Chapter 11

Financial innovation can lead to financial crises​ as:

financial institutions lack the ability to monitor credit risks of the new financial products.

Identify the differences between the United​ States' experiences during the Great Depression and the Great Recession financial crisis of​ 2007-2009. ​(Check all that​ apply.)

no bank panic occurred in 2007-2009 as opposed to the Great Depression The two episodes differ in the source of asset-price increases

A​ well-functioning financial​ system:

solves asymmetric information problems.

It is a good idea for macroprudential policies to require countercyclical capital requirements​ because:

this type of policy reduces lending and helps to mitigate credit bubbles during economic booms.

How did the global financial crisis promote a sovereign debt crisis in​ Europe?

-Surging budget deficits raised fears that governments might default on their​ debt, causing interest rates on that debt to soar. -Government outlays rose as bailouts became necessary for failing financial institutions. -The contraction in economic activity accompanying the financial crisis sharply reduced tax revenues for many governments.

Which of the following were effects from a decline in housing prices that helped trigger the subprime financial crisis in the United States starting in​ 2007? 1. Subprime borrowers found that the value of their houses fell below the amount of the mortgage. 2. Defaults on houses declined during this period. 3. Banks began to restrict the availability of credit to households.

1 and 3 only

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

A decline in the price level raises the real value of borrowing​ firms' liabilities while lowering the​ firms' real net worth

What role did the shadow banking system play in the​ 2007-2009 financial​ crisis?

A decrease of funding from the shadow banking system caused a restriction of lending and a decline in economic activity.

How can a bursting of an​ asset-price bubble in the stock market trigger a financial crisis​?

All of the above

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

All of the above are correct (Once the mortgage broker earns his or her​ fee, the broker does not care if the borrower makes good on his payment The more volume the broker​ originates, the more he or she makes The mortgage broker has little incentive to ensure the borrower is​ credit-worthy, since loans will be sold as​ mortgage-backed securities)

Which of the following is associated with asymmetric information in a financial​ crisis?

All of the above are correct. (Moral hazard could occur when only borrowers know if the funds will be used to finance​ high-risk activities. Adverse selection can occur if lenders must select from a pool of bad credit risks. There is a lack of information about one or more of the parties involved in a transaction.)

During the subprime financial crises of​ 2007-2008, why did Canadian banks fare better than banks in other​ countries?

All of the above.

Select one reason why Canadian banks fared better than banks in the United States and other countries in the financial crises?

Canadian banks are​ well-diversified and do not limit themselves to traditional retail banking.

Why do credit spreads rise significantly during a financial​ crisis?

Credit spreads rise because asymmetric information problems​ increase, making it more difficult to judge the risk of potential borrowers.

Financial engineering always leads to a more efficient financial system.

False

Define​ "financial frictions." Explain why an increase in financial frictions is a key element in financial crises

Financial frictions are a set of conditions that prevent financial markets from effectively assigning funds to the best investment opportunities. Financial frictions are a key element in financial crises because as the channelling of funds through the financial market is interrupted or​ limited, the economy slows down. This could trigger an asset-price decline, an increase in uncertainty, and the deterioration in financial institutions' balance sheets.asset-price increase, a decrease in uncertainty, and the improvement in financial institutions' balance sheets.asset-price decline, an increase in uncertainty, and the deterioration in financial institutions' balance sheets.

What would be the result of an increase in haircuts on​ collateral?

Financial institutions would engage in fire sales on assets.

What are the three approaches to limiting the​ too-big-to-fail problem? Select all that apply

Imposing higher capital requirements on the large SIFIs. Forcing the large SIFIs to break up their different activities into​ smaller, cohesive companies. Imposing stricter regulations on​ SIFIs, and through application of the Volcker rule.

What role does weak financial regulation and supervision play in causing financial​ crises?

It allows financial institutions a better opportunity to engage in excessive​ risk-taking behaviour.

How does the process of financial innovation impact the effectiveness of macroprudential​ regulation?

It may be difficult for regulators to understand how new financial innovations will impact the overall financial​ system, as these innovations may often be mismanaged or misunderstood.

Which of the following statements is likely to contradict the idea that the Fed was responsible for the U.S. housing price bubble of the​ mid-2000s? ​(Select all that​ apply.)

Lowering of lending standards The Fed set the federal funds interest rate​ (a benchmark interbank loan​ rate) at an extremely low level.

Deposit insurance prevents financial crisesLOADING.... Is this statement always​ true? Which of the following statements support your​ answer? ​(Select all that​ apply.)

No Deposit insurance creates moral hazard​ incentives, encouraging risk taking on the part of banks Deposit insurance is unable to prevent the effects of an asset price decline or the spread of a financial crisis to international financial markets.

Some countries do not advertise that a system of deposit insurance like the CDIC in Canada exists in their banking system. Which of the following explain why some countries do not advertise that a system of deposit insurance exists in their banking​ system?​ (Select all that​ apply.)

Not advertising deposit insurance may reduce the problem of moral​ hazard, which is created by a system of deposit insurance. The information about the presence of a system of deposit insurance makes depositors and bank clients less likely to monitor a​ bank's activities.

Which of the following statements are likely to be in favour of the idea that the Fed was responsible for the U.S. housing price bubble of the​ mid-2000s? ​(Select all that​ apply.)

The Fed was not stringent enough in regulating and monitoring financial intermediaries. The Fed set the federal funds interest rate​ (a benchmark interbank loan​ rate) at an extremely low level.

Why do bank panics worsen asymmetric information problems in credit​ markets?

The collection of information about the creditworthiness of​ borrower-spenders is inhibited.

What is a credit​ spread?

The difference between interest rates on loans to households and businesses and interest rates on completely safe assets such as U.S. Treasury bonds.

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

The mortgage broker has little incentive to ensure the borrower is​ credit-worthy, since loans will be sold as​ mortgage-backed securities

Which of the following did not help prevent the financial crisis of​ 2007-2009 from becoming a​ depression?

The purchase of stock and ownership takeovers of troubled banks by the Federal Reserve.

Why would haircuts on collateral increase sharply during a financial​ crisis?

There is an increase in the uncertainty over the value of assets.

What is the disadvantage of the break up​ large, systemically important financial​ institutions?

There might be a decrease in the efficiency of the financial system.

Advances in computer technology and new statistical techniques led to the development of subprime mortgages.

True

​'A general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard​ problems.' Is this statement true or​ false?

True because of the inability of lenders to accurately separate risks.

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

When housing prices​ fell, many subprime borrowers found that the value of the house fell below the amount of the mortgage. As subprime borrowers could not make their​ payments, it led to many​ defaults, and struggling homeowners had incentives to walk away from their houses when housing prices fell. This created a deterioration in​ banks' balance​ sheets, and with these weaker balance​ sheets, banks began to sell off assets. Faced with reduced​ capital, the banks began to restrict the availability of credit to households and​ businesses, leading to a slowing of the economy.

Consumer protection provisions were included in the financial reform legislation in the aftermath of the global financial crisis​ because:

consumer protection would avert future financial problems related to the issuance of residential mortgages.

A deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity​ by:

creating a substantial contraction in their capital that decreases lending and investment spending.