TCHE 303 – MONEY AND BANKING

TUTORIAL 5

Từ câu 4 đến 21 là Questions chap 8 Mishkin

1. What kind of moral hazard problems do banks worry about?
The borrowers may not use the loans they receive efficiently. They may invest in dangerous
projects and may be unable to repay the loans to banks. Some measures to
preventmoral hazard are monitoring the borrowers’ activities and restricting risky
behavior,requiring collateral, periodic auditing of the borrowers, etc
2. Describe two ways in which financial intermediaries help lower transaction costs in an
economy.
Two ways: they (1) pool many small deposits together and (2) specialize in loan risk
assessment and other forms of expertise.
The first way in which financial intermediaries help lower transaction costs in the economy
is by pooling many small deposits together. This means that instead of individuals making
small deposits on their own, financial intermediaries collect these small deposits from many
individuals and pool them together. By doing so, they can create a larger pool of funds that
can be used for lending and investment purposes. This pooling of funds allows for
economies of scale, as the intermediaries can make larger loans or investments that would
not have been possible with individual small deposits. This helps to lower transaction costs
because it reduces the number of individual transactions that need to take place.
Additionally, financial intermediaries specialize in loan risk assessment and other forms
of expertise. This means that they have the knowledge and resources to evaluate the
creditworthiness of borrowers and assess the risks associated with lending. By specializing
in this area, financial intermediaries can efficiently allocate funds to borrowers who are most
likely to repay their loans. This helps to lower transaction costs because it reduces the risk of
default and the associated costs of collection and enforcement.
3. Why are financial intermediaries willing to engage in information collection activities
when investors in financial instruments may be unwilling to do so?
Financial intermediaries, such as banks and investment firms, are willing to engage in
information collection activities because they can take advantage of economies of scale and
scope, as well as their expertise in the field. This allows them to gather and analyse
information more efficiently and effectively than individual investors. Additionally,
financial intermediaries can spread the costs of information collection across multiple
clients, making it more cost-effective for them to engage in these activities.
On the other hand, individual investors may be unwilling to engage in information collection
activities due to the high costs and time-consuming nature of the process. They may also
lack the necessary expertise to effectively analyse the information they gather. As a result,
individual investors often rely on financial intermediaries to provide them with the
necessary information and analysis to make informed investment decisions.
In summary, financial intermediaries are willing to engage in information collection
activities because they can take advantage of economies of scale and scope, as well as their
expertise, to gather and analyse information more efficiently and effectively than individual
 investors. Individual investors may be unwilling to engage in these activities due to the high
costs, time-consuming nature, and lack of expertise.
4. How can economies of scale help explain the existence of financial intermediaries?
Economies of scale refer to the cost advantages that a firm can achieve when it increases its
scale of production or operation. In the case of financial intermediaries, economies of scale
can help explain their existence in the following ways:
B. Financial intermediaries are able to operate with lower transaction costs relative to
individual lenders or borrowers. Financial intermediaries, such as banks or credit unions,
deal with a large number of customers and transactions. By pooling together the funds from
many depositors and lending to many borrowers, they can spread their fixed costs (such as
administrative expenses or technology infrastructure) over a larger volume of transactions.
This allows them to achieve cost savings and offer more competitive interest rates to both
lenders and borrowers.
D. Financial intermediaries are relatively large institutions. Due to their large size, financial
intermediaries can benefit from economies of scale in various aspects of their operations.
For example, they can negotiate better deals with suppliers, have access to more resources
and expertise, and have the ability to invest in advanced technology and infrastructure.
These advantages enable them to provide a wider range of financial services and attract
more customers, further enhancing their economies of scale.
A. Financial intermediaries with their vault technology can specialize in keeping deposits
safe. While financial intermediaries do provide a safe place for depositors to keep their
funds, this is not directly related to economies of scale. The ability to specialize in keeping
deposits safe is more of a function of their expertise and infrastructure rather than economies
of scale.
C. Financial intermediaries have exclusive access to communications technology in the
financial sector. This statement is not accurate. While financial intermediaries do utilize
advanced communications technology to facilitate their operations, it is not exclusive to
them. Many other players in the financial sector, such as investment firms or insurance
companies, also have access to similar technology. The use of communications technology
is not directly linked to economies of scale.
In conclusion, the most relevant explanation for the existence of financial intermediaries
based on economies of scale is that they are able to operate with lower transaction costs
relative to individual lenders or borrowers.
5. “The lemons problem applies not only to corporate debt but also to government debt.”
Is this statement true or false? Explain.
The lemons problem refers to issues that arise regarding the value of an investment or
product due to asymmetric information possessed by the buyer and the seller.
The problem of asymmetrical information arises because buyers and sellers don't have equal
amounts of information required to make an informed decision regarding a transaction. The
seller or holder of a product or service usually knows its true value or at least knows
whether it is above or below average in quality. Potential buyers, however, typically do not
have this knowledge, since they are not privy to all the information that the seller has.
The basic tenet of the lemons principle is that low-value cars force high-value cars out of the
market because of the asymmetrical information available to the buyer and seller of a used
car. This is primarily due to the fact that a seller does not know what the true value of a used
car is and, therefore, is not willing to pay a premium on the chance that the car might be a
 lemon. Premium-car sellers are not willing to sell below the premium price so this results in
only lemons being sold.
A lemon is a very disappointing investment in which your expected return is not even close
to being achieved, and more than likely ends up costing you some or all of the capital
committed. Lemon investments can be associated with poor money management, economic
factors, financial fraud, or just plain bad luck.
Like in 2007-2008 (great depression) financial crisis , for some classes of securities trade
has ceased. And where trade does occur, it appears that market prices are well below what
one might believe to be the intrinsic value for that class of security. This seems to be
especially true for those securities where the payouff streams are particularly complex (for
example, CDOs). This misinformation leads to the collapse of complete market and had a
very adverse effects on the life of people.
Solutions to the Lemon Problem
Guarantees and Warranties: Guarantees and warranties benefit both the firm, by attracting
customers with an assurance of higher quality goods and services, as well as consumers
who, in the case of receiving a faulty product, can return the item or have it replaced.
The solution to the adverse selection problem in financial markets is to eliminate
asymmetric information by providing the relevant information regarding borrowers (sellers
of securities) to investors (buyers of securities).
6. 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.
7. Wealthy people often worry that others will seek to marry them only for their money.
Is this a problem of adverse selection?
Yes, this is an example of an adverse selection problem. Because a person is rich, the people
who are most likely to want to marry him or her are gold diggers. Rich people thus may
want to be extra careful to screen out those who are just interested in their money from those
who want to marry for love.
8. Do you think the lemons problem would be more severe for stocks traded on the New
York Stock Exchange or for those traded over-the-counter? Explain.
 The lemons problem would be less severe for firms listed on the New York Stock Exchange
because they are typically larger corporations that are better known in the market place.
Therefore it is easier for investors to get information about them and figure out whether the
firm is of good quality or is a lemon. This makes the adverse selection–lemons problem less
severe.
9. 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.
10. What specific procedures do financial intermediaries use to reduce asymmetric
information problems in lending? (Mishkin, 13e, P.220)
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’ behaviour (to lessen moral
hazard), and
- require collateral against the loans they make (to lessen both adverse selection and moral
hazard problems).
11. What steps can the government take to reduce asymmetric information problems and
help the financial system function more smoothly and efficiently? (Mishkin, 13e, Page
220)
- 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 behaviour 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.
12. How can asymmetric information problems lead to a bank panic?
Even though banks are well suited to overcome the adverse selection and moral hazard
problems inherent in lending because they make private loans and have incentives to invest
in information production about the borrowers to whom they lend, 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.
13. In December 2001, Argentina announced it would not honor its sovereign
(government-issued) debt. Many investors were left holding Argentinean bonds priced
at a fraction of their previous value. A few years later, Argentina announced it would
pay back 25% of the face value of its debt. Comment on the effects of information
asymmetries on government bond markets. Do you think investors are currently
willing to buy bonds issued by the government of Argentina?
Information asymmetries are also present in government bond markets. Usually investors
resort to many information sources about the characteristics of particular governments to
assess their ability or willingness to honor their debt. As the Argentinean case illustrates,
sometimes this lack of information results in huge losses for bondholders. In this respect, the
problem is not significantly different from an investor who decides which corporate bond to
buy, although it may be fair to say that information about corporate bonds is more
standardized (making it easier to compare firms). After the Argentinean default, investors
were willing to buy bonds issued by its government only at a significant risk premium,
making it very costly for Argentina to raise funds in bond markets.
14. How does the free-rider problem aggravate adverse selection and moral hazard
problems in financial markets?
The free-rider problem means that private producers of information will not obtain the full
benefit of their information-producing activities, and so less information will be produced.
This means that there will be less information collected to screen out good from bad risks,
making adverse selection problems worse, and that there will be less monitoring of
borrowers, increasing the moral hazard problem.
15. 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.
16. How do standardized accounting principles help financial markets work more
efficiently?
Standardized accounting principles make profit verification easier, thereby reducing adverse
selection and moral hazard problems in financial markets, hence making them operate
better. Standardized accounting principles make it easier for investors to screen out good
firms from bad firms, thereby reducing the adverse selection problem in financial markets.
In addition, they make it harder for managers to over- or understate profits, thereby reducing
the principal-agent (moral hazard) problem.

17. Which firms are most likely to use bank financing rather than issue bonds or stocks to
finance their activities? Why?

Smaller firms that are not well known are the most likely to use bank financing. Because it
is harder for investors to acquire information about these firms, it will be hard for the firms
to sell securities in financial markets. Banks that specialize in collecting information about
smaller firms will then be the only outlet these firms have for financing their activities.
18. How can the existence of asymmetric information provide a rationale for government
regulation of financial markets?

Because there is asymmetric information and the free-rider problem, not enough information
is available in financial markets. Thus there is a rationale for the government to encourage
information production through regulation so that it is easier to screen out good from bad
borrowers, thereby reducing the adverse selection problem. The government can also help
reduce moral hazard and improve the performance of financial markets by enforcing
standard accounting principles and prosecuting fraud.

19. “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 your answer.

True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less,
because the collateral can be sold to make up any losses on the loan. Thus adverse selection
is not as severe a problem.

20. Explain how the separation of ownership and control in American corporations might
lead to poor management.

The separation of ownership and control creates a principal-agent problem. The managers
(the agents) do not have as strong an incentive to maximize profits as the owners (the
principals). Thus the managers might not work hard, might engage in wasteful spending on
personal perks, or might pursue business strategies that enhance their personal power but do
not increase profits.

21. Gustavo is a young doctor who lives in a country with a relatively inefficient legal and
financial system. When Gustavo applied for a mortgage, he found that banks usually
required collateral for up to 300% of the amount of the loan. Explain why banks might
require that much collateral in such a financial system. Comment on the consequences
of such a system for economic growth.

inefficient legal and financial system >> economic growth?

Financial intermediaries operating in countries with relatively weak property rights and legal
systems usually require a lot of collateral when making loans. The rationale for that
behavior is that in the event that the borrower defaults, the bank knows that it will be quite
difficult and expensive to recover its loan. Therefore, requesting extra collateral might help
the bank speed up the process. In practice, a bank that has requested two other houses as
collateral for a mortgage has better chances to recover its loan in the event of default. Of
course this means that fewer individuals will have access to mortgages (even those with
excellent credit risk are left out), since it is quite difficult to come up with such an amount of
collateral (usually having your parents as cosigners and using your parents’ house as
collateral is not enough). Inefficient financial systems make access to credit much more
difficult in some countries, but it is fair to say that this might be the result of inefficient
legal systems. As explained earlier, inefficient financial systems contribute to lower
economic growth rates. This example illustrates how difficult it can be for a young
individual to buy a house, resulting in less expenditure in residential investment.
 >> Mới explain vế đầu, chưa comment consequences on economic growth (hoặc là
comment chỉ cần nhận xét nó làm lower)

22. Why does the government find it necessary to heavily regulate the financial system?
Give one example of such government involvement into financial markets.

Tựa tựa câu 11 ở trên (asymmetric info), chỉnh lại thêm ý đầu

23. Life insurance companies tend to invest in long-term assets such as loans to
manufacturing firms to build factories or to real estate developers to build shopping
malls and skyscrapers. Automobile insurers tend to invest in short-term assets such as
Treasury bills. What accounts for these differences?

Automobile insurers generally need to have funds readily available when a policyholder
makes a claim, and Treasury bills are highly liquid. Life insurance companies have
liabilities with a much longer horizon. A life insurance policy is expected to pay off in 30
years, say, so that assets with longer horizons correspond to their longer-term liabilities.

24. List three types of financial intermediaries, give examples.

Final answer:

Financial intermediaries, such as banks and finance companies, act as a link between savers
and borrowers. Examples of financial intermediaries include banks, finance companies, and
insurance companies.

Explanation:

A financial intermediary is an institution that operates between savers and borrowers,

providing a place for savers to save and borrowers to obtain funds. Examples of financial
intermediaries include banks, finance companies, and insurance companies. Banks, in
particular, play a crucial role as financial intermediaries by accepting deposits from savers
and providing loans to borrowers.

Finance companies, such as Bank of America Merrill Lynch Dealer Financial Services,
Chase Auto Finance, and Ford Motor Credit Company, specialize in making loans directly
to consumers and buying installment contracts from merchants who sell goods on credit.

Insurance companies and pension funds are also financial intermediaries, but they are not
depository institutions like banks and finance companies.

25. Joe and Mike purchase identical houses for $200,000. Joe makes a down payment of
$40,000, while Mike only puts down $10,000; for each individual, the down payment is
the total of his net worth. Assuming everything else is equal, who is more highly
leveraged? If house prices in the neighborhood immediately fall by 10 percent (before
any mortgage payments are made), what would happen to Joe’s and Mike’s net worth?

Explanation:
Joe and Mike both purchase identical houses which has a net worth of $200,000.
 Down Payment made by Joe: $40,000
Down Payment made by Mike: $10,000
Down Payment is the total of his net worth for both individuals.

A) Who is more highly leveraged?

Mike borrowed $190,000 and Joe borrowed $160,000
Mike is more leveraged because he borrows much more to purchase a $200,000
house.

Mike's leverage ratio:LR = $200,000/$10,000 = 20.

Joe's leverage ratio: LR = $200,000/$40,000 = 5.

B) If housing prices in the neighborhood immediately fall by 10%, what

would happen to Joe'sand Mike's net worth?

ROE = (ROA) (LR)

Mike: ROE = (-10%) (20) = -200%

Mike will have a decrease of 200% in his net worth. He will surly go bankrupt as
the value of his assets are less than the value of the liabilities on him.

Joe: ROE = (-10%) (5) = -50%

Mike will have a decrease of 50% in his net worth. He still has the worth of his
property because his assets are still greater than his liabilities.

26. You decide to start a business selling covers for smartphones in a mall kiosk. To buy
inventory, you need to borrow some funds. Why are you more likely to take out a bank loan
than to issue bonds?

27. Why do large corporations find it easier to raise funds in securities markets while small
businesses rely mostly on bank loans?

28. Will finance companies be replaced by commercial banks?

29. Discuss the following: Money market funds attract money from investors who do not know
what else to do with their money. Thus money market funds are merely a last resort when
there are no better alternatives for investment. Since they invest only in short term securities,
they do not play a role in financing economic growth.

30. Why can a money market mutual fund allow its shareholders to redeem shares at a fixed
price but other mutual funds cannot?

31. Should financial institutions be regulated in order to reduce their risk? Offer at least one
argument for regulation and one argument against regulation.