Chapter 11 – The Economics of Financial Intermediation
95. What is the difference between economies of scale and economies of scope? Provide an
example of each that pertains to financial institutions.
96. Is the lender/borrower (owner) conflict, an example of adverse selection or moral hazard?
Explain.
Chapter 11 – The Economics of Financial Intermediation
97. If a lender faces a potential loan applicant pool made up of equal amounts of good risks
and high risks, will charging an average interest rate provide the average (expected) return?
Explain.
98. Please explain how Federal Deposit Insurance (FDIC) could potentially create a moral
hazard for the managers of deposit institutions.
99. Why is it that financial intermediaries are so important in most economies?
Chapter 11 – The Economics of Financial Intermediation
100. What are the five functions performed by financial intermediaries?
101. Provide an example of how a bank achieves lower cost in making a large loan to a
company than could be achieved without the bank.
Chapter 11 – The Economics of Financial Intermediation
102. If diversification is such a good idea for a saver, why do so many people put a lot of their
savings in the same bank?
103. Explain how mutual funds offer small investors a low-cost way to achieve
diversification.
Chapter 11 – The Economics of Financial Intermediation
104. If buyers cannot distinguish quality, and on average, people value a good used car at
$15,000 and a “lemon” at $5,000, explain why an average price of $10,000 for used cars will
not bring the average of quality used cars to the market.
105. A bank advertises a very competitive loan interest rate. Explain how this strategy can
avoid the problem of adverse selection.
106. Discuss the role that companies like Standard & Poor’s, Dun & Bradstreet, and Moody’s
play in solving the problem of adverse selection.
Chapter 11 – The Economics of Financial Intermediation
107. Respond to the following: “If it takes a significant period of time to uncover accounting
manipulations by individuals in a major corporation, honesty may be the best policy but
dishonesty can be a lot more profitable!”
108. Private Mortgage Insurance (PMI) is often required by mortgage lenders when the
borrowers have less than a 20% down payment. Link the requirement of PMI to the concepts
of net worth, moral hazard, and transfer of risk.
Chapter 11 – The Economics of Financial Intermediation
109. Explain the difference between a secured and an unsecured loan, and the interest rate you
would expect to see charged on each (all other factors equal).
110. Explain what is likely to happen to the rate of mortgage loan default given the following:
“For years home values across the country have increased on average 3 to 4% percent each
year. Mortgage lenders have come to expect this to always be the case and so begin to offer
mortgages with little to nothing down and not requiring PMI insurance. An economic
slowdown occurs hitting a few areas of the country harder than others. Home values across
the country begin to decrease with some areas seeing decreases of as much as 10%.”
Chapter 11 – The Economics of Financial Intermediation
111. Explain why deflation can be so troubling to borrowers and lenders.
112. Life insurance companies usually offer a lower premium to non-smokers than the
premium charged to smokers. Discuss first the potential for adverse selection and moral
hazard and then ways the company can seek to reduce or eliminate these problems.
Chapter 11 – The Economics of Financial Intermediation
113. You have a friend that has run up a pretty large balance on his credit card. He mentions
to you that he has missed a few payments but doesn’t think it is that big of a deal since all it
cost him is a little more interest on his balance. You tell him it may end up costing him a lot
more that. He presses you for an explanation. Explain to him how his handling of this debt
can impact what he pays for future debt.
114. It is not uncommon to read about highly successful mutual fund managers that spend
considerable amounts of time visiting the companies that they have placed their clients’ funds
with. What might be the motive(s) behind these visits?
Chapter 11 – The Economics of Financial Intermediation
11–43
115. Explain how the threat of a leveraged buyout or a takeover can actually treat the problem
of moral hazard.
116. The United States, the United Kingdom, Germany and Japan are all developed countries
with highly developed and efficient financial markets. However, in all four countries the main
source of business finance is internal funding. Why is this so?
Essay Questions
Chapter 11 – The Economics of Financial Intermediation
117. Most credit cards charge a relatively high rate of interest, yet many people carry them,
including people who would be considered low-risk borrowers. Our discussion of adverse
selection said that low-risk borrowers should have been discouraged from these What gives?
118. A friend who is taking her first class in investments asks you why the regulatory bodies
place so much emphasis on minimizing insider information if many of the potential problems
associated with financial transactions stem from information asymmetry or a lack of
information. How would you respond?
Chapter 11 – The Economics of Financial Intermediation
119. Prosper.com is a San Francisco-based web site that facilitates peer-to-peer micro lending.
If you were going to consider making a loan through Prosper would you be more concerned
about adverse selection or moral hazard, and why?
120. How did information asymmetries in the home mortgage market contribute to the
financial crisis of 2007-2009?