Ch 10

Question 1

Main problem with financial markets

Answer 1

asymmetric information

when different parties in a financial contract do not have the same information

Question 2

adverse selection

Answer 2

Big risk takers are more likely to seek loans and more likely to default and never pay back

Lenders may choose to make no loans even to good credit borrower

Question 3

Moral Hazard

Answer 3

Borrowers may use the funds for other high-risk purposes

lenders may choose to make no loan

Question 4

Solutions to adverse selection

Answer 4

private production and sale of information (S&P)

Gov regulation (SEC)

Financial intermediaries

Collateral

Question 5

Government safety net

Answer 5

FDIC, lending from the central bank, providing funds from U.S. Treasury

Question 6

Drawbacks of government safety net - moral hazard

Answer 6

no fear of losing deposits

incentive to take greater risk

Question 7

Drawbacks of government safety net - adverse selection

Answer 7

risk-lovers find banking attractive

depositors have little reason to monitor financial institutions

Question 8

Drawbacks to government safety net - “Too big to fail”

Answer 8

government provides guarantees of repayment to large uninsured creditors of large financial institutions, even when not entitled

banks take on more risk, no incentive for monitorization

financial crisis

Question 9

drawback of gov safety net - financial consolidation

Answer 9

removing restrictions on bank opening and branching

larger and more complex financial organizations challenge regulations - “too big to fail”

Question 10

8 types of financial regulations

Answer 10

1. restrictions on asset holdings
2. capital requirements
3. prompt corrective action
4. financial or prudential supervision - chartering and examination
5. assessment of risk mgmt
6. disclosure requirements
7. consumer protection
8. restrictions on competition

Question 11

Why are regulations of the financial markets difficult?

Answer 11

moving targets of companies who find loopholes, cat and mouse, lobbying politicians

Question 12

Basel Accord risk-weightings

Answer 12

0% - risk-free assets (reserves, cash, Treasuries)

20% - loans to other banks w/ high ratings

50% - residential mortgages

100% - corporate debt

Question 13

formula to tell how well-capitalized a bank is

threshold

Answer 13

capital / total assets

> 5%, well capitalized

Question 14

formula for basel accord

risk weighted capital ratio, threshold

Answer 14

capital / risk-weighted assets

if >8%, hold basel accord requirement

Question 15

capital requirements formulas

Answer 15

Basel accord: risk-based capital requirements

minimum leverage ratio: capital/assets