ECON 390: Exam 2

If a bank has $10 million of checkable deposits, a required reserve ratio of 10 percent, and it holds $2 million in reserves, then it will not have enough reserves to support a deposit outflow of

$1.2 million

If a bank has $200,000 of deposits, a required reserve ratio of 20 percent, and it holds $80,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is

$50,000

With a 10% reserve requirement ratio, a $100 deposit into New Bank means that the maximum amount New Bank could lend is

$90

The Basal Accord requires banks to hold as capital an amount that is at least _________. of their risk-weighted assets

8%

A bank failure occurs whenever

A bank cannot satisfy its obligations to pay its depositors and have enough reserves to meet its reserve requirements.

A bank failure is less likely to occur when

A bank has more bank capital

A serious consequence of a financial crisis is

A contraction in economic activity

When financial intermediaries deleverage, firms cannot fund investment opportunities resulting in

A contraction of economic activity

If a bank has $50 million in rate-sensitive assets and $20 million in rate-sensitive liabilities then

A decrease in interest rates will reduce bank profits

If bad credit risks are the ones who lost actively seek loans then financial intermediaries face the problem of

Adverse selection

If borrowers with the most risky investment projects seek bank loans in higher proportion to those borrowers with the safest investment projects, banks are said to face the problem of

Adverse selection

When bad drivers line up to purchase collision insurance, automobile insurers are subject to the

Adverse selection problem

Collateral requirements lessen the consequences of ________ because the collateral reduces the lender's losses in the case of a loan default and it reduces ________ because the borrower has more to lose from a default.

Adverse selection; moral hazard

The chartering process is especially designed to deal with the _________ problem, and regular banks examination help to reduce the _________ problem

Adverse selection; moral hazard

The problem created by asymmetric information before the transaction occurs is called ________, while the problem created after the transaction occurs is called ________.

Adverse selection; moral hazard

The analysis of how asymmetric information problems affect economic behavior is called ________ theory

Agency

Debt deflation occurs when

An economic downturn causes the price level to fall and a deterioration in firms' net worth because of the increased burden of indebtedness.

All else the same, if a bank's liabilities are more sensitive to interest rate fluctuations than are its assets, then ________ in interest rates will ________ bank profits.

An increase; reduce

Equity contracts

Are claims to a share in the profits and assets of a business

A possible sequence for 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 the price level

Duration analysis involves comparing the average duration of the bank's ________ to the average duration of its ________.

Assets; liabilities

The presence of _______ in financial markets leads to adverse selection and moral hazard problems that interfere with the effect functioning of financial markets

Asymmetric information

In a bank panic, the source of contagion is the

Asymmetric information problem

If uncertainty about banks' health causes depositors to begin to withdraw their funds from banks, the country experiences a(n)

Banking crisis

Why is the originate-to-distribute business model subject to the principal-agent problem?

Because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a good credit risk.

Asset transformation can be described as

Borrowing short and lending long

A bank with insufficient reserves can increase its reserves by

Calling in loans

A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system

Causes severe adverse selection and moral hazard problems that make financial markets incapable of channeling funds efficiently

Which of the following are reported as liabilities on a bank's balance sheet

Checkable deposits

Which of the following statements is true

Checkable deposits are payable on demand

Credit risk management tools include

Collateral

Net worth can perform a similar role to

Collateral

How does collateral help to reduce the adverse selection problem in credit market?

Collateral is property that is promised to the lender if the borrower defaults thus reducing the lender's losses. Lenders are more willing to make loans when there is collateral that can be sold if the borrower defaults.

Because of asymmetric information, the failure of one bank can lead to runs on other banks. This is the

Contagion effect

When financial institutions go on a lending spree and expand their lending at a rapid pace they are participating in a

Credit boom

Since they require less monitoring of firms, ________ contracts are used more frequently than ________ contracts to raise capital.

Debt; equity

When the value of loans begins to drop, the net worth of financial institutions falls causing them to cut back on lending in a process called

Deleveraging

Regulations designed to provide information to the marketplace so that investors can make informed decisions are called

Disclosure requirements

Bank loans from from the Federal Reserve are called ________ and represent a ________ of funds

Discount loans; source

Bank loans from the Federal Reserve are called _________ and represent a __________ of funds

Discount loans; source

The amount of assets per dollar of equity capital is called the

Equity multiplier

To prevent bank runs and the consequent bank failures, the United States established the ________ in 1934 to provide deposit insurance.

FDIC

Microprudentail supervision does all of the following except

Focusing on financial system liquidity

Deposit insurance is only one type of government safety net. All of the following are types of government support for troubled institutions expect

Forgiving tax debt

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

Free-rider; adverse selection

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

Free-rider; adverse selection

Analysis of adverse selection indicates that financial intermediaries, especially banks,

Have advantages in overcoming the free-rider problem, helping to explain why indirect finance is a more important source of business finance than is direct finance

A debt contract is incentive compatible

If the borrower has the incentive to behave in the way that the lender expects and desires, since doing otherwise jeopardizes the borrower's net worth in the business

What do you think prevented the financial crisis of 2007-2009 from becoming a depression?

In general, it is believed that the country as a whole probably learned from the experience of the Great Depression, and have put in place more sophisticated policy frameworks to help deal with severe economic downturns more effectively. For instance, bank panics, which were widespread during the Great Depression, were virtually nonexistent during the 2007-2009 crisis; this is probably due to bank accounts now being insured by the FDIC, when they were not during the Great Depression. Another factor seems to be the resolve by policymakers not to make the same mistakes made during the Great Depression by instituting more aggressive, swifter policies to avoid any contagion effects that would unnecessarily deepen or lengthen the crisis. Specifically, the Federal instituted a number of effective policies in the form of liquidity funding facilities and quantitative easing.

As the costs associated with deposit outflows ________, the banks willingness to hold excess reserves will ________

Increase; increase

The growth of the subprime mortgage market led to

Increased demand for houses and helped fuel the boom in housing prices

Risk that is related to the uncertainty about interest rate movements is called

Interest-rate risk

A venture capital firm protects its equity investment from moral hazard by

It places people on the board of directors to better monitor the borrowing firm's activities

A venture capital firm protects its equity investment from moral hazard through which of the following means

It places people on the board of directors to better monitor the borrowing firm's activities

Which investment bank filed for bankruptcy on September 15, 2008 making it the largest bankruptcy filing in U.S. history?

Lehman Brothers

Because of the adverse selection problem,

Lenders are reluctant to make loans that are not secured by collateral

Why is it a good idea for macroprudential policies to require countercyclical capital requirements?

Leverage cycles indicate that over business cycles, lending increases substantially in booms and decreases substantially in downturns. If countercyclical capital requirements were initiated, this would require more capital held at institutions during booms, which would reduce lending and help to mitigate credit bubbles that can be damaging later on. Likewise, when the economy goes into a downturn, capital requirements could be lowered, which would encourage more lending and facilitate faster economic growth.

American businesses get their external funds primarily from

Loans from nonbank financial intermediaries

When Jane Brown writes a $100 check to her nephew and he cashes the check, Ms. Brown's bank ________ assets of $100 and ________ liabilities of $100.

Loses; loses

Which of the following are primary concerns of the bank manager

Maintaining sufficient reserves to minimize the cost to the bank of deposit outflows

One way of describing the solution that high net worth provides to the moral hazard problem is to say that it

Makes the debt contract incentive compatible

For restrictive covenants to help reduce the moral hazard problem they must be ________ by the lender

Monitored and enforced

Although debt contracts require less monitoring than equity contracts, debt contracts are still subject to ________ since borrowers have an incentive to take on more risk than the lender would like.

Moral hazard

When one party to a transaction has incentives to engage in activities detrimental to the other party, there exists a problem of

Moral hazard

A problem for equity contracts is a particular type of _______ called the _______ problem

Moral hazard; principle-agent

If a bank has ________ rate-sensitive assets than liabilities, a ________ in interest rates will reduce bank profits, while a _________ in interest rates will raise bank profits

More; decline; rise

The result of the too-big-to-fail policy is that _______ banks will take on _______ risks, making bank failures more likely

More; greater

A well-capitalized financial institution has ________ to lose if it fails and thus is ________ likely to pursue risky activities.

More; less

Would moral hazard and adverse selection still arise in financial markets if information were not asymmetric? Explain.

No. If the lender knows as much about the borrower as the borrower does, then the lender is able to screen out the good from the bad credit risks and so adverse selection will not be a problem. Similarly, if the lender knows what the borrower is up to, then moral hazard will not be a problem because the lender can easily stop the borrower from engaging in moral hazard.

The principal-agent problem would not occur if _________ of a firm has complete information about actions of the ____________

Owners; managers

The free-rider problem occurs because

People who do not pay for information use it

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

Principle-agent

The current structure of financial markets can be best understood as the result of attempts by financial market participants to

Reduce transaction costs

The amount of checkable deposits that banks are required by regulation to hold are the

Required reserves

Which of the following bank assets is the most liquid

Reserves

Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding. These clauses are

Restrictive covenants

The Basal Accord, an international agreement, requires banks to hold capital based on

Risk-weighted assets

Banks acquire the funds that they use to purchase income-earning assets from such sources as

Savings accounts

________ is a process of bundling together smaller loans (like mortgages) into standard debt securities

Securitization

If, after a deposit outflow, a bank needs an additional $3 million to meet its reserve requirements, the bank can

Sell $3 million of securities

In general, banks make profits by selling _________ liabilities and buying _________ assets

Short-term; longer-term

If a bank needs to raise the amount of capital relative to assets, a bank manager might choose to

Shrink the size of the bank

The share of checkable deposits in total bank liabilities has

Shrunk overtime

Although the FDIC was created to prevent bank failures, its existence encourages banks to

Take too much risk

The primary difference between the "payoff" and the "purchase and assumption" methods of handling failed banks is

That the FDIC guarantees all deposits when it uses the "purchase and assumption" method

The ___________ that required separation of commercial and investment banking was repealed in 1999,

The Glass-Steagall Act

Government regulations require publicly traded firms to provide information, reducing

The adverse selection problem

What are the costs and benefits of a too-big-to-fail policy?

The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are that it increases the incentives for moral hazard by big banks who know that depositors do not have incentives to monitor the banks' risk-taking activities. In addition, it is an unfair policy because it discriminates against small banks.

A bank asset

The building owned by the bank

How does a general increase in uncertainty as a result of a failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?

The failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity.

Do you think the lemons problem would be more severe for stocks traded on the New York Stock Exchange or those traded over-the-counter? Explain?

The lemons problem would be less severe for firms listed on the New York Stock Exchange because they are typically larger corporations that are better known in the market place. Therefore it is easier for investors to get information about them and figure out whether the firm is of good quality or is a lemon. This makes the adverse selection-lemons problem less severe.

When $1 million 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, then, in the bank's final balance sheet,

The liabilities increase by $1,000,000

When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then

The liabilities of Citibank increase by $10

Explain the principal-agent problem as it pertains to equity contracts

The principals are the stockholders who own most of the equity. The agents are the managers of the firm who generally own only a small portion of the firm. The problem occurs because the agents may not have as much incentive to profit maximize as the stockholders.

If a bank finds that its ROE is too low because it has too much capital, what can it do to raise its ROE?

To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares. Alternatively, it can keep its capital constant, but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds.

The Volcker Rule addresses the off-balance-sheet problem involving

Trading risks

The principle-agent problem

Would not arise if the owners of the firm had complete information about the activities of the managers

You are in the market for a used car. At a used car lot, you know that the blue book value for the cares you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much about the car as you, how much are willing to pay? Why? Assume that you care only about the expected value of the car you buy and that the car values are symmetrically distributed. Note that the expected value of an event is a probability weighted average, the sum of each possible outcome multiplied by the probability of the event occurring. Now you believe the dealer knows more about cars than you. How much are you willing to pay? Why? How can this be resolved in a competitive market?

You are willing to pay the average price. If the distribution of car values is symmetric, you are willing to pay $22,000 for a randomly selected car. You are willing to pay the average price up front: $22,000. However, the dealer will know this, and only sell you a car worth between $20,000 and $22,000. But you know this. So you will only pay $21,000. And so on. This ends with you paying $20,000, and the car being worth $20,000. This is OK for you, but the dealer can never sell cars worth more than $20,000. The resolution, of course, is to get more information. This may include a test drive, mechanical inspection, warranty, etc.

A bank is insolvent when

its liabilities exceed its assets

Long-term customer relationships ________ the cost of information collection and make it easier to ________ credit risks

reduce; screen