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?

Copyright (c) 2006 McGraw-Hill Ryerson Limited

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

The Function of Financial Institutions

 

Intermediation



assets transforming Brokerage



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

Copyright (c) 2006 McGraw-Hill Ryerson Limited

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) Copyright (c) 2006 McGraw-Hill Ryerson Limited

  

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 Copyright (c) 2006 McGraw-Hill large deposits with small loans

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

A Legacy from the Past:

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 Copyright (c) 2006 McGraw-Hill Ryerson Limited

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

Types of Financial Institutions

1. 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 Copyright (c) 2006 McGraw-Hill Ryerson Limited

      

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-Financial Assets 42.2% 57.8% Financial Assets Copyright (c) 2006 McGraw-Hill Ryerson Limited

Most important Financial Instruments, 2004

14 12 10 8 6 4 2 0 Currency Mortgages Insurance Bank loans Corporate Bonds Foregin Currency Copyright (c) 2006 McGraw-Hill Ryerson Limited

The Relative Importance of the Financial Sector

Non-Financial Sector 40.98% Financial Sector 59.02% Copyright (c) 2006 McGraw-Hill Ryerson Limited

Key Financial Sector Institutions in Canada

50 40 30 20 10 0 1990 1992 1994 1996 Year 1998 2000 2002 Insurers Non-deposit-taking instituions Investment Funds Deposit-taking instituion Copyright (c) 2006 McGraw-Hill Ryerson Limited

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 Copyright (c) 2006 McGraw-Hill Ryerson Limited