Deck 11: Financial Instability and Strains on the Financial System

Question 1

A critical upset in a financial market characterized by sharp declines in asset prices and the default of many financial and nonfinancial firms is called a

A)panic.
B)bank run.
C)debt deflation.
D)financial crisis.

Answer 1

D

Question 2

Credit risk is best managed through the prudent use of

A)diversification.
B)expert analysis of potential borrowers and investments.
C)futures and options to profit from speculation.
D)Both a and b are correct

Answer 2

D

Question 3

A critical upset in financial markets characterized by sharp declines in asset prices and the default of many financial and nonfinancial firms is known as which of the following?

A)a moral hazard problem
B)a financial crisis
C)an off-balance-sheet upset
D)a bank run

Answer 3

B

Question 4

Which of the following is false?

A)FIs use diversification and expert credit analysis to manage credit risk.
B)FIs use adjustable rate loans, forwards, futures, options, swaps, and securitizations to manage interest rate risk.
C)Liquidity risk is managed by the ability to borrow funds.
D)Exchange rate risk is managed by the ability to borrow funds at a fixed exchange rate.

Question 5

Which of the following is true?

A)Financial intermediation inherently involves risk and although risk can be reduced, it can never be eliminated.
B)The layering of payments opens the possibility that a random default will set off a chain reaction of multiple defaults.
C)A recession can cause a financial crisis but a financial crisis can never cause a recession.
D)Both a and b are true.

Question 6

A financial crisis

A)may cause a downturn in the economy.
B)may be caused by a downturn in the economy.
C)generally results in the default of many financial and nonfinancial firms.
D)All of the above are correct.

Question 7

Which of the following is false?

A)Moral hazard refers to the reduction in market discipline that comes with the presence of a safety net to prevent losses. The presence of deposit insurance or the belief that regulators will take mitigating actions in the event of a financial crisis creates moral hazard.
B)Banks and other intermediaries are given an incentive to invest in riskier loans and investments because of deposit insurance.
C)Mega mergers in the financial services industry may lead to a moral hazard problem in the future if market participants believe that the resulting firms would be bailed out if they ran into serious problems.
D)The moral hazard problem also exists in international financial markets if participants believe that no one would bail out a country in crisis, thus reducing losses from what they otherwise would be.

Question 8

Which of the following is false?

A)Because of more aggressive oversight, financial crises will most likely not occur in the future.
B)A financial crisis can be caused by a recession.
C)A financial crisis can cause a recession.
D)A financial crisis is a critical upset in a financial market that leads to falling asset prices and the failure of many financial and nonfinancial firms.

Question 9

Which of the following are used to minimize both exchange rate and interest rate risks?

A)futures and options
B)adjustable rate loans
C)expert credit analysis
D)nondeposit liabilities

Question 10

A situation where prices (including wages) are falling and leading to an inability to service existing debts is which of the following?

A)an opportunity for program trading
B)a debt deflation
C)an opportunity for refinancing and growth
D)disinflation

Question 11

Credit risk is best managed through the wise use of which of the following?

A)diversification and expert analysis
B)futures and options
C)nondeposit liabilities
D)securitizations

Question 12

Which of the following would not increase the possibility of a financial crisis?

A)a sharp unexpected increase in interest rates
B)unanticipated random bankruptcies
C)stable long-term interest rates
D)unanticipated decreases in the overall price level

Question 13

An Alt-A mortgage is

A)a mortgage to some one with bad credit.
B)is the top fixed rate mortgage.
C)is made to a borrower with good credit where the lender does not verify the income stated by the borrower.
D)a derivative.

Question 14

A subprime loan is

A)a mortgage to some one with bad credit and little or no down payment.
B)the lowest rated fixed rate mortgage.
C)is made to a borrower with good credit where the lender does not verify the income stated by the borrower.
D)a derivative.

Question 15

Which of the following is false with regards to the financial crisis of 2007-2008?

A)The financial crisis began in the subprime mortgage market.
B)The financial crisis spread to the broader economy.
C)To mitigate the crisis, the government put a one year moratorium on all foreclosures.
D)Many of the subprime loans reset to much higher interest rates after the first few years.

Question 16

A hedge spending unit is a spending unit

A)where the anticipated revenues significantly exceed the anticipated payment obligations.
B)is one in which the funds coming in may potentially fall short of the payment outflows if there is an increase in interest rates.
C)must continuously increase its outstanding debt to meet its current obligations or payments.
D)None of the above is correct.

Question 17

A speculative spending unit is a spending unit

A)where the anticipated revenues significantly exceed the anticipated payment obligations.
B)is one in which the funds coming in may potentially fall short of the payment outflows if there is an increase in interest rates.
C)must continuously increase its outstanding debt to meet its current obligations or payments.
D)None of the above is correct.

Question 18

A Ponzi spending unit is a spending unit

A)where the anticipated revenues significantly exceed the anticipated payment obligations.
B)is one in which the funds coming in may potentially fall short of the payment outflows if there is an increase in interest rates.
C)must continuously increase its outstanding debt to meet its current obligations or payments.
D)None of the above is correct.

Question 19

Which of the following is true with regards to the financial crisis of 2007-2008?

A)Although the housing bubble peaked in July 2006, the Fed did not begin to act to mitigate the crisis until late 2007 because it thought the crisis could be contained in the subprime market.
B)In October 2008, a $700 billion bailout package was signed into law to mitigate the crisis.
C)The new Obama administration was expected to pass an even bigger bailout package since the economy continued to deteriorate into 2009.
D)All of the above are true.

Question 20

Which of the following are examples of off-balance-sheet activities of banks?

A)lines of credit
B)overdraft protection
C)unused credit card balances
D)All of the above are examples.

Question 21

Activities such as standby lines of credit, overdraft protection, and unused credit card balances are examples of

A)off-balance-sheet activities.
B)junk bonds.
C)illegal activities for commercial banks.
D)derivatives.

Question 22

Which of the following is true with regards to the financial meltdown of 2008?

A)The financial crisis of 2008 had been in the subprime mortgage markets and later spread to the financial system and the broader economy.
B)The five largest investment banking firms were merged with other financial institutions, went bankrupt, or converted to bankholding companies to gain access to borrow from the Fed.
C)A series of unprecedented collapses of financial institutions began that culminated in a massive bailout of the financial system by the government.
D)All of the above are true.

Question 23

A/an __________ is a document that guarantees that a bank will lend an issuer of commercial paper the funds to pay off creditors on the due date if the issuer of the commercial paper cannot.

A)standby line of credit
B)junk bond
C)unused credit line
D)derivative

Question 24

The economist that developed the financial instability hypothesis is

A)Hyman Minsky.
B)Irving Fisher.
C)John Maynard Keynes.
D)Charles Ponzi.

Question 25

__________________ is the degree to which a spending unit relies on borrowed funds.

A)The debt-to-income ratio
B)The debt deflation ratio
C)Leveraging
D)The moral hazard.

Question 26

Which of the following is false?

A)Financial crisis occur with regular predictability.
B)Financial crisis have occurred in the past and will continue to occur in the future.
C)A debt deflation is a real decrease in debt burdens cause by falling incomes and prices and debt burdens that are denominated in dollars.
D)According to the financial instability hypothesis, in an extended period of recovery spending units forget the lessons of the past and take on more payments relative to their incomes.

Question 27

__________ are financial contracts the values of which are derived from the values of other underlying assets such as foreign exchange, bonds, equities, or commodities; examples include financial futures and options.

A)Standby letters of credit
B)Junk bonds
C)Unused credit lines
D)Derivatives

Question 28

Derivatives are financial contracts the values of which are derived from the values of other underlying assets such as

A)foreign exchange
B)bonds
C)equities
D)All of the above

Question 29

Which of the following statements about derivatives is false?

A)Derivatives are financial contracts the values of which are derived from the values of other underlying assets.
B)Examples of derivatives include futures, options, and combinations thereof.
C)Bank participation in derivative markets is severely limited because of the inherent riskiness of the instruments.
D)Derivatives can be used to hedge or to speculate.

Question 30

Interest rate risk may be reduced by using which of the following?

A)adjustable-rate loans
B)better credit analysis
C)nondeposit liabilities
D)only fixed-rate loans

Question 31

Which of the following refers to the risk most associated with a shortage of cash?

A)interest rate risk
B)liquidity risk
C)exchange rate risk
D)credit risk

Question 32

Exchange rate risk can be hedged

A)with futures and options.
B)by purchasing funds in the repurchase agreement, fed funds, or Eurodollar markets.
C)by using adjustable rate loans.
D)by diversifying portfolios.

Question 33

Which of the following has not contributed to the growing use of futures and options?

A)the increased volatility of foreign exchange rates and interest rates
B)the globalization of finance
C)the increase in credit risk
D)increased price instability

Question 34

Liquidity risk may be reduced by which of the following?

A)the purchase of fed funds, repurchase agreements, and Eurodollars
B)the purchase of currency swaps
C)the purchase of interest rate swaps
D)All of the above are correct.

Question 35

Risk is especially intensified in financial claims because

A)it is unwise to hedge interest rates.
B)the Eurodollar market is highly volatile.
C)payments from one party to another are usually dependent upon payments from third parties.
D)of deposit insurance.

Question 36

When spending units become more and more heavily dependent on payments from others, the risk of multiple defaults

A)remains the same.
B)decreases.
C)increases.
D)dramatically decreases.

Question 37

Which of the following does not help explain why financial crises occur?

A)the inherent risk of financial intermediation
B)the low savings rate in the United States
C)the layering or interconnectedness of financial claims
D)sophisticated global electronic funds transfers

Question 38

Which of the following may increase the probability of a financial crisis?

A)a sharp unexpected rise in interest rates
B)unexpected decreases in the overall level of prices
C)a fall in stock values
D)All of the above are correct.

Question 39

A fall in stock prices can

A)reduce the net worth of the firm.
B)reduce the net worth of the stockholders.
C)possibly lower the value of a firm's collateral.
D)All of the above are correct.

Question 40

__________ describes real increases in debt burdens caused by falling incomes and prices.

A)Debt deflation
B)Debt inflation
C)Real income depreciation
D)Real income inflation

Question 41

The last widespread debt deflation in the United States occurred during

A)World War I.
B)the Great Depression.
C)the 1950s.
D)the 1970s Middle East Oil Crisis.

Question 42

Financial crises may occur periodically because of which of the following?

A)the layering of financial claims
B)the inherent risks in financial intermediation
C)the fungibility of funds
D)All of the above are correct.

Question 43

Which of the following terms best describes the U.S. Savings and Loan industry during the 1980s?

A)expanding
B)strained and failing
C)healthy and stable
D)overburdened by excessive regulations

Question 44

Why was the deposit interest rate ceiling for S&Ls higher than the ceiling for commercial banks?

A)to encourage lending to small businesses
B)to discourage commercial banks from borrowing short term in order to finance long-term mortgage loans
C)to encourage savings in S&Ls that could then be used to make mortgage loans
D)because S&Ls were not as safe as banks

Question 45

Nominal interest rates are

A)approximately equal to real interest rates plus the past year's inflation rate.
B)approximately equal to real interest rates plus the expected inflation rate.
C)a reflection of prior real interest rates plus past year's inflation rates.
D)considered Regulation Q ceiling rates plus the current inflation rate.

Question 46

When interest rates rise, the value of long-term bonds

A)remains the same.
B)rises.
C)falls.
D)rises at diminishing rates.

Question 47

When interest rates rise, the value of long-term fixed-rate mortgages

A)remains the same.
B)rises.
C)falls.
D)rises at diminishing rates.

Question 48

In 1981, the S&L industry

A)is estimated to have had a negative net worth.
B)was very healthy by today's standards.
C)was in the process of being nationalized which led to severe strains.
D)none of the above

Question 49

Which of the following did not contribute to the 1980s Savings and Loan crisis?

A)expanded lending powers of the S&Ls
B)higher capital requirements
C)hesitation on the part of regulators and legislators
D)the falling value of S&L assets

Question 50

In 1999 dollars, the estimated cost to taxpayers of the Savings and Loan bailout was

A)$124 million
B)$124 billion
C)less than initially estimated.
D)Both b and c are correct.

Question 51

What problem occurs when FDIC-insured banks make riskier loans than they would if they did not have deposit insurance?

A)lower rate of returns
B)moral hazard
C)negative cash flows
D)resource allocation

Question 52

The FDIC presently insures deposits up to what amount?

A)$25,000 per account
B)$50,000 per account
C)$250,000 per account
D)$1,000,000 per account

Question 53

Deposit insurance can be credited with

A)increasing the rates of interest demanded by depositors.
B)preventing any significant general run on FDIC-insured banks.
C)creating a moral hazard problem that leads banks to make riskier loans.
D)Both b and c are correct.

Question 54

Which of the following is false?

A)In the early 2000s, moral hazard is a concern among those who are designing an international framework for financial stability.
B)As financial flows across national borders increase, excessive risk taking may occur if financial participants think that a country in crisis will be bailed out.
C)If investors' losses are reduced or eliminated, a moral hazard problem will exist that will encourage excessive risk taking.
D)Previous crises in Mexico, Asia, Russia, and Argentina resulted in massive international financial support so that investors did not lose anything.

Question 55

Disintermediation

A)is the removal of funds from financial intermediaries.
B)is a response to falling interest rates.
C)occurs when the Fed raises Regulation Q interest rate ceilings.
D)is the cashing in of financial claims such as stocks and bonds.

Question 56

Disintermediation occurred in the S&L industry

A)when funds were transferred from commercial paper markets into S&L deposits.
B)when funds were withdrawn from S&Ls and reinvested directly in the open market.
C)because the Fed raised Regulation Q ceilings.
D)because sharply falling interest rates led depositors to abandon the low returns paid on S&L deposits.

Question 57

Some of the new areas of concern for banking regulation are

A)changing balance sheets.
B)activities that do not show up on financial statements.
C)overall growth of the financial system.
D)All of the above are correct.

Question 58

Domestic financial assets are not a part of national wealth because

A)assets to one party are liabilities to other parties.
B)they are not included in the national product accounts.
C)they have no productivity capacity.
D)All of the above are correct.

Question 59

Off-balance-sheet activities include which of the following?

A)Overdraft protection
B)Stand-by lines of credit
C)Unused credit card balances
D)All of the above are correct.

Question 60

New financial risk situations result from

A)the changing composition of balance sheets.
B)activities that do not appear on financial statements.
C)overall growth of the financial system relative to the real sector.
D)All of the above are correct.

Question 61

Domestic financial assets

A)are a part of national wealth.
B)are not a part of national wealth.
C)include financial liabilities.
D)are not a part of national wealth, but include financial liabilities.

Question 62

The financial instability hypothesis attempts to explain

A)why a period of prosperity may lead to an eventual collapse.
B)how the mixture of hedge, speculative, and Ponzi spending units determines the overall health of the economy.
C)why there is a natural tendency for the economy to experience long term boom-crisis cycles.
D)All of the above are correct.

Question 63

Which of the following is false?

A)According to Minsky, in an extended recovery, the seeds of an eventual downturn are planted.
B)A long term cycle of boom and bust is an inherent part of a capitalist economy.
C)As spending units move from hedge to speculative to Ponzi units, their debt-income ratios rise.
D)Minsky's financial instability hypothesis attempts to explain the short-term year to year gyrations in the economy.

Question 64

Leveraging

A)is the degree to which spending units rely on borrowed funds.
B)declines of the course of an economic expansion or recovery.
C)causes problems for the economy only if there is not enough.
D)is higher for hedge units than Ponzi units.

Question 65

Debt-to-income ratios

A)rise over the course of the expansion or recovery.
B)fall over the course of the expansion or recovery.
C)fall over the course of the downturn.
D)Both a and c are correct.

Question 66

Which of the following is true?

A)As confidence grows, spending units rely less on borrowed funds and reduce their debt-to-income ratios.
B)The mixture of hedge, speculative, and Ponzi spending units determines the overall health of the economy.
C)National wealth includes financial liabilities.
D)Speculative spending units are more at risk than Ponzi spending units.

Question 67

The financial instability hypothesis attempts to explain

A)The long-term decline of the U.S. economy that became apparent in the 1990s.
B)how the mixture of hedge, speculative, and Ponzi spending units determines the overall health of the economy.
C)why there is a natural tendency for the economy not to experience long term boom-crisis cycles.
D)All of the above are correct.

Question 68

Which of the following is true?

A)According to Minsky, in an extended recovery, the seeds of an eventual downturn are planted.
B)A long term cycle of boom and bust has never happened in the U.S. economy.
C)As spending units move from hedge to speculative to Ponzi units, their debt-income ratios fall.
D)Minsky's financial instability hypothesis attempts to explain the short-term year to year gyrations in the economy.

Question 69

According to the financial instability hypothesis, when government intervenes to break a downturn

A)The economy returns to a financially stable position.
B)Spending units do not reduce their leveraging and the economy remains financially fragile.
C)the knowledge that the government will do so may create banks to take on more risks.
D)Both b and c are correct.

Question 70

Financial instability is caused by all of the following except:

A)a severe fall in stock prices
B)a sharp and unexpected rise in interest rates
C)a housing price collapse
D)stable Fed policy

Question 71

The insurance company that insured the deposits in S&Ls until 1989 when it was dissolved because of insolvency is

A)the Federal Home Loan Bank.
B)the Federal Savings and Loan Insurance Corporation (FSLIC).
C)the Federal Deposit Insurance Corporation (FDIC).
D)savings Association Insurance Fund.

Question 72

A real increase in debt burdens caused by falling wages and prices is a

A)debt inflation.
B)falling debt-to-income ratio.
C)debt deflation.
D)moral hazard.

Question 73

Which of the following is false?

A)The great financial meltdown of 2008 started with a crisis in the subprime mortgage market
B)Government has not tried to mitigate the downturn of 2007-2008.
C)In the early 2000s, many subprime loans had been packaged together and sold as mortgage-backed securities.
D)Minsky's financial instability hypothesis attempts to explain the long-term boom-bust cycle of a capitalist economy.

Question 74

The risks included in financial intermediation

A)cause financial crisis to occur from time to time.
B)include default, interest rate, liquidity, and exchange rate risks.
C)combine with the layering of financial claims.
D)All of the above are correct.

Question 75

The risks included in financial intermediation

A)can always be successfully managed with prudent lending so that no defaults will occur.
B)include moral hazard and exchange rate risks.
C)Are managed by the government
D)None of the above is correct.