Financial System Overview

Overview of the Financial System

• Financial markets and intermediaries direct funds from savers to borrowers
• This direction enables those with surplus funds to connect with those in need, supporting economic health

Preview

• Financial markets channel funds from those with surplus funds to those with shortages
• Financial intermediaries and markets address these needs
• Chapter provides overview of financial markets' structure, operation, instruments, and regulations which are then addressed in Chapters 8-11.

Function of Financial Markets

• Financial markets channel funds from savers to borrowers
• This function enables those with surplus funds to connect with those in need
• Lender-savers are those who save and lend funds
• Borrower-spenders are those who borrow funds to finance spending
• Direct finance occurs when borrowers borrow funds directly from lenders via securities
• Indirect finance involves financial intermediaries borrowing funds and then lending to borrowers
• Securities are assets for purchasers, but are liabilities for the issuer
• Companies issue debt via bonds and equity via stocks
• Efficient financial markets are essential for economic efficiency

Structure of Financial Markets

• Debt instruments involve fixed payments until maturity, with maturity ranging from short-term (less than a year) to intermediate-term (1-10 years), to long-term (10+ years)
• Equity holders are residual claimants, and ownership provides them certain rights
• Primary markets involve the initial sale of securities to buyers
• Secondary markets allow for reselling of existing securities
• Investment banks aid in the initial sale of securities by underwriting them which guarantees a price for securities then sells to the public
• Brokers match buyers with sellers, while dealers use stated prices
• Exchanges are centralized locations for trading, while over-the-counter (OTC) markets involve dealers at different locations

Money and Capital Markets

• Money markets trade with short-term debt instruments (less than a year), are more liquid/safer
• The capital market trades long-term debt and equity instruments (longer than a year)
• Short-term securities have fewer price fluctuations

Financial Market Instruments

• Money market instruments are short-term debt, so they are less risky and have fewer price fluctuations

Government of Canada Treasury Bills

• These bills have 1-12 month maturities for funding the government
• These are sold at discount and have good liquidity

Certificates of Deposit

• A certificate of deposit (CD), pays annual interest and has principal paybacks at maturity
• May or may not be negotiable
• CDs important to trust and loan companies

Commercial Paper

• Commercial paper are short-term debt instruments for corporations or banks
• A finance paper is where companies issues promissory notes

Repurchase Agreements

• Repurchase agreements (repos) are short-term loans with Treasury bills used as collateral

Overnight Funds

• Overnight funds are overnight bank loans of deposits at the Bank of Canada
• Overnight interest rates measure credit-market conditions in banking

Capital Market Instruments

• Capital Market Instruments are long-term plus 1 financial year
• Price fluctuates more, riskier than money market items
• Examples include stocks, mortgages, and bonds

Stocks

• Stocks are equity claims on net corporate income and assets
• The value of stocks is over $3 trillion in Canada, $55 trillion in the United States, and $90 trillion globally
• The amount of new stock issues is less than 1% of the total value of shares outstanding

Mortgages and Mortgage-Backed Securities

• Mortgages are loans for house or land purchases via structure/land as collateral
• A mortgage market is the largest debt market
• A mortgage-backed Security is a bond-like debt that covers many individual mortgages

Corporate Bonds

• Used by large corporations
• Pay interest twice a year
• Have face value payback when bonds mature

Government of Canada Bonds

• Government of Canada Bonds are intermediate to long term
• Used to finance deficits
• Are liquid securities

Provincial and Municipal Government Bonds

• Provincial bonds, from provincial governments
• Used to finance programs, schools
• Denominated in foreign/domestic currency

Government Agency Securities

• These are long-term bonds by government agencies who assist with municipal finances

Consumer and Bank Commercial Loans

• Consumer and Bank Commercial Loans are provided principally by banks and also finance companies

Internationalization of Financial Markets

• Financial markets becoming globalized
• US markets growing more competitive

International Bond Market, Eurobonds, Eurocurrencies

• Foreign bonds are sold in different countries, and denominated to what those countries use
• A eurobond is in currency not in the originating country
• A eurocurrency are foreign currencies in the originating banks

World Stock Markets

• US stock markets decrease as other countries stock markets grow
• Canada investors pay more attention to stocks in countries like Japan or London.

Function of Financial Intermediaries: Indirect Finance

• Indirect finance uses financial intermediaries
• They stand between the two parties and help transfer funds

Transaction Costs

• Transaction costs are the time and money you put to help the process of the financial transactions themselves

Economies of Scale

• Banks spend money on lawyers to write up a legal document
• This allows one document to be used many times
• This cuts down legal cost

Liquidity Services

• Bank offers depositors with checking accounts
• Depositors can earn interest via checking and savings accounts

Risk Sharing

• Helps cut any uncertainty that could come about in investments
• They make assets with good risk to their shareholders
• Let shareholders buy certain purchases that bare more risk

Diversification

• Helps people lower how much risk they have
• Put all investments in different areas to not only lose your whole investment
• Makes new assets, and then selling to individuals

Asymmetric Information: Adverse Selection and Moral Hazard

• This is where one party does not know more than the other party

Adverse Selection

• This is where information occurs before everything
• When a potential borrower is seen as a possible bad risk to not paying
• If no ones told of this possible risk, the lender may decide to not lend

Moral Hazard

• This is where things happen after the transactions occur
• Risks are bad and looked down upon
• The borrower might engage in things that go against whats in the lender's head

Problems

• Adverse selection in financial markets
• Financial intermediaries can alleviate these problems

Types of Financial Intermediaries

• Depository Institutions (banks)
• Contractual Savings Institutions
• Investment Intermediaries

Depository Institutions

• Financial intermediaries that accept deposits from people and create loans

Chartered Banks

• Mainly raise funds

Trust and Loan Companies

• Mainly do cheque and savings deposits/terms etc

Credit Unions and Caisses Populaires

• Only borrow funds from members, and primarily lend to members

Contractual Savings Institutions

• Financial intermediaries that gain funds from intervals
• Because they are accurate with their information, they dont worry to lose money fast
• They invest in long-term securities

Life Insurance Companies

• Insure people after accidental death
• They take premium funds and reinvest in mortgages
• They have rules they have to follow

Property and Casualty Insurance Companies

• Insure people from fire, theft and accident from accidents
• Used to buy assets

Pension Funds and Government Retirement Funds

• Give retirement income automatically
• Establishments have actively been getting pushed by government

Investment Intermediaries

• Finance Companies
• Mutual Funds
• Money Market Mutual Funds

Finance Companies

• Raise funds by selling commercial papers
• Lend those funds to people for furniture or cars

Mutual Funds

• Get funds from people and use proceeds to buy diversed portfolio for stock and bonds

Money Market Mutual Funds

• They sell shares to get funds
• Money is used to buy money market instruments that are safe and liquid

Hedge Funds

• Type of fund but minimum ranges are very high
• Many different types of assets

Investment Banks

• Help issue securities
• Advise firms on securities, then sell them by purchasing with predetermined prices

Regulation of the Financial System

• Government does it to increase info for investors
• Also do it to ensure how sound the system is

Increasing Information Available to Investors

• This provides investors more info on certain sectors

Regulation goals

• Reduce adverse selection
• Enhance efficiency

Ensuring the Soundness of Financial Intermediaries

• They have multiple reasons to do what they do

Regulations

• Restrictions on entry
• Disclosure
• Restrictions on assets/activities
• Deposit Insurance
• Limits on Competition

Financial Regulation Abroad

• Similar to what happens here