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Chapter 2Chapter 2An Overview of the Financial System

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An Overview of the An Overview of the Financial SystemFinancial System

Primary Function of the Financial System is Financial Intermediation

The channeling of funds from households, firms and governments who have surplus funds (savers) to those who have a shortage of funds (borrowers).

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An Overview of the Financial An Overview of the Financial SystemSystem

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Classifications of Financial Classifications of Financial MarketsMarkets

Debt Markets• Short-term (maturity < 1 year) – the

Money Market

• Long-term (maturity > 10 year) – the Capital Market

• Medium-term (maturity >1 and < 10 years)

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Classifications of Financial Classifications of Financial MarketsMarkets

Equity Markets - Common stocks• Primary Market - New security issues sold to

initial buyers• Secondary Market - Securities previously

issued are bought and sold

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Classifications of Financial Classifications of Financial Markets Markets (Cont’d)(Cont’d)

Secondary Markets Exchanges• Trades conducted in central locations (e.g.,

Toronto Stock Exchange and New York Stock Exchange)

Over-the-Counter Markets• Dealers at different locations buy and sell

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Financial Market InstrumentsFinancial Market Instruments

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Financial Market Instruments Financial Market Instruments (Cont’d)(Cont’d)

Other Money Market Instruments• Certificates of deposit• Repurchase agreements• Overnight funds

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Financial Market Instruments Financial Market Instruments (Cont’d)(Cont’d)

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Financial Market Instruments Financial Market Instruments (Cont’d)(Cont’d)

Other Capital Market Instruments• Canada savings bonds• Provincial and municipal bonds

• Government agencies securities

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Internationalization of Internationalization of Financial MarketsFinancial Markets

International Bond Market• Foreign bonds - sold in a foreign country and

denominated in that country• Eurobonds – denominated in a currency other than

the country in which it is sold • Eurocurrencies – foreign currencies deposited in

banks outside the home country

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World Stock MarketsWorld Stock Markets

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Function of Financial Function of Financial IntermediariesIntermediaries

Financial Intermediaries• Engage in process of indirect finance• Are needed because of transactions costs and

asymmetric information

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Function of Financial Function of Financial Intermediaries Intermediaries (Cont’d)(Cont’d)

Transactions Costs1. Financial intermediaries make profits by

reducing transactions costs.

2. They reduce transactions costs by developing

expertise and taking advantage of

economies of scale.

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Function of Financial Function of Financial Intermediaries Intermediaries (Cont’d)(Cont’d)

Risk Sharing• Create and sell assets with low risk characteristics

and then use the funds to buy assets with more risk (also called asset transformation)

• Lower risk by helping people to diversify portfolios

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Asymmetric Information Asymmetric Information

Adverse Selection• Before transaction occurs• Potential borrowers most likely to produce adverse

outcomes are ones most likely to seek loans and be selected

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Asymmetric InformationAsymmetric Information (Cont’d) (Cont’d)

Moral Hazard• After transaction occurs• Hazard that borrower has incentives to engage in

undesirable activities making it more likely that loan won’t be paid back

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Financial IntermediariesFinancial Intermediaries

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Size of Financial Size of Financial IntermediariesIntermediaries

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Regulation of Financial Regulation of Financial MarketsMarkets

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Regulation of Financial Regulation of Financial MarketsMarkets

Primary Reasons for Regulation1. Increase information to investors

- Decreases adverse selection and moral hazard problems

- Securities commissions force corporations to disclose information

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Regulation of Financial Regulation of Financial Markets Markets (Cont’d)(Cont’d)

Primary Reasons for Regulation (continued)

2. Ensuring the soundness of intermediaries- Prevents financial panics- Restrictions on entry/assets/activities, disclosure,

deposit insurance, limits on competition