The Financial System

Chapter

16

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.

Learning Objectives

LO 16.5 Discuss the organization and functioning of financial institutions.

LO 16.6 Explain the functions of the Bank of Canada and the tools it uses to control the supply of money and credit.

LO 16.7 Understand the impact of regulations and laws affecting the financial system.

LO 16.8 Describe the global 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

Understanding the Financial System

Savings is a function of many variables. Funds can be transferred between users

and savers directly or indirectly.

Understanding the Financial System

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)

Types of Securities

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.  

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

Test Your Knowledge

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

Money Market Instruments

Government 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

Bonds

Types of 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

Quality Ratings for Bonds

Standard & Poor’s Bond Ratings

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 

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

Test Your Knowledge

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

Convertible Securities

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

Financial 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

Understanding Stock Markets

electronic communication networks (ECNs) The fourth market Buyers and sellers meet in a virtual

market and exchange with one another

ECNs and the Future of Stock Markets

Investors use brokerage firms to:1. Establish an account2. Enter orders3. Trade shares

The brokerage firm handles the trade on behalf of the investor, charging a fee for the order.

Market order Limit order

Investor Participation in the Stock Market

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

Financial Institutions

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.

Electronic and Online Banking

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.

Deposit Insurance

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.

Credit Unions

Three examples Insurance companies Pension funds Finance companies

Mutual funds Financial intermediaries that raise money from investors by selling shares

Nondepository Financial Institutions

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

The Role of the Bank of Canada

Virtually all nations have a central bank similar to the Bank of Canada.

a. Trueb. False 

Test Your Knowledge

Virtually all nations have a central bank similar to the Bank of Canada.

a. Trueb. False Answer: A

Test Your Knowledge

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

Monetary Policy

Total M2 Money Supply

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.

Regulation of the Financial System

The financial system is more connected.

Financial institutions are more global.

Almost all nations have a central bank.

The Financial System: A Global Perspective