FINANCIAL INSTITUTIONS

AND
FINANCIAL MARKETS:
BANGLADESH PERSPECTIVE

PRESENTATION BY:
DR. TOUFIC A. CHOUDHURY
Former Director General, BIBM
Financial Institutions represent indirect mode of
finance and financial markets represent direct mode
of finance. Both direct and indirect mode of
finance will constitute a financial system.
Therefore, let us start with financial system.
Financial System is concerned with Finance.
But what is this Finance?

S D

Provision of fund from one party (Surplus

Economic Unit: I>E) to another party (Deficit
Economic Unit: I<E). Or, mobilization of fund
from SEUs and deployment of fund to DEUs.
Funds may be provided in two different ways:
Direct and Indirect. In case of Direct mode of
Finance, SEUs are providing funds directly to
DEUs; but in case of Indirect mode of finance,
SEUs are providing fund to DEUs through
intermediaries, known as financial Intermediaries.
 INDIRECT FINANCE

Financial
FUNDS FUNDS
Intermediaries

Surplus Units/ Financial Deficits Units/

FUNDS FUNDS Borrowers
Savers/Lenders Markets

DIRECT FINANCE
Financial System Defined: It is the system concerned
with mobilization of fund from SEUs and deployment
of funds to DEUs either directly or indirectly. System
comprises rules, regulations, guidelines, legal
framework etc. These are collectively known as
“institutional framework”.

What is the nature of Banks’ Mode of Finance? Who

used to practices direct Mode of Finance? Which one
is more risky from fund owners’ point of view?
An important feature of financial system is that
individual transactions have substantial transactions
and information cost. An economic analysis will
show that Indirect Mode of Finance can better
address the transactions and information cost than
Direct Mode of Finance
Indirect Mode of Finance (or financial
intermediaries) can reduce transaction costs and
allow small savers and borrowers to benefit from
financial transactions because of following two
reasons:
- Economies of Scale
- Development of Expertise
In a financial transaction between SEU and DEU,
one party often does not know enough about the
other party to make accurate decisions. This
inequality is called Asymmetric Information. Lack
of information creates problems in the financial
system on two fronts: before the transaction
(Adverse Selection) and after the transaction
(Moral Hazard).
Adverse Selection is the problem created by
asymmetric information before the transaction
occurs. Adverse selection in financial markets
occurs when the potential borrowers who are the
most likely to produce an undesirable (adverse)
outcome-the bad credit risks-are the ones who most
actively seek out a loan and are thus most likely to
be selected. Because adverse selection makes it
more likely that bad credit risks might be selected,
lenders may decide not to make any loans even
though there are good credit risks in the
marketplace.
Moral Hazard is the problem created by asymmetric
information after the transaction occurs. Moral
hazard in the financial markets is the risk (hazard)
that the borrower might engage in activities that are
undesirable (immoral) from the lender’s point of
view, which makes it less likely that the loan will be
paid back. Because moral hazard lowers the
probability that the loan will be repaid, lenders may
decide that they would rather not make a loan.
The constituents of financial system are: financial
institutions, financial instruments and financial
markets. Now let us discuss FIs and FMs as
constituents of a Financial System
Financial institutions are those institutions which mobilize funds from
surplus units (depositors) and deploy funds to deficit units (borrowers).
They are of two types: banking financial institutions (BFIs) and non-
banking financial institutions (NBFIs). Depending on the ownership
structure, there are four categories of BFIs in Bangladesh: SCBs, SBs,
PCBs and FCBs. Total of BFIs operating in FY22 was 61. The number of
bank branches stood at 10,963 at the end of June, 2022. Currently, 35
NBFIs are operating in Bangladesh. The number of branches of NBFIs
stood at 271 as on 30 June, 2022. The licensing and regulatory authority
for BFIs and NBFIs in Bangladesh is Bangladesh Bank. Performances of
both BFIs and BNFIs are evaluated through the CAMELS rating
indicating capital Adequacy, Asset Quality, Management Efficiency,
Earnings, Liquidity and Sensitivity to Market Risk.
Different Roles FIs play in an Economy:
- Intermediation Role
- Payment Role
- Guarantor Role
- Safe-keeping Role
- Agency Role
- Risk Management Role
- Policy Role
Services FIs offer in an economy:
Balance Sheet Activities (BSA)
and
Off Balance Sheet Activities (OBSA)
How come BFIs are different from NBFIs? BFIs belong to
Monetary System, but NBFIs are not. Monetary System is
centered around money. Therefore, first of all, we must
know what is Money?
Money is anything that is generally acceptable as a medium
of exchange or means of payment in the settlement of all
transactions including debt. General acceptability as a
medium of exchange or means of payment is a unique
feature of money.
Other than medium of exchange, money has got
some other functions. The functions of money have
been well summed up in a couplet:
Money is a matter of functions four:
A medium, a measure, a standard, a store.
Money has several incarnations. In Bangladesh
money consists of coins, paper currency and
cheques. Coins and currency notes are known as
legal tender money or fiat money and cheques (or
deposit money) are known as Non-legal Tender or
fiduciary money.

Is cheque really Money?

What about Debit Card, Credit Card and
Cryptocurrency?

Supply of Money: Money Supply is the total stock of
money of various kinds at a particular point of time
held by the public. We must note two things about
money supply. First, the supply of money refers to its
stock at any point of time. Therefore, money is a
stock variable. Secondly, the term public is defined
to include all economic units (households, firms and
institutions) except the producers of money (Central
Bank and BFIs).
A single measure of money supply defined as the sum
of currency and demand deposits, both held by the
public, we call it the narrow measure of money supply
(M1). A ‘broader’ measure of money supply (M2) is
defined empirically as money narrowly defined plus the
time deposits of banks held by the public.
M1= COB + DD
M2= M1 + TD
Now, the Producers’ of Money: Central Bank and BFIs.
Central Bank prints money, and BFIs create money. BFIs
can create money simply by lending fund to the borrowers.
A single bank can create money to the extent of its excess
reserves and banking system (all BFIs together) as a whole
can create money to the extent of reciprocal times of
required reserve.
Monetary System is the system which is concerned with
issuance and circulation of money. Central Bank is involved
with it by printing money and BFIs are associated with it by
creating money. Therefore, Monetary System is comprising of
Central Bank and BFIs
and
Financial System is equal to –
Monetary System + NBFIs.
It also means –
BFIs liability is Money, but the liability of NBFIs is not money.
Then, what is the liability of NBFIs?
Financial instruments are the evidences of financial claims
of one party (holder) against another party (issuers). In order
to become a financial instrument, it must show the evidence
of financial claims. Financial claims against financial sector
are indirect financial instruments (secondary securities) such
as currency notes, cheques, deposits etc. and financial clams
against non-financial (real) sector are direct financial
instruments (primary securities) such as loans, shares, bonds
etc.
What is the difference between –
Money and Financial Instruments?
Financial markets are the markets where financial instruments
are bought and sold or traded. Based on the maturity of
financial instruments, financial markets are classified into
Money Market and Capital Market.

Interest rate determination is one of the important functions of

financial market.
Bond Market Approach: Demand for bond and supply for bond will
determine price of bond and since price of bond is inversely related to rate
of interest, that way interest rate is determined.

Tk. 120(6%) ------------- SB

PB: Tk. 100(8%)

Tk. 80 (10%) ------------- DB

DB is supply of loanable fund and SB is demand for loanable fund, that’s

why, Bond Market approach of interest determination is also known as
loanable fund theory.
Macroeconomic Loanable Fund Approach:
National savings is the supply of loanable fund and national investment
is the demand for loanable fund, comprising of domestic investment and
net capital outflow
Y = C + I + G + NX
or, Y – C – G = I + NX NX = Net Export
or, S = I + NX NCO = Net Capital Outflow

S = I + NCO SLF
NS = SLF

Rate of Interest
(Real)
NI = DLF = I + NCO DLF
QLF
An alternative theory of how interest rates are determined is
provided by the liquidity Preference Framework, which
analyzes the supply of and demand for money.

r MS
MP = ROI = r
MD

It show that interest rates will change when the demand

for money changes because of alterations in income or
price level or when the supply of money is changed by the
Central Bank
The term money market is actually a misnomer. Money-
currency-is not traded in the money markets. Because the
financial instruments that do trade there are short-term and
highly liquid, and are close to money. Money market
securities have three basic characteristics in common:
• They are usually sold in large denominations.
• They are very liquid and have low default risk.
• They mature in one year or less from their original issue
date.
Money market securities usually have an active secondary
market.
Money Market Instruments:
Treasury Bills
Federal Fund
Repurchase Agreements
Negotiable Certificates of Deposits
Commercial Paper
Banker’s Acceptances
BFIs and NBFIs are the major players in the money markets in
Bangladesh. Bangladesh Bank is the leader of MM in
Bangladesh. The money market components in Bangladesh are:
inter-bank market, call market, repo and reverse report and
treasury (government) bill market. Call market is the most
sensitive part of money market in Bangladesh. Money market is
basically used for monetary policy purposes. Corporate use of
money market is totally absent and there is no brokerage house in
our money market. Interest rate fixing mechanism is absent and
transaction takes place through bilateral transactions.
A capital market is a financial market where long-term financial
instruments are bought and sold. The financial instruments of
capital market are both equity-based and/or debt based. Equity
based part of capital market is known as Stock Market and
debt-based part of capital market is known as Bond Market.
The capital market may be divided into primary markets and
secondary markets. Newly issued securities are bought and sold
in primary markets, such as during initial public offerings.
Secondary markets allow investors to buy and sell existing
securities. The transactions in primary markets happen between
issuers and investors, while secondary market transactions
happen among investors. There are two types of exchange in
the secondary market for capital securities: organized
exchanges and over-the-counter exchanges
Capital Market Products:
Debt Part: Bond Market:
Treasury Bond
Agency Bond
Municipal Bond
Corporate Bond
Sub-ordinated Bond
Junk Bond
Equity Part: Stock Market:
Common Stock
Preferred Stock
Capital market of Bangladesh is equity dominated. Debt part
is not significant. Even in terms of raising long-term
industrial funds, the contribution of equity security part is
very insignificant as compared to bank lending, showing
overwhelming preference of bank finance. In the absence of
an active govt. bond market, specially secondary part of
govt. bond market, the corporate bond market is also not
developing.
Bangladesh Securities and Exchange Commission (BSEC)
is the regulator of Securities Market in Bangladesh.
International Financial Markets are primarily required
for making foreign investments, foreign borrowing,
providing credit in the foreign markets, in addition to
settlement of international transactions like exports and
imports. These markets are:
• Foreign Exchange Market
• Euro Currency Market
• Euro Security Market
• International Security Market
• Foreign Exchange Derivative Market
The Foreign Exchange Market in Bangladesh is still
spot dominated, that too in dollars. Forward market is
very limited. Currency Swaps are permitted only
against approved underlying commercial transactions.
FEM is dealer based. Net open position is limited to
15% of capital. Inter-bank FEM is not very active,
showing a limited scope for price discovery.
References:
1. Mishkin, F.S and Eakins, S.G. Financial Markets and
Institutions. Addision Wesly Longman. U.S.A.
2. Mishkin, F.S, The Economics Money, Banking and
Financial Markets Pearsons, U.S.A.
3. Gupta, Suraj B, Monetary Economics: Institutions,
Theory and Policy, S. Chand and Company, New
Delhi.
Thank You