FINA 481 CLASS NOTES | CONCORDIA UNIVERSITY

FINA 481 CLASS NOTES

Chapt.1: Why are financial institutions special?

Flow of funds without FI’s




Problems without FIs: low funds flow due to high monitoring costs, liquidity concerns, and price
risk

Flow of funds with FIs




Functions of FIs

Brokerage function: provide information, transaction services, economies of scale

Asset transformation: issue attractive claims (deposits, insurance) backed by primary securities
(stocks, bonds)

Primary securities: issued directly by corporations (equity, bonds, loans)

Secondary securities: created by FIs, backed by primary securities, more liquid & attractive to
small savers

,Role of FIs in cost reduction

Information costs
 Investors face agency costs when monitoring borrowers
- Delegated monitor:
 FIs monitor on behalf of savers
 Have stronger incentive + economies of scale in monitoring
- Information producer:
 Create secondary securities (ex: bank loan) to improve monitoring
 Use short-term contracts for more control
 Reduce information asymmetry between borrowers and savers

In short: FIs cut costs by monitoring efficiently, producing information, and reducing asymmetry


Specialness of FIs

Liquidity & Price Risk
 Secondary claims from FIs carry less price risk
 Demand deposits & similar claims are highly liquid  attractive to small investors
 FIs can diversify better than households due to their larger size

In short: FIs make investments safer, more liquid, and more diversified

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 service (ex: interact)
 Denomination intermediation

The Canadian Regulatory System

Office of the Superintendent of Financial Institutions (OSFI): Prudential regulator of banks
& federally regulated FI’s; enforces Basel rules

Bank of Canada (BoC): Canada’s central bank; sets monetary policy & ensures system stability

Department of finance: Designs laws & legislative framework for FIs

Canada Deposit Insurance Corporation (CDIC): Crown corporation (1967); insures deposits
up to $100,000; manage bank failures & resolution

Specialness and Regulation

, Why regulate FIs
 Failures create negative externalities (system-wide damage)
 They provide special services (pmts, credit, money supply)
 Some functions are institution specific (bank  monetary policy, credit allocation, pmts)

Net Regulatory Burden
 Regulation = costs vs benefits for FI’s
 Protects society, but comes at a cost for institutions

In short: FIs are regulated because their failure hurts everyone, but regulation isn’t free

 Rules keep bank safe, help the economy, and protect both customers and investors
Ex:
- Safety and soundness regulation
- Monetary policy
- Credit allocation
- Consumer protection
- Investor protection
- Entry and chartering


Safety and soundness regulation

Purpose: Stop banks from failing

 Diversification: don’t lend too much to one person (U.S. rule = max 15%)
 Capital requirements: banks must keep some on their own money as a safety cushion
 Deposit insurance: protects people’s money if a bank fails
- Canada  CDIC
- U.S.  FDIC
 Monitoring: regulators check banks with exams + reports
- In Canada  OSFI does this
 After crises: Rules get stricter
 Downside: following the rules costs banks money

In short: Safety rules = diversify, keep capital, insure deposits, monitor banks — but it costs
money.

Office of the Superintendent of financial Intuitions (OSFI)

OSFI – Who They Regulate (Sep 2023)

 Banks → 81 (main job of OSFI)
 Loan & Trust Companies → 57
 Life Insurance Companies → 59