Mishkin/Serletis

The Economics
of Money, Banking,
and Financial Markets
Fifth Canadian Edition

Chapter 2

An Overview
of the Financial System
Copyright 2014 Pearson Canada Inc.

Learning Objectives
1. Summarize the basic function performed by
financial markets
2. Explain why financial markets have several
classifications
3. Describe the principal money market and
capital market instruments
4. Express why the government regulates
financial markets and financial
intermediaries

Copyright 2014 Pearson Canada Inc.

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Function of Financial Markets

Channel funds from economic players that
have surplus funds to those that have a
shortage of funds
Direct finance
borrowers borrow funds directly from lenders in
financial markets by selling them securities

Copyright 2014 Pearson Canada Inc.

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Function of Financial Markets

(contd)
Promotes economic efficiency by producing
an efficient allocation of capital
Directly improves the well-being of
consumers by allowing them to time
purchases better

Copyright 2014 Pearson Canada Inc.

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Flows of Funds Through the

Financial System

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Structure of Financial Markets:

Debt Markets
Debt instruments
a contractual agreement by the borrower to pay
the holder of the instrument fixed dollar amounts
at regular intervals (interest and principal
payments) until a specified date (the maturity
date)

Maturity
short-term (maturity < 1 year)
intermediate-term (maturity >1 and < 10 years)
long-term (maturity > 10 year)

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Structure of Financial Markets:

Equity Markets
Equity Markets - Common stocks
some make dividend payments
equity holders are residual claimants

Primary Market
new security issues sold to initial buyers

Secondary Market
securities previously issued are bought and sold

Copyright 2014 Pearson Canada Inc.

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Structure of Financial Markets:

Equity Markets (contd)
Brokers
agents of investors who match buyers with
sellers of securities

Dealers
link buyers and sellers by buying and selling
securities at stated prices

Copyright 2014 Pearson Canada Inc.

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Structure of Financial Markets:

Secondary Markets
Exchanges and Over-the-Counter (OTC)
Markets
Exchanges: Toronto Stock Exchange, NYSE
OTC Markets: Dealers at different locations buy
and sell

Money and Capital Markets

Money markets deal in short-term debt
instruments
Capital markets deal in longer-term debt and
equity instruments
Copyright 2014 Pearson Canada Inc.

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Structure of Financial Markets:

Maturity
Money and Capital Markets
Money markets deal in short-term debt
instruments (maturity < 1 year)
Capital markets deal in longer-term debt and
equity instruments (maturity > 1 year)

Copyright 2014 Pearson Canada Inc.

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Money Market Instruments

Government of Canada Treasury Bills
Certificates of Deposit
Negotiable (marketable ie can sell) and nonnegotiable

Commercial Paper
Repurchase Agreements
Loans to banks, T-bills as collateral

Overnight Funds

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Principal Money Market Instruments

Copyright 2014 Pearson Canada Inc.

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Capital Market Instruments

Stocks
Mortgages and mortgage-backed securities
Corporate bonds
Government of Canada bonds
Canada Savings bonds
Provincial and municipal government bonds
Government agency securities
Consumer and bank commercial loans

Copyright 2014 Pearson Canada Inc.

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Principal Capital Market Instruments

Copyright 2014 Pearson Canada Inc.

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Internationalization of Financial
Markets
Foreign Bonds
sold in a foreign country and denominated in that
countrys currency

Eurobond
bond denominated in a currency other than that of the
country in which it is sold

Eurocurrencies
foreign currencies deposited in banks outside the home
country
Eurodollars: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
Copyright 2014 Pearson Canada Inc.

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Capitalization of Equity Markets in Developed Countries (US$bn)

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Market Capitalization of
Developing Countries
The other 25% is accounted for by the
market capitalization of developing
countries in emerging markets.

Latin America
Asia
Eastern Europe
Mideast/Africa

Recently the growth rates in these emerging

markets have been strong, but with more
volatility than in developed countries
Copyright 2014 Pearson Canada Inc.

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Market Capitalization in Selected Emerging Markets (US$ bn)

Copyright 2014 Pearson Canada Inc.

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Function of Financial
Intermediaries: Indirect Finance
1. Reduce transaction costs (time and money
spent in carrying out financial transactions)
economies of scale (good at collecting funds)
liquidity services

2. Reduce the exposure (from deposits) of

investors to risk
risk Sharing (asset transformation)
diversification

Copyright 2014 Pearson Canada Inc.

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Function of Financial
Intermediaries: Indirect Finance
(contd)

3. Deal with asymmetric information problems

a. Adverse Selection

before the transaction

avoid selecting the risky borrower
gather information about potential borrower

b. Moral Hazard

after the transaction

ensure borrower will not engage in activities that will

prevent him/her to repay the loan
sign a contract with restrictive covenants

Copyright 2014 Pearson Canada Inc.

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Types of Financial Intermediaries

Depository Institutions
Chartered Banks
Trusts and Mortgage Loan Companies
Credit Unions and Caisses Populaires

Contractual Savings Institutions

Life Insurance Companies
Property and Casual Insurance Companies
Pension Funds and Government Retirement Funds

Copyright 2014 Pearson Canada Inc.

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Types of Financial Intermediaries

(contd)
Investment Intermediaries
Finance Companies (lends to consumers ie IKEA,
Toyota)
Mutual Funds
Sell shares to shareholders, buy larger block of funds,
diversified

Money Market Mutual Funds

Like mutual funds but also offer deposit like instruments

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Primary Assets and Liabilities of

Financial Intermediaries

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Relative Shares of Financial

Institutions and Pension Plans

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Regulation of Financial Markets

Primary Reasons for Regulation:
1. Increase information to investors
-

reduce adverse selection and moral hazard

problems
increase efficiency of financial markets by
increasing the amount of information available
to investors
provincial securities & exchange commissions
require corporations to disclose information
and restrict insider trading

Copyright 2014 Pearson Canada Inc.

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Regulation of Financial Markets

(contd)
2. Ensuring the soundness of intermediaries
-

prevents financial panics

restrictions on entry/assets/activities;
disclosure; deposit insurance; limits on
competition

3. Improve control of monetary policy

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Principal Regulatory Agencies of

the Canadian Financial System

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Institutions matter for growth

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