Chapter 16

The Financial System

Financial System: The mechanism by which money flows from savers to users

Overview of the Financial System and Its Components

Savers

- Have excess funds as they choose not to spend all of their current income
- Savings produced by some households, business and firms
- In Canada, households are generally net savers
- Career progression and age are two factors which determine individual savings

Users

- Have spending needs greater than income, so need to obtain additional funds to make
up the difference
- Businesses are generally net users

Direct and Indirect Transfer of Funds

Direct

- A direct transfer means that user raises needed funds directly from savers
- Direct transfers do occur, but most funds flow through either financial markets or
financial institutions

Indirect

- Financial Markets
o Involves selling instruments such as bonds and shares in markets
- Financial Institutions
o Involves generating income from financial institutions e.g. commercial banks
o Bank pools, or combines, customer deposits and uses funds to make loans to
businesses and households
o Borrowers pay the bank interest

Securities: Financial instruments that represent the obligation of the issuers-business and
governments-to provide the purchasers with the expected or stated returns on the funds
invested or loaned

Categories of Securities

Money Market Instruments

- Short term debt securities issued by governments, financial institutions, and

corporations
- All money market instruments mature within one year from the date of issue
- Generally low-risk, and purchased by investors when they have surplus cash
- Examples include
o Treasury Bills
 Short-term securities issued by Canadian Treasury and backed by full
faith and credit of Canadian Government
o Commercial Paper
 Securities sold by corporations which is slightly riskier than Treasury Bills,
but still considered a low risk security
o Certificate of Deposit
 A time deposit at a financial institution, whose size and maturity date can
be tailored to meet needs of purchasers
 Large CD’s are insured by Canada Deposit Insurance Corporation

Bonds

- Bondholders are creditors of a corporation or government body

 - Firm may sell bonds to obtain long-term debt capital
- Governments also acquire funds through bonds
- As bondholders are creditors, their claim on firm assets must be satisfied before
shareholders if firm enters bankruptcy
- Factors that affect price of a bond include its risk and its interest rate

Shares

- Common Shares are basic form of corporate ownership

- Common shares allow individuals to vote on major company decisions, and receive a
return
- Return can be cash dividend payments, expected increases in share value, or both
- Holders of preferred shares receive preference in the payment of dividends
- However holders of preferred shares rarely have voting rights

Types of Bonds

Government Bonds

- Bonds sold by the Canadian government

- Backed by full faith and credit of govt, so are least risky of all bonds

Municipal Bonds

- Bonds issued by municipal governments

- Two types are available

o Corporate Bonds
 Include a diverse group of bonds and vary depending on collateral that
backs the bond
 Secured bond is backed by a specific pledge of company assets
 Debentures are backed only by financial reputation of issuing
corporations

o Mortgage-Backed Corporate Bonds

 Backed by a pool of mortgage loans purchased from lenders, such as
chartered banks
 Very safe, as all mortgages in pool are ensured by CMHC

Investment Grade Bonds: Bonds with ratings of BBB and above

Speculative/Junk Bonds: Bonds with ratings of BB and below

Convertible Securities: Bonds or preferred shares that include a conversion feature (can
exchange for fixed number of common shares)
Financial Markets: Markets where securities are issued and traded

Types of Financial Markets

Primary Market

- Market where firms and governments issue securities and sell them initially to the
general public
- Initial Public Offering (IPO) is when a company offers shares for sale to the general
public for the first time
- Sales of most corporate and municipal securities are made through financial institutions
like TD Securities
- These institutions purchase the issue from the firm or government and then resell the
issue to investors, in a process known as underwriting
- Financial institutions underwrite shares and bond issues at a discount
- Corporations and governments are willing to pay for services provided by financial
institutions as they are financial market experts

Secondary Market

- A collection of financial markets where previously issued securities are traded among
investors
- Corporations of governments that originally issued the securities being traded aren’t
directly involved in secondary market

Stock Markets/Exchanges: Markets where shares of stock are bought and sold by investors

Major Stock Exchanges

Toronto Stock Exchange (TSX)

- Canada’s largest stock exchange

- Firm must apply for a listing and meet certain requirements for its stock to be traded on
TSX

New York Stock Exchange (NYSE)

- Sometimes referred to as the ‘Big Board’, is the world’s largest stock exchange
- Shares traded on NYSE represent most of largest, best known companies in US

NASDAQ

- A computerized communications network that links member investment firms

- All trading on NASDAQ takes place through its intranet, not on a trading floor
London Stock Exchange

- Most international of all stock markets

Electronic Communications Networks: Virtual stock markets where buyers and sellers can
trade directly with one another

Types of Orders for Brokerage Firms

Market Order

- This instructs broker to obtain best possible price – the highest price when selling and
lowest price when buying

Limit Order

- This sets a price ceiling when buying or a price floor when selling

Financial Institutions: Intermediaries between savers and borrowers that collect funds from
savers then lend to individuals, governments and businesses

- FI’s improve transfer of funds by increasing efficiency and effectiveness of process

- FI’s make it easier for savers to earn more and for users of funds to pay less
- FI’s can be classified into depository and non-depository institutions

Types of Depository Institutions

Commercial Banks

- Commercial Banks offer a range of services, including chequing and savings accounts,
consumer loans, home mortgage loans etc.
- CB’s pool deposits and lend most of them out in form of consumer and business loans
- CB’s are important sources of funds for small businesses
- Banks make money as interest rate they charge borrowers is higher than rate of interest
they pay depositors
- Most commercial bank deposits are insured by Canada Deposit Insurance Corporation
- CDIC ensures public confidence in banking system and prevent runs on banks

Credit Unions

- Credit Unions are cooperative institutions that are owned by their depositors
- CU’s are designed to serve consumers, not businesses
- Members are offered different chequing and savings accounts, and these funds are then
leant to members
 - CU’s often pay higher rate of interest on deposits, charge lower rate of interest on loans,
and charge lower fees

Types of Non-Depository Institutions

- Non-Depository Institutions accept funds from businesses and households, and then
invest most of these funds

Insurance Companies

- Accept risk from households and businesses in return for a series of payments, called
premiums
- Underwriting is the process insurance companies use to determine whom to insure and
how much to charge
- Major source of short-and-long term financing for businesses

Pension Funds

- Provide retirement benefits to workers and their families

- Set up by employers and funded by regular contributions from employers and
employees

Finance Companies

- Offer short-term loans to borrowers

- Supplies short-term funds to businesses that use their tangible assets as collateral for
the loan

Mutual Fund: An intermediary that raises money by selling shares to investors. It then pools, or
combines, investor funds and purchases securities that meet the mutual fund’s objectives

Tools Used by Bank of Canada to Regulate Growth in the Money Supply

Bank Regulation

- Banks are among nation’s most heavily regulated businesses

- Under the Bank Act, federal government is responsible for regulating the banking sector

Government Regulation of the Financial Markets

- At provincial level, regulation of Canadian financial markets is administered by

organizations such as the Manitoba Securities Commission or Ontario Securities
Commission
- These organizations are coordinated by Canadian Securities Administrators (CSA)
- One area that provincial regulators pay particular attention to is insider trading

Industry Self-Regulation

- Securities markets are also heavily self-regulated by professional associations and the
major financial markets
- Rules and regulations promote investor confidence and benefit all parties
- Market Surveillance can be used for self-regulation
- TSX outsources market surveillance to IIROC, which does real-time monitoring of trading
activity

Fact: Only 3 of the world’s 50 largest banks are based in Canada