CH-8-9 An Economic Analysis of Financial Structure – The Economics of Money, Banking and Financial Markets : Exam Guide

This Document Contains Chapters 8 to 9 Chapter 8 An Economic Analysis of Financial Structure 8.1 Basic Facts About Financial Structure Throughout the World 1) American businesses get their external funds primarily from A) bank loans. B) bonds and commercial paper issues. C) stock issues. D) loans from nonbank financial intermediaries. Answer: D 2) Of the sources of external funds for nonfinancial businesses in the United States, loans from banks and other financial intermediaries account for approximately ________ of the total. A) 6% B) 40% C) 56% D) 60% Answer: C 3) Of the sources of external funds for nonfinancial businesses in the United States, corporate bonds and commercial paper account for approximately ________ of the total. A) 5% B) 10% C) 32% D) 50% Answer: C 4) Of the following sources of external finance for American nonfinancial businesses, the least important is A) loans from banks. B) stocks. C) bonds and commercial paper. D) loans from other financial intermediaries. Answer: B 5) Of the sources of external funds for nonfinancial businesses in the United States, stocks account for approximately ________ of the total. A) 2% B) 11% C) 20% D) 40% Answer: B 6) Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are true? A) Stocks are a far more important source of finance than are bonds. B) Stocks and bonds, combined, supply less than one-half of the external funds. C) Financial intermediaries are the least important source of external funds for businesses. D) Since 1970, more than half of the new issues of stock have been sold to American households. Answer: B 7) Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are true? A) Issuing marketable securities is the primary way that they finance their activities. B) Bonds are the least important source of external funds to finance their activities. C) Stocks are a relatively unimportant source of finance for their activities. D) Selling bonds directly to the American household is a major source of funding for American businesses. Answer: C 8) With regard to external sources of financing for nonfinancial businesses in the United States, which of the following are accurate statements? A) Marketable securities account for a larger share of external business financing in the United States than in Germany and Japan. B) Since 1970, most of the newly issued corporate bonds and commercial paper have been sold directly to American households. C) Direct finance accounts for more than 50 percent of the external financing of American businesses. D) Smaller businesses almost always raise funds by issuing marketable securities. Answer: A 9) Nonfinancial businesses in Germany, Japan, and Canada raise most of their funds A) by issuing stock. B) by issuing bonds. C) from nonbank loans. D) from bank loans. Answer: D 10) As a source of funds for nonfinancial businesses, stocks are relatively more important in A) the United States. B) Germany. C) Japan. D) Canada. Answer: D 11) Direct finance involves the sale to ________ of marketable securities such as stocks and bonds. A) households B) insurance companies C) pension funds D) financial intermediaries Answer: A 12) Regulation of the financial system A) occurs only in the United States. B) protects the jobs of employees of financial institutions. C) protects the wealth of owners of financial institutions. D) ensures the stability of the financial system. Answer: D 13) One purpose of regulation of financial markets is to A) limit the profits of financial institutions. B) increase competition among financial institutions. C) promote the provision of information to shareholders, depositors and the public. D) guarantee that the maximum rates of interest are paid on deposits. Answer: C 14) Property that is pledged to the lender in the event that a borrower cannot make his or her debt payment is called A) collateral. B) points. C) interest. D) good faith money. Answer: A 15) Collateralized debt is also know as A) unsecured debt. B) secured debt. C) unrestricted debt. D) promissory debt. Answer: B 16) Credit card debt is A) secured debt. B) unsecured debt. C) restricted debt. D) unrestricted debt. Answer: B 17) The predominant form of household debt is A) consumer installment debt. B) collateralized debt. C) unsecured debt. D) unrestricted debt. Answer: B 18) If you default on your auto loan, your car will be repossessed because it has been pledged as ________ for the loan. A) interest B) collateral C) dividend D) commodity Answer: B 19) Commercial and farm mortgages, in which property is pledged as collateral, account for A) one-quarter of borrowing by nonfinancial businesses. B) one-half of borrowing by nonfinancial businesses. C) one-twentieth of borrowing by nonfinancial businesses. D) two-thirds of borrowing by nonfinancial businesses. Answer: A 20) A ________ is a provision that restricts or specifies certain activities that a borrower can engage in. A) residual claimant B) risk hedge C) restrictive barrier D) restrictive covenant Answer: D 21) A clause in a mortgage loan contract requiring the borrower to purchase homeowner's insurance is an example of a A) proscriptive covenant. B) prescriptive covenant. C) restrictive covenant. D) constraint-imposed covenant. Answer: C 22) Which of the following is not one of the eight basic puzzles about financial structure? A) Stocks are the most important source of finance for American businesses. B) Issuing marketable securities is not the primary way businesses finance their operations. C) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. D) Banks are the most important source of external funds to finance businesses. Answer: A 23) Which of the following is not one of the eight basic puzzles about financial structure? A) Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. B) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. C) Collateral is a prevalent feature of debt contracts for both households and business. D) There is very little regulation of the financial system. Answer: D 8.2 Transaction Costs 1) The current structure of financial markets can be best understood as the result of attempts by financial market participants to A) adapt to continually changing government regulations. B) deal with the great number of small firms in the United States. C) reduce transaction costs. D) cartelize the provision of financial services. Answer: C 2) The reduction in transactions costs per dollar of investment as the size of transactions increases is A) discounting. B) economies of scale. C) economies of trade. D) diversification. Answer: B 3) Which of the following is not a benefit to an individual purchasing a mutual fund? A) reduced risk B) lower transactions costs C) free-riding D) diversification Answer: C 4) Financial intermediaries develop ________ in things such as computer technology which allows them to lower transactions costs. A) expertise B) diversification C) regulations D) equity Answer: A 5) Financial intermediaries' low transaction costs allow them to provide ________ services that make it easier for customers to conduct transactions. A) liquidity B) conduction C) transcendental D) equitable Answer: A 6) How does a mutual fund lower transactions costs through economies of scale? Answer: The mutual fund takes the funds of the individuals who have purchased shares and uses them to purchase bonds or stocks. Because the mutual fund will be purchasing large blocks of stocks or bonds they will be able to obtain them at lower transactions costs than the individual purchases of smaller amounts could. 8.3 Asymmetric Information: Adverse Selection and Moral Hazard 1) A borrower who takes out a loan usually has better information about the potential returns and risk of the investment projects he plans to undertake than does the lender. This inequality of information is called A) moral hazard. B) asymmetric information. C) noncollateralized risk. D) adverse selection. Answer: B 2) The presence of ________ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets. A) noncollateralized risk B) free-riding C) asymmetric information D) costly state verification Answer: C 3) The problem created by asymmetric information before the transaction occurs is called ________, while the problem created after the transaction occurs is called ________. A) adverse selection; moral hazard B) moral hazard; adverse selection C) costly state verification; free-riding D) free-riding; costly state verification Answer: A 4) If bad credit risks are the ones who most actively seek loans then financial intermediaries face the problem of A) moral hazard. B) adverse selection. C) free-riding. D) costly state verification. Answer: B 5) An example of the ________ problem would be if Brian borrowed money from Sean in order to purchase a used car and instead took a trip to Atlantic City using those funds. A) moral hazard B) adverse selection C) costly state verification D) agency Answer: A 6) The analysis of how asymmetric information problems affect economic behavior is called ________ theory. A) uneven B) parallel C) principal D) agency Answer: D 8.4 The Lemons Problem: How Adverse Selection Influences Financial Structure 1) The "lemons problem" exists because of A) transactions costs. B) economies of scale. C) rational expectations. D) asymmetric information. Answer: D 2) Because of the "lemons problem" the price a buyer of a used car pays is A) equal to the price of a lemon. B) less than the price of a lemon. C) equal to the price of a peach. D) between the price of a lemon and a peach. Answer: D 3) Adverse selection is a problem associated with equity and debt contracts arising from A) the lender's relative lack of information about the borrower's potential returns and risks of his investment activities. B) the lender's inability to legally require sufficient collateral to cover a 100% loss if the borrower defaults. C) the borrower's lack of incentive to seek a loan for highly risky investments. D) the lender's inability to restrict the borrower from changing his behavior once given a loan. Answer: A 4) The ________ problem helps to explain why the private production and sale of information cannot eliminate ________. A) free-rider; adverse selection B) free-rider; moral hazard C) principal-agent; adverse selection D) principal-agent; moral hazard Answer: A 5) The free-rider problem occurs because A) people who pay for information use it freely. B) people who do not pay for information use it. C) information can never be sold at any price. D) it is never profitable to produce information. Answer: B 6) In the United States, the government agency requiring that firms that sell securities in public markets adhere to standard accounting principles and disclose information about their sales, assets, and earnings is the A) Federal Communications Commission. B) Federal Trade Commission. C) Securities and Exchange Commission. D) Federal Reserve System. Answer: C 7) Government regulations require publicly traded firms to provide information, reducing A) transactions costs. B) the need for diversification. C) the adverse selection problem. D) economies of scale. Answer: C 8) A lesson of the Enron collapse is that government regulation A) always fails. B) can reduce but not eliminate asymmetric information. C) increases the problem of asymmetric information. D) should be reduced. Answer: B 9) That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that these intermediaries A) have been afforded special government treatment, since used car dealers do not provide information that is valued by consumers of used cars. B) are able to prevent potential competitors from free-riding off the information that they provide. C) have failed to solve adverse selection problems in this market because "lemons" continue to be traded. D) have solved the moral hazard problem by providing valuable information to their customers. Answer: B 10) Analysis of adverse selection indicates that financial intermediaries, especially banks, A) have advantages in overcoming the free-rider problem, helping to explain why indirect finance is a more important source of business finance than is direct finance. B) despite their success in overcoming free-rider problems, nevertheless play a minor role in moving funds to corporations. C) provide better-known and larger corporations a higher percentage of their external funds than they do to newer and smaller corporations which rely to a greater extent on the new issues market for funds. D) must buy securities from corporations to diversify the risk that results from holding non-tradable loans. Answer: A 11) The concept of adverse selection helps to explain all of the following except A) why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from the securities markets. B) why indirect finance is more important than direct finance as a source of business finance. C) why direct finance is more important than indirect finance as a source of business finance. D) why the financial system is so heavily regulated. Answer: C 12) As information technology improves, the lending role of financial institutions such as banks should ________. A) increase somewhat B) decrease C) stay the same D) increase significantly Answer: B 13) That only large, well-established corporations have access to securities markets A) explains why indirect finance is such an important source of external funds for businesses. B) can be explained by the problem of moral hazard. C) can be explained by government regulations that prohibit small firms from acquiring funds in securities markets. D) explains why newer and smaller corporations rely so heavily on the new issues market for funds. Answer: A 14) Because of the adverse selection problem, A) good credit risks are more likely to seek loans causing lenders to make a disproportionate amount of loans to good credit risks. B) lenders may refuse loans to individuals with high net worth, because of their greater proclivity to "skip town." C) lenders are reluctant to make loans that are not secured by collateral. D) lenders will write debt contracts that restrict certain activities of borrowers. Answer: C 15) Net worth can perform a similar role to ________. A) diversification B) collateral C) intermediation D) economies of scale Answer: B 16) The problem of adverse selection helps to explain A) why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from securities markets. B) why collateral is an important feature of consumer, but not business, debt contracts. C) why direct finance is more important than indirect finance as a source of business finance. D) why lenders refuse loans to individuals with high net worth. Answer: A 17) The concept of adverse selection helps to explain A) why collateral is not a common feature of many debt contracts. B) why large, well-established corporations find it so difficult to borrow funds in securities markets. C) why financial markets are among the most heavily regulated sectors of the economy. D) why stocks are the most important source of external financing for businesses. Answer: C 18) How does collateral help to reduce the adverse selection problem in credit market? Answer: Collateral is property that is promised to the lender if the borrower defaults thus reducing the lender's losses. Lenders are more willing to make loans when there is collateral that can be sold if the borrower defaults. 8.5 How Moral Hazard Affects the Choice Between Debt and Equity Contracts 1) Equity contracts A) are claims to a share in the profits and assets of a business. B) have the advantage over debt contracts of a lower costly state verification. C) are used much more frequently to raise capital than are debt contracts. D) are not subject to the moral hazard problem. Answer: A 2) A problem for equity contracts is a particular type of ________ called the ________ problem. A) adverse selection; principal-agent B) moral hazard; principal-agent C) adverse selection; free-rider D) moral hazard; free-rider Answer: B 3) Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer. A) principal-agent B) adverse selection C) free-rider D) debt deflation Answer: A 4) Managers (________) may act in their own interest rather than in the interest of the stockholder-owners (________) because the managers have less incentive to maximize profits than the stockholder-owners do. A) principals; agents B) principals; principals C) agents; agents D) agents; principals Answer: D 5) The principal-agent problem A) occurs when managers have more incentive to maximize profits than the stockholders-owners do. B) in financial markets helps to explain why equity is a relatively important source of finance for American business. C) would not arise if the owners of the firm had complete information about the activities of the managers. D) explains why direct finance is more important than indirect finance as a source of business finance. Answer: C 6) The recent Enron and Tyco scandals are an example of A) the free-rider problem. B) the adverse selection problem. C) the principal-agent problem. D) the "lemons problem." Answer: C 7) The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is A) costly state verification. B) the free-rider problem. C) costly avoidance. D) debt intermediation. Answer: A 8) Because information is scarce A) helps explain why equity contracts are used so much more frequently to raise capital than are debt contracts. B) monitoring managers gives rise to costly state verification. C) government regulations, such as standard accounting principles, have no impact on problems such as moral hazard. D) developing nations do not rely heavily on banks for business financing. Answer: B 9) Government regulations designed to reduce the moral hazard problem include A) laws that force firms to adhere to standard accounting principles. B) light sentences for those who commit the fraud of hiding and stealing profits. C) state verification subsidies. D) state licensing restrictions. Answer: A 10) One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the A) venture capital firm. B) money market mutual fund. C) pawn broker. D) savings and loan association. Answer: A 11) A venture capital firm protects its equity investment from moral hazard through which of the following means? A) It places people on the board of directors to better monitor the borrowing firm's activities. B) It writes contracts that prohibit the sale of an equity investment to the venture capital firm. C) It prohibits the borrowing firm from replacing its management. D) It requires a 50% stake in the company. Answer: A 12) Equity contracts account for a small fraction of external funds raised by American businesses because A) costly state verification makes the equity contract less desirable than the debt contract. B) of the reduced scope for moral hazard problems under equity contracts, as compared to debt contracts. C) equity contracts do not permit borrowing firms to raise additional funds by issuing debt. D) there is no moral hazard problem when using a debt contract. Answer: A 13) Debt contracts A) are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals. B) have a higher cost of state verification than equity contracts. C) are used less frequently to raise capital than are equity contracts. D) never result in a loss for the lender. Answer: A 14) Since they require less monitoring of firms, ________ contracts are used more frequently than ________ contracts to raise capital. A) debt; equity B) equity; debt C) debt; loan D) equity; stock Answer: A 15) Explain the principal-agent problem as it pertains to equity contracts. Answer: The principals are the stockholders who own most of the equity. The agents are the managers of the firm who generally own only a small portion of the firm. The problem occurs because the agents may not have as much incentive to profit maximize as the stockholders. 8.6 How Moral Hazard Influences Financial Structure in Debt Markets 1) Although debt contracts require less monitoring than equity contracts, debt contracts are still subject to ________ since borrowers have an incentive to take on more risk than the lender would like. A) moral hazard B) agency theory C) diversification D) the "lemons" problem Answer: A 2) A debt contract is incentive compatible A) if the borrower has the incentive to behave in the way that the lender expects and desires, since doing otherwise jeopardizes the borrower's net worth in the business. B) if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced. C) if the debt contract is treated like an equity. D) if the lender has the incentive to behave in the way that the borrower expects and desires. Answer: A 3) High net worth helps to diminish the problem of moral hazard problem by A) requiring the state to verify the debt contract. B) collateralizing the debt contract. C) making the debt contract incentive compatible. D) giving the debt contract characteristics of equity contracts. Answer: C 4) One way of describing the solution that high net worth provides to the moral hazard problem is to say that it A) collateralizes the debt contract. B) makes the debt contract incentive compatible. C) state verifies the debt contract. D) removes all of the risk in the debt contract. Answer: B 5) A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a A) collateral-insurance clause. B) prescription covenant. C) restrictive covenant. D) proscription covenant. Answer: C 6) Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding. These clauses are A) limited-liability clauses. B) risk insurance. C) restrictive covenants. D) illegal. Answer: C 7) For restrictive covenants to help reduce the moral hazard problem they must be ________ by the lender. A) monitored and enforced B) written in all capitals C) easily changed D) impossible to remove Answer: A 8) Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that A) borrowers may find loopholes that make the covenants ineffective. B) they are inexpensive to monitor and enforce. C) too many resources may be devoted to monitoring and enforcing them, as debtholders duplicate others' monitoring and enforcement efforts. D) they reduce the value of the debt contract. Answer: A 9) Solutions to the moral hazard problem include A) low net worth. B) monitoring and enforcement of restrictive covenants. C) greater reliance on equity contracts and less on debt contracts. D) greater reliance on debt contracts than financial intermediaries. Answer: B 10) A key finding of the economic analysis of financial structure is that A) the existence of the free-rider problem for traded securities helps to explain why banks play a predominant role in financing the activities of businesses. B) while free-rider problems limit the extent to which securities markets finance some business activities, nevertheless the majority of funds going to businesses are channeled through securities markets. C) given the great extent to which securities markets are regulated, free-rider problems are not of significant economic consequence in these markets. D) economists do not have a very good explanation for why securities markets are so heavily regulated. Answer: A 11) One reason financial systems in developing and transition countries are underdeveloped is A) they have weak links to their governments. B) they make loans only to nonprofit entities. C) the legal system may be poor making it difficult to enforce restrictive covenants. D) the accounting standards are too stringent for the banks to meet. Answer: C 12) One reason China has been able to grow so rapidly even though its financial development is still in its early stages is A) the high savings rate of around 40%. B) the shift of labor to the agricultural sector. C) the stringent enforcement of financial contracts. D) the ease of obtaining high-quality information about creditors. Answer: A 13) Why does the free-rider problem occur in the debt market? Answer: Restrictive covenants can reduce moral hazard but they must be monitored and enforced to be effective. If bondholders know that other bondholders are monitoring and enforcing the restrictive covenants, they can free ride. Other bondholders will follow suit resulting in not enough resources devoted to monitoring and enforcing restrictive covenants. 8.7 Conflicts of Interest 1) The presence of economies of scope may benefit financial institutions but may create potential costs from ________. A) conflicts of interest B) multiple profitable enterprises C) economies of scale D) unsecured debt Answer: A 2) Because conflicts of interest increase asymmetric information problems A) the economy will not operate as efficiently. B) loans will not be made. C) banks will not be able to make a profit. D) the financial markets will operate more smoothly. Answer: A 3) Investment banks ________ companies issuing securities and ________ these securities by selling them to the public on behalf of the issuing companies. A) research; underwrite B) research; monitor C) monitor; underwrite D) monitor; manipulate Answer: A 4) A conflict of interest arises in investment banking because the banks are attempting to simultaneously serve two client groups A) the security-issuing firms and the security-buying investors. B) the government and the stockholders. C) the government and the security-issuing firms. D) the security-issuing firms and the lawyers. Answer: A 5) The practice of ________ is allocating initially underpriced initial public offerings to executives in companies the investment bank hopes to do underwriting business with in the future. A) discounting B) spinning C) peppering D) wiring Answer: B 6) A conflict of interest can occur for accounting firms when the firms both A) provide auditing services and nonaudit consulting services. B) provide nonaudit services and tax advice. C) enter data and record data. D) monitor data and underwrite securities. Answer: A 7) Credit-rating agencies may face a conflict of interest because they A) both advise clients on how to structure debt issues and determine the creditworthiness of the debt issues. B) underwrite securities and advise clients on how to structure debt issues. C) underwrite securities and determine the creditworthiness of the debt issues. D) both advise clients on how to structure debt issues and write restrictive covenants. Answer: A 8) The fact that the credit-rating agencies both advised clients on how to structure the financial instruments that paid out cash flows from subprime mortgages and also rated these financial instruments contributed to the A) subprime financial crisis that began in 2007. B) Enron collapse. C) demise of Arthur Andersen. D) technology bust. Answer: A 9) All of the following are credit-rating agency reforms proposed by the SEC in 2008 except A) prohibit credit-rating agencies from structuring the same products that they rate. B) disclose historical ratings performance. C) differentiate the ratings on structured products from those issued on bonds. D) sever links between research and securities underwriting. Answer: A 10) The Sarbanes-Oxley Act of 2002 increased supervisory oversight by A) giving the FDIC the authority to review independent audits. B) increasing the SEC's budget to supervise securities markets. C) creating a new Department of Conflict Resolution. D) reducing the penalties for obstruction of an official investigation. Answer: B 11) While Sarbanes-Oxley is designed to reduce the problems caused by conflicts of interest critics say that it might diminish economies of scope and A) reduce information in financial markets. B) encourage IPOs in the U.S. C) encourage smaller firms to list on the U.S. financial markets. D) increase U.S. capital markets relative to those abroad. Answer: A 12) The Global Legal Settlement of 2002 required investment banks to separate ________ and ________. A) research; securities underwriting B) deposits; securities underwriting C) research; legal analysis D) deposits; legal analysis Answer: A 13) What three types of financial service activities have led to serious conflict of interest problems in financial markets in recent years? Answer: Serious conflict of interest problems have resulted from both underwriting and research activities by investment banks, both auditing and consulting by accounting firms, and both credit assessment and consulting by credit-rating agencies. Chapter 9 Financial Crises and the Subprime Meltdown 9.1 Factors Causing Financial Crises 1) A major disruption in financial markets characterized by sharp declines in asset prices and firm failures is called a A) financial crisis. B) fiscal imbalance. C) free-rider problem. D) "lemons" problem. Answer: A 2) A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system A) causes severe adverse selection and moral hazard problems that make financial markets incapable of channeling funds efficiently. B) allows for a more efficient use of funds. C) increases economic activity. D) reduces uncertainty in the economy and increases market efficiency. Answer: A 3) A serious consequence of a financial crisis is A) a contraction in economic activity. B) an increase in asset prices. C) financial engineering. D) financial globalization. Answer: A 4) A sharp decline in the stock market means that the ________ of corporations has fallen making lenders ________ willing to lend. A) net worth; less B) net worth; more C) liability; less D) liability; more Answer: A 5) A sharp stock market decline increases moral hazard incentives A) since borrowing firms have less to lose if their investments fail. B) because it is immoral to profit from someone's loss. C) since lenders are more willing to make loans. D) reducing uncertainty in the economy and increasing market efficiency. Answer: A 6) An unanticipated decline in the price level increases the burden of debt on borrowing firms but does not raise the real value of borrowing firms' assets. The result is A) that net worth in real terms declines. B) that adverse selection and moral hazard problems are reduced. C) an increase in the real net worth of the borrowing firm. D) an increase in lending. Answer: A 7) If debt contracts are denominated in foreign currency, then an unanticipated decline in the value of the domestic currency results in A) a decline in a firm's net worth. B) an increase in a firm's net worth. C) a decrease in adverse selection and moral hazard. D) an increase in willingness to lend. Answer: A 8) Factors that lead to worsening conditions in financial markets include: A) declining interest rates. B) unanticipated increases in the price level. C) the deterioration in banks' balance sheets. D) increases in bond prices. Answer: C 9) In a bank panic, the source of contagion is the A) free-rider problem. B) too-big-to-fail problem. C) transactions cost problem. D) asymmetric information problem. Answer: D 10) A bank panic can lead to a severe contraction in economic activity due to A) a decline in international trade. B) the losses of bank shareholders. C) the losses of bank depositors. D) a decline in lending for productive investment. Answer: D 11) In addition to having a direct effect on increasing adverse selection problems, increases in interest rates also promote financial crises by ________ firms' and households' interest payments, thereby ________ their cash flow. A) increasing; increasing B) increasing; decreasing C) decreasing; decreasing D) decreasing; increasing Answer: B 12) In emerging economies, government fiscal imbalances may cause fears of A) debt deflation. B) default on government debt. C) stock price declines. D) lower interest rates. Answer: B 13) How can asymmetric information lead to a bank panic? Answer: Depositors cannot judge the quality of their banks' loan portfolios. So, when they hear about a failed financial institution, they may worry about the safety of their deposits and begin to withdraw their funds from their bank. Even healthy institutions can go under if enough deposits are withdrawn quickly. 9.2 Dynamics of Past U.S. Financial Crises 1) When financial institutions go on a lending spree and expand their lending at a rapid pace they are participating in a A) credit boom. B) credit bust. C) deleveraging. D) market race. Answer: A 2) When the value of loans begins to drop, the net worth of financial institutions falls causing them to cut back on lending in a process called A) deleveraging. B) releveraging. C) capitulation. D) deflation. Answer: A 3) When financial intermediaries deleverage, firms cannot fund investment opportunities resulting in A) a contraction of economic activity. B) an economic boom. C) an increased opportunity for growth. D) a call for government regulation. Answer: A 4) A credit boom can lead to a(n) ________ such as we saw in the tech stock market in the late 1990s. A) asset-price bubble B) liability war C) decline in lending D) decrease in moral hazard Answer: A 5) Many 19th century U.S. financial crises were started by A) spikes in interest rates. B) financial innovation. C) onerous financial regulations. D) a strong improvement in banks' balance sheets. Answer: A 6) Most U.S. financial crises have started during periods of ________ either after the start of a recession or a stock market crash. A) high uncertainty B) low interest rates C) low asset prices D) high financial regulation Answer: A 7) If uncertainty about banks' health causes depositors to begin to withdraw their funds from banks, the country experiences a(n) A) banking crisis. B) financial recovery. C) reduction of the adverse selection and moral hazard problems. D) increase in information available to investors. Answer: A 8) Debt deflation occurs when A) an economic downturn causes the price level to fall and a deterioration in firms' net worth because of the increased burden of indebtedness. B) rising interest rates worsen adverse selection and moral hazard problems. C) lenders reduce their lending due to declining stock prices (equity deflation) that lowers the value of collateral. D) corporations pay back their loans before the scheduled maturity date. Answer: A 9) A substantial decrease in the aggregate price level that reduces firms' net worth may stall a recovery from a recession. This process is called A) debt deflation. B) moral hazard. C) insolvency. D) illiquidity. Answer: A 10) A possible sequence for the three stages of a financial crisis in the U.S. might be ________ leads to ________ leads to ________. A) asset price declines; banking crises; unanticipated decline in price level B) unanticipated decline in price level; banking crises; increase in interest rates C) banking crises; increase in interest rates; unanticipated decline in price level D) banking crises; increase in uncertainty; increase in interest rates Answer: A 11) The economy recovers quickly from most recessions, but the increase in adverse selection and moral hazard problems in the credit markets caused by ________ led to the severe economic contraction known as The Great Depression. A) debt deflation B) illiquidity C) an improvement in banks' balance sheets D) increases in bond prices Answer: A 12) Typically, the economy recovers fairly quickly from a recession. Why did this not happen in the United States during the Great Depression? Answer: The 25% decline in the price level from 1930-1933 triggered a debt deflation. The loss of net worth increased adverse selection and moral hazard problems in the credit markets and increased and prolonged the economic contraction. 9.3 The Subprime Financial Crisis of 2007-2008 1) Financial innovations that emerged after 2000 in the mortgage markets included all of the following except A) adjustable-rate mortgages. B) subprime mortgages. C) Alt-A mortgages. D) mortgage-backed securities. Answer: A 2) ________ is a process of bundling together smaller loans (like mortgages) into standard debt securities. A) Securitization B) Origination C) Debt deflation D) Distribution Answer: A 3) A ________ pays out cash flows from subprime mortgage-backed securities in different tranches, with the highest-rated tranch paying out first, while lower ones paid out less if there were losses on the mortgage-backed securities. A) Collateralized debt obligation (CDO) B) Adjustable-rate mortgage C) Negotiable CD D) Discount bond Answer: A 4) The growth of the subprime mortgage market led to A) increased demand for houses and helped fuel the boom in housing prices. B) a decline in the housing industry because of higher default risk. C) a decrease in home ownership as investors chose other assets over housing. D) decreased demand for houses as the less credit-worthy borrowers could not obtain residential mortgages. Answer: A 5) The originate-to-distribute business model has a serious ________ problem since the mortgage broker has little incentive to make sure that the mortgagee is a good credit risk. A) principal-agent B) debt deflation C) democratization of credit D) collateralized debt Answer: A 6) Mortgage brokers often did not make a strong effort to evaluate whether the borrower could pay off the loan. This created a A) severe adverse selection problem. B) decline in mortgage applications. C) call to deregulate the industry. D) decrease in the demand for houses. Answer: A 7) Agency problems in the subprime mortgage market included all of the following except A) homeowners could refinance their houses with larger loans when their homes appreciated in value. B) mortgage originators had little incentives to make sure that the mortgage is a good credit risk. C) underwriters of mortgage-backed securities had weak incentives to make sure that the holders of the securities would be paid back. D) the evaluators of securities , the credit rating agencies, were subject to conflicts of interest. Answer: A 8) When housing prices began to decline after their peak in 2006, many subprime borrowers found that their mortgages were "underwater." This meant that A) the value of the house fell below the amount of the mortgage. B) the basement flooded since they could not afford to fix the leaky plumbing. C) the roof leaked during a rainstorm. D) the amount that they owed on their mortgage was less than the value of their house. Answer: A 9) Although the subprime mortgage market problem began in the United States, the first indication of the seriousness of the crisis began in A) Europe. B) Australia. C) China. D) South America. Answer: A 10) Like a CDO, a structured investment vehicle pays off cash flows from pools of assets, however, rather than long-term debt the structured investment vehicle backs A) commercial paper. B) Treasury notes. C) corporate bonds. D) municipal bonds. Answer: A 11) Which investment bank filed for bankruptcy on September 15, 2008 making it the largest bankruptcy filing in U.S. history? A) Lehman Brothers B) Merrill Lynch C) Bear Stearns D) Goldman Sachs Answer: A 12) The largest bank failure in U.S. history was ________ which went into receivership by the FDIC on September 25, 2008. A) Washington Mutual B) Bank of America C) J.P. Morgan D) Wells Fargo Answer: A 13) Credit market problems of adverse selection and moral hazard increased as a result of all of the following except A) increase in housing market prices. B) increased uncertainty from the failures of financial institutions. C) deterioration in financial institutions' balance sheets. D) decline in the stock market of over 40% from its peak. Answer: A 14) The Economic Recovery Act of 2008 had several provisions to promote recovery from the subprime financial crisis. These provisions included all of the following except A) guaranteed all the deposits of the commercial banks. B) purchase of subprime mortgage assets from troubled financial institutions by the Treasury. C) temporarily raised the limit of the federal deposit insurance from $100,000 to $250,000. D) guarantee of par value for money market mutual fund shares for one year by the Treasury. Answer: A 15) The government bailout of troubled financial institutions occurred in the U.S. and many other countries. Which country saw their banking system collapse requiring the government to take over its three largest banks? A) Iceland B) England C) Germany D) Belgium Answer: A 9.4 Dynamics of Financial Crises in Emerging Market Economies 1) Financial crises generally develop along two basic paths: A) mismanagement of financial liberalization/globalization and severe fiscal imbalances. B) stock market declines and severe fiscal imbalances. C) mismanagement of financial liberalization/globalization and stock market declines. D) stock market declines and unanticipated declines in the value of the domestic currency. Answer: A 2) In emerging market countries, the deterioration in bank's balance sheets has more ________ effects on lending and economic activity than in advanced countries. A) negative B) positive C) affirming D) advancing Answer: A 3) The mismanagement of financial liberalization in emerging market countries can be understood as a severe ________. A) principal/agent problem B) asymmetric information problem. C) lemons problem. D) free-rider problem. Answer: A 4) Factors likely to cause a financial crisis in emerging market countries include A) fiscal imbalances. B) decreases in foreign interest rates. C) a foreign exchange crisis. D) too strong oversight of the financial industry. Answer: A 5) The two key factors that trigger speculative attacks on emerging market currencies are A) deterioration in bank balance sheets and severe fiscal imbalances. B) deterioration in bank balance sheets and low interest rates abroad. C) low interest rates abroad and severe fiscal imbalances. D) low interest rates abroad and rising asset prices. Answer: A 6) Severe fiscal imbalances can directly trigger a currency crisis since A) investors fear that the government may not be able to pay back the debt and so begin to sell domestic currency. B) the government may stop printing money. C) the government may have to cut back on spending. D) the currency must surely increase in value. Answer: A 7) In emerging market countries, many firms have debt denominated in foreign currency like the dollar or yen. A depreciation of the domestic currency A) results in increases in the firm's indebtedness in domestic currency terms, even though the value of their assets remains unchanged. B) results in an increase in the value of the firm's assets. C) means that the firm does not owe as much on their foreign debt. D) strengthens their balance sheet in terms of the domestic currency. Answer: A 8) A sharp depreciation of the domestic currency after a currency crisis leads to A) higher inflation. B) lower import prices. C) lower interest rates. D) decrease in the value of foreign currency-denominated liabilities. Answer: A 9) The key factor leading to the financial crises in Mexico and the East Asian countries was A) a deterioration in banks' balance sheets because of increasing loan losses. B) severe fiscal imbalances. C) a sharp increase in the stock market. D) a sharp decline in interest rates. Answer: A 10) Factors that led to worsening conditions in Mexico's 1994-1995 financial markets include A) failure of the Mexican oil monopoly. B) the ratification of the North American Free Trade Agreement. C) increased uncertainty from political shocks. D) decline in interest rates. Answer: C 11) Factors that led to worsening financial market conditions in East Asia in 1997-1998 include A) weak supervision by bank regulators. B) a rise in interest rates abroad. C) unanticipated increases in the price level. D) increased uncertainty from political shocks. Answer: A 12) Factors that led to worsening conditions in Mexico's 1994-1995 financial markets, but did not lead to worsening financial market conditions in East Asia in 1997-1998 include A) rise in interest rates abroad. B) bankers' lack of expertise in screening and monitoring borrowers. C) deterioration of banks' balance sheets because of increasing loan losses. D) stock market decline. Answer: A 13) Argentina's financial crisis was due to A) poor supervision of the banking system. B) a lending boom prior to the crisis. C) fiscal imbalances. D) lack of expertise in screening and monitoring borrowers at banking institutions. Answer: C 14) A feature of debt markets in emerging-market countries is that debt contracts are typically ________. A) very short term B) long term C) intermediate term D) perpetual Answer: A 15) The economic hardship resulting from a financial crises is severe, however, there are also social consequences such as A) increased crime. B) difficulty getting a loan. C) currency devaluations. D) loss of output. Answer: A 16) Before the South Korean financial crisis, sales by the top five chaebols (family-owned conglomerates) were A) nearly 50% of GDP. B) about 10% of GDP. C) almost 90% of GDP. D) nearly 25% of GDP. Answer: A 17) The chaebols encouraged the Korean government to open up Korean financial markets to foreign capital. The Korean government responded by A) allowing unlimited short-term foreign borrowing but maintained quantity restrictions on long-term foreign borrowing by financial institutions. B) allowing unlimited short-term and long-term foreign borrowing by financial institutions. C) maintaining quantity restrictions on short-term foreign borrowing but allowing unlimited long-term foreign borrowing by financial institutions. D) not allowing any foreign borrowing by financial institutions. Answer: A 18) At the time of the South Korean financial crisis, the government allowed many chaebol owned finance companies to convert to merchant banks. Finance companies ________ allowed to borrow abroad and merchant banks ________. A) were not; could borrow abroad B) were not; could not borrow abroad C) were; could borrow abroad D) were; could not borrow abroad Answer: A 19) At the time of the South Korean financial crisis, the merchant banks were A) almost virtually unregulated. B) subject to heavy government regulation. C) engaged in long-term lending to the corporate sector. D) restricted to long-term foreign borrowing. Answer: A 20) What two key factors trigger speculative attacks leading to currency cries in emerging market countries? Answer: The deterioration in bank balance sheets and severe fiscal imbalances are the key factors. To counter a speculative attack, a country might try to raise interest rates. Raising interest rates, however, would worsen the problem of banks that are already in trouble. Speculators recognize this and seize the opportunity. When their are severe fiscal imbalances, there is concern that government debt will not be paid back. Funds are pulled out of the country and domestic currency is sold leading to a decline in the value of the domestic currency. Speculators will once again seize the opportunity. Test Bank for The Economics of Money, Banking and Financial Markets Frederic S. Mishkin 9780321599797, 9780134734200, 9780133836790, 9780134734606, 9780134733821