The Commercial Banks in Singapore - Essay Example

? Financial System Table of Contents Table of Contents 2 Q 3 Q.2 5 Q: 3: Market Risk: 8Fundamental Concepts 8 Risk management strategy 9 Risk management policies 9 Risk management procedures 9 Risk measurement, monitoring and control 9 Credit Risk 10 Fundamental Concepts 10 Risk management strategy, policies & procedures 10 Risk measurement, monitoring and control 10 Conclusion: 14 Works Cited 14 Q.1 a.1. Activities performed by the Commercial Banks in Singapore include: 1) Taking of deposits 2) Giving out loans 3) Cheque services 4) Financial advisory services (if allowed by the central bank of Singapore - Monetary Authority of Singapore) 5) Insurance Broking 6) Capital Market Services 7) Full Banking (a type of commercial bank) can deal with the local financial institutions on a commercial basis 8) Retirement schemes and pension fund investment schemes (Monetary Athority of Singapore) a.2. Commercial banks are the backbone of any economy and they contribute to the economic development in the following ways: 1) Promoting capital formation in the economy 2) Promotion of trade and industry through loans and investments 3) Development of agriculture through Agri-financing 4) Transferring surplus capital from developed to less developed regions to allow for balanced development of the economy 5) Encouraging businesses related to export by providing them support so as to improve the GDP of the country through positive trade (Janan, 2009) b.1. Following are the 5 principles on which the Islamic banking model operates: 1) Sanctity of contract – it must be ensured that the contract is halal (all components valid and not voidable) according to the Sharia rulings 2) Risk Sharing – profit must not be earned by a party without having a stake in the asset generating the said profit 3) No Riba/Interest – money should not be lent to earn additional amount on its underlying value 4) Economic Purpose – the activity should be for economic purpose 5) Fairness – the terms and conditions should be fair to all parties involved and be disclosed full to avoid any doubt in the contract (Ahmad & Shabbir) b.2. Advantages of Islamic Banking over Conventional Banking: 1) Islamic modes of finance can’t be marketed beyond the initial parties of the contract and are also non-callable – both these features protect the financial system from collapsing. Conventional bank lending is a pyramid shaped chain where one party can further the loan attained from the bank, thus when a financial crisis occurs and one party defaults the whole system crashes. Also the non-callable feature allows for more certainty as the party is able to keep the loan until its maturity. (Ahmad & Shabbir) 2) Islamic banks bear the liability of getting involved in a transaction with the customer unlike conventional banks – thus they do not have a guaranteed return in form of fixed payments from customers (interest) rather they take risk of partnering in a venture with their client. For example in Musharika which is a mode of Islamic finance, the bank gets into a partnership agreement with the client and the profit sharing ratio is agreed upon by the parties while the ratio of loss sharing is in proportion to the capital invested by the bank and the client. (Ahmad & Shabbir) 3) Credit worthiness of the client is not the only determining factor in Islamic finance – the type, nature, viability and profitability of the business are the main determining factors. Islam does not allow unethical and immoral business activities, thus lending for businesses such as alcohol, pornography, etc. is forbidden as these activities are also harmful and negatively affect the productivity of the economy. (Ahamed, 2008) Q.2 a) The loanable funds market is a driving force of any economy in today’s world as it determines the supply and demand of loans for investment in the economy which in turns determines the gross domestic product and the subsequent economic growth and wellbeing. The supply of loanable funds is mainly derived from the economy’s propensity to save or the savings ratio. Higher the savings ratio, more the supply of loanable funds. The individuals who provide their savings for the purpose of loan are called lenders. Subsequently there is a constant demand for these loanable funds in the market by budding enterprises and expanding businesses who want to buy capital assets as an investment. These people are known as the borrowers. The lenders agree to lend their money to the borrowers at a predetermined rate which is the real rate of interest, r at the time of lending. For the borrowers the real rate of interest becomes the cost of capital/investment. (Evans, 1997) Thus we can say that r is the most important rate in the loanable funds market, determined by the demand and supply of funds. Higher the demand of funds (more investment and business activity) and lower the supply (less propensity to save), greater will be the real interest rate. Similarly lower the demand of funds (less investment and business activity) and higher the supply (more propensity to save), lesser the real interest rate. (ANG, BEKAERT, & WEI, 2008) Furthermore various researches have come up with the conclusion that there is a negative correlation between the expected inflation and real interest rates, that is, the real interest rates will fall if the inflation is expected to rise in the near future. The effect is negligible if the rise/fall in expected inflation is small; however, it becomes quite transparent with significant changes in expected inflation. This can be connected to the loanable funds model as we see that people tend to accumulate and save more when they expect future inflation to increase thus increasing the supply of funds and forcing the real interest rates to go down. (Kandel, Ofer, & Sarig, 1996) b) Liquidity Premium can be explained as the only difference between two securities having all same terms except for the maturity. Normally investors expect a comparatively higher return on a similar security of longer maturity than on the shorter maturity as they will have their capital stuck for a longer period. This additional return is known as the liquidity premium that is charged by investors for investing for a longer period which are perceived to be riskier than short term securities. (Ireland) (Liquidity premium, 2011) Preferred Habitat theory talks from the point of view of the investor. It states that every individual investor has his/her own preferred maturity. Some investor might prefer short term investment to remain liquid while others might prefer long term investment to avoid reinvestment risk. Forcing each investor from his preferred habitat (maturity) will require an added incentive to lure him. Thus we can say that for a short term investor added incentive in form of higher return is essential not only to provide him with a liquidity premium but also to lure him out of his preferred maturity, indicating the importance of both maturity and subsequent returns. (Ireland) (Preferred Habitat Theory) From the above explanations we see that liquidity premium and preferred habitat theory is able to explain all three empirical facts observed in the term structure of interest rates as it is a combination of the expectations hypothesis which explains the first two facts and the segmented markets theory which explains the third fact. It explains that the future rates of short term and long term securities are interconnected and move in the same direction or else a paradox situation would arise. Secondly the theory explains that the yield curve will be upward sloping when investors expect short term interest rate to rise (usually when the rates are low) and it will be downward sloping when the short term rate is expected to fall (usually when the rates are on the higher side). Lastly the theory explains the fact that the trend of yield curve is normally upward sloping as the curve bends into downward sloping only when the interest rate is expected to decline sharply. (Ireland) Q: 3: Market Risk: Fundamental Concepts Market risk refers to the risk arising from the change in market price of the security/investment or the interest rate prevailing in the market. Market risk also arises from other forms of risk. For example, when an issuer of a security defaults the market price of the security also tends to fall leading to market risk. (MAS, 2006) Risk management strategy Every company has to bear some amount of market risk. First of all a company should decide how much risk it can bear. Then it should prepare some strategy of how to manage it. There are several factors that should be considered when forming this strategy such as the markets in which it should operate, the combination of portfolio and what market risk will it result in etc. The risk strategy should be revised with time and its implementation should be ensured. (MAS, 2006) Risk management policies Policies for managing market risk should be formed after the strategy is developed. These policies are formed to bring the strategy into action. These policies divide the roles and responsibilities of managing risk among the different employees. Moreover, it also sets a limit on the maximum market risk that can be assumed and the penalties for crossing those limits. Risk management procedures The risk management procedures are ones in which operational steps are identified as to how the risk management policies are to be followed. A manual is usually developed so that it’s easier for employees to refer and use it. Risk measurement, monitoring and control Every company should have a proper risk management system at place. The risk management system should be according to the trading by the company and the extent of risk the company is exposed to. For example, companies whose risk fluctuates from day to day should have a daily risk monitoring system at place. (MAS, 2006) On the other hand a company should also ensure that the risk measurement models it is using are appropriate to its portfolio. There are various models used such as scenario analysis, VAR (value at risk) etc. (MAS, 2006) Credit Risk Fundamental Concepts Credit risk is the risk arising from the uncertainty of whether the party who is supposed to pay will pay or not. Credit risk can arise on investments done by a company as there is risk of whether the issuer will repay the money or not. (MAS-Credit, 2006) Risk management strategy, policies & procedures A company when developing its credit risk management strategy should consider the amount of credit risk it can bear depending on the type of business it is in. the credit policies on the other hand should consider how to avoid credit risk by having proper collateral, documents etc. the procedures should lay out the operational details of the policies as in the case of market risk. (MAS-Credit, 2006) Risk measurement, monitoring and control In order to measure the credit risk of a particular party, it is important to consider its financial condition before giving loan. Security and collaterals shouldn’t be used as a substitute of risk mitigation as inspection of the party is very important in order to avoid future loss. Even after disbursement of the loan it is important for the company to keep monitoring the financial conditions of the party so that it is able to take action at the right time and avoid loss. (MAS-Credit, 2006) Q: 4: Shareholder value is the value created for the shareholders who are the real owners of the company. Value is created for shareholders in two forms i.e. dividend distributed and capital gains earned. There are various drivers of shareholder value but the four main drivers of shareholder value are amount of capital invested, rate of return on investments, the rate required and planning period. Amount of capital invested is simply the shareholder’s equity section of the balance sheet which includes the share capital, reserves and retained earnings also. Required return is the minimum rate of return which investors require on a particular investment. This rate is not determined by a single individual but the market of buyers and sellers decide this. The rate depends on a number of factors such as the riskiness of the investment, tenor of the investment etc. Actual rate of return is the actual return earned on a particular investment. If the actual return is more than the required than it is good for the investors and creates additional value for the shareholder. Planning horizon is the time period for which the planning is done i.e. short term or long term. (F. Marchesi) It is the responsibility of the management to create value for the shareholders but it should not focus on generating short-term profits for the company, thereby satisfying the shareholders and earning bonuses/promotions. Instead they focus on increasing the long-term free cash flow i.e. generating growth which is sustainable. For example if demand for cement rises suddenly due to some temporary factor such as increase in construction after some natural disaster, then the company management should know that for how much time this demand will last. If the demand is only for 5-6 months e.g. then building a new plant to cater to this extra demand is not sensible as it would require huge investment and after few months the capacity would be unused. Therefore, management should focus on short term profits from extra demand and should think about the long term. This also doesn’t mean that the management should not cash on short-term opportunities. They can take advantage of this short-term opportunity by working overtime or having 2 shifts. Return on capital is the return on both debt and equity employed by the company. The return generated by the company is for both debtors and shareholders. The actual return for shareholders is what is left after the claim of debtors (interest payments) and preference shareholders (dividend). This return is from the company’s point of view. From the investor’s point of view, return is that earned on the actual amount of debt and equity employed. Investors are concerned about economic profit which is different from accounting profit due to different accounting policies. There are several adjustments that need to be made in the accounting profit to reach the economic profit. For example, some accounting reserves are almost permanent such as deferred tax assets which are unlikely to be paid by companies which remain going concern. Another adjustment can be made to the debt by adding off-balance sheet liabilities to the debt. After making these adjustments, we can get the actual rate of return on capital employed. (T.Lupia) The required rate of return depends on operational and financial risk. Operational risk is the risk related to the operations of the business like what business the company is in, how stable the business is in. Financial risk on the other hand is the risk related to the capital structure of the business. For example if a company has high debt level, then it is highly risky and investors would require higher return than otherwise they would have if the debt level of the company. Therefore, we can see that there are four main drivers of shareholder value and in order to generate value it is important that the actual rate of return for the shareholders is more than the required rate. Moreover, the amount of capital invested and the capital structure is also important. Last but not the least is the planning horizon which is important because managers tend to focus much on the short term profit instead of long term which is not right as sustainable returns are more important. Conclusion: There are various financial institutions at work in the financial system of an economy and each has its own different function. To oversee these financial institutions, there are regulatory bodies such as MAS to regulate them and to have some set standards. These are to protect the investors. Moreover investors themselves should also be vigilant enough to manage their risks wisely. Works Cited Liquidity premium. (2011). Retrieved July 2012, from Wikipedia: http://en.wikipedia.org/wiki/Liquidity_premium Ahamed, K. (2008, January). Benefits of Islamic Banking - Financial Times. Retrieved July 2012, from The Sunday Times Online: http://sundaytimes.lk/080120/FinancialTimes/ft337.html Ahmad, I., & Shabbir, G. (n.d.). Frequently Asked Questions on Islamic Banking. Karachi: Islamic Banking Department - State Bank of Pakistan. ANG, A., BEKAERT, G., & WEI, M. (2008). The Term Structure of Real Rates and Expected Inflation. The Journal of Finance, 797-849. Evans, G. (1997). Chapter 3 - THE LOANABLE FUNDS MODEL. In G. R. Evans, Red Ink: The Budget, Deficit, and Debt of the U.S. Government. Academic Press. F. Marchesi, R. (n.d.). Maximizing Shareholder Value by Improving Growth and Reducing the Company’s Discount Rate. Demarche Associates,INC. Ireland, P. (n.d.). Lecture Notes on MONEY, BANKING, AND FINANCIAL MARKETS. MONEY, BANKING, AND FINANCIAL MARKETS. Department of Economics Boston College. Janan, S. (2009, October). SlideShare. Retrieved July 2012, from Role Of Commercial Banks In The Economic Development Of A Country: http://www.slideshare.net/Mustafaseady/role-of-commercial-banks-in-the-economic-development-of-a-country Kandel, S., Ofer, A., & Sarig, O. (1996). Real Interest Rates and Inflation: An Ex-ante Empirical Analysis. The Journal of Finance, 205-225. MAS. (2006). Guidelines on risk management practices-market risk. Monetary Authority of Singapore. MAS-Credit. (2006). Guidelines on Risk management practices- Credit Risk. Monetary Authority of Singapore. Monetary Athority of Singapore. (n.d.). Commercial Banks. Retrieved July 2012, from Monetary Authority of Singapore: http://www.mas.gov.sg/en/Singapore-Financial-Centre/Types-of-Institutions/Commercial-Banks.aspx Preferred Habitat Theory. (n.d.). Retrieved July 2012, from Investopedia: http://www.investopedia.com/terms/p/preferred-habitat-theory.asp#axzz208za9mXo T.Lupia, D. (n.d.). Measuring Shareholder Value. CMC. 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