Chapter
16
The Financial System
Learning Objectives
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.
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.
Understanding the
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.
Types of Securities
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)
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.
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
Money Market Instruments
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
Bonds
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
Types of Bonds
Quality Ratings for 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
Standard & Poor’s Bond Ratings
Test Your Knowledge
A(n) ________ is an unsecured bond backed by
the financial reputation of the issuing
corporation.
a.
b.
c.
d.
general obligation bond
Debenture
pass-through security
note
Test Your Knowledge
A(n) ________ is an unsecured bond backed by
the financial reputation of the issuing
corporation.
a.
b.
c.
d.
general obligation bond
Debenture
pass-through security
note
Answer: B
Convertible Securities
Bondholder has
the right to
exchange the
bond or
preferred
shares for a
fixed number of
common
shares.
Financial Markets
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
Understanding Stock 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
ECNs and the Future of
Stock Markets
electronic communication networks
(ECNs)
The fourth market
Buyers and sellers meet in a virtual market
and exchange with one another
Investor Participation in
the Stock Market
Investors use brokerage firms to:
1. Establish an account
2. Enter orders
3. Trade shares
The brokerage firm handles the trade on behalf
of the investor, charging a fee for the order.
Market order
Limit order
Financial Institutions
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
Electronic and Online Banking
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.
Deposit Insurance
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.
Credit Unions
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.
Nondepository Financial
Institutions
Three examples
Insurance companies
Pension funds
Finance companies
Mutual funds
Financial intermediaries that raise money from investors
by selling shares
The Role of the Bank of Canada
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
Test Your Knowledge
Virtually all nations have a central bank similar to
the Bank of Canada.
a. True
b. False
Test Your Knowledge
Virtually all nations have a central bank similar to
the Bank of Canada.
a. True
b. False
Answer: A
Monetary Policy
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
Total M2 Money Supply
Regulation of the Financial System
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.
The Financial System:
A Global Perspective
The financial system
is more connected.
Financial institutions
are more global.
Almost all nations
have a central bank.