The Role of Financial Intermediaries and Financial Markets

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The Role of Financial Intermediaries and Financial Markets

FOCUS OF THE CHAPTER

This chapter provides an analysis of the roles and importance of financial institutions and financial markets, two important parts of the financial system. A broad classification of Canadian financial institutions is presented with an historical overview. Some basic classifications of financial markets are described. The chapter ends with an evaluation of the importance of the financial system to the Canadian economy, and of the future of banks, given recent developments in the financial system.

Learning Objectives:
□ Explain what financial intermediaries do
□ Explain a classification of the financial system by type of institution □ Name the original four pillars of the financial system
□ Provide a classification of the financial system by type of market □ Describe the financial system in Canada
□ Discuss the effects of technology and deregulation on banks, and whether banks as we know them will survive

SECTION SUMMARIES

Intermediation
A financial intermediary (such as a bank) simultaneously interacts with savers (or lenders) and borrowers and produces a set of services which facilitate the transformation of its liabilities (such as deposits) into assets (such as loans). The function of facilitating liabilities (or assets) into assets (or liabilities) is called intermediation. Through intermediation financial intermediaries allow indirect lending (and borrowing) between savers and borrowers.

Direct lending between savers and borrowers is, like barter, inefficient. In order for financial transactions to be completed there must be a double coincidence of wants. People with savings will have a given amount of funds that they will want to lend for a particular time period. They will need to find someone to lend to with matching circumstances, the same approximate amount of funds and the same time period. Direct lending will necessitate a contract of some sort which will have to be negotiated. Subsequent transactions involving repayments of interest and principle will have to be accounted for. A further problem to be encountered by lenders is that they will have limited ability to diversify and minimize their exposure to default risk. They could try to do this by lending very small sums to many borrowers, but the transaction costs would be prohibitively high. Financial intermediaries exist because they can simultaneously reduce transaction costs and minimize risk..

The Functions of Intermediation: Financial intermediation can improve economic efficiency in at least five ways, by: 1) facilitating transactions; 2) facilitating portfolio creation; 3) easing household liquidity constraints; 4) spreading risks over time; and 5) reducing the problem of asymmetric information.

Brokerage: Brokerage is acting as an agent to bring buyers and sellers together in order to complete financial transactions. Financial institutions such as stockbrokers specialize in brokerage, while some financial institutions engage in brokerage in addition to intermediation.

Externalities: Spillover effects, negative or positive, generated by the actions of financial institutions in particular, and the financial system in general, are called externalities. Negative spillover effects are often used as a justification for government regulation of the financial system.

Financial Institutions
Institutions which permit indirect lending (financial intermediaries) include both deposit-takers and non-deposit-takers.

Types of Financial Institutions: At present, the Canadian financial system has three broad categories of financial institutions: 1) deposit-taking institutions; 2) insurance companies and pension funds; and 3) investment dealers and investment funds. In addition, there are government financial institutions.

Deposit-Taking Institutions: Also called depository institutions, these institutions accept and manage deposits and make...
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