Deck 3: The What, How, and Why of Financial Intermediaries

Question 1

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
Given that there are five depositors, 40% of them will withdraw at t = 1, and 2 merchants who need $100 each, will the bank have sufficient funds at t = 1 if the safeguarding fee is $5, and the monitoring cost is $3?

A)No, it will only have $39 while it must pay $98
B)No, it will only have $98 while it must pay $135
C)Yes, it will have $98 to pay $98
D)Yes, it will have $135 to pay $135
E)Yes, it will have $196 to pay $135

Answer 1

A

Question 2

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
There are five depositors with the same pattern of income and consumption as in the original problem, a fraction of them 0.4) will withdraw at t = 1.If the bank charges $5 for safeguarding fee and it costs $3 to monitor a merchant, what is the minimum number of merchants that the bank can lend to without exposing itself to withdrawal risk at t = 1?

A)zero
B)one
C)two
D)three
E)Four

Answer 2

D

Question 3

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
Suppose that there are now five depositors with the same pattern of income and consumption as in the original problem.There is a known fraction of 0.4 of the depositors who wish to withdraw at the end of the first period.The remaining depositors will withdraw at the end of the second period.What is the amount of money that the bank must have available at the end of the first period?

A)$50
B)$90
C)$150
D)$180
E)$225

Answer 3

B

Question 4

Why would a goldsmith ever want to print more receipts than the amount of gold deposited?

A)in a rational expectations equilibrium, gold was never withdrawn by the depositors
B)the goldsmith had acquired a good reputation and therefore was allowed by the depositors to print more receipts
C)the gold inventory was relatively stable over time so there was little withdrawal risk
D)the goldsmith simply wanted to save the depositors the unnecessary needs to convert receipts to gold
E)all of the above

Question 5

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
Suppose the banking industry is competitive.If the bank charges a loan rate of 18%, safeguarding fee of $5, and there are five depositors and two merchants, what would be the deposit interest rate that the bank can offer to the depositors?

A)18.0%
B)15.6%
C)13.5%
D)12.4%
E)-10%

Question 6

Due to the nature of the fractional reserve banking, a bank

A)is always exposed to interest rate risk
B)is always exposed to credit risk
C)is always exposed to a risk that the amount withdrawn by depositors exceeds the amount of cash available
D)is never exposed to withdrawal risk
E)can always hedge its risk exposure

Question 7

The trade-off faced by a goldsmith when deciding to print more receipts than the amount of gold available is

A)between insolvency risk and interest rate risk
B)between profitability and interest rate risk
C)between interest rate risk and credit risk
D)between profitability and credit risk
E)between profitability and insolvency risk

Question 8

A possible solution to reduce the vulnerability of the fractional banking system is

A)to create a private arrangement whereby banks agree to put their combined resources to help their members in difficult times
B)to create a central bank as a lender of last resort
C)to require all banks to invest in Treasury bills
D)all of the above
E)both a and b

Question 9

What is the key service performed by a goldsmith?

A)screening
B)liquidity transformation
C)monitoring
D)funding
E)origination

Question 10

Suppose a bank doesn't have sufficient fund to meet the depositors' withdrawal In this case, to maintain stability and public confidence in the banking system the government can

A)close the bank, sell it, and distribute the proceeds to the depositors
B)provide deposit insurance facility to prevent bank runs
C)let the bank merge with another solvent bank which will then pay the depositors
D)ask the bank to raise more equity to pay off the depositors
E)both c and d

Question 11

The vulnerability of the fractional banking system is due to

A)the volatility of interest rates
B)the nature of demand deposits
C)the illiquidity of loans
D)both b and c
E)a, b, and c are all correct

Question 12

Use the following information for questions
Suppose that the banking industry is competitive and it has zero equity.The effective legal reserve requirement is 25%.Assume that there are three banks, A, B, and C.Bank A initially receives $2,500 in deposits.
According to the Fixed Coefficient Model, what is the amount of excess reserves in Bank A?

A)$500
B)$625
C)$1,250
D)$1,875
E)$2,500

Question 13

Which of the following statements is are) false?

A)In the absent of the lender of last resort facility, the goldsmith would print unlimited volume of receipts.
B)In the absent of the lender of last resort facility, the goldsmith would have an incentive to build his reputation and therefore the volume of receipts would be limited.
C)The presence of the lender of the last resort facility strengthens the goldsmith's incentive to maintain his reputation.
D)The presence of the lender of the last resort facility weakens the goldsmith's incentive to maintain his reputation
E)both a and c

Question 14

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
Suppose that there are two merchants who wish to borrow $100 at t = 0.There are five depositors who have the same pattern of income and consumption as in the original problem.How much can the bank promise to pay to the depositors in the aggregate if it does not pass along any profits it receives from the loan?

A)$50
B)$75
C)$155
D)$225
E)$245

Question 15

Use the following information for questions
Suppose that the banking industry is competitive and it has zero equity.The effective legal reserve requirement is 25%.Assume that there are three banks, A, B, and C.Bank A initially receives $2,500 in deposits.
Suppose that the effective legal reserve requirement is now 40%.Bank A loans out its excess reserves, which are deposited in Bank B.How much excess reserves does Bank B have?

A)$1,500
B)$1,000
C)$900
D)$750
E)$600

Question 16

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
A known fraction of 0.4 of the depositors will withdraw at t = 1.How much will they receive?

A)$45
B)$90
C)$98
D)$135
E)$196

Question 17

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
If there are two merchants who wish to borrow $100 at t = 0, and the bank charges 18% loan rate, what is the bank's aggregate profit from lending?

A)$66
B)$42
C)$36
D)$18
E)$0

Question 18

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
If the probability of theft is 0.2, what is the necessary and sufficient condition for personal safeguarding to be optimal?

A)The personal safeguarding fee is $5
B)The personal safeguarding fee is less than $5
C)The personal safeguarding fee is greater than $5
D)The personal safeguarding fee is between $5 and $10
E)Any fee would make personal safeguarding optimal

Question 19

Use the following information for questions
Suppose there is one depositor who earns an income of $100 in each period.She spends $50 for consumption and the remainder goes to her savings account.Assume that a bank doesn't do anything with this money except safeguards it.The bank charges $5 for safeguarding fee.
Assume that there is a merchant who needs $100 to open a shop at t = 0.There are five depositors.The shop can generate a cash flow of $130 at t = 2.The bank charges the merchant a loan rate of 18%.However, due to moral hazard, the merchant must be monitored, and this costs $3.The merchant will

A)borrow directly from the depositors since his expected payoff is $9 compared to borrowing from the bank which gives him an expected payoff of $6
B)borrow directly from the depositors since his expected payoff is $6 compared to borrowing from the bank which gives him an expected payoff of $9
C)borrow from the bank since his expected payoff is $9 compared to borrowing directly from the depositors which gives him an expected payoff of $6
D)borrow from the bank since his expected payoff is $6 compared to borrowing directly from the depositors which gives him an expected payoff of $9
E)not open his shop since his expected payoff is negative

Question 20

Fractional reserve system means that

A)an intermediary funds itself with demand deposits and holds all of those liabilities in the form of liquid assets
B)an intermediary funds itself with demand deposits and holds only a fraction of those liabilities in the form of liquid assets
C)an intermediary funds itself with all equity and holds only a fraction of it in the form of liquid assets
D)an intermediary funds itself with commercial papers and holds a substantial portion of them in the form of liquid assets
E)none of the above

Question 21

A reduction in the legal reserve requirement will, other things equal,

A)reduce the depositors' incentive to run the banks
B)reduce the amount of funds available for lending
C)induce the banks to buy back their stocks
D)increase the amount of lending by banks
E)both b and c

Question 22

Use the following information for questions
Suppose there are assets whose owners wish to attract capital.Due to adverse selection problem, a cost must be incurred in order to learn the value of those assets.There are individuals who specialize in producing information about firms.It costs the information producer i.p. $5 to produce information.The i.p.is risk averse and has a utility function of where X is the i.p.'s wealth.Each i.p.has an alternative employment which provides a minimum level of expected utility of $30.Suppose that the owners of the assets approach the
i.p.directly, and assume that they can monitor the i.p.to learn if the i.p.has invested in information production.The monitoring is noisy and it says that the i.p.produced information with probability 0.6 and did not produce information with probability 04.If the i.p.did not produce information, the signal says that he did with probability 0.5, and that he did not with probability 0.5.Suppose the asset owners tell the i.p.that they will pay $H if the i.p.produced information and $L if he did not.

-What is the incentive compatibility condition for the i.p.compensation i.e., that induces the i.p.to produce information)?

A) $0.2 \sqrt { H } + 0.8 \sqrt { L } \geq 30$
B) $0.6 \sqrt { H } + 0.4 \sqrt { L } \geq 35$
C) $0.4 \sqrt { H } + 0.6 \sqrt { L } \geq 35$
D) $0.5 \sqrt { H } + 0.5 \sqrt { L } \geq 5$
E) $0.1 \sqrt { H } + 0.1 \sqrt { L } \geq 5$

Question 23

Other thing equal, an increase in the reserve requirement will

A)induce the depositors to withdraw money from the banks
B)increase the amount of deposits available for lending
C)reduce the amount of deposits available for lending
D)not change the amount of funds available for lending
E)induce the banks to invest in Treasury securities

Question 24

The differences in the ownership structure of a stock S&L and a mutual S&L can lead to...

A)a higher incidence of an agency problem between the owners and managers in a stock S&L than a mutual S&L
B)a higher incidence of an agency problem between the owners and managers in a mutual S&L than a stock S&L
C)a diseconomy of scope in mutual S&Ls
D)both a and c
E)both b and c

Question 25

Use the following information for questions
Suppose there are assets whose owners wish to attract capital.Due to adverse selection problem, a cost must be incurred in order to learn the value of those assets.There are individuals who specialize in producing information about firms.It costs the information producer i.p.) $5 to produce information.The i.p.is risk averse and has a utility function of where X is the i.p.'s wealth.Each i.p.has an alternative employment which provides a minimum level of expected utility of $30.Suppose that the owners of the assets approach the
i.p.directly, and assume that they can monitor the i.p.to learn if the i.p.has invested in information production.The monitoring is noisy and it says that the i.p.produced information with probability 0.6 and did not produce information with probability 04.If the i.p.did not produce information, the signal says that he did with probability 0.5, and that he did not with probability 0.5.Suppose the asset owners tell the i.p.that they will pay $H if the i.p.produced information and $L if he did not.
What is the expected cost of information production?

A)$1,825
B)$1,827.50
C)$2,160
D)$2,172.50
E)$2,500

Question 26

When two or more information producers coalesce by forming a financial intermediary to cooperatively generate information about particular firms,

A)there is a diversification effect which serves to reduce the risk of individual information producers
B)there is an increase in the expected cost of information production since the firm that hires the information producers have to pay more
C)the individual information producers can increase their expected utility and to the extent that the benefits of this increased utility is shared with the firm, there is a reduction in the expected cost of information production
D)both a and b
E)both a and c

Question 27

Use the following information for questions
Suppose there are assets whose owners wish to attract capital.Due to adverse selection problem, a cost must be incurred in order to learn the value of those assets.There are individuals who specialize in producing information about firms.It costs the information producer i.p.) $5 to produce information.The i.p.is risk averse and has a utility function of where X is the i.p.'s wealth.Each i.p.has an alternative employment which provides a minimum level of expected utility of $30.Suppose that the owners of the assets approach the
i.p.directly, and assume that they can monitor the i.p.to learn if the i.p.has invested in information production.The monitoring is noisy and it says that the i.p.produced information with probability 0.6 and did not produce information with probability 04.If the i.p.did not produce information, the signal says that he did with probability 0.5, and that he did not with probability 0.5.Suppose the asset owners tell the i.p.that they will pay $H if the i.p.produced information and $L if he did not.
What is the amount of compensation H and L) that will solve this problem?

A)H=$2,000 and L=$150
B)H=$2,500 and L=$50
C)H = $3,025 and L = $25
D)H = $3,600 and L = $0
E)H = $3,600 and L = $25

Question 28

Suppose the government uses open market operations to buy Treasury securities from public.This will result in

A)the increase in the public confidence about the stability of the monetary system
B)the increase in the bank's incentive to hold Treasury securities
C)the decrease in the batik's incentive to hold Treasury securities
D)the increase in the amount of lending by the private sectors or banks
E)the increase in the depositors' incentive to withdraw from the banks and invest in the Treasury securities

Question 29

With respect to the discount rate policy, an increase in the discount rate, other things equal, will

A)increase the amount of lending by banks
B)decrease the amount of lending by banks
C)not change the amount of lending by banks
D)reduce the borrower's credit risk
E)make the banks more prone to withdrawal risk

Question 30

Other things equal, a decrease in the discount rate will

A)reduce the amount of lending by banks
B)not change the amount of lending by banks
C)spur lending by banks
D)signal to the general public that the stock market is too volatile
E)induce the banks to hold Treasury securities

Question 31

Use the following information for questions
Suppose that the banking industry is competitive and it has zero equity.The effective legal reserve requirement is 25%.Assume that there are three banks, A, B, and C.Bank A initially receives $2,500 in deposits.
The legal reserve requirement is now changed to 20%.Bank A receives an initial deposit of $2,500.Bank A has excess reserves which will be deposited in Bank B, which in turn, has excess reserves which will be deposited in Bank C.What does Bank C have in excess reserves?

A)$2,000
B)$1,600
C)$1,280
D)$1,000
E)$880

Question 32

The following are major tools of monetary policy, except

A)reserve requirement changes
B)open market operations
C)discount rate changes
D)sales and purchases of government securities
E)controlling a borrower's credit risk

Question 33

Inside debt is

A)debt incurred by the firm's insiders
B)the amount of money raised by the firm's insiders
C)a contract giving the creditor access to the firm's inside information
D)the amount of money owed to the firm's employees
E)a contract that empowers the creditor to seize the firm's assets in the event that the firm defaults

Question 34

Use the following information for questions
Suppose there are assets whose owners wish to attract capital.Due to adverse selection problem, a cost must be incurred in order to learn the value of those assets.There are individuals who specialize in producing information about firms.It costs the information producer i.p. $5 to produce information.The i.p.is risk averse and has a utility function of where X is the i.p.'s wealth.Each i.p.has an alternative employment which provides a minimum level of expected utility of $30.Suppose that the owners of the assets approach the
i.p.directly, and assume that they can monitor the i.p.to learn if the i.p.has invested in information production.The monitoring is noisy and it says that the i.p.produced information with probability 0.6 and did not produce information with probability 04.If the i.p.did not produce information, the signal says that he did with probability 0.5, and that he did not with probability 0.5.Suppose the asset owners tell the i.p.that they will pay $H if the i.p.produced information and $L if he did not.

-To make sure that the i.p.has an incentive to produce information, his compensation must satisfy

A) $0.5 \sqrt { H } + 0.5 \sqrt { L } \geq 25$
B) $0.4 \sqrt { H } + 0.6 \sqrt { L } \geq 25$
C) $0.4 \sqrt { H } + 0.6 \sqrt { L } \geq 30$
D) $0.6 \sqrt { H } + 0.4 \sqrt { L } \geq 30$
E) $0.6 \sqrt { H } + 0.4 \sqrt { L } \geq 35$

Question 35

What is the benefit of having a large financial intermediary consisting of many information producers?

A)information reusability
B)information reliability
C)reduction in the expected cost of information
D)both b and c
E)a, b, and c are correct

Question 36

Which of the following statements is are) false?

A)When a firm is young, it usually has an entrepreneur with no established management expertise
B)When a firm is young, it may find it in the best interest to approach a bank that can provide a secured loan
C)When a firm is mature and has established credit histories, it may find it easier to raise money from the capital market
D)When a firm is young, approaching a venture capitalist is usually the preferred way to raise a financing
E)All of the above

Question 37

When the government sell Treasury securities via open market operations, there will be...

A)an increase in the banks' incentive to lend
B)a decrease in the banks' incentive to lend
C)an increase in the investors' incentive to buy the Treasury securities
D)a general increase in the volatility of the banks' stock price
E)both c and d

Question 38

The increased number of conversion from mutual S&Ls to stock S&Ls in recent years can be attributed to...

A)an increase in competition as the stock S&Ls are more efficient than mutual S&Ls
B)managers of mutual S&Ls found it more costly to consume perks excessively
C)the deposit insurance eliminated the agency cost of debt advantage of the mutuals
D)all of the above
E)both a and c