The Financial System

1. 16 Chapter The Financial System

2. 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 the organization and functioning of financial institutions. LO 16.6 Explain the functions of the Bank of Canada and the tools it uses to control the supply of money and credit. LO 16.7 Understand the impact of regulations and laws affecting the financial system. LO 16.8 Describe the global financial system.

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

4. Savings is a function of many variables. Funds can be transferred between users and savers directly or indirectly. Understanding the Financial System

5. 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) Types of Securities

6. 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. Test Your Knowledge

7. 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 Test Your Knowledge

8. 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 Money Market Instruments

9. Government 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 Bonds

10. Types of Bonds

11. 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 Quality Ratings for Bonds

12. Standard & Poor’s Bond Ratings

13. 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 Test Your Knowledge

14. 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 Test Your Knowledge

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

16. 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: Acollection of financial markets where previously issued securities are traded among investors Financial Markets

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

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

19. 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 Investor Participation in the Stock Market

20. 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 Financial Institutions

21. 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. Electronic and Online Banking

22. 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. Deposit Insurance

23. 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. Credit Unions

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

25. 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 The Role of the Bank of Canada

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

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

28. 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 Monetary Policy

29. Total M2 Money Supply

30. 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. Regulation of the Financial System

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