The Role of Financial Intermediaries and Financial Markets

1. The Role of Financial Intermediaries and Financial Markets Reading: Siklos: Chapter 3

2. Overview • 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?

3. The Function of Financial Institutions • Financial intermediaries channel funds between borrowers and lenders. Intermediation  transforming assets • the function of transforming assets or liabilities into other assets or liabilities • Liabilities – deposits • Assets – loans • this is the principal activity of most financial institutions. • intermediation improves social welfare by channeling resources to their most effective use.

4. The Functions of Intermediation • Facilitate the acquisition/payment of goods &services via lower transactions costs • Chequing services provided by banks improve economic efficiency. • Facilitate the creation of a “portfolio” • A portfolio is a collection of financial assets • The financial system provides economies of scale & scope • Economies of Scope: cost savings that stem from engaging in complementary activities. • Economies of Scale: obtained when the unit cost of an operation decreases as more of it is done.

5. Ease liquidity constraints • Reallocate consumption/savings patterns • Often the liquidity required to make certain purchases is not in line with the immediate flow of income available to individuals. • The ability to influence the allocation of consumption and investment is probably the most important function of intermediation. • Provide security • Intermediation provides a host of services that reduce or shift risk. • Financial institutions can also influence the riskiness of financial transactions [contracts and insurance].

6. Reduce asymmetric information problem • Moral hazard • the chance that an individual may have an incentive to act in a way such as to put that individual at greater risk; the individual perceives as beneficial actions that are deemed undesirable by another. • Adverse selection • decision making that results from the incentive for some people to engage in a transaction that is undesirable to everyone else • Banks have a comparative advantage in offering specialized services that help to reduce this problem. • Banks can also take advantage of this asymmetric information problem, with dire consequences.

7. Adverse Selection 1. Before transaction occurs 2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Moral Hazard 1. After transaction occurs 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

8. The Function of Financial Institutions • Brokerage an “agency” function • Brokers are agents who bring would-be buyers and sellers together so transactions can be made. Intermediation provides value-added but there are potential “externalities”. One intermediary’s actions can have consequences for the entire system.

9. Banks are particularly adept at intermediation because they can perform the necessary functions more cheaply than most institutions. • Technological change and deregulation have narrowed the comparative advantage of banks.

10. Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004

11. Types of Financial Institutions • Deposit-taking (a.k.a. depository institutions) accept and manage deposits and make loans. These institutions are divided into banks and other deposit-taking institutions (near-banks). Other deposit-taking institutions: • Trust companies – also provide administrative services for estates and trusts (fiduciaries). • Credit unions or caisses populaires – these are member owned so that depositors are also shareholders. • Mortgage loan companies – also permit investors to invest in a portfolio of assets primarily real estate.

12. Insurance Companies and Pension Funds • Insurance companies provide the means of channeling savings to provide for unforeseen expenses by pooling the risks of their clientele. • There are also institutions that specialize in the management of pension plans and funds. Government legislation plays are large role in dictating how these pensions are administered. • Registered Retirement Savings Plans (RRSPs) are individuals’ tax-sheltered funds administered by the individuals themselves or by a deposit-taking institution or investment dealer on their behalf. • Registered Retirement Plans (RRPs) are the pooled retirement savings of a group of employees administered by their employer or labour union.

13. Investment Dealers and Investment Funds • The plethora of investment funds (a.k.a. mutual funds) pool funds for investment in a wide range of activities and instruments without providing the other functions of a typical bank • Investment dealers primarily underwrite corporate and government securities. • Government financial institutions • Deposit-taking role • Channeling funds from the public to private sector • Protecting private funds by providing deposit insurance (CDIC). • Other Intermediaries • Sales, finance, and consumer loan companies.

14. The “Four-Pillars” • Chartered banks: personal, commercial loans and deposits • Trust companies and credit unions: fiduciary responsibilities, personal loans and deposits • Insurance companies: underwriting insurance contracts. • Further subdivided into Life Insurers and Property and Casualty Insurers • Investment dealers:underwriting and brokering securities.

15. Regulation played a crucial role in producing the four separate pillars. Companies in one category could not engage in the activities of another and cross-ownership was prohibited for the most part. • Thanks to deregulation prompted in large part by innovations in financial instruments, rapid development in computer technology and the increased perception of volatility, the distinction between the four pillars has crumbled. • Rising international competition has also played a significant role. • Provincial governments continue to relax restrictions on the services that near banks can provide.

16. Conflict in Regulation: • Canada’s financial institutions are governed by a wide spectrum of legislation due in part to the sharing of power between the federal government and the provinces. Federal vs. Provincial • The federal government has sole jurisdiction over banking. • All chartered banks and other federally regulated institutions fall under the federal Bank Act. • Most credit unions are supervised by the provinces. • Canada’s principal financial regulators are the Bank of Canada, the Department of Finance, the Canada Deposit Insurance Corporation and the Office of the Superintendent of Financial Institutions.

17. Types of Financial Markets • Type of transactions • Direct vs. Indirect transactions • Primary vs Secondary Market • A primary market is the one for newly issued financial instruments • A secondary market is the one for previously issued financial instruments. • Duration • Term to maturity – length of time until the loan must be repaid. • Short term – matures in a year or less • Medium term – matures in one to five years • Long term – matures in more than five years • money market vs capital market • Money Market – trading of short term instruments • Capital Markets – trading of long term instruments

18. Complexity • Securitization: describes the phenomenon whereby assets that are normally not liquid, like mortgages, are made liquid by pooling them and reselling the combined amount as short term assets. • Sectoral Classifications • Size • Retail: transactions of less than $100,000 • Wholesale: transactions of more than $100,000 • Organization • open auction, private, public

19. Breakdown of Assets, 2004 Non-Financial Assets 42.2% 57.8% Financial Assets

20. Relative Importance of Financial Sector, 2004 Non-Financial Sector 40.98% Financial Sector 59.02%

21. The Future of 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

22. Primary Assets and Liabilities of Financial Intermediaries Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004

23. Relative Size of Financial Intermediaries Regulated by OSFI From: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004

24. Regulatory Agencies of the Canadian Financial System Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004

25. Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004

26. Regulation of Financial Markets Two Main Reasons for Regulation 1. Increase information to investors A. Decreases adverse selection and moral hazard problems B. Securities commissions force corporations to disclose information 2. Ensuring the soundness of financial intermediaries A. Prevents financial panics B. Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measures

27. Key Points • 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