Chapter Two
Overview
of the Financial System
Primary Function of Financial Markets
 Primary function: To facilitate the flow of
funds from savers to borrowers
 Improves economic efficiency
 In the absence of borrowing, one can only “eat
what they kill”
 Hard to accumulate wealth without saving
Slide 2–3
Function of Financial Markets
Slide 2–4
Six Functions of Financial Markets &
Intermediaries
1.
2.
3.
4.
5.
6.
To transfer economic resources through time, across borders
& among industries
To provide a mechanism for the pooling of resources & the
subdividing of shares in enterprises
To provide a mechanism to clear & settle payments
To provide mechanisms for managing risk
To provide price information to help coordinate decentralized
decision making
To provide ways of dealing with the incentive problems that
arise due to asymmetric information
Source: The Global Financial System: A functional perspective by Crane, Froot,
Mason, Perold, Merton, Bodie, Sirri & Tufano
Slide 2–5
Transfer economic resources
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The financial system facilitates the transfer of economic
resources through time, across geographic regions, and across
different industry sectors
Facilitates the efficient allocations of household capital to the
most productive use in the business sector
Facilitates the efficient separation of ownership and
management of money
Facilitates specialization in production according to the
principles of comparative advantage
Slide 2–6
Mechanism for the pooling of resources
 Mechanism for the pooling of funds from small
investors to undertake large scale indivisible
investments in enterprises
 Mechanism for subdividing of investments in
enterprises to facilitate diversification and
distribution
 Can be done through financial intermediaries or
the market mechanism
 Examples: Bank deposits & loans; mutual funds;
common stocks; securitization
Slide 2–7
Payments System
 Payments System: Set of institutions and
arrangements that facilitate transfer of purchasing
power from A to B
 Includes methods for clearing and settling cash and
securities transactions
 Payments go through two steps: first they are cleared,
then they are settled.
 Clearing is the daily process by which CPA members
exchange deposited payment items and the net amounts
owed to each other are then determined
 Settlement is the procedure by which CPA members use
funds on deposit at the Bank of Canada to fulfil their net
obligations to all other members.
Slide 2–8
Canadian Payments System (CPA)
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Over eighteen million times a day, Canadians withdraw cash from banking
machines, use cheques, debit cards and pre-authorized payments, or make other
payments that result in one financial institution owing money to another. These
transactions total more than $147 billion a day which, over the 2003 calendar year,
amounted to more than 38 times Canada's GDP.
Prior to 1980, the Canadian payments system was administered by the Canadian
Bankers Association
The CPA was created as a not-for-profit organization by an Act of Parliament in
1980 & assumed control of the Canadian payments system in 1983. The
Association’s mandate, as amended through the Canadian Payments Act in 2001,
is:
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(i) to establish and operate national systems for the clearing and settlement of
payments and other arrangements for the making or exchange of payments,
(ii) to facilitate the interaction of the CPA’s systems with others involved in the
exchange, clearing and settlement of payments, and
(iii) to facilitate the development of new payment methods and technologies.
The Act also explicitly identifies public policy objectives for the CPA. It states that
the Association will:
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Promote the efficiency, safety and soundness of the clearing and settlement systems
Take into account the interest of users.
Slide 2–9
Managing Risk
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Ways to manage uncertainty and control risk
Risk-pooling versus risk-shifting
 Risk-pooling – Insurance - individual losses are spread over a large
number of members in the pool, thereby reducing the impact on any
one member
 Risk shifting – Derivatives - risk is assumed by those willing to
absorb a loss in exchange for a higher expected return
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Basic ways of managing risk:
 Insurance
 Diversification
 Other hedging strategies
Slide 2–10
Price Information
 Provision of price information to help coordinate
decentralized decision-making in various sectors of
the economy
 A primary function of markets is to allow the trading of
assets
 A secondary function of markets is to provide price
information that affects consumption-savings decisions
and portfolio wealth allocation decisions
 Capital is analogous to water. Water will always flow
downhill. Capital will always flow to the source of the
highest, risk-adjusted returns. Market prices provide the
information that investors require to make their portfolio
investment decisions.
Slide 2–11
Dealing with the incentive problems :
Adverse Selection and Moral Hazard
 Asymmetric information – problems arise when two parties to
a transaction have access to different information
 Adverse Selection
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Before transaction occurs
Potential borrowers most likely to produce adverse outcome are ones
most likely to seek a loan and be selected
 Moral Hazard
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After the transaction has occurred
The use of private information for personal gain
Slide 2–12
Adverse Selection in Insurance Markets
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Adverse selection can be a problem when there is asymmetric information
between the seller of insurance and the buyer; in particular, insurance will often
not be profitable when buyers have better information about their risk of claiming
than does the seller.
Ideally, insurance premiums should be set according to the risk of a randomly
selected person in the insured slice of the population (55-year-old male smokers,
say). In practice, this means the average risk of that group.
When there is adverse selection, people who know they have a higher risk of
claiming than the average of the group will buy the insurance, whereas those who
have a below-average risk may decide it is too expensive to be worth buying.
In this case, premiums set according to the average risk will not be sufficient to
cover the claims that eventually arise, because among the people who have bought
the policy more will have above-average risk than below-average risk.
Increasing the premium will not solve this problem, for as the premium rises the
insurance policy will less attractive to more of the people who know they have a
lower risk of claiming.
One way to reduce adverse selection is to make the purchase of insurance
compulsory, so that those for whom insurance priced for average risk is
unattractive are not able to opt out.
Slide 2–13
Moral Hazard in Insurance Markets
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Moral hazard means that people with insurance may take greater risks than they would do
without it because they know they are protected, so the insurer may get more claims than it
bargained for.
Fire insurance increases the incentive to commit arson, especially if someone is operating a
failing business and decides that they'd rather have the cash from the insurance proceeds on
the buildings than the buildings themselves. (The value of a business often is based on
profitability; after arson, the owner can claim the business was profitable.)
In a worst case scenario (from the insurer's viewpoint), the building is over-insured or
valuable contents are removed but claims are filed that they were destroyed in the fire.
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Many, perhaps most, police investigations of arson are the result of leads from suspicious
insurance adjusters.
More generally, having insurance discourages preventive measures, such as proper fire
prevention. For example, the expectation of US federal government disaster aid seems to
encourage the residents of Malibu, California to let bushes and trees grow near their houses,
as part of their landscaping. This increased vegetation raises the risk of fire damage to their
houses.
Automobile insurance reduces the costs to insured people who have accidents, making
people less cautious when driving (compared to how they would drive if they paid 100
percent of the damages they cause in an accident).
http://insurancefraud.org/Hall_of_Shame_05/hallofshame_set.html
Slide 2–14
Moral Hazard & Insurance: Examples
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You never know who might be listening. One fairly common type of fraud people
commit is buying coverage after their car's been damaged. What's less common is
when they buy it from the scene of the accident. Take the case of the motorcyclist
who wiped out and, while lying on the side of the road with a ruptured spleen, had
the presence of mind to call 1-800- PROGRESSIVE to buy coverage. What he
didn't know was that a witness who saw the accident also heard him make the call.
In another case, a couple's car caught on fire. While the husband was on the phone
with Progressive buying a policy, his wife was overheard yelling in the
background that the car was about to explode.
Unintended consequences. Some people figure the easiest and quickest way to
collect insurance money is to destroy their car by setting it on fire. Not necessarily.
Consider the case of two brothers who were hired to set a car on fire. They doused
it with gasoline, and to make sure the vehicle would be completely destroyed, they
decided to throw in a pipe bomb. The bomb exploded, setting one of the men on
fire. He was likely killed instantly from the explosion, but his brother, not
realizing that, rushed to extinguish the flames and ended up catching on fire. He
ran toward a nearby highway for help and flagged down a state trooper who had
come to investigate the black cloud of smoke. The man told the trooper what he
and his brother had done and then, like his brother, passed away from his injuries.
Slide 2–15
Moral Hazard & Insurance: Examples
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What's wrong with this picture? A customer said some parts were stolen from his
car, and to support his claim, he submitted what appeared to be phony invoices
along with Polaroid photos. At first blush the photos looked pretty good, but
something seemed a little odd about them. On closer inspection, investigators
realized the guy had taken extreme close-ups of a toy car that was the same color
and make of his actual car. The customer eventually admitted he took photos of
the toy car in an attempt to get his claim paid.
Miracle cure? A passenger riding in a customer's car was injured in a crash and
needed chiropractic treatment. No problem. The customer's insurance covered it.
However, sometime before completing the prescribed series of doctor visits, the
passenger died of unrelated, natural causes. Now, you'd think that a person who is
deceased would no longer benefit from a doctor's care, but evidently, the
chiropractor thought otherwise. He continued to bill for treatment for a full month
after the patient's death.
That's gonna leave a mark. A woman decided to take her boyfriend's motorcycle
for a ride. Unfortunately, she didn't know how to drive and crashed it. Luckily, she
wasn't injured. The man, however – afraid his insurance wouldn't cover the
damage to his motorcycle because his girlfriend wasn't listed as a driver on his
policy – decided to pretend that he had crashed the motorcycle. He figured he
needed some injuries to make his story credible, so he tied himself to the back of a
truck and asked a friend to drag him around a little bit to produce the road rash he
would have gotten from the wreck. Well, he got the injuries he wanted, but they
didn't do him any good. His girlfriend told investigators that in fact it was she who
crashed the motorcycle.
Slide 2–16
Classifications of Financial Markets
1. Debt Markets
 Short-Term (maturity < 1 year) Money Market
 Long-Term (maturity > 1 year) Capital Market
2. Equity Markets
 Common Stock
 Forms part of the Capital Market
Slide 2–17
Classifications of Financial Markets
1. Primary Market
 New security issues sold to initial buyers
2. Secondary Market
 Securities previously issued are bought and sold
Slide 2–18
Classifications of Financial Markets
1. Securities are traded on an Exchange
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Trades conducted in central locations
(e.g., Toronto Stock Exchange)
2. Securities are traded Over-the-Counter
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Dealers at different locations buy and sell
Slide 2–19
Internationalization of Financial Markets
 International Bond Market
 Foreign bonds – any bond sold in a domestic market,
denominated in the domestic currency, by a foreign issuer
 Eurobonds – sold in a foreign market by a non-resident
issuer and denominated in a currency other than the
currency of the country where the bond is issued
Slide 2–20
Foreign Bonds
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Yankee bonds – A bond issued in the United States,
denominated in U.S. dollars, by a foreign issuer
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Samurai Bonds – A bond issued in Japan, denominated in
Yen, by a foreign issuer
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Bulldog Bonds - A bond issued in the UK, denominated in
pounds sterling, by foreign issuer
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Matador bonds - A bond issued in Spain, denominated in
pesetas, by a non-Spanish company
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Matilda bonds – A bond issued in the Australian market,
denominated in Australian dollars, by a foreign entity
Slide 2–21
Eurobonds - Characteristics
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Trading A Eurobond is a tradable instrument: it is intended to be bought
and sold during the period up to it maturity. It is usually launched through
a public offering and is listed on a stock exchange.
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Payments There is no central register where holders of the issue are
named. Eurobonds are, in this sense, a bearer instrument - interest is paid
upon presentation of detachable coupons, while the principal amount is
repaid on presentation of the Eurobond itself.
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Listing Although Eurobonds are listed in several stock exchanges, the
London and Luxemburg stock exchanges are those most frequently used.
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Taxation Eurobonds are not subject to tax and largely free from
government regulation.
Slide 2–22
International Stock Markets
Slide 2–23
Financial Intermediaries
Slide 2–24
Size of Financial Intermediaries
Slide 2–25
Regulatory Agencies
Slide 2–26
Regulation of Financial Markets
 Three Main Reasons for Regulation
1. Increase Information to Investors
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Decrease adverse selection and moral hazard problems
Provincial securities commissions (such as the Ontario &
Alberta Securities Commission) force corporations to
disclose information
2. Ensure the Soundness of Financial Intermediaries
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Prevents financial panics
Chartering, reporting requirements, restrictions on assets
and activities, deposit insurance, and anti-competitive
measures
3. Improve Monetary Control
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Reserve requirements
Deposit insurance to prevent bank panics
Slide 2–27