4. Economic functions of FIs A) Brokerage B) Asset/Risk transformationBenefits:lIncreased liquidity, Price risk reduction lDecreased costslInformation costs lTransaction CostsEfficiency in the financial marketsC) Other functions1A) Brokerage: Providing information and transaction services ExampleslInvestment analysts, stock brokerslInsurance brokers2B) Asset/risk transformationThe FI transforms a financial claim in a different financial claim with different risk characteristicsTechnically: The FI purchase financial claims -primary securities (issued by corporations) by selling financial claims -secondary claims (issued by FIs)Balance Sheet of a Non-Financial firm (e.g., BCE) Balance Sheet of an FI AssetsLiabilitiesAssetsLiabilitiesReal Assets(Plant, Machinery) Primary Securities(Debt, Equity)Primary Securities(Debt, Equity). E.g., loans, bonds, shares.SecondarySecurities(Deposits, insurance policies, mutual fund shares)3BENEFITS: Liquidity and Price RisklLiquidity: The ease of converting an asset into cash.lIn capital markets liquidity can also refers to the ability to quickly trade large size orders at low costlPrice risk: the risk that price of an asset will be lower than its purchase price.It is more attractive for investors to buy the financial claims of FIs (e.g., secondary securities) instead of investing directly in primary securities issued by non-FIs. Example: Investing in a well diversified portfolio vs. investing in an barely traded individual security.Thus, Investing in secondary securities Liquidity and Price risk (cost, returns)4BENEFITS: Decreased information costs and transaction costsInformation costs lCosts associated in the gathering of information due to Information Asymmetry * Adverse Selection * Moral Hazard 5lAdverse Selection: lOccurs when the potential borrower who knows better his credit (bad) risk is the most likely to seek out a loan. Problem created by asymmetric information before the transaction occurslMoral Hazard:lOccurs when the borrower might engage in activities that are undesirable from the lenders point of view because they make it less likely that the loan will be paid back. Problem created by asymmetric information after the transaction occurs lMoral Hazard creates Agency CostslCosts related to the risk that borrowers (managers, owners) will use the funds contrary to the interests of savers (lenders).6Financial Intermediaries are Better equipped in - Screening out good from bad risk profiles- Monitoring the entities after the transaction occurs - Reducing agency costs Thus, information asymmetry costsTransaction costs lEconomies of scale. FIs have the resources to trade large volume of transactions such as the transaction cost per unit is highly reduced.7Other FunctionslTransmission of monetary policy lBanks, trusts, and credit unions. Mainly by the Big Six BankslCredit allocation (Providers of credit to households/firms that face money shortages to finance their consumption/operational and/or investment needs) lBanks, trusts, credit unions, and finance companies (e.g., in financing home mortgages, student loans)lIntergenerational transfer of wealth or time intermediationlPension funds; life insurance companies, and deposit-taking FIs.lPayment services lBanks, trusts, and credit unions. (e.g., cheque-clearing, electronic transfers, etc).lDenomination intermediationl Pension Funds, Mutual funds. With small amount of money savers can invest in securities that are sold in large denominations only.85. Financial InnovationDriving factors/events of financial innovationlHigh volatility in price indices, is, FX rate, share prices, commodity priceslGovernment RegulationslGlobalization lTechnological advances lMarket crisesFinancial Innovation allows to better Measure and Manage Risk with appropriate levels of Return using financial instruments including:options, forwards, futures, swaps, VAR, stock index futures, interest rate futures, futures options, s. 9Types of Risks faced by FIs lLiquidity risk lInterest rate risk lMarket risk lCredit risklInsurance risk lOperational risk lForeign exchange risklOther risks most of them are related to changes in interest rates.106. Regulation of the Financial System1.Main reason: Systemic risk A failure of FIs may cause problems to the financial system and/or economic system (a major negative externality) How can the soundness of Financial Intermediaries be ensured to avoid systemic risk (financial panics)?lRestrictions on entrylDisclosurelRestrictions on Assets and ActivitieslDeposit InsurancelLimits on Competition (foreign). Restriction on large banks mergers (domestic)112.To protect investors from illegal or unethical practices from FI and non-FIs. Provincial Securities Commissions, TSX, ME, Asymmetric Information3.Better control of monetary policy by the Bank of CanadaFor example Canadian depository institutions are required to keep funds (settlement balances) in an account of the BofC to facilitate their clearing and settlement better control over the money supply.12Regulation is not costlesslNet regulatory burden. It is the degree to which the private costs of FI regulation exceeds the private benefits. Costs: Filing, restricted activity, periodic on-site inspections, taxes, underinvestment. Benefits: Restricted competition, government aid when banks are in distress.13FinancialRegulators:lBankofCanadalOfficeoftheSuperintendentofFinancialInstitutions(OSFI)lCanadianDepositInsuranceCorporationlFinancialConsumerAgencyofCanada147. TrendslIncreased regulation due to the subprime mortgage crisislConsolidation of the banking industry.lGrowth of the mutual fund industry.lIncreased technological innovationslSingle national securities regulator.lIncreased competition from foreign FIs at home and abroad158. ConclusionsBasic Function of Financial marketslTransfer funds from savers to spenderslVia lDirect/Indirect FinancelFinancial InstitutionslFinancial InstrumentsClassification of Financial MarketslMoney and Capital MarketslPrimary and Secondary MarketsInnovation and Internationalization of Financial MarketsRole of Government and others to ensure the soundness of the financial system16Well functioning Financial System:lAllows the transfer of funds from savers to borrowers more efficientlylAllows transfer of risk between unitslReduce information asymmetry and transacting costslIncrease liquidity of securitieslAbility to quickly trade large size at low costlFacilitate the price discovery of securitieslDetermination of market value of shares, bonds, Increase efficiency in the economy17Pertinent WebsitesThe BankerThe Bank of CanadaCDICDepartment of FinanceThe Financial Consumer Agency of Canada Subprime mortgage crisis 18