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How can economies of scale help explain the existenece of financial intermediaries?
High transaction cost greatly effect the average American because they don't have the money to diversify there investing* money. Which intermediaries are cheaper to invest because of economies of scale.
Describe two ways in which financial intermediaries help lower transaction cost in the economy.
1. Economies of Scale - 3 ways to lower costs. A) Bundle Investors. B) Mutual Funds; selling shars to individuals; then proceed in bonds or stocks. C) Telecommunications system for transactions is easier and cheaper.
2. Expertise - A) Having an expert using a computer quickly and effiecently to help customers, with, figuring out how well their investment is doing with a toll-free number. B) Liquidity Services - easier for a customer to conduct a transaction.
Would moral hazard and adverse selection still arise in financial markets if information were not asymmetric? Explain.
No. Asymmetric information is the inability of knowing the borrowers exact intentions. A) Whether its adverse selection(Before transaction) where crooks try to take out loans and never repay. Or B) Whether its moral hazard (After Transaction) where the borrower will take the higher risk route since its not their money they're playing with. NO LEMON PROBLEM HERE!
How do standard accounting principles help financial markets work more efficiently?
By disclosing accurate info about Sales, Assets, and Earnings. Causes it to give more additional info about the company for investors to make wiser decisions. Disclosing requirements wasn't so great (Enron Ex.). It lessons the Lemon problem, but doesn't eliminate. Firms could lie on their Balance Sheets about their substantial amounts of debt and taking off financial contracts, what Enron did.
Do you think the lemons problem would be more severe for stocks traded on the New York Stock Exchange or those traded over-the-counter? Explain.
over-the-counter. A lemon problem is the idea that there isn't enough information about something and a buyer is only seeking to purchase at an average price. Which, the willingness to pay for a "peach" isn't enough and would not be sold. NYSE would have a lot more info than over-the-counter.
Which firms are most likely to use bank financing rather than to issue bonds or stocks to finance their activities? Why?
Smaller firms. Bigger firms are well known and can easily sell bonds and stocks. Smaller firms are better off to finance through the bank.
How can the existence of asymmetric information provide a rationale for gov't regulation of financial markets?
Bringing savers to burrowers... Firms are highly regulated by the gov't because asymmetric information gives uncertainity to people to want to purchuse bonds or securities. This will drop the financial market, thus, the governement regulates it to create more certainity so more cash flows.
Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done so? Why?
I would be willing to do so. Her intentions on this business would always be for a profitable cause and she wouldn't take high risk, thus, you are more likely to get your moeny back.
Wealthy people often worry that others will seek to marry them only for their money. Is this a problem of adverse selection?
Maybe? That woman can be a crook and who only seeks for the death of the significant other and take all his money upon death?
The more collateral there is backing a loan, the less the lender has to worry about adverse selection. Is this statement true, false, or uncertain? Explain.
True. When an individual has a lot of collateral on a loan, the more he will act in the lenders favor because he has much at risk too.
How does the free-rider problem aggravate adverse selection and moral hazard problems in finacial markets?
Adverse Selection - Stock Market; Purchasing information to better yourself on your investment that a private company provides will cost a lot of money. That cost will be given freely to many others that follow your lead.
Moral Hazard - Security Market; Spending time and money monitoring the business. Other people will no and allow you to do all the monitoring, while they sit back and save that monitoring money.
Explain how the seperation of ownership and control in American corporations might lead to poor management.
All these regulations are causing higher prices. Espeacially Has Sarbanes-Oxley and Global Legal Settlement of 2002. These cost are driving out corporations and reducing US capital or poorer management is hired so they make up for their losses.
Why can the provision of several types of financial services by one firm lead to a lower cost of information production?
This is known as economies of scope. Financial institutions are always collecting, producing, and distributing information. Re-using this information can lead to lower cost of info pro.
How does the provision of several types of financial services by one firm lead to conflicts of interest?
Moral Hazard problems are created. 1) Underwriting and Research in Investment Banking 2) Auditing and Consulting in Accounting Firms 3)Credit Assessment and Consulting in Credit-Rating Agencies.
How can conflicts of interest make financial service firms less efficient?
The information that the firms give off isn't provided correctly.
Describe two conflicts of interest that occur when underwriting and research are provided by a single investment firm.
1) When underwriting greatly exceed the brokerage commissions from selling, the bank will have a strong incentive to alter the info to favor the issuing firm's needs or else they will lose that business.
2) Spinning occurs to attarct other exucutives from companies' to their investment bank.
How does spinning lead to a less efficient financial system?
Diminishes the capital market. Why? because an investment bank allocates hot. Initial Public Offerings is a share of newly issued stock to other companies in response for them to trasfer to their banks, which the newly stock goes up in price. Since the new company comes over, they sell their shares with this new bank investment, which would not be the highest price for the company's securities.
Descibe two conflicts of interest that occur in accounting firms.
Auditors may skew things to win consulting business from same clients. Or may audit info systems or tax and finacial plans and put it in their nonaudit counterparts and may criticize the systems or advice.
Which provisions of Sarbanes-Oxley do you think are beneficial, and which are not?
Beneficial- Created PCAOB public acc. oversight board overseen by the SEC to supervise acc. firms. AND made it illegal to provide any nonaudit service to a client. AND increased criminal charges.
Not Beneficial- Increased SEC's budget. AND increased cost for businesses are causing smaller business to list abroad. AND causing US captial to drop.
Which provisions of the Global Legal Settlement do you think are beneficial, and which are not?
Beneficial- Requires investment banks to sever the links between research and securities underwriting. AND banned Spinning AND increased charges AND investment banks to make their analysts recommendations public.
How can a bursting of an asset-price bubble in the stock market help trigger a financial crisis?
Asset-price bubble is the rise of prices in the stock market. Therefore, at the bursting point, it causes all the stocks prices to realign to regular value. When this happens, IT DECREASES NET WORTH, WHICH THEN INCREASES ASYMMETRIC INFORMATION. or LEAD TO A DETERIORATION IN FINANCIAL INSTITUTIONS' BALANCE SHEETS, CAUSING THEM TO DELEVERAGE.
This bubble is driven by: Investor Psychology raising prices, and Credit Booms.
How does an unanticipated decline in the price level cause a drop in lending?
This is in stage 3 of 3 in U.S. financial crisis. This drop in price level creates the Asmmetric Information to be at its highest. Also, can push the I/R even higher. Causing lenders uncertainty rate to lend at its steepest, plus their is very little cash flow at this point and lenders might not have the capital to lend.
When can a decline in the value of a country's currency exacerbate adverse selection and moral hazard problems? Why?
When a country is using foreign currencies rather than their own cash. Typically, developing countries do this. If domestic currency drops, then it effects the firms assets(money) and results in deterioration in the firms' balance sheets, which declines net worth. Declining net worth causes declining in investments and economic activity.
When can a decline in real estate prices cause deleveraging and a decline in lending?
During Mismanagement of Financial Liberalization/Innovation.
When a credit boom comes along because of mismanagement, the governement creates a saftey net, which tells banks to keep lending. "Don't create a bank panic". So they keep lending and are in win/win situation. either investor pays loan or tax payers do. But when this fund ends, they lose their losses on those loans and then drive their net worth (capital) down. Less capital creates a tighter budget and now the deleverage. Deleveraging is seen by depositors and then they withdraw their money out, which leads even to less lending money. Lending boom to Lending crash.
How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?
Bank panic is refrenced as the simultaneous failures of institutions. This is located in Stage 2 of 3 in the U.S. Finacial crisis. Bank panic occurs when businesses are hit with worsening conditions and are uncertain about their banks health and all depositers begin to take their money out of the bank because they maybe saw another big bank fall. This creates less money for the bank to lend to potential businesses to create cash flow.
How does a general increase in uncertainty as a result of a failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?
This can occur because of the failure of a Prominent Financial or Nonfinancial Instituion, a Recession, or a Stock Market Crash.
Any of those makes it hard for lenders to screen good from bad credit risks because information if harder to find about new borrowers.
What are the two ways that spikes in interest rates lead to an increase in adverse selection and moral hazard problems?
1. Bank Panic creates interest rates to shoot up.
2. Decline in cash flow creates a decline in lenders to some good risk borrowers who won't receive the loan cause of limited of cash flow, squezing potentially good risk borrowers out of the picture.
How can government fiscal imbalances lead to a financial crisis?
The imbalances are in emerging market countries (Brazil, Russia) that creates fear of default on governement debt. Therefore, individual investors have a very low demand for governement bonds. Thus, the government forces financial institutions to purchase them. If the debt then declines in price then, this weakens the financial institutions' balance sheets. This can also spark a foreigner exchange crisis and make them pull their money out too. Causing domestic currency vaule to decline. Which results foreigner exchangers currency in the domestic land to be tweaked. This all leads to increase in adverse selection and moral hazard problems.
How can financial liberalizations lead to financial crises?
If managed improperly, where they make excessive amount of risk. Because of less restrictions. Managers tend to go on a lending spree (Credit Boom).
Financial Liberalizations - eliminations of restrictions on financial markets institutions Or when major financial new idea is introduced to the market place(subprime residential mortgage incident).
What role does weak financial regulation and supervision play in causing financial crises?
It's Mismanagement of Financial Liberalization. If there isn't a great supervisor, they will go on a lending spree and have a great amount of risk, where they wont be able to keep up with information resources. Which later the government will put a saftey net in with tax payers money so the bank can take higher risk and possibly receive that profit and not create a bank panic.
Why do debt deflations occur in advanced countries, but not in emerging market countries?
Because our currency is used globally. When we hit debt deflation is because our prices plummit. Emerging markets don't plummit.
What technological innovations led to the development of the subprime mortgage market?
Data Mining - quantitative evaluation of the credit risk for a new class of riskier reidential mortgages.
Why is the originate-to-distribute business model subject to the principal-agent problem?
True. false. or uncertain: Financial engineering always leads to a more efficient financial system.
How did a decline in housing prices help trigger the subprime financial crisis starting in 2007?
It burst the Housing Bubble.
How can opening up to capital flows from abroad lead to a financial crisis?
Bringing capital abroad and not domestically can cause currency issues and less lending to domestic firms.
Why does the "twin crises" phenomenon of currency and banking crisis occur in emerging market countries?
Emerging market countries tend to use foreign currency and there assets are in their currency. So they take a double header with debt.
How can a currency crisis lead to higher interest rates?
When ever prices drop, interest rates rise. Same as vis-versa. Plus this crisis brings them closer to inflation, when inflation goes up, I/R does too.
How can a deterioration in bank balance sheets lead to a currency crisis?
With all the banking systems sitting at the bottom. Its hard to get them on there feet, but to get them on there feet is to encourage capital inflows. This can only be done if interest rates go up, but if interest rates go too high, then they might sink.
Why might a bank be willing to borrow funds from other banks ata higher rate than it can borrow from the Fed?
Creditability- loan from another bank means your creditable. It also sets off a warning light to the Feds that your bank is in trouble. Then regulates other banks.
Rank the bank assets from most to least liquid.
Reserves, securities, physical capital, and commercial loans
Using the T-accounts of the first National Bank and the Second National Bank, describe what happens when Jane Brown Writes a 50 check on her account at the First National Bank to pay her friend Joe Green, who in turn deposits the check in his account at the Second National Bank.
First national bank withdraws 50 bucks from reserve and the checkable deposit accounts. And Second National Bank shows a deposit into reserve and checkable account.
What happens to reserves at the First National Bank if one person withdraws 1000 of cash and another person deposits 500 of cash? Use T-accounts to explain your answer.
Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves?
If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customre down, explaining that you don't have any excess reserves to lend out? Why? What options are available for you to provide the funds your customer needs?
No, 1) you should seek to borrow money at a lower rate and then lend to him at a higher rate. 2) Raise bank capital by selling shares. 3) Sell crapy previous loans at a loss so you can give to your creditable. 4) Cosign another loan at another bank.
If a bank finds that its ROE is too low because it has too much capital, what can it do to raise its ROE?
Reduce amount of bank capital by buying back stock.
Reduce banks capital by paying out dividends
Buy CD's, but with that money purchase securities or sell loans
If a bank is falling short of meeting its capital requirements by 1mil, what three things can it do to rectify the situation?
Issue equity Common Stock
Make fewer loans
sell off securities
"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.
uncertain.. goes both ways. depending.. many banks went down because of putting all their eggs in one basket. but there is a technique of illiminating potential adverse selectioin and moral hazard.
Suppose that you are the manager of a bank whose 100billion of assets have an average duration of 4 years and whose 90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 2% points. What actions could you take to reduce the bank's interest-rate risk?
Suppose that you are the manager of a bank that has 15mil of fixed-rate assets, 30 mill of rate sensitive assets, 25 mil of fixed-rate liabilities, and 20 mil of rate-sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates rise by 5% points. What actions could you take to reduce tha bank's interest-rate risk?
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