FINA 481:

Management of Financial Institutions

Radomir Todorov

1. Introduction
1. Why Are Financial Institutions Special?
 Why Are Financial Institutions (FIs)
Special?
 Objectives:
– Explain the special role of FIs in the financial
system and the functions they provide
– Explain why the various FIs receive special
regulatory attention
– Discuss what makes some FIs more special
than others

2
 Flow of Funds Without FIs

Equity and debt

claims

Households Corporations
(net savers) (net borrowers)
Cash

3
 FIs’ Specialness
 Without FIs, a low level of funds flow between
households and corporations.

 The average household saver may view direct

investment in corporate securities as unattractive
because of:

 Monitoring costs
 Economies of scale reduce costs for FIs to screen
and monitor borrowers
 Liquidity costs
 Price risk
4
 With FIs

FI
(brokers)
Households Corporations
FI
(asset
Cash Equity and debt
transformers)

Deposits and Cash

insurance policies

5
 Functions of FIs
 Brokerage function
 Acts as an agent for the saver by providing information and
transaction services
 Results in economies of scale
 Asset-transformers
 Issue more attractive financial claims to household savers
 Finance the purchase of primary securities by selling financial claims to
household investors and others
 Primary securities
 FIs purchase financial claims issued by corporations incl.
equities, bonds, and other debt claims.
 Secondary securities
 FIs consider secondary securities because they are backed
by primary securities.
 Secondary securities are often more attractive to
household savers 6
 Role of FIs in Cost Reduction
 Information costs
 Investors exposed to agency costs
 Role of FI as delegated monitor
∙ FI likely to have greater incentive to monitor
∙ Economies of scale in obtaining information
 FI as an information producer
∙ New secondary securities may enable FIs to monitor
more effectively (e.g., bank loans)
∙ Short-term contracts allow more control and
monitoring power for FIs
∙ Reduction of information asymmetry 7
 Specialness of FIs
 Liquidity and Price Risk
– Secondary claims issued by FIs have less
price risk
– Demand deposits and other claims are
more liquid
 More attractive to small investors

– FIs have advantage over households in

ability to diversify due to size
8
 Other Special Services
– Reduced transactions costs
– Maturity intermediation
– Monetary policy transmission
– Credit allocation (areas of special need
such as home mortgages)
– Intergenerational transfers or time
intermediation
– Payment services (e.g. Interac)
– Denomination intermediation
9
 FI Service provision coming
with some risk
 Payment systems disruption (infrastructure
risk)

10
 Specialness and Regulation
 FIs receive special regulatory attention
– Negative externalities of FI failure
– Special services provided by FIs
– Institution-specific functions such as money
supply transmission (banks), credit allocation,
payment services (banks), etc.
– Net regulatory burden: the difference between the
private costs of regulations and the private benefits
for the producers of financial services

11
 Specialness and Regulation
(cont.)
 Types of regulation that seek to enhance the
net social welfare benefits of financial
intermediaries’ services
– Safety and soundness regulation
– Monetary policy regulation
– Credit allocation regulation
– Consumer protection regulation
– Investor protection regulation
– Entry and chartering regulation
12
The Financial System in Canada

13
Canadian Regulatory System

14
 Canadian Regulatory System
Domestic

The prudential regulator of Canadian banks

and other federally regulated financial
Office of the Superintendent of Financial institutions. Also responsible for implementing
Institutions (OSFI) Basel Committee principles and guidance in
Canada.
www.osfi-bsif.gc.ca
Canada’s central bank, responsible for setting
monetary policy and promoting a stable and
Bank of Canada (BoC) efficient financial system.
www.bankofcanada.ca
Responsible for the legislative framework
governing banks and other federally regulated
Department of Finance financial institutions in Canada.
www.fin.gc.ca
CDIC is a federal Crown corporation created
by Parliament in 1967 to protect deposits made
with member financial institutions in case of
Canada Deposit Insurance Corporation their failure. CDIC insures deposits of up to
(CDIC) $100,000. CDIC also oversees bank resolution
planning and has the authority to intervene in a
failing institution.
www.cdic.ca
15
Source: CBA
 Safety and Soundness
Regulation
 Protect against the risk of FI failure:
 Diversification of assets
• (In the US): No more than 15 percent of
equity to single borrower
 Minimum capital requirements
 Guaranty funds:
 Deposit Insurance (CDIC in Canada, US: FDIC)

16
 Safety and Soundness
Regulation (cont.)
 Monitoring and surveillance:
 Involves on-site examinations and review of
accounting statements
 In Canada, OSFI monitors and regulates DTIs
 Increased regulatory scrutiny following crises

 Regulation is not costless

 Net regulatory burden

17
 Office of the Superintendent of Financial
Institutions (OSFI)
 Who OSFI regulates: (as of Sep 2023):
– Banks (81)
– Federally Regulated Loan & Trust Companies (57)
– Life Insurance Companies (59)
– Fraternal Benefit Societies (9)
– Property & Casualty Insurance Companies (147)
– Federally Regulated Credit Unions (2)
– Foreign Bank Representative Offices (17)
– Federally Regulated private pension plans

Source: OSFI (http://www.osfi-bsif.gc.ca/Eng/wt-ow/Pages/wwr-er.aspx)

 Reporting to OSFI:
 Financial data for banks and other FIs who are regulated by
OSFI
 Balance sheets (reported monthly)
– Consolidated Monthly Balance Sheet Total (All Banks)
– Data for individual banks
 Regulatory (BCAR) Capital and Leverage (reported
quarterly)
– Regulatory Capital and Leverage ratios
 BCAR Derivatives Contracts (reported quarterly)
– Derivative Contracts Total (All Banks)
 Income statements (reported quarterly)
– Consolidated Statement of Comprehensive Income
– Allowances for Expected Credit Losses
 Office of the Superintendent of Financial
Institutions (OSFI) (cont.)

 Regulatory Guidelines and Returns:

– Capital Adequacy Requirements
– Prudential Limits and Restrictions
– Accounting and Disclosure
– Sound Business and Financial Practices

Source: OSFI (http://www.osfi-bsif.gc.ca/Eng/fi-if/rg-ro/gdn-ort/gl-ld/Pages/default.aspx)

 CDIC
 Founded: 1967 by an Act of Parliament
 Mandate:
“We are the federal Crown corporation that contributes to the
stability of the Canadian financial system by providing deposit
insurance against the loss of eligible deposits at member institutions
in the event of failure…

…Eligible deposits are automatically covered to a limit of $100,000

per insured category at each CDIC member financial institution.
Members include banks, federally-regulated credit unions, as well as
loan and trust companies…

…We are funded by premiums paid by our member institutions and

do not receive public funds to operate.”

Source: OSFI (https://www.cdic.ca/about-us/)

 Key Regulatory Agencies in
the USA
 Federal Deposit Insurance Corporation (FDIC):
- Deposit Insurance Fund (DIF)
- Role in preventing contagious “runs” or panics
 Office of the Comptroller of Currency (OCC):
- Primary function is to charter (and close) national banks.
- Primary regulator
 Federal Reserve System (FRS):
- Conduct of monetary policy, lender of last resort
- National banks are automatically members of the FRS
- State-chartered banks can elect to become members
 State authorities (ca. 50 individual state agencies):
- perform similar functions as OCC (state-level)
 Dual banking system:
- Coexistence of national and state-chartered banks
22
 Bank Regulators in the USA

23
Source: FDIC (internal figures), 2021. www.fdic.gov
 Primary Bank Regulators in
the US
 Office of the Comptroller of Currency
(OCC)
 Federal Deposit Insurance Company
(FDIC)
– Deposit Insurance Fund (DIF)
– Same regulatory structure applied to
commercial banks

24
 Regulatory institutions at the
global level
Swiss-based organization of which many central banks –
including Canada’s – are members. BIS and its
Bank for International Settlements committees lead much of the global regulatory work
(BIS) stemming from the global financial crisis. BIS was created
in 1930.
www.bis.org
The BCBS is one of the committees of the BIS. It is the
global standard setter for the prudential regulation of
banks. Its mandate is to strengthen the regulation,
Basel Committee on Banking supervision and practices of banks worldwide with the
Supervision (BCBS) purpose of enhancing financial stability. Basel Committee
members include OSFI and the Bank of Canada. The
Basel Committee was established in 1974.
www.bis.org/bcbs
Global group created by the G20 countries in 2009 to
monitor and make recommendations about the global
financial system. The FSB coordinates the work of national
authorities and international standard setters (such as the
Financial Stability Board (FSB) BCBS) and develops policies to enhance financial
stability. Canadian FSB members include the Department
of Finance, Bank of Canada, and OSFI. 25
www.fsb.org
Source: CBA
 Monetary Policy Regulation
 Banks have role in transmitting monetary
policy from the central bank to the rest of
the economy
– Bank of Canada directly controls outside money,
such as notes and coins
– Bulk of money supply is inside money (deposits)
– In some countries, banks may be required to
maintain a specified level of cash reserves
against deposits

28
 Monetary Policy Regulation
(cont.)

29
Source: Bank of Canada
 Inflation in Canada

Source: Bank of Canada

14–30
Bank of Canada FAD – Jan 24
BoC FAD reactions – Jan 24
 Tools of Monetary Policy: Overnight
Rates

Source: G&M, Bank of Canada

14–33
 Credit Allocation Regulation
 Supports socially important sectors, such as
housing and farming, or small businesses,
and others.
 Requirements:
– minimum amounts of assets in one
particular sector, OR
– max. interest rates or fees to subsidize
certain sectors
– May also require meeting other
eligibility criteria 34
 Credit Allocation Regulation
(cont.)

Funds distributed via

banks and / or government
agencies, including
development banks.

35
Source: Government of Canada
Consumer Protection Regulation

 Protecting rights and interests of consumers

of financial products and services
 Financial Consumer Agency of Canada

 May include potential extensions of

regulations to other FIs, such as insurance
companies, in light of consolidation and
trend toward universal banking

36
 Consumer Protection Regulation
(cont.)
Financial Consumer Agency of Canada

37
Source: FCAC
Investor Protection Regulation
 Aimed at protecting investors that use
investment banks or similar entities
directly/indirectly

– Protection against abuses such as insider

trading, lack of disclosure, malfeasance,
breach of fiduciary responsibilities.

– Regulation at the provincial level in

Canada
38
 Investor Protection Regulation
(cont.)
 Each province has its own regulator
 Examples:
• Ontario Securities Commission

• Autorité des marchés financiers (AMF)

39
Source: OSC, AMF
 Entry Regulation
 Entry and activities of FIs are regulated
– Level of entry impediments affects
profitability and value of charter
– Regulations define scope of permitted
activities
– Affects charter value and size of net
regulatory burden
– OSFI regulates bank entry in Canada
40
 Enterprise Risk Management
 Recognizes the value in prioritizing and
managing the impact of risks on an
interrelated portfolio basis
 The 2007-2009 financial crisis led to the focus
on enterprise risk management (ERM)
 Prior to the crisis, the focus was on processes and
systems
 After the crisis, attention shifted to building a
strong risk culture that is supported by
government arrangements
41
©McGraw-Hill Education.
 Enterprise Risk Management

• Trader used his knowledge of the

bank’s procedures to speculate while
giving the appearance of arbitraging.
• Unmonitored access to multiple
internal systems at the bank, allowing
for the unauthorized trading.
• Size of the unhedged position growing
to tens of billions of euros.
• Unwinding the position led to a loss of
$6.3 billion dollars for SocGen.
43
©McGraw-Hill Education.
Source: the Atlantic (https://www.theatlantic.com/business/archive/2012/11/meet-the-most-indebted-man-in-the-world/264413/)
 FinTech
 Financial technology, or FinTech: the use of technology
to deliver financial solutions in a manner that competes
with traditional financial methods
 Services include cryptocurrencies (e.g., bitcoin) and
blockchain, AI & ChatGPT, P2P lending, etc.
 It may bring many benefits but also significant risks
 Major risk: Regulation development typically takes place
with a time lag

44
Fintech Innovation Sectors:
An Overview

10-45
 FinTech Benefits…

Source: Financial Times (https://www.ft.com/content/c1cbe5cc-bfcb-11e7-823b-ed31693349d3)

 and FinTech Risks

Sources: NYT (https://www.nytimes.com/2023/04/11/business/dealbook/bitcoin-price.html?searchResultPosition=3)

©McGraw-Hill Education.
(https://www.nytimes.com/2023/01/20/technology/genesis-bankruptcy-crypto.html?searchResultPosition=2)
 …and FinTech Risks (cont.)

©McGraw-Hill Education.
Source: CBC (https://www.cbc.ca/radio/asithappens/as-it-happens-friday-edition-1.5875363/this-man-owns-321m-in-bitcoin-but-
he-can-t-access-it-because-he-lost-his-password-1.5875366)