Chapter 3: Learning Objectives

Copyright (c) 2006 McGraw-Hill Ryerson Limited

Copyright (c) 2006 McGraw-Hill Ryerson Limited

Chapter 3:Learning Objectives

What Do Financial Institutions Do? Functions of Intermediaries Financial Institutions and Market Types

The “four pillars” The role of technology & government

regulation How Important is the Financial System?

Financial Institution

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

Copyright (c) 2006 McGraw-Hill Ryerson Limited

Copyright (c) 2006 McGraw-Hill Ryerson Limited

The Function of Financial Institutions

Intermediation transforming assets

Brokerage an “agency” function: bringing would-be buyers and sellers together

Financial Intermediary

A financial institution that connects surplus and deficit agent 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

Maturity transformation Converting short-term liabilities to long term

assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)

Risk transformation Converting risky investments into relatively risk-

free ones (lending to multiple borrowers to spread the risk)

Convenience denomination Matching small deposits with large loans and

large deposits with small loansCopyright (c) 2006 McGraw-Hill Ryerson Limited

Copyright (c) 2006 McGraw-Hill Ryerson Limited

The Functions of Intermediaries

Facilitate the acquisition/payment of goods & services via lower transactions costs

Facilitate the creation of a “portfolio” economies of scale & scope

Ease liquidity constraints Reallocate consumption/savings patterns

Provide security Reduce asymmetric information problem

Copyright (c) 2006 McGraw-Hill Ryerson Limited

The “Four-Pillars”•Chartered banks

•personal, commercial loans, and deposits

•Trusts company and credit unions•fiduciary responsibilities and personal loans and deposits

•Insurance company•underwriting insurance contracts

•Investment dealers•underwriting and brokering securities

A Legacy from the Past:

Conflict in Regulation

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

Copyright (c) 2006 McGraw-Hill Ryerson Limited

Copyright (c) 2006 McGraw-Hill Ryerson Limited

Types of Financial Institutions1. 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

Primary vs Secondary newly-issued vs previously issued

Term to maturity short vs long term, money vs capital

Direct vs Indirect brokerage vs intermediation functions

Size Retail vs Wholesale

Organization open auction, private, public

Sectoral classification 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-FinancialAssets

Financial Assets

57.8%42.2%

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Most important Financial Instruments, 2004

0

2

4

6

8

10

12

14

CurrencyMortgagesInsuranceBank loansCorporateBondsForegin Currency

Perc

ent

of t

otal f

inanci

al a

sset

s

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The Relative Importance of the Financial Sector

Non-Financial Sector

FinancialSector

40.98% 59.02%

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Key Financial Sector Institutions in Canada

0

10

20

30

40

50

1990 1992 1994 1996 1998 2000 2002

InsurersNon-deposit-taking instituionsInvestment FundsDeposit-taking instituion

Perc

ent o

f tota

l ass

ets

, fin

anci

al s

ect

or

Year

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What Future for Banking?

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

Copyright (c) 2006 McGraw-Hill Ryerson Limited

Summary

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