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 on 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 a one stop financial solutions to the clients.

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 economic of scale. They can leverage
on their existing database and workforce to effectively roll out new services. So 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
 Providing finance
 Payments

Banks generate income majority from Interest Income

Commercial banks’ major source of income is from their interest income. Which is income from
their lending operations.

Banks also generate income from

 Commissions and Fees
 Commissions from investment products:
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  Mutual funds
 Insurance products
 Retirement products
 Service Charges
 ATM machines
 Credit card machines
 Investment income
 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

 Deal maker 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 profits from advisory fees, service fees, trading commissions and selling of
financial securities.

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
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 cashflows of the
business.

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 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 Patrick runs a wholesale trading operations. His suppliers require a 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.
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 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
bank’s undertake for such loans are higher, in which requires a higher return in the bank’s
perspective.
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 treatment of their banking processes that are different than conventional
banking are as follows:

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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.

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.

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 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
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 − 7.2𝑏
290𝑏
2.86%
DEF Bank
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
6.2𝑏 − 3.1𝑏
90𝑏
3.44%

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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.