2. 16
Chapter
The Financial System

3. Learning Objectives
LO 16.1 Outline the structure and importance of the financial system.
LO 16.2 List the various types of securities.
LO 16.3 Define financial market, and distinguish between primary and secondary financial markets.
LO 16.4 Describe the characteristics of the major stock exchanges.
LO 16.5 Discuss how financial institutions are organized and how they function.
LO 16.6 Explain the functions of the Bank of Canada and the tools it uses to carry out these functions.
LO 16.7 Describe the regulation of the financial system.
LO 16.8 Describe the global financial system.

4. Understanding the Financial System
Financial system: The mechanism by which money flows from savers to users
Made up of households, businesses, government, financial institutions, and financial markets

5. Financial System (cont’d)
Understanding the
Financial System (cont’d)
Savings is a function of many variables
Funds can be transferred between users and savers directly or indirectly
FIGURE 16.1 Overview of the Financial System and its Components

6. Types of Securities
Securities: Financial instruments that represent the obligations of the issuers to provide the purchasers with the expected stated returns on the funds invested or loaned
Obligations on the part of the issuer
Businesses and governments
Provide rate of return to purchasers
Three categories
Money market instruments
Bonds
Shares (stock)

7. Test Your Knowledge Securities are a) stocks and savings accounts.
b) risk-free or speculative ownership stakes in publicly traded corporations.
c) obligations on the part of the borrower to provide returns on funds invested or loaned.
d) bonds and debentures.
Answer: c

8. Money Market Instruments
Short-term debt securities
Issued by governments, financial institutions, and corporations
Investors are paid interest for the use of their funds
Generally low-risk
Canadian Treasury bills, commercial paper, and bank certificates of deposit

9. Bonds Government bonds Municipal bonds Corporate bonds
Bonds sold by the Canadian government
Municipal bonds
Bonds issued by municipal/local governments
Corporate bonds
A diverse group; often vary based on the collateral

10. Types of Bonds
Table 16.1 Types of Bonds

11. Quality Ratings for Bonds
Price is determined by risk and interest rate
Several firms rate bonds
Dominion Bond Rating Service (DBRS) in Canada
Standard & Poor’s (S&P)
Moody’s
Investment-grade
Speculative/junk

12. Standard & Poor’s Bond Ratings

13. Test Your Knowledge
A(n) ______ is an unsecured bond backed by the financial reputation of the issuing corporation.
a) general obligation bond
b) debenture
c) pass-through security
d) note
Answer: b

14. Convertible Securities
Bondholder has the right to exchange the bond or preferred shares for a fixed number of common shares

15. Financial Markets
Primary market: Financial markets where firms and governments issue securities and sell them initially to the general public
When a firm offers a stock for sale to the general public for the first time, it is call an initial public offering (IPO)
Secondary market: A collection of financial markets where previously issued securities are traded among investors

16. Understanding Stock Markets
Stock markets (exchanges): Markets where shares of stock are bought and sold by investors
Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE), NASDAQ

17. ECNs and the Future of Stock Markets
Electronic communication networks (ECNs)
The fourth market
Buyers and sellers meet in a virtual market and exchange with one another

18. Investor Participation in the Stock Markets
Investors use brokerage firms to:
1. Establish an account
2. Enter orders
3. Trade shares
The brokerage firm handles the trade on behalf of the investor, charging a fee for the order
Market order
Limit order

19. Financial Institutions
Financial institutions: Intermediaries between savers and borrowers that collect funds from savers and then lend the funds to individuals, businesses, and governments
Depository institutions
Commercial banks
Non-depository institutions
Life insurance companies
Pension funds
Mutual funds

20. Electronic and Online Banking
An increasing amount of funds move through electronic funds transfer systems (EFTSs)
Millions of businesses and consumers now pay bills and receive payments electronically
Most employers directly deposit employee paycheques
Nearly all social assistance and other federal payments are made electronically
Most banks now offer customers debit cards
The number of annual ATM and debit card transactions in Canada is expected to grow to more than 4 billion
According to a recent survey, Canadians were the highest users of Internet banking

21. Deposit Insurance
Canada Deposit Insurance Corporation (CDIC): The federal agency that insures deposits at commercial and savings banks
Formed in 1967 to build public confidence in the banking system
Before deposit insurance, runs were common as people rushed to withdraw their money from the bank because of rumoured instability
Deposit insurance shifts the risk of bank failures from individuals to the CDIC

22. Credit Unions
Cooperative financial institutions owned by depositors/members
Offer a variety of consumer services
More than 5 million Canadians belong to one of the nation’s approximately 379 credit unions
Deposits are insured at the provincial level

23. Nondepository Financial Institutions
Three examples
Insurance companies
Pension funds
Finance companies
Mutual funds
Financial intermediaries that raise money from investors by selling shares

24. The Role of the Bank of Canada
The Bank of Canada (The Bank): The central bank of Canada
Created In 1935
Four basic responsibilities
Regulate monetary policy
Design and issue bank notes
Regulate the financial system
Manage funds for the federal government

25. Test Your Knowledge
Virtually all nations have a central bank similar to the Bank of Canada.
a) True
b) False
Answer: a

26. Monetary Policy The Bank controls the supply of money and credit
Measures of the money supply: M1 and M2
M1: currency in circulation and the balances in bank chequing accounts
M2: M1 plus balances in some savings accounts and money market mutual funds
The government requires banks to maintain reserves
Set the discount rate
Open market operations

27. Total M2 Money Supply
FIGURE 16.4 Total M2 Money Supply

28. Regulation of the Financial System
Under the Bank Act, the federal government is responsible for regulating the banking sector
Several regulatory bodies are involved in regulating Canadian banks, including the Department of Finance, the Bank of Canada, the Office of the Superintendent of Financial Institutions (OSFI), and the CDIC

29. The Financial System: A Global Perspective
The financial system is more connected
Financial institutions are more global
Almost all nations have a central bank

30. Copyright
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