Chapter 2- An Overview of the Financial System

What is the main function of financial markets?

• Channel funds from lender-savers to borrower-spenders

• helping funds reach productive investments

• improve economic efficiency

• help consumers time purchases

What is direct finance?

• Borrowers obtain funds directly from lenders by selling securities such as stocks or bonds.

• Example: Ford sells bonds directly to investors.

What is indirect finance?

• A financial intermediary transfers funds from lender-savers to borrower-spenders.

• Example: You deposit money → bank → bank lends it.

Why are financial intermediaries important?

• reduce transaction cost

• share risk

• address asymmetric information

• provide liquidity

• benefit from economies of scale

What are transaction costs?

• The time and money required to carry out a financial transaction.

• Intermediaries reduce them through economies of scale.

What is risk sharing?

• Reducing exposure to risk by investing in assets with different risk characteristics.

• Also called asset transformation.

What is diversification?

Investing in multiple assets whose returns do not all move together, reducing overall risk.

What is asymmetric information?

• One party has more information than another.

• It creates adverse selection and moral hazard.

What is the difference between adverse selection and moral hazard?

• Adverse selection = BEFORE: high-risk borrowers are more likely to seek loans.

• Moral hazard = AFTER: borrowers may take actions that increase repayment risk.

What is an example of moral hazard?

A borrower receives a loan to open a coffee shop but uses the money for a vacation instead. Their behaviour changes after receiving the loan.

What is an example of adverse selection?

• Example: subprime lending can create a pool of particularly risky borrowers.

What is an economy of scale?

• Cost per transaction decreases as an institution handles more transactions.

• Example: a $5,000 legal cost spread over 2,000 loans = $2.50 per loan.

What is an economy of scope?

• Financial institution provides several services

• uses information from one service for another

• lowering information costs

• It can also create conflicts of interest

What are conflicts of interest?

• Competing objectives may cause an institution to conceal or provide misleading information

• worsening asymmetric information

What is the difference between debt and equity?

• Debt:

  • requires interest/principal payments

  • has a maturity date

• Equity

  • represents ownership

  • may pay dividends

  • has no maturity date

  • may include voting rights

If a company goes bankrupt, who is paid first: bondholders or shareholders?

Bondholders. Debt holders have priority over equity holders.

What is a primary market?

Where new securities are sold for the first time.

What do secondary markets do?

• Provide liquidity

• determine security prices

• provide market information

• make securities more desirable in primary markets

What is the difference between an exchange and an OTC market?

• Exchange = organized marketplace where buyers and sellers meet.

• OTC = dealers in different locations buy/sell securities at quoted prices.

What is the difference between the money market and capital market?

Money market = short-term debt, generally less than 1 year. Capital market = long-term debt (1+ year) and equity.

What are the major money-market instruments?

• Treasury bills

• CDs

• commercial paper

• repos

• overnight funds

What is a repurchase agreement (repo)?

• A short-term loan using Treasury bills as collateral

• with an agreement to repurchase the securities shortly afterward

What are the major capital-market instruments?

• Stocks (corporate)

• residential mortgages

• Bonds (corporate)

• Government of Canada bonds

• provincial/municipal bonds

• government agency securities

• consumer/commercial loans

What are the three major types of financial intermediaries?

1. Depository

2. Contractual savings

3. Investment

What is a depository institution?

A financial intermediary that primarily raises funds through deposits and uses them for loans and investments.

• Examples: chartered banks, credit unions, and trust & mortgage loan companies.

What is a contractual savings institution?

• institution receives funds through contractual payments and invests them

• Examples: insurance companies and pension funds.

What is an investment intermediary?

• raises funds and invests/lends them

• Examples: finance companies, mutual funds, and money market mutual funds

What does a chartered bank do?

• Raises funds

• mainly through deposits

• uses them for commercial, consumer, mortgage loans and government securities/bonds

What is a credit union?

A cooperative financial institution that raises funds through deposits and primarily makes consumer and mortgage loans.

What does a finance company do?

Raises funds through:

• commercial paper

• stocks

• bonds

• AND makes consumer and business loans

What is a mutual fund?

• Sells shares to investors

• uses the funds to buy diversified portfolios of stocks and bonds

What is a money market mutual fund?

• Sells shares and invests in money-market instruments

• generally providing safe and liquid investments

What does an investment bank do?

• Helps corporations issue securities

• assists with activities such as mergers and acquisitions

What does OSFI do?

• Regulates federally regulated financial institutions

• sets standards for capital adequacy, accounting, and board responsibilities

What does the Bank of Canada do in financial regulation?

• Examines the books of deposit-taking institutions

• coordinates with OSFI and other federal agencies

What does CDIC do?

• Insures eligible deposits up to $100,000 per depositor at member institutions

• helps protect against bank failures and panics

What do provincial securities commissions do?

• Regulate securities markets

• require disclosure

• restrict insider trading

What does CompCorp do?

Compensates policyholders if a life insurance company fails.

Why is financial regulation necessary?

1. Increases information available to investors

• reducing adverse selection and moral hazard.

2. Promotes financial-system soundness and helps prevent panics/failures.

What are common methods of financial regulation?

• Disclosure requirements

• restrictions on entry & assets/activities

• deposit insurance

• inspections/reporting

What is a foreign bond?

• A bond sold in a foreign country and denominated in that country's currency.

• Example: CAD bond sold in Canada by a foreign company.

What is a Eurobond?

A bond denominated in a currency different from the country where it is sold.

What is a Eurocurrency?

A foreign currency deposited in a bank outside its home country.

What is a Eurodollar?

A U.S. dollar deposited outside the United States.

How do you identify a Eurobond?

• Look at the currency and the country.

• If they don’t match → Eurobond.

• Yen bond in Tokyo → ❌ Not a Eurobond (yen is Japan’s currency)

• Yen bond in Vancouver → ✅ Eurobond (yen ≠ Canada’s currency)

Why has internationalization of financial markets grown?

• Increased foreign savings

• deregulation

• greater international investment

• corporations seeking funding internationally

delete

• Benefit: more funding sources and investment opportunities.

• Risk: financial problems can spread across interconnected countries.

What is a mortgage-backed security?

a bond-like debt instrument backed by a pool of mortgages

Why might a bank be better positioned than an individual to make a loan?

Banks can:

• investigate/monitor borrowers

• reduce transaction costs

• diversify loans

• use economies of scale

• reduce asymmetric-information problems

Why would you put money in a bank instead of lending directly to a neighbour?

The bank handles:

• borrower information

• monitoring

• transaction costs

while you earn interest on your deposit

What is liquidity?

How easily and quickly an asset can be converted into cash. Secondary markets increase liquidity.

Why do financial markets allow consumers to better time purchases?

People can borrow now and repay later instead of waiting until they have enough savings.

Why can financial markets improve economic growth?

They channel funds toward productive investment, increasing production and economic efficiency.

Why can a loan shark sometimes make a borrower better off?

If the loan finances an investment whose return exceeds the borrowing cost, the borrower may benefit.

• therefore you can build a case to legalize it

Why do loan sharks worry less about moral hazard?

Loan sharks use threats/violence as enforcement, so borrowers have a strong incentive to repay and avoid risky behaviour.

Why do life insurance companies care about corporations and housing markets?

• They hold corporate bonds and mortgage assets

• changes in these markets can affect their financial position

What is the purpose of deposit insurance?

Reassures depositors their money is protected if a bank fails, helping prevent bank panics.

What is NOT a function of secondary markets?

• Matching savers with borrowers needing new funds.

• Secondary markets mainly provide liquidity, price determination, and information.

Who does not grant bank charters?

• CDIC

• OSFI supervises federally regulated institutions

• governments are involved in chartering

Why did the FDIC increase U.S. deposit insurance coverage from $100,000 to $250,000 in 2008?

To reassure depositors their money was safe and help prevent bank runs/panics.

Why can financial regulation be desirable across countries but still differ?

• Common regulation can make international operations easier

• but countries have different preferences/may choose different regulations

What caused the growth of foreign financial markets?

Deregulation of foreign financial markets was an important factor.

Why did European banks suffer when the U.S. housing market declined?

• They held mortgage-backed securities connected to the U.S. housing market.

• When these lost value, the banks experienced losses.

Why did internationalization benefit European banks investing in U.S. mortgages?

They could:

• provide capital to U.S. markets

• earn returns

• access investment opportunities outside home country

Why did subprime mortgages involve adverse selection?

Lenders provided loans to a pool containing borrowers with particularly high credit risk and low net wealth.

Why would a company likely to go bankrupt make bonds more attractive than equity to an investor?

Bondholders have priority over shareholders when a company is liquidated.

What type of financial intermediary is a money market mutual fund?

Investment intermediary.

How do financial intermediaries benefit from risk sharing?

• can earn a profit from the spread between returns on risky assets

• payments made on safer assets sold to investors

What is the difference between an asset and a liability for a security?

• Buyer/owner: security is an asset.

• Issuer: security is a liability because it represents a claim against the issuer.

Why are you more likely to lend to a family member than a stranger when you know the family member's honesty and risk?

More information reduces asymmetric information and makes adverse selection less severe.

What would happen to financial intermediaries if there were no information costs and no transaction costs?

They would be much less necessary because people could make loans directly without major costs or information problems.

Why were British and American investors both better off when Britain lent money to U.S. railroads in the 19th century?

• American borrowers gained capital for railroad projects

• British lenders earned interest

How do you calculate a foreign exchange gain or loss?

1. Convert original amount to CAD.

2. Convert final amount to CAD.

3. Gain/loss = final CAD value − original CAD cost

What is the exchange-rate result if £45 is bought at $1.50 per pound and £50 is sold at $1.25 per pound?

Original cost = $67.50 CAD. Final value = $62.50 CAD. Loss = $5.00.

What is the key difference between the money market and capital market in terms of risk and liquidity?

• Money market = generally more liquid and smaller price fluctuations.

• Capital market = generally wider price fluctuations and higher risk.

Why do pension funds and insurance companies hold many capital-market securities?

• Their future obligations are predictable

• so they can invest in longer-term securities that match future cash-flow needs

What is a residual claimant?

• Receives what remains after higher-priority claims, such as debt obligations, are paid.

• Equity holders are residual claimants.

What is commercial paper?

• Unsecured short-term debt

• issued by large, creditworthy corporations

What are Treasury bills?

• Short-term Canadian government debt securities

• typically 1, 3, 6, or 12 months

• sold at a discount

• redeemed at face value

What are overnight funds?

• Overnight loans between banks involving deposits at the Bank of Canada.

• The overnight rate reflects banks' credit needs and monetary-policy conditions.

What are Government of Canada bonds?

• Intermediate and long-term debt instruments

• issued by the Government of Canada to finance federal deficits

What are corporate bonds?

• Long-term debt issued by corporations.

• Bondholders receive interest and face value at maturity.

What are government agency securities?

• Long-term bonds issued by government agencies

• to finance activities such as mortgages or farm loans

• they may have government guarantees

What are non-marketable Government of Canada bonds offered to individuals, estates, and specified trusts?

Government of Canada savings bonds/securities designed for these investors that cannot be freely traded in the secondary market.

What does a trust and loan company do?

• Accepts deposits and provides loans

• including mortgage and consumer loans

• while also offering trust-related financial services

delete

• Short-term = less than 1 year

• Intermediate-term = 1–10 years

• Long-term = more than 10 years

What is the difference between a foreign bond and a Eurobond?

• Foreign bond = sold in a foreign country and uses that country's currency.

• Eurobond = sold in a country but uses a different currency.

Can moral hazard exist if lenders and borrowers have equal information?

Yes. Even if the lender knows what the borrower is doing, the borrower may still take actions that increase repayment risk. Knowing about the behaviour does not automatically mean the lender can stop it.

Why might the same financial regulation be desirable or undesirable across countries?

• Desirable: it can make international operations easier and less costly and reduce incentives for firms to move to countries with more favourable regulations.

• Undesirable: different countries may have different preferences for the type and level of financial regulation.

What are provincial securities and exchange commissions?

Regulate organized exchanges and financial markets