Money and Banking Midterm 2

To minimize moral hazard, many banks require:

A) covenants in a loan contract. B) compensating balances. C) collateral. D) All of the answers are correct.

Place the following list in a bank's balance sheet: checking deposits, commercial and industrial (C&I) loans, reserves, nontransaction deposits, bank capital, buildings, securities, consumer loans, borrowings.

ASSETS: Reserves, C&I loans, Consumer loans, securities, buildings LIABILITIES: Checking deposits, non transaction deposits, borrowings, bank capital

To reduce information asymmetries in financial market, we can use:

All of the answers are correct

________ occurs when one party in a transaction has more information than the other.

Asymmetric information

Briefly explain the reason for the decline in banks' core funds beginning in the 1970s and the consequences of this shift

Core funds, mainly checking deposits, were the main source of funding for banks' loans. In the 1970s, new types of interest-bearing instruments were introduced, money market mutual funds and mutual funds, the removal of interest restrictions on checking accounts, and increased banking competition, which channeled money away from core funds.The consequences of this shift is that banks can no longer rely on "free money" to fund loans, so they have had to offer more high-interest accounts, "purchased funds," squeezing profits. As a result, banking fees have risen, as have "off-balance-sheet" activities such as underwriting.

Subprime lenders include: A) payday lenders .B) pawnshops. C) loan sharks. D) All of the answers are correct.

D) All of the answers are correct.

Consider a bank with the following income statement: It has $100 in loans with an interest rate of 5 percent; $50 in security holdings, paying 10 percent; reserves of $10; $100 in savings accounts that earn an interest rate of 2.5 percent; checking deposits equal to $30, a net worth of $30, and other expenses of $15. Find bank profit, the return on equity, and return on assets.

First, we need to find bank profit which is equal to total income minus total expenses: Total Income: 100 x .05 + 50 x .1 = 10 Total expenses: 100 x .025 = 2.5 Profit= 10-2.5=$7.50 Return on equity is given by: ROE = Profit/capital = 7.50/30=25% and return on assets is: ROA= Profit/assets = 7.50/160=4.69% where assets are equal to: .Assets loans securities reserves= 100+50+10=160

One of the main reasons that investment banks are used to underwrite initial public offerings is they:

Help to reduce the problem of adverse selection

A Ponzi scheme is characterized by:

II only

Hedge funds often use ________, which is/are defined as ________

Leverage; borrowing money to buy other assets

The key difference between mutual funds and hedge funds is that mutual funds are

More heavily regulated to protect small investors

Which of the following arranges a bank's assets from most to least liquid? A)Loans Checkable deposits Reserves B)Checkable deposits Savings accounts Federal funds C)Reserves Savings accounts Securities D)Reserves Securities Loans

Reserves Securities Loans

For economists, when a household buys a share of Google it is:

Saving

Efficient-markets hypothesis (EMH)

Says that the price of every stock equals the value of the stock, so no stock is a better buy than any other

Over time, stock ownership has spread to a larger fraction of the U.S. population. Which of the following can be identified as a reason behind this trend?

The 401(k) plans that channel workers' retirement savings into securities have grown.

Which of the following allowed Fannie Mae and Freddie Mac to pay relatively low interest on their bonds?

They were implicitly backed by the U.S. government.

An investment bank's duties include

Underwriting large investments and providing financial advice

letter of credit

a bank's guarantee, in return for a fee, of a payment promised by a firm

Consequences of the adverse selection problem in securities markets include:

a decrease in the overall number of good-quality securities issued.

asymmetric information

a situation in which one side of the market has more reliable information than the other side

Security issuers have more elements to assess the quality of a security than the potential buyer of such a security. This creates a problem in securities markets known as:

adverse selection

Banks are reluctant to lend to borrowers with weak credit histories because of _____; they rely on ______ to reduce this problem.

adverse selection; credit reports

When a firm issues bonds instead of stocks it is lessening the problem of ________ because bonds ________.

adverse selection; pay a given amount as long as the firm does not default

Net worth is:

assets minus liabilities.

Off-balance-sheet (OBS) activities

bank activities that produce income but are not reflected in the assets and liabilities reported on the balance sheet

purchased funds

banks' expensive sources of funds (borrowings and large time deposits)

core deposits

banks' inexpensive sources of funds (checking deposits, savings deposits, and small time deposits)

The adverse selection problem helps to explain why sometimes firms issue _____ rather than _____

bonds; stocks

Unlike brokers, who ________, dealers ________

buy and sell securities for others; buy and sell securities for themselves

The reason the Modigliani-Miller theory holds is because according to the ________, the price of a stock or bond equals the ________

classical theory; present value of its expected income

Banks that are considered too big to fail

could disrupt the entire financial system if allowed to fail.

An institution that is owned by its depositors is called a:

credit union

Which of the following is a "thrift" institution? A) finance company B) insurance company C) commercial bank D) credit union

credit union

vault cash

currency in banks' branches and ATMs

Because the efficient markets hypothesis states that analysts ________, it is best to choose a(n) ________ mutual fund.

do no better than the market; indexed

Banks typically have standardized contracts for the most common loans (e.g., car loans), which significantly decrease the cost of making these loans. The concept of spreading such costs over many loans is known as:

economies of scale.

When banks merge they benefit from ________ which reduces ________.

economies of scale; transaction costs

Which of the following is not an off-balance-sheet bank activity? A) federal fund loans B) investment banking C) derivatives D) lines of credit

federal fund loans

Loans from one bank to another are called:

federal funds

Primary markets are where

firms and governments issue new securities

The main problem with moral hazard in the bond market is that:

firms take excessive risks with their borrowed funds.

indirect finance

funds are loaned and borrowed through a financial intermediary

loan guarantee

government promise to pay off a loan if the borrower defaults

Fannie Mae and Freddie Mac are both an unusual kind of institution called:

government sponsored enterprises.

An over-the-counter market differs from a stock exchange because it

has no physical location

Empirical research that examined mutual funds with above-average returns found that _____, thereby adding to the body of evidence _____ the efficient markets hypothesis

in general, these funds did not beat the market index in the following years; supporting

Most households that buy and sell securities do so

in the secondary market.

Securitization benefits for banks include:

increased liquidity.

In securities markets, we can see evidence for the free-rider problem because:

individual savers can observe others' actions and do the same.

usury laws

laws that impose an upper limit on the interest rate that lenders can charge

The moral hazard problem is _____ severe in bond markets than in stock markets. In addition, moral hazard arises in bond markets when firms issue bonds with ____ default risk.

less; high

The primary assets of commercial banks are ________, but they also earn income from holdings of ________

loans; bonds

Finance companies only ________; they do not ________.

make loans; accept deposits

Hostile takeovers reduce ________ because if a company is poorly managed, there is an incentive to ________.

moral hazard; change things

Community banks continue to play a strong role in the economy because:

of their role in reducing adverse selection.

Return on assets

profits/assets

Return on Equity

profits/capital

A ________ is when a bank sells a security to another institution with a promise to buy it back later.

repurchase agreement

Because ________ generate no income, banks hold a ________ portion of their assets in this form.

reserves; small

When choosing which types of assets to hold, the buyer must determine the trade-off between:

risk and return

Direct finance

savers buy securities from investors in financial markets

Banks mitigate adverse selection by:

screening potential borrowers.

The process of transforming loans into securities is called

securitization

Banks are allowed to hold all of the following, except:

stocks

According to the Modigliani-Miller theorem, ________ and ________ are ________ ways to raise funds

stocks; bonds; equally good

Commercial banks' main function(s) is(are) to

take deposits and make loans

Reasons why indirect finance is so important include:

the fact that banks provide liquidity to depositors

The efficient markets hypothesis (EMH) states that

the price of every stock equals the value of the stock, so no stock is a better buy than any other.

adverse selection

the problem of incomplete information - of choosing alternatives without fully knowing the details of available options

Which of the following is an advantage of issuing stocks over issuing bonds as a way to raise funds?

the risk of bankruptcy

reserves

vault cash plus banks' deposits at the Federal Reserve. (the most liquid asset)

Pawnshops give small short-term loans but require ________ in return.

very high collateral

The free-rider problem arises:

when people benefit from a good without paying for it.