Money and Banking Test 2 Questions

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.

Rank the following bank assets from most to least liquid: a. Commercial loans b. Securities c. Reserves d. Physical capital

They rank from most to least liquid is (c), (b), (a), (d).

Through the summer and fall of 2008, as the global financial crisis began to take hold, international financial institutions and sovereign wealth funds significantly increased their purchases of U.S. Treasury securities as a safe haven investment. How should this have affected U.S. dollar exchange rates?

This should (and did) lead to a sharp appreciation of the dollar relative to many other currencies. The strong demand for U.S. treasuries led to a rise in the demand for U.S. dollar-denominated assets during this time, hence appreciating the dollar.

If a bank finds that its ROE is too low because it has too much bank 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.

What specific procedures do financial intermediaries use to reduce asymmetric information problems in lending?

To overcome asymmetric information problems, banks screen potential borrowers before making loans (to lessen adverse selection problems), monitor borrowers' financial conditions and how they are using borrowed funds after making loans (to lessen moral hazard problems), insert restrictive clauses into debt contracts to limit borrowers' behavior (to lessen moral hazard), and require collateral against the loans they make (to lessen both adverse selection and moral hazard problems).

When the U.S. dollar depreciates, what happens to exports and imports in the United States?

U.S. dollar depreciation makes U.S. domestic goods cheaper, thus both domestic and foreign consumers buy more U.S.-produced goods. At the same time, imported goods become more expensive since they require more dollars per foreign currency to purchase. Thus, U.S. exports will increase and imports into the United States will decrease.

"A country is always worse off when its currency is weak (falls in value)." Is this statement true, false, or uncertain? Explain your answer.

False. Although a weak currency has the negative effect of making it more expensive to buy foreign goods or to travel abroad, it may help domestic industry. Domestic goods become cheaper relative to foreign goods, and the demand for domestically produced goods increases. The resulting higher sales of domestic products may lead to higher employment, a beneficial effect on the economy.

"Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans." Is this statement true, false, or uncertain? Explain your answer.

False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize in certain types of lending. For example, a bank may have developed expertise in screening and monitoring borrowers for a particular kind of loan, thus improving its ability to handle problems of adverse selection and moral hazard.

If the president of a bank told you that the bank was so well run that it has never had to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in that bank? Why or why not?

No, because the bank president is not managing the bank well. The fact that the bank has never incurred costs as a result of a deposit outflow means that the bank is holding a lot of reserves that do not earn any interest. Thus the bank's profits are low, and stock in the bank is not a good investment.

Would you be more willing to lend to a friend if she had put all of her life savings into her business than you would be if she had not done so? Why?

Yes. The person who is putting her life savings into her business has more to lose if she takes on too much risk or engages in personally beneficial activities that don't lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off.

When the euro appreciates, are you more likely to drink California wine or French wine?

You are more likely to drink California wine because the euro appreciation makes French wine relatively more expensive than California wine.

If you are a banker and expect interest rates to rise in the future, would you prefer to make short-term loans or long-term loans

You should want to make short-term loans. Then, when these loans mature, you will be able to make new loans at higher interest rates, which will generate more income for the bank.

How can asymmetric information problems lead to a bank panic

bank depositors face an asymmetric information problem of their own: They do not know as much as bank managers do about how much risk banks are taking and are uncertain about the safety of their deposits and their banks' ability to pay them back in full. If some banks fail because they have become insolvent and cannot repay their deposits, these bank failures increase the uncertainty facing all depositors, who lack the information needed to determine whether their banks (and their deposits) are safe or not. This increase in uncertainty, the result of asymmetric information, can lead to bank runs in which depositors are scrambling to withdraw their deposits before their banks run out of cash, and in extreme cases can lead to a contagion in which a large number of banks fail within a short period of time.

Why do equity holders care more about ROE than about ROA?

Because ROE, the return on equity, tells stock holders how much they are earning on their equity investment, while ROA, the return on assets, only provides an indication how well the bank's assets are being managed.

Why might a bank be willing to borrow funds from other banks at a higher rate than the rate at which it can borrow from the Fed?

Because if the bank borrows too frequently from the Fed, the Fed may restrict its ability to borrow in the future.

Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves?

Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan markets quickly; thus, it does not need to acquire reserves at a high cost by calling in or selling off loans. The presence of overnight loan markets thus reduces the costs associated with deposit outflows, so banks will hold fewer excess reserves.

A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?

Compensating balances can act as collateral. They also help establish long-term customer relationships, which make it easier for the bank to collect information about prospective borrowers, thus reducing the adverse selection problem. Compensating balances help the bank monitor the activities of a borrowing firm so that it can prevent the firm from taking on too much risk, thereby not acting in the interest of the bank.

Suppose you go to your local bank, intending to buy a certificate of deposit with your savings. Explain why you would not offer a loan, at an interest rate that is higher than the rate the bank pays on certificates of deposit (but lower than the rate the bank charges for car loans), to the next individual who enters the bank and applies for a car loan.

During your visit at the bank you will probably realize that you will receive an annual interest rate of 1% or 2% if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7% or 8%. At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make both of you better off. However, you would probably like to know that individual better, in particular his net worth (to assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?). This process will probably be time consuming and costly for you. Even if you decide to engage in this transaction anyway, you will probably want to write a contract to be able to recover your money if this individual does not pay you back. As before, this will be costly. Your local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information, so much so that you are better off by buying a certificate of deposit and avoiding all the transaction costs associated with making a loan.

How can economies of scale help explain the existence of financial intermediaries?

Financial intermediaries can take advantage of economies of scale and thus lower transactions costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks' large scale allows them to keep legal and computing costs per transaction low. Economies of scale, which help financial intermediaries lower transactions costs, explains why financial intermediaries exist and are so important to the economy.

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

Financial intermediaries develop expertise in such areas as computer technology so that they can inexpensively provide liquidity services such as checking accounts that lower transactions costs for depositors. Financial intermediaries can also take advantage of economies of scale and engage in large transactions that have a lower cost per dollar of transaction.

Why is being nosy a desirable trait for a banker?

In order for a banker to reduce adverse selection she must screen out good from bad credit risks by learning all she can about potential borrowers. Similarly, in order to minimize moral hazard, she must continually monitor borrowers to ensure that they are complying with restrictive loan covenants

Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so?

Investors in financial instruments who engage in information collection face a free-rider problem, which means other investors may be able to benefit from their information without paying for it. Individual investors therefore have inadequate incentives to devote resources to gather information about borrowers who issue securities. Financial intermediaries avoid the free-rider problem because they make private loans to borrowers rather than buy the securities borrowers have issued. Since they will reap all the benefits from the information they collect, their information collection activities will be more profitable. They thus have greater incentive to invest in information collection.

If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation?

It can raise $1 million of capital by issuing new stock. It can cut its dividend payments by $1 million, thereby increasing its retained earnings by $1 million. It can decrease the amount of its assets so that the amount of its capital relative to its assets increases, thereby meeting the capital requirements.

If the Japanese price level rises by 5% relative to the price level in the United States, what does the theory of purchasing power parity predict will happen to the value of the Japanese yen in terms of dollars?

It predicts that the value of the yen will fall 5% in terms of dollars.

If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don't have any excess reserves to lend out? Why or why not? What options are available that will enable you to provide the funds your customer needs?

No. When you turn a customer down, you may lose that customer's business forever, which is extremely costly. Instead, you might go out and borrow from other banks, corporations, or the Fed to obtain funds so that you can make loans to the customer. Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary funds.

If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE?

ROE will fall in half

What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?

The benefit is that the bank now has a larger cushion of bank capital and so is less likely to go broke if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower ROE, return on equity.

What steps can the government take to reduce asymmetric information problems and help the financial system function more smoothly and efficiently?

The government can produce information about borrowers and provide it to investors free of charge, it can require borrowers to report honest information about themselves to investors, and it can set and enforce rules that govern the behavior of financial institutions so they do not take on too much risk. These prudential regulations for banks include banning certain activities and asset categories considered too risky, establishing minimum capital requirements, and requiring disclosure of financial information to regulators and investors.