Exam 2

Question 1

Recognize, but not state verbatim, the eight basic facts regarding how the financial system works

Answer 1

a Stocks are not the most important source of external financing
b Marketable securities are not the primary source of finance
c Indirect finance is more important than direct finance
d Financial intermediaries, primarily banks, are the most important source of external funds
e The financial system is heavily regulated
f Only large, well-established firms have access to securities markets
g Collateral is prevalent in debt contracts
h Debt contracts have numerous restrictive covenants

Question 2

Define transaction costs

Answer 2

a Important role of indirect finance
b expenses incurred when buying or selling goods or services, beyond the item’s price itself

Question 3

Explain how financial intermediaries take advantage of economies of scale and expertise in order to reduce transaction costs.

Answer 3

a Economies of scale – they handle a large volume of transactions, and that allows them to spread fixed costs (lower fees, better rates, faster services)
b Expertise – Hiring specialists that asses risk, value assets, and screen borrowers

Question 4

Define the term asymmetric information.

Answer 4

a situation where one party in a transaction has more or better information than the other party

Question 5

Adverse Selection - whats is the lemon’s problem

Answer 5

i Lemon’s problem – difficulty in distinguishing good and bad borrowers
1 How sellers of high-quality and low-quality assets interact in a market where buyers cannot fully assess the quality of an asset

Question 6

Moral Hazard - what is the principal-agent problem

Answer 6

i Principal-agent problem – conflict between managers (agents) and owners (principals)

Question 7

Define the term costly state verification.

Answer 7

a Verifying a borrower’s actual financial condition is expensive, so lenders don’t monitor continuously
b Concept closely related to financial contracting, adverse selection, and moral hazard

Question 8

Describe how costly state verification explains why the financial system is so heavily regulated.

Answer 8

a Because verifying the true financial condition of borrowers and institutions is expensive
i Regulation reduces these verification costs by enforcing disclosure, auditing, and supervision, which improves transparency, limits moral hazard, and helps maintain stability and confidence in the financial system

Question 9

Define the term free-rider problem.

Answer 9

a Occurs when investors rely on others to monitor firms
b Individuals have little incentive to pay for producing information because others can benefit for free
i Result: less information is produced privately, markets become inefficient and prone to adverse selection, and financial intermediaries and regulation arise to reduce the problem by generating and sharing credible information efficiently

Question 10

Describe how the free-rider problem explains why the financial system is so heavily regulated

Answer 10

a Individuals and firms lack incentives to produce and share accurate financial information on their own
b Government regulation ensures that essential information is disclosed and verified, reducing information asymmetry, protecting investors, and promoting trust and efficiency in the financial system

Question 11

Describe how financial intermediaries help reduce the principal-agent problem

Answer 11

a By screening and monitoring borrowers, designing incentive-aligned contracts, and acting as delegated monitors for investors

Question 12

Define the term venture-capital firm.

Answer 12

a Specialize in reducing the free-rider problem by closely monitoring startups

Question 13

Describe how moral hazard influences financial structure in debt markets.

Answer 13

a Encouraging the use of collateral, restrictive covenants, and financial intermediaries to align borrower and lender incentives

Question 14

Explain how net worth help to solve moral-hazard problems in debt contracts.

Answer 14

when borrowers have a high net worth they have more to lose if a project fails, personal investment gives them a strong incentive to avoid risky behavior (discourage risky behavior)

Question 15

Explain how restrictive covenants help to solve moral-hazard problems in debt contracts.

Answer 15

prevent the borrower from taking on excessive risk, require maintaining insurance, minimum working capital, or regular financial reporting (legally limit actions that could endanger repayment)

Question 16

Explain how financial intermediation help to solve moral-hazard problems in debt contracts

Answer 16

banks specialize in monitoring borrowers, the intermediaries are more efficient and effective (monitor and enforce these agreements efficiently, ensuring borrowers act in the lender’s best interest)

Question 17

Define the term incentive compatible.

Answer 17

a A contract, agreement, or system is designed so that each party’s best interest is to behave in the desired way

Question 18

Define, in the context of banking, the term liabilities.

Answer 18

a Are the funds a bank owes to depositors and other creditors, the bank’s sources of money that are used to make loans and investments.

Question 19

Identify, distinguish between, and provide examples of bank liabilities.

Answer 19

a Checkable deposits – demand deposits that allow withdrawals via check or electronic transfers
b Non-transaction deposits – includes savings account and time deposits
c Borrowings – banks borrow from sources such as parent holding companies, the Fed, etc.
d Bank capital – consists of retained earnings and equity capital

Question 20

Define, in the context of a bank’s balance sheet, the term bank capital.

Answer 20

a Balance Sheet – Total assets = total liabilities + capital
i Provides insights into how banks manage risk and liquidity

Question 21

Define, in the context of banking, the term assets.

Answer 21

a Banks allocate finds to assets such as loans and securities
b Asset management involves balancing liquidity, return, and risk

Question 22

Identify, distinguish between, and provide examples of bank assets.

Answer 22

a Loans – primary source of bank earnings, consumer loans
b Securities – income with low risk, U.S. treasury securities, Municipal bonds
c Reserves – liquidity and safety, cash in banks, deposits held at the FED
d Physical assets – tangible and intangible property the bank owns

Question 23

Identify, in general terms, how a typical bank earns profit.

Answer 23

a Borrowing funds at a low interest rate (from depositors)
b Lending or investing those funds at a higher rate
c Charging fees for financial services

Question 24

Use a standard T-account approach to determine how basic bank transactions—withdrawals, deposits, loan initiations, and write-offs, etc.—are reflected on a bank’s balance sheet.

Answer 24

Transaction Assets Liabilities Equity
Deposit ↑ Reserves ↑ Deposits —
Withdrawal ↓ Reserves ↓ Deposi —
Loan made ↑ Loans ↑ Deposits —
Loan repaid ↓ Loans ↓ Deposits —
Loan write-of. ↓ Loan. — ↓ Capital
Buy securities + Securities, – Reserves — —

Question 25

Identify the four primary areas of bank management: liquidity, asset, liability, and capital.

Answer 25

a Liquidity – meet withdrawal and payment needs, managing reserves and short-term funds b Asset – maximize returns for given risk, loan and investment decisions c Liability – obtain funds at lowest cost, managing deposits and borrowings d Capital – maintain solvency and stability, managing bank equity and risk exposure

Question 26

[9] Specify the equation for return on assets (ROA), a basic measure of bank profitability that provides information on how efficiently a bank is run.

Answer 26

a ROA = Net profit (net income) / Total assets b Net profit – banks total earnings after all expenses, taxes, and loan losses c Total assets – everything the bank owns d ROA – measures how efficiently management uses assets to earn income i Higher ROA means the bank is generating more profit per dollar of assets

Question 27

Specify the equation for return on equity (ROE), a basic measure of bank profitability that provides information on owners’ return on their investment in the bank.

Answer 27

a ROE = Net profit (net income) / Equity Capital b Equity capital – owner’s funds in the bank (stockholders’ equity or bank capital) c ROE – tells shareholders how much profit they earn for each dollar of equity they have invested d Higher ROE – means the bank is more profitable relative to its capital base

Question 28

Explain the economic significance of the so-called equity multiplier (EM), the amount of assets per dollar of equity capital.

Answer 28

a EM = Total assets / equity capital b EM – reflects how much a bank relies on debt (liabilities) relatie to equity to finance its assets c Higher EM – means bank is using more leverage – more assets are funded with borrowed money

Question 29

a Screening and Monitoring

Answer 29

reduce adverse selection and moral hazard – reduces risk of lending to bad borrowers i Screening = before, monitoring = after

Question 30

b Establishing long-term customer relationships

Answer 30

to reduce information costs and build trust – lowers adverse selection

Question 31

c Loan Commitments

Answer 31

provide future credit access – lowers moral hazard

Question 32

e Credit Rationing

Answer 32

limit risky lending – lowers adverse selection

Question 32

d Collateral and Compensating balances

Answer 32

secure loans and align incentives – lowers moral hazard

Question 33

Explain why a sudden and unexpected rise in interest rates will reduce bank profits if the bank has more rate-sensitive liabilities than assets.

Answer 33

a Because its interest expense increase faster than its interest income i Higher cost of funds narrows the interest rate spread, decreasing net interest income and profitability

Question 34

[14] Describe basic gap analysis.

Answer 34

a Used to measure how sensitive a banks profits are to changes in interest rates by comparing rate-sensitive assets and liabilities

Question 35

[15] Identify and provide examples of off-balance-sheet activities.

Answer 35

a Financial transactions or commitments that do not appear directly on a bank’s balance sheet as assets or liabilities i Loan commitments ii Standby letters of credit iii Loan sales and securitization

Question 36

[1] Summarize the type of banking regulation that falls under the category Government Safety Net.

Answer 36

a Moral Hazard and Adverse Selection

Question 37

[2] Identify the untended consequences—adverse selection and/or moral hazard—of government safety net legislation.

Answer 37

a Moral Hazard – “Too Big to Fail” – large institutions may take on excessive risks, knowing the government will bail them out if they fail b Adverse Selection – government may inadvertently attract riskier institutions or investors, knowing they will be protected, which undermines financial stability

Question 38

[3] Summarize the types of banking regulations that fall under the categories Restrictions on Asset Holdings and Bank Capital Requirements.

Answer 38

a Restrictions on Asset Holdings – limit risk and prevent unsafe investments – prohibit stock ownership, restrict risky securities, require diversification b Bank Capital Requirements – ensure banks can absorb losses and remain solvent – minimum capital ratios, leverage limits

Question 39

[4] Explain briefly the essence of the Basel Accord’s risk-based capital requirements.

Answer 39

a Ensures that banks hold capital in proportion to the riskiness of their assets b Assigning higher risk weights to riskier assets, the framework requires banks to maintain sufficient capital buffers to absorb losses, protect depositors, and promote global financial stability

Question 40

[5] Compare and contrast the effectiveness (in terms of keeping a bank solvent) of risk-based capital requirements and simple-leverage-ratio-based capital requirements.

Answer 40

a Leverage Ratio = Equity Capital / Total Assets b Are better at preventing insolvency, whereas simple leverage ratios provide basic but limited protection

Question 41

[6] Summarize the type of banking regulation that falls under the category Prompt Corrective Action.

Answer 41

a Regulatory framework designed to intervene early when a bank’s capital falls below required levels b Goal is to prevent bank insolvency and limit losses to the deposit insurance fund

Question 42

[7] Summarize the type of banking regulation that falls under the category Bank Supervision: Chartering and Examination.

Answer 42

a Regulatory process by which authorities monitor, evaluate, and oversee banks to ensure safely, soundly, and in compliance with laws b Main components: i Chartering – process of granting a bank the legal authority to operate ii Examination – ongoing monitoring and inspection of bank’s activities

Question 43

[8] Identify the asymmetric information problem—adverse selection and/or moral hazard—that chartering and examination legislation seeks to address.

Answer 43

a Asymmetric information occurs when one party has more or better information than other

Question 44

[10] Identify the acronym CAMELS.

Answer 44

a C = Capital adequacy – measures the bank’s ability to absorb losses and remain solvent b A = Asset Quality – evaluates the riskiness and performance of the banks loans and investments c M = management – assesses the effectiveness, experience, and quality of the bank’s management team d E = Earnings – reviews profitability and the sustainability of income e L = liquidity – examines the bank’s ability to meet short-term obligations and withdrawals f S = Sensitivity to Market Risk – Measures the bank’s exposure to interest rate, exchange rate, and other market risks

Question 45

[11] Explain briefly the purpose of a CAMELS rating and a call report.

Answer 45

a Supervisory tool used by regulators to assess the overall health and soundness of a bank b Evaluates overall bank health and determines regulatory actions

Question 46

[12] Recognize, but not state verbatim, the four elements of sound risk management on which regulators assess banks in order to come up with the risk management rating.

Answer 46

a Risk Identification – banks recognize and understand the types of risk they face b Risk Measurement and Assessment – quantify or evaluate the level of risk c Risk Monitoring – track risks over time d Risk Control – policies and procedures to manage and mitigate risks

Question 47

[13] Summarize the type of banking regulation that falls under the category Disclosure Requirements.

Answer 47

a Regulations that compel banks to provide clear, accurate and timely information

Question 48

[17] Define the term redlining.

Answer 48

a Redlining is the discriminatory practice in which banks or other financial institutions refuse to provide loans, mortgages, or insurance

Question 49

[1] Summarize briefly the controversies surrounding the Bank of the U.S. and the Second Bank of the U.S.

Answer 49

a Both banks were criticized for concentrating economic power, raising constitutional questions, and sparking political battles over the balance between federal authority and democratic control

Question 50

[4] Define the term dual-banking system.

Answer 50

banks can choose to be chartered and regulated at either the state or federal level

Question 51

[5] Identify the U.S. central bank and the decade it was established.

Answer 51

1913

Question 52

[6] Identify, based on bank charter, banks that must join the Fed and banks that have the option to do so.

Answer 52

a Must join – all national banks b Option – state banks

Question 53

[7] Identify the decade that Congress established the Federal Deposit Insurance Corporation (FDIC) and describe briefly the fundamental purpose of this regulatory agency.

Answer 53

a 1933 b Purpose is to protect depositors by insuring bank deposits against loss in the event of bank failure

Question 54

[9] Define the payoff and purchase-and-assumption methods associated with an FDIC bank bailout.

Answer 54

a Payoff method – FDIC pays insured deposits directly and liquidated the bank b Purchase-and-assumption method – another bank takes over the failed bank’s assets/liabilities, maintaining continuity of service

Question 55

[11] Define, in general terms, the term bank holding company (BHC).

Answer 55

a Raise money directly in the financial markets, and, thus, effectively enable their banks to access non-deposit sources of funds

Question 56

[12] Identify the regulatory institution that regulates BHCs in the U.S.

Answer 56

a FED – Board of Governors of the FED

Question 57

[13] Define and identify examples of an adjustable-rate mortgage and a financial derivative.

Answer 57

a ARM - Issued in 1975 by a California S&L, home loan with an interest rate that changed periodically b Financial derivative - Hedging and futures contracts, emerged in 1975

Question 58

[14] Describe briefly why most economists link the evolution of adjustable-rate mortgages and financial derivatives to interest-rate volatility, which grew considerably during the 1970s and 1980s.

Answer 58

a Both ARMs and derivatives evolved as tools to manage or transfer interest-rate risk b ARMS – protect themselves from losses c Derivatives – manage and hedge the risks

Question 59

[15] Define the term commercial paper.

Answer 59

a Short-term, unsecured promissory note – low-cost

Question 60

[16] Define the term securitization

Answer 60

a Process of bundling otherwise-illiquid assets into marketable securities

Question 61

[17] Describe briefly why most economists link the evolution of credit and debit cards, electronic banking, junk bonds, commercial paper and securitization to rapid developments in information technology.

Answer 61

a Rapid development in information technology made modern financial innovation possible by improving speed, accuracy, and access in financial transactions and risk management

Question 62

[18] Describe briefly why most economists link the evolution of money-market mutual funds and sweep accounts to government regulations regarding reserve requirements and restrictions on interest rates paid on deposits.

Answer 62

a Circumvent regulatory limits on deposit interest rates and reserve requirements i Higher returns and banks greater efficiency

Question 63

[19] Explain briefly why there are so many commercial banks in the U.S. today.

Answer 63

a Growth of many small, locally chartered banks

Question 64

[1] Define the term financial friction and describe the problem this friction creates in the financial system

Answer 64

a Render the system incapable of allocating capital to its most productive uses b Economic activity contracts sharply

Question 65

[2] Identify three factors that typically initiate a financial crisis in advanced economies.

Answer 65

a Mismanagement of financial liberalization or innovation i Credit booms b Asset price boom and bust i Fundamental values vs. irrational exuberance c Increase in uncertainty

Question 66

[3] Explain how each of the factors to which [2] refers increase financial frictions and, thus, effectively reduce lending and economic activity.

Answer 66

a Asset price boom and bust i Restricting credit to protect themselves b Increase in uncertainty i Banks may hold back credit or charge higher interest rates c Mismanagement i Lenders and borrowers may take on excessive risk or make mistakes

Question 67

[4] Describe how a deterioration in financial institutions’ balance sheets can lead to banking crises.

Answer 67

a Banks lose asset value their capital shrinks, this weakens confidence and causes deposit withdrawals. If many banks are affected, a bank crisis can occur, reducing lending and slowing the economy

Question 68

[5] Define, in the context of a banking crisis, the term fire sale

Answer 68

a When a bank or financial institution sells assets quickly at heavily discounted prices – to meet withdrawal demands or cover losses

Question 69

[6] Explain how debt deflation occurs and why it increases adverse selection and moral hazard problems and, thus, depresses lending for a long time

Answer 69

a Real value of debt rises because prices fall (deflation) b Worsens adverse selection because only the riskiest borrowers remain able or willing to borrow c Increase moral hazard because borrowers may take on riskier projects

Question 70

[7] Identify and explain the causes and effects of the global financial crisis of 2007–2009

Answer 70

a Cause – crisis triggered by the U.S. housing bubble, risky lending, excessive leverage, and weak financial regulation b Effect – banks became illiquid, lending and investment fell, housing and stock prices collapsed

Question 71

[8] Explain how financial innovations such as securitization, subprime and alt-A mortgages, mortgage-backed securities, collateralized debt obligation (CDOs), and structured credit products contributed to the recent financial crisis

Answer 71

a Encouraged excessive borrowing and lending, and when housing prices fell, widespread defaults caused massive losses, triggering the financial crisis

Question 72

What is things fiscal and monetary policy to help the financial market

Answer 72

a Fiscal – cut interest rates or insure investments for banks or the FED merging b Monetary – stimulus checks or lower taxes or increase spending