16 Chapter The Financial System

Learning Objectives LO 16.1 Outline the structure and importance of the financial system. LO 16.2 List the various types of securities. LO 16.3 Define financial market, and distinguish between primary and secondary financial markets. LO 16.4 Describe the characteristics of the major stock exchanges. LO 16.5 Discuss how financial institutions are organized and how they function. LO 16.6 Explain the functions of the Bank of Canada and the tools it uses to carry out these functions. LO 16.7 Describe the regulation of the financial system. LO 16.8 Describe the global financial system.

Understanding the Financial System Financial system: The mechanism by which money flows from savers to users Made up of households, businesses, government, financial institutions, and financial markets

Financial System (cont’d) Understanding the Financial System (cont’d) Savings is a function of many variables Funds can be transferred between users and savers directly or indirectly FIGURE 16.1 Overview of the Financial System and its Components

Types of Securities Securities: Financial instruments that represent the obligations of the issuers to provide the purchasers with the expected stated returns on the funds invested or loaned Obligations on the part of the issuer Businesses and governments Provide rate of return to purchasers Three categories Money market instruments Bonds Shares (stock)

Test Your Knowledge Securities are a) stocks and savings accounts. b) risk-free or speculative ownership stakes in publicly traded corporations. c) obligations on the part of the borrower to provide returns on funds invested or loaned. d) bonds and debentures.   Answer: c

Money Market Instruments Short-term debt securities Issued by governments, financial institutions, and corporations Investors are paid interest for the use of their funds Generally low-risk Canadian Treasury bills, commercial paper, and bank certificates of deposit

Bonds Government bonds Municipal bonds Corporate bonds Bonds sold by the Canadian government Municipal bonds Bonds issued by municipal/local governments Corporate bonds A diverse group; often vary based on the collateral

Types of Bonds Table 16.1 Types of Bonds

Quality Ratings for Bonds Price is determined by risk and interest rate Several firms rate bonds Dominion Bond Rating Service (DBRS) in Canada Standard & Poor’s (S&P) Moody’s Investment-grade Speculative/junk

Standard & Poor’s Bond Ratings

Test Your Knowledge A(n) ______ is an unsecured bond backed by the financial reputation of the issuing corporation. a) general obligation bond b) debenture c) pass-through security d) note   Answer: b

Convertible Securities Bondholder has the right to exchange the bond or preferred shares for a fixed number of common shares

Financial Markets Primary market: Financial markets where firms and governments issue securities and sell them initially to the general public When a firm offers a stock for sale to the general public for the first time, it is call an initial public offering (IPO) Secondary market: A collection of financial markets where previously issued securities are traded among investors

Understanding Stock Markets Stock markets (exchanges): Markets where shares of stock are bought and sold by investors Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE), NASDAQ

ECNs and the Future of Stock Markets Electronic communication networks (ECNs) The fourth market Buyers and sellers meet in a virtual market and exchange with one another

Investor Participation in the Stock Markets Investors use brokerage firms to: 1. Establish an account 2. Enter orders 3. Trade shares The brokerage firm handles the trade on behalf of the investor, charging a fee for the order Market order Limit order

Financial Institutions Financial institutions: Intermediaries between savers and borrowers that collect funds from savers and then lend the funds to individuals, businesses, and governments Depository institutions Commercial banks Non-depository institutions Life insurance companies Pension funds Mutual funds

Electronic and Online Banking An increasing amount of funds move through electronic funds transfer systems (EFTSs) Millions of businesses and consumers now pay bills and receive payments electronically Most employers directly deposit employee paycheques Nearly all social assistance and other federal payments are made electronically Most banks now offer customers debit cards The number of annual ATM and debit card transactions in Canada is expected to grow to more than 4 billion According to a recent survey, Canadians were the highest users of Internet banking

Deposit Insurance Canada Deposit Insurance Corporation (CDIC): The federal agency that insures deposits at commercial and savings banks Formed in 1967 to build public confidence in the banking system Before deposit insurance, runs were common as people rushed to withdraw their money from the bank because of rumoured instability Deposit insurance shifts the risk of bank failures from individuals to the CDIC

Credit Unions Cooperative financial institutions owned by depositors/members Offer a variety of consumer services More than 5 million Canadians belong to one of the nation’s approximately 379 credit unions Deposits are insured at the provincial level

Nondepository Financial Institutions Three examples Insurance companies Pension funds Finance companies Mutual funds Financial intermediaries that raise money from investors by selling shares

The Role of the Bank of Canada The Bank of Canada (The Bank): The central bank of Canada Created In 1935 Four basic responsibilities Regulate monetary policy Design and issue bank notes Regulate the financial system Manage funds for the federal government

Test Your Knowledge Virtually all nations have a central bank similar to the Bank of Canada. a) True b) False   Answer: a

Monetary Policy The Bank controls the supply of money and credit Measures of the money supply: M1 and M2 M1: currency in circulation and the balances in bank chequing accounts M2: M1 plus balances in some savings accounts and money market mutual funds The government requires banks to maintain reserves Set the discount rate Open market operations

Total M2 Money Supply FIGURE 16.4 Total M2 Money Supply

Regulation of the Financial System Under the Bank Act, the federal government is responsible for regulating the banking sector Several regulatory bodies are involved in regulating Canadian banks, including the Department of Finance, the Bank of Canada, the Office of the Superintendent of Financial Institutions (OSFI), and the CDIC

The Financial System: A Global Perspective The financial system is more connected Financial institutions are more global Almost all nations have a central bank

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