Like it or not, the vast majority of us have to work. We work to sustain ourselves and our dependents. Often, we earn money for our labour and use that money to purchase goods and services. But money can be used for more than everyday needs. If we spend less than we earn, we have savings. If we seek to earn a return on our savings, we are investing. To explain how savers become investors, consider the example of a Canadian entrepreneur who needs money to set up a new business. She needs to find savers who are willing to invest in her business, so she spends weeks asking her friends and neighbours until she eventually finds a friend who is willing to invest. This friend believes he will get back more money than he lends, so he is prepared to invest some of his savings. The entrepreneur is happy because she can now start her business. But the search for money has taken a long time; it could have been so much quicker and easier for her to find the money if there was a system that connected those who need money with those who have savings and are willing to invest these savings. Well, there is such a system! It is called the financial system.
The Financial System
The financial system helps link savers who have money to invest and spenders who need money. Within the financial system, the financial services industry offers a range of products and services to savers and spenders and helps channel funds between them. Note that in this chapter and in the rest of the curriculum, the terms money, cash, funds, and financial capital (or capital) are used interchangeably.1 Savers include individuals (households), companies, and governments that have money to invest. Spenders also include individuals, companies, and governments. For example, individuals borrow to pay for houses, education, and other expenses. Companies borrow to invest in land, buildings, and machinery. Governments borrow when their current tax receipts are insufficient to meet their current spending plans.
Savings can be invested in a wide range of assets. Assets are items that have value and include real assets and financial assets. Real assets are physical assets, such as land, buildings, machinery, cattle, and gold. They often represent a company’s means (or factors) of production and are sometimes referred to as physical capital. In contrast, financial assets are claims on real, or possibly other financial, assets. For example, a share of stock represents ownership in a company. This share gives its owner, who is called a shareholder, a claim to some of the company’s assets and earnings. An investor’s total holdings of financial assets is usually called a portfolio or investment portfolio. Financial assets that can be traded are called securities. The two largest categories of securities are debt and equity securities.
Debt securities are loans that lenders make to borrowers. Lenders expect the borrowers to repay these loans and to make interest payments until the loans are repaid. Because interest payments on many loans are fixed, debt securities are also called fixed-income securities. They are also known as bonds, and investors in bonds are referred to as bondholders. More information about debt securities is provided in the Debt Securities chapter.
Equity securities are also called stocks, shares of stock, or shares. As mentioned earlier, shareholders (also known as stockholders) have ownership in a company. The company has no obligation to either repay the money the shareholders paid for their shares or to make regular payments, called dividends. However, investors who buy shares expect to earn a return by being able to sell their shares at a higher price than they bought them and, possibly, by receiving dividends. Equity securities are discussed further in the Equity Securities chapter.
Markets are places where buyers meet sellers to trade. Places where buyers and sellers trade securities are known as securities markets, or financial markets. How securities are issued, bought, and sold is explained in The Functioning of Financial Markets chapter. Exhibit 1 shows how the financial services industry helps channel funds between those that have money to invest (the savers that become providers of capital) and those that need money (the spenders that become users of capital). Key industry participants and processes are described in more detail later in this chapter.
Providers and users of capital may interact through financial markets or through financial intermediaries. The movement of funds through financial markets is called direct finance because the providers of capital have a direct claim on the users of capital. For example, if you own shares of Nestlé, you have a claim on the assets and earnings of Nestlé. Providers and users of capital often rely on financial intermediaries to find each other and to channel funds between each other. This process is indirect finance because financial intermediaries act as middlemen between savers and spenders; the former do not have direct claims on the latter. Financial intermediaries may also create new products and securities that depend on other assets. Financial intermediaries play an important role in the financial services industry. Many savers do not have the time or the expertise to identify and select individuals, companies, and governments to lend to or invest in. Once savers have lent money, they have to monitor the borrower’s behaviour and financial health to ensure that they will get their money back—a task that is time consuming and costly. Matching savers and borrowers and monitoring borrowers’ behaviour and financial health are functions that financial intermediaries can perform better and more cheaply than most investors can do on their own.