Unit 1

FINANCIAL STRUCTURE P2112/1/1

FINANCIAL STRUCTURE

OBJECTIVES

General Objective : To understand the structure of financial system in Malaysia.

Specific Objectives

At the end of the unit you will be able to :

explain the evolution, function, role and structure of the financial system in

Malaysia which consist of banking system, non-bank financial intermediaries and

financial market.

explain the role and function of financial institution and financial intermediaries in

the country’s development.

explain the assets, sources and uses of fund and steps taken to develop the system.

explain in details about the flow of funds and the direction of credits.

explain in details about the latest monetary policies.

UNIT 1


explain the acts that regulate financial institution – BAFIA 1989, the Offshore

Banking Act 1990 and Islamic Banking Act 1983.

explain the role and purpose of regulatory body in Malaysian financial system.

explain the characteristics, roles and objectives of International Offshore Financial

Centre (IOFC).

discuss the factors that contribute to the successful operation of the International

Offshore Financial Centre’s (IOFC).

describe the financial services which is offered by International Offshore Financial

Centre (IOFC). Discuss the incentives given to the participants who operate in

Labuan.

identify the challenges faced by the financial sector in the global economy.


1.0 EVOLUTION, ROLES AND STRUCTURE OF THE FINANCIAL

SYSTEM

In this chapter, we will discuss about the Malaysian financial structure. Let us begin

with the:

EVOLUTION OF THE FINANCIAL SYSTEM

The development of a sound and financial system is a necessary pre-condition for a

stable and balanced economic and social development in Malaysia. In this regard,

Bank Negara Malaysia (BNM) has consciously and systematically developed a

modern and sophisticated financial system. The financial system has effectively

mobilized and allocated resources for productive use in tandem with the rapid

transformation of the economy.

The development can be divided into four phases:

First phase.

The first priority of BNM in the early 1960s was to create the basic infrastructure for

the financial system. It is also to develop a truly Malaysian-oriented banking system

to complement the presence of strong foreign banking in the economy. Therefore,

early efforts were focused on institutional building in order to develop an extensive

domestic banking network and re-orientate the operations foreign banks branches to

domestic needs.

Second phase

In the 1970s, BNM’s efforts were focused on introducing other financial

intermediaries. The establishment of merchant banks, the first of which was set up in

1970, satisfied the growing need for financial expertise in wholesale banking and

corporate financing. This is caused by the expansion of the public and private

INPUT


enterprises which progressed towards more technology-oriented activities, involving

more complicated forms of financing. In addition, BNM was also instrumental in

establishing a number of development finance institutions and the Credit Guarantee

Corporation to ensure a better position for the financial system to serve the financing

needs of a more diversified economy. Another significant development during the

decade was the enactment of a new legislation, the Banking Act 1973, to strengthen

the regulation and supervision of banking institutions.

Third phase

In the 1980s, BNM’s efforts were focused on further strengthening the regulatory

and supervisory framework for the banking system. The latter part of the 1980s was

a period of prudential re-regulation and significant structural changes in the banking

system. These changes were comprehensive and prompted by lessons from domestic

development as well as the global recession in the early 1980s. As a result, the

Malaysian banking system was strengthened considerably, and was able to remain

sound and intact despite the severe consequences of the sharp recession following

the Asian financial crisis.

Fourth phase

The 1990s was characterized by rapid changes shaped by the forces of liberalization

and globalization, aided by technology which broke new frontiers in the functioning

of financial markets and in the development of financial products. The Asian crisis

was a catharsis that catalyzed national and international efforts to strengthen

domestic financial system and the financial architecture. These issues will remain on

the Malaysian agenda in the years ahead, including an acceleration of on-going

efforts to consolidate the banking industry and to inject greater dynamism and

competition into the system.


ROLES OF THE FINANCIAL SYSTEM

Banking System

The banking system consists of BNM, the banking institutions and other

financial institutions, namely the discount houses, the representative offices of

foreign banks and offshore banks in the International Offshore Financial Centre

in Labuan (Labuan IOFC).

- BNM, as the central bank, is at the apex of the banking system, and is

responsible for the regulation and supervision of the banking system, with the

exception of the offshore banks operating in the Labuan IOFC which comes

under purview of the Labuan Offshore Financial Services Authority

(LOFSA).

- The commercial banks are the main players in the banking system. They are

the largest and most significant providers of funds in the banking system. The

range of transaction accounts typically offered are savings account, current

account, fixed deposits and negotiable instruments of deposits (NIDs). They

provide facilities for making payments or monetary transfers in domestic or

foreign currencies, both locally and internationally; makes commercial and

industrial loans and trade finance.

- Finance companies form the second largest group of deposit-taking

institutions in Malaysia. They provide finance (credit) , e.g. to operate hire

purchase transactions on behalf of retailers of consumer goods such as cars

and electronic and electrical equipment.

- Merchant banks filled the need for large corporations which require bulky

financing and complex banking services, by complementing the facilities

offered by commercial banks which are more focused on providing short-

term credit for working capital and trade financing. They also play a role in

the short-term money market and capital raising activities.

- Discount houses specialized in short-term money market operations and

mobilize deposits from the financial institutions and corporations in the form

of money at call, overnight money and short-term deposits. The funds

mobilized are invested in The Malaysian Treasury bills (TB), Malaysian


Government Securities (MGS), bankers acceptances (BA), negotiable

instrument of deposit (NID) and Cagamas bonds.

Non-bank financial intermediaries

- These institutions are generally under the supervision of various government

departments and agencies. All of them deal with funds. They mobilize funds

from certain sources and channel them to the deficit units. Like their sources,

the uses of these funds varies.

- Development finance institutions help to promote the development of certain

economic sectors through long-term investment financing. On the other hand,

provident and pension funds is designed to meet contingent financial needs of

their clients and further assist the public sector’s development efforts by

subscribing to government securities. Finally, saving institutions are

important to the small-time savers ant the rural population who usually have

less opportunities to utilize existing banking facilities.

● Financial Market

- The financial market in Malaysia comprise the money and foreign exchange

market, the capital markets, the derivatives markets and offshore markets.

- The money market is an avenue for the channeling of short-term funds with

maturities typically not exceeding 12-month. It provides a ready source of

funds for market participants facing temporary shortfalls in funding, while at

the same time, providing short-term investment outlets for those with

temporary surplus funds.

- Unlike the money market, capital markets are markets for raising long-term

funds containing the equity and bond markets.

- The derivatives markets are for trading instruments that provide contingent

claims on underlying assets, and whose values depend on the price of the

underlying assets or securities.


- The Labuan IOFC is aimed at enhancing the attractiveness of Malaysia as a

regional financial centre, as well as to promote the economic development of

Labuan and its vicinity.

STRUCTURE OF THE FINANCIAL SYSTEM

The structure of Malaysian Financial System is presented in Figure 1.1.

FINANCIAL INSTITUTIONS FINANCIAL MARKETS

Banking System

Bank Negara Malaysia

Banking Institutions

- Commercial Banks1

- Finance Companies

- Merchant Banks

● Others

- Discount Houses

- Representative Offices of Foreign

Banks

- Offshore Banks in Labuan IOFC

Non-Bank Financial Intermediaries

● Provident and Pension Funds

● Insurance Companies2

● Development Finance Institutions

● Savings Institutions

- National Savings Bank

- Co-operative societies

● Other Non-Bank Financial Intermediaries

- Unit Trusts

- Pilgrims Fund Board

- Housing Credit Institutions

- Cagamas Berhad

- Credit Guarantee Corporation

- Leasing Companies

- Factoring Companies

- Venture Capital Companies

Money & Foreign Exchange Markets

● Money Market

● Foreign Exchange Market

Capital Market

● Equity Market

● Bond Market

- Public Debt Securities

- Private Debt Securities

Derivatives Market

● Commodity Futures

● KLSE CI Futures

● KLIBOR Futures

Offshore Market

● Labuan International Offshore FinancialCentre

(IOFC)

1Including Islamic banks 2Including Takaful

Figure 1.1 Financial System

( Source: The Central Bank and the Financial System in Malaysia – A Decade of Change; BNM 1999)


1.1 ROLES OF FINANCIAL INSTITUTIONS AND FINANCIAL

INTERMEDIARIES IN THE DEVELOPMENT OF COUNTRY.

1) Intermediation function

The financial system, comprising both financial institutions and markets, acts as

an intermediary of resources in the economy. This intermediation function

involves the mobilization of resources by providing the means for savers to hold

monetary and financial assets, and allocating these resources for productive

investment. An efficient financial intermediation system helps channel resources

efficiently towards activities with high rate of return, as well as allow

implementation of projects that are larger in scale, and with longer gestation

period and riskier prospects. In addition, efficiency also means that information

is processed well, allowing investment opportunities to be identified so that

resources can be channeled to these activities.

2) Operation of the payment system

A payment system essentially refers to a network of services that facilitates

transactions involving the exchange a means of payment in return for goods,

services, real assets and financial assets. The means of payment can take on

many forms such as currency, cheques and credit cards, as well as modern

electronics means such as stored-value cards. The instruments, institutions and

services that facilitate the transfer of value to discharge the payment obligation,

serve as the payment system architecture. Therefore the payment system is a

central element in the economic infrastructure that facilitates the efficient

clearing and settlement process. Therefore, it has a significant effect on the

operating efficiency of an economy. As key players in the payment system,

strong and efficient financial institutions are essential for the efficient

functioning of the payment system.


3) As a channel for transmission of monetary policy

In addition to its contribution to the development of the economy, a well-

functioning and efficient financial system is vital for the effective conduct of

monetary policy. This is because monetary policy is transmitted primarily

through the banking system. On the other hand, an inefficient banking system,

usually characterized by financially weak banking institutions and inefficient

market mechanisms may render monetary policy less effectively in achieving its

objectives. In an environment of emerging inflationary pressure, the ability of a

central bank to raise interest rates would be constrained if the financial

institutions are weak. This is because higher interest rates would weaken the

health of the corporate sector and lead to the deterioration in the asset quality of

the banking institutions.


1.2 ASSETS, SOURCES AND USES OF FUND AND STEPS TAKEN TO

DEVELOP THE SYSTEM.

ASSETS OF THE FINANCIAL SYSTEM

Assets of the financial system are presented in Table 1.1.

Banking system1

Bank Negara Malaysia

Banking Institutions

Commercial banks2

Finance companies

Merchant banks

Discount Houses

Non-bank Financial Intermediaries

Provident and Pensions Funds

Insurance funds

Development Finance Institutions

Saving Institutions

Other Non-bank Financial Intermediaries

Growth (% per annum) Outstanding (end-period)

1988 –

1997

(Avg.)

1998

1988 –

1998

(Avg.)

RM billion

As % of

financial

system

1987 1998 1987 1998

19.2

16.2

19.7

18.9

21.8

21.5

21.4

17.2

15.4

18.6

12.5

13.3

25.0

-5.6

14.5

-8.8

-5.4

-18.9

-11.4

-4.6

8.5

12.6

11.1

28.0

-4.2

-1.6

16.7

16.1

16.7

16.5

17.3

18.0

18.8

16.4

15.2

17.9

13.8

11.6

22.3

140.6

24.2

113.4

85.8

21.3

6.3

3.0

61.6

36.8

6.4

4.8

5.4

8.3

766.7

124.7

622.0

459.2

123.6

39.2

20.2

326.6

174.0

39.3

19.8

18.0

75.5

69.5

12.0

56.1

42.4

10.5

3.1

1.5

30.5

18.2

3.2

2.4

2.7

4.1

70.1

11.4

56.9

42.0

11.3

3.6

1.8

29.9

15.9

3.6

1.8

1.6

6.9

Total Assets 18.6 -1.8 16.6 202.2 1,093.3 100.0 100.0

1Excludes Offshore Banks in Labuan IOFC 2Includes Bank Islam Malaysia Berhad

Table 1.1 Assets of the financial system

(Source: The Central Bank and the Financial System in Malaysia – A Decade of Change; BNM 1999)


SOURCES AND USES OF FUNDS

Table 1.2 summarizes the structure of the sources and uses of funds of the financial system

in selected years of the period.

Sources of funds: Capital, reserve & profit

Currency

Demand deposits

Other deposits1 (of which):

Public sector

Other financial institutions2

Private sector

Foreign

Borrowings

Funds from other financial institutions

Domestic2

Foreign

Insurance, provident & pension funds

Other liabilities

1988 1993 1998

RM million % RM million % RM million %

17,866

9,037 11,387

93,347

25,130

18,615

49,328

274

5,612

12,208

7,567 4,641

47,438

32,913

7.8

3.9 5.0

40.6

10.9

8.1

21.5

0.1

2.4

5.3

3.3 2.0

20.6

14.3

41,936

14,649 33,450

198,015

28,351

38,868

127,237

3,558

5,768

56,403

27,014 29,389

99,653

119,460

7.4

2.6 5.9

34.8

5.0

6.8

22.3

0.6

1.0

9.9

4.7 5.2

17.5

21.0

102,445

20,547 65,111

457,954

40,393

103,870

305,699

7,993

14,400

66,074

39,600 26,474

189,791

176,998

9.4

1.9 6.0

41.9

3.7

9.5

28.0

0.7

1.3

6.0

3.6 2.4

17.4

16.2

Total liabilities 229,808 100.0 569,335 100.0 1,093,321 100.0

Uses of funds:

Currency

Deposits with other financial institutions

Domestic

Foreign

Bills

Treasury

Commercial

Loans & advances

Public sector

Other financial institutions

Private sector

Foreign

Securities

Malaysian government

Foreign

Corporate

Others

Gold & foreign exchange reserves

905

33,479

28,418

5,061

5,962

4,472

1,490

93,084

2,242

2,264

87,562

1,016

62,717

51,349

2

11,366

0

17,271

0.4

14.6

12.4

2.2

2.6

1.9

0.6

40.5

1.0

1.0

38.1

0.4

27.3

22.3

0.0

4.9

0.0

7.5

1,597

115,827

108,768

7,060

7,825

2,737

5,088

209,802

2,860

3,767

201,787

1,388

105,245

61,047

69

41,703

2,427

75,309

0.3

20.3

19.1

1.2

1.4

0.5

0.9

36.9

0.5

0.7

35.4

0.2

18.5

10.7

0.0

7.3

0.4

13.2

3,224

151,578

136,138

15,440

14,648

3,796

10,852

485,712

5,567

28,995

448,318

2,832

225,569

71,575

1,269

141,781

10,944

96,265

0.3

13.9

12.5

1.4

1.3

0.3

1.0

44.4

0.5

2.7

41.0

0.3

20.6

6.5

0.1

13.0

1.0

8.8


Other assets

16,390

7.1

53,729

9.4

116,324

106

Total Assets 229,808 100.0 569,335 100.0 1,093,321 100.0

1Equal savings, fixed and other (NIF,LPHT, etc) deposits + NIDs + repos 2Effective 1998, the statutory reserves of the banking institutions have been reclassified as

“ Funds from other financial institutions” rather than “ Other deposits from other financial institutions”.

In this regard, data for prior years have also been revised accordingly.

Table 1.2 Sources and uses of funds of the financial system


STEPS TAKEN TO DEVELOP THE SYSTEM

The development of Malaysia’s financial system has evolved over several decades against

the backdrop of rapid changes in the economy and the international financial environment.

This development has been significantly shaped by BNM, and the approach of BNM in this

regard has been pragmatic and flexible. Consequently, policies have been modified

according to the changing circumstances, to achieve the objective of financial sector

development, that is, to develop an efficient and sophisticated financial system that can

support balanced economic development.

The steps taken are as discussed below:

1. Leveling the playing field

Several measures were introduced during the period of 1989-99 to level the playing field

to allow commercial banks, finance companies and merchant banks to compete on equal

ground with each other. These include the adoption of a standard ratio for the statutory

reserve requirement (SRR), as well as the introduction of the risk-weighted asset

approach as the uniform method of capital adequacy assessment for the three groups of

banking institutions. The harmonization of standards was aimed at enhancing

competition among the three groups of banking institutions, which were essentially

engaged in the same type of business.


2. Interest rate reforms

In line with the objective to develop a more market-driven financial system, the process

of interest rate reforms resumed, following its abandonment during the period of tight

liquidity from 1985-87.The pegged deposit rate arrangement was dismantled in 1987.

Meanwhile, with effect from 1st February 1991, the base lending rate (BLR) of the

banking institutions was completely freed from administrative control, with banking

institutions allow to charge a maximum of 4 percentage points above their declared

BLR. With the freeing of the BLR, both the deposit and lending rates were expected to

be determined competitively by the banking institutions, taking market forces into

consideration.

There was, however, a long transmission lag for policy (approximately 2-3 months). To

reduce this lag, a new BLR framework was introduced in November 1995, whereby the

BLR was linked to the weighted monthly average of the 3-month BNM interbank rate.

In 1998, the BLR was linked to the 3-month BNM intervention rate instead of the 3-

month interbank rate. This has reduced the transmission lag to within one week. In

addition, the maximum margin over the quoted BLR was also reduced from 4

percentage points to 2.5 percentage points.

3. Institutional development

- International Offshore Financial Centre (IOFC) was established on 1st October 1990

in Labuan, in order to enhance the attractiveness of Malaysia as a regional financial

centre, increase the contribution of the financial services sector to the nation’s GDP and

promote the economic development of Labuan and its vicinity. The IOFC conducts a

variety of international banking, insurance and investment activities.

- As part of the institutional building to develop the capital markets, BNM initiated the

establishment of the Securities Commission (SC) on 1 March 1993. A separate

institution is necessary to consolidate the regulation and supervision of the capital

markets as well as oversee future measures to broaden and deepen the markets. In


addition, it is also recognized that there is a need to further develop the capital markets as

an alternative source of funding primarily for the private sectors.

- BNM also developed the private debt securities market and the Rating Agency

Malaysia Berhad (RAM) to rate debt issues by corporations.

- To further develop Kuala Lumpur as a key financial centre, the decade also saw

initiatives being taken to promote trading in options and financial futures. On 15th

December 1995, with the launching of KLOFFE’s stock index futures contract,

Malaysia becomes the fourth Asian country after Singapore, Hong Kong and Japan to

offer domestic equity derivatives product. Another milestone during the decade was the

commencement of trading on the Malaysian Exchange of Securities Dealing &

Automated Quotation Bhd. (MESDAQ), a stock exchange targeted specifically at

growth and technology companies, on 30 April 1999.

- In the banking system, the launching of the interest-free banking scheme in March

1993 provided the foundation for developing a viable and comprehensive Islamic

banking system.

4. Consolidation and restructuring of the financial system

The consolidation of the banking institutions over the past decade, in essence, begin with

efforts by BNM to restructure the banking system following the banking crisis in the mid-

1980s. While the banking sector entered the financial crisis in 1997 from a position of

strength, the severity of the crisis weakened the health of the banking sector, as reflected

in the deterioration in capitalization and asset quality. Following these developments and

anticipation of further adverse implications of the crisis on the banking system, BNM

adopted a pre-emptive and comprehensive four-pronged plan to restructure the financial

system. This involved a strategy to consolidate the finance company industry, and

establishing Danaharta, Danamodal and Corporate Debt Restructuring Committee to deal

with the emerging problems of deteriorating asset quality and capitalization, as well as

corporate debts, respectively.


Nonetheless, the crisis exposed the vulnerability of small banking institutions and the

need for these institutions to maintain a high level of capital. In this regard, it has always

been on the agenda to encourage banking institutions to merge in order to achieve

economies of scale and higher level of efficiency. This move is aimed at strengthening

the capacity, capability and ability of domestic banking institutions to meet the

challenges arising from an increasingly competitive global environment.

5. Payment system

The design and development of effective and efficient payment systems have been an

integral part of BNM’s initiative to further enhance the operations of the financial system.

The forces of financial globalization and rapid technological advancements have also

provided the impetus for the promotion for payment mechanism that are inexpensive,

secure, reliable and efficient.

Towards this, BNM launched the payment system masterplan in 1996 to chart the

development and implementation of payment system in Malaysia. The masterplan was

formulated along the lines of the four major modes of payment instruments, namely,

cash, cheques, card-based payment instruments and electronic-based payment

mechanism.

6. Prudential and regulatory reforms

In Malaysia, the regulatory and supervisory framework of the banking system has been

continually reviewed since the early 1980s in order to ensure that it remains relevant in

the light of structural changes in the domestic economy and external environment. This

review led to the introduction of the Banking and Financial Institution Act 1989

(BAFIA) in October 1989. BAFIA provides a framework for an integrated supervision of

the Malaysian financial system and enhances the powers and duties of the auditors of

licensed institutions and made a director, officer or controller of a licensed institution

liable to indemnify the institution in full for any loss or damage in any form arising from

or caused by on offence committed by any person.


Another major related development was the transfer of regulation and supervision of the

insurance industry to BNM with effect from 1st May 1988. The main rationale behind the

relocation was to streamline and adopt an integrated approach to the supervision of the

entire financial system in the country and to realize economies of scale in regulation and

supervision.

On its part, BNM has also reviewed its supervisory approach by focusing on areas of high

risk that have adverse implications on the soundness of the banking institutions. In this

regard, BNM has adopted risk-based supervision which emphasizes a combination of

dynamic off-site surveillance and on-site examination.

7. Liberalization of the financial sector

Malaysia recognizes that the opening up of the domestic financial sector to foreign

competition would contribute towards a more efficient, competitive and market-driven

financial sector, thus enabling the sector to play a more efficient and effective role in the

economy. At the same time, it is recognized that for the benefits of liberalization to be

fully realized, the pace of liberalization has to be in tandem with the capacity and ability

of the system to absorb these changes without undermining financial stability. This policy

has resulted in a high foreign participation in the Malaysian financial sector.


Activity 1A

TEST YOUR UNDERSTANDING BEFORE YOU CONTINUE WITH THE

NEXT INPUT…!

1.1 Describe briefly the structure of the financial system in Malaysia.

1.2 What are the roles of the financial institutions and financial intermediaries in the

development of a country?

1.3 List down three sources and uses of the financial system funds.


Feedback To Activity 1A

1.1 a) Financial institution

i. Banking system

ii. Non-bank financial intermediaries

b) Financial markets

i. Money and foreign exchange markets

ii. Capital market

iii. Derivative market

iv. Offshore market

1.2 a) Intermediation function

b) Operation of the payment system

c) As a channel for transmission of monetary policy

1.3 Sources of fund: a) Deposits

b) Insurance, provident and pension funds

c) Capital, reserve and profit

Uses of fund: a) Loans and advances

b) Securities

c) Deposits with other financial institutions


1.3 FLOW OF FUNDS AND DIRECTION OF CREDITS

FLOW OF FUNDS IN AN ECONOMY

The evolution of a financial system can be broadly categorized into four basic stages.

1. Barter trade to monetary system

The first stage is when the economy moves from a barter trade system into a monetary

system, whereby commodity money was used as the basic transmission unit. Under this

system, tokens, often made of precious metals served as a standard unit of account and

measures of value to facilitate trade.

2. Saving and borrowing practices

The second stage came when the practice of borrowing began. Funds accumulated by

wealthy persons were loaned to other individuals or companies who were willing to pay

for these funds for a fee or interest. This is where those economic units who are in need

of funds “deficit” units came to terms with those who have excess funds to be lent out or

called “surplus” units. At this stage, however, there are some problems such as the

difference in amount, maturity and the element of risks.

3. Establishment of financial intermediaries

The third stage came following the establishment of financial intermediaries to

overcome the problems of primary debt in the direct borrowing-lending process. During

this stage, financial intermediaries mobilize from the surplus units and reduce their risk of

default by issuing relatively risk-free liabilities. At the same time, through their

specialized knowledge of the credit market, they were able to supply funds to deficit units

INPUT


in the amount and terms that these units were willing to pay to meet its financing needs.

The liabilities of these financial intermediaries are known as secondary or indirect debt.

4. Varied financial instruments

The final stage is when a complete set of financial intermediaries were established to

form a financial system which provide a variety of financial instruments as saving media

for the surplus units, as well as a varied range of credit and investment facilities to meet

the financing requirements of the deficit units. In of Malaysia, the country can be

considered to have arrived at the final stage of the evolution process in establishing a

complete monetary system.

Major sectors of the economy

To illustrate how fund flows in an economy with a developed financial system, it can be

divided into five major institutional sectors. These sectors are:

a) households

b) enterprises

c) government

d) financial institutions

e) external sectors

Each sector has different sources and uses of funds from the other sectors and behaves

relatively homogeneous as a group.

The household sector, as a group is usually the major net surplus unit in an economy since

they save a large proportion of their income and invest their savings in the form of real and

financial assets. However, not all households are surplus units as a significant proportion of

the funds mobilized by the financial intermediaries are channeled back to household in the

form of consumer credits and housing loans.


The private enterprises and the government sectors are usually the deficit units since they

are the sectors primarily involved in the investment process in an economy. These sectors

mobilize resources mainly through the financial system in the form of loans equity capital,

bills and long-term securities.

The financial system basically serves to assist in the allocation of scarce resources in an

economy from the surplus units to the deficit units. To do this, an efficient recycling

mechanism is essential in order that scarce resources would be used to their optimum for

the development of the nation.

Financial intermediaries primarily operate in two markets. First is the saving markets

where they operate as borrowers while meeting the demand for financial assets by surplus

units. To fulfill this function, financial institutions have introduced various savings and

investment instruments to attract funds from the surplus units. The other one is the credit

market where financial intermediaries supply the financial resources required by the deficit

units. Here, again, they offer various financial instruments as a conduit to supply funds to

the deficit units.

Under the present situation, financial intermediaries operate in various markets such as the

money and foreign exchange markets, the capital markets and the financial futures and

option markets.


Table 1.3 The flow of funds in an economy

SOURCES OF FUNDS

SURPLUS

UNIT

FINANCIAL

INSTRUMENTS

FINANCIAL

INTERMEDIARIES

USES OF FUNDS

FINANCIAL

INSTRUMENTS

DEFICIT

UNITS

Currency Deposits

Bills

Loans Bonds

Unit trusts Share capital

Insurance premiums

Provident funds Pension funds

Foreign loans Investments

Central bank

Commercial banks Finance companies

Merchant banks Discount houses

Industrial Fin. Inst. Saving inst.

Provident funds Pension funds

Insurance companies Unit trusts

Building societies Cooperatives

Other fin. inst.

Money at call

Overdrafts Bills

Term loans Hire purchase Bridging loans

Leasing

Securities Bonds

Debentures External reserves

Investment or

expenditure of:

Households

Enterprises

Government

Financial institutions

External sector

Saving or Investment

of:

Households

Enterprises

Government

Financial institutions

External

sector


DIRECTION OF CREDITS

The financial system extended credit to the non-financial private sector in the form of loans

and advances, as well as through the holding of corporate securities. Figure 1.2 below

provides a graphic illustration of the change in the direction of credit to the non-financial

private sector over the period.

Sector 1988 1998

Investment in corporate securities 11.5% 24.0%

Manufacturing 15.6% 9.7%

Construction 18.8% 15.6%

Housing 13.7% 11.1%

Consumption credit 4.1% 8.5%

Purchase of shares 1.1% 4.8%

Others 35.3% 26.3%

Table 1.4 Direction of credit. (% of total credit outstanding)


0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

Investment in

corporate

securitiesManufacturing

Construction

Housing

Consumption

credit

Purchase of

shares

Others

Figure 1.2: Direction of credit (1988)


0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%Investment in corporate

securities

Manufacturing

Construction

Housing

Consumption credit

Purchase of shares

Others

Figure 1.3: Direction of credit (1998)

1.4 LATEST MONETARY POLICIES

The Malaysian economy was fundamentally strong prior to the start of the crisis. In the

first two quarters of 1997, real GDP continued to grow at about 8%. The government

continued to record fiscal surpluses and, very importantly, the level of external debt was

low at 43.2% of GNP. At the end of 1997, the fundamentals of the economy were

strengthened further. The economic growth was achieved resulting in a lower inflation

rate and an improved balance of payments position. In the banking sector, the structural

reforms undertaken since the mid-1980s strengthened the banking system.

Given the strong macroeconomic and institutional fundamentals at the outset of the

crisis, Malaysia had greater flexibility in responding to the crisis. While there were

structural imbalances present such as the current account deficit, asset inflation and high

credit growth, policies were already in place to address these weaknesses and positive

results began to emerge.


Despite strong fundamentals, the East Asian financial crisis affected Malaysian

economy in numerous ways. In addition to instability of financial markets, the crisis

affected the real sector and weakened the financial sector. Towards the end of 1997, the

real GDP increased by 7.5% (10% in 1996). However, in 1998, the real GDP declined

by 7.5%. That was the first negative growth registered since 1985 and the trough was

reached in the third quarter of 1998. The crisis affected all the broad sectors in

Malaysian economy including the financial, real and external sectors. However, due to

the stronger fundamentals and affirmative action to eradicate poverty, the social

consequences from the crisis was less severe on Malaysia.

The impact of the crisis on Malaysian economy was discussed as below:

Depreciation of Ringgit

The crisis was felt in the KL foreign exchange and stock markets. Between end of

June 1997 and end of December 1998, ringgit was depreciated by 33.6% against the

United States Dollar. It was further depreciated to a historic low of RM4.88 against

the US Dollar on 7th January 1998, but strengthened thereafter. From February to

June 1998, the value of ringgit was relatively stable between US$1= RM3.84-3.98.

From June to August 1998, the downward pressure on ringgit was intensified

following the depreciation of the Japanese Yen, the contraction in the domestic

economy and increased speculative activity.

The immediate impact of the ringgit depreciation was on the stock market, with the

Kuala Lumpur Stock Exchange Composite Index (KLSE CI) declining about 144.8%

in the second half 1997. As the contagion spread in the region, investors’ confidence

was further eroded, the reversal of short-term capital flows caused the ringgit to be

depreciated further by as much as 20% on 7th January 1998 and the KLSE CI to

decline to as low as 286 points on 1st September 1998.


State of the banking system

The sharp depreciation of ringgit combined with the fall in share prices had a

material adverse effects on earnings and overall performance of the banking sector.

The decline in the property and stock markets, the debt-servicing capacity of

borrowers was also affected by the economic contraction, resulting in deterioration

in the asset quality of the portfolio of the banking institutions. The reluctance of the

banking institutions to lend, combined with higher interest rate led to severe

difficulties for individuals and businesses, including viable businesses in productive

economic activities, to obtain financing. These development caused loan growth

(including loans sold to Danaharta) to slow down from of 26.5% at the end of 1997

to 1.3% at the end of 1998.

Inflation

The price pressures arose from the depreciation of ringgit became apparent towards

the end of 1997. Inflation, in terms of CPI, peaked at 6.2% on an annual basis in

June 1998, and moderated thereafter. In 1998 alone, the CPI rose by 5.3%, the

highest increase since 1982. The PPI also increased by 10.7% in 1998 (2.7% in

1997). The rather “mild” inflation, despite the severe depreciation, was due mainly

to the contraction of domestic demand.


Policy response to the crisis.

Initial Policy Response

Initially, Malaysia did follow some of the standard IMF prescriptions adopted by other crisis

countries, but subsequently choose a different route. While the policy direction was changed

early in the crisis, the ultimate objective of ensuring growth with the price stability remained

unchanged. The selective exchange control measures were a necessary part of the efforts to

stabilize domestic financial markets to ensure that the prospects for an economic recovery

would not be jeopardized by external developments and contagion.

High interest rate to contain speculation against the ringgit was adopted only for a brief

period. When it proved ineffective, interest rate were restored to pre-crisis levels soon after,

and were maintained till September 1997. Thereafter, interest rates were adjusted to reflect

higher rates of inflation to ensure a positive real rate of return to savers.

As higher interest rates were considered detrimental to the real sector, a credit plan was

introduced in September 1997 to moderate loan growth. The target loan growth rate was set

as 25% by the end 1997 (from 29% at end September 1997), a 20% by the end of the first

quarter of 1998 and 15% by the end of 1998. In addition, more stringent guidelines were

imposed on hire purchase loans for non-commercial passenger vehicles.

With respect to fiscal policy, the government reduced its expenditure and deferred

implementation of selected infrastructure projects. The government, however, ensured that

budget allocations with respect to health, education and the provision of other basic

amenities were maintained. In early 1998, the IMF advised against Malaysia’s plans to

reverse fiscal policy to a deficit position to arrest emerging signs of economic contraction.

However, in April – may 1998, when it was clear that the economy was contracting,

Malaysia unilaterally allocated additional fiscal expenditures amounting to RM3 billion.

In the financial sector, prudential regulations of the financial sector were adjusted further to

be consistent with international standards. This included reclassification of loans as non-

performing which had been in arrears for 3 months (instead of 6 month previously),


increasing the rate for general provisioning and requiring greater financial disclosure by

banking institutions.

The need for a change in policy direction

The combination of tight monetary policy and fiscal restraint adopted in an environment of

weakening external demand caused aggregate demand to fall more sharply than anticipated.

Then, the Malaysian Government adopted a more comprehensive and forward-looking

policy approach. Policies were formulated taking into account the likely developments and

the associated risks. The approach was a pragmatic one to adjust the policy direction to the

changing economic circumstances.

Economic Recovery Plan – Mid 1998

Beginning mid-1998, the policy focus shifted towards reviving the economy. In view of this

objective, the government eased its monetary and fiscal policies. Amidst the deteriorating

economic conditions, the National Economic Action Council (NEAC) was established on 7

January 1998 to make concrete recommendations to the government to arrest the worsening

economic situation and revitalize the economy. On 23 July 1998, the NEAC launched the

National Economic Recovery Plan (NERP) to provide a comprehensive framework for

economic recovery and to counter the negative impact of the ringgit depreciation and the

decline of the stock market.

The NERP had six objectives, which included the short-term focus of stabilizing the ringgit;

restoring market confidence; and maintaining financial market stability. These were

complemented with structural reform objectives of strengthening economic fundamentals;

continuing the socio-economic agenda; and restoring adversely affected sectors.

Since early August 1998, monetary policy has become accommodative by reducing interest

rates and the SRR to reinforce expansionary fiscal policy and revive the economy. The 3-

month intervention rate of BNM was reduced in three successive steps, from 11% to 9.5%


during the month of August. The SRR was reduced from 8% to 6 % on 1 September, when

the selective exchange controls were imposed and further to 4% on 16 September in order to

ensure adequate liquidity in the banking system and to reduce their cost of funds.

The importance of the efficient functioning of the intermediation role of the banking

institutions came to the forefront during the crisis period. In an environment of uncertainty,

banking institutions had become excessively cautious in their lending decisions, causing a

sharp slowdown in credit. To avoid a credit crunch situation, banking institutions with

sufficient capacity were encouraged to achieve a minimum loan growth rate of 8% for 1998.

Pre-emptive measures were also introduced to strengthen the resilience of the financial

sector to avoid systemic risks and to ensure the continued efficient functioning of the

banking sector and promote market confidence in the face of deteriorating economic

conditions. The measures were multi-pronged - aimed at strengthening all aspects of the

financial system. The measures included the consolidation of the finance companies, the

establishment of Danaharta, to purchase NPLs from banking institutions and manage these

NPLs in order to maximize their recovery value; Danmodal, to facilitate the recapitalisation

of banking institutions; and the Corporate Debt Restructuring Committee (CDRC), a

platform for both the borrowers and the creditors to work out feasible debt restructuring

schemes without having to resort to legal proceedings.

Selective Exchange Control Measures

The selective exchange control measures were designed to achieve specific objectives. The

controls were aimed specifically at eliminating access to ringgit by speculators by reducing

the offshore market in ringgit and limiting the supply of ringgit to speculators. In addition,

the measures were also aimed at stabilizing short-term capital flows. They were carefully

designed to have minimal impact on economic activities. Thus, rules that governed trade

transactions and foreign direct investment were left unchanged. Current account

convertibility continued to be maintained. The only requirement was for trade settlements to

be carried out in foreign currencies. These measures were essentially aimed at curbing the


internationalization of the ringgit. As such, the exchange controls affect only short-term

flows. Medium and long-term flows of foreign funds into the country continue to be

unaffected by the controls.

The main selective exchange control measures were:

control the transfer of funds in the external accounts to immobilize trading of ringgit

offshore;

control on ringgit loans to non-residents;

imposition of the 12-month holding rule on the repatriation of funds in external

accounts (replaced by repatriation levy on portfolio funds on 15 February 1999

which was subsequently liberalized further on 21 September 1999);

limiting the amount of ringgit that could be imported or exported and the amount of

foreign currency that could be exported.

1.5 ACTS THAT REGULATE FINANCIAL INSTITUTION

The Banking and Financial Institutions Act 1989 (BAFIA)

A major event which took place in 1989 was the introduction of the Banking and

Financial Institutions Act 1989 (BAFIA) to replace the Banking Act 1973 and Finance

Companies Act 1969. The introduction of BAFIA was intended to provide an integrated

supervision of the Malaysian financial system and to modernize and streamline the laws

related to banking and banking institutions.

Rationale for BAFIA

The growing competition in the banking system had resulted in the blurring of lines of

business between the three traditional groups of banking institutions under the Central

Bank supervision, namely, commercial banks, merchant banks and finance companies.

This had let to the extent that the methodology of supervision of these institutions had

increasingly converged although the legislative basis for supervision was legally


separated under the repealed Banking Act 1973 and repealed Finance Companies Act

1969.

BAFIA placed all banking institutions supervised by the Central Bank, including

discount houses and money and foreign exchange brokers which were previously

supervised on an administrative basis, under one supervisory and regulatory scheme.

BAFIA was built on the strength of the regulatory regime in the two repealed acts, while

the prudential and structural regulatory features essential for ensuring the stability of the

banking system have not been changed under the BAFIA.

The Institutions under BAFIA

a) Licensed institutions

Comprising commercial banks, merchant banks, finance companies, discount

houses, money brokers and foreign exchange brokers.

b) Scheduled institutions

Comprising the major non-bank sources of credit and finance and representative

offices of foreign banks or foreign institutions which carry out the business or

activities similar to the scheduled institutions.

c) Non-scheduled institutions

Comprising all other statutory bodies and institutions involved in the provision of

finance and credit.

The Offshore Banking Act 1990

The Offshore Banking Act 1990 (OBA) governs the activities of offshore banking

and offshore investment banking. Bank and financial institutions intending to

operate as an offshore investment bank in Labuan are required to seek a license from

the Minister of Finance through Labuan Offshore Financial Services Authority

(LOFSA).

In the amendments to OBA in 1996, major changes were made, among others, by

expanding the definition of offshore banking business to include a wide range of

financial services that could be undertaken by offshore banks instead of only

providing credit facilities and accepting deposits.


The Islamic Banking Act 1983

An act which came into effect on April 7th

1983, to provide for the licensing and

regulation of Islamic banking business. The act inter alia has provisions on the

financial requirements and duties of an Islamic Bank, ownership, control and

management of Islamic banks, restriction of its business, powers of supervision and

control over Islamic bank and other general provision such as penalties etc.

1.6 ROLE AND PURPOSE OF REGULATORY BODIES

i. Bank Negara Malaysia

Bank Negara Malaysia (BNM) is a regulatory body to have primary oversight of the

monetary and banking system in Malaysia. To enable BNM to meet its objectives, it is

vested with comprehensive legal powers under various Acts and Ordinances to regulate and

supervise the financial system. BNM was also as agent of the government on exchange

control matters. Furthermore, effective 1 May 1988, BNM was also responsible for the

supervision, regulation and development of the insurance industry as part of the financial

system.

ii. Security Commission

To streamline the regulatory structure of the capital markets, the Security Commission (SC)

was established under the Securities Commission Act 1993, as a self-funding statutory body

with investigate and enforcement powers. The mission is to promote and maintain fair,

efficient, secure and transparent securities and futures markets and to facilitate the orderly

development of an innovative and competitive capital market.

The SC’s many regulatory functions include:

Supervising exchanges, clearing houses and central depositors;

Registering authority for prospectuses of corporations other than unlisted recreational

clubs;

Approving authority for corporate bond issues;

Regulating all matters relating to securities and futures contracts;


Regulating the take-over and mergers of companies;

Regulating all matters relating to unit trust schemes;

Licensing and supervising all licensed persons;

Encouraging self-regulation; and

Ensuring proper conduct of market institutions and licensed persons.


Activity 1B

TEST YOUR UNDERSTANDING BEFORE YOU CONTINUE TO THE NEXT

INPUT…!

1.4 List down five major sectors in the economic fund flow.

1.5 Name three special mechanisms which are established to overcome the serious increas

NPLs banking industry.

1.6 Name the regulatory bodies in Malaysian financial system.


Feedback To Activity 1B

1.4 i) Households

ii) Enterprises

iii) Government

iv) Financial institutions

v) External sectors

1.5 Danaharta, Danamodal and Corporate Debt Re-structuring Committee (CDRC)

1.6 Bank Negara Malaysia and Security Commission


1.7 CHARACTERISTICS, ROLES AND OBJECTIVES OF IOFC

The Characteristics of an IOFC

An offshore is basically a small territory or jurisdiction that imposes low or no taxes

on income, profit, dividend and interest earned or derived from the offshore business

activities or transactions carried out by offshore multinational corporation in or from

those jurisdictions. Generally also, it does not have any exchange control or

limitation or transboundary movement of funds into and out of the jurisdiction by the

offshore company, no stamp death, inheritance or estate duties and no value added

tax. An IOFC maintains a high degree of secrecy through limitation on public

inspection of company files, prohibition from disclosure of the shareholding or

beneficial ownership and management of the business, financial or other affairs of

the company other than in compliance with the law.

The roles and objectives of IOFC

In summary, the objectives of establishing Labuan IOFC are as follows:

a) to enhance the attractiveness of Malaysia as an investment centre.

b) to supplement the onshore financial system centre in Kuala Lumpur by

tapping the growing demand for tailored financial and related services.

c) to strengthen the contribution of broad financial sector to the progress of

diversified economic growth.

d) To form part of the broad national strategy to spread out and diversify the

growth opportunities of the nation, focusing attention on the further

development of East Malaysia in terms of industrial and services (including

tourism) development.

INPUT


1.8 FACTORS THAT CONTRIBUTE TO THE SUCCESSFUL OPERATION OF

IOFC

There are some factors that contribute to the success of the existing IOFC:

a) Political stability in the country which is a crucial factor in the investment decisions

of the potential players.

b) Stable currency with minimum or no exchange control.

c) Banking secrecy and confidentiality coupled with minimum rules and regulations.

d) A competitive tax regime. The tax rate imposed on offshore companies is among the

lowest in the world.

e) Lower operating costs compared to other financial centres in the region.

f) Good infrastructural support facilities such as excellent communications and

transportation system with other financial centres.

g) Professionally qualified and experienced workforce.

1.9 FINANCIAL SERVICES WHICH IS OFFERED BY IOFC AND

INCENTIVES GIVEN TO THE PARTICIPANTS

Financial services offered in Labuan IOFC

Some of the international business activities that can be conducted in Labuan IOFC are:

a) offshore banking operations

b) offshore insurance and offshore insurance-related businesses

c) corporate funding

d) investments and trust management

e) offshore investment holding companies

f) professional services and other related services.


Incentives to operate in Labuan IOFC

Some of the incentives offered to financial institutions to attract them to operate in

Labuan IOFC are:

a) Low or no taxes on income, profit, dividend and interest earned from offshore

business activities or transactions carried out by the offshore multinational

corporation in or from the territory.

b) No limitation or exchange control on the movement of funds in or out of the territory

(other than the standard exchange control requirements on resident and nonresident

institutions).

c) No levy stamp, inheritance, death or estate duties and no value added tax.

d) Strict rules on confidentiality in the territory or accounts in the territory’s banks.

1.10 CHALLENGES OF THE FINANCIAL SECTOR IN GLOBAL ECONOMY

The rapid intensification of globalization in recent years has significantly affected the

structure and operations of financial institutions all over the world, including Malaysia.

Globalisation is rapidly and irreversibly changing the way business and policy are

conducted. For instance, the global trend towards liberalization in the financial system

has led to the blurring of traditional demarcation lines separating the activities of the

different groups of financial institutions and removed artificial barriers to competition.

As a result, the array of activities that can be undertaken by different groups of financial

institutions is converging.

Technological advances in telecommunications, information processing and computing

have been a key factor in integrating financial markets across the globe, and in enabling

the design of innovative and complex financial instruments that have helped to improve

risk management and shifted risks to those who are better able to manage them.

Consequently, economic agents have become willing to assume greater risk, while

short-term capital funds have flowed rapidly in large amounts from developed

economies into emerging economies since the late 1980s.


The measures that have been undertaken so far would serve as the foundation to further

enhance the capability and capacity of the domestic financial system, and to achieve the

agenda for the financial system, as follows:

To create strong, efficient, competitive and resilient banking system that would be

better able to withstand future shocks, thereby, minimizing the adverse implications

on macroeconomic stability.

To accelerate implementation of measures to broaden and deepen financial markets

and strengthen the financial infrastructure. In particular, efforts will be intensified to

increase the proportion of non-bank financing in the economy and diversify risks

away from the banking system. In this regard, the further development of the bond

market and securitization would be accelerated.

To inculcate strong risk management skills in order to ensure that there is no

excessive risk taking that could result in adverse implications, given the increasing

volatility of the financial environment.

To promote dynamism in developing new products and management systems.


Activity 1C

TEST YOUR UNDERSTANDING BEFORE YOU CONTINUE TO THE NEXT

INPUT…!

1.7 What are the main objectives of establishing International Offshore Financial Centre

(IOFC)?

1.8 What are the challenges faced by the financial sectors in global economy?


Feedback To Activity 1C

1.7 To complement Kuala Lumpur as a regional financial centre, strengthen the

contributions of the financial services sector to the gross national product of Malaysia

and promote the economic development of Labuan and its vicinity.

1.8 i) Liberalization in the financial system

ii) Technological advances in telecommunications, information processing and

computing.


KEY FACTS

1. Briefly the structure of the financial system is as follow:

a) Financial institutions

i.i Banking system

i.ii Non-bank financial intermediaries

b) Financial markets

i. Money and foreign exchange markets

ii. Capital market

iii. Derivative market

iv. Offshore market

2. The roles of financial institutions and financial intermediaries in the country’s

development:

a) Intermediation function

b) Operation of the payment system

c) As a channel for transmission of monetary policy

3. The main assets of the financial system:

a) Commercial banks

b) Provident and pension funds

c) Bank Negara Malaysia

d) Finance companies


4. Financial intermediaries primarily operate in two markets. First in the saving market

where they operate as borrowers while meeting the demand for financial assets by

surplus units. The other one is the credit market where financial intermediaries supply

the financial resources required by the deficit units.

5. The main objectives of establishing International Offshore Financial Center (IOFC) are

to complement Kuala Lumpur as a regional financial center, strengthen the contributions

of the financial services sector to the gross national product of Malaysia and promote the

economic development of Labuan and its vicinity.


SELF-ASSESSMENT 1

You are approaching success. Try all the questions in this self-assessment section

and check your answers with those given in the Feedback on Self-Assessment 1 given

on the next page. If you face any problems, discuss it with your lecturer. Good luck.

1. The Malaysian financial system can be broadly divided into banking system and non-

bank financial intermediaries.

Distinguish the groups of institutions that fall into the two categories.

2. In an economy, the financial system acts as the conduit for the flow of funds, channeling

savings of the economy for productive investment.

The more efficient the system of financial intermediation, the more effective it would be

in mobilizing previously idle resources for development in those areas that need these

funds the most.

Describe how funds flow an economy. Identify the units that are considered having

surplus funds and those in need of funds.


Feedback To Self-Assessment 1

1. a) Financial Institutions

The banking system which is the major component of the financial sector consists of:

- Bank Negara Malaysia

- Commercial banks (include Bank Islam Malaysia Berhad and Bank Muamalat

Malaysia Berhad)

- Finance companies

- Merchant banks

- Discount houses

- Foreign bank’s representative offices

They are regulated and supervised by the central bank.

b) Non-bank financial intermediaries

The non-bank financial intermediaries are mainly supervised by other government

agencies.

These institutions can be divided into five major groups consisting of:

i. Provident and pension funds

ii. Insurance companies

iii. Development financial institutions

iv. Saving institutions

v. Other non-bank financial intermediaries comprising Unit trusts, Pilgrims

Fund board, Housing Credit Institutions, Cagamas Berhad, Credit Guarantee

Corporation, Leasing Companies, Factoring Companies and Venture Capital

Companies.


2. The flow of fund is presented in graphical form table below to provide information on

how savings are mobilized through the organized financial system including banking

institutions. It also illustrate how these funds are utilized.

The units that are considered having surplus funds and those in need of funds:

- Household: usually the major net surplus unit

- Enterprises: usually the deficit units

- Government: usually the deficit units

- External sector: usually the deficit units

CONGRATULATIONS!!!!…..

May success be with you

always….

Private sector

savings

Net Inflow of

Long-Term

Funds

Public sector

savings

Financial

Intermediaries:

Saving and

Other Financial

Institutions

TOTAL

FLOWS OF

CAPITAL

FUNDS

Private

Investment

R

I

GF

F

FF

r

iv

a

t

e

i

nv

e

st

m

e

nt

Accumulation of

International

Reserves

c

cu

m

u

la

t

io

n

o

f

in

t

er

n

a

ti

o

na

l

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e

s

er

v

es

Unidentified

private payments

abroad

Public

investment

Documents

Unit 1