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MN BC 3
MN BC 3
Overview
What Do Financial Institutions Do? Functions of Intermediaries Financial Institutions and Market Types
The four pillars The role of technology & government regulation
this is the principal activity of most financial institutions. intermediation improves social welfare by channeling resources to their most effective use.
Natalya Brown 2008
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].
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.
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 wont pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits
Natalya Brown 2008
Intermediation provides value-added but there are potential externalities. One intermediarys actions can have consequences for the entire system.
Natalya Brown 2008
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.
Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004 Natalya Brown 2008
Deposit-taking (a.k.a. depository institutions) accept and manage deposits and make loans. These institutions are divided into banks and other deposittaking 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.
Other Intermediaries
Sales, finance, and consumer loan companies.
Natalya Brown 2008
The Four-Pillars
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.
Natalya Brown 2008
Conflict in Regulation:
Canadas 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.
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 trading of short term instruments Capital Markets trading of long term instruments
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.
Organization
open auction, private, public
Non-Financial Assets
42.2%
57.8%
Financial Assets
40.98%
Financial Sector
59.02%
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
Natalya Brown 2008
Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004 Natalya Brown 2008
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From: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004 Natalya Brown 2008
LECTURE 3: Role of of the Canadian Financial System Regulatory Agencies Financial Intermediaries and Markets
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Natalya Brown 2008 Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004
Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004 Natalya Brown 2008
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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
Natalya Brown 2008