1. AN OVERVIEW OF THE FINANCIAL SYSTEM
Mishkin/Serletis
The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition
Chapter 2
AN OVERVIEW OF THE FINANCIAL SYSTEM

2. Learning Objectives
Summarize the basic function performed by financial markets
Explain why financial markets have several classifications
Describe the principal money market and capital market instruments
Express why the government regulates financial markets and financial intermediaries

3. Function of Financial Markets
Channel funds from economic players that have surplus funds to those that have a shortage of funds
Indirect financing
- borrowers borrow funds through financial intermediaries from lenders(financial investors)
examples:
Direct financing
borrowers borrow funds directly from lenders in financial markets by selling them securities

4. Function of Financial Markets (cont’d)
Promotes economic efficiency by producing an efficient allocation of capital
Improves the well-being of consumers by allowing them to time purchases better

5. Flows of Funds Through the Financial System

6. Relative Shares of Financial Institutions and Pension Plans

7. Structure of Financial Markets: Debt Markets
Debt instruments
a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date)
Maturity
short-term (maturity < 1 year)
intermediate-term (maturity >1 and < 10 years)
long-term (maturity > 10 year)

8. Structure of Financial Markets: Equity Markets
Equity Markets - Common stocks
some make dividend payments
equity holders are residual claimants
Primary Market
new security issues sold to initial buyers
Secondary Market
securities previously issued are bought and sold

9. Structure of Financial Markets: Equity Markets (cont’d)
Brokers
agents of investors who match buyers with sellers of securities
Dealers
link buyers and sellers by buying and selling securities at stated prices

10. Structure of Financial Markets: Secondary Markets
Exchanges and Over-the-Counter (OTC) Markets
Exchanges: Toronto Stock Exchange, NYSE
OTC Markets: Dealers at different locations buy and sell
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and equity instruments

11. Structure of Financial Markets: Maturity
Money and Capital Markets
Money markets deal in short-term debt instruments (maturity < 1 year)
Capital markets deal in longer-term debt and equity instruments (maturity > 1 year)

12. Money Market Instruments
Government of Canada Treasury Bills
Certificates of Deposit
Commercial Paper
Repurchase Agreements
Overnight Funds

13. Principal Money Market Instruments

14. Capital Market Instruments
Stocks
Mortgages and mortgage-backed securities
Corporate bonds
Government of Canada bonds
Canada Savings bonds
Provincial and municipal government bonds
Government agency securities
Consumer and bank commercial loans

15. Principal Capital Market Instruments

16. Internationalization of Financial Markets
Foreign Bonds
sold in a foreign country and denominated in that country’s currency
Eurobond
bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies
foreign currencies deposited in banks outside the home country
Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

17. Function of Financial Intermediaries: Indirect Finance
Reduce transaction costs (time and money spent in carrying out financial transactions)
economies of scale
liquidity services
Reduce the exposure of investors to risk
risk Sharing (asset transformation)
diversification

18. Function of Financial Intermediaries: Indirect Finance (cont’d)
Deal with asymmetric information problems
Adverse Selection
before the transaction (ex ante)
avoid selecting the risky borrower
gather information about potential borrower
Moral Hazard
after the transaction (ex post)
ensure borrower will not engage in activities that will prevent him/her to repay the loan
sign a contract with restrictive covenants

19. Types of Financial Intermediaries
Depository Institutions
Chartered Banks
Trusts and Mortgage Loan Companies
Credit Unions and Caisses Populaires
Contractual Savings Institutions
Life Insurance Companies
Property and Casual Insurance Companies
Pension Funds and Government Retirement Funds

20. Types of Financial Intermediaries (cont’d)
Investment Intermediaries
Investment Bank(U.S.) and Brokerages example1;
or Securities Houses(Canada; Common Wealth) example2
Finance Companies
Mutual Funds
Money Market Mutual Funds

21. Four Pillars of Canadian Financial System

22. Excellent Overview of the Canadian Financial System is given here
Excellent Overview of the Canadian Financial System is given here. At a personal level mindful of future careers in finance, you may click here. ( )

23. Primary Assets and Liabilities of Financial Intermediaries

24. Regulation of Financial Markets
Primary Reasons for Regulation:
1. Increase information to investors
reduce adverse selection and moral hazard problems
increase efficiency of financial markets by increasing the amount if information available to investors
provincial securities & exchange commissions require corporations to disclose information and restrict insider trading

25. Regulation of Financial Markets (cont’d)
2. Ensuring the soundness of intermediaries
prevents financial panics
restrictions on entry/assets/activities; disclosure; deposit insurance; limits on competition
3. Improve control of monetary policy

26. Principal Regulatory Agencies of the Canadian Financial System