Financial Intermediation

1. © Natalya Brown 2008
ECON 2017 Money, Banking
and the Canadian Financial System
The Role of Financial Intermediaries
and Financial Markets
Reading: Siklos: Chapter 3

2. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
• 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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
• 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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
• 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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
• 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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
• 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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
• 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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
• 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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
Breakdown of Assets, 2004
Non-Financial
Assets
42.2% 57.8%
Financial
Assets

20. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
Relative Importance of Financial
Sector, 2004
40.98%
Non-Financial
Sector
59.02%
Financial
Sector

21. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
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. © Natalya Brown 2008
LECTURE 3: Role of Financial Intermediaries and Markets
25
Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian
Edition, Pearson Addison Wesley, 2004

26. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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. © Natalya Brown 2008
LECTURE 3:
Role of
Financial
Intermediaries
and Markets
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