THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 224

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PA R T I I I

Financial Institutions
The global settlement had measures to improve the quality of information in financial markets:
It required investment banks to make their analysts recommendations public.
Over a five-year period, investment banks were required to contract with at
least three independent research firms that would provide research to their
brokerage customers.
A great deal of regulatory initiatives with
respect to corporate governance have also occupied public attention in Canada in
recent years, in reaction to the issues raised by the corporate and accounting scandals in the United States. For example, in October 2002, the Ontario government
introduced Bill 198, in response to the strong reforms taking place in the United
States. Similar to the Sarbanes-Oxley Act, Bill 198 made several reforms to the
securities laws in Ontario, including auditor independence, CEO and CFO
accountability for financial reporting, enhanced penalties for illegal activities, and
faster disclosure to the public. Moreover, in February 2005 the Canadian Securities
Administrators released for comment the Internal Control Instrument and the
Certification Instrument, two proposed instruments that substantially mirror the
requirements of the Sarbanes-Oxley Act in the United States.

CONTROL ATTESTATION IN CANADA

Summary

It is too early to evaluate the impact of the Sarbanes-Oxley Act and the Global
Legal Settlement, but the most controversial elements were the separation of functions (research from underwriting, and auditing from nonaudit consulting).
Although such a separation of functions may reduce conflicts of interest, it might
also diminish economies of scope and thus potentially lead to a reduction of information in financial markets. In addition, there is a serious concern that implementation of these measures, particularly Sarbanes-Oxley, is too costly and is leading
to a decline in U.S. capital markets (see the FYI box, Has Sarbanes-Oxley Led to

a Decline in U.S. Capital Markets?).

S U M M A RY
1. There are eight basic facts about financial structure throughout the world. The first four emphasize the importance of financial intermediaries and
the relative unimportance of securities markets for
the financing of corporations; the fifth recognizes
that financial markets are among the most heavily
regulated sectors of the economy; the sixth states
that only large, well-established corporations have
access to securities markets; the seventh indicates
that collateral is an important feature of debt contracts; and the eighth presents debt contracts as
complicated legal documents that place substantial restrictions on the behaviour of borrowers.
2. Transaction costs freeze many small savers and borrowers out of direct involvement with financial markets. Financial intermediaries can take advantage of
economies of scale and are better able to develop

expertise to lower transaction costs, thus enabling
savers and borrowers to benefit from the existence
of financial markets.
3. Asymmetric information results in two problems:
adverse selection, which occurs before the transaction, and moral hazard, which occurs after the transaction. Adverse selection refers to the fact that bad
credit risks are the ones most likely to seek loans,
and moral hazard refers to the risk of the borrower s
engaging in activities that are undesirable from the
lender s point of view.
4. Adverse selection interferes with the efficient functioning of financial markets. Tools to help reduce the
adverse selection problem include private production
and sale of information, government regulation to
increase information, financial intermediation, and
collateral and net worth. The free-rider problem