Chapter 2

An Overview of
the Financial
System

2.1 © 2008 Pearson Education Canada

 An Overview of the
Financial System

Primary Function of the Financial System

is Financial Intermediation

The channeling of funds from households, firms

and governments who have surplus funds (savers)
to those who have a shortage of funds (borrowers).

2.2 © 2008 Pearson Education Canada

 An Overview of the
Financial System

2.3 © 2008 Pearson Education Canada

 Classifications of
Financial Markets
Debt Markets
• Short-term (maturity < 1 year) – the
Money Market
• Long-term (maturity > 10 year) – the
Capital Market
• Medium-term (maturity >1 and < 10
years)

2.4 © 2008 Pearson Education Canada

 Classifications of
Financial Markets
Equity Markets - Common stocks
• Primary Market - New security issues sold to
initial buyers
• Secondary Market - Securities previously
issued are bought and sold

2.5 © 2008 Pearson Education Canada

 Classifications of
Financial Markets (Cont’d)
Secondary Markets
Exchanges
• Trades conducted in central locations (e.g.,
Toronto Stock Exchange and New York Stock
Exchange)
Over-the-Counter Markets
• Dealers at different locations buy and sell

2.6 © 2008 Pearson Education Canada

 Financial Market
Instruments

2.7 © 2008 Pearson Education Canada

 Financial Market
Instruments (Cont’d)
Other Money Market Instruments
• Certificates of deposit
• Repurchase agreements
• Overnight funds

2.8 © 2008 Pearson Education Canada

 Financial Market
Instruments (Cont’d)

2.9 © 2008 Pearson Education Canada

 Financial Market
Instruments (Cont’d)
Other Capital Market Instruments
• Canada savings bonds
• Provincial and municipal bonds
• Government agencies securities

2.10 © 2008 Pearson Education Canada

 Internationalization of
Financial Markets
International Bond Market
• Foreign bonds - sold in a foreign country and
denominated in that country
• Eurobonds – denominated in a currency other than
the country in which it is sold
• Eurocurrencies – foreign currencies deposited in
banks outside the home country

2.11 © 2008 Pearson Education Canada

 World Stock Markets

2.12 © 2008 Pearson Education Canada

 Function of Financial
Intermediaries
Financial Intermediaries
• Engage in process of indirect finance
• Are needed because of transactions costs and
asymmetric information

2.13 © 2008 Pearson Education Canada

 Function of Financial
Intermediaries (Cont’d)
Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs.
2. They reduce transactions costs by developing
expertise and taking advantage of
economies of scale.

2.14 © 2008 Pearson Education Canada

 Function of Financial
Intermediaries (Cont’d)
Risk Sharing
• Create and sell assets with low risk characteristics
and then use the funds to buy assets with more risk
(also called asset transformation)
• Lower risk by helping people to diversify portfolios

2.15 © 2008 Pearson Education Canada

 Asymmetric Information

Adverse Selection
• Before transaction occurs
• Potential borrowers most likely to produce adverse
outcomes are ones most likely to seek loans and
be selected

2.16 © 2008 Pearson Education Canada

 Asymmetric Information
(Cont’d)

Moral Hazard
• After transaction occurs
• Hazard that borrower has incentives to engage in
undesirable activities making it more likely that loan
won’t be paid back

2.17 © 2008 Pearson Education Canada

 Financial Intermediaries

2.18 © 2008 Pearson Education Canada

 Size of Financial
Intermediaries

2.19 © 2008 Pearson Education Canada

 Regulation of Financial
Markets

2.20 © 2008 Pearson Education Canada

 Regulation of Financial
Markets
Primary Reasons for Regulation
1. Increase information to investors
- Decreases adverse selection and moral
hazard problems
- Securities commissions force corporations
to disclose information

2.21 © 2008 Pearson Education Canada

 Regulation of Financial
Markets (Cont’d)
Primary Reasons for Regulation
(continued)

2. Ensuring the soundness of intermediaries

- Prevents financial panics
- Restrictions on entry/assets/activities, disclosure,
deposit insurance, limits on competition

2.22 © 2008 Pearson Education Canada