islamic financial system

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• TOPIC 1.
• CONCEPT, FUNCTIONS AND OPERATIONS OF FINANCIAL
  SYSTEM

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The Financial System

• Definition comprise of financial markets,
  institutions, laws, regulations
• Markets Bonds, stocks, and other securities are
  traded
• Financial institutions
• Financial services and financial assets
• Global financial system
• Financial regulation

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Financial System
Financial System within an Economic System
Indirect Financial Flows - Institutions
Direct Financial Flows - Markets
Contractual savings institutions
Investment Institutions
Depository Institutions
Capital Market
Money Market
Mutual funds company
Banking Institutions
Stock Market
Insurance
Bond Market
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Primary Task of Financial System

• Channeling funds from surplus units to deficit
  units (FMs are critical for the efficient
  allocation of resources / to improve economic
  efficiency)
• Surplus units person/business without investment
  opportunities - Lenders/Savers - Supplier of
  funds (capital providers)
• Deficit units person/business with investment
  opportunities but shortage of funds -
  Borrowers/Spenders - Demander of funds
• Often, surplus units (particularly savers) ?
  people who have profitable investment
  opportunities
• When funds flow from SU to DU, a financial asset
  is created
• A claim against future income or wealth of the
  borrower
• Represented usually by a certificate receipt,
  computer record file, or other legal document

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Characteristics of FAs

• FAs vs real assets
• Do not depreciate like physical goods
• Physical condition or form does not determine
  market value
• Have little or no value as a commodity
• Cost of transportation and storage is low
• Fungible can easily be changed in form and
  substituted for other assets

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Channels of Flow of Funds
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Channels of Funds Flow

• Direct Finance
• Borrowers borrow directly from lenders in
  financial markets by selling financial
  instruments/securities
• Financial markets issue claims on borrowers
  directly to savers
• Securities Asset to buyers (lenders) but
  liabilities to issuers (borrowers)
• Example Bond
• Indirect Finance
• Financial intermediaries act as middle-man by
  holding a portfolio of assets and issuing claims
  to savers
• Borrowers borrow indirectly from lenders via
  financial intermediaries (FI)
• FI established to source both loanable funds and
  loan opportunities

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Primary Task of Financial System

• Reallocate scarce financial resources
• Funds move from surplus units (savers) to deficit
  units (borrowers)
• Increases standard of living of the individuals
  involved
• FS determines cost and quantity of loanable funds
• Impact real economic activities
• Funds ? spending ? employment ? production ?GDP

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Importance of Financial System

• FS critical for enabling efficient allocation of
  capital
• Funds transferred from savers to entrepreneurs
• Nonproductive (idle) to productive purposes
• FS improve economic well-being
• Savers-saving returns borrowers-use
  opportunities (spend)
• Both can share profit
• Without FM, status quo or even worse off
• FS contributes to higher production and
  efficiency of overall economy

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Transforming Savings into Investment

• Investment increases productivity of labor ?
  higher standard of living
• FS enables the exchange of current income for
  future income and transformation of savings into
  investment so that production, employment, and
  income can grow, improving our standard of living
• Suppliers of funds expect to earn additional
  income on their lending as a reward for waiting
  and assuming risk
• Receive promises packaged in financial claims
  future flow of income in the form of dividends,
  interests, etc

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FAs and Financial System

• For the economy as a whole we are NOT made
  better off in real terms by the mere creation of
  FAs and liabilities
• Financial system provides the essential channel
• Necessary for the creation and exchange of FAs
• Exchange between savers and borrowers so that
  real assets can be acquired
• Society can increase its wealth
• By saving and increasing the quantity of its real
  assets
• Real assets enable the economy to produce more
  goods and services

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Classifications of Financial Markets

• According to type of financial claims traded
  debt versus equity - stock market, bond market
• According to maturity capital markets and money
  markets
• According to issuance primary markets and
  secondary market

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CLASSIFICATION OF FINANCIAL INTERMEDIARIES
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Functions of FS

1. Saving function
2. Wealth function
3. Liquidity function
4. Credit function
5. Payments function
6. Risk protection function
7. Policy Function

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1. Functions of FS Saving

• Provides a conduit for the savings profitable
  outlet for utilization of savings in bonds,
  stocks and other financial claims
• Savings flow through financial markets to
  allowing for increased production

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2. Functions of FS Wealth

• Definition accumulated savings built up over
  time stock of assets
• Wealth measures the stock of assets
• Financial instruments represent a typically
  non-depreciating store of wealth

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Example

• Wealth from prior period 1000
• Savings from this period 50
• Rate of return on wealth 10
• Return 0.10(1000) 100
• Wealth at the end of the period
• 1000 50 100 1150

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3. Functions of FS Liquidity

• Definition immediately spendable cash
• Provide liquidity for savers who hold financial
  instruments but are in need of money
• Money is mainly currency and deposits held in
  depository institutions
• Can be spent without need of conversion-no
  transaction cost
• But, earns the lowest rate of return of all
  financial assets value eroded by inflation

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4. Functions of FS Credit

• Furnish credit to finance current consumption and
  investment spending
• Borrowers access to credit by pledging future
  income
• Flipside of savings
• Volume of credit in the US is huge and growing
• Total credit funds raised in the financial
  markets was approximately 4.5 trillion in 2007
• Due to the great credit crisis of 2007-2009, this
  fell to just above 2.6 trillion in 2008
• Gives impact on the economic cycles

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5. Functions of FS Payment

• A mechanism for making payments for purchases of
  goods and services
• Certain financial assets have been popular means
  of exchange (currency, demand deposits, etc.)
• Debit and credit cards
• Many other instruments are also growing in
  popularity due to advancements in technology
  internet banking, Stored-value cards, etc.
• Would replace physical money as means of payment

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6. Functions of FS Risk Protection

• Financial markets offer businesses, consumers and
  governments protection against life, health,
  property, and income risks
• Risk coverage policies by insurance companies
• Engage in risk-sharing activities
  individual/entity transfers risk exposure to
  someone who is willing to accept the risk
• Risk-reducing activities diversifying wealth
  across wide variety of different assets to reduce
  the likelihood of loss

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7. Functions of FS Policy

• A channel through which governments may attempt
  to influence the economy
• Affects borrowing and spending plans
• Impacts the growth rates of jobs, production, and
  prices
• Task of managing the economy through the
  financial system has been given largely to
  central banks economic stabilization and avoid
  inflation

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Services Provided by FS

• There are many financial services that are widely
  sought after
• Payments services
• Thrift services
• Insurance services
• Credit services
• Hedging services
• Agency services

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REGULATION OF FINANCIAL SYSTEM

• Three main reasons for regulation
• Increase Information to Investors
• Ensure Soundness of Financial Intermediaries
• Improve Monetary Control

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Regulation of the Financial System

• 1. To Increase Information Available to
  Investors
• Asymmetric Information in FMs means that
  investors may be subject to adverse selection and
  moral hazard problems (in terms of misleading
  information and adverse risks undertaken in a
  financial transaction) may hinder efficient
  operation of FMs and keep investors away from FMs
• Securities and Exchange Commission (SEC) requires
  corporations issuing securities to disclose
  certain information about their sales, assets,
  and earnings to the public and restricts trading
  by the largest stockholders (known as insiders)
  in the corporation
• Such government regulation can reduce adverse
  selection and moral hazard problems in FMs and
  increase their efficiency by increasing the
  amount of information available to investors

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Regulation of Financial System

• 2. To Ensure Soundness of Financial
  Intermediaries
• Because providers of funds to financial
  intermediaries may not be able to assess whether
  the institutions holding their funds are sound or
  not, if they have doubts about the overall health
  of financial intermediaries, they may want to
  pull their funds out of both sound and unsound
  institutions, with the possible outcome of a
  financial panic that produces large losses for
  the public and causes serious damage to the
  economy
• To protect the public and the economy from
  financial panics, the government has implemented
  six types of regulations
• Restrictions on Entry
• Disclosure
• Restrictions on Assets and Activities
• Deposit Insurance
• Limits on Competition
• Restrictions on Interest Rates

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Regulation of Financial System

• 3. To Improve Monetary Control
• Because banks play a very important role in
  determining the supply of money (which in turn
  affects many aspects of the economy), much
  regulation of these financial intermediaries is
  intended to improve control over the money supply
• One such regulation is reserve requirements,
  which make it obligatory for all depository
  institutions to keep a certain fraction of their
  deposits in accounts with the central
• Reserve requirements help the central banks to
  exercise more precise control over the money
  supply

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Regulation of Financial Institutions and Markets
Case of the US