Economics 330
Money and Banking
Third Handout
Identifications:
I. Below is a list of terms that is not meant to be inclusive for this next group of chapters: define and explain the significance of each.
External finance
Internal finance
Collateral
Secured debt
Unsecured debt
Restrictive covenants
Economies of scale
Adverse selection
Moral hazard
Asymmetric information
Free-rider problem
Net worth
Equity capital
Principal-agent problem
Costly state verification
Incentive-compatible
Financial crisis
Insolvent
Debt deflation
Balance sheet
Discount loans
Reserves
Required reserve ratios
Excess reserves
Loan loss reserves
Correspondent banking
Secondary reserves
Asset transformation
T-account
Deposit outflows
Liquidity management
Asset management
Liability management
Capital adequacy management
Credit risk
Interest-rate risk
Discount rate
Money center banks
Insolvent
Return on assets
Return on equity
Compensating balances
Credit rationing
Gap analysis
Duration analysis
Off-balance sheet activities
Deposit rate ceilings
Disintermediation
Central bank
Dual banking system
National Banking Act of 1863
Federal Reserve Act of 1913
Glass-Steagall Act: Banking Act of 1933
Securitization
Regulation Q
Bank Failure
Payoff Method
Purchase and assumption method
Too big to fail
Leverage Ratio
DIDMCA
Regulatory forbearance
FIRREA
FDICIA of 1991
II. True/False/Uncertain
Read each statement below and decide whether you think it is true, false, or you are uncertain. Explain your position in a paragraph.
1. Stocks are a major source of funding for businesses in need of external funding.
2. All corporations have equal access to external funds in the securities markets in the United States.
3. Adverse selection occurs because there is an inequality of information between the two parties to a transaction: this enables one party to benefit unfairly, or adversely, once the transaction is finalized.
4. Adverse selection is only a problem in financial markets.
5. Moral hazard refers to any behavior that is deemed morally hazardous to anyone.
6. An example of adverse selection is when office workers spend time on the job doing non-work related activities even though there is office work to be done.
7. Paying employees by the piece, i.e. using a piece rate rather than an hourly wage, is an effective means of addressing the moral hazard problem.
8. Banks collect information and make it freely available to anyone who would like to have it.
9. The principal-agent problem only arises when the owners have a debt contract and not an equity contract with the business.
10. Costly state verification is impossible to achieve because of the free rider problem.
11. An increase in interest rates, ceteris paribus, reduces the probability of a moral hazard problem.
12. An increase in interest rates, ceteris paribus, increases the probability of an adverse selection problem.
13. If the stock market declines this may result in a decrease in a company’s net worth and this, in turn, will increase the likelihood that a moral hazard problem may arise in any transaction with this company.
14. If there is an increase in uncertainty this will increase the likelihood that an adverse selection problem will arise.
15. An increase in the volatility of interest rates, ceteris paribus, will increase the default risk exposure for a bank.
16. Financial innovation is best explained as a reaction to a change in the demand conditions in the financial environment.
17. Interest rate risk occurs when a company defaults on one of its liabilities.
18. The reserve requirement is a tax levied by the government on banks.
19. The United States throughout its history has had a central bank.
20. The asset side of the bank’s t-account refers to the sources of funds for the bank.
21. The lower the net worth of a business the greater the potential leverage that business can experience when the value of its assets positively changes.
22. Liquidity management refers to the necessity of calling in loans whenever the bank has insufficient funds to cover its deposit outflows.
III. Essays
1. Comment on the relevance of the statement “The decision makers do not bear the full impact of their decisions.” Make sure you show the connection between this statement and what we have been studying: provide examples to enhance your answer.
2. Comment on the quote of Edward Lazear that “incentives are the essence of economics”. Make sure you show the connection between this statement and what we have been studying: provide examples to enhance your answer.
3. Economists often talk about the free rider problem. What is the free rider problem and how does it relate to our study of financial markets and institutions? Provide illustrative examples in your answer.
4. The United States banking system is characterized as having many, many banks. Does this mean that the banking industry is highly competitive? Why do you think the United States banking system evolved with so many banks while other similarly developed countries have banking systems characterized by having a small number of very large banks?
5. Successful banks balance liquidity management, asset and liability management, interest rate risk management, and capital adequacy requirements. Briefly explain each of these management areas and then comment on any potential conflict a banker might experience in trying to simultaneously achieve all of these goals.