LECTURE 1 Introduction: Bank and Financial Intermediation

Islamic Banking Management

Wahyu JATMIKO, PhD

wahyujatmiko@ui.ac.id | w.jatmiko09@gmail.com

@wj.miko

February 2023

​

Objectives

• Definition and concept of Financial intermediation
• Definition and concept of bank
• Bank business model
• Types of Banking

​

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Reading Materials

MAT Ch. 3

MOL Ch.1 | MOL Ch.3 | MOL Ch.8

Financial intermediation

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Conceptual Definition of Financial Intermediation

• “Financial intermediation refers to borrowing by deficit units from financial institutions rather than directly from the surplus units themselves.
• Hence, financial intermediation is a process which involves surplus units depositing funds with financial institutions who in turn lend to deficit units.” (MAT)
• Three categories of Financial Intermediaries:
• Accept deposits and make loans directly to borrowers: Ex: banks and building societies.
• Lend via the purchase of securities thus providing capital indirectly via the capital market rather than making loans: Ex: insurance companies, pension funds and the various types of investment trusts.
• A broker who acts as a third party to arrange deals but does not act as a principal.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Financial Intermediation

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

(MAT)

Direct vs Indirect Finance

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

(MKN Pp. 56)

Issues with Direct Finance

Two types of barriers can be identified to the direct financing process:

• The difficulty and expense of matching the complex needs of individual borrowers and lenders.
• The incompatibility of the financial needs of borrowers and lenders.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Lenders vs. borrowers' requirements (1 of 2)

LENDERS

• The minimisation of risk. This includes the minimisation of the risk of default (the borrower not meeting repayment obligations) and the risk of assets dropping in value.
• The minimisation of cost. Lenders aim to minimise their costs.
• Liquidity. Lenders value the ease of converting a financial claim into cash without loss of capital value; therefore they prefer holding assets that are more easily converted into cash. One reason for this is the lack of knowledge of future events, which results in lenders preferring short-term to long-term lending.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Lenders vs. borrowers' requirements (2 of 2)

BORROWERS

• Funds at a particular specified date.
• Funds for a specific period of time; preferably long-term. (Think of the case of a company borrowing to purchase capital equipment which will achieve positive returns only in the longer term or of an individual borrowing to purchase a house.)
• Funds at the lowest possible cost.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why Indirect Finance (Fin. Intermediary) is Important? (1 of 5)

Transaction costs

• The time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend.
• Without financial intermediaries you will need:
• Spending time to find the right person.
• Spend additional money to hire lawyer writing up the contract for you.
• It does not mean that financial intermediaries make the transaction cost zero.
• Instead, they benefit from their economies of scale, the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases.
• This lower transaction costs also mean that they can provide their customers with liquidity services, services that make it easier for customers to conduct transactions

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why Indirect Finance (Fin. Intermediary) is Important? (2 of 5)

Risk Sharing

• Financial intermediaries can help reduce the exposure of investors to risk—that is, uncertainty about the returns investors will earn on assets.
• They can perform asset transformation by creating and selling assets with risk characteristics that people are comfortable with
• The intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk.
• Low transaction costs allow financial intermediaries to share risk at low cost.
• They can also perform less costly portfolio diversification (not put all your eggs in one basket).

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why Indirect Finance (Fin. Intermediary) is Important? (3 of 5)

Asymmetric Information: Adverse Selection and Moral Hazard

One party often does not know enough about the other party to make accurate decisions.

Ex: How do you know that your chosen business partner is the right one? How do you know that s/he will not use the money for other thing not related to the business?

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why Indirect Finance (Fin. Intermediary) is Important? (4 of 5)

Adverse selection (Finding the right one)

• The problem created by asymmetric information before the transaction occurs (ex-ante).
• The potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected.
• Lenders then may decide not to make any loans even though good credit risks exist in the marketplace.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why Indirect Finance (Fin. Intermediary) is Important? (5 of 5)

Moral hazard (monitoring and controlling)

• This occurs after the transaction (ex-post).
• The borrower might engage in undesirable (immoral) activities making it less likely that the loan will be paid back.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Bank

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Conceptual Definition of Bank

• “A bank is a financial intermediary that offers loans and deposits, and payment services.” (MOL)
• It acts as intermediaries between borrowers and savers.
• Banks offers an important function of promoting a better allocation of resources by channelling funds from savers to borrowers.

​

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Roles of Bank (1 of 3)

Size transformation

• Savers/depositors are willing to lend smaller amounts of money than the amounts required by borrowers.
• Banks perform this size-transformation function exploiting economies of scale associated with the lending/borrowing function because they have access to a larger number of depositors than any individual borrower.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Roles of Bank (2 of 3)

Maturity transformation

• Banks transform funds lent for a short period of time into medium- and long-term loans.
• Banks are said to be ‘borrowing short and lending long’ and in this process they are said to ‘mismatch’ their assets and liabilities.
• This mismatch can create problems in terms of liquidity risk, which is the risk of not having enough liquid funds to meet one’s liabilities.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Roles of Bank (3 of 3)

Risk transformation

• Individual borrowers carry a risk of default (known as credit risk), that is the risk that they might not be able to repay the amount of money they borrowed.
• Savers wish to minimise risk and prefer their money to be safe.
• Banks are able to minimise the risk of individual loans by diversifying their investments, pooling risks, screening and monitoring borrowers and holding capital and reserves as a buffer for unexpected losses.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why do banks exist? (1 of 5)

Delegated monitoring

• An intermediary (such as a bank) is delegated the task of costly monitoring of loan contracts written with firms who borrow from it.
• It has a gross cost advantage in collecting this information because the alternative is either duplication of effort if each lender monitors directly or a free- rider problem in which case no lender monitors.
• Financial intermediation theories are generally based on some cost advantage for the intermediary. Schumpeter assigned such a delegated monitoring role to banks.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why do banks exist? (2 of 5)

Information production

• If information about possible investment opportunities is not free, then economic agents may find it worthwhile to produce such information.
• Surplus units could incur substantial search costs if they were to seek out borrowers directly
• Banks have economies of scale and other expertise in processing information relating to deficit units – this information may be obtained upon first contact with borrowers but in reality is more likely to be learned over time through repeated dealings with the borrower.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why do banks exist? (3 of 5)

Liquidity transformation

• Banks provide financial or secondary claims to surplus units (depositors) that often have superior liquidity features compared with direct claims (such as equity or bonds).
• Banks’ deposits can be viewed as contracts offering high liquidity and low risk that are held on the liabilities side of a bank’s balance sheet.

​

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why do banks exist? (4 of 5)

Consumption smoothing

• Banks are institutions that enable economic agents to smooth consumption by offering insurance against shocks to a consumer’s consumption path.
• The argument goes that economic agents have uncertain preferences about their expenditure and this creates a demand for liquid assets.
• Financial intermediaries in general, and banks in particular, provide these assets via lending and this helps smooth consumption patterns for individuals.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Why do banks exist? (5 of 5)

Commitment mechanisms

• To control the risk-taking propensity of banks, demand deposits have developed because changes in the supply and demand of these instruments will be reflected in financing costs and this disciplines or commits banks to behave prudently (ensuring banks hold sufficient liquidity and capital resources)

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Bank Business Model

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Payment Services

• Credit transfers
• Standing orders
• Direct debits
• Plastic cards
• Credit cards
• Pre-paid credit cards
• Debit cards
• Delayed debit cards
• Cheque guarantee cards
• Travel and entertainment cards (or charge cards)
• Smart, memory or chip cards

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Deposit and lending services

• Current or checking accounts
• Time or savings deposits
• Consumer loans and mortgages

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Investment, pensions and insurance services

• Investment products
• Pensions and insurance services
• Payment protection insurance

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

E-Banking

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Evolving role of the branch in a multi-channel environment, 1980–2011

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Types of Banking

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Traditional versus modern banking

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Universal Banking

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Investment, pensions and insurance services

• Investment products
• Pensions and insurance services
• Payment protection insurance

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Retail or personal banking

Commercial banks

• They are the major financial intermediary in any economy. They are the main providers of credit to the household and corporate sector and operate the payments mechanism.
• Commercial banks are typically joint stock companies and may be either publicly listed on the stock exchange or privately owned.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Retail or personal banking

Savings banks

• Savings banks are similar in many respects to commercial banks although their main difference (typically) relates to their ownership features – savings banks have traditionally had mutual ownership, being owned by their ‘members’ or ‘shareholders’, who are the depositors or borrowers.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Retail or personal banking

Co-operative banks

Another type of institution similar in many respects to savings banks are the co-operative banks. These originally had mutual ownership and typically offered retail and small business banking services. Co-operative banks are an important part of the financial sector in Germany, Austria, Italy, France, the Netherlands, Spain and Finland.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Retail or personal banking

Building societies

Another type of financial institution offering personal banking services prevalent in the United Kingdom and various other countries (such as Australia and South Africa) are building societies. These are similar to savings and co-operative banks as they have mutual ownership and focus primarily on retail deposit taking and mortgage lending.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Retail or personal banking

Credit unions

Credit unions are another type of mutual deposit institution that are non-profit co-operative institutions that are owned by their members who pool their savings and lend to each other. They are usually regulated differently from banks. Many of their staff are part-time.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Retail or personal banking

Finance houses

Finance companies provide finance to individuals (and also companies) by making consumer, commercial and other types of loans. They differ from banks because they typically do not take deposits and raise funds by issuing money market (such as commercial paper) and capital market (stocks and bonds) instruments.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Private banking

Private banking concerns the high-quality provision of a range of financial and related services to wealthy clients, principally individuals and their families. Typically, the services on offer combine retail banking products such as payment and account facilities plus a wide range of up-market investment-related services. Market segmentation and the offering of high-quality service provision forms the essence of private banking. Key components include:

• tailoring services to individual client requirements;
• anticipation of client needs;
• long-term relationship orientation;
• personal contact;
• discretion.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Corporate banking

Corporate banking relates to banking services provided to companies, although typically the term refers to services provided to relatively large firms.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Investment banking

The main role of investment banks is to help companies and governments raise funds in the capital market, either through the issue of stock (otherwise referred to as equity or shares) or debt (bonds).

Their primary business relates to issuing new debt and equity that they arrange on behalf of clients as well as providing corporate advisory services on mergers and acquisitions (M&As) and other types of corporate restructuring. Typically, their activities cover the following areas:

• Provision of financial advisory services (advice on M&A and other financial transactions).
• Asset management – managing wholesale investments (such as pension funds for corporate clients) as well as providing investment advisory services to wealthy individuals (private banking) and institutions.
• Other securities services – brokerage, financing services and securities lending.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Islamic banking

• Islamic banking services have to develop products and services that do not charge or pay interest.
• Their solution is to offer various profit sharing-related products whereby depositors share in the risk of the bank’s lending.
• Depositors earn a return (instead of interest) and borrowers repay loans based on the profits generated from the project on which the loan is lent.

Wahyu Jatmiko | Introduction: Bank and Financial Intermediation

Thank you

Wahyu JATMIKO, PhD

wahyujatmiko@ui.ac.id

w.jatmiko09@gmail.com

@wj.miko