financial systam a comparative study

FINANCIAL SYSTEMA COMPARATIVE STUDY

FINANCIAL SYSTEM DEFINED

The financial system provides a mechanism whereby an individual, firm or household, who is a surplus spending unit (SSU), may conveniently make funs available to a deficit spending units (DSUs) who intend to spend more than their current income. The key word ‘conveniently’ is important. It means the financial system will be so developed and mechanism for transactions so designed and rule and regulations for dealings so formulated that both the supplier and demanders of funds will not face any difficulties while they will be transacting with each other.

Islamic Financial System Defined

The Islamic financial system provides a mechanism whereby an individual, firm or household, who is a surplus spending unit (SSU), may conveniently make funds available directly or indirectly to a deficit spending units (DSU) on a participatory basis.

CONSTITUENT AND FEATURES OF CONVENTIONAL FINANCIAL SYSTEM

Mechanism: Based on both ‘Financing’ mode and ‘Investment’ mode.

Institutions: Commercial Banks, Depository Institutions, Credit Unions, Finance Companies, Merchant Banks, Leasing Companies, Investment Banks, Stock Exchange

CONSTITUENT AND FEATURES OF CONVENTIONAL FINANCIAL SYSTEM

Instruments: (long term) Ordinary Share, Cumulative and non-cumulative preference share, debenture and bonds

Instruments: (Short term), commercial paper, CDs, financial paper, marketable securities

Reward : Interest for Debt, profit for equity and rent/interest for leasing.

Basic Forms of Financial Instruments

Money: Medium that is universally acceptable in an economy both by sellers of goods and services as payment for the goods and services and by creditors as payments for debts.

Security: A security is a written evidence of the extension of loan. They are the printed documents providing ownership or creditorship in a business organization or public body such as local, state or federal government. Most of the financial instruments take the form of securities.

Security Type Financial Instruments

Main types of financial instruments are as follows:

a. Equity Instruments b. Debt Instrumentsc. Asset-backed Instrumentd. Hedging Instrument

Equity Instruments

Common Stock: A certificate of per ownership in a corporation that entitles the owner to certain voting privileges and to a share in profits Preferred Stock: A share of ownership in a firm that entitles the holder to first claim on the asset of the firm but afford less control than a common stock holder over the firm’s direction and management

Types of Preferred Stock

Participating Preferred Share: That preference share which first receives its preferential dividend at the prescribed rate, and then participates or shares with the common stock in the remainder of the funds declared as dividends. Nonparticipating Preferred Share: That share which, through the term of its issue and sale, is to receive a preferential dividend at a stipulated rate and nothing whatever beyond that. All other dividends in this case, regardless of amount, go to the common shareholders.


Cumulative Preferred share: Cumulative preference share is stock, the stipulated dividend of which, if not paid in full in one or more years, carries over or accumulates from year to year until fully paid. Commons Shareholders are not entitled to receive any dividend whatever as long as the cumulative preferred dividends is in arrears.Non-cumulative Preferred Share: On the other hand when the provision is such that dividends or part of dividends not paid to the preferred shareholders in any given year are lost to them forever, is known as no cumulative preference share.


Redeemable Preferred stock: This means that the corporation has the option, under the conditions and on the terms specified in the certificate of incorporation, of redeeming or buying back the shares from the shareholders. This redemption right rests, of course, entirely with the company and the shareholders can neither compel nor refuse the redemption of their shares.


Convertible preference share: Some preferred shares are exchangeable at the option of the holder into some other specified security of the company (for example common share). Conversion, unlike redemption, is at the option of the holder.Protected preferred stock: Sometimes options are given to preferred share to enhance attractiveness to investors, in addition to paying the current dividend on the preferred stock to put aside a reserve fund to cover one or two years' future preferred dividends before anything could be paid to the common stockholders

CONSTITUENT AND FEATURES OF ISLAMIC FINANCIAL SYSTEM

Mechanism: Based on ‘investment’ mode, ‘buy’(Trading) mode and ‘Lease’ mode

Institutions: Mudarabah companies, PLS Institutions/banks, Finance companies, Leasing Companies, Investment Banks, Stock Exchange

CONSTITUENT AND FEATURES OF ISLAMIC FINANCIAL SYSTEM

Instruments: Ordinary Share, Mudaraba bonds, noncumulative preference share, Short term investment paper,

Reward: Profit and Rent

Financial Market vs Financial Intermediary

The financial system has two major components. One is the Financial Market where SSUs can invest or lend their funds directly to the DSUs. This is called Direct Finance. An example is the market for corporate bonds. Purchase of Stock is another example of direct finance.

Financial Market vs Financial Intermediary

The other major component of the financial system is made up of the Financial Intermediaries - various institutions such as banks, savings and loan associations and credit unions - that as go-betweens to link up SSUs and DSUs. Here the linkage between saver and borrower is indirect. This is called Indirect Finance. Even though the ultimate lender is the SSU, the DSU owes repayment to the financial intermediary, and the financial intermediary owes repayment of the deposit to the SSU.

Financial intermediation and its advantages

The process that channels funds from savers to users to make investments iis referred to as financial intermediation.

Under conventional system financial intermediaries borrow from the savers against a deposit interest rate and lend the same to the ultimate users/borrowers against a leding interest rate higher then the deposit interest rate.

Under Islamic system both procurement and disbursement of fund is done on a participatory basis.

The advantages of financial intermediation

It allows smaller businesses (for whom stock and bond issuance is impractical) access to saving funds.

Allows savers to purchase assets that are relatively safe and more liquid and also earn interest/profit.

financial institutions can pool their funds and diversify their investments, thereby reducing risk to small savers.

Saving deposits are insured by regulatory agencies.

Disadvantages of financial intermediation

It increases the cost of financing It deprives the ultimate savers by giving a

lower rate of interest/profit It encourages effortless income It helps concentration of wealth It imposes all burden on entrepreneurs

Financial Market

The institutions and procedures that facilitate the transaction of financial securities are called financial market. These securities may be short or long in terms of maturity. Again the securities may be earning fixed income for certain period known as interest or may be participating in the profit and loss of the organization. The fixed income securities are known as debenture whereas the profit and loss sharing securers are known as shares.

Classification of Financial Market

Money Market: A money market means the institutions and procedures that facilitate the transaction of short-term securities. Short-term securities have the maturity of one year or less than one year. Examples of these securities are Govt. treasury bonds, bills of exchange, commercial paper etc.

The money market is a market for short term (less than one year) loan; in fact it is money or near money that is being bought and sold. It is not a place (like the stock market) but an activity.

Classification of Financial Market

Capital market : A capital market includes the institutions and procedures that facilitates the transaction of long term securities. The maturity of long term securities are considered to be more than one year. Examples of long term securities are shares, debentures etc.

Constituent of money market

Bankers acceptance market Commercial paper market Treasury Bill market Call money market The Eurodollar market The Interest rate Futures market Supplier of Money Market

a) Individual b) Banks c) Financial Institution d) Govt. Treasurye) Trading Companies

Constituent of Capital market

The Stock exchange : The Security and Exchange Commission Investment Banks : Development Banks and Financial

Institutions: Finance Companies : Brokers : The investors The Hedgers: The Arbitragers:

THE MONETARY SYSTEM

Islamic vs. Conventional View of Money

Islamic concept of money Conventional concept of money

Money is considered as servant

Money is considered as Master (nest to God)

Money is considered as only the medium of exchange

Money is considered as both commodity and medium of exchange



Money should not be stored or used for speculative purpose

Money should be stored and used for speculative purpose

Money is not considered as commodity and hence can not be traded

Money is considered as commodity and hence can be traded



Value of money should be kept stable at any cost

Value of money could be eroded for the sake of development

Money is considered as blessing as it help avoiding ’Riba AL Fadl’

Money is used to earn Riba or interest



Supply of money is controlled and conditional

Supply of money is uncontrolled and almost unconditional

Credit Money is discouraged

Credit Money is encouraged

Why according to Islam money is not a commodity

(a) Money has no intrinsic utility. It cannot be utilized in direct fulfillment of human needs. It can only be used for acquiring some goods or services. A commodity, on the other hand, has intrinsic utility and can be utilized directly without exchanging it for some other thing. For example, rice, cloth, chair, pen etc. are commodity because they are used directly to satisfy human need. If a person is hungry he cannot eat money directly rather he has to use money to buy food for eating. A thirsty person has to buy a glass of water against money to drink. One cannot write by money rather he has to buy a pen to write anything.


(b) Money Has no variety of Quality: The commodities can be of different qualities while money has no quality except that it is a measure of value or a medium of exchange. Therefore, all the units of money of the same denomination are hundred percent equal to each other. An old and dirty note of Rs.1000 has the same value as a brand new note of Rs.1000. On the other hand goods like clothe, food, furniture, household appliances have got variety of qualities and categories. Each quality of goods and services had different value or price.


© Money has no Individual Identity: In commodities, the transactions of sale and purchase are effected on an identified particular good. A buyer of a car, for example, agrees to buy a of a particular brand, model, color etc. and the seller agreeing thereupon, is obliged to supply that particular car. The seller cannot compel the buyer to take the delivery of another car, though of the same type or quality. Money, on the contrary, cannot be pinpointed in a transaction of exchange. If A has purchased a commodity from B by showing him a particular note of Rs.1000/- he can still pay him another note of the same denomination.

Islamic verdict on use of money

Firstly, money (of the same denomination) is not held to be the subject matter of trade, like other commodities. Its use has been restricted to its basic purpose i.e. to act as a medium of exchange and a measure of value.

Secondly, if for exceptional reasons, money has to be exchanged for money or if it is borrowed, the payment on both sides must be equal, so that it is not used for the purpose it is not meant for i.e. trade in money itself.

financial systam a comparative study

Economy & Finance