ECON 321- EXAM 2

Which of the following statements is TRUE? a. A liquid asset is one that can be quickly and cheaply converted into cash. b. The demand for a bond declines when it becomes less liquid, decreasing the interest rate spread between it and relatively more liquid bonds. c. The differences in bond interest rates reflect differences in default risk only. d. The corporate bond market is the most liquid bond market.

A liquid asset is one that can be quickly and cheaply converted into cash.

Nonfinancial businesses in Germany, Japan, and Canada raise most of their funds from

Bank Loans

Brad buys homeowners insurance and then is less careful to make sure he puts out his cigarettes. Abby buys healthinsurance because she knows that she has health issues that wouldn't be obvious to an insurance company. What are these examples of?

Brad illustrates moral hazard: Abby illustrates adverse selection

According to the "liquidity premium theory" of the term structure, a flat yield curve indicates that short-term interest rates are expected to

Decline moderately in the future

The ______ that required separation of commercial and investment banking, it was repealed in 1999 by _____.

Glass-Steagall Act; Gramm-Leach-Bliley Financial Services Modernization Act.

Bank consolidation will likely result in ____; and critics of nationwide banking fear __.

Increased competition; the elimination of community bank

1. Which of the following is NOT part of "Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 a. Created Resolution Trust Corporation to resolve insolvent thrifts. b. Abolished FSLIC. c. Created Office of Thrift Supervision (OTS). d. Raised deposit insurance premiums e. Increased deposit insurance to $100,000 per account.

Increased deposit insurance to $100,000 per account.

U.S. banks may engage in international banking activities EXCEPT

Investment banks overseas.

A possible sequence of the three stages of a financial crisis in an advanced economy might be _____ leads to ___ leads to _______.

asset price declines; banking crises; unanticipated decline in price level

A financial crisis could be caused by severe asset-price decline. A sharp decline in the stock market means that the ________ of corporations has fallen making lenders ________ willing to lend

net worth; less

Fact six of financial structures

only well established large corporations have access to the security market finance their activities

The originate-to-distribute business model in the mortgage market has a serious _______ problem since the mortgage broker has little incentive to make sure that the ______ is a good credit risk

principal-agent; mortgage borrower

If the FDIC decides that a bank is too big to fail, it will use the ______ method, effectively ensuring that ___will suffer losses.

purchase and assumption; no depositors

Fact one of financial structures

stock are not most important source of external finance

The developments that have reduced banks' cost advantages include ____.

the competition from money market mutual funds

the developments that have reduced banks' income advantages include ____.

the growth of securitization.

If a banker expects interest rates to fall in the future, her best strategy for the present is

to increase money market deposit accounts to buy long term bonds.

When a bank needs to raise the amount of capital relative to assets (the leverage ratio), a bank manager might choose to

use the reserves to pay off "borrowings from other banks".

If the expected path of 1-year interest rates over the next five years are 2 percent, 4 percent, 1 percent, 4 percent, and 3 percent, the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of a. one year. b. two years. c. three years. d. four years. e. five years.

Answer: TWO YEARS a. one year (1.02)^(1/1)-1=2% b. two years (1.02*1.04)^(1/2)-1= 3% c. three years (1.02*1.04*1.01)^(1/3)-1=2.3% d. four years (1.02*1.04*1.01*1.04)^(1/4)-1 =2.74 e. five years (1.02*1.04*1.01*1.04*1.03)^(1/5)-1 = 2.79%

Four operations to meet deposit outflow are

1. borrow from other banks (incur interest costs) 2. sell securities (selling them less than purchase price:loss) 3. call in loans (will reduce assets and income) 4. reduce dividend payments (will reduce income and shareholder payouts)

What are the 7 categories of regulations

1. consumer protection 2. annual stress tests 3. resolution authority 4. risk regulations 5. voucher rule 6. limits on federal lending 7. derivatives

The Basel Accord, an international agreement, requires banks to hold as capital an amount that is at least ____ of their ______.

5%; risk-weighted assets.

The chartering process is especially designed to deal with the ___ problem; and regular bank examinations help to reduce the ___ problem.

adverse selection; moral hazard

1. Which of the following is NOT included in Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010? a. It permanently increased FDIC deposit insurance to $250,000. b. It requires large banks be subject to annual stress tests. c. It established Orderly Liquidation Authority to handle failing financial institutions. d. It prohibits banks from trading excessive derivatives. e. It designates systemically important financial institutions. These firms are subject to additional regulations.

It permanently increased FDIC deposit insurance to $250,000.

______ filed for bankruptcy on September 15, 2008 making it the largest bankruptcy filing in U.S. history. In early September 2008, ______ were put into conservatorship (in effect, run by the government).

Lehman Brothers; Freddy Mac

To eliminate the abuses of the state-chartered banks, the ________ created a new banking system of federally chartered banks, supervised by the ________.

National Bank Act of 1863; Office of the Comptroller of the Currency

Reserve shortfalls equal

Reserve shortfalls= required reserves- reserves

Which of the following does NOT provide charters of depository institutions? a. The Federal Reserve System b. The Office of the Comptroller of the Currency c. The National Credit Union Administration d. State banking and insurance commission.

The Federal Reserve System

Big risk takers or out-right crooks might be the most eager to take out a loan because they know that they are unlikely to pay it back. In this case, the lenders face ________ problem before the loans are made; and the lenders face ____problem after the loans are made.

adverse selection; moral hazard

International banking facilities (IBFs)

US establishments that accept foreign deposits

The federal deposits insurance (FDIC) creates ________ problem because risk-loving bank-managers would want to increase banks' risky assets. The ___ is especially designed to deal with this problem.

a moral hazard; frequent examination of banks.

Edge Act corporations

a special subsidiary of US banking to bank internationally

Which of the following is NOT included in Banking Acts of 1933 (Glass-Steagall) and 1935? a. Regulated investment companies. b. Created FDIC. c. Separated commercial banking from the securities industry d. Put interest-rate ceilings on deposits.

a. Regulated investment companies.

Both ________ and ________ were financial innovations that occurred because of interest rate volatility.

adjustable-rate mortgages; adjustable-rate mortgages; financial derivatives

Debt deflation occurs when

an economic downturn causes the price level to fall and a deterioration in firms' net worth

Which of the following is NOT a government intervention during the 2007-2009 financial crisis? a. The Fed established many facilities to provide liquidity into the economy. b. Congress passed Sarbanes-Oxley Act to require certification by CEO and CFO of financial statements. c. U.S. government bailed out AIG (American International Group). d. Congress passed Troubled Asset Relief Program (TARP) to spend $700 billion to inject liquidity into troubled financial institutions. e. Congress passed American Recovery and Reinvestment Act to provide $787 billion fiscal stimulus package.

b. Congress passed Sarbanes-Oxley Act to require certification by CEO and CFO of financial statements.

Which of the following about Eurodollars held by US banks is correct? a. Eurodollar deposits are insured by the FDIC. b. *Eurodollar deposits are not subject to reserve requirements. c. The minimum transaction sizes of Eurodollars are very low, making it an attractive savings instrument for consumers. d. The Eurodollar deposits are heavily regulated.

b. Eurodollar deposits are not subject to reserve requirements.

Which of the following is NOT one of the reasons that financial intermediaries are an important source of external funds for businesses? a. Financial intermediaries experience economies of scale thus reduce transaction costs b. **Financial intermediaries can eliminate moral hazard problems between the lenders and borrowers. c. Financial intermediaries have expertise to reduce adverse selection problem between borrowers and lenders. d. Financial intermediaries experience economies of scope thus reduce transaction costs.

b. Financial intermediaries can eliminate moral hazard problems between the lenders and borrowers.

Which of the following is NOT a tool to help solve/reduce principal-agent problem in equity markets? a. The principals monitor the agents' activities. b. Government regulation to increase information available to the agents. c. Use financial intermediations. d. Use debt contracts instead of equity contracts.

b. Government regulation to increase information available to the agents.

Which of the following is NOT included in "Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010"? a. Created Consumer Financial Protection Bureau (CFPB). b. Increased deposit insurance on individual retirement accounts to $250,000 per account. c. Created Financial Stability Oversight Council. d. Banned banks from owning large percentage of hedge funds. e. Regulate financial derivatives.

b. Increased deposit insurance on individual retirement accounts to $250,000 per account.

Fact four of financial structures

banks are the most important source of external funds

Based on the most recent report of all commercial banks in the United States (banks' balance sheet), a. The total amount of assets of all commercial banks in the US was below $10 trillion. b. The largest liabilities item is "loans". c. Among the deposits, the amount of "savings deposits" is largest. d. Banks as a group hold more securities than loans. e. The largest type of loans is "consumer loans".

c. Among the deposits, the amount of "savings deposits" is largest.

Which of the following depository institutions do NOT purchase deposits insurance from FDIC? a. National banks b. Savings and Loans. c. Credit Unions d. Mutual Savings banks e. None of the above

c. Credit Unions (are federally insured)

If the yield curve slope is flat for short maturities and then slopes steeply upward for longer maturities, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting a. a rise in short-term interest rates in the near future and a rise further out in the future. b. constant short-term interest rates in the near future and further out in the future. c. a decline in short-term interest rates in the near future and a rise further out in the future. d. constant short-term interest rates in the near future and a rise further out in the future. e. a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

c. a decline in short-term interest rates in the near future and a rise further out in the future.

By bundling share purchases of many investors together mutual funds can take advantage of economies of scale and thereby lower a. adverse selection. b. moral hazard. c. transactions costs. d. diversification.

c. transactions costs.

Fact seven of financial structures

collateral is prevalent for both household and business finance

Which of the following is NOT a financial innovation responding to the improvements in information technology? a. Bank credit and debit cards. b. Junk bonds. c. Securitization of banks' assets. d. Money market mutual funds

d. Money market mutual funds

Fact eight of financial structures

debt contract are complex legal documents that heavily restrict behavior of borrowers

Mutual savings banks are owned by _____; and they are primarily regulated by ___.

depositors; the states in which they are located.

1. Which of the following are true statements concerning financial structure throughout the world? a. Issuing marketable securities is the primary way businesses finance their operations. b. Collateral is a prevalent feature of equity contracts. c. Together, bonds and stocks supply more than 60% of the external funds that corporations use to finance their activities. d. Direct finance is many times more important than indirect finance. e. Financial intermediaries are the most important source of external funds used to finance businesses.

e. Financial intermediaries are the most important source of external funds used to finance businesses. (fact #4 of finance structure)

1. Which of the following about "the Great Depression" is incorrect? a. It was the worst economic downturn in U.S. history. b. It was led by the stock market boom and bust. c. The severe droughts in the Midwest worsened the bank balance sheets in agricultural regions. d. Bank panics worsened the asymmetric information problems. e. Neither the government nor the Fed attempted to intervene to stop the crisis.

e. Neither the government nor the Fed attempted to intervene to stop the crisis.

All of the following are examples of off-balance sheet activities that generate fee income for banks EXCEPT a. Endorsing bankers' acceptance. b. selling collateralized debt obligations (CDOs) c. guaranteeing debt securities. d. back-up lines of credit. e. making commercial loans to local businesses.

e. making commercial loans to local businesses.

financial derivatives

financial instruments with payoffs bast off past securities; risk reduction tool

Fact five of financial structures

financial systems is a heavily regulated sector of the economy

The ________ problem helps to explain why the private production and sale of information cannot eliminate ________.

free-rider; adverse selection

The interest rate on a 20-year Treasury bond is lower than the interest rate on a 20-year bond issued by XYZ corp, because Treasury securities

have lower default risks and higher liquidity than those of XYZ bonds

National Bank Act of 1863

imposed a prohibitive TAX on state banknotes: intended to dry up funds toward state banks

If the probability of a bond default increases because corporations begin to suffer large losses, then the default risk on corporate bonds will ________ and the expected return on these bonds will ________, everything else held constant.

increase; decrease

An ________ in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

increase; decrease; increase increased risk = less desirable decreased price - bc its harder to sell increased yield - to attract new buyers

In addition to having a direct effect on increasing adverse selection problems, increases in interest rates also promote financial crises by ________ firms' and households' interest payments, thereby ________ their cash flow.

increasing; decreasing

Fact three of financial structures

indirect finance is more important than direct finance

According to the "liquidity premium" theory of the term structure

interest rates on bonds of different maturities move together over time (fact 3)

Financial innovations that emerged after 2000 in the mortgage markets included all of the following except

interest-rate swaps

opportunity cost

is the difference between the earned interest rates on loans and the paid interest rate on reserves ex. OC= (4.5%-1.8%)(reserves)

Fact two of financial structures

issuing debt and equity securities is not the primary way for business to finance their opperations

Because of the adverse selection problem

lenders are reluctant to make loans that are not secured by collateral.

A well-capitalized financial institution is ______ likely to pursue risky activities; its return on equity tends to be _____.

less; lower

In 2013, Congress approved legislation favored by the Obama administration to increase the income tax rate on high-income taxpayers from 35% to 39%. This increase in income tax rate for the wealthy helped to _______ interest rates on municipal bonds and ______ interest rates on Treasury bonds.

lower; raise