Banking and Financial Institutions in Society Exam 2 CH 7 & 8

How does an unanticipated decline in the price level cause a drop in lending?

A decline in pricing means a firms net worth has decreased without a corresponding decrease in liabilities. Lower net worth leads to an increase in adverse selection and moral hazard.

How can a sovereign debt crisis make an economic contraction more likely?

A government will try to reduce the current level of debt, to reduce budget deficits. Sovereign debt decreases on the balance sheets of companies holding the debt, decreasing their net worth, leading to asymmetric information, lower lending, and then economic contraction.

How does the concept of asymmetric information help to define a financial crisis?

Asymmetric information plays a major role in crises. Lenders give loans to non-worthy borrowers and they know it (adverse selection), leading to decreasing asset value, higher interest rates, leading worthy borrowers not being able to pay interest rates, increasing adverse selection again. People may also submit fraudulent information just to secure a profit or a loan.

What is a credit spread? Why do credit spreads rise during financial crises?

Credit spreads measure the difference between interest rates on corporate bonds and Treasuries. In a financial crisis, the information about corporate borrowers is less reliable because of asymmetric information. Demand for Treasury bonds has increased because risk relative to corporate bonds has decreased, driving their price up. Demand for corporate bonds has decreased because of their relative risk, driving prices down, and the spread increases.

Why can the provision of several types of financial services by one firm lead to a lower cost of information production?

Definition of economies of scope. Information about one person can be used by many different services. The total costs are not reduced per say, but the average cost is driven down.

Describe two ways in which financial intermediaries can help lower transaction costs in the economy.

Economies of scale and developing expertise. Savings in costs gained by increasing production and becoming knowledgeable about one thing rather than average at many.

How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?

Free rider problem is that not enough information is produced to solve asymmetric information because other people can use it without having to pay for it. Reduces the amount of information collected about the borrowers, thus aggravating adverse selection. Reduces the amount of monitoring in corporations, aggravating moral hazard.

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

In the originate to distribute model, banks created mortgages to sell them as packaged securities and not to hold them for their own benefit. They no longer had the interest of the borrower. with the mortgage-backed securities they weren't lending their own money any more, because they were going to sell the payments of those mortgages as securities, thus making the securities holders the lenders, i.e. the principals. This separated the principal from the agent, because the financial institutions were still originating the loans, and thus gave rise to a principal-agent problem.

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

No. Lender and borrower would know everything about each other.

True, false, or uncertain: Financial engineering always leads to a more efficient financial system.

Not all financial products are successful. When they get too complicated they can do more harm than good.

Explain how the separation of ownership and control in American corporations might lead to poor management.

Principal agent problem- moral hazard. Goals of management and owners are not aligned.

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?

Private information is lost, which increases adverse selection. Public may lose confidence in financial institutions, which increases moral hazard, since lenders are more likely to invest in risky enterprises.

How can financial liberalizations lead to financial crises?

Provides less restriction to financial institutions, increasing asymmetric information while contributing to a spending spree. If the lending spree goes on too long, a financial crisis can occur.

How can a decline in real estate prices cause deleveraging and a decline in lending?

Real estate prices lowering lowers the value of collateral on the mortgages, which decreases firms net worth. Lower net worth leads to increase in adverse selection and moral hazard.

Describe two similarities and two differences between the U.S. experiences dur- ing the Great Depression and those during the global financial crisis of 2007-2009.

Similarities Both started by asset price bubbles high unemployment recession Differences lending spree vs investors expectations Federal Reserve involvement

Which firms are most likely to use bank financing than to issue bonds or stocks to finance their activities?

Smaller firms. Reason is adverse selection, it is harder for investors and lenders to find information on smaller companies, whereas banks can find it easier and faster

How does spinning lead to a less efficient financial system?

Spinning is a practice done by investment bankers where they offer IPO shares to the executives of other corporations at a low price so that the great return they make on that IPO will convince them to use the investment bank's services. Less efficient because the IPO raises less money. Hidden cost of the firm going public.

What is the shadow banking system, and why was it an important part of the 2007-2009 financial crisis?

The shadow banking system is composed by non-depository financial firms that also make loans. Less regulated, could take on more risk. When people started defaulting on loans, they were the first to stop lending. Because they were responsible for a large portion of the spending spree, they were suffering the biggest losses.

What causes bank panics?

When people lose faith in the financial stability of their bank because of an increase in asymmetric information.

How does the provision of several types of financial services by one firm lead to conflicts of interest?

When you are producing information about a firm to be used by the general public while also servicing the firm in a different way. Incentive to provide good information to ensure client's business.

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?

Yes. She thinks the investment is worth it (adverse selection solved) and she will take care of your money to increase her return (moral hazard solved)