The capital market connects households’ saving decisions with firms’
borrowing decisions. Households save some part of their income. They
can lend (make a deposit) to a commercial bank or other financial
intermediary. They can lend directly to a firm by buying a bond. Or they
can purchase stock and thereby become a part owner in a firm. Firms
finance their investments (purchases of new capital equipment) by using
their retained earnings, borrowing from a bank, issuing a bond and
borrowing directly from a lender, or issuing and selling stock.
During normal times, the process of financial intermediation—the flow of
funds between households and firms through institutions, such as
commercial banks—works so well that we barely notice its presence. In
the financial crisis that began in 2008, however, this process was
disrupted by the failure of several large financial institutions in the United
States and Europe. With globally integrated financial markets, the result
in Canada and elsewhere was an increase in the perceived risks
associated with borrowing and lending, and thus a dramatic decline in the
flows depicted in Figure 15-1. By 2010, however, these financial flows
had returned approximately to normal, partly in response to significant
policy actions taken by governments and central banks in many countries.