An Overview of the Financial System

Fundamental Functions of Financial Markets

  • Financial markets channel surplus funds from economic agents who have saved excess funds (lender-savers) to agents who have a shortage of funds and wish to spend or invest (borrower-spenders).

    • Lender-savers comprise households, business firms, governments, and foreigners, with households representing the principal source of savings.

    • Borrower-spenders comprise business firms, governments, households, and foreigners, with businesses and governments representing the primary users of funds.

  • Key macroeconomic benefits provided by financial markets include:

    • Efficient allocation of capital: Financial markets allocate financial resources to the most productive investment opportunities, generating higher economic output and economic growth.

    • Purchase timing flexibility: Financial markets allow individual consumers to time and smooth their consumption patterns over their lifetimes, such as borrowing to purchase real estate or finance higher education before sufficient cash flow exists, and subsequently saving for retirement.

    • Risk sharing: Financial markets enable agents with differing risk appetites to transfer, distribute, and hedge economic and financial risks.

Channels of Financial Flows: Direct versus Indirect Finance

Flows of funds through the financial system

  • Direct Finance:

    • In direct finance, borrowers borrow funds directly from lender-savers in financial markets by issuing and selling financial instruments known as securities.

    • Securities represent contractual claims on the issuer's future income or assets.

    • From the perspective of the borrower-spender, securities are liabilities (debt obligations or IOUs).

    • From the perspective of the lender-saver who purchases them, securities are financial assets.

    • Securities issued in direct finance can take the form of debt instruments (such as bonds) or equity instruments (such as corporate stock).

  • Indirect Finance:

    • In indirect finance, funds flow between lender-savers and borrower-spenders via a financial intermediary.

    • The intermediary borrows funds from lender-savers (issuing secondary liabilities such as bank deposits) and deploys these funds to make loans or buy securities from borrower-spenders (acquiring primary assets).

    • Indirect finance represents the primary conduit for moving funds from savers to borrowers in modern financial systems.

Structure and Classifications of Financial Markets

  • Debt versus Equity Markets:

    • Debt Markets:

    • Involve the trading of debt instruments, such as bonds or mortgages, which are contractual agreements where the borrower agrees to pay regular fixed amounts to the holder until the date of maturity.

    • Short-term instruments: Instruments with an initial maturity of less than one year (<1 year< 1\text{ year}).

    • Intermediate-term instruments: Instruments with a maturity between one and ten years (1 to 10 years1\text{ to }10\text{ years}).

    • Long-term instruments: Instruments with a maturity of ten years or longer (≥10 years\ge 10\text{ years}).

    • Equity Markets:

    • Involve the trading of corporate equities, such as common shares, representing residual claims on the ownership, assets, and net earnings of a corporation.

    • Equities do not possess maturity dates.

    • Equities often provide periodic cash distributions termed dividends.

    • Equity holders are classified as residual claimants, meaning they receive distributions only after all contractual debt obligations have been satisfied.

  • Primary versus Secondary Markets:

    • Primary Market:

    • A market in which newly created and issued securities are sold to initial investors.

    • Issuing corporations and governments receive new capital exclusively when securities trade in the primary market.

    • Investment banks assist issuers by underwriting new issues, which involves guaranteeing a minimum price for the securities and selling them to the investing public.

    • Secondary Market:

    • A market in which previously issued securities are subsequently traded among investors.

    • The original issuing corporation does not raise new cash when trades occur in the secondary market.

    • Provides essential liquidity, making securities easier to convert into cash and establishing prevailing asset valuations.

    • Secondary market participants include:

      • Brokers: Agents of investors who match prospective buyers with sellers.

      • Dealers: Market participants who facilitate trading by buying and selling securities from their own inventory at quoted bid and ask prices.

  • Organization of Secondary Markets: Exchanges versus Over-the-Counter (OTC) Markets:

    • Exchanges:

    • Centralized trading locations where buyers and sellers meet either in person or electronically to execute transactions.

    • Examples include the Toronto Stock Exchange (TSX) for equities and ICE Futures Canada for agricultural commodities such as wheat and oats.

    • Over-the-Counter (OTC) Markets:

    • Decentralized markets where dealers situated in multiple locations stand ready to buy and sell securities over an electronic network to any counterparty willing to accept their terms.

    • The Canadian government bond market operates primarily as an OTC market.

    • Heightened competition and technological links make contemporary OTC markets operate with speeds and spreads comparable to organized exchanges.

  • Maturity Horizon: Money Markets versus Capital Markets:

    • Money Markets:

    • Financial markets where only short-term debt instruments with maturities of less than one year (<1 year< 1\text{ year}) are traded.

    • Exhibits high liquidity and minimal price fluctuation risk.

    • Extensively utilized by commercial banks and non-financial corporations to generate interest earnings on temporary surplus funds.

    • Capital Markets:

    • Financial markets where longer-term debt instruments with maturities greater than one year (>1 year> 1\text{ year}) and equity instruments are traded.

    • Securities feature wider price fluctuations and higher risk profiles.

    • Utilized by corporations and governments to finance long-term capital investments.

Principal Money Market Instruments and Growth Trends

  • Primary types of money market instruments include:

    • Government of Canada Treasury Bills: Short-term debt instruments issued at a discount by the federal government to finance expenditure.

    • Certificates of Deposit (CDs): Term deposits sold by depository institutions paying regular interest and repaying face value at maturity.

    • Commercial Paper: Unsecured short-term promissory notes issued by large, creditworthy corporate borrowers and financial firms.

    • Repurchase Agreements (Repos): Short-term loans where Treasury bills serve as collateral; the seller sells the security and agrees to repurchase it at an agreed-upon higher price within a few days.

    • Overnight Funds: Very short-term interbank transfers facilitating instantaneous overnight lending between financial institutions to balance reserves.

  • Amounts outstanding of principal money market instruments in Canada (in millions of dollars\text{in millions of dollars}):

    • Government of Canada Treasury Bills:

    • 19901990: $113 654 million\$113\,654\text{ million}

    • 20002000: $76 633 million\$76\,633\text{ million}

    • 20102010: $150 830 million\$150\,830\text{ million}

    • 20202020: $190 431 million\$190\,431\text{ million}

    • Corporate Short-Term Paper — Commercial Paper:

    • 19901990: $31 303 million\$31\,303\text{ million}

    • 20002000: $125 751 million\$125\,751\text{ million}

    • 20102010: $56 338 million\$56\,338\text{ million}

    • 20202020: $55 766 million\$55\,766\text{ million}

    • Corporate Short-Term Paper — Bankers’ Acceptances:

    • 19901990: $46 059 million\$46\,059\text{ million}

    • 20002000: $51 409 million\$51\,409\text{ million}

    • 20102010: $47 316 million\$47\,316\text{ million}

    • 20202020: $88 453 million\$88\,453\text{ million}

Principal Capital Market Instruments and Growth Trends

  • Primary types of capital market instruments include:

    • Corporate stocks (equities)

    • Residential mortgages and mortgage-backed securities (MBS)

    • Corporate bonds

    • Government of Canada bonds

    • Canada Savings bonds

    • Provincial and municipal government bonds

    • Government agency securities

    • Bank commercial loans and consumer credit loans

  • Amounts outstanding of principal capital market instruments in Canada (in billions of dollars\text{in billions of dollars}):

    • Corporate Stocks (Market Value):

    • 19901990: $112.5 billion\$112.5\text{ billion}

    • 20002000: $243.9 billion\$243.9\text{ billion}

    • 20102010: $378.4 billion\$378.4\text{ billion}

    • 20202020: $667.1 billion\$667.1\text{ billion}

    • Residential Mortgages:

    • 19901990: $245.3 billion\$245.3\text{ billion}

    • 20002000: $429.1 billion\$429.1\text{ billion}

    • 20102010: $976.6 billion\$976.6\text{ billion}

    • 20202020: $1669.8 billion\$1669.8\text{ billion}

    • Corporate Bonds:

    • 19901990: $72.3 billion\$72.3\text{ billion}

    • 20002000: $186.2 billion\$186.2\text{ billion}

    • 20102010: $333.7 billion\$333.7\text{ billion}

    • 20202020: $624.7 billion\$624.7\text{ billion}

    • Government of Canada Securities:

    • 19901990: $175.9 billion\$175.9\text{ billion}

    • 20002000: $355.9 billion\$355.9\text{ billion}

    • 20102010: $394.3 billion\$394.3\text{ billion}

    • 20202020: $699.9 billion\$699.9\text{ billion}

    • Bank Commercial Loans:

    • 19901990: $133.9 billion\$133.9\text{ billion}

    • 20002000: $157.7 billion\$157.7\text{ billion}

    • 20102010: $187.1 billion\$187.1\text{ billion}

    • 20202020: $507.9 billion\$507.9\text{ billion}

    • Consumer Loans:

    • 19901990: $99.6 billion\$99.6\text{ billion}

    • 20002000: $193.8 billion\$193.8\text{ billion}

    • 20102010: $474.3 billion\$474.3\text{ billion}

    • 20202020: $629.8 billion\$629.8\text{ billion}

    • Nonresidential Mortgages:

    • 19901990: $7.2 billion\$7.2\text{ billion}

    • 20002000: $15.6 billion\$15.6\text{ billion}

    • 20102010: $30.8 billion\$30.8\text{ billion}

    • 20202020: $79.4 billion\$79.4\text{ billion}

International Dimensions of Financial Markets

  • International Bond Markets:

    • Foreign Bonds:

    • Debt instruments sold in a foreign host nation and denominated in the currency of that foreign nation.

    • Example: A Canadian corporation issuing a debt security in the United Kingdom denominated in British pounds.

    • Eurobonds:

    • Debt instruments sold outside the home country and denominated in a currency other than the domestic currency of the nation where they are issued.

    • Example: A Canadian company selling a bond in the United Kingdom denominated in United States dollars or Canadian dollars.

    • Market significance: Eurobonds are a modern financial innovation representing more than 80%80\% of all newly issued international debt offerings.

  • Eurocurrencies and Eurodollars:

    • Eurocurrencies: National currencies deposited in commercial banks situated outside their native domestic borders.

    • Eurodollars: United States dollars held on deposit in financial institutions outside the United States, or within foreign branches of United States banks.

  • Global Equity Markets:

    • Cross-border securities trading occurs across integrated international stock exchanges, including the New York Stock Exchange (NYSE), the Tokyo Stock Exchange (Nikkei index), the London Stock Exchange (FTSE 100-Share Index), and other equity markets worldwide.

Economic Rationale and Roles of Financial Intermediaries

  • Financial intermediation serves as the primary route for routing savings into productive investment across economies.

  • Three economic functions performed by financial intermediaries include:

    • 1. Lowering Transaction Costs:

    • Economies of scale: High-volume operational scale reduces transaction and legal costs per dollar invested (e.g., standardized contracts and automated loan agreements).

    • Economies of scope: Intermediaries apply unified data systems and financial infrastructure to provide multiple related services concurrently.

    • Liquidity services: Intermediaries provide transactional mechanisms that allow customers to execute transfers and convert balances into spendable currency with minimal cost.

    • 2. Risk Sharing and Asset Transformation:

    • Asset transformation: Intermediaries convert risky, illiquid, and long-term assets (such as commercial loans or mortgages) into less risky, liquid liabilities tailored to retail investors (such as savings deposits).

    • Diversification: Intermediaries pool individual funds across large portfolios of non-correlated assets, lowering total variance and risk for depositors beyond what individual investors could accomplish on their own.

    • 3. Resolving Asymmetric Information:

    • Asymmetric information occurs when one transacting party possesses superior private information relative to the counterparty, creating market frictions.

    • Intermediaries mitigate asymmetric information through rigorous borrower vetting and continuous post-loan oversight.

    • Adverse Selection (ex-ante\text{ex-ante} problem):

      • Occurs prior to the closing of a transaction.

      • Low-quality borrowers or individuals with higher credit and default risks are the most aggressive seekers of loans.

      • Intermediaries counter this through credit scoring, financial auditing, and loan screening.

    • Moral Hazard (ex-post\text{ex-post} problem):

      • Occurs subsequent to the disbursement of funds.

      • Borrowers face incentives to undertake high-risk or unapproved activities that generate private upside while shifting default risk onto the lender.

      • Intermediaries counter this through monitoring, auditing, and enforcing restrictive covenants.

Taxonomy and Balance Sheets of Financial Intermediaries

  • Depository Institutions (Banks):

    • Chartered Banks:

    • Primary Liabilities (Sources of Funds): Deposits.

    • Primary Assets (Uses of Funds): Loans, mortgages, government bonds.

    • Trust and Loan Companies (TMLs):

    • Primary Liabilities (Sources of Funds): Deposits.

    • Primary Assets (Uses of Funds): Mortgages.

    • Credit Unions and Caisses Populaires (CUCPs):

    • Primary Liabilities (Sources of Funds): Deposits.

    • Primary Assets (Uses of Funds): Mortgages.

  • Contractual Savings Institutions:

    • Life Insurance Companies:

    • Primary Liabilities (Sources of Funds): Premiums from policies.

    • Primary Assets (Uses of Funds): Corporate bonds and mortgages.

    • Property and Casualty (P&C) Insurance Companies:

    • Primary Liabilities (Sources of Funds): Premiums from policies.

    • Primary Assets (Uses of Funds): Corporate bonds and stocks.

    • Pension Funds:

    • Primary Liabilities (Sources of Funds): Retirement contributions.

    • Primary Assets (Uses of Funds): Corporate bonds and stocks.

  • Investment Intermediaries:

    • Finance Companies:

    • Primary Liabilities (Sources of Funds): Finance paper (commercial paper), stocks, bonds.

    • Primary Assets (Uses of Funds): Consumer and business loans.

    • Mutual Funds:

    • Primary Liabilities (Sources of Funds): Shares.

    • Primary Assets (Uses of Funds): Stocks and bonds.

    • Money Market Mutual Funds:

    • Primary Liabilities (Sources of Funds): Shares.

    • Primary Assets (Uses of Funds): Money market instruments.

    • Additional entities include hedge funds and investment banking institutions.

Asset Distribution Across Canadian Financial Intermediaries

  • Distribution of total assets among financial institutions and pension funds regulated by OSFI (as of December 31, 2020):

    • Chartered Banks:

    • Domestic: $6 909 661 million\$6\,909\,661\text{ million} (60.34%60.34\% of total system assets)

    • Foreign bank subsidiaries: $77 million\$77\text{ million} (0.00%0.00\% of total system assets)

    • Foreign bank branches: $1876 million\$1876\text{ million} (0.02%0.02\% of total system assets)

    • Trust Companies: $155 988 million\$155\,988\text{ million} (1.36%1.36\% of total system assets)

    • Loan Companies: $249 636 million\$249\,636\text{ million} (2.18%2.18\% of total system assets)

    • Cooperative Credit Associations: $270 200 million\$270\,200\text{ million} (2.36%2.36\% of total system assets)

    • Life Insurance Companies:

    • Canadian-incorporated: $1 683 840 million\$1\,683\,840\text{ million} (14.71%14.71\% of total system assets)

    • Foreign branches: $19 116 million\$19\,116\text{ million} (0.17%0.17\% of total system assets)

    • Fraternal Benefit Societies:

    • Canadian-incorporated: $18 770 million\$18\,770\text{ million} (0.16%0.16\% of total system assets)

    • Foreign branches: $3944 million\$3944\text{ million} (0.03%0.03\% of total system assets)

    • Property and Casualty Insurance Companies:

    • Canadian-incorporated: $132 000 million\$132\,000\text{ million} (1.15%1.15\% of total system assets)

    • Foreign branches: $35 569 million\$35\,569\text{ million} (0.31%0.31\% of total system assets)

    • Pension Plans: $1 970 000 million\$1\,970\,000\text{ million} (17.20%17.20\% of total system assets)

    • Total Regulated Assets: $11 450 677 million\$11\,450\,677\text{ million} (100.00%100.00\%)

Purpose and Framework of Financial Regulation

  • The financial system is heavily regulated for two core economic reasons:

    • 1. Increasing Information Available to Investors:

    • Regulatory disclosure mandates curb asymmetric information problems.

    • Minimizing adverse selection and moral hazard prevents market disruptions and fraud.

    • Transparent information promotes informational efficiency, allowing capital to flow toward viable, high-productivity ventures.

    • 2. Ensuring the Soundness of Financial Intermediaries:

    • Mitigates the risk of widespread intermediary failure, contagion, and financial panics.

    • Specific regulatory mechanisms implemented to ensure institutional soundness include:

      • Restrictions on entry and competition: Stringent chartering processes to limit unqualified or fraudulent entities from operating.

      • Restrictions on assets and activities: Mandates preventing intermediaries from holding speculative or high-risk assets.

      • Reporting and auditing requirements: Regular, legally mandated accounting reports and periodic regulatory audits.

      • Deposit insurance schemes: Guarantees on consumer deposits to eliminate bank run incentives.

Principal Regulatory Agencies of the Canadian Financial System

  • Provincial Securities and Exchange Commissions:

    • Regulated entities: Organized securities exchanges and provincial financial markets.

    • Nature of regulation: Imposes strict disclosure standards on security issuers and prevents insider trading.

  • Bank of Canada:

    • Regulated entities: Chartered banks, trust and mortgage loan companies (TMLs), and credit unions and caisses populaires (CUCPs).

    • Nature of regulation: Audits and reviews financial records of deposit-taking institutions, coordinating directly with other federal regulatory bodies (OSFI and CDIC).

  • Office of the Superintendent of Financial Institutions Canada (OSFI):

    • Regulated entities: Federally chartered banks, TMLs, CUCPs, life insurance firms, property and casualty insurance firms, and federally registered pension plans.

    • Nature of regulation: Defines capital adequacy standards, standardizes accounting practices, mandates board governance rules, audits institutions, and aligns policies with provincial securities commissions.

  • Canada Deposit Insurance Corporation (CDIC):

    • Regulated entities: Member chartered banks, TMLs, and CUCPs.

    • Nature of regulation: Provides government-backed insurance up to $100 000\$100\,000 per depositor per insured institution, inspects financial records, and places restrictions on allowable asset classes.

  • Québec Deposit Insurance Board:

    • Regulated entities: Trust and mortgage loan companies and credit cooperatives registered in Québec.

    • Nature of regulation: Supplies deposit protection and regulatory oversight analogous to the CDIC within provincial jurisdiction.

  • Canadian Life and Health Insurance Compensation Corporation (CompCorp):

    • Regulated entities: Life insurance companies.

    • Nature of regulation: Compensates life and health policyholders and honors insurance liabilities should an issuing life insurer enter insolvency.

  • Property and Casualty Insurance Compensation Corporation (PACIC):

    • Regulated entities: Property and casualty insurance companies.

    • Nature of regulation: Protects and compensates policyholders against financial losses should a property and casualty insurer collapse.