Money, Banking And Financial Markets 4th Edition By Stephen G. Cecchetti – Test Bank

Chapter 11
The Economics of Financial Intermediation

Conceptual and Analytical Problems

1. Describe the problem of asymmetric information that an employer faces in hiring a new employee. What solutions can you think of? Does the problem persist after the person has been hired? If so, how and what can be done about it? Is the problem more or less severe for employees on a fixed salary? Why or why not? (LO2)

Answer: Prior to hiring a new employee, an employer may have difficulty identifying candidates who would do the best job – that is, there are difficulties in screening candidates in the face of asymmetric information. Probationary periods when the new employee can be terminated are a simple solution to this problem.

After someone has been hired, the employer may not know whether that person is working hard due to problems with monitoring. Salaries based on performance can mitigate the problem by providing the employee with the incentive to work hard without constant monitoring.

A fixed salary makes it difficult to create the proper incentives for employees to do their best and so the problem is likely to be more severe.

2. In some cities, newspapers publish a weekly list of restaurants that have been cited for health code violations by local health inspectors. What information problem is this feature designed to solve, and how? (LO2)

Answer: This solves both adverse selection and moral hazard. People who dine out at restaurants may have a difficult time identifying restaurants that don’t meet certain health standards. Because of this, some people may not want to eat out at all. Also, restaurants don’t have an incentive to follow health regulations if diners can’t distinguish restaurants that meet the health standards from those that don’t. However, publishing the names of restaurants cited for health code violations allows people to identify unsanitary restaurants and thus holds restaurants accountable for following health regulations.

3. What problem associated with asymmetric information was central to Bernard Madoff’s success in cheating so many investors for so long? (LO2)

Answer: The Madoff fraud is an example of a moral hazard problem that arises from the absence of perfect monitoring. Investors with Bernard Madoff did not adequately monitor his behavior to insure that he was using their funds as they expected. Perhaps they assumed that earlier investors had carried out this monitoring and so they did not need to incur the cost. They may also have assumed that the oversight of the SEC was sufficient to safeguard their funds.

4. Financial intermediation is not confined to bank lending but is also carried out by non-bank firms such as mutual fund companies. How do mutual funds help overcome information problems in financial markets? (LO1)

Answer: Mutual funds, like other financial intermediaries, are specialists at screening and monitoring. They assess companies when deciding what stocks and bonds to include in their funds and monitor these companies on behalf of individual investors. By making these choices, the mutual funds alter the asset prices that help guide resources in the economy to their most productive uses.

5. In some countries it is very difficult for shareholders to fire managers when they do a poor job. What type of financing would you expect to find in those countries? (LO3)

Answer: When shareholders can’t fire managers, people will be less willing to purchase equity because there is no way to discipline managers who fail to act in the interests of the shareholders. Companies in those countries are more likely to issue bonds or seek bank loans to obtain funding.

6. Define the term economies of scale and explain how a financial intermediary can take advantage of such economies. (LO1)

Answer: Economies of scale occur when average costs fall as production increases. By using standardized forms for gathering information about potential borrowers and for issuing loans, financial intermediaries can take advantage of economies of scale.

7. The Internet can have a significant influence on asymmetric information problems. (LO2)
a. How can the Internet help to solve information problems?
b. Can the Internet compound some information problems?
c. On which problem would the Internet have a greater impact, adverse selection or moral hazard?

Answer:
a. The Internet provides people with a wealth of information, whether they are evaluating a company before deciding whether to purchase its stock or doing a “Google” search on someone before going out on a date.
b. Not all of the information available is accurate, which can make the problem of adverse selection worse.
c. The Internet provides information to reduce adverse selection, but isn’t very helpful in reducing moral hazard, although in some circumstances it might provide a less costly means of monitoring.

8. The financial sector is heavily regulated. Explain how government regulations help to solve information problems, increasing the effectiveness of financial markets and institutions. (LO1)

Answer: The government requires firms to disclose information. For example, public financial statements prepared according to standard accounting practices are required by the Securities and Exchange Commission. Investors can feel more secure in assessing the financial health of a firm given this government-mandated and standardized information, thus reducing problems associated with adverse selection. Since they know they are required to disclosure certain information, firms may be less willing to engage in excessively risky behavior, reducing problems associated with moral hazard.

9. One of the solutions to the adverse selection problem associated with asymmetric information is the pledging of collateral. However, the collateral may be riskier than initially thought. As an example, explain why the collateral did not work adequately to mitigate the mortgage securitization problems associated with the financial crisis of 2007-2009? (LO3)

Answer: The ultimate collateral behind the mortgage-backed securities were the houses purchased with the mortgages underlying these securities. When house prices fell, the value of the collateral was not sufficient to cover the investments. If the collateral is riskier than thought, the loans are mispriced. The lender should ask for a larger down payment, charge a higher interest rate, or both.

10. *Deflation causes the value of a borrower’s collateral to drop. Define deflation and explain how it reduces the value of a borrower’s collateral. How might a lender who anticipates deflation alter the terms of a loan? (LO3)

Answer: Deflation is a fall in the overall price level. A borrower’s liabilities will remain the same since loan repayment is usually specified in nominal terms. But, the value of the borrower’s assets will decline, decreasing the net worth of the borrower. If the lender properly anticipates the deflation, and thus the falling net worth of the borrower, a higher interest rate should be charged or additional collateral should be required. At the margin, low net worth borrowers will find financing unavailable.