THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 200

168

PA R T I I I

Financial Institutions
Similarly small figures apply in the other countries presented in Figure 8-1 as
well. Why is the stock market less important than other sources of financing in
Canada and other countries?
2. Issuing marketable debt and equity securities is not the primary way
in which businesses finance their operations. Figure 8-1 shows that
bonds are a more important source of financing than stocks in Canada (15%
versus 12%). However, stocks and bonds combined (27%), which make up the
total share of marketable securities, still supply less than one-third of the
external funds corporations need to finance their activities. The fact that issuing marketable securities is not the most important source of financing is true
elsewhere in the world as well. Indeed, as we see in Figure 8-1, other countries (except the United States) have a much smaller share of external financing supplied by marketable securities than Canada. Why don t businesses use
marketable securities more extensively to finance their activities?
3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. Direct
finance involves the sale to households of marketable securities such as stocks
and bonds. The 27% share of stocks and bonds as a source of external financing for Canadian businesses actually greatly overstates the importance of direct
finance in our financial system. In general, only a small fraction of newly issued
corporate bonds, commercial paper, and stocks are sold directly to Canadian
households. The rest of these securities are bought primarily by financial intermediaries such as insurance companies, pension funds, and mutual funds.
Because in most countries marketable securities are an even less important
source of finance than in Canada, direct finance is also far less important than
indirect finance in the rest of the world. Why are financial intermediaries and
indirect finance so important in financial markets? In recent years, indirect
finance has been declining in importance. Why is this happening?
4. Financial intermediaries, particularly banks, are the most important
source of external funds used to finance businesses. As we can see in
Figure 8-1, the primary source of external funds for businesses throughout the
world are loans made by banks and other nonbank financial intermediaries

such as insurance companies, pension funds, and finance companies (56% in
the United States, but over 70% in Japan, Germany, and Canada). In other industrialized countries, bank loans are the largest category of sources of external
finance and so the data suggest that banks in these countries have the most
important role in financing business activities. In developing countries, banks
play an even more important role in the financial system than they do in the
industrialized countries. What makes banks so important to the workings of the
financial system? Although banks remain important, their share of external funds
for businesses has been declining in recent years. What is driving their decline?
5. The financial system is among the most heavily regulated sectors of the
economy. The financial system is heavily regulated in Canada and all other
developed countries. Governments regulate financial markets primarily to
promote the provision of information, and to ensure the soundness (stability)
of the financial system. Why are financial markets so extensively regulated
throughout the world?