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Chapter 11 The Economics of Financial Intermediation Conceptual and Analytical Problems 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? 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. In some cities, media outlets 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? 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. What problem associated with asymmetric information was central to Bernard Madoff’s success in cheating so many investors for so long? 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. 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? 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. 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? 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. Define the term economies of scale and explain how a financial intermediary can take advantage of such economies. 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. The Internet can have a significant influence on asymmetric information problems. How can the Internet help to solve information problems? Can the Internet compound some information problems? 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. The financial sector is heavily regulated. Explain how government regulations help to solve information problems, increasing the effectiveness of financial markets and institutions. 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. 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? 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. 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? 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. Answer: Investors became less sure of their ability to distinguish good firms from bad ones, so their willingness to purchase stocks and bonds decreased. You are in charge of setting policies for implementing construction loans at a bank once the loan officer has approved the borrowers’ applications. (Construction loans finance the development of a structure during the building process and are later converted to mortgages.) How would you protect your bank’s interests? Answer: The loan officer has addressed the adverse selection problem, so you are seeking a solution to a moral hazard problem. To protect the bank’s interests, you first would like the policy to specify collateral. In this case, the land upon which the structure is to be built might be an option for either a home construction project or a business structure. For a business, other options might be requiring collateral in terms of inventory or a requiring the borrowing firm to purchase a certificate of deposit. Second, you would likely release only a portion of the total loan when construction begins. Third, as construction proceeds, you could conduct periodic inspections to be sure that all relevant building codes and other design specifications were being followed prior to releasing additional funding. Your parents give you $2,000 as a graduation gift and you decide to invest the money in the stock market. If you are risk averse, should you purchase some stock in a few different companies through a web site with low transaction fees or put the entire $2,000 into a mutual fund? Explain your answer. Answer: As a small investor, a mutual fund is the best way to reduce risk by diversifying your investment. By purchasing shares in a mutual fund, you can acquire fractions of shares in the large number of companies included in the fund. If you opt to buy individual shares, you will be limited to a handful of companies. Mutual funds offer investors a low-cost way to diversify a small sum across a wide range of companies. Suppose a new website was launched providing up-to-date, credible information on all firms wishing to issue bonds. What would you expect to see happen to the overall level of interest rates in the bond market? Answer: You would expect interest rates overall to fall. The web site would reduce the adverse selection problem by making it easier for investors to distinguish between firms of different levels of creditworthiness. Demand for bonds should rise, raising bond prices and reducing interest rates. Suppose two types of firms wish to borrow in the bond market. Firms of type A are in good financial health and are relatively low risk. The appropriate premium over the risk-free rate for lending to these firms is 2 percent. Firms of type B are in poor financial health and are relatively high risk. The appropriate premium over the risk-free rate for lending to these firms is 6 percent. As an investor, you have no other information about these firms except that type A and type B firms exist in equal numbers. At what interest rate would you be willing to lend if the risk-free rate were 5 percent? Would this market function well? What type of asymmetric information problem does this example illustrate? Answer: The appropriate interest rate for type A firms’ bonds is 7 percent while that for type B firms’ bonds in 11 percent. As investors don’t know which type of firm they are dealing with and there is an equal probability of either type of firm, they will be only be willing to lend if they receive at least the average rate of 9 percent. No. The type A firms would not be willing to pay this interest rate and so would withdraw from the market, leaving only type B firms. This is an example of an adverse selection problem. Only the less desirable firms are willing to borrow. Consider again the low-risk type A firm described in Problem 14. If you were the financial advisor to such a firm, what suggestions would you make to the firm’s management about obtaining borrowed funds? Answer: One suggestion would be to provide as much information as possible about the firm to potential investors in order to identify itself as a type A firm. Ideally, the information should come through someone other than the firm for credibility, so this suggestion might be difficult to implement. Another suggestion would be to utilize the services of a financial intermediary. If the firm has been banking with the same institution for a while, that institution will have evidence of the firm’s quality from its existing accounts and would likely be willing to lend to the firm at a more favorable rate. Consider a small company run by a manager who is also the owner. If this company borrows funds, why might a moral hazard problem still exist? Answer: Even when the owner and the manager of the firm are the same person, when he or she borrows money there is an incentive to take on excessive risk. The downside is limited to the collateral posted while the upside is unlimited. The owner/manager receives all the profits above the loan repayment. The island of Utopia has a very unusual economy. Everyone on Utopia knows everyone else and knows all about the firms they own and operate. The financial system is well developed on Utopia. Everything else being equal, how would you expect the mix on Utopia between internal finance (where companies use their own funds such as retained earnings) and external funding (where companies obtain funds through financial markets) to compare with other countries? What role would financial intermediaries play in this economy? Answer: As Utopia doesn’t suffer from asymmetric information problems to the same degree as other countries, you would expect external finance to be more important. Although overcoming information problems is a key function of financial intermediaries, they also reduce transaction costs and therefore would still have a role in this economy. For example, financial intermediaries could pool savings from small depositors to make a large loan more cheaply than a group of islanders trying to identify those with surplus funds and those needing to borrow in the absence of an intermediary. You and a friend visit the headquarters of a company and are awestruck by the expensive artwork and designer furniture that graces every office. Your friend is very impressed and encourages you to consider buying stock in the company, arguing that it must be really successful to afford such elegant surroundings. Would you agree with your friend’s assessment? What further information (other than the usual financial data) would you obtain before making an investment decision? Answer: The luxurious surroundings could be a result of the principal-agent problem, where managers who do not own the company they run have different objectives than the shareholders. You should find out if there is a separation between ownership and management and if so, if there is any evidence of a pattern of lavish and unnecessary spending by the management. If there is evidence of a clear disconnect between the objectives of the management and the best interests of the shareholders, buying stock in this company is probably not your best option. Under what circumstances, if any, would you be willing to participate as a lender in a peer-to-peer lending arrangement? Answer: Your willingness will likely be influenced by how well you believe the problems associated with asymmetric information can be dealt with. For example, the ability to review credit scores and other financial information of potential borrowers and the accuracy of that information for predicting default should reduce your concerns about adverse selection. The ability to spread your lending across a group of borrowers rather than lend to just one would also reduce the risk associated with choosing one poor-quality borrower. Moral hazard concerns might be alleviated by a commitment from the peer-to-peer lending site you use to report missed payments by borrowers to credit bureaus. You might also consider the time you have available to monitor the loan yourself for signs of trouble. Upon graduation, both you and your roommate receive your first credit cards with identical features. You use your card extensively to make purchases, always paying your credit card balance in a timely manner so that you incur no interest cost. Your roommate pays for everything in cash, reserving the credit card only for an emergency that never happened. After two years, you both look for a new credit card. Explain why you are offered a new card at a much lower interest rate than your roommate, despite both of you working in similar jobs for the same income. Answer: This scenario illustrates the problem of adverse selection. When you and your roommate apply for a credit card at graduation time, you likely had little or no credit history, so the credit card company assumes, in the absence of information to the contrary, that you represent a high default risk. After two years of establishing a credit history through borrowing and timely repayments, your behavior provides the credit card company with information that allows them to revise that assessment. In contrast, even though your roommate behaved in a safe manner, her behavior did not provide sufficient new information to the credit card company to warrant a revised assessment to the same degree. What would you expect to happen to the mix between internal and external financing for new investment projects in a country that experiences a large increase in financial market uncertainty? Answer: You would likely see a rise in the share of projects financed from retained earnings, as the increased market uncertainty would raise the cost of external financing (either direct or indirect), making it relatively less attractive or even unattainable. Data Exploration Financial intermediaries connect savers and borrowers. Examine growth in intermediation from the following perspectives. Plot the ratio of total credit market debt owed (FRED code: TCMDO) to population (FRED code: POP). (Hint: Because credit market debt is expressed in billions and population in thousands, multiply TCMDO by one million to correct for the difference in units.) Interpret the plot. Plot the ratio of total credit market debt to nominal GDP (FRED code: GDP). Interpret the plot. Plot the ratio to nominal GDP of the value added by financial corporate business (FRED code: A454RC1Q027SBEA). Multiply the ratio by 100 to express it in percent. Interpret the plot since 2005. Answer: The plot of per capita credit market debt is: Per capita debt accelerated in the 1980s and again in the 1990s until the onset of the financial crisis of 2007-2009. Unlike other recessions, per capita debt then fell during and after the Great Recession as agents deleveraged; it has begun rising again, but at a slower pace than in the 1980s and 1990s. While per capita debt is large, much of this debt is not the direct obligation of individuals; corporations and the public sector have issued a significant portion of this debt. The plot of total credit market debt relative to GDP is shown below. Financial innovations beginning in the 1980s, such as the popularization of money market mutual funds, facilitated intermediation. As a result, a dollar’s worth of GDP now “supports” a larger volume of debt. The economy also is more highly leveraged.

The ratio to nominal GDP of the value added by financial corporate business is shown below. The financial crisis of 2007-2009 arrested for at least several years the long-term trend of financial deepening (that is, of a rising share of intermediation in GDP). It remains unclear whether the earlier trend will resume on a sustained basis. How has the use of credit evolved in key sectors of the economy? Plot as ratios to total credit market debt outstanding (FRED code: TCMDO) the debt of: (a) households (FRED code: HSTCMDODNS); (b) nonfinancial corporate businesses (FRED code: BCNSDODNS); and (c) the domestic financial sector (FRED code: TCMDODFS). Compared with the prior two decades, account for the pattern of debt in the household sector since 2000. What do the downturns during the financial crisis in the household and financial sector ratios mean in terms of leverage? What important sector is omitted from this plot? Answer: The data plot for the sector ratios is below. Until the financial crisis of 2007-2009, financial firms used an increasing share of outstanding debt in support of intermediation, while other sectors showed a mildly declining share since 1970. The housing boom and bust in the 2000s influenced both the financial firms and households. In the boom, households borrowed (especially through mortgages) as house prices rose. The post-2007 downturns in the household and financial sectors reflect the process of deleveraging. As part of this process, when housing prices fell, many households defaulted, lowering their indebtedness. The key sector omitted from the plot is the public sector (including federal, state and local governments and their agencies). Financial crises are often associated with rising, and then persistently high, unemployment rates. Plot the U.S. unemployment rate during the Great Depression until the end of the 1930s (FRED code: M0892AUSM156SNBR). Compare the U.S. experience then with unemployment rates in Spain (FRED code: LRUN64TTESQ156S ), Greece (FRED code: LRUN64TTGRQ156S), Italy (FRED code: LRUN64TTITQ156S), and Portugal (FRED code: LRHUTTTTPTQ156S) since the beginning of the financial crisis in 2007. (Turn off the recession bars for the European data plot.) Answer: The plot of the unemployment rate in the U.S. in the Great Depression is shown below. Notice that after the unemployment rate rose to about 25 percent in the depths of the Depression, it stayed at elevated levels throughout the 1930s. The post-2007 plot of the unemployment rate in selected European countries is shown below. European employment conditions deteriorated through 2013: in both Greece and Spain, the unemployment rate surpassed 26 percent, while the unemployment rate rose above 17 percent in Portugal and above 11 percent in Italy. As in the United States in the 1930s, unemployment in these European countries remained high for years after the euro-area financial crisis began in earnest in 2009 before beginning to decline. Organization for Economic Co-operation and Development, Unemployment Rate: Aged 15-64: All Persons for Greece© [LRUN64TTGRQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRUN64TTGRQ156S; Unemployment Rate: Aged 15-64: All Persons for Italy© [LRUN64TTITQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRUN64TTITQ156S; Harmonized Unemployment: Total: All Persons for Portugal© [LRHUTTTTPTQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRHUTTTTPTQ156S Unemployment Rate: Aged 15-64: All Persons for Spain© [LRUN64TTESQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRUN64TTESQ156S. The rise of securities markets and the expansion of intermediation by nonbanks has come partly at the expense of commercial banks. Plot the ratio of bank credit (FRED code: TOTLL) to total credit market debt outstanding (FRED code: TCMDO) and comment on the trend. Answer: Relative to total credit market debt, banks’ share has eroded dramatically since the 1970s. Part of this shift reflects the increased access of nonfinancial borrowers to global investors through securities markets. In addition, financial innovations allowed nonbank intermediaries to compete effectively in the supply of credit. Some of these institutions also are more lightly regulated than depositories, as well as being more highly leveraged. Deflation raises the real burden of repaying fixed-rate debt. Japan has recently experienced a long deflation. Plot the percent change from a year ago of consumer prices in Japan (FRED code: JPNCPIALLQINMEI) and discuss the long-term patterns of inflation and deflation. (Turn off the recession bars.) Plot on a new graph the percent change from a year ago of the GDP deflator in Japan (FRED code: JPNGDPDEFQISMEI). How does it compare with the post-1994 evolution of consumer prices? (Turn off the recession bars.) (Hint: The GDP deflator is a price index for all final goods and services produced domestically. It is a broader measure than the price index for goods and services consumed by households in part (a).) Why might deflation become self-perpetuating? Answer: The plot of inflation based on consumer prices in Japan appears below. Japan experienced moderate to high consumer price inflation in the 1960s and 1970s. From the mid-1990s until 2013, Japan endured continuing deflationary pressures. Organization for Economic Co-operation and Development, Consumer Price Index of All Items in Japan© [JPNCPIALLQINMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNCPIALLQINMEI. The plot of inflation based on Japan’s GDP deflator is below. While this index is available only since 1994, it has fallen significantly more than consumer prices in this period, highlighting the breadth and persistence of deflation in Japan. Like consumer prices, however, the GDP deflator began to turn up after 2013. Organization for Economic Co-operation and Development, GDP Implicit Price Deflator in Japan© [JPNGDPDEFQISMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNGDPDEFQISMEI. When debtors have loans denominated in fixed nominal terms, the declining price level raises the real cost of repayment. If borrowers did not anticipate these higher real costs, they may be forced to cut other spending, helping to sustain deflationary pressures. A shift toward expected deflation also raises the real interest rate, diminishing the incentive to spend on consumption or investment, reinforcing downward pressure on prices indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075

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