MGEC71: Chapter 2
An Overview of the Financial System
Marking Scheme
Lectures delivered in-person
 The lectures of the section on Mon. are
recorded using AuRA & made available
to ALL students via Quercus)
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Midterm (40%;TBA)
 Assignment (10%; due on last day of
classes)
 Final Exam (50%; final exam period)
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2
An Overview of the Financial System
2.1 Function of Financial Markets
2.2 Structure of Financial Markets
2.3 Internationalization of Financial Markets
2.4 Function of Financial Intermediaries
2.5 Financial Intermediaries
2.6 Regulation of the Financial System
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An Overview of the Financial System
Financial markets perform the essential
economic function of channeling of funds
from households, firms and governments
who have surplus funds (savers) to those
who have a shortage of funds (borrowers).
 Securities are assets to those who buy
them, but liabilities to those who sell them
 Some securities are transferable (i.e., can
be resold) others cannot
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An Overview of the Financial System II
Direct finance vs. Indirect finance
 Direct finance – borrowers borrow funds
directly from lenders in financial markets
by selling them securities (financial
instruments), which are claims on the
borrower’s future income or assets
 A primary function of the Financial
System is Financial Intermediation
(Indirect finance)
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An Overview of the Financial System II
Financial Intermediaries (Indirect finance)
 Deposit taking banks (chartered banks, trusts,
credit unions, mortgage & loans, savings institutions etc.)
Government banks (CMHC, BDBC, EDBC etc.)
 Investment banks
 Mutual funds & other investment funds
 Pension funds
 Insurance companies
 Finance companies, etc.
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An Overview of the Financial System III
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Economic Efficiency
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Financial markets are critical for producing an
efficient allocation of capital, which
contributes to higher production and efficiency
for the overall economy
Well-functioning financial markets also directly
improve the welfare of consumers by allowing
them to: 1) ease liquidity constraints (borrow); 2) create a
portfolio (save); 3) diversify risks; 4) lower transactions costs; 5)
earn a (positive) rate of return; 6) obtain liquidity services, etc.
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When financial markets break down during
financial crises, severe economic hardship (at
the micro & macro level) results which can even lead
to dangerous political instability
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Economic Efficiency II
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(Private) Banks have a comparative advantage
at (versus public banks and other institutions) at:
1) Assessing Risk (i.e., deciding who gets a loan)
2) Pricing Risk (i.e., setting the loan terms)
3) Monitoring Risk (i.e., follow the loan thereafter)
Role of changes to: 1) technology; 2) rules &
regulations; 3) preferences &/or 4) int. comp.
(influences the Comparative Advantage of financial intermediaries)
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Scale economies, scope economies & learning economies
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Changes to the environment of business can
cause changes in (profit maximizing) business
behaviour – this can alter the level of efficiency
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Economic Efficiency III
Financial markets that are operating well
(efficiently) improve the economic welfare of
society
 Operational efficiency measures the
degree of cost effectiveness of the operation
of financial markets or institutions
 Allocational (or allocative) efficiency
measures how effectively financial markets
or institutions allocate funds (to borrowers)
from society’s perspective
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Efficiency Operational versus Allocational
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Both these measures of efficiency
represent relative comparisons between
financial markets or institutions.
For “banks” these statements are versus:
• Other domestic financial institutions;
• International banks;
• Public banks;
• Themselves in the past (or future); or versus
• The ideal level of efficiency, etc.
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Operational Efficiency
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How well the financial system undertakes the
function of transferring funds from lenders
to borrowers (operational costs)
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How do computers, the internet & AI/ML matter?
If banks are highly competitive, the “costs”
associated with this function should be small (i.e., if
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they utilize their comparative advantage they should be able to keep
operational costs down)
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Are Canadian banks operationally efficient?
There are “many” possible relative comparisons
and thus many possible answers.
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Operational Efficiency
iB and iL
DEAD WEIGHTLOSS
(for society)
iB
LFS
Without perfect competition
less than the Optimal amount
of LF (or LF*) is transferred
through the financial system
i*
iL= idep
LFD
LF
LF*
Loanable Funds
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Operational Efficiency
Why might iB > iL ?
Discuss
 To cover the cost of doing business & attempt
to make a profit
– Internet and computers have …. (tech change)
– Rules & regulations (changes) make ….
– International competition (changes) cause ….
 Profitability: Competition should drive this down
– If there is little competition, banks can make
excess profits from having iB > iL
– Large bank profits mean …. (imperfect comp)
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Allocative Efficiency
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How well the financial system allocates funds
which are transferred (through the financial system) from
lenders to borrowers (measured from societies perspective)
That is, are the most socially productive loans
(or investments) selected?
(Private) Banks have a comparative advantage at
(versus public banks and other institutions) at loan
making – this applies not just to the “cost” of running
their operations – but also to the “quality” of the
loans made from a private r.o.r perspective
(social r.o.r) = (private r.o.r) + (any spillovers)
Are Canadian banks allocatively efficient?
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Structure of Financial Markets I
Debt Markets – Bonds & other loans
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Can be characterized on the basis of credit
quality/issuer (gov’t vs. corporate); term to
maturity; etc.
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Short-term (maturity ≤ 1 year) – traded in
the Money Market
Long-term (maturity ≥ 10 year) – traded in
the Capital Market
Medium-term (maturity >1 and < 10 years)
– traded in the Capital Market
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Structure of Financial Markets II
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Equity Markets - Common stocks
Some make dividend payments
 Right to vote & No maturity date
 Equity holders are residual claimants
Primary Market - New security issues sold to
initial buyers
Secondary Market - Securities previously
issued are bought and sold
Brokers (agent: direct finance) their actions matter
Dealers (principal: indirect finance)
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Structure of Financial Markets II
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Structure of Financial Markets III
Exchanges (stock/futures/options/commodities)
 Trades conducted in central locations
(e.g., Toronto Stock Exchange and New
York Stock Exchange)
 Brokers, dealers, mkt makers, investment
banks etc. buy/sell on the exchange
Over-the-Counter (OTC) Markets (bonds/FX)
 Dealers at different locations buy and sell
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Structure of Financial Markets IV
Money and Capital Markets
Money market – trade in short-term
debt instruments (maturity ≤ 1 year)
 Capital Market – trade in longer term
debt & equity (maturity > 1 year)
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Financial Market Instruments I
Some important Money Market Instruments:
 Government of Canada Treasury Bills
 Certificates of Deposit
 Commercial Paper
 Repurchase Agreements
 Overnight Funds
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We will define them in detail (later in course).
But will describe some trends on the next table
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Financial Market Instruments II
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Financial Market Instruments III
Capital Market Instruments – debt and
equity instruments with maturities
greater than 1 year.
Some important capital market securities:
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Stocks
Mortgages
Corporate bonds
Government of Canada bonds
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Financial Market Instruments IV
Additional Capital Market Instruments
Include:
 Canada Savings Bonds
 Provincial and Municipal Government Bonds
 Government Agency Securities (CMHC,
Business Development Bank of Can (BDC),
Export Dev Bank (EDC), etc.)
 Consumer and Commercial Bank Loans
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Financial Market Instruments V
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Internationalization of Financial Markets
International Bond Market
 Foreign bonds – bonds sold in a foreign country
and denominated in that country’s currency (ex.
Panda & Maple bonds)
 Eurobonds – denominated in a currency other
than the country in which it is sold
 Eurocurrencies – foreign currencies deposited in
banks outside the home country (of that currency)
– S.T. deposits similar to S.T. Eurobonds
 Eurodollars – US dollars deposited in foreign
banks outside the US or foreign branches of US
banks (most important ex. of Eurocurrencies)
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World Stock Markets
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Function of Financial Intermediaries I
Financial Intermediaries
Engage in process of indirect finance
 Are needed because of (or arise from)
transaction costs, risk sharing and
asymmetric information
 Transaction costs – time and money
spent carrying out (financial) transactions
 Asymmetric information – inequality of
information between counterparties
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Function of Financial Intermediaries II
1. Reduce Transaction Costs
Financial intermediaries (FI) make profits by
reducing transactions costs
 They reduce transaction costs by developing
and taking advantage of expertise (learning
economies) and economies of scale &
scope
 Of course, this refers to the FI’s own costs.
The costs (fees) for agents transacting with
them are lowered as well due to…
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Function of Financial Intermediaries III
2. Risk Sharing
Create and sell assets with low risk
characteristics and then use the funds
raised to buy assets with more risk
(also called asset transformation)
 Lower risk by helping people to diversify
portfolios
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Asymmetric Information
3. Two types of asymmetric information
a. Adverse Selection
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Asymmetric Information before transaction occurs
Potential borrowers most likely to produce
adverse outcomes are ones most likely to
seek loans (and be selected)
Can result in lenders’ reluctant to make loans (ex
ante) even though there are good risks in the mkt
E.g., Akerlof’s Lemons Problem applied to
finance
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Asymmetric Information II
b. Moral Hazard
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Asymmetric information after transaction occurs
Hazard that borrower has incentives (ex post)
to engage in undesirable activities making it
more likely that loan won’t be paid back
Lenders may decide that they would rather not
make a loan (ex post)
E.g., Borrowed funds are used for another
purpose.
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Asymmetric Information II
Successful financial intermediaries have
higher earnings on their investments than
small savers because they are better
equipped than individuals to screen out (&
price) good from bad credit risks, thereby
reducing losses due to adverse selection.
 Also, they have high earnings because
they develop expertise in monitoring the
parties they lend to, thus reducing losses
due to moral hazard
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Asymmetric Information II
Due to their better capability to deal with
asymmetric information (adverse
selection and moral hazard), financial
intermediaries can afford to pay lendersavers interest and/or provide substantial
(liquidity & other) services and still earn a
profit (but this spread moves around)
 Of course, transactions costs & risk
sharing also play a significant role
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Types of Financial Intermediaries
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Depository Institutions (“Banks”)
Chartered Banks
 Trusts and Mortgage Loan Companies (TMLs)
 Credit Unions and Caisses Populaires (CUCPs)
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Contractual Savings Institutions
Life Insurance Companies
 Property and Casualty Insurance Companies
 Pension Funds and Government Retirement
Funds (ex. CPP/QPP etc.)
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Types of Financial Intermediaries II
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Investment Intermediaries
Finance Companies
 Mutual, Hedge & Other Investment Funds
 Money Market Mutual Funds
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Size of Financial Intermediaries
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Regulation of Financial Markets
Primary Reasons for Regulation
1. Increase information to investors
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Decreases adverse selection and moral hazard problems
Securities commissions force corporations to disclose
information
2. Ensuring the soundness of intermediaries
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Prevents financial panics
Restrictions on entry/assets/activities, disclosure, deposit
insurance, limits on competition (ex. 4 pillars regulation)
3. Financial Regulation Abroad
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Principal Regulatory Agencies
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