Chapter 14
Regulating the Financial System
Multiple-Choice Questions
1. Empirical evidence points to the fact that financial crises:
a. are newsworthy but have no impact on economic growth.
b. have a negative impact on economic growth only for the year of the crisis.
c. have a negative impact on economic growth for years.
d. can have a positive impact on economic growth as weak borrowers are weeded out.
2. Rumors of a bank failing, even if not true, can become a self-fulfilling prophecy because:
a. customers will not want to obtain loans from this bank.
b. equity investors will not be able to sell the bank’s stock.
c. regulators will scrutinize the bank heavily looking for something wrong.
d. depositors will rush to the bank to withdraw their deposits and the bank under normal
situations would not have sufficient liquid assets on hand.
3. What matters most during a bank run is:
a. the number of loans outstanding.
b. the solvency of the bank.
c. the liquidity of the bank.
d. the size of the bank’s assets.
4. Contagion is:
a. the failure of one bank spreading to other banks through depositors withdrawing of funds.
b. the phenomenon that if one bank loan defaults it will cause other bank loans to default.
c. the rapid contraction of investment spending that occurs when interest rates are increased
by the Federal Reserve.
d. the rapid inflation that results from the printing of money.
5. A bank run involves:
a. illegal activities on the part of the bank’s officers.
b. a bank being forced into bankruptcy.
c. a large number of depositors withdrawing their funds during a short time span.
d. a bank’s return on assets being below the acceptable level.
6. The federal government is concerned about the health of the banking system for many
reasons, the most important of which may be:
a. banks are where government bonds are traded.
b. a significant number of people are employed in the banking industry.
c. many people earn the majority of their income from interest on bank deposits.
d. banks are of great importance in enabling the economy to operate efficiently.
7. When healthy banks fail due to widespread bank panics, those who are likely to be hurt
are:
a. government regulators.
b. households and small businesses.
c. the FDIC.
d. the Federal Reserve.
8. It is difficult for depositors to know the true health of banks because:
a. regulations prohibit banks making their financial statements publicly
available.
b. the financial statements of banks are too difficult for most people to understand.
c. most of the information on bank loans is private and based on sophisticated models.
d. banking is competitive and financial records of banks are not divulged to prevent
competitor banks from having an advantage.
9. The reason that a run on a single bank can turn into a bank panic that threatens the entire
financial system is:
a. information asymmetries.
b. moral hazard.
c. the lack of regulation.
d. the increased reliance on web-based funds transfers.
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10. Bank failures tend to occur most often during periods of:
a. stock market run ups when, like many companies, banks tend to be overvalued.
b. high inflation when the fixed rate loans of many banks cause their real returns to decrease.
c. recessions when many borrowers have a difficult time repaying loans and lending activity
slows.
d. wars and other civil unrest.
11. Bank panics have often begun as a result of:
a. rumors only.
b. real economic events only.
c. both rumors and real economic events.
d. neither rumors nor economic events.
12. Deflation can cause widespread bank crises for all of the following reasons except:
a. a decline in the value of borrowers’ net worth but not their liabilities.
b. borrowers’ default rates increase.
c. bank balance sheets deteriorate as the level of economic activity decreases.
d. information asymmetry problems decrease during deflationary
peri
ods.
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13. Recession can cause widespread bank crises for all of the following reasons except:
a. there is less business investment as banks make fewer loans.
b. borrowers’ default rates increase.
c. bank capital increases.
d. the negative effect on banks’ balance sheets.
14. The reasons for the government to get involved in the financial system include each of
the following, except:
a. to protect the bank’s monopoly position.
b. to protect investors.
c. to ensure the stability of the financial system.
d. to protect bank customers from monopolistic exploitation.
15. An economic rationale for government protection of small investors is that:
a. large investors can better afford losses.
b. many small investors cannot adequately judge the soundness of their bank.
c. there is inadequate competition to ensure a bank is operating efficiently.
d. banks are often run by unethical managers who will often exploit small investors.
16. The government regulates bank mergers, sometimes denying the proposed merger.
Often the reason given for the denial is to protect small investors. What are small investors
being protected from?
a. with a larger bank the bank is likely to take greater risk and may fail.
b. in order to pay for the merger, the bank may seek higher returns putting the
depositors’ funds at greater risk.
c. mergers can increase the monopoly power of banks and the bank may seek to exploit
this power by raising prices and earning unwarranted profits.
d. bank runs hurt larger banks more than smaller banks.
17. The financial system is inherently more unstable than most other industries due to the
fact that:
a. while in most other industries customers disappear at a faster rate, in banking
they disappear slowly so the damage is done before the real problem is identified.
b. banks deal in paper profits, not in real profits.
c. a single firm failing in banking can bring down the entire system; this isn’t true in
most other industries.
d. there is less competition than in other industries.
18. The government’s role of lender of last resort is directed to:
a. large manufacturing firms that employ thousands of people.
b. depositors; this is role the government plays when they insure depositors’ balances
in banks that fail.
c. developing countries that are trying to build their financial systems.
d. banks that experience sudden deposit outflows.
19. The government provides deposit insurance; this insurance protects:
a. large corporate deposit accounts, but only the amounts that exceed the $250,000
deductible.
b. depositors for up to $250,000 should a bank fail.
c. the deposits of banks in their Federal Reserve accounts.
d. the deposits that people have, but only for federally chartered banks.
20. The government’s providing of deposit insurance and functioning as the lender of
last resort has significantly:
a. decreased the incentive for bank managers to take on risk.
b. increased the amount of regulation of banks required, but has had no effect on
bank’s incentive to take on risk.
c. increased the incentive for banks to take on risk, but has had no effect on the amount
of regulation of banks required.
d. increased the amount of regulation of banks required and increased the incentive for
banks to take on risk.
21. One of the unique problems that banks face is:
a. they hold liquid assets to meet illiquid liabilities.
b. they hold illiquid assets to meet liquid liabilities.
c. they hold liquid assets to meet liquid liabilities.
d. both their assets and their liabilities are illiquid.
22. The interbank loans that appear on banks’ balance sheets represent what proportion of
bank capital?
a. Less than 4 percent
b. Almost three-fourths
c. About one-third
d. Less than one percent
23. The best way for a government to stop the failure of one bank from turning into a bank
panic is to:
a. make sure solvent institutions can meet the withdrawal demands of depositors.
b. declare a bank holiday until solvent banks can acquire adequate liquidity.
c. limit the withdrawals of depositors.
d. provide zero-interest rate loans to all banks regardless of net worth.
24. The need for a lender of last resort was identified as far back as:
a. the start of the Great Depression in 1929.
b. 1913, when the Federal Reserve was created.
c. 1873, by British economist Walter Bagehot.
d. 1776, by the first U.S. Secretary of the Treasury, Alexander Hamilton.
25. The creation of the Federal Reserve in 1913:
a. provided the opportunity for lender of last resort but not the guarantee that it would be
used.
b. guaranteed the Federal Reserve would always act as lender of last resort.
c. eliminated bank panics in the U.S.
d. was in response to the Great Depression in the U.S.
26. If the lender of last resort function of the government is to be effective in working
to minimize a crisis, it must be:
a. reserved only for those banks that are most deserving.
b. used on a limited basis.
c. credible, with banks knowing they can get loans quickly.
d. only available during economic downturns.
27. The first test of the Federal Reserve as lender of last resort occurred with the:
a. attack on Pearl Harbor by the Japanese.
b. widespread failures of Savings and Loans in the 1980’s.
c. introduction of flexible exchange rates in the U.S. in 1971.
d. stock market crash in 1929.
28. One lesson learned from the bank panics of the early 1930’s is:
a. the lender of last resort function almost guarantees that bank panics are a thing of the past.
b. the mere existence of a lender of last resort will not keep the financial system from
collapsing.
c. only the U.S. Treasury can be a true lender of last resort.
d. the financial system will collapse without a lender of last resort.
29. During a bank crisis:
a. officials at the Federal Reserve find it easy to sort out solvent from insolvent banks.
b. it is important for regulators to be able to distinguish insolvent from illiquid
ba
nks.
c
. it is easy to determine the market prices of bank’s assets.
d. a bank will go to the central bank for a loan before going to other banks.
30. A moral hazard situation arises in the lender of last resort function because:
a. a central bank finds it difficult to distinguish illiquid from insolvent banks.
b. a central bank usually will only make a loan to a bank after it becomes insolvent.
c. a central bank usually undervalues the assets of a bank in a crisis.
d. the central bank is the first place a bank facing a crisis will turn.
31. If your stockbroker gives you bad advice and you lose your investment:
a. the government will reimburse you similar to reimbursing depositors if a bank fails.
b. the government will not reimburse you for the loss; you are not protected from bad advice
by your stockbroker.
c. these losses would be covered under FDIC insurance.
d. your investment would only be covered if the stockbroker was employed by a bank.
32. The existence of a lender of last resort creates moral hazard for bank managers because:
a. they have an incentive to take too much risk in their operations.
b. officials are likely to undervalue the bank’s portfolio of assets.
c. they are less likely to apply for a direct loan from the central bank.
d. banks seek loans from the central bank only after exploring other options.
33. During the financial crisis of 2007-2009 in the United States it was revealed that
the function of a lender of last resort had not kept pace with the evolving financial
system because:
a. financial intermediaries had grown sufficiently large so as not to need a lender of last resort.
b. shadow banks lacked access to the financial resources available through the lender of
la
s
t
re
s
ort.
c. banks were sufficiently linked to one another that the need for a lender of last resort
had diminished.
d. banks had become sufficiently diversified so as to be able to provide for their own
liquidity.
34. When the Federal Reserve was unable to stem the bank panics of the 1930s,
Congress responded by:
a. taking over the lender of last resort function and assigning this function to the
U.S. Treasury.
b. ordering the printing of tens of billions of dollars of additional currency.
c. creating the FDIC and offering deposit insurance.
d. declaring a bank holiday and closing banks for 30 days.
35. One reason customers do not care about the quality of their bank’s assets is:
a. most people cannot distinguish an asset from a liability.
b. the quality of a bank’s assets changes almost daily.
c. they assume the bank only has high quality assets.
d. with deposit insurance, there isn’t any real reason to care; their deposits are protected
even if the bank fails.
36. On November 20, 1985, the Bank of New York needed to use the lender of last
resort function due to:
a. a run on the bank started by a rumor that the president of the bank embezzled tens
of millions of dollars from the bank.
b. a computer error caused the bank’s records to wipe out the balances of all of its customers.
c. a rumor that the bank was about to be taken over by FDIC due to insolvency.
d. a computer error that made it impossible for the bank to keep track of its Treasury bond
trades.
37. The payoff method used by the FDIC to address the insolvency of a bank is when the
FDIC:
a. pays the owners of the bank for the losses they would otherwise face.
b. pays off all depositors the balances in their accounts so no depositor suffers a loss,
though the owners of the bank may suffer losses.
c. pays off the depositors up to the current $250,000 limit, so it is possible that
some depositors will suffer losses.
d. takes all of the assets of the bank, sells them, pays off the liabilities of the bank in full,
and then replenishes their fund with any remaining balance.
38. Under the purchase-and-assumption method of dealing with a failed bank, the FDIC:
a. finds another bank to take over the insolvent bank.
b. takes over the day to day management of the bank.
c. sells the failed bank to the Federal Reserve.
d. sells off the profitable loans of the failed bank in an open auction.
39. Considering the methods available to the FDIC for dealing with a failed bank, the
depositors of the failed bank should:
a. be indifferent between the two since it really does not matter to them which method is used.
b. prefer the purchase and assumption method since the deposits over $250,000 will also be
protected.
c. prefer the payoff method because they will have access to their funds earlier.
d. prefer the payoff method since a lot less paperwork is involved for the depositor.
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40. Under the purchase-and-assumption method, the FDIC usually finds it:
a. can sell the failed bank for more than the bank is actually worth.
b. can sell the bank at a price equaling the value of the failed banks assets.
c. has to sell the bank at a negative price since the bank is insolvent.
d. cannot sell the bank and almost always has to revert to the payoff method for dealing
with a failed bank.
41. Many states had their own insurance fund to protect depositors. The critical problem
with these state funds is:
a. they are monopolies in their own state and extract extremely high prices for the
insurance they provide.
b. they are highly inefficient they cannot achieve the economies of scale a federal fund
can achieve.
c. they do not have regulators as knowledgeable as the regulators at FDIC.
d. no state fund is large enough to withstand a run on all of the banks it insures.
42. Deposit insurance only seems to be viable at the federal level. This is likely due to
the fact that:
a. state funds are less informed about the solvency of national banks.
b. a run on the banks within a state will always spread countrywide.
c. the U.S. Treasury backs the FDIC and can therefore withstand virtually any crisis.
d. the cost of state insurance is prohibitively high.
43. In the ten years after the FDIC limit was increased to $100,000:
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a. more than four times the number of banks and savings and loans failed than did during
the first 46 years of FDIC’s existence.
b. less than one-fourth the number of banks and savings and loans failed than during the first
46 years of FDIC’s existence.
c. the cost to taxpayers of failed institutions in that period was negligible because FDIC was
in place.
d. increasing the deposit insurance limit to $250,000 provided complete coverage for all
deposits except those of large corporations.
44. Which of the following statements is most correct?
a. The higher the deposit insurance limit the lower the risk of moral
haza
rd.
b. The higher the deposit insurance limit the greater the risk of moral hazard.
c. Deposit insurance limits do not impact moral hazard, they impact adverse selection.
d. Increasing the deposit insurance limits above $100,000 would increase coverage for over
50 percent of all depositors.
45. Since the 1920’s, the ratio of assets to capital has almost tripled for commercial
banks. Many economists believe this is the direct result of:
a. lower quality management in banks.
b. the increase in branch banking.
c. allowing banks to offer non-bank services.
d. government provided deposit insurance.
46. As a result of government provided deposit insurance, the ratio of assets to capital
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for commercial banks since the 1920s has:
a. just about doubled.
b. almost tripled.
c. not changed.
d. decreased.
47. The moral hazard problem caused by government safety nets:
a. is greater for larger banks.
b. is greater for smaller banks.
c. is pretty constant across banks of all sizes.
d. only exists for banks with high leverage ratios.
48. The government’s too-big-to-fail policy applies to:
a. certain highly populated states where a bank run impacts a large percent of the
total population.
b. large banks whose failure would start a widespread panic in the financial system.
c. large corporate payroll accounts held by some banks where many people would lose their
income.
d. banks that have branches in more than two states.
49. Implicit government support for “too-big-to–fail” banks:
a. increases the scrutiny of the bank’s risk by large corporate depositors.
b. reduces the risk faced by depositors with accounts less than $250,000.
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c. reduces the risk faced by depositors with accounts exceeding $250,000.
d. reduces the moral hazard problem of insuring large banks.
50. If the government did not offer the too-big-to-fail safety net:
a. large banks would be more disciplined by the potential loss of large corporate accounts.
b. the moral hazard problem of insuring large banks would increase.
c. the moral hazard problem of insuring large banks would not be affected.
d. the FDIC deposit insurance limits would have to be raised.
51. Governments employ three strategies to contain the risks created by government safety
nets. These include each of the following, except:
a. government supervision.
b. an excise tax on bank profits.
c. government regulation.
d. formal bank examination.
52. The purpose of the government’s safety net for banks is to do each of the following,
except:
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a. protect the integrity of the financial system.
b. eliminate all risk that investors face.
c. stop bank panics.
d. improve the efficiency of the economy.
53. Governments supervise banks mainly to do each of the following, except:
a. reduce the potential cost to taxpayers of bank failures.
b. be sure the banks are following the regulations set out by banking laws.
c. reduce the moral hazard risk.
d. eliminate all risk faced by investors.
54. Savings banks and savings and loans are regulated by a combination of agencies
which includes all of the following except:
a. The Federal Reserve System.
b. The Comptroller of the Currency.
c. The Federal Deposit Insurance Corporation.
d. state authorities.
55. Savings banks and savings and loans are regulated by a combination of agencies
which includes the:
a. Federal Reserve System.
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b. Office of the Comptroller of the Currency.
c. Securities and Exchange Commission.
d. Internal Revenue Service.
56. Which of the following regulates commercial banks as well as savings banks and
savings and loans?
a. The Federal Reserve System
b. Securities and Exchange Commission
c. The Office of the Comptroller of the Currency
d. The Internal Revenue Service
57. Credit Unions are regulated by a combination of agencies which includes:
a. state authorities.
b. The Federal Reserve.
c. The Federal Deposit Insurance Corporation.
d. The Office of the Comptroller of the Currency.
58. Banks can effectively choose their regulators by deciding whether to:
a. be a private or public corporation.
b. be a member of the Federal Reserve or not.
c. purchase FDIC insurance or to forego the coverage.
d. be chartered at the national or state level.
59. The fact that banks can be either nationally or state chartered creates:
a. situations where some banks go unregulated.
b. situations where banks operating in more than one state can escape regulation.
c. regulatory competition.
d. banks being simultaneously regulated by more than one agency.
60. One negative consequence of regulatory competition is:
a. it is expensive.
b. financial institutions are over regulated at a cost to customers.
c. financial institutions often seek out the most lenient regulator.
d. it minimizes competition.