Economics of Money, Banking, and Financial Markets, 12e, Global Edition (Mishkin)
Chapter 10 Economic Analysis of Financial Regulation
10.1 Asymmetric Information as a Rationale for Financial Regulation
1) Depositors lack of information about the quality of bank assets can lead to
A) bank panics.
B) bank booms.
C) sequencing.
D) asset transformation.
2) The fact that banks operate on a “sequential service constraint” means that
A) all depositors share equally in the bank’s funds during a crisis.
B) depositors arriving last are just as likely to receive their funds as those arriving first.
C) depositors arriving first have the best chance of withdrawing their funds.
D) banks randomly select the depositors who will receive all of their funds.
3) Depositors have a strong incentive to show up first to withdraw their funds during a bank
crisis because banks operate on a
A) last-in, first-out constraint.
B) sequential service constraint.
C) double-coincidence of wants constraint.
D) everyone-shares-equally constraint.
4) Because of asymmetric information, the failure of one bank can lead to runs on other banks.
This is the
A) too-big-to-fail effect.
B) moral hazard problem.
C) adverse selection problem.
D) contagion effect.
5) The contagion effect refers to the fact that
A) deposit insurance has eliminated the problem of bank failures.
B) bank runs involve only sound banks.
C) bank runs involve only insolvent banks.
D) the failure of one bank can hasten the failure of other banks.
6) During the boom years of the 1920s, bank failures were quite
A) uncommon, averaging less than 30 per year.
B) uncommon, averaging less than 100 per year.
C) common, averaging about 600 per year.
D) common, averaging about 1,000 per year.
7) To prevent bank runs and the consequent bank failures, the United States established the
________ in 1934 to provide deposit insurance.
A) FDIC
B) SEC
C) Federal Reserve
D) ATM
8) The primary difference between the “payoff” and the “purchase and assumption” methods of
handling failed banks is
A) that the FDIC guarantees all deposits when it uses the “payoff” method.
B) that the FDIC guarantees all deposits when it uses the “purchase and assumption” method.
C) that the FDIC is more likely to use the “payoff” method when the bank is large and it fears
that depositor losses may spur business bankruptcies and other bank failures.
D) that the FDIC is more likely to use the purchase and assumption method for small institutions
because it will be easier to find a purchaser for them compared to large institutions.
9) Deposit insurance has not worked well in countries with
A) a weak institutional environment.
B) strong supervision and regulation.
C) a tradition of the rule of law.
D) few opportunities for corruption.
10) When one party to a transaction has incentives to engage in activities detrimental to the other
party, there exists a problem of
A) moral hazard.
B) split incentives.
C) ex ante shirking.
D) pre-contractual opportunism.
11) Moral hazard is an important concern of insurance arrangements because the existence of
insurance
A) provides increased incentives for risk taking.
B) is a hindrance to efficient risk taking.
C) causes the private cost of the insured activity to increase.
D) creates an adverse selection problem but no moral hazard problem.
12) When bad drivers line up to purchase collision insurance, automobile insurers are subject to
the
A) moral hazard problem.
B) adverse selection problem.
C) assigned risk problem.
D) ill queue problem.
13) Deposit insurance is only one type of government safety net. All of the following are types of
government support for troubled financial institutions EXCEPT
A) forgiving tax debt.
B) lending from the central bank.
C) lending directly from the government’s treasury department.
D) nationalizing and guaranteeing that all creditors will be repaid their loans in full.
14) Although the FDIC was created to prevent bank failures, its existence encourages banks to
A) take too much risk.
B) hold too much capital.
C) open too many branches.
D) buy too much stock.
15) A system of deposit insurance
A) attracts risk-taking entrepreneurs into the banking industry.
B) encourages bank managers to decrease risk.
C) increases the incentives of depositors to monitor the riskiness of their bank’s asset portfolio.
D) increases the likelihood of bank runs.
16) The government safety net creates ________ problem because risk-loving entrepreneurs
might find banking an attractive industry.
A) an adverse selection
B) a moral hazard
C) a lemons
D) a revenue
17) Since depositors, like any lender, only receive fixed payments while the bank keeps any
surplus profits, they face the ________ problem that banks may take on too ________ risk.
A) adverse selection; little
B) adverse selection; much
C) moral hazard; little
D) moral hazard; much
18) Acquiring information on a bank’s activities in order to determine a bank’s risk is difficult for
depositors and is another argument for government
A) regulation.
B) ownership.
C) recall.
D) forbearance.
19) The existence of deposit insurance can increase the likelihood that depositors will need
deposit protection, as banks with deposit insurance
A) are likely to take on greater risks than they otherwise would.
B) are likely to be too conservative, reducing the probability of turning a profit.
C) are likely to regard deposits as an unattractive source of funds due to depositors’ demands for
safety.
D) are placed at a competitive disadvantage in acquiring funds.
20) In May 1991, the FDIC announced that it would sell the government’s final 26% stake in
Continental Illinois, ending government ownership of the bank that it had rescued in 1984. The
FDIC took control of the bank, rather than liquidate it, because it believed that Continental
Illinois
A) was a good investment opportunity for the government.
B) could be the Chicago branch of a new governmentally-owned interstate banking system.
C) was too big to fail.
D) would become the center of the new midwest region central bank system.
21) If the FDIC decides that a bank is too big to fail, it will use the ________ method, effectively
ensuring that ________ depositors will suffer losses.
A) payoff; large
B) payoff; no
C) purchase and assumption; large
D) purchase and assumption; no
22) Federal deposit insurance covers deposits up to $250,000, but as part of a doctrine called
“too-big-to-fail” the FDIC sometimes ends up covering all deposits to avoid disrupting the
financial system. When the FDIC does this, it uses the
A) “payoff” method.
B) “purchase and assumption” method.
C) “inequity” method.
D) “Basel” method.
23) The result of the too-big-to-fail policy is that ________ banks will take on ________ risks,
making bank failures more likely.
A) small; fewer
B) small; greater
C) big; fewer
D) big; greater
24) A problem with the too-big-to-fail policy is that it ________ the incentives for ________ by
big banks.
A) increases; moral hazard
B) decreases; moral hazard
C) decreases; adverse selection
D) increases; adverse selection
25) The too-big-to-fail policy
A) reduces moral hazard problems.
B) puts large banks at a competitive disadvantage in attracting large deposits.
C) treats large depositors of small banks inequitably when compared to depositors of large
banks.
D) allows small banks to take on more risk than large banks.
26) Increased size of financial institutions resulting from financial consolidation increases the
________ problem, because there are now more large institutions whose failure would expose
the financial system to systemic risk.
A) too-big-to-fail
B) asset transformation
C) transactions costs
D) economies of scale
27) Financial consolidation of banks with other financial services in recent years poses
government safety net problems. The safety net intended for depository institutions may be
A) extended to other activities such as securities underwriting.
B) too small to do any good.
C) filled with large gaps.
D) unnecessarily increased when there is a problem in an area that does not impact depository
institutions.
28) The government safety net creates both an adverse selection problem and a moral hazard
problem. Explain.
10.2 Types of Financial Regulation
1) Regulators attempt to reduce the riskiness of banks’ asset portfolios by
A) limiting the amount of loans in particular categories or to individual borrowers.
B) encouraging banks to hold risky assets such as common stocks.
C) establishing a minimum interest rate floor that banks can earn on certain assets.
D) requiring collateral for all loans.
2) A well-capitalized financial institution has ________ to lose if it fails and thus is ________
likely to pursue risky activities.
A) more; more
B) more; less
C) less; more
D) less; less
3) A bank failure is less likely to occur when
A) a bank holds less U.S. government securities.
B) a bank suffers large deposit outflows.
C) a bank holds fewer excess reserves.
D) a bank has more bank capital.
4) The leverage ratio is the ratio of a bank’s
A) assets divided by its liabilities.
B) income divided by its assets.
C) capital divided by its total assets.
D) capital divided by its total liabilities.
5) To be considered well capitalized, a bank’s leverage ratio must exceed
A) 10%.
B) 8%.
C) 5%.
D) 3%.
6) The FDIC must take steps to close down banks whose equity capital is less than ________ of
assets.
A) 4%
B) 3%
C) 2%
D) 1%
7) Off-balance-sheet activities
A) generate fee income with no increase in risk.
B) increase bank risk but do not increase income.
C) generate fee income but increase a bank’s risk.
D) generate fee income and reduce risk.
8) The Basel Accord, an international agreement, requires banks to hold capital based on
A) risk-weighted assets.
B) the total value of assets.
C) liabilities.
D) deposits.
9) The Basel Accord requires banks to hold as capital an amount that is at least ________ of their
risk-weighted assets.
A) 10%
B) 8%
C) 5%
D) 3%
10) Under the Basel Accord, assets and off-balance sheet activities were sorted according to
________ categories with each category assigned a different weight to reflect the amount of
________.
A) 2; adverse selection
B) 2; credit risk
C) 4; adverse selection
D) 4; credit risk
11) The practice of keeping high-risk assets on a bank’s books while removing low-risk assets
with the same capital requirement is known as
A) competition in laxity.
B) depositor supervision.
C) regulatory arbitrage.
D) a dual banking system.
12) Banks engage in regulatory arbitrage by
A) keeping high-risk assets on their books while removing low-risk assets with the same capital
requirement.
B) keeping low-risk assets on their books while removing high-risk assets with the same capital
requirement.
C) hiding risky assets from regulators.
D) buying risky assets from arbitragers.
13) Because banks engage in regulatory arbitrage, the Basel Accord on risk-based capital
requirements may result in
A) reduced risk taking by banks.
B) reduced supervision of banks by regulators.
C) increased fraudulent behavior by banks.
D) increased risk taking by banks.
14) One of the criticisms of Basel 2 is that it is procyclical. That means that
A) banks may be required to hold more capital during times when capital is short.
B) banks may become professional at a cyclical response to economic conditions.
C) banks may be required to hold less capital during times when capital is short.
D) banks will not be required to hold capital during an expansion.
15) Overseeing who operates banks and how they are operated is called
A) prudential supervision.
B) hazard insurance.
C) regulatory interference.
D) loan loss reserves.
16) The chartering process is especially designed to deal with the ________ problem, and regular
bank examinations help to reduce the ________ problem.
A) adverse selection; adverse selection
B) adverse selection; moral hazard
C) moral hazard; adverse selection
D) moral hazard; moral hazard
17) The chartering process is similar to ________ potential borrowers and the restriction of risk
assets by regulators is similar to ________ in private financial markets.
A) screening; restrictive covenants
B) screening; branching restrictions
C) identifying; branching restrictions
D) identifying; credit rationing
18) Banks will be examined at least once a year and given a CAMELS rating by examiners. The
L stands for
A) liabilities.
B) liquidity.
C) loans.
D) leverage.
19) The federal agencies that examine banks include
A) the Federal Reserve System.
B) the Internal Revenue Service.
C) the SEC.
D) the U.S. Treasury.
20) Banks are required to file ________ usually quarterly that list information on the bank’s
assets and liabilities, income and dividends, and so forth.
A) call reports
B) balance reports
C) regulatory sheets
D) examiner updates
21) Regular bank examinations and restrictions on asset holdings help to indirectly reduce the
________ problem because, given fewer opportunities to take on risk, risk-prone entrepreneurs
will be discouraged from entering the banking industry.
A) moral hazard
B) adverse selection
C) ex post shirking
D) post-contractual opportunism
22) The current supervisory practice toward risk management
A) focuses on the quality of a bank’s balance sheet.
B) determines whether capital requirements have been met.
C) evaluates the soundness of a bank’s risk-management process.
D) focuses on eliminating all risk.