Towards A Competitive Malaysia #62

Chapter 9: Institutions Matter

Financial Intermediaries

A modern economy requires an efficient system linking owners of capital with its users, or to quote the Canadian Management Professor Reuven Brenner, “matching talent with capital, and holding both sides accountable.”18 There will always be those who have capital but unable to use it (or use it efficiently) and those who lack capital but have the expertise to use it efficiently. If we could link the two, we would have an arrangement that would benefit both parties as well as society.

Such arrangements have been part and parcel of human society. I may own land, but if for some reason I were unable to till it, I would get someone else to do it for me. He would get some of the harvest, a marked improvement in both our positions than before we entered into the arrangement. Society too would benefit from the excess of our harvests.

Such “tenant farming” is a feature even in primitive societies. The concept may be simple and unsophisticated, nonetheless such tenant farming has been the subject of modern analyses, and many an elegant insight of economics have emerged from such studies.19

Financial intermediaries like banks link owners of money (savers) to its users (investors). Imagine that I have some excess money. If I hide it underneath my mattress, I risk it being stolen or chewed by moths, and that money is not doing anyone any good. If I were to deposit it in a bank, the bank could use my otherwise idle money.

Consider that my neighbor wants to start a taxi business, but he has no money to buy the car. So he goes to the local bank to negotiate the loan. The bank manager, after assessing the applicant’s creditworthiness (essentially his ability to repay the loan), gives him the money (that it obtained from me and other savers) to buy the car. The bank expects the taxi business would generate enough revenue to repay the loan plus give the driver a decent income (in that order!) to make it worthwhile for him to get into the taxi business. For that service the bank would charge him a fee in the form of interest on the loan. To entice the likes of me to put my money in that bank, it offers interest on my savings.

As a result of this simple transaction, my neighbor gets to start his taxi business, the bank earns a fee for the loan, and I receive interest on my otherwise idle money. All parties gained. The greatest beneficiary of all is the community: it now has a taxi service. This benefit cannot be quantified; it may mean the saving of a life in getting someone to the hospital quickly.

Multiply such transactions a million times, and you would have a vibrant economy.

Imagine if there were no banks. My neighbor, knowing that I have some extra cash, would approach me directly for a loan. As I have no expertise in assessing his creditworthiness, I may be reluctant to lend him my money, remembering Shakespeare’s immortal admonition, “Neither a borrower, nor a lender be; For loan oft loses both itself and friend.”20 The end result is that nobody benefits; my money remains idle under my mattress; it stays as “dead capital.” While its impact on me would be simply that I could not earn interest on my idle money, the impact on society would be much more consequential. My neighbor would remain without a job and the town without a taxi service.

An efficient banking system is indispensable to a modern economy. By being efficient the bank could reduce its costs and thus could pay its depositors more interest thereby encouraging even more people to save. It could also then charge lower interest rates so that more people could borrow more money to start even more businesses. With less interest to pay, the taxi driver gets to keep more of the fares he earned from his passengers. With the greater earnings and lower interest rates, he would want to buy more cars and expand his taxi service, thus providing even better service to the community, quite apart from creating more jobs.

Imagine where the banking system is inefficient. First, savors would not trust it with their money. If banks were inefficient and had to employ thousands to do chores that could be done efficiently and cheaply by computers, they would not make much profit. They could not then pay much to their depositors, thus discouraging them from saving. To cover the added costs, the bank would then have to charge more for its loans, thus cutting out many more potential borrowers. High interest rates would quickly snuff out economic activities.

Banks can be inefficient in many other ways. If they dole out loans indiscriminately without paying close attention to the commercial viability of the projects they are funding (and thus the ability of the borrower to repay the loan), that would impact their profits. Loans to insiders, cronies, and the politically powerful without the usual rigorous credit checks or through corrupt and criminal activities are particularly dangerous.

Then there are imprudent practices. Bankers are humans, susceptible to the herd mentality. Often they help create speculative bubbles by encouraging over investments in particular areas. Strict rules preventing such over concentrations are useless unless they are fully enforced. The central bank must be vigilant, nabbing early those bankers who would be tempted to stray. Prior to the 1997 economic crisis, Malaysian banks were dangerously over exposed in financing the glut of real estate, margin stock buying, and lending to political cronies.

It is criminal that only seven or eight principals were responsible for over 80 percent of the non-performing loans of Malaysian banks during the economic crisis of 1997. Obviously these people had powerful connections such that the bankers could not say no. Either that or Malaysian bankers are a reckless lot, oblivious of their fiduciary responsibility in protecting their depositors’ assets. One also wonders of the oversight role of the central bank.

Next: Strengthening Financial Intermediaries