FIN 2024 Financial Institutions and

Markets
Tutorial 1 Overview of the Financial Systems
Discussion Questions:
Susie has inherited MYR500,000 from her grandparents and is thinking of investing them. She is
thinking if she would be better off lending the money to her brother in his existing business or
putting them into fixed deposits in Maybank. Susie’s brother is offering an interest of 8% p.a. for
her lending and the Maybank’s 1-year fixed deposit rate is at 3.2% per annum.

a. By using what you learnt about the benefits of financial intermediation, what advantages
would she have if she puts her money in a fixed deposit in Maybank rather than lending it
to her brother?
Lowering transaction costs
Susie may incur high transaction cost when she directly lends her money to her brother.
Susie or the brother may have to bear legal fees and stamp duties while setting up the loan
agreement. This is why bond issuances issue in large amounts to investors who can invest in
bulk, because in order for them to approach many small investors, it may incur too much
transaction cost. Financial intermediaries make profits by reducing transactions costs,
investors also save in transaction costs that would be incurred if invested in the financial
markets. Financial intermediaries reduce transactions costs by developing expertise and
taking advantage of economies of scale.

Risk Sharing
Another benefit made possible by the FI’s low transaction costs is that they can help reduce
the exposure of investors to risk, through a process known as risk-sharing. Susie lending
directly to her brother has all her risk focused on one person, which is her brother. Same
like lending money to a corporation through bond issuances, the risk is also focused on one
entity. Through financial intermediaries, banks borrow from many customers and lend to
many as well. They allow depositors to share the risk of many borrowers from default.

Liquidity
Financial institutions such as banks provide liquidity to depositors and concurrently
provides lending services to customers in a long term basis through the process of keeping
adequate reserves. Direct finance, or in this case through her brother, may not give Susie as
much liquidity as she needs.

Reduce Asymmetric Information. FIs create and sell assets with lesser risk (many) to one
party in order to buy assets with greater risk (many) from another party. This process is
referred to as asset transformation because in a sense risky assets are turned into safer
assets for investors.

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b. In your opinion, should return on investment be the final ultimatum of Susie’s decision?
You could answer this critically by thinking about the common relationship between risk
and return. If the return on investment is the only factor, then everyone should put their
money in stocks. If you remember in Principles of Business Finance, stockholders are
residual owners, thus get residual returns. Higher returns come with higher risk, thus a
rational investor should not only consider seeking returns as the only factor. Further in
the semester, you will learn more about financial markets and financial intermediaries to
help you with this question even further.

Short Discussions
1. Why are financial markets important to the health of the economy? What were the
financial assets have you learnt so far in your first year of study?
What do we mean by the health of the economy?
Trade, business, income level, production, currency, buying power, government
spending and revenue, unemployment, supply and demand, GDP.

Why are the financial markets important for all those above?
Because they channel funds from those who do not have a productive use for them to
those who do, thereby resulting in higher economic efficiency. The lack of an efficient
financial market prevents the utilization of money in a more effective manner. Savers
have fewer avenues in saving/investing their money, businesses have fewer avenues in
acquiring funds for their business. You would have learnt about stocks and bonds. You
have learnt about their general characteristics on equity and debt as well as their
valuations in FIN1014.

2. Some economists suspect that one of the reasons that economies in developing
countries grow so slowly is that they do not have well-developed financial markets.
Does this argument make sense?
Yes, because the absence of financial markets means that funds cannot be channelled
to people who have the most productive use for them. Entrepreneurs then cannot
acquire funds to set up businesses that would help the economy grow rapidly. Financial
markets like the equity and bond market accelerate economy expansion by allowing
businesses to acquire funds more rapidly, thus increasing productivity in a country.

3. Discuss the importance of direct finance and indirect finance in the financial system by
explaining their roles.
Direct Finance
Borrowers borrow directly from lenders in financial markets by selling financial
instruments which are claims on the borrower’s future income or assets. Direct finance
is important to the financial system because it allows governments and businesses to
directly access capital funding through public and foreign investors. Financial

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 intermediaries such as banks may not be sufficient because of their limitations in
funding, as well as in accessing foreign investors.

Indirect Finance
Borrowers borrow indirectly from lenders via financial intermediaries (established to
source both loanable funds and loan opportunities) by issuing financial instruments
which are claims on the borrower’s future income or assets. Financial intermediaries are
important to the economy because it of the benefits they provide such as liquidity, risk
sharing, transaction cost reduction and resolving asymmetric information issues.

4. Provide an example of how a commercial bank plays a crucial role in indirect financing in
a financial system. Can you name other structures of financial institutions that play a
role in indirect financing?
Commercial banks are the largest and most influential financial intermediary in the
financial system when it comes to deposit-taking and lending. It is where the public and
businesses keep savings and deposits, as well as the largest lending entity in any
country. They are the main hub that connects savers and borrowers in an economy.

Commercial banks in Malaysia such as Maybank, Public Bank, RHB Bank raise funds
primarily by issuing checkable, savings, and time deposits which are used to make
commercial, consumer and mortgage loans. They earn a profit from the difference in
interest rates that they charge. Collectively, these banks comprise the largest financial
intermediary and have the most diversified asset portfolios. Through their collection of
interest income, they help distribute interest income to the depositors in the economy,
allowing savers to also earn through the prosperity of the country.

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5. Discuss how diversification promotes risk-sharing among investors in financial
institutions.
Diversification in financial terms refers to holding of a variety to financial assets to
reduce the risk of a concentrated loss from a single asset. Financial intermediaries such
as investment companies help in risk-sharing by providing the means for individuals and
businesses to diversify their asset holdings no matter how small or big the deposit
amount is. Risk-sharing occurs as investors pool their funds together in order to
purchase many financial assets, therefore collectively benefiting from diversification. In
terms of banks, depositors also benefit from diversification when banks borrow from
many and lend to many.

Low transaction costs allow them to buy a range of assets, pool them, and then sell
rights to the diversified pool to individuals. They allow depositors to share the risk of
many borrowers from default.