LECTURE SHEET FOR 3RD AND 4TH SESSION

FINANCIAL INTERMEDIARIES
What are the financial intermediarie ! Financial intermediaries are financial institutions that borrow funds (accept deposits) from people who willingly surrender current purchasing power. Financial intermediaries then lend these funds to (or buy securities from) those who wish to use the funds for current expenditures. In effect,financial intermediaries act as middlepersons who accepts household savings and lend it to businesses that use the saving for investment purposes. Examples of financial intermediaries are depository institutions like credit unions, thrifts institutions and commercial banks etc. H"# d"e the e$i tence "f m"ne% facilitate the e&arati"n "f the act "f a'in( and in'e tment! ns! "eople save in a barter economy by nonconsuming some of the goods they receive for their work efforts# they thereby ac$uire real goods. Investment also re$uires some nonconsumption of real%goods income, which then must be traded for plant and e$uipment. In a money economy, however, saving takes the form of a generali&ed purchasing power ' money. "eople can ac$uire money instead of goods. (hus money makes it easier for people to separate the acts of saving and investment. )aving represents a nonexpenditure out of money income# when people save, they accumulate wealth, or a generali&ed store of purchasing power. (his generali&ed store of purchasing power, or saving funds, can be turned over to an investor*who need not engage personally in the of saving. (his transfer of purchasing power from saver to investors benefits savers*who benefit by earning interest paid willingly by profit%seeking investors. (he transfer also benefits investors, who can now earn profits from which interest payments can be made, because they are not forced to save. H"# d"e m"ne% facilitate the tran fer "f f)nd fr"m a'er t" in'e t"r ! +oney facilitate the transfer of funds from savers to investors by both direct and indirect financing.,y direct financing. ,usinesses can sell stocks or bonds directly to the public in primary markets. (hese assets are made more li$uid for the public when secondary markets permit the public to resell them. (he incentive for a stockholder is dividends whereas the incentive for a bond holder is the interest. What i financial intermediati"n and #hat are it ad'anta(e ! Financial institutions have evolved as financial intermediaries that channel saving funds from savers to businesses that use the funds to make investments. (his process is referred to as financial intermediation. In the process of financial intermediation financial intermediaries borrow from the ultimate savers against a deposit interest rate and lend the same to the ultimate users-borrowers against a leding interest rate higher then the deposit interest rate. (he difference between the borrowing and lending rate is the profit for financial intermediaries. (he advantages of financial intermediation can be described as follows! a) It is beneficial to society because it allows smaller businesses (for whom stock and bond issuance is impractical) access to saving funds. b) Financial intermediation allows savers to purchase assets that are relatively safe and more li$uid and clso earn interest. For example when a saver deposit money in his or her account at the local credit union, the saver is implicitly purchasing shares in the credit union. c) Financial intermediation also benefits smaller savers because financial institutions can pool their funds and diversify their investments, thereby reducing risk to small savers. d) +oreover, saving deposits are insured by regulatory agencies. H"# d" ("'ernment affect the financial intermediati"n &r"ce ! .overnments also affect the process of financial intermediation. (hrough the Federal Financing ,ank, three mortgage associations provide funds to the housing mortgage market by selling bonds and using the funds to purchase mortgages# and three federal government agency banks issue securities and use the proceeds to make loans to farmers. What i meant *% Financial Di intermediati"n! (he reverse of the financial intermediation is the financial disintermediaton. (he situation when savers take funds out of deposit accounts and invest directly in private and government securities is known as financial disintermediation. In other words, when savers do not allow financial intermediaries to use the saver/s deposited fund

Financial disintermediation occurs when the retun from the direct purchase from the financial claims issued by households, corporations and governments bring returns higher than the return from a savings account of a financial intermediary. (he amount of disintermediation depends mostly on the difference between the interest rate offered by the finacial intermediaries and those offered by such ultimate borrowers as corporations and government. In +an(lade h during the period of Ershad govt. the banking sector were suffering from over li$uidity problem because of the highest interest rate being offered by the banks specially on fixed deposits. 0uring 1 st 2haleda .ovt. 0eposit interest rate was reduced substantially. s a result life came back to the stock market. ,ut again after debacle of the share marketing 1334 again money came back to the banking sector and the problem of li$uidity surplus arised again. (hen the deposit interest arte was further reduced but no result was produced because of i).no confidence on capital market ii) 5undi business iii)excessive amount of tax evaded money CONSTITUENT AND FEATURES OF CON,ENTIONAL FINANCIAL S-STEM Mechani m. ,ased on 6fnancing/and 6ivestment/ mode. 1. In tit)ti"n . 7ommercial banks, depository institutions, credit unions, finance companies, leasing companies, investment banks, stock exchange 8. In tr)ment . 9rdinary )ahare, 7umulative and noncumulative preference share, debeture and bonds, commcial paper, 70s, financial paper, marketable securities :. Re#ard . ,oth interest and profit is considered. "rofit is considered as reward for e$uity CONSTITUENT AND FEATURES OF ISLAMIC FINANCILA S-STEM 1. Mechani m. ,ased on 6investment/ and 6buy/ mode. 8. In tit)ti"n . +udaraba companies, ";) Institutions-banks, finance companies, leasing companies, investment banks, stock exchange :. In tr)ment 9rdinary )ahre, noncumulative preference share, +udaraba bonds, )hort term investment paper, <. Re#ard "rofit

MONE-. CON,ENTIONAL ,S/ ISLAMIC ,IEW M"ne% Defined

+oney as defined by 9xford dvanced ;earners 0ictionary of 7urrent English is 67oins stamped from metal, printed notes, given and accepted when buying and selling/. In other words anything that functions as a means of payment (medium of exchange), unit of account, and store of value# something acceptable and generally used as payment for goods and services is known as money.

The de ira*le &r"&ertie "f m"ne%

At minim)m m"ne% ha'e i$ re0)i ite &r"&ertie / The% are. 1. 1"rta*ilit%! +oney must be easy to carry around and easy to transfer in order to make purchase in different locations. If money is not easily portable, people will not widely use it. 8. D)ra*ilit%! +oney that does not have the $uality of physical durability will lose its value as money. :. Di'i i*ilit%. =e must be able to divide money easily into e$ual parts to allow for purchase of small units. 7ow cannot be money because it is not divisible. <. Standardi2a*ilit%! =e must be able to standardi&e money if money is to be useful. It units should be of e$ual $uality and indistinguishable. 9nly if we can standardi&e money can individual be certain of what they are receiving when they make economic exchanges. merican colonists used tobacco as money but they could never standardardi&e tobacco. >. Rec"(ni i*ilit%! +oney must be easily recognised. If people cannot easily recognise money then they will find it difficult to determine whether they are dealing with money or some inferior asset.

4. Acce&ta*ilit%. +oney must be acceptable by the people in general. If people in general decline to accept
anything as a means of payment that can be treated as money.

3ind "f M"ne%

456 Metallic C"in and De&" it M"ne%
(here are three principal kinds of money! (?) metallic coins, (8) paper money, and (:) deposit money. (he first two categories, coins and paper money, are commonly grouped together and designated as @currency@. 0eposit money is issued by commercial banks on the basis of their demand liabilities or deposits, which are transferable, by che$ue.+etallic coins are further classified as standard or Full%bodied coins and (oken coins. standard coin is that coin whose face value is e$ual (or almost e$ual)(to its intrinsic value. (oken money on the other hand is one where intrinsic value does not represent the face value of the money.

476 Le(al Tender M"ne% and O&ti"nal M"ne% ;egal tender is that money which is officially designated by the government as an ade$uate instrument for the discharge of obligations stand to be payable in domestic money. ;imited ;egal (ender and Anlimited ;egal (ender 9ptional money is that money which is ordinarily accepted by the people in final payments, but has no legal sanction behind it. 7redit instruments like che$ue, drafts, bills of exchange, promissory notes etc. are optional money. Bo one can be forced to accept them# but they are generally accepted because people have confidence in the credit of the paper. F)ll8*"died M"ne%.
+oney whose face value is e$ual to its market value, such as pure gold or silver coins. (hey are the minted coin whose metallic value had a value in non%monetary uses (e.g. in Cewellary) e$ual to their exchange value as money. Re&re entati'e F)ll 9*"died m"ne%. +oney that is of negligible value as a commodity but is backed by a valuable commodity, such as gold or silver. "eople may use alternative tokens other than coins such as pieces of paper, alongside or in place of gold or silver coins. (hese are examples of representative full%bodied money.

(4) Narr"# M"ne% ' +r"ad M"ne%. Barrow money is sum total of the money in circulation and the demand deposits. 9n the other hand ,road +oney implies the narrow money plus all other credit instrument that are convertible to li$uidity without any decrease to its nominal value. (:) M5; M7; M3 . M5 composed of 7urrency in circulation, demand deposits, other checkable deposits andtraveller/s checks. +1 is based on the transaction approach of money. M7 composed of +1 plus the following a. )avings and money market deposit accounts b. )mall denomination time deposit at all depository institutions c. 9vernight repurchase agreements at commercial banks. d. 9vernight Eurodollars held by A) residents (other than banks ) at 7aribbean branches of Fed member banks. e. +oney market mutual funds. f. +oney market deposit accounts. M3 composed of +8 plus thefollowing! a. ;arge denomination of time deposits at all depository institutions. b. (erm repurchase agreements at commercial banks and savings and loan associations c. (erm Eurodollars d. Institution%only money market mutual fund balances e. Fiat M"ne%. +oney that has a &ero market value or whose face value is more than its market value. "aaaaper money, for example, not backed by anything but faith in its universal acceptance .

FUNCTIONS OF MONE456 Medi)m "f e$chan(e It facilitates trade by providing a medium, which everyone is willing to accept in exchange for goods and services or in payment of debts. Individuals can sell their output for money and use that money to buy goods and services in the future. In the process money makes speciali&ation possible. )peciali&ation is essential to any efficient economy# it allows individuals to purchase most product rather than producing theproducts themselves. +oney functioning as a medium of exchange has, perfected the price mechanism. 476 C"mm"n mea )re "f 'al)e 4a )nit "f acc")nt6 s a common measure of value, money expresses the values of all commodities. (he common measure of value function of money has been given many names, of which the most common are Dunit of valueD, Dstandard of valueD, Dand unit of account and common denominator of valueD. It serves as the unit in terms of which the value of all goods and services is measured and expressed as a DpriceD. If there were only 1,EEE goods and services to be compared, there would be <33,>EE different exchange ratios. ,ut with the use of money the number of prices or exchange ratios needed is reduced to 333. =e may say that money measures the value, Cust as we say that feet, inches and meters and used to measure linear distance# ounces, pounds, grams and tons to measure weight# gallons, liters and barrels to measure li$uid volume# and so on. 436 A St"re "f ,al)e

+oney to be acceptable as a means of payment must also act as store of value. If one is paid for his labour services today and does not need to purchase anything until tomorrow, he would presumably be unwilling to accept anything in payment that is likely to decline in value before he opened it. (hat is why a football or cinema show ticket is not accepted as money. 7onversely, people will accept something as a means of payment for goods and services when they believe that they can easily exchange it for something else of like value in future. 446 Standard "f Deferred &a%ment It also serves as a standard of deferred payments when obligations to make future payments are stated in terms of it. (his function simultaneously involves the use of money as a medium of exchange and as a unit of account. =e typically state debts in terms of a unit of account# we pay these debts with a monetary medium of exchange. corporate bond, for example, has a face value stated in dollar. =hen the bond comes due at maturity, that corporation pays the face face value to holders of the b