sourced in haste and at a higher
cost. At the same time, without any knowledge of investment decisions, the
liability management team may be acquiring funds at unnecessarily higher
costs. The advantages of simultaneous management of both assets and
liabilities certainly outweigh the additional work required. The bank
management will undoubtedly realise that the coordination between asset
management decisions and liability management decisions can help the
bank achieve the optimum cost of funds.
2." The similarities between asset management decisions and liability

management decisions of banks are as follows:
•" Both types of decisions are made to ensure bank liquidity.
•" Both types of decisions are made to ensure that there will be sufficient
funds to fulfill deposit withdrawals.
•" Both types of decisions are made to ensure that there will be sufficient
funds to fulfill the requests for loans.
•" Both types of decisions are made to up hold the net profit margin and
profitability of banks.
The differences between asset management decisions and liability

management decisions of banks are as follows:
•" Asset management decisions are investment decisions while liability
management decisions are financing decisions.
•" Asset management decisions involve allocation of available funds
among various categories of assets while liability management
decisions involve acquisition of funds for banks.
3." To find out what factors influence net profit margin, we have to look at the
net profit margin formula first:
Interest received – Interest Paid

Net profit margin =
Acquired assets

ANSWERS W 291
As seen in the formula, net profit margin is influenced by three main

factors, i.e.:
Interest received, interest paid and acquired assets. The most critical
relationship is the one between interest received and interest paid, which is
sometimes known as interest scatter. The bigger their difference is, the
higher the net profit margin. Besides, the rates of change of these three
factors can also have a bearing on net profit margin.
Exercise 7.2
Fund gap management in different interest rate scenarios:
•" When interest rates are rising – widen the fund gap.
•" When interest rates are at their peaks – fund gap should be at its widest.
•" When interest rates are declining – narrow the fund gap.
•" When interest rates are at rock-bottom levels – fund gap should be at its
narrowest.
TOPIC 8 BANK’S CAPITAL MANAGEMENT
Exercise 8.1
Type of Capital Advantage Disadvantage

Ordinary shares •" Since dividend payment •" Dividend payments
is not mandatory, bank are not tax
income will not be deductible.
reduced by any fixed •" Have the highest
payment. capital cost
•" No external claims compared to other
against bank. sources of capital.
•" No maturity dates. •" Issuance of new
shares can dilute the
owner ship of
existing
shareholders.

292 X" ANSWERS"
Bonds •" Interest payment is tax •" Interest payments

deductible. are fixed and must
•" Have the lowest capital be made regardless
cost because interest of whether the
payment is tax bank is profitable.
deductible. •" Failure to make
•" Provide financial interest payment can
leverage. result in the bank
being liquidated.
•" Financial risk of the
bank increases with
the amount of bonds
used.
Convertible •" Have the advantages •" Have the
securities of both ordinary disadvantages of
shares and bonds. both ordinary shares
and bonds.
Preference shares •" Dividend payments •" Dividend payments
can be accrued. are fixed although
•" No maturity dates. they can be deferred.
•" Can avoid diluting the •" Dividend payments
ownership of ordinary are not tax
shareholders. deductible.
Exercise 8.2
The three main functions of bankÊs capital are operation function, protection
function and supervision function. Protection function is to cushion occasional
losses so that depositors are protected at all times. In the alliance of the three
functions, the second function is to provide funds for buildings, equipment and
other non-income assets that a bank requires for operation purposes. Clearly, this
is the operation function. The alliance also takes into account the obligation to
fulfill the requirement enforced by the regulatory body regarding capital
adequacy in connection with risk exposure. This is indeed the supervision
function.

ANSWERS W 293
Exercise 8.3
1. Five incidents that can trigger a bank run:
•" Rumours regarding bank stability
•" Losses to the extent of wiping out the accumulated capital
•" Losses to the extent of jeopardising bank liquidity
•" Any extraordinary investment that involves high risk
•" Failure of other banks in the banking system
2. (a) The bank run at International bank of Asia (IBA) was caused by three
reasons:
•" The general public had lost confidence in the stability of the bank.
•" Rumours regarding the operations of the bank.
•" Non-performing loans of the bank were on the rise.
(b) The three parties made their respective statements to assure the public
of bank security in Hong Kong. The Hong Kong leader wanted to
assure the public that the fundamentals of the banks in Hong Kong
were strong. The Monetary Board, by expressing its confidence in
IBAÊs stability, wanted to ensure that the stability of the financial
system in Hong Kong would remain intact. The board of directors
wanted to assure the shareholders and depositors that IBA was able to
fulfill all deposit withdrawals and to meet all of its other obligations.
(c) One of the actions would be to let the branch open until night with an
objective to assure the public that the bank is able to meet all deposit
withdrawal demands. We could also make announcements on special
offers related to loans, as a measure to ensure the public that we
certainly had enough funds not only for deposit withdrawals but also
for loan purposes.
(d) The most recent bank run involved MBf Finance Berhad as many
depositors believed in the rumours regarding the demise of the
companyÊs Chief Executive Officer.

294 X" ANSWERS"
TOPIC 9 CAPITAL ADEQUACY
Exercise 9.1
The Relationship between BankÂs Security and Capital Adequacy Bank security
refers to safeguarding the interests of the depositors, borrowers, banking
regulatory body and public. A secure bank is one that is able to fulfill deposit
withdrawals at any time, to grant loans to all eligible borrowers, to help the
regulatory body ensure the stability of the banking system as a whole and to
make the public feel confident in dealing with the bank. Such security can be
supported by adequate capital that can absorb all losses that arise. If the losses
cannot be absorbed, bank operations will cease, depositors will lose their
deposits, customers will not be able to obtain loans, the banking system will be
under threat due to the failure of a bank, and the general public will lose.
TOPIC 10 LENDING POLICY
Exercise 10.1
1. There is a definite and close relationship between the principle of purpose
and the principle of payment that ensures the soundness of a bankÊs credit
decisions. The principle of purpose requires credit officers to establish the
purpose of loan before making any credit decision. Only after it has been
confirmed that the purpose of the loan is valid and consistent with the rules
and policy set by the bank, the source of loan repayment can be identified.
This is where the principle of payment plays its role in credit decision
making. For example, if the purpose of the loan is for working capital, then
we can expect the income generated from the use of the loan (working
capital) as the source of repayment. Hence, the principle of purpose must
be in line with the principle of payment, or vice versa.
2. Should any one of the principles be neglected or excluded from the decision
making process, the credit decision will likely be vulnerable. For example, if
we evaluate a loan application based on the principle of purpose and the
principle of protection only, i.e., without taking account of the principle of
payment, we are bound to have non-performing loan (NPL) problem since
the source of loan repayment should be the borrower Ês income and not the
collateral.

ANSWERS W 295
Exercise 10.2
1. Lending policy should provide definite and effective guidelines in order to
facilitate effective lending activities. These guidelines should include
matters related to the evaluation of loan applications, as well as all matters
related to the supervision and management of approved loans. Lending
policy should also be effective and clear enough to guide new credit
officers.
2. (a) Three external factors that can influence the lending policy of a
commercial bank:
(i) Economic Situation

Economic situation can influence the lending policy of a
commercial bank because the demand for banking products and
services is closely related to the prevailing economic situation. If
the economy is in recession, the demand for banking products
and services will decrease, a result of the decrease in demand for
the goods, products and services sold by bank customers.
Economic recession means general slowdown in economic
activities, which definitely affects the lending and investment
activities of any bank.
(ii) Monetary Policy

The countryÊs monetary policy is influential to the lending
policy of a commercial bank because the availability of bank
funds is determined by the monetary policy practised by the
government. If the government practises contractionary
monetary policy, i.e. the policy that reduces the supply of money
in the country, the bank will have less financing for lending
activities. That means the bank will have to reduce its lending
activities and or be more selective in lending.
(iii) Fiscal Policy

Fiscal policy such as taxation policy practised by the
government can also influence the direction of a bankÊs lending
policy. If the government provides greater tax protection or tax
relief for bank loans offered to a certain economic sector, the
bank will definitely skew its lending activities towards the
economic sector concerned.

296 X" ANSWERS"
(b) Two internal factors that can influence the lending policy of a
commercial bank:
(i)" Capital Position

The bigger the capital base a bank has, the more risk-weighted
loans it can offer. A bank may have to increase its capital in
order to provide more loans and to fulfill CAR requirement at
the same time.
(ii) Stability of Deposits

A stable deposit base can facilitate lending activity planning.
When we talk about deposit stability, indeed we make reference
to the volatility level of each type of deposits; the higher the
volatility level, the less stable a deposit. The level of credit risk
acceptable to a bank depends on the amount and stability of the
deposits placed with the bank.
Factors that can influence the lending policy of banks are ranked as
follows:
1. Capital position;
2. Stability of deposits;
3. Economic situation;
4. Bank staffÊs capability and experience; and
5. Monetary and fiscal policies of the country.
Internal factors are accorded with higher ranking because banks are able to
control these factors, while external factors are indeed beyond the control of
any bank.
TOPIC 11 CREDIT ANALYSIS
Exercise 11.1
1." Bankers have to conduct credit analysis to evaluate the credit integrity of
loan applicants. Through credit analysis, bankers can decide whether the
loan applicant concerned will be able to fulfill loan repayment obligations.
Credit analysis is also used to assess the probability of non-payment by
each customer.

ANSWERS W 297
2." The character element can be evaluated in several ways. The first approach
involves interviewing the loan applicant to assess his willingness to repay
the loan. The second approach involves obtaining information from any
other bank or financial institution that has granted credit facility to the
applicant. Other sources of information include the applicantÊs creditors
and suppliers, and any trade association that has a relationship with the
applicant.
3." The conditions element refers to any economic situation that may affect the
credit integrity of a loan applicant. In the evaluation of this element, the
credit officer has to consider all factors, such as technology, that may
influence the demand for the applicantÊs products. Factors that have
negative impact on the demand for the applicantÊs products will also have
negative impact on the applicantÊs income, hence his loan repayment
capacity.
4." The capacity element is important in credit analysis because it is related to

the legal capacity and financial capacity of the loan applicant. If a bank
grants a loan to an applicant who has no legal capacity to obtain a loan for
himself or for his company, the bank is likely to face much difficulty
recovering the loan. Financial capacity can be evaluated with ratio analysis
and cash analysis on the applicantÊs company.
Exercise 11.2
1." Collateral evaluation in credit analysis is about examining the collateral
proposed by a loan applicant and determining if it is acceptable to the bank.
Characteristics such as liquidity and marketability of the proposed
collateral are to be examined thoroughly to determine if the collateral can
adequately protect the bankÊs interests.
2." The capital of a loan applicant shows the applicantÊs contribution towards
the success of his company. The retain earnings of a company shows to
what extent the company has achieved success. The accumulated growth
profits of a company shows the financial growth of the loan applicant. All
of these signs show the commitment level of a loan applicant towards his
business. The more capital is retained in his business, the more committed
the loan applicant is in achieving success for the business.

298 X" ANSWERS"
TOPIC 12 PRICING POLICY
Exercise 12.1
1." If the pricing policy of a bank is not properly formulated, the bank is likely
to over-price or under-price its products and services. If its prices are too
high, customers will shun the bank. That means less income for the bank.
Conversely, if its prices are too low, the bank may attract more customers,
but at the expense of profitability, since the prices may not have
incorporated all the relevant costs.
2." Originally, base lending rate (BLR) comprised these elements:

Cost of funds + Overhead cost + Staff cost + 0.25% Profit margin
The formula used presently for the calculation of commercial banksÊ BLR is:
BNM 3-month intervention rate × 0.8

BLR = + 2.5%
1 – SRR%
BNM intervention rate is a rate fixed by BNM to represent the cost of funds
of banks. „0.8‰ figure is the provision for adjustment pertaining to zero-
interest current account balances; „2.5%‰ is to take into account the
administrative cost borne by the bank, and nominal profit margin; „1 –
SRR%‰ is to take into account the statutory reserve requirement (SRR).
For example, letÊs say the intervention rate is 4% and the SRR rate 3.5%,
commercial banksÊ BLR would be:
4% × 0.8
BLR = + 2.5%
1 − 3.5%
= 3.31% + 2.5%
= 5.81%
3." Bank Perdana Berhad is about to approve the following loans applications:
•" Application by a lawyer for a loan to purchase a house.
Interest rate imposed should be BLR (i.e. 6%) + 1.5% = 7.5% because
housing loan is fully secured by the house concerned. Since the credit
risk is not so high, the risk premium should not reach the maximum
mark of 2.5%.

ANSWERS W 299
•" Application by an entrepreneur for a loan to buy consumer goods.

The maximum risk premium of 2.5% should be imposed since
consumer loans have the highest credit risk. Therefore the interest rate
charged on this loan should be 6% +2.5% = 8.5%.
•" Application by the state government for a loan to build a bridge.
This loan should be charged BLR rate.
TOPIC 13 COLLATERAL POLICY
Exercise 13.1
1." Collateral is still required despite the purpose of the loan and the loan
repayment capacity of the borrower is adequate because of the existence of
uncertainties which can affect the borrower and his business in future, and
hence his loan repayment capacity. Collateral is required to protect the
interests of the depositors specify, and generally the interests of the bank.
2." Various types of loans and the relevant collateral:

Type of Loan Collateral
Term loan to finance construction of a factory Mortgage on the new factory
Working capital loan Assignment of rights
Loan for the purchase of furniture and other Mortgage on the to-be acquired assets
equipment
Loan for the purchase of shares To-be acquired shares
Loan to finance corporate takeover Interests in the to-be acquired company
Personal loan Third party guarantee
Housing loan To-be acquired house
Education loan Third party guarantee
3. It is difficult to dispose off any collateral that lacks marketability, i.e. no

ready market available. In other words, it is difficult to convert this type of
collateral into cash. The bank involved may have to hold the collateral for a
long time before it can be sold. This translates into high holding cost and
losses to the bank. Due to lack of marketability, the bank may even have to
sell the collateral at a low price.

300 X" ANSWERS"
TOPIC 14 NON-PERFORMING LOAN (NPL)

MANAGEMENT
Exercise 14.1
1." In general, a non-performing loan is a loan that has not been repaid in
accordance with the loan agreement. BNM defines a non-performing loan
as a loan whereby its interest has not been paid for at least 6 months.
2." NPL and bad debt are not exactly the same. They are similar to the extent
that they both can jeopardise the profitability of any bank. Non-performing
loan is a loan that still has the possibility of being collected. A bad debt is a
loan that can no longer be collected from the borrower and will be written
off from the books of accounts of the bank concerned. An NPL that can no
longer be collected will become a bad debt.
3." 5Cs of good credit are used by bankers to ensure the soundness of their
credit decisions while the 5Cs of bad credit explain the causes of non-
performing loans. Bankers can use 5Cs of bad credit as a guide to ensure
that their credit decisions do not comprise any of those bad elements.
4." „Complacency‰ refers to a credit officer Ês over-dependence on collateral to

the extent that other principles in lending such as the principle of payment
and the principle of purpose are forgotten or neglected. All the three
principles in lending must be taken into account in every credit decision.
Exercise 14.2
(a)" Deterioration in the CompanyÊs Current Ratio
Deterioration in the companyÊs current ratio means deterioration in the
companyÊs liquidity. This shows the deterioration in the companyÊs
capacity to repay short-term debts. That means there is a high probability
that the company may have difficulty meeting its debt repayments in
general.
(b)" Liened Assets

The existence of lien means there is some restriction on the ownership of
the asset. This will affect the companyÊs eligibility and ability to sell the
asset to make loan repayment when the needs arise.

ANSWERS W 301
(c)" Increasing Debt Ratio

Increasing debt ratio shows that more and more debts have been used by
the company to finance its operations. This can lead to higher financial risk,
hence higher credit risk. Such problems, if not contained, will appear in the
form of NPL.
(d)" Overly Optimistic Budgets

Overly optimistic budgets will probably result in NPL because the actual
financial achievement of the company may not generate sufficient
repayment capacity to repay the loan obtained based on the overly
optimistic budgets.
(e)" Loss of Key Customer

A lot of companies are overly dependent on their key customers, who are
usually few. Any company that practises this business strategy is indeed
taking a high level of risk; the companyÊs cash flow can be seriously
affected in the event that the company loses any of its key customers. That
means the companyÊs capacity to repay loans will be jeopardised too.
(f)" Borrower is Suffering from Serious Illness

Some companies are very dependent on their owners, especially if the
owners are hard-working and committed. Any company that fits into this
category is likely to face deterioration in its operation and performance
should anything happen to its owner, for example, if its owner is suffering
from any serious illness. This means loan repayment will become a
problem.
Exercise 14.3
1. A loan officer or credit officer should have the following strengths in order
to prevent or alleviate NPL problem:
•" Competence in corporate analysis
•" Ability to evaluate loan applications
•" Possession of at least minimum knowledge and experience
•" Interpersonal relationship skills
•" Desirable character traits

302 X" ANSWERS"
2. Danaharta was a vehicle set up to take over NPLs from the affected banking
institutions so that these institutions could carry on their lending activities
as per normal. Danamodal was a vehicle set up to inject fresh capital into
the banking institutions facing capital inadequacy problem as a result of
severe NPL problems. Banking institutions receiving capital injection from
Danamodal were required to hand over their NPLs to Danaharta.
3. NPLs can affect the following aspects of bank management:

•" Bank profitability
•" Bank liquidity
•" Bank capital adequacy
•" Bank staffÊs psychology

MODULE FEEDBACK
MAKLUM BALAS MODUL
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OR
2. Fill in the Print Module online evaluation form available on myVLE.
Thank you.
Centre for Instructional Design and Technology

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BBBM4103

Copyright © Open University Malaysia (OUM)

Module Writer: Shamsudin Ismail

Moderator: Assoc Prof Dr Shamsubaridah Ramlee

Developed by: Centre for Instructional Design and Technology

Printed by: Meteor Doc. Sdn. Bhd.

First Edition, August 2007

Copyright © Open University Malaysia (OUM)

Topic 1 Structure of Financial System in Malaysia 1

Topic 2 Banking and Financial Institutions Act (BAFIA) 1989 41

Copyright © Open University Malaysia (OUM)

2.3 The Effect of BAFIA, 1989 on the Management of

Topic 3 Branch Banking 55

Topic 4 Islamic Banking 74

Topic 5 Asset Management 94

Copyright © Open University Malaysia (OUM)

5.8 Liquidity Measurement 120

Topic 6 BankÊs Liability Management 128

Topic 7 Asset and Liability Management 141

Topic 8 BankÊs Capital Management 152

Copyright © Open University Malaysia (OUM)

Topic 9 Capital Adequacy 166

Topic 10 Lending Policy 189

Topic 11 Credit Analysis 204

Copyright © Open University Malaysia (OUM)

Topic 12 Pricing Policy 232

Topic 13 Collateral Policy 247

Topic 14 Non-Performing Loan (NPL) Management 257

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

COURSE GUIDE DESCRIPTION

As an open distance learner, you should be acquainted with learning

Copyright © Open University Malaysia (OUM)

Table 1: Estimation of Time Accumulation of Study Hours

Copyright © Open University Malaysia (OUM)

Topic 3 discusses the advantages and disadvantages of branch banking as well as

Topic 8 discusses banksÊ capital management by looking at the types and

Topic 11 focuses on commercial banksÊ credit analysis. Main topics in this

Copyright © Open University Malaysia (OUM)

Topic 12 explains commercial banksÊ pricing policy by exploring the historical

Topic 13 discusses commercial banksÊ security policy through topics such as

Topic 14 covers matters related to non-performing loans (NPL) such as the

TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Activity: Like Self-Check, the Activity component is also placed at various

Copyright © Open University Malaysia (OUM)

References: The References section is where a list of relevant and useful

Peter, S. R. (2001). Commercial bank management (5th ed.). Boston: McGraw-

Shamsudin Ismail. (2002). Pengurusan bank perdagangan di Malaysia, Jilid 2.

Shamsudin Ismail. (1989). A survey of commercial bank lending practices in

Copyright © Open University Malaysia (OUM)

TAN SRI DR ABDULLAH SANUSI (TSDAS)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

1.1 FINANCIAL SYSTEM IN MALAYSIA

Financial Institutions Financial Markets