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Chapter 3:
Learning Objectives
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What Do Financial Institutions Do?
Functions of Intermediaries
Financial Institutions and Market Types
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The “four pillars”
The role of technology & government regulation
How Important is the Financial System?
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Financial Institution
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An institution that provides financial
services for its clients or members
The most important financial service
provided by financial institutions is
acting as financial intermediaries
Most financial institutions are highly
regulated by government
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The Function of Financial Institutions
Intermediation  transforming
assets
 Brokerage an “agency” function:
bringing would-be buyers and
sellers together

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Financial Intermediary
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A financial institution that connects surplus
and deficit agent
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Bank, trusts, credit union
Channel funds, resources from people who
have extra money (savers) to those who do
not have enough money to carry out a
desired activity (borrowers)
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Financial Intermediaries Provide
3 Major Functions
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Maturity transformation
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Risk transformation
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Converting short-term liabilities to long term
assets (banks deal with large number of lenders
and borrowers, and reconcile their conflicting
needs)
Converting risky investments into relatively riskfree ones (lending to multiple borrowers to
spread the risk)
Convenience denomination

Matching small deposits with large loans and
large deposits with small loans
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The Functions of Intermediaries
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Facilitate the acquisition/payment of goods
& services
 via lower transactions costs
Facilitate the creation of a “portfolio”
 economies of scale & scope
Ease liquidity constraints
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Reallocate consumption/savings patterns
Provide security
Reduce asymmetric information problem
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A Legacy from the Past:
The “Four-Pillars”
•Chartered
•personal,
•Trusts
banks
commercial loans, and deposits
company and credit unions
•fiduciary
deposits
•Insurance
responsibilities and personal loans and
company
•underwriting
•Investment
dealers
•underwriting
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insurance contracts
and brokering securities
Conflict in Regulation
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Regulation prevented banks to sell insurance
Currently, much blending between all “Pillars”
due to ease of legislation and financial
innovations
Protect the public if the institutions go
bankruptcy
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Types of Financial Institutions
1. Deposit-taking institutions – accept deposits and make loans
 chartered banks, trusts, credit unions
2. Insurance Companies and Pension Funds
 RRSPs (individual); RPPs (employer); CPP (Public)
3. Investment Dealers and Investment Funds
 Mutual funds, underwrite corporate and government securities
4. Government financial institutions
 Alberta Treasury Branch (ATB), Business Development Bank,
CDIC
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Types of Financial Markets:
A Selection of Types
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Primary vs Secondary
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Term to maturity
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open auction, private, public
Sectoral classification
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Retail vs Wholesale
Organization
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brokerage vs intermediation functions
Size
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short vs long term, money vs capital
Direct vs Indirect
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newly-issued vs previously issued
Households and unincorporated businesses
Nonfinancial corporations
The financial
The government or public
The Rest of the world
Complexity
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Assets as a Percent of total assets
Non-Financial
Assets
42.2%
57.8%
Financial
Assets
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Most important Financial Instruments, 2004
Percent of total financial assets
14
12
10
8
6
4
2
0
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Currency
Mortgages
Insurance
Bank loans
Corporate
Bonds
Foregin Currency
The Relative Importance of the Financial
Sector
Non-Financial
Sector
Financial
Sector
40.98%
59.02%
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Key Financial Sector Institutions in Canada
Percent of total assets, financial sector
50
40
30
Insurers
Non-deposit-taking instituions
Investment Funds
Deposit-taking instituion
20
10
0
1990
1992
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1994
1996
Year
1998
2000
2002
What Future for Banking?
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Non-bank firms are increasingly
offering financial services
Are banks better at spreading risks?
The threat & opportunities from
technology
Banks: One-stop shopping for all
financial services
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Summary
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Intermediation is a central concept
Financial institutions can be classified by
type, size, function
Financial markets can be classified by size,
term, organization, type of assets issued
Banks are the most adept at the
intermediation function
Financial systems should strive for efficiency
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