Chapter 11
The Economics of Financial Intermediation
Multiple-Choice Questions
1. Financial intermediation is:
a. far less important than direct finance through stock and bond markets.
b. only a little more important than direct finance in the United States.
c. much more important than direct finance through stock and bond markets.
d. the same thing as finance through stock and bond markets.
2. Financial intermediation exists, in part, because:
a. financial markets work so well.
b. direct finance through stocks and bonds is the dominant form of financing.
c. transaction costs of financial intermediation is always higher than direct finance.
d. the transaction costs associated with direct finance can at times be prohibitive.
3. When the amount of direct and indirect financing are summed, the result is usually:
a. greater than 100% of GDP.
b. equal to GDP.
c. less than GDP.
d. approximately 50% of GDP.
4. Emerging market economies, compared to industrialized economies, have financial markets
that:
a. differ in composition and size.
b. differ in composition but not in size.
c. are the same in composition but differ in size.
d. are similar in composition and size.
5. The reason financial intermediaries play such an important role in economies has to do with
all of the following except:
a. information costs.
b. transaction costs.
c. complexity of a lot of financial transactions.
d. the composition of GDP.
6. Which of the following is not a role of a financial institution acting as a financial
intermediary?
a. Pooling the resources of small savers
b. Formulating oversight regulations
c. Providing ways to diversify risk
d. Supplying liquidity
7. Financial institutions, acting as financial intermediaries, perform all of the following, except:
a. provide ways to diversify risk.
b. pooling resources of small savers.
c. increase transactions costs.
d. provide safekeeping and accounting services.
8. Financial intermediaries pool the resources of many small savers so that they can:
a. charge fees to these small savers and earn substantial income.
b. obtain the funds necessary to make loans to borrowers seeking large amounts.
c. lower their transaction costs of obtaining funds.
d. avoid paying any interest to obtain funds to lend.
9. If financial intermediaries did not have the ability to pool the resources of small savers:
a. borrowers needing large amounts of money would find it more costly to obtain the funds.
b. the economy would grow faster.
c. people would likely save more.
d. the risk associated with lending would decrease.
10. Financial intermediaries:
a. increase the cost of financial transactions but offset these higher costs by providing
safekeeping of customer funds.
b. provide handling of payments but usually less efficiently than other firms.
c. reduce the cost of financial transactions.
d. provide safety of resources, but only for the large borrowing customers who can afford it.
11. Financial intermediaries, through their ability to lower transaction costs:
a. allow for people to be more self-sufficient.
b. increase the amount of trading that occurs in an economy.
c. take people away from their comparative advantage.
d. reduce the number of financial transactions that occur.
12. Financial intermediaries, through their ability to lower transaction costs:
a. reduce the opportunity cost of specialization.
b. decrease the efficiency of an economy.
c. allow for people to be more self-sufficient.
d. make collecting and processing information unprofitable.
13. The fact that a financial intermediary can hire a lawyer to write one contract that works for
many customers is an example of:
a. economies of scale.
b. the law of diminishing marginal returns.
c. the law of increasing opportunity cost.
d. the law of demand.
14. The fact that financial intermediaries employ experts to carry out particular activities and so
lower transactions costs is usually associated with the following economic concept:
a. the law of demand.
b. economies of scale.
c. comparative advantage.
d. information costs.
15. Economies of scale associated with financial intermediaries means:
a. the total cost of handling transactions falls as more transactions of different kinds are handled.
b. the cost per transaction falls as a larger volume of similar transactions are handled.
c. the cost per transaction increases as more transactions are handled.
d. the cost per transaction decreases regardless of the number of transactions.
16. Examples of economies of scale are:
a. the additional fees financial intermediaries charge on small accounts.
b. the decrease in overall transaction costs that occur as volume increases.
c. the reduction in the cost per transaction that occurs as the number of transactions increase.
d. the decrease in overall information costs that occurs as more transactions are handled.
17. The reduction in transaction costs provided by financial intermediaries benefit:
a. small borrowers and small savers.
b. large borrowers but not small savers.
c. society in the net, but small savers bear much of the cost.
d. small borrowers but not small savers.
18. Automated teller machines provided by financial intermediaries are an example of:
a. high transactions costs associated with financial intermediaries.
b. diseconomies of scale.
c. the ability of financial intermediaries to provide liquidity.
d. the ability of financial intermediaries to earn profits by raising transaction costs above the
norm.
19. The function of providing liquidity by financial intermediaries:
a. includes depositors withdrawing funds but not borrowers.
b. only considers people who borrow on a short-term basis, but not depositors.
c. affects people who need to borrow and depositors who withdraw their funds.
d. only affects customers with savings accounts.
20. Since one function of financial intermediaries is to provide liquidity:
a. they must keep all of their funds in short-term securities.
b. they keep almost all of their funds in cash.
c. they must know approximately how much liquidity their customers will need each day and
have these funds available.
d. regulations require financial intermediaries to keep 50% of their assets in cash.
21. A bank can usually offer a saver a higher return for the same risk for all of the following
reasons except:
a. the bank can usually purchase assets at a lower cost than any one saver.
b. the bank can pool the resources of small savers and purchase higher valued assets.
c. economies of scale can also be applied by the bank in its purchase of assets.
d. savers do not have good enough information to know if the return is sufficient.
22. Lines of credit provided by financial intermediaries:
a. decrease liquidity for customers but increase income for the intermediary.
b. are pre-approved loans that can increase liquidity and lowering transaction costs.
c. are costly for intermediaries to provide so are only available to large commercial customers.
d. require deposits in the intermediary that equal or exceed the amount of the line of credit.
23. When a bank takes savings from many small savers and lends it to many borrowers, the
bank:
a. decreases the risk to savers through diversification.
b. increases the risk to borrowers through high transaction costs.
c. decreases the risk to savers through economies of scale.
d. decreases the return to savers and increases the cost to borrowers.
24. If a bank has 1,000 depositors, each of whom deposits $1,000 in the bank, and the bank
makes loans of $10,000 each, then each depositor has contributed:
a. $100 to each loan.
b. $1 to each loan.
c. $10 to each loan.
d. $1000 to each loan.
25. Mutual funds offer investors:
a. a greater return for greater risk than what an investor can earn on his own.
b. a lower return for more risk than what the investor could earn on his own.
c. a lower return for less risk than what the investor could earn on his own.
d. a way for individuals to eliminate the idiosyncratic risk associated with any single investment.
26. Mutual funds are attractive because:
a. they provide high returns from purchasing the financial securities of a few select companies.
b. they provide the investor with greater diversification at a lower cost than what most investors
could obtain individually.
c. they have inside information that is not available to other investors.
d. they usually have inside information because they run most of the companies they invest in.
27. A bank has 10,000 depositors, each of whom deposits $100 in the bank. If the bank makes
1000 loans for $1,000 each then each depositor has contributed:
a. $1 to each loan.
b. $100 to each loan.
c. $0.10 to each loan.
d. $10 to each loan.
28. A lender usually knows less about the creditworthiness of a borrower than the borrower
does. This is an example of:
a. opportunistic behavior.
b. economies of scale.
c. diminishing marginal returns.
d. information asymmetry.
29. Most individuals save at banks rather than lend directly because:
a. the bank creates information asymmetry.
b. moral hazard exists only when individuals make loans directly to borrowers, it does not occur
when banks issue loans.
c. banks can reduce the cost of information asymmetry.
d. information asymmetry is a problem for individuals but not for banks.
30. Financial intermediaries reduce the problems in lending associated with information
asymmetries by all of the following except:
a. collecting and processing standardized information.
b. screening applicants to be sure they are creditworthy.
c. monitoring loan recipients to be sure the funds are used properly.
d. charging interest rates high enough to discourage undesirable borrowers.
31. Asymmetric information poses two important obstacles to the smooth flow of funds from
savers to investors. They are:
a. adverse selection, which arises before the transaction occurs, and moral hazard, which occurs
after the transaction.
b. moral hazard, which arises before the transaction occurs, and adverse selection, which occurs
after the transaction.
c. adverse selection and moral hazard, both of which occur after the transaction.
d. adverse selection and moral hazard, both of which occur before the transaction.
32. Financial markets do not function as well as they could due to:
a. the fact that banking is highly monopolized.
b. the cost of obtaining information which can be high.
c. regulation by governments.
d. fluctuations in the inflation rate.
33. The usual situation in banking regarding asymmetric information is:
a. borrowers know more than lenders.
b. lenders know more than borrowers.
c. borrowers and lenders have the same information.
d. lenders and borrowers have perfect information.
34. Mom’s Pizzeria goes out of business due to a dramatic decrease in sales from a local
newspaper article highlighting the fact that Mom’s Pizzeria has been purchasing expired meat
from a distributor at cut rate prices for years. The decrease in business also results in Mom’s
defaulting on the loan they have with the bank. This is an example of:
a. symmetric information in the financial markets.
b. perfect information in the financial markets.
c. asymmetric information in the financial markets.
d. perfect information in the pizza market.
35. Mom’s Bakery goes out of business due to decreasing sales resulting from the dramatic
increase in people on low carbohydrate diets. The decrease in business also results in Mom’s
defaulting on the loan they have with the bank. This is an example of:
a. lack of perfect information in financial markets.
b. asymmetric information in financial markets.
c. moral hazard in financial markets.
d. symmetric information in financial markets.
36. Often times we see companies offering money back guarantees to customers if they are not
satisfied. These guarantees are a way to treat the problem of:
a. buyers having more information about the product than the seller.
b. the seller having more information about the product than the buyer.
c. symmetric information.
d. adverse selection.
37. Which of the following is not true of adverse selection?
a. It exists because information is perfect.
b. It describes the problem a lender faces in identifying loan applicants as good or bad risk
borrowers.
c. It arises because borrowers have more information than lenders regarding their
creditworthiness.
d. It arises if lenders try to charge an average price to all applicants.
38. In a financial market where information is symmetric:
a. there would be moral hazard.
b. one party to a transaction knows information the other party does not.
c. the ability to obtain information is available to only one party.
d. there would be no adverse selection.
39. Two problems that arise from asymmetric information are:
a. adverse selection and diseconomies of scale.
b. moral hazard and the free-rider problem.
c. moral hazard and adverse selection.
d. the free-rider problem and adverse selection.
40. Which of the following is a problem of adverse selection?
a. The lender has a problem of distinguishing good risk from bad risk borrowers.
b. The lender has a problem determining that the proceeds from a loan are being used as the
borrower stated.
c. A person takes up the hobby of bungee jumping after purchasing health insurance.
d. Individuals use more medical services as a result of their purchase of a health insurance plan.
41. Which of the following is a problem of moral hazard?
a. A lender cannot distinguish good risk from bad risk borrowers.
b. An individual who purchases auto insurance begins to leave his or her keys in the car while
running into a store.
c. Life insurance companies offer an average premium to smokers and non-smokers so they do
not have to have two different premiums.
d. An auto insurance company charges higher premiums to younger drivers than what they
charge to older drivers.
42. One of the conclusions from Akerlof’s paper titled “The Market for Lemons” was:
a. high quality goods will drive low quality goods out of the market.
b. lacking the ability to distinguish high from low quality, the quality the market will end up
offering will be the average quality.
c. lacking the ability to distinguish high from low quality, low quality may drive high quality out
of the market.
d. high quality is always demanded by consumers over low quality.
43. Mary Jones is the president of a local bank. She knows that half of the loan applicants in
town she would classify as high risk and the other half as low risk. She observes that the other
banks in town charge two different interest rates, a lower rate for low risk borrowers and the
higher rate for high risk borrowers. She decides that to have an advantage over the other banks
she will offer an average rate to everyone. The likely result will be:
a. Mary’s bank will be highly successful as this will provide the bank with a large competitive
advantage.
b. Mary’s bank is likely to see a dramatic increase in both types of borrowers.
c. Mary’s bank will experience adverse selection and have a disproportionate number of low risk
borrowers.
d. Mary’s bank will experience adverse selection and have a disproportionate number of high risk
borrowers.
44. One lesson that Akerlof’s Lemons model provides is:
a. that for high quality providers to survive they must provide a way that customers can
distinguish high quality from low quality.
b. low quality will not survive in a market.
c. people always prefer high quality to low quality goods.
d. moral hazard is unavoidable.
45. A firm that has a well-earned reputation for providing high quality:
a. has found a way to address the free-rider problem.
b. has found a way to address the moral hazard problem.
c. has found a way to address the problem of adverse selection.
d. will not survive in a market if low quality is provided at a lower price.
46. The interest rates charged on most credit cards is:
a. high due to the problem of adverse selection.
b. high because Visa and MasterCard have a virtual monopoly on this business.
c. high due to diseconomies of scale that exist in this market.
d. lower than they should be given the problem of adverse selection.
47. Assume there are two companies. Both issue stock, but one is high quality and the other low
quality. If potential investors cannot distinguish the quality of the company:
a. the shares of the low quality firm will disappear from the market.
b. the shares of both companies will trade on the market.
c. the shares of the high quality firm will disappear from the market.
d. this is an example of moral hazard and the shares of both companies will cease to trade.
48. The publication, Consumer’s Reports, is one tool designed to address:
a. adverse selection.
b. moral hazard.
c. the free-rider problem.
d. symmetric information.
49. In the bond market, the assigning of a risk premium is a tool designed to address the
problem of:
a. adverse selection.
b information asymmetry.
c. the free-rider.
d. moral hazard.
50. Used car dealers that provide warranties on the cars they sell are addressing the:
a. lemons problem.
b. monopoly problem.
c. problem of people preferring foreign cars.
d. free rider problem of buyers preferring new versus used cars.
51. Adverse selection:
a. increases the efficiency of most markets.
b. usually causes prices to adjust faster than they otherwise would.
c. makes it easier for all customers to find what they want.
d. results in fewer market transactions.
52. Which of the following statements is true?
a. Adverse selection is a problem of monopoly and moral hazard is a problem of information
asymmetry.
b. Adverse selection and moral hazard are problems stemming from asymmetric information.
c. Adverse selection is a problem that occurs after a transaction.
d. Moral hazard is a problem that occurs before a transaction.
53. Which of the following statements is true?
a. Adverse selection is a problem that occurs after a transaction.
b. Moral hazard is a problem that occurs before a transaction.
c. Adverse selection is a problem stemming from asymmetric information.
d. Both adverse selection and moral hazard occur before a transaction.
54. One reason lenders usually require a lot of information from loan applicants is to avoid:
a. the problems of moral hazard.
b. the problem of adverse selection.
c. being harmed by symmetric information.
d. charges of discrimination in lending.
55. One reason the government requires public corporations to disclose so much information is
to:
a. minimize the monopoly profits some corporations earn.
b. give small corporations a better chance of competing against large corporations.
c. address the potential harm from asymmetric information.
d. discourage risk-taking by investors.
56. A lender who wants to avoid the problem of adverse selection could:
a. charge a very high interest rate and assume all loan applicants are high risk.
b. charge the same average interest rate to all borrowers.
c. charge a low interest rate and make the applicant prove they warrant the low rate by providing
information.
d. only lend by issuing credit cards.
57. The First Bank of Podunk has recently suffered some extraordinary losses on its loan
portfolio due to the closing of the largest employer in town. As a result, the bank’s management
decides to raise the interest rate to new loan applicants. This move is likely to:
a. increase the profitability of the bank.
b. cause even greater losses.
c. significantly increase both loan applicants and profits.
d. treat the problem of adverse selection that contributed to the losses the bank is experiencing.
58. The problem of adverse selection created the opportunity for:
a. lenders to profit significantly at the expense of borrowers.
b. significant deregulation of financial markets.
c. a new market in the trading of information.
d. stock prices for many years to be much lower than what they should have been.
59. Recent history has shown that the government regulations requiring the disclosure of
information from public corporations have:
a. all but eliminated the problems of asymmetric information.
b. reduced but not eliminated the problems of asymmetric information.
c. just about eliminated the market for information services.
d. resulted in symmetric information.
60. The price for private information is likely higher than it should be due to the problem of:
a. adverse selection.
b. free-riders.
c. the government regulations regarding information.
d. moral hazard.