ECON 320 EXAM 2
If a bank has $1000 in deposits and the required reserve ratio is 10%, then the amount required as the bank's reserves is $____________
$100
For this problem, use the fact that the expected value of an event is a probability weighted average, the sum of each probable outcome multiplied by the probability of the event occurring. You are in the market for a used car. At a used car lot, you know that the blue book value for the cars you are looking at is between $20,000 and $25,000. If you believe the dealer knows more about the cars than you, how much are you willing topay? Assume that you care only about the expected value of the car you buy and that the car values are symmetrically distributed. You are willing to pay $__________. (Round your response to the nearest whole number.) Can this problem be resolved in a competitive market? A. No, the dealer will always have more information about the car than you. B. Yes, you can obtain more information about the car that you would like to buy.
$20,000 B. Yes
Suppose that a bank's balance sheet consists of the following: On the liability side it has $93 of deposits and $7 of capital, while on the asset side it has $10 of reserves and $90 of loans. This bank can then sustain $_______of bad loans before it becomes insolvent.
$7
Suppose $10,000 is deposited at a bank. The required reserve ratio is 20 percent, and the bank chooses not to hold any excess reserves but makes loans instead. What are the bank's total loans? Total loans are equal to $______________.
$8,000
Angus Bank holds no excess reserves but complies with the reserve requirement. The required reserves ratio is 9%, and reserves are currently $27 million. The amount of deposits is $____A_______ million. (Round your response to one decimal place.) The reserve shortage created by a deposit outflow of $5 million is $____B_____ million. (Round your response to two decimal places.) The cost of the reserve shortage if Angus Bank borrows in the federal funds market (assume the federal funds rate is 0.25%) is $____C_____.
A $300 million B $ -4.55 million C $ 11,375 STEPS TO SOLVE IN GREEN
How can a bursting of an asset-price bubble in the stock market trigger a financial crisis?
A reduction in asset prices causes a serious deterioration in borrowing firms' balance sheets. This will increase adverse selection and moral hazard problems, increasing the likelihood of a financial crisis. The value of a corporation's net wealth is reduced, making lenders less willing to lend. Less lending reduces investment and aggregate output; at the same time, the borrowing firms have less to lose so they can take on additional risk.
Because of transaction costs in financial markets, we can say that A. investors are less likely to invest in different stocks. B. investors choose to invest a smaller amount on stocks. C. more investors will find it profitable to keep their money in the financial markets. D. some investors may find it less profitable to invest in something else other than financial markets.
A. Investors are less likely to invest in different stocks
Suppose you have data about two groups of countries, one with efficient legal systems and the other with slow, costly, and inefficient legal systems. Which group of countries would you expect to exhibit higher living standards? A. The countries with efficient legal systems. They are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem. B. The countries with inefficient legal systems. Costly, slow and inefficient legal systems promote lending and thereby funding of investment opportunities.
A. The countries with efficient legal systems. They are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem.
Why does a financial crisis ultimately cause a substantial reduction in economic activity? A. The resulting credit crash severely reduces investment for productive activities. B. The financial crisis causes a fiscal deficit. C. Only corrupt bankers survive the crisis. D. The government responds to the crisis with excessive regulation.
A. The resulting credit crash severely reduces investment for productive activities.
If no decent lending opportunity arises in the economy, and the central bank pays an interest rate on reserves that is similar to other low-risk investments, do you think banks will be willing to hold large amounts of excess reserves? A. Yes. Banks will be willing to hold large amounts of excess reserves since these are safe investments. B. No. The bank must manage the liquidity of its assets so that it can meet deposit outflows. C. No. In managing their assets, banks must attempt to lower risk by diversifying.
A. Yes. Banks will be willing to hold large amounts of excess reserves since these are safe investments.
Unexploited profit opportunities A. are quick to disappear. B. are quickly eliminated by arbitrage. C. are split equally among all investors. D. help investors generate abnormally high returns in the long run.
A. are quick to disappear
Relatively smaller companies are more likely than large, well-known to acquire funds through A. banks B. nonbank financial intermediaries C. direct finance D. issuing collatera
A. banks
Required reserves are a fixed percentage of a bank's A. checkable deposits. B. liabilities. C. assets. D. loans. E. capital.
A. checkable deposits
Bonds account for a larger fraction of external funds relative to equities raised by American businesses because: A. costly state verification makes the equity contract less desirable than the debt contract. B. equity contracts do not permit borrowing firms to raise additional funds by issuing debt. C. of the reduced scope for moral hazard problems under equity contracts as compared to debt contracts. D. there is no moral hazard problem when using a debt contract.
A. costly state verification makes the equity contract less desirable than the debt contract
The bank manager has four primary concerns as given by the following except A. credit history management B. liquidity management C. asset management D. capital adequacy management
A. credit history management
Which of the following is true regarding how banks manage their assets? Banks seek assets that A. generate high returns. B. are not liquid. C. have no default risk. D. do not provide diversification.
A. generate high returns
Debt contracts are A. long legal documents with substantial provisions. B. meant to guide relatively small businesses obtain some additional investment. C. very simple legal documents that place restrictions on the borrower. D. established by borrowers to differentiate themselves from other individuals or firms.
A. long legal documents with substantial provisions
Large-denomination CDs are _____A_______, so that like a bond, they have a _______B_____ degree of liquidity and can be sold in secondary markets.
A. negotiable B. greater
The sum of a bank's vault cash plus its deposits at the Fed is the bank's A. reserves. B. excess reserves. C. capital. D. federal funds. E. cash items in the process of collection.
A. reserves
Asymmetric information can lead to a bank panic when: A. rumors of impending bank failure lead to mass withdrawals of customer deposits. B. rumors of government intervention cause mistrust of the government. C. rumors that the government will not enact a "safety net" lead to public protests. D. bank managers panic about the economy and begin selling the bank's assets.
A. rumors of impending bank failure lead to mass withdrawals of customer deposits.
Rank the following bank assets from most liquid (1) to least liquid (4). (Enter a numerical value between 1 and 4.) Asset: Commercial loans Securities Reserves Physical capital
Asset: Commercial loans 3 Securities 2 Reserves 1 Physical capital 4
Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a mortgage, he found that banks usually required collateral for up to 300% of the amount of the loan. Why might banks require that much collateral in a financial system like Gustavo's country? A. An inefficient legal system implies strong property rights, and under such a strong system, collateral is more highly valued and hence more desirable. B. An inefficient legal system implies weak property rights, and collateral helps banks recoup some of their loan if the borrower defaults. C. An inefficient legal system implies weak property rights but also high property values, making collateral more highly valued and hence more desirable. D. An inefficient legal system implies strong property rights, and collateral helps banks recoup some of their loan if the borrower defaults
B An inefficient legal system implies weak property rights, and collateral helps banks recoup some of their loan if the borrower defaults.
What role does weak financial regulation and supervision play in causing financial crises? A. It helps establish tighter rules and regulations for lending activities. B. It allows financial institutions a better opportunity to engage in excessive risk-taking behavior. C. It creates higher interest rates, as government expenditures will tend to increase. D. It reduces the risk that financial institutions will make bad loans.
B It allows financial institutions a better opportunity to engage in excessive risk-taking behavior.
At the height of the global financial crisis in October 2008, the U.S. Treasury forced nine of the largest U.S. banks to accept capital injections, in exchange for nonvoting ownership stock, even though some of the banks did not need the capital and did not want to participate. What could be the rationale for doing this? A. Government control of banks and other financial institutions would guarantee an end to the financial crisis. B. By forcing all banks to accept capital injections, it would help prevent bank runs on the weakest banks. C. With capital injections, institutions would have less "skin in the game" and would thus pursue less-risky investments. D. These actions were mandated by the Basel Accord to help end the financial crisis.
B. By forcing all banks to accept capital injections, it would help prevent bank runs on the weakest banks.
How might it be possible for this episode to still adhere to the efficient market hypothesis? A. Due to the increased value of assets, investors were able to produce a positive environment for their businesses and thus increase market efficiency. B. Investors were acting on the best information available at that time in valuing their stocks. C. Investor expectations that overvalue assets and then expect them to be sold at higher prices are representative of rational expectations, a key factor of the efficient market hypothesis. D. New and more effective ways to invest were a result of this stock market bubble.
B. Investors were acting on the best information available at that time in valuing their stocks.
Regardless of the original source of the financial crisis, all credit booms end in a credit crash because of A. collateralized debt obligations. B. an increase in adverse selection and moral hazard in the loan market. C. corruption in the mortgage industry. D. massive government deficits.
B. an increase in adverse selection and moral hazard in the loan market
Restrictive covenants A. are most common in equity contracts. B. make debt contracts more incentive compatible. C. solve the lemons problem. D. reduce adverse selection.
B. make debt contracts more incentive compatible
The free rider problem: A. will only occur if information costs are zero B. results from the production of information being much like a public good where exclusion is not possible C. will make more people willing to provide information services D. makes it easier for an investor to continue to buy securities at less than the true value
B. results from the production of information being much like a public good where exclusion is not possible
An institution in our financial structure that helps reduce the moral hazard arising from the principal-agent problem is the: A. savings and loan association. B. venture capital firm. C. money market mutual fund. D. pawn broker.
B. venture capital firm
How does an unanticipated decline in the price level cause a drop in lending? A. A decline in the price level reduces the moral hazard associated with borrowing firms B. A decline in the price level lowers the nominal value of loan contracts that have already been made C. A decline in the price level raises the real value of borrowing firms' liabilities while lowering the firms' real net worth D. A decline in the price level does not affect lending
C. A decline in the price level raises the real value of borrowing firms' liabilities while lowering the firms' real net worth
Which of the following is NOT an ...asset... on a bank's balance sheet? A. Reserves. B. Government securities. C. Checkable deposits. D. Loans.
C. Checkable Deposits
__________ occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in a firm's net worth because of the increased burden of indebtedness. A. Deleveraging B. Adverse selection C. Debt deflation D. Moral hazard
C. Debt deflation
If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE? A. Given the ROA, if bank capital doubles, then ROE will also double. B. Even if the bank doubles its amount of capital, if ROA is constant, then ROE will remain unchanged. C. Given the ROA, if bank capital doubles, then ROE will fall by half. D. The effect on ROE cannot be determined based on the information provided.
C. Given the ROA, if bank capital doubles, then ROE will fall by half.
The principal-agent problem arises because of many reasons except the statement that indicates that A. agents have information not readily available to the principal. B. principals have incentives to free ride off the monitoring expenditures of other principals. C. agents' incentives are always compatible with those of the principals. D. principals find it difficult and costly to monitor agents' activities.
C. agents' incentives are always compatible with those of the principals. This is the correct answer.
The process of asset transformation is frequently described by saying that banks are in the business of A. lending as much as possible. B. borrowing as little as possible. C. borrowing short and lending long. D. borrowing long and lending short.
C. borrowing short and lending long
Which of the following would not be considered a managed liability? A. negotiable certificates of deposit B. Eurodollar borrowings C. checkable deposits D. federal funds borrowed
C. checkable deposits
When you deposit your $5000 paycheck in your bank, which was written on an account at a different bank, the immediate impact on your bank's balance sheet is that your bank's cash items in the process of collection rise by $5000 and yourbank's A. capital rises by $5000. B. reserves rise by $5000. C. deposits rise by $5000. D. loans rise by $5000.
C. deposits rise by $5000
As a result, when compared to other countries, we would expect Gustavo's nation to have: A. more investment and slower economic growth. B. less investment and faster economic growth. C. less investment and slower economic growth. D. more investment and faster economic growth.
C. less investment and slower economic growth
Of the following sources of external finance for American nonfinancial businesses, the most important is: A. loans from banks. B. bonds and commercial paper. C. loans from other financial intermediaries. D. stock market shares.
C. loans from other financial intermediaries
The principal-agent problem: A. is a type of adverse selection. B. eliminates costly state verification. C. occurs because owners have incomplete information about the motives and behavior of managers. D. is not related to asymmetric information.
C. occurs because owners have incomplete information about the motives and behavior of managers. This is the correct answer.
Which of the following is an example of a restrictive covenant in a debt contract? A. encouraging borrowers to keep their collateral valuable B. allowing firms to opt out of periodic accounting reports C. requiring borrowers to have life insurance D. requiring borrowers to pay a high interest rate
C. requiring borrowers to have life insurance
Bank chartering reduces adverse selectionLOADING... problems by: A. developing a set of regulations, or bank charter, by which all banks will operate. B. assigning a mentor bank to conduct examinations and screen for principal-agent problems. C. screening proposals for new institutions to prevent undesirable people from running the institution. D. conducting regular on-site examinations of the financial institution.
C. screening proposals for new institutions to prevent undesirable people from running the institution.
_________ is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments.
Collateral
What is the reason for this problem? Principle-agent problem A. Owners limit the manager's ability to run the corporation efficiently. B. A manager does not have access to sufficient resources to run the corporation efficiently. C. Stockholder meetings are infrequent, and the manager has to wait for these results to get anything done. D. A manager does not have sufficient incentive to maximize the company's profits.
D. A manager does not have sufficient incentive to maximize the company's profits.
Which of the following statements about market bubbles is accurate? A. Loss aversion, investor overconfidence, and social contagion often lead to decreases in market bubbles. B. Bubbles represent irrational behavior because asset prices are higher than their fundamental value, but investors continue to hold these assets anyway. C. With market bubbles, unexploited profit opportunities may exist, adding further proof to the stronger view of market efficiency. D. Bubbles can occur when investors buy an asset above its fundamental price in the belief that someone else will buy the asset for a higher price in the future.
D. Bubbles can occur when investors buy an asset above its fundamental price in the belief that someone else will buy the asset for a higher price in the future.
Why are deposit insurance and other types of government safety nets important to the health of the economy? A. Government safety nets were designed to weaken the shadow banking system. B. Deposit insurance prevents depositors from withdrawing their funds and thus eliminates runs on banks. C. Deposit insurance and other types of government safety nets eliminate the adverse selection problem. D. Deposit insurance and other government safety nets help to eliminate a contagion effect.
D. Deposit insurance and other government safety nets help to eliminate a contagion effect.
In the late 1990s, as information technology rapidly advanced and the Internet widely developed, U.S. stock markets soared, peaking in early 2001. Later that year, these markets began to unwind, and then crash, with many commentators identifying the previous few years as a "stock market bubble." Why was this episode considered a bubble? A. A higher number of risky but potentially profitable investments appeared. B. The growth rate of stock market prices increased by more than 25% during this time. C. Investors were able to exploit profit opportunities but only in the short term. D. Stock market prices were overvalued and rose well above their fundamental values.
D. Stock market prices were overvalued and rose well above their fundamental values.
What are the costs and benefits of a too-big-to-fail policy? A. The benefit is that it makes bank panics less likely; however, the cost is that it increases the incentive for adverse selection by big banks B. The benefit is shareholders of common stock in big banks are better protected against losing money; however, the cost is that it increases the incentive for adverse selection by big banks C. The benefit is shareholders of common stock in big banks are better protected against losing money; however, the cost is that it increases the incentive for moral hazard by big banks D. The benefit is that it makes bank panics less likely; however, the cost is that it increases the incentive for moral hazard by big banks
D. The benefit is that it makes bank panics less likely; however, the cost is that it increases the incentive for moral hazard by big banks
How can the existence of asymmetric information provide a rationale for government regulation of financial markets? A. Good information becomes quickly obsolete B. The production of information to combat these asymmetries is subject to moral hazard C. The production of good information is so costly that all potential buyers of this information are priced out of the market D. The production of information to combat these asymmetries is subject to the free-rider problem
D. The production of information to combat these asymmetries is subject to the free-rider problem
Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done so? A. You would be more willing because putting her life savings into her business provides you protection against the problem of adverse selection B. Whether or not she puts her life savings into her business has no bearing on whether she repays the loan or not. Therefore, it should have no effect on your decision to loan her money C. You would be less willing because putting her life savings into a business that can potentially fail makes it more risky for you to loan her money. If the business fails, she will protect her investment before she considers repaying you D. You would be more willing because putting her life savings into her business provides you protection against the problem of moral hazard
D. You would be more willing because putting her life savings into her business provides you protection against the problem of moral hazard
A bank's balance sheet includes several components such as the following EXCEPT A. bank capital. B. nontransaction deposits. C. cash items in process of collection. D. employed workers.
D. employed workers
Announcements of already-known information A. improve forecasts of stock prices. B. generate unexploited profit opportunities. C. reduce stock returns. D. fail to affect stock prices.
D. fail to affect stock prices
What might lead to poor management when control and ownership are separate, like in many American corporations? A. Sarbanes-Oxley problem. B. Adverse selection. C. Free-rider problem. D. Principal-agent problem.
D. principal agent problem
A well-functioning financial system: A. creates unpredictable market disruptions. B. causes financial frictions to increase in an economy. C. acts as a barrier to efficient allocation of capital. D. solves asymmetric information problems.
D. solves asymmetric information problems
Suppose a country has weak institutions, prevalent corruption, and an ineffectively regulated financial sector. Would you recommend the adoption of a system of deposit insurance, like the FDIC in the United States, for this country? _______ Based on the information given above, which of the following is likely to be a reason for not recommending the adoption of a system of deposit insurance for this country? A. It might increase the moral hazard incentives for banks to engage in risky lending. B. It might increase the problem of adverse selection of potential customers by banks. C. It might increase the economy's dependency on big financial institutions.
NO A. It might increase the moral hazard incentives for banks to engage in risky lending.
Suppose a country has weak institutions, prevalent corruption, and an ineffectively regulated financial sector. Would you recommend the adoption of a system of deposit insurance, like the FDIC in the United States, for this country?
No
What happens to reserves at the First National Bank if one person withdraws $1,000 of cash and another person deposits $500 of cash? Use a T-account to explain your answer. The T-account for First National Bank is: Assets: Reserves $ ________ Liabilities: Checkable Deposits $ _______
The T-account for First National Bank is: Assets: Reserves $ -500 Liabilities: Checkable Deposits $ -500
Does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?
Yes
A banks balance sheet is a list of it's __________, it uses to which the funds are put in
assets
One solution to the problem of high transaction costs is to bundle the funds of many investors to take advantage of_______________
economies of scale
____________are the most important source of external funds to finance businesses.
financial intermediaries
According to the efficient market hypothesis, in order to earn abnormally high returns, an investor would need to__________
have exclusive information
IBM announces a merger with Dell Computer. The deal is so complex that only financial analysts and other financially sophisticated people can correctly assess that it will make both firms much more efficient and profitable. If the efficient market hypothesis is true, then the price of IBM stock will______________
increase
The principal-agent problem causes___________
moral hazard
IBM announces profits of $400 million. Stock analysts predicted profits of $400 million. If the efficient market hypothesis is true, the price of IBM stock will____________
remain the same
