Overview Of Financial System

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02 Nov 2017

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The financial system is the system that allows the lenders and borrowers exchange money or funds. It consists one or more application and use for collection, procedure, maintenance, sending and reporting financial data activities. Also, its use to support the planning of financial or budget events or activities, reporting and accumulating cost information or support the arrangement of the financial statement. Beside, financial system can be known as world, regional or firm specific standard. The company’s financial system is one set of implementation program that trace the financial events of the firm. Basically, the global financial system is a wider regional system that including the financial institutions, lenders and borrowers within the global economy.

Financial system provides an essential economic function of channeling the extra funds from the parties such as households, business firms, government and foreigners to the parties with shortage of funds. Financial system able to provide a mechanism to transfer the resources to one place to another place, allocating capital to the most needed users and monitoring to ensure all the resources are being well traded. In short, financial system provides three main functions, first they channel funds from the lender to the investors or borrowers that need the fund to make the investment. Second, financial system enables to reduce the risk that will be faced by both parties. Third, financial system can provide the liquidity in the market.

2.0 Development of financial system

A financial system in Malaysia consists of a wide range of mechanisms to serve diversify and sophisticate demands of the internal economy. The financial system can separate into two types which are conventional financial system and Islamic system and operates and co-exists in parallel. Over the past decade, the significant growth of the Malaysian financial system has produced new financial innovation products and services in order to support economic activities. In addition to support and intermediate economic development, financial sector development also played an important role in producing value-added business to attract investment and increase job opportunities. Malaysia has always taken a prudent and sequencing method to financial liberalization complemented with enough protection to ensure that the functionality and stability of the overall financial intermediaries’ financial system remain unchanged. Sustained by the advancement and achievement of the implementation of the Financial Sector Master Plan, strengthening the fundamentals of the financial sector is already positioned to seize opportunities, embrace a more liberalized and competitive business environment in the financial industry.

In April 2009, the government published a liberalization package that comprised measures in the conventional and Islamic financial system, which will contribute to further growth of the financial system in Malaysia and generate net profits to the economy as a whole in the maintenance of financial stability.Financial system’s objective is to channel cash from surpluses’ broker to deficits’ broker. There are two ways of analyzing the procedure in the conventional literature. The first way is to think over how brokers interact through financial market. The second ways are based on the operation of financial intermediaries like insurance firms and banks.

2.1 Roles of financial system

Financial System is also a network of financial markets and institutions, equity markets and debt markets, that can define as an intermediary system. The buyers and the sellers take part in the trade of assets in any marketplaces such as bonds, currencies, equities and derivatives. Financial market normally defined as the basic regulations of the transaction, transparent price, costs and expenses, and market forces to determine the price of the securities that trade. There are some certain condition that only allows some financial market participants to meet may be based on the factors such as the amount of money held, the investor’s geographical location, market knowledge or industry participants Financial markets also can covert illiquid assets like long term capital investments in illiquid production procedure into liquid liabilities like financial instrument. The financial market lenders of liquidity can keep assets such as if the lenders need to access their savings, bonds or equity that can be easily and quickly transfer into the power of purchasing. For lenders, the services that fulfill by the financial intermediaries and financial markets are substitutable about the desired risk; liquidity and return carry out by specific investments. The long term investments that make by the financial intermediaries and financial market are more facilitated and attractive investment in higher rate of return, longer gestation investment and technologies. They also provide vary terms of finance to borrowers. Arms length debt or equity finance that provide by the financial markets for example like those companies that have the capability to access markets, usually at a lower cost than finance from financial intermediaries.

The financial intermediaries and financial markets second major service is provide the changes of the risk features of assets. Financial system fulfills this function by at least two approaches. The first approach is they can improve risk diversification and the second approach is that they settle the problem of asymmetric information which may otherwise avoid the goods and services exchange. Risk-sharing that facilitates by financial systems to decrease the transaction costs and information. If the costs related to the funds channeling between lenders and borrowers, financial systems can decrease the costs of preserving a diversified portfolio of assets. Beside, financial intermediaries play this role by taking benefit of economies of scale, financial markets also do so through facilitating the promotion and the trade of assets including the portfolio of investors.

The transaction costs and information decrease by a financial system that occurs from asymmetric information between lenders and borrowers. An information asymmetry occurs in credit markets due to the borrowers normally focus on their projects of investment than lenders. If financial intermediaries get information, they should be having capable to get a return of market on that information before any signaling of that information benefit effect on it being bid away. If financial intermediaries can not avoid information that being disclose prior to get that return, then they will not promise the resources necessary to get it. One of the reasons that financial intermediaries can get information at a lower cost than individual lenders is that financial intermediaries prevents the production of information that's being reproduced and faced by multiple individual lenders.

In addition, financial intermediaries exploit unusual skills in assessing the borrowers with prospective and the projects of investment. They also can develop cross-consumer information and re-apply information over the time. Thus, financial intermediaries enhance the screening of borrowers with potential and investment projects before finance is promised and implement controls and corporate manage after investment projects have been invested. Financial markets come out their own incentives to obtain and process information for listed companies. The more liquid and bigger financial markets had become more incentive market participants have to gather information about these companies. Thus, due to information is quickly showed in the financial market by issuing prices, which means that brokers who do not ensure the costly process of ex ante screening and ex post in financial prices. Continuous discloses requirements is one of the rules and regulation that may help to encourage the production of information.

However, the borrower is trying to conceal some information and do not fully transform the information to the lender or more simply, lenders do not know the information about a looming financial risk that currently facing by the firm. And the firm may not wish to share it with past or potential lenders. Therefore, lenders unable to differentiate between borrowers with different credit risks before providing a loan and leads to an adverse selection problem. As a result, lenders are more likely to make a loan to high-risk borrowers, and at last they are suffering in the high potential of default risks. In some cases this may lead to the lenders being unwilling to purchase securities from borrowers. Financial intermediaries and financial markets settle ex post asymmetry information and come out the problem of moral hazard by enhancing the capability of investors to directly assess the returns to projects by controlling, by improving the capability of investors to effect management decisions and by facilitating the undertake of poorly managed companies. When these matters cannot manage well, investors are not willing to representative control of their savings to borrowers.

3.0 Problems that lead to financial instability

3.1 Decline in quality asset

One of the problems that lead to financial instability is deterioration in asset quality, it will affect the profitability and hence the capital of the bank (Hawkesby, 1999). The quality of the asset decline means that the proportion of a bank loans that are not being repaid on time and the loans have been restructured. A significant increase in non-performing loans or restructured loans will influence the banking profitability and capital adequacy. In other words, it will decline the level of capitalization of banks or other financial institutions and hence they only have a small capital base. In the event of significant financial losses, such a small capital base can cause the banks or financial institutions more vulnerable to insolvency problems. As a result, a severe deterioration in asset quality can cause the bank insolvency and bank failure. In addition, deterioration in asset quality also will causes decline in bank lending.

3.2 Lack of financial transparency

Besides, insufficient transparency also is one of the problems of the financial system. Because of the technological progress, financial innovation, and increasing the market competition have all combined to dramatically transform the financial market, insufficient transparency will make the investors or buyers more difficult to evaluate the risk exposure, risks buyers may not fully understand the nature of the risks involved (Wagner and Marsh, 2006). Financial institutions not fully disclose the information to investors such as the price level, the quality of the bank's asset and some important financial information about the company. Insufficient transparency will decrease the ability of depositors, creditors and shareholders make well informed assessments of the health of financial institutions. They are unable to evaluate and monitor banks because they have not enough information about the risks incurred by banks and the quality of their portfolios and the amount of the bank exposure to the risks. Thus, lack of transparency has prevented market working in a well manner.

3.3 Lack of regulations and supervision

In addition, lack of regulation can cause the financial instability. Differences in regulation are necessary to provide financial institution with the correct incentives to choose an optimal allocation of risk across the sector (Wagner and Marsh, 2006). Apart from these, the authorities failed to have a proper regulation. Two major elements of regulation are transparency and sufficient assets to meet contractual obligations. However, these two elements are not often found in today’s business world. During 2000s, the US citizens are getting easier loan to purchase housing properties without a proper investigation by the financial institutions. When the housing bubble burst in 2007, the borrowers default on their payment. This is the consequence of insufficient assets to meet their contractual obligations. When a person is paying more than he is earning, it is logical that he will be unable to make the repayments. When more and more borrowers default on payment, the lenders face problem in their liquidity, hence resulting in another wave of financial crisis. Same situations happened in the Euro zone when the affected countries spent more than they earn. Moreover, poor corporate governance and supervision has also been the problem of the financial system that causes financial instability. Corporate governance is the structures that determine the way in which corporations are governed. A poor corporate governance reduces the ability or capacity of bank's director a management to identify and manage their bank's risks. Besides, lack of supervision also can lead to financial instability, especially in a poor governance financial system.

3.4 Asymmetric information that leads to the adverse selection and moral hazard

Furthermore, the problem of asymmetric information is an important impediment to well functioning the financial markets. It will lead to the adverse selection and moral hazard (Mishkin, 1999). First of all, the asymmetric information problem is a situation that arises when one party have insufficient information or knowledge about the other party in a transaction to make accurate decisions which is a major aspect of financial market. For example, a borrower who makes a loan normally has better information about the potential returns and risks associated with the investment projects than the lender. Besides, there is usually an asymmetric information between banks and depositors which means that depositors and other creditors do not have enough information or knowledge to identify the safety financial institution. Thus, if one of the party lack of information will lead to problems in the financial system before the and after the transaction is started. The asymmetric information will lead to the adverse selection and moral hazard problem. These will affect the financial system to become instability and hence affects the economic activity as well. Next, the adverse selection problem is the problem caused by the asymmetric information before the transaction occurs. The adverse selection problem occurs in financial market when the potential borrowers or potential bad credit risks produce an undesirable outcome who are the one always seek out the loans and most likely want to engage in a transaction. This will make lenders decide not to lend out any loans because the adverse selection increases the chances that the loans might be made to a bad credit risks (Mishkin, 1999).

Moral hazard is the problem caused by the asymmetric information after the transaction occurs. It occurs because the borrower has incentives to invest in immoral activities or in projects with high risk, but the lender bears most of the loss if the projects fail. Besides, the borrower also might be misallocating funds for personal use and to undertake investment in unprofitable projects that only for personal power. Thus, a lender is subject to the hazard because the borrower has incentives to engage in undesirable activities which are make it less likely that the loan will be paid back from the lender’s point of view. The lender may decide not lend out the loans because the moral hazard problem decrease the probability that the loans will be repaid. As a result, the asymmetric information that leads to the adverse selection and moral hazard problem will cause the financial system become instability and prevent the financial market to well functioning (Mishkin, 1999).

The financial system has struggled with the problems of asymmetric information in which the economic activity focuses on the differences in information available to different parties in a financial contract. It means that borrowers have an informational advantage over lenders because borrowers know more about the investment projects they want to undertake than the lenders. For example, borrowers usually will have better knowledge than the lenders about the returns and risk associated with the investment projects they plan to undertake. This asymmetric information leads to two basic problems in the financial system such as adverse selection and moral hazard. This informational advantage in financial system leads to adverse selection and a classic "lemons" problem first described by Ackerloff (1970). This lemons problem usually will occur in a debt market because lenders have problems in determining whether a lender is a good risk or bad risk. Good risk here means the lender has a good investment opportunity with low risk and bad risk means the lender has poor investment projects with high risk. If the lenders do know how to differentiate between the borrowers of good quality and bad quality, the lender will only make the loan at an interest rate that reflects the average quality borrowers will be paying a higher interest rate than they should because the low quality borrowers pay a lower interest rate than they should. Therefore, one of the results of this lemons problem is that some of the high quality borrowers may drop out of the market and this will cause the profitable investment projects that should be undertaken will not be.

Another problem lead by asymmetric information is that credit rationing in which some borrowers are arbitrarily denied loans. This is because higher interest rates lead to even greater adverse selection. This is mean that riskiest investment projects will now be the likeliest to want to take out loans at the higher interest rate. If the lender cannot discriminate who are the borrowers with the riskier investment projects, then the lender may cut down the numbers of loans he make and this will cause the supply of loan to decrease with higher interest rate. According to Mankiw (1986), a small rise in the riskless interest rate can lead to a very large decrease in lending and even a possible collapse in the market.

Other than that, asymmetric information also can cause a moral hazard problem which will affect the efficiency of financial markets. This is because lenders will have problem in ascertaining the quality of investment projects that undertake by the borrowers. At the same time the borrower has incentives to engage in activities that may be personally beneficial and will increase the probability of default thus will harm the lender. For example, borrowers may cheat by misallocating the funds for personal use either through embezzlement or by spending on perquisites. Besides that, borrower also engages in undertaking investment projects which are unprofitable. This is because in order to increase his power or stature. The lending and investment will be at the suboptimal level because of the conflicts between lenders and borrowers which is also known as agency problem. According to Bernanke and Gertler (1989), a lower amount of a borrower’s net worth increases the agency problem because the borrower has less to lose by engaging in moral hazard. Therefore, decrease in lending, investment and aggregate economic activity are caused by declining in borrowers net worth.

3.5 Increase risks that arising from higher volatility of interest rate

The level of real interest rate can also be the problem of financial instability. An increase in interest rate will lead to higher interest rate payments and decrease a firm’s cash flow. A high level of interest rate will affect the ability of borrowers to repay their loans and tend to reduce asset prices, reducing the value of collateral, and hence decrease the quality of a bank loan portfolio. With a pegged exchange rate regime, a high level of real interest rate may also encourage banks and corporate to borrow oversea at lower foreign currency interest rate. The borrowers will have a significant loss if the peg is broken and value of the domestic currency is devalued.

4.0 Consequences of financial system instability

The stability of the financial system is important in every corner of the world (Thiam, 2012). In general, many of us will deal with banks and financial institutions as our daily life practices to make a transaction. If the instability financial system arises in a country, their depositors will not willing to enroll in the financial institutions, because they are afraid their financial institutions unable to pay back the deposits or loans out the capital to them. If such situation happens, people in the country will be suffering, their day to day life will be affected and this directly will link to the economy downturn. Depositors will lose confidence in banks and financial institutions and the whole financial system will be in danger of extinction and the functioning of the entire economy will be slow down and even worse in the country will become bankruptcy.

Financial instability generally can explain as a situation where many of the banks, financial institution and markets are failing to manage the resources that are generated. If financial instability happens, the general public will find it difficult to perform their transactions of money. Depositors will lose their saving due to the failure in banks and financial institutions. While, some parties such as individual entrepreneurs, businessman will unable to borrow loans to finance their investment projects. In this situation, adverse outcome on International transactions, exports, imports, in certain county will be affected and will automatically have an effect on the economic activities. Unemployment and inflation rate in a country will get higher. In short, financial system stability is essential to drive a good value of economy.

5.0 Financial system instability causes financial crises

According to the researches, one of the factors that causing financial crises is, increase in interest rate due to the financial system instability. Or more directly, financial crisis arises when the instability of the financial system have an effect on the interest rate and result in costly credit, it was weakened banks and increase debt service (Obstfeld, 1994). If the interest rate in the market is driven up sufficiently because of the increase demand for credit or decrease in the money supply, good credit risk is less likely to borrow while bad credit risks are still willing to borrow. As a result of rises in adverse selection, lenders will no longer want to make loans. Thus, the decline in substantial lending will lead to a substantial decline in investment development and economic activity.

On the other hand, an increase in the interest rate also will lead to higher interest payments and decline in a company’s cash flow (Mohamed, Saidi, Zakaria, 2012). When a firm has less cash flow, it has insufficient fund to cover the cost of borrowing and unable to finance its projects internally. So, the firm has to raise funds from the bank. The bank does not know whether the firm will invest in a safe project or a riskier project. The bank may choose not to lend the money even the firm with a good risk due to the increased adverse selection and moral hazard. Hence, the instability of the financial system that leads to increase in interest rate will cause adverse selection, moral hazard problem, decline in cash flow and also the economic activity. Moreover, all of these factors will increase the uncertainty in financial markets. During a recession, lenders are difficult to identify the good or bad credit risks. Thus they are less willing to lend due to the adverse selection problem. As a result, this will lead to a decline in lending, investment and also the economic activity.

6.0 Importance of financial stability

Financial systems play an important role in improving the efficiency inters temporal trade and economic growth (Thiam, 2012). Evidence from research at the World Bank proves that countries with more develop a financial system experiences more rapid growth of economic comparison to the countries that less develop in the financial system and less liquidity in the financial market. Meanwhile, developed countries are tend to more organized in the financial system to facilitate the flow of funds between borrowers and lenders, while in developingcountries, the financiall system is much less evolved.

Financial system can encourage economic growth through several channels such as easing the exchange of goods and services, mobilizing and pooling savings from a large number of investors, allocating saving to most productive use, diversifying to portfolio assets, increasing liquidity and reducing the potential of risk. Besides that, financial intermediaries and markets can also produce better information about the firm and investment projects in order to improve the resource allocation. An expanded system of financial intermediation is able to allocate more capital to efficient investments and thus to foster economic growth.

Moreover, the ability of financial intermediaries to offer profitable investments able to increase a lender’s confidence and this will tend to attract the additional savings in the markets. Functions of financial intermediaries such as portfolio diversification through the stock market may have an additional growth effect by encouraging specialization of production which able to assist the economic development in a country. Last but not least, financial intermediaries enhanced stock market liquidity, reduce the discouragement for investing in a long term project and encourage higher return projects. Consequently, since investors can easily sell their securities in any time before the maturity date, is expected to increase the productivity growth. In overall, efficient operation of financial intermediaries leads to output growth and increases in demand for deposits and financial services and hence can enhance the economic expansion.

7.0 Compare and contrast Islamic finance system versus the conventional financial system

In recent years, Islamic finance has grown rapidly around the world including Malaysia. In theory, there are several differences of principles and rules that occur between the Islamic finance system and the conventional finance system in term of dealing, transaction, business approach, product feature, investment focus, and responsibility. In particular, Islamic financial products are aimed at the investors, who want to comply with the Islamic laws that govern a Muslim's daily life. According to Zamiriqbal (1997) in Islamic laws, they are prohibited from giving or receiving interest (riba). They believe that, earning profit from an exchange of money for money is considered as immoral. Moreover, Islamic rules permission all the financial transactions must be based on the real economic activity and cannot make an investment in sectors such as tobacco, alcohol, gambling, and armaments that consider ‘haram’ in the Shariah role (El-Gamal.M.A, 2000). In addition, Islamic financial institutions are also providing in many kinds of financial services that are similar to the conventional finance such as fund mobilization, asset allocation, payment and exchange settlement services, risk transformation and mitigation. However, all this transaction must use financial instruments that are compliant with Sharia principles.

In conventional finance, all the transactions earn are based on the interest based. Investors are allowed to be involved in option market such as in the short selling transaction. Investors can enter any of an agreement, as long as can help them to earn profits as in the products sectors that prohibit in the Islamic Shari’ah role. Normally in the conventional finance, all the transactions are risk and uncertainty elements. While Islamic finance is prohibited of gharar (uncertainty). Because of the latter phenomenon, short selling is considered as ‘haram’ under the Shariah role.

In Islamic Finance, they believe making money out of money is prohibited. This statement is against to the conventional way of thinking that creating a new dollar out of every dollar (Ahmad.A.U.F, Hassan.M.K). Islamic roles only allow generated money through legitimate and permissible trade and investment. By short selling a stock, an investor may earn a profit while the underlying company is going to lose value. In theory, Islamic Finance is about serving society and ensures its distribution; exchange and transfer take place in an orderly is equitable manner. Short selling a stock, when comes to the bad economic condition, an avalanche of more short-sellers might be triggered and this will lead the firm to buyback initiatives or to bankruptcy. As after the incident of financial crisis, some countries scrambled to prohibit short-selling in their respective stock markets since they realize short-selling could cause a market downtrend (Asyraf Wajdi Dusuki ,Abdelazeem Abozaid, 2008). While In Islamic finance, short-selling is prohibited upfront for it violates a basic Shariah principle that is one cannot sell the things that are not own in hand.

A fundamental difference between Islamic financing and a conventional loan is in the Islamic financing transaction. In a conventional loan, the purchaser will pay an interest, and in Islamic financing, the purchaser will pay an amount of money to the bank. In Islamic finance, bank essentially buys the property from the seller (in case of refinancing), and re-sells it to the customer at a selling price which comprises the bank's purchase price and a predetermined profit margin, while allowing the customers to pay for the purchase in instalments (Dr Jalil M.A, Rahman.M.K 2010). This agreement usually is called as property sale agreement. Since the customers will know the total amount that he has to pay to the bank and so the customer’s monthly instalment of the bank's selling price will not change throughout the tenure of the financing and no need to worry about the change in the interest rate. And even if the customers are delay to make a payment, there is no interest or default charge by the bank. Hence, in Islamic finance, the creditor should not take advantage of the borrower. However, conventional loan is given to a debtor, creditor, borrower or bank relationship. Interest is representing the bank’s cost of funds is charged. The customer will repay to the bank the loan amount, together with interest at the prescribed rate. Once the customers delay or default to make any payment, the bank is entitled to charge compound interests, which is the double amount that they need to pay. In short, conventional finance is more to maximize in profit without any restriction as lending money and getting it back with compounding interest which they can earn.

Last but not least, another difference between Islamic and conventional finance is any contract that are based on the uncertainty is prohibited such as speculated and hedging and also involved in the derivative markets. However, in conventional finance, there is no rule about prohibition in this and so conventional financial systems allow trading in the derivative of various forms. All the products or services that offer by the Islamic bank are similar and also available in the conventional bank. The only difference amongst these two types of bank is about the term and condition that must be followed under the Shari’ah role in the Islamic bank.

8.0 Comparision

Financial systems in every country are different based on a country's economy development. Different economic development level, social and cultural background, government regulation, national economic management will lead to a different financial system in each country especially in developed and developing countries. There is some difference of financial system as follows.

Central bank independence is where the bank in a certain country has generated substantial debate over the world. Or in other words, the current system of central banks in developed countries has a very sound, perfect and strong after many years of development. Theoretical suggest that if central bank independence is relatively high, could be produced better monetary policy in order to stabilize the currency. Besides that, they can also free from outside interfering to formulate and implement monetary policy. For example, German Federal Bank is the most powerful central bank independence in the exercise that freedom from government interference.

After many years of development, with the highly constant of economy, well-developed service sector, market openness and competition, the market provides varieties of great demand of financial services in developed countries in order to promote the continuous improvement of the financial system. In developed countries, commercial banking system has implemented a universal banking system such as in Germany, France, European countries. Commercial banks can freely to carry out a comprehensive range of financial services without disruption of the central bank. Therefore, the banking sector and financial system in a developed country is entering a new era and comprehensive range.

Meanwhile, the central bank in the developing countries such as India, Thailand, Cambodia are belong to the central government that control over the whole financial system, lower the monetary policy and they will more focus on economic growth and full employment as the goal at the expense of currency stability. In adverse, this will affect the independence of the central bank to implement or formulate efficient monetary policy. Activities of financial system in developing countries are active not comparable to the developed countries. In developing countries, Commercial banks property rights system can be divided into government-owned, privately owned and foreign-funded. However the main state-owned is the government and central bank intervention in the business activities of commercial banks provided a breeding ground. Basically, Commercial banks are implemented separate operating system and its professional business; as they only carry out the traditional deposit and loan business.

In terms of Marco-economy control system, developed countries have been market oriented and standardized with use of market mechanisms to implement the open market operation, legal instrument, interest drive mechanism to affect the cost of capital of financial institutions. In order to achieve the macro-economic regulation, banks will consciously to control over their credit expansion or the scale of social adjustment of money supply. While in developing countries, macro- economy control systems are not yet fully establish.

9.0 Suggestions / Recommendations

9.1 Recommendations for financial instability and lack of financial transparency

The potential risk may threaten the financial stability if it is not protected, therefore an evaluation of the financial stability is important, which involve the continuous monitoring, and analysis of the potential risk. To evaluate the changes in the financial stability, the central bank can disclosure their internal report (annual or semi annual) publicly, such as Financial Stability Review (FRS). According to Oosterloo, De Haan, and Jong-A-Pin (2007), financial stability review (FRS) were published by the first forty central bank was possibility provided for financial stability, increased accountability and transparency of authorities responsible for financial stability and reinforce cooperation on financial stability issues between several significant authorities.

From the above arguments for publishing the assessment of financial stability can be supported by the previous researcher studies and other national bank that applied the publication. The first one, to provide stability over the financial system, through announcing the financial system publicly and the assessment of the central bank concerning the system stability. In additional, it also provides more information on the financial system, that help in the decision making. As stated by the Austrian National bank (2001) whenever the evolution of financial market goes wrong, the players on financial market and the community able to conscious of the problem that may arise when there is a constant publish on the financial stability report. Hence, appropriate action will be taken to eliminate the risk of the financial system that cause instability. The second points increase accountability and transparency for financial stability. According to Lastra (2001) "accountability is an obligation to give an account of, explain, and justify one’s action, while transparency is the degree to which information on such actions is available." As claimed by the International Monetary Fund (2000), to provide an appropriate accountability understanding, transparency is essential. For instance, the community must in an understandable, accessible and timely manner on the purposes of policy, legal, policy decisions and their rationale, economic framework, the terms of agencies’ accountability, information and data that related to policies and so on. Last but not least, reinforce cooperation on financial stability issues between several significant authorities, as stated by National Bank of Belgium (2002), the financial stability review should not only provide the discussion but also the authorities that in charge of macro and micro-prudential administration and financial market operators.

Besides that, Financial Stability review (FRS) also encourages the bank and other institutions held an international forum that provide the future issues of the review, and give an opinion in the various discussions. Based on the previous researcher Svensson (2003), also argues that the publication of a financial stability review (FRS) provides a positive view, that the overall financial sectors is well, in order to encourage the general public and economic agents. For instance, they will immediately alert the anxious agents and financial regulatory authority when the issue shows up and take action to prohibit financial instability to take place.

However, according to Schinasi (2003) central bank usually act to preserve the financial stability where it is the only provision of the legal process of payment and quick convertible. Besides that, the central bank also establishes a smooth operation of the national payment system. For example, in order to prevent the failure of one bank overflow the payment system and affecting others banks payments system which is the systemic risk, through G-10 efforts there is the existence of the real time gross payment settlement systems. In addition, the banking system is important in the transmission mechanism through which monetary policy affects the economy. The central bank will be facing difficulty to sustain whatever liquidity that is required to obtain monetary policy when the banking system experiencing distress. In order to maintain the stability of the banking system, a natural interest in sound financial institutions and stable financial markets that the central bank had would have the ability to detect the problem at an early stage and take action on it.

Nevertheless, Hermes and Lensink (2000) also mention that central bank duty is to modify and protecting of the payment system. As a consequence, it will provide stability to the banking system via controlling the banks’ behavior and representing as the lender of last resort (LOLR). Besides that, by acting independently of the central government is also one of the methods that the central bank able to lowering the inflationary pressure., which in turn to stabilize the real value of the domestic currency, therefore it will limit from the financing government budget deficit.

According to Hermes and Lensink (2000) studies suggest that deposit insurance is a useful instrument that help the country to avoid the financial failure, for instance the depositors being protected by the deposit insurance system to counter the major losses of banks, furthermore it also protects the banks against runs on their liabilities cause by the public uncertain. The previous researcher Davis (1995) and Talley and Mas (1990) also mention that the owner financial saving being protected to counter the danger of losing their financial wealth and across the harmful impact of the bank activities, is the deposit insurance system main purpose. When the depositor influence by the lack of information, they will reduce their deposit holding because they are not confident with the safety of the banks, and this will cause damage to the financial intermediate process. Therefore, the past studies of Diamond and Dybvig (1983) offer the effect of the deposit contracts by using attractive maturity transformation that provides higher liquidity risk-sharing to risk-averse saver.

Moreover, the prior studies of Davis (1995) propose that there is a precise rules in the depository contract, when the banks are insolvent, the bank guarantees the depositor that part of the deposit value will get to pay back. In order to increase their confidence that their claims are returned, this rule provides the depositor motivation to be first in the queue (first come,first served) to withdraw from the bank. Therefore this motivation allows the depositors to hold their wealth in the bank and simultaneously it also increase the investment and development of the financial system. Besides that, the deposit insurance goal is to cut down the possibility of the appearance of the contagious bank run which could cause the financial markets instable and financial crisis.

The bank may concern to liquidity risk, when the liquid assets less than the liabilities. In reality, the bank can attract the new deposits to refinance in order to reach the withdrawals more than liquid asset holding. If the bank increase the deposit rate over some stage to refinance deposits, thus, for transfer the liquidity asset holdings, liquidity risk will become an insolvency risk. Asset return risk and liquidity risk will cause the effect of insolvency risk. According to the prior researcher Diamond and Dybvig (1983) to manage the liquidity risk, they use deposit insurance where the purpose is to minimize the liquidity risk that create the bank runs. On the other hand, Bagehot (1873) researcher recommends that lender of last resort policy, where the bank has the ability to generate liquidity quickly and at extremely low direct cost. Last but not least, Goodfriend and King (1988); Humphrey (1989) advocated, the central bank can minimize the risk of large fluctuation in the cost of servicing short term liabilities by smooth the short term interest rate and in consequences reduce the liquidity risk. The bank has the encouragement to reduce the liquidity and increase the risk taking when there are in the environment of interest rate smoothing. In a conclusion, the role of deposit insurance, lender of last resort (LOLR) , and interest rate smoothing encourage financial stability.

9.2 Recommendation for higher volatility of interest rate

According to Smith and Egteren (2005) research, they found out the the lender of last resort (LOLR) policy use by the central bank to smooth the variation in interest rate, which help the financial to stabilize. The main element that effect of the lender of last resort policy is the direct effect of less interest rate volatility on a bank possibility of insolvency. For example, if interest rate volatility being removed by interest smoothing, a higher capital requirement might have to be established to maintain financial stability when the lender of last resort policy causes a large change in the proportion of the bank’s optimal portfolio. Besides that, the lender of last resort (LOLR) policy also show the effect, an increase in the liability of the deposit insurance system. Interest rate smoothing is essential to promote financial stability, where according to previous research Goodfriend (1987) it can maintain "orderly money market", as well as Rudebusch (1995) past studies suggest that to avoid the financial market from "undue stress".

There are several research on the interest rate smoothing and financial stability. First, the agreement of the Federal Reserve consistent with the "elastic supply of currency". Miron (1986) argues that the number of bank insolvencies has been reduced when the Fed’s policy, smooth the seasonal liquidity shocks. Whereas Cukierman (1991 ; 1992) built a model on the higher future short term interest rates adversely affect bank profitability, as a result, it shows the bank profitability increase through the smoothing interest rate fluctuations. Garfinkel (1991) also agrees with Cukierman’s model where the bank does not have a chance to become insolvent and all the bank assets are riskless.

9.3 Recommendations for asymmetric information

One way to reduce the asymmetric information of adverse selection in the debt markets is that a borrower must provide collateral for a loan. This is because the lender can take the collateral which can sell and make up for the loss when the borrowers default on the loan. It is no longer important whether the borrower is of good quality or bad quality since the loss incurred by the lender if the loan defaults are substantially reduced, if the collateral is of good quality. Therefore, the fact that there is asymmetric information between the borrower and lenders is no longer an important factor in the market. The collateral is important in reducing the asymmetric information about the adverse selection problem because financial disruption adversely affects aggregate economic activity in debt markets. According to Calomiris and Hubbard (1990) and Greenwald and Stiglitz (1988), a sharp decrease in the valuation of firm’s assets in a stock market crash lowers the value of collateral and thereby makes adverse selection a more important problem for lenders since the losses from loan defaults are now higher.

Other than that, institutional structure of financial markets also can reduce the asymmetric information problems of adverse selection and moral hazard which is described by Gertler (1988) and Bernanke, Gertler and Gilchrist (1998). Some of the financial intermediaries such as commercial banks, thrift institutions, finance companies, insurance companies, mutual funds and pension funds are the important banks which have the ability and the incentives to address problems of asymmetric information. For example, banks have an ability to collect information when the time they consider making a loan and this ability is only rising when banks are engaged in long term customer relationships and credit line arrangements. In addition, banks provide an additional advantage in monitoring the borrowers’ behavior by the means of the ability of the banks to scrutinize the checking account balances of their borrowers. According to Diamond (1984),banks also have an advantages in reducing moral hazards because they can engage in lower cost monitoring than individuals and because as mentioned by Stiglitz and Weiss (1983), they have advantages in preventing risk taking by borrowers since they can use the threat of cutting off lending in the future to improve a borrowers’ behavior. The advantages of bank in gathering information and reducing the moral hazard problems explain why banks play an important role in financial markets around the world. According to Rojas-Suarez and Weisbrod (1994), the greater difficulty of acquiring information on private firms in emerging market countries explains why banks play a more important role in the financial systems in emerging market countries than they do in industrialized countries.

Besides that, asymmetric information also can be solved by using different loan size. Therefore, banks offer many different loan contracts that induce the auto selection of the firms. This is because firms of different categories of risks will obtain different marginal profits from an additional unit of loan invested. This leads the marginal rate of substitution between interest rate and loan sizes differs between both groups of firms. The investment level under asymmetric information can be higher compare to the complete information because of the signaling effect of the loan size. Although this result is stringent, but the empirical condition is opposite in which the loan contracts are standardized or the bank investigates the creditworthiness of the individual firm before extending higher amounts of loans.

According to Webb (1991), it shows that long term contract can be used to reduce the adverse selection problem by separating entrepreneurs of different project risk. Banks offer better terms of contract and make lower repayments in the following period for the firms that do not go into bankruptcy whereas risky firms will only get a loan to the old contract conditions.

9.4 Recommendations for declining asset quality

Decline in bank asset quality also one of the problems we found in the financial system. There are two recent changes in the banks’ operating environment are increased competition and bigger temporal volatility in borrower credit risks. This result in which the former has directly reduced the banks’ informational surplus while the latter has impaired the informational reusability. Therefore, the screening expenditures have been declined and the diminution of screening has lowered the quality of bank assets. The increase in deposit insurance premium has a similar effect to that of narrowing interest spreads. Therefore, this will result in reduced asset screening and harmful for asset quality.

The problem of decline in bank asset quality can be solved by using the reusability of information. This induces more costly screening by the bank and leads to better quality of assets. Environmental turbulence has presumably widened temporal fluctuations in borrower credit ratings and this leads the payoff relevant information about borrowers should have become less durable. However, the deregulations have raised the competition among banks which are both from other banks and from non financial institutions. This causes the decrease in interest rates on loans and increased the interest rates on bank liabilities. This narrowed interest rate difference has increased the bank’s risk of ruin and providing another reason to reduce screening expenditures. A similar idea was brought by Chan, Greenbaum and Thakor (1985) using a more rudimentary model.

Decline in bank asset quality can be solved when the credit risks of borrowers are less likely to change and the information is more durable because banks devote more resources to costly screening. The information durability enhances the value by providing an increased second period return to the lender. This enhancement is expressed in terms of higher correlation between the successful first period loans and second period loan outcomes. The return on screening expenditures will increase as the beta increase and this will cause the bank to spend more on screening, sort loan applicants more successfully and therefore cause the quality of asset to increase.

9.5 Recommendation for lack of regulation and supervision

Accoding to the Harald A.Benink,Reinhard H.Schmid (2007), Pablo E.Guidotti,Liliana Roberto Zahler (2004), regulations are a rule and principle to monitor, manage, protect or supervise in financing for the systematic risk in financial institutions. One of the reasons is ensuring soundness of financial institutions to protect public and economy from financial sectors such as disclosure requirement, restrictions of entry and report requirements for financial institutions. Bank Negara Malaysia (BNM) is a financial institution responsible for monetary policy for a nation and also is a financial adviser to the Government. Functions of BNM are developing the financial market, implementing monetary policy, consumer protection, collect statistical information.

Accoding to the Bank Negara Malaysia (BNM) on 21 December 2011, they use new method to the recommendation of the financial system. Besides that, they promote a new plan to improve our financial system is a Financial Sectors Blueprint (FSB) can develop our country financially achieve a high income economy and high value in our country and most important is in development of financial sector in Malaysia especially is an International Islamic Financial. This system can replace the Financial Sector Masterplan (FSMP). FSMP is to capacity in our country for financial infrastructure and can raise competition to become market oriented. Compare to the FSB, the FSB is more effective in every area especially in Asia, focus to promote Malaysia financial market’s trade and investment in every area enhance the financial growth in Asia, can strongly linkages in the financial sectors and can attract the Asia people to invest or supply their funds in every area.

Based on BNM developing this plan,have many advantages. Advantages of the FSB are flexible in performance. It can bring more foreign investors to participate in regional, can remove or transaction the fund from local to another country and bring our general account to a different country. Besides that, broadly endorsed is the international recognized body’s people become a representation to consultation or collection the stakeholder’s information and through the internet for the public to know any information. Such as researchers Harald A.Benink, Reinhard H.Schmid (2004) had mentioned in the IMF or World Bank. In addition, FSB can liberalization of foreign exchange rules. It can introduce the international area of financial market and to measure foreign currency from other country and protect the foreign currency become a safeguard and to permit the investment or trade the foreign currency in the region This can help our domestic currency become more stable, more effective and to improve our domestic currency become more valuable. Other than that, the FSB also important is can strengthen regional and international financial integration. BNM promotes this plan purpose is wanting to let many foreign investors know Malaysia’s financial market and interest and economy If more foreign investors in our country, domestic currency will become more valuable and economic growth of Malaysia will increase.

Besides that, international of Islamic Finance also can improve the financial system in Malaysia BNM promote the new FSB can make many people to know the Islamic finance to invest their funds in Islamic Finance and can let this institution become more channel and global. Islamic Financial can design a single system to authority Shariah and can help Islamic Finance to become a leader in further.

FSB is a great plan, Malaysia’s financial sectors can follow the European plan to manage financial system which is Investment Services Directive (ISD) especially International of Islamic Finance can use it plan to developing the Islamic finance. Based on Harald A.Benink,Reinhard H.Schmid (2007)) ISD is part of the financial market plan also call the regulation market. ISD can provide a single passport to the financial market is measure trade and internal governance and reduce investor cost of trading. This is a system to call a "home country control" is a system to help the country to authority the financial service in a foreign country. Besides that, is to protect itself financial market and to hold back the foreign competition. The ISD is a system control by a home country must deal in formal way which is "listed stock". If have any change the home country will know and monitor .Such as rating agency, government institution.

9.6 Recommendations to improve the financial system

Nowadays, education is very important. It can improve one of person have the knowledge and skills to bring in everyday life and work. If a person has higher education, measure that the person have more professional. The financial system is to provide the current income for future income and transformation of savings into investment. Therefore, education is more important in financial market especially financial institutions. They must have high skills and financial knowledge to develop financial sectors and provide technological innovation it is provided by pervious researcher FATF, (2012) to become an efficiency and effectiveness.

In Malaysia, most of the university has offered financial courses such as Universiti Utara Malaysia (UUM), Universiti Kebangsaan Malaysia (UKM), Universiti Malaya (UM) to help student understand the financial skills and mange strategies. Even though, in our country have provided these kinds of course but compare to other country, we stills lack professional of finances. This is because other country’s universities such as United State, Europe had the most knowledge in financial skills and in the past, these two counties are the financial applause person. In these countries, they will request same professional and have experience job relevance financial to professor the next generation. Therefore, our country can emulate the developed countries to improve our knowledge. Besides that government can send same student go to oversee to practice and can learn their knowledge and bring new technological innovation back to Malaysia to enhance our financial market.

The financial institution is any institution that moves money between savers and borrowers and can exist to spread the risk of financial investments between savers and borrowers. Besides that, also provide liquidity to contribution for their investments and risk and return. Based on pervious researcher FATF (2012) have mentioned that they normally will face risk either a systematic risk or unsystematic risk. Systematic risk is cannot control like war, interest rate change. Unsystematic risk is can control like strikes, the effects of foreign competition. Risk is damage thing so that we want to manage and use a method to reduce risk. The financial institution should take the risk conversion to new business practices or product. We suggest can use beta to measure of systematic risk. This method is to measure the responsiveness of a security in the market portfolio.

Beta can compute as a slope of a regression line between the return on the market portfolio and security.

When the beta is higher, the risk will high and the expected return will also high. Capital Asset Pricing Model (CAPM) is a Jack Treynor (1961,1962),William Sharpe (1964),John Lintner (1965) and Jan Mossin (1966)to provide and can to measure expected return and share value based on required return.

In the equilibrium Security Market Line (SML).The security below the line, the expected return low, investor will sell shares when the price down until the expected return rises. When the security above the line, the expected return high, investor will bid up the price. Therefore, CAPM and beta can help financial institution and investors to measure risk and return. Another way is risk management to protect risk.



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