FIN 2024 Financial Institutions and Markets

Tutorial 2 Financial Institutions – Banks (1)

Discussion Questions:
Commercial banks are usually the backbone of an economy in terms of the circulation of
money. They provide the main avenue source to store money, as well as to borrow money in
an economy. However, they have come far from being a basic deposit and loan provider.
In your opinion, why do banks have (or want) to go the extra mile to provide more than
basic banking services?
The question of why banks offer more than basic banking service is a subjective one. The
question is not examinable but is get the students to think more about the financial
institution’s point of view rather than the public, in which probably students never thought
of before. Tutors may give ideas such as:
a) The competitive nature of the industry requires banks to offer one-stop financial solutions
to the clients. For example, the customer find the retirement plan
b) Bank Negara’s initiatives in developing a more inclusive financial system through financial
institutions.
c) They have lower costs to set up these services due to the benefit of economies of scale.
They can leverage their existing database and workforce to effectively roll out new services.
So it is realistic for them to do so.

Why banks provide more than basic banking services is a subjective question. This question
is not testable, but makes students think more about the views of financial institutions than
the public, and students may never think about it. The instructor may suggest the following
ideas:
a) The competitive nature of the industry requires banks to provide customers with one-stop
financial solutions.
b) Negara Bank's initiative to establish a more inclusive financial system through financial
institutions.
c) Because of the benefits of economies of scale, they have a lower cost of establishing these
services. They can use existing databases and employees to effectively launch new services.
Therefore, it is realistic for them to do so.

Short Discussions
1) Discuss the different functions of commercial and investment banks by looking at
how they generate income. Complement your answers by looking at how are they
important to the economy.
Both commercial and investment banks are called banks but they serve very
different purposes in the financial system.
Commercial banking generally has 3 functions:
 Deposits and savings (deposits transaction & activities)
 Providing finance
 Payments (provide mobile, internet banking , telegraphic transfer service)

Banks generate income majority from Interest Income

Commercial banks’ major source of income is from their interest income that is
derived from their lending operations.
Banks also generate income from
 Commissions and Fees
 Commissions from investment products:
 Mutual funds
 Insurance products
 Retirement products
 Service Charges
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  ATM machines
 Credit card machines
 Investment income (for company who place some the investment such as: nestle, FN
,if they sold will get the capital gain)
 Dividends from financial assets
 Disposing of financial assets
 Other income
 Foreign exchange
 Disposal of properties
 Insurance premium (if there is insurance arm)

Investment banks perform a variety of crucial functions in financial markets:

 Underwriting - Underwrite the initial sale of stocks and bonds
 Dealmaker in mergers, acquisitions, and spin-offs
 Other functions
Investment banks do not primarily earn money from interest income, even if they do, it is to
complement their core functions which are in trading of securities, advisory, underwriting
and broking services. They provide deposit and loan services to their clients for a bigger goal,
in earning commissions and profit margins revenue from trading of financial assets.
Investment banks primarily profit from advisory fees, service fees, trading commissions and
selling of financial securities.

Commercial banks and investment banks are both called banks, but their service purposes in
the financial system are completely different.
Commercial banking usually has 3 functions:
• Deposits and savings
•Funding
•payment

Banks generate most of their income from interest income

The main source of income of commercial banks comes from interest income generated by
their lending business.
Bank also from
 Commissions and fees
 Commission for investment products:
 Mutual funds
 Insurance products
 Retirement products
Service fee
 ATM
 Credit card machine
Investment income
 Dividends from financial assets
 Disposal of financial assets
 Other income
Forex
Property disposal
 Insurance premium (if there is an insurance department)

Investment banks perform various key functions in financial markets:

Underwriting – help company to get listed.
• Underwriting-Underwriting the initial sale of stocks and bonds
• Dealers in mergers, acquisitions and spin-offs
•Other functions
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Investment banks mainly do not make money from interest income. Even if they make
money, it is only to supplement their core functions in securities trading, consulting,
underwriting and brokerage services. They provide customers with deposit and loan services
to achieve the greater goal of earning commissions and profits from financial asset
transactions.
Investment banks mainly profit from consulting fees, service fees, transaction commissions
and financial securities sales.

2) Discuss how an overdraft facility works in providing financing to clients through

current accounts. Discuss the types of clients who would benefit from an overdraft
facility and provide an example of how would it be useful in a business scenario.
An overdraft facility allows customers to borrow up to a stated maximum amount or
limit, through the customer’s current account. The amount borrowed at any time is
the negative balance on the customer’s account. Swings between credit and debit
balances can occur as deposits and withdrawals are made when the overdraft facility
is utilised. Businesses find this useful as a facility to solve mismatches in the timing
of their receipts and payments. This means that the balance in the client’s current
account can swing from positive to negative depending on the cash flows of the
business.
Students may create a business scenario when an overdraft facility may be useful to
solve short term cash timing issues from using the account to pay account payable
items while waiting payments from account receivables come in to settle the
balance.
An example would be as follows: Patrick runs a wholesale trading operation. His
suppliers require payment of RM50,000 from last week’s shipment but his business
current account is left with a balance of RM20,000. His overdraft facility allows him
to write a cheque for RM50,000 without bouncing but his account will show –
RM30,000. Each day that he does not settle the deficit, the banks will accumulate
interest based on the balance. 5 days later, Patrick’s customer made a payment of
RM60,000. Patrick’s balance in the account will end up to be RM30,000 before
interest payments at the end of the month.

The overdraft limit allows customers to borrow the maximum amount or limit of
funds through the customer's current account. The amount borrowed at any time is
the negative balance in the client's account. When deposits and withdrawals are
made using overdraft lines, fluctuations may occur between credit balances.
Companies find this feature very useful and can solve the problem of mismatch
between revenue and expenditure. This means that the balance in the client's
current account can change from positive to negative, depending on the company's
cash flow.

When the overdraft facility can be used to solve the problem of short-term cash
injection time, students may create a business plan that uses the account to pay the
amount payable while waiting for the balance from the accounts receivable to settle.
An example is as follows: Patrick runs a wholesale trading business. His supplier
asked for a payment of RM50,000 from the shipment last week, but his business
current account balance was RM20,000. His overdraft limit allows him to write a
check of RM50,000 without bouncing, but his account will show –RM30,000. When
he does not settle the deficit every day, the bank will accumulate interest based on
the balance. Five days later, Patrick's client paid RM60,000. Patrick's unpaid interest
balance before the end of the month will be RM30,000.

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 Overdraf facility is the simply the back up funding for businesses. Individual usually
does not use this function.The purpose is enable the corporation to manage the
working capital of management. In the event , there have the problem of mismatch
problem between the creditor and debtor, then the corporation will utilize this
function.

3) Discuss why commercial banks charge higher interest rates to borrowers of

unsecured loans in comparison to secured loans.
With a secured loan, the bank takes security from the borrower, as protection
against the risk that the borrower may default and fail to repay the loan or an
instalment on the loan. Collateral may be provided in the form of an asset or several
assets. If the borrower defaults, the bank has the right to obtain repayment by
taking control of the secured asset and selling it to repay the loan.

With unsecured loans, the bank evaluates past track record, income capacity
integrity and so on to approve the loans on an unsecured basis. They generally come
with higher interest rates due to higher risks that the bank undertakes. It is different
than a secured loan where there is a certain amount of value to back up a loan
whenever things turn sour.

The willingness of a bank to accept unsecured loans depends solely on the bank’s
judgement on the ability of the borrower to repay the funds. Usually, it’s based on
the income capacity of a person. Because of this, the risk that the banks undertake
for such loans is higher, which requires a higher return in the bank’s perspective.

With a mortgage loan, the bank can obtain a guarantee from the borrower to
prevent the risk that the borrower may default and fail to repay the loan or
installment payments. Collateral can be provided in the form of assets or several
assets. If the borrower defaults, the bank has the right to obtain repayment by
controlling the secured assets and selling them to repay the loan.

For secured loans, borrowers are usually pledged such assets as collateral.From the
bank’s perspective, this particular borrower will be considered risk-free, because if
he defaults on repayment, the bank has a backup plan to sell assets and use the
proceeds.

For unsecured loans, the bank evaluates past records, completeness of income
ability, etc., and approves the loan in an unsecured manner. Because banks take
higher risks, they usually have higher interest rates. It is different from a secured
loan, which has a certain value to support the loan when things go bad.

For unsecured loan, there is not backup plan. That means the organization and
company are taking additional risk .When taking additional risk, you will expect the
return to be higher. The bank are replying on the income capacity , track record and
integrity of the particular for the borrower .

The willingness of banks to accept unsecured loans only depends on the bank's
judgment on the borrower's ability to repay the funds. Usually, it is based on a
person's earning ability. Therefore, banks are more risky to assume such loans,
which requires banks to obtain higher returns from them.

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4) Discuss how Islamic banks differ in comparison to conventional banks. Are their
functions similar?
Conventional banks and Islamic banks have similar functions, where their core
business is to receive deposits from the public and providing loans to the public.
However, what is different is the underlying processes, treatment of funds and the
distribution of profits that Islamic banks have to adhere to Islamic principles.
Conventional banking relies heavily on the idea that depositors receive interest from
lending the money to the bank, and borrowers pay interest to the bank. According
to Islamic principles, interest (riba) is haram (prohibited), whether it’s to receive or
pay interest. This changes everything, from how depositors receive income and how
borrowers pay for the funds that they have borrowed. Other treatments of their
banking processes that are different than conventional banking are as follows:

Traditional banks and Islamic banks have similar functions, and their core business is
to accept deposits from the public and provide loans to the public. However, the
difference is that Islamic banks must abide by the basic procedures of Islamic
principles, capital processing methods and profit distribution.
Traditional banking business relies heavily on the idea that depositors earn interest
by lending money to banks, while borrowers pay interest to banks. According to
Islamic teachings, whether it is collecting interest or paying interest, interest (riba) is
Haram (prohibited). This changes everything, from how depositors get income and
how borrowers pay for the funds they borrow. Other banking business processing
methods that are different from regular banking business are as follows:

Characteristics Islamic Banking Conventional Banking

Business Based on Shariah Law. Bank Based on prudential banking

Framework must ensure that all business principles and fiduciary
activities are in compliance guidelines.
with it.

Prohibition of riba Financing is not interest- Financing is interest-oriented

in financing. oriented. It is based on the and a fixed or floating interest
principle of buying and selling rate is charged for the use of
of assets, whereby selling the money.
price includes a profit margin.

Prohibition of riba Deposits are not interest- Deposits are interest-oriented.

in deposits. oriented.

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 Characteristics Islamic Banking Conventional Banking
Equity financing Banks may offer equity Equity financing not offered.
with risk-sharing financing for a project or
venture. Profit is shared on a
pre-agreed ratio. Any losses
are shared based on the
equity participation.
Shariah Committee Each bank should have a No requirement.
Shariah Committee (or
Shariah Supervisory Board) However risk management,
to ensure that all business loan approval and audit
activities are in line with committees oversee that
Shariah requirements. lending prudence and credit
policy guidelines are observed.

Zakat (religious tax) In the modern Islamic Banks do not pay zakat.
banking system, banks pay
zakat.

Characteristics Islamic Banking Conventional Banking

Restrictions Islamic banks do not participate in There are no such restrictions with
economic activities that are not respect to conventional banks.
Shariah-Compliant. For example,
Islamic Banks would not be allowed
to finance business involving pork,
alcohol or gambling. However, these
banks can provide financing if these
items are only a small percentage of
the overall business.
Prohibition of gharar Transactions with elements of Speculative trading is allowed. Trading
gambling and speculation are and dealing in derivatives such as
forbidden. Eg. Speculative trading in futures are allowed.
securities and derivatives.
Customer relations The status of the bank in relation to The status of the bank, in relation to its
its clients is that of partner / investor clients, is that of creditor and debtor.
and entrepreneur.
Statutory requirement Banks must comply with Bank Banks must comply with Bank Negara
Negara Malaysia’s statutory Malaysia’s statutory requirement only.
requirements and also the Shariah
guidelines.

5) Calculate the NIM of the two banks below:

ABC Bank
Interest Income $15.5 billion
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Interest Expense $7.2 billion
Total Assets $290 billion
DEF Bank
Interest Income $6.2 billion
Interest Expense $3.1 billion
Total Assets $90 billion

Which one has a higher NIM? What is the significance of the comparison? Who is
more efficient?

ABC Bank
Interest Income−Interest Expense
Total Assets
15.5b−7.2 b
290 b
¿ 2.86 %

DEF Bank
Interest Income−Interest Expense
Total Assets
6.2b−3.1 b
90 b
¿ 3.44 %

Even though ABC bank is larger in terms of their interest income and total assets
than DEF bank, ABC bank has a lower NIM of 2.86%, compared to DEF bank’s NIM of
3.44%. The higher the NIM, the better it is for the bank, because it signifies that:
a) It is more efficient in managing its interest expense
b) It produces more revenue for each dollar of assets. For every $1 of total
asset, DEF bank generated $0.0344 of net interest.