Chapter 11

Question 0

Transaction costs characteristics:

Answer 0

• Banks consolidate savings and lend them out. This lowers the costs of borrowers finding total funds they need individually to equal full amount.
• Avoids major cost of time
• Can do things cheaper
• Mutual fund is cheap

Question 1

What are the 3 factors why financial intermediaries exist:

Answer 1

1. Transaction Costs
2. Diversification
3. Production of information

Question 2

Diversification characteristics:

Answer 2

• Can help portfolio diversification (not all eggs in one basket)
• Example would be intermediaries who offer stock index mutual fund
• A stock index mutual fund is an intermediary that offers small investors a way to participate in the performance of the stock market as a whole, thereby benefiting from diversification.

Question 3

Production of Information:

Answer 3

• Produces information about borrower credit worthiness

- Does this because of asymmetrical information

Question 4

Asymmetrical Information

Answer 4

• occurs when buys and sellers are not equally informed. Example in securities would be issuer knows more about future performance than the investor.

Question 5

Adverse Selection

Answer 5

• arises before financial transaction is consummated. Information related to information about a business before bank makes a loan. Market failure occurs when banks don’t make loans on any small business.

Question 6

Moral Hazard:

Answer 6

• arises after financial transaction occurs. Borrower may choose riskier projects after loan. Owners have more upside potential and lenders have more downside potential. More risk is owners advantage and banks disadvantage.

Question 7

What solves adverse selection and moral hazard?

Answer 7

More information

Question 8

Contracts can be quite restrictive for

Answer 8

monitoring.

Question 9

Which financial intermediaries prospered and which did not?

Answer 9

• winners were mutual funds, pension funds and MMMF

- losers were S&L, mutual savings banks, credit unions, banking industry and life insurance

Question 10

Regulation Q definition:

Answer 10

• gave the Fed the responsibility of imposing ceilings on deposit rates.
• the intent was to promote stability in the banking industry by preventing “destructive competition” among depository institutions trying to outbid each other by offering increasingly higher deposit rates.

Question 11

Regulation Q characteristics:

Answer 11

• Reg Q ceilings made banks non-competitive with deposits.

Question 12

Financial Disintermediation definition:

Answer 12

• when ST rates were higher than Reg Q ceilings, more wealthy individuals would move from deposits to these shorter term instruments and this was called Financial Disintermediation. Had to be in large denominations.

Question 13

First major loophole of Regulation Q was:

Answer 13

Negotiable CD’s

Question 14

Why some financial intermediaries prospered and some didn’t:

- MMMF’s

Answer 14

• money market mutual funds took deposits away from banks as well because smaller investors could benefit from this.

Question 15

Savings and Loan Crisis:

Answer 15

• high and volatile interest rates first
• mostly dependent on small savers for funds
• assets were below liabilities
• assets were constructed on historical cost basis meaning loss was not incurred until sold so this kept people in the dark

Question 16

** Rise of Commercial Paper Market:

Answer 16

• more issuance of corporate paper hurt commercial banks (CB’s)
• banks lost highest quality borrowers to commercial paper via MMMF’s
• banks replaced loans with riskier borrowers and more riskier borrowers in the end of 1980’s than the 1970’s
• migration of financing from ST bank loan to commercial paper represented a shift from non-traded loans to traded loans
• MMMF was trigger for this shift
• advances in computer tech made MMMF lower cost
• analytical techniques combined with Comp tech made it easy for anyone to warrant access to commercial paper market
• tech made it easier to monitor collateralized loans

Question 17

Define Institutionalization:

Answer 17

• the fact that more and more funds in the US have been flowing indirectly into the financial markets through financial intermediaries, particularly pension funds, mutual funds and insurance companies.
• occurred b/c of growth these financial intermediaries brought about by technological and financial innovation mentioned above.

Question 18

Institutionalization of financial markets:

- Pension funds

Answer 18

• pension funds grew b/c gov’t policy and tax laws, encouraging firms to substitute wages for pension benefits. Employers are willing to cooperate b/c wage and pensions are non-taxable to employer.
• changes in how pension funds work enabled them to invest in mutual funds, which helped mutual funds grow.

Question 19

Decline in Banking:

Answer 19

• Bank assets as a fraction of overall assets have decreased, but actual bank assets have increased.
• Banks still have a comparative advantage for smaller loans like individuals or small businesses.
• Banks are still ideal for non-traded loans b/c of production of information.