ECON CHAPTER 11

Which of the following is true about banks as a source of funding

Banks are not as dominant a source of funding as they once were, but they are still quite important

Which of the following is not a method used to reduce moral hazard?

Credit screening

Define the term economies of scale and explain how a financial intermediary can take advantage of economies of scale.

Economies of scale occur when average costs FALL as production increases. By using STANDARDIZED FORMS for gathering information about potential borrowers and for issuing loans, financial intermediaries can take advantage of economies of scale.

Which of the following states is true as it relates to financial systems?

Ensuring that high-quality borrowers are funded is extremely important Credit to the private sector and GDP are positively related Rich countries have advanced levels of financial development

Indicate the purpose of financial institutions.

For financial intermediation

Which of the following is true?

moral hazard and adverse selection are two obstacles presented by asymmetric information

Mutual funds

offer a low-cost way for savers to diversify

Solutions to the moral hazard in equity financing are complicated unless

owners can easily fire managers.

Debt financing

partially eliminates the problem of moral hazard.

The network that transfers funds from one account to another is called the ________

payment systems

Services offered by banks include

providing Internet access to bank information and ATM machines

Which of the following is a key role played by financial intermediaries, according to the text?

providing liquidity

Today, banks make depositors feel that their deposited funds will be safe in part by

relying on their strong reputations

One way to help with adverse selection problems in financial markets is to

require more collateral from borrowers

To be able to find funds to make large loans, it's essential that banks attract sufficient ______

savers

The concept of moral hazard originated in

the insurance industry

The payment system refers to

the network that transfers funds from one account to another

Which of the following is true about solving principal-agent problems in debt and equity markets?

the problem may be reduced if managers report more directly to owners

How does a mutual fund assist in diversification?

they allow investors to purchase fractions of shares

When adverse selection problems exist in stock and bond markets, high-quality stocks will be priced ________ and high-quality bonds will pay a risk premium that is ___________.

too low; too high

Which of the following is true about adverse selection and loan contracts?

unsecured contracts tend to have higher interest rates

Which of the following is the most liquid asset?

$20 bill

Which of the following is not an example of monitoring to reduce moral hazard?

- A bank employee verifying cars on a new car lot - Financial intermediaries holding a large number of shares in a firm - eBay buyers' insurance

Which of the following is a solution to the moral hazard in equity finance?

- Align managers' interests with stockholders' interests - The ability to fire managers - Require managers to own a stake in the firm

Why do we keep money in commercial banks?

- for debit cards - safekeeping - virtual access to accounts

Historically, goldsmiths

- held gold for people in lieu of a receipt - began to loan gold from wealthy people to the less fortunate - began to hold gold for people as a way of safekeeping

Venture capital firms

- monitor new companies. - specialize in risky ventures.

Financial intermediaries tend to lower the cost of lending and borrowing. Which of the following is NOT a function that achieves this?

- safekeeping and accounting services - supplying liquidity - diversifying risk - pooling resources for small savers

Of the four listed, which of the following nations receives the highest percentage of business financing from financial intermediaries

Japan

Which of the following is NOT a key role played by financial intermediaries, according to the text

Setting interest rates

Suppose two types of firms wish to borrow in the bond market. Firms of type A are in good financial health and are relatively low risk. The appropriate premium over the risk-free rate for lending to these firms is 2 percent. Firms of type B are in poor financial health and are relatively high risk. The appropriate premium over the risk-free rate for lending to these firms is 6 percent. As an investor, you have no other information about these firms except that type A and type B firms exist in equal numbers.

The appropriate interest rate for bonds of type A firms would be: 5 percent. The appropriate interest rate for bonds of type B firms would be: 9 percent. Since investors don't know which type of firm they are dealing with and there is an equal probability of either type of firm, they will only be willing to lend if they receive at least the average rate of: 7 percent Would this market function well? no What type of asymmetric information problem does this example illustrate? Adverse selection

You and a friend visit the headquarters of a company and are awestruck by the expensive artwork and designer furniture that grace every office. Your friend is very impressed and encourages you to consider buying stock in the company, arguing that it must be really successful to afford such elegant surroundings.

The luxurious surroundings could be the result of a principal-agent problem. You should find out if there is a separation between ownership and management and, if so, if there is a pattern of lavish and unnecessary spending by management.

Figure 11.1, which puts domestic credit as a percentage of GDP on the horizontal axis and real GDP per capita on the vertical axis, indicates that ______

There is a strong positive relationship between a nation's financial development and its per-capita real GDP

What type of financing would you expect to find in those countries?

When shareholders can't fire managers, people will be LESS willing to purchase equity because there is no way to discipline managers who fail to act in the interests of the shareholders. Companies in those countries are MORE likely to issue bonds or seek bank loans to obtain funding.

Your parents give you $300 as a graduation gift and you decide to invest the money in the stock market. If you are risk-averse, should you purchase some stock in a few different companies through a website with low transaction fees or put the entire $300 into a mutual fund?

You should put the money into a mutual fund. This reduces your risk by allowing you to acquire fractions of shares in the large number of companies included in the fund, enabling you to spread your risk across a larger number of companies.

What would you expect to happen to the mix between internal financing (where companies use their own funds such as retained earnings) and external financing (where companies obtain funds through financial markets) for new investment projects in a country that experiences a large increase in financial market uncertainty?

You would likely see a RISE in the share of projects financed from retained earnings, as the increased market uncertainty would RAISE the cost of external financing, making it RELATIVELY LESS attractive

Borrowers and lenders come together through banks. As such, this financial institution acts as

a financial intermediary.

According to Akerlof's paper on adverse selection in used car markets, if used cars can be classified as either "peaches" (above-average quality) or "lemons" (below-average quality), then used cars will sell for _______ and the supply of used cars will be made up of ______

a price between a peach and a lemon; lemons only

Adverse selection problems happen _______ a loan is made; moral hazard problems happen ______ a loan is made

before; after

Lending and borrowing involve ______ costs; the text credits financial intermediaries' skill in lowering _______ costs with their continued importance

both transaction and information; information

As a firm's net worth rises, adverse selection problems tend to ______, and pledging personal items as collateral becomes _____ necessary

decrease; less

Liquidity for a bank means

depositors have easy access to funds

The insurance industry tend to be recognized as the starting point for

moral hazard

Consider a $100,000 loan made by a bank. The bank would be most likely to provide risk diversification by

forming the loan from small amounts - say, $100 each - from many deposits

Moral hazard problems occur in stock transactions when

funds are used for reasons that benefit managers instead of owners

The original bankers were _______

goldsmiths

Financial intermediaries can reduce adverse selection problems in lending by

having access to borrower credit info and account history.

Restrictive covenants

help solve the moral hazard in debt finance.

Which of the following best summarizes the information available when a loan is made

information is asymmetric (uneven) because the borrower knows more than the lender

The text showed in an exhibit that the United States, the United Kingdom, Germany and Japan all fund the majority of their businesses through

internal funds

A measure of the ease and cost with which an asset can be turned into the means of payment refers to _______; a highly _____ asset can be transformed into money quickly, easily, and at low cost

liquidity; liquid

Diversification on the part of banks can be achieved by

making loans from many different depositors