Financial Markets and Institutions, 8e (Mishkin)
Chapter 18 Financial Regulation
18.1 Multiple Choice
1) 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 2,000 per year.
2) 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) precontractual opportunism.
3) Moral hazard is an important consequence of insurance arrangements because the existence of
insurance
A) provides increased incentives for risk taking.
B) impedes efficient risk taking.
C) causes the private cost of the insured activity to increase.
D) does both A and B of the above.
E) does both B and C of the above.
4) 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.
5) 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.
6) 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.
7) Deposit insurance
A) attracts risk-prone entrepreneurs to the banking industry.
B) encourages bank managers to take on greater risks than they otherwise would.
C) reduces the incentives of depositors to monitor the riskiness of their banks’ asset portfolios.
D) does all of the above.
E) does only A and B of the above.
8) The possibility that the failure of one bank can hasten the failure of other banks is called the
A) bank run effect.
B) moral hazard effect.
C) contagion effect.
D) adverse selection effect.
9) 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
10) If the FDIC uses the purchase and assumption method to handle a failed bank,
A) all deposits will suffer losses.
B) small deposits will be paid in full but deposits over the insurance limit will not.
C) all deposits will be paid in full.
D) none of the above will occur.
11) One problem of the too-big-to-fail policy is that it ________ the incentives for ________ by
big banks.
A) reduces; moral hazard by big banks
B) increases; moral hazard by big banks
C) reduces; adverse selection by big banks
D) increases; adverse selection by big banks
12) 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) large; fewer
D) large; greater
13) The too-big-to-fail policy
A) exacerbates 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) does only A and C of the above.
14) Which of the following solutions have been proposed to solve the too-big-to-fail problem?
A) Break up large, systemically important financial institutions.
B) Impose higher capital requirements on large, systemically important financial institutions.
C) Do nothing, since Dodd-Frank effectively eliminated the problem.
D) All of the above have been proposed.
15) Some view that Dodd-Frank eliminated the too-big-to-fail problem. How did it achieve this?
A) By making it harder for the Federal Reserve to bail out financial institutions
B) By eliminating the Volcker rule
C) By reducing the regulation of SIFIs
D) All of the above.
16) The primary difference between the “payoff” and the “purchase and assumption” methods of
handling failed banks is that the FDIC
A) guarantees all deposits, not just those under the $250,000 limit, when it uses the “payoff”
method.
B) guarantees all deposits, not just those under the $250,000 limit, when it uses the “purchase
and assumption” method.
C) 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) does both A and B of the above.
E) does both B and C of the above.
17) The primary difference between the “payoff” and the “purchase and assumption” methods of
handling failed banks is that the FDIC
A) guarantees all deposits, not just those under the $250,000 limit, when it uses the “payoff”
method.
B) guarantees all deposits, not just those under the $250,000 limit, when it uses the “purchase
and assumption” method.
C) is less 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) does both A and B of the above.
E) does both B and C of the above.
18) 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) prohibiting banks from holding risky assets such as common stocks.
C) establishing a minimum interest rate floor that banks can earn on certain assets.
D) doing all of the above.
E) doing only A and B of the above.
19) One way for bank regulators to assure depositors that a bank is not taking on too much risk is
to require the bank to
A) diversify its loan portfolio.
B) reduce its equity capital.
C) reduce the size of its loan portfolio.
D) do both A and B of the above.
E) do both B and C of the above.
20) Banks do not want to hold too much capital because
A) they do not bear fully the costs of bank failures.
B) higher returns on equity are earned when bank capital is smaller, all else equal.
C) higher capital levels attract the scrutiny of regulators.
D) all of the above.
E) only A and B of the above.
21) When regulators engage in microprudential regulation, they focus on ________.
A) the safety and soundness of individual financial institutions
B) the credit standards of individual loans
C) the safety and soundness of each customer of a financial institution
D) the safety and soundness of each asset the financial institution holds
22) When regulators engage in macroprudential regulation, they focus on ________.
A) the safety and soundness of the entire financial institution
B) the credit standards of all loans held by the financial institution
C) the safety and soundness of the financial system in aggregate
D) the safety and soundness of each liability of the financial institution
23) The increased integration of financial markets across countries and the need to make the
playing field equal for banks from different countries led to the Basel Accord agreement to
A) standardize bank capital requirements internationally.
B) reduce, across the board, bank capital requirements in all countries.
C) sever the link between risk and capital requirements.
D) do all of the above.
24) Under the Basel plan,
A) assets and off-balance sheet activities are assigned to various categories to reflect the degree
of credit risk.
B) a bank’s total capital must equal or exceed 8 percent of total risk-weighted assets.
C) both of the above occur.
D) none of the above occur.
25) Of the following assets, the one which has the highest capital requirement under the Basel
Accord is
A) municipal bonds.
B) residential mortgages.
C) commercial paper.
D) securities issued by industrialized countries’ governments.
26) Which of the following is not true regarding the Basel 2 proposal to reform the original 1988
Basel Accord?
A) It attempts to link capital requirements more closely to actual risk by expanding the number
of risk categories.
B) It focuses on assessing the quality of risk management in banking institutions.
C) It attempts to improve market discipline by requiring increased disclosure of pertinent
information about banks.
D) It has been well received by banks and national regulatory agencies.
27) Ways in which bank regulations reduce the adverse selection and moral hazard problems in
banking include
A) a chartering process designed to prevent crooks from getting control of a bank.
B) restrictions that prevent banks from acquiring certain risky assets, such as common stocks.
C) high bank capital requirements to increase the cost of bank failure to the owners.
D) all of the above.
E) only A and B of the above.
28) 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
29) The chartering process is especially designed to deal with the ________ problem, and
restrictions on asset holdings 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
30) Regular bank examinations and restrictions on asset holdings indirectly help to 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
31) Regular bank examinations and restrictions on asset holdings indirectly help to ________ the
adverse selection problem because, given fewer opportunities to take on risk, risk-prone
entrepreneurs will be ________ from entering the banking industry.
A) increase; encouraged
B) increase; discouraged
C) reduce; encouraged
D) reduce; discouraged
32) The legislation that separated commercial banking from the securities industry is known as
the ________.
A) National Bank Act
B) Federal Reserve Act
C) Glass-Steagall Act
D) McFadden Act
33) The Depository Institutions Deregulation and Monetary Control Act of 1980
A) approved NOW accounts nationwide.
B) restricted the use of ATS accounts.
C) imposed interest rate ceilings on bank loans.
D) did all of the above.
34) The Depository Institutions Deregulation and Monetary Control Act of 1980
A) approved NOW accounts nationwide.
B) imposed uniform reserve requirements.
C) mandated the phase out of interest-rate ceilings on deposits.
D) did all of the above.
E) did only A and B of the above.
35) As a way of stemming the decline in the number of savings and loans and mutual savings
banks, the Garn-St. Germain Act of 1982 allowed
A) money market certificates.
B) money market mutual funds.
C) money market deposit accounts.
D) negotiable order of withdrawal accounts.
36) An impact of the Garn-St. Germain Act of 1982 has been to
A) put savings and loans at a competitive disadvantage.
B) make the banking system more competitive.
C) give money market mutual funds a competitive advantage.
D) do both A and B of the above.
E) do both A and C of the above.
37) Moral hazard and adverse selection problems increased in prominence in the 1980s
A) as deregulation opened up more avenues for savings and loans and mutual savings banks to
take on more risk.
B) following a burst of financial innovation in the 1970s and early 1980s that produced new
financial instruments and markets, thereby widening the scope for risk taking.
C) following an increase in federal deposit insurance from $40,000 to $100,000.
D) because of all of the above.
E) because of only A and B of the above.
38) Moral hazard and adverse selection problems increased in prominence in the 1980s
A) as deregulation opened up more avenues for savings and loans and mutual savings banks to
take on more risk.
B) following a burst of financial innovation in the 1970s and early 1980s that produced new
financial instruments and markets, thereby widening the scope for risk taking.
C) following a decrease in federal deposit insurance from $100,000 to $40,000.
D) because of all of the above.
E) because of only A and B of the above.
39) The Federal Deposit Insurance Corporation Improvement Act of 1991
A) increased the FDIC’s ability to borrow from the Treasury to deal with failed banks.
B) reduced the scope of deposit insurance in several ways.
C) eliminated governmentally administered deposit insurance.
D) did only A and B of the above.
40) The Federal Deposit Insurance Corporation Improvement Act of 1991
A) reduced the scope of deposit insurance in several ways.
B) eliminated restrictions on nationwide banking.
C) allowed well-capitalized banks to do some securities underwriting.
D) did only A and B of the above.
E) did only A and C of the above.
41) The Federal Deposit Insurance Corporation Improvement Act of 1991
A) reduced the scope of deposit insurance in several ways.
B) limited the FDIC’s ability to use the “too-big-to-fail” policy.
C) requires the FDIC to intervene earlier when a bank gets into trouble.
D) did all of the above.
42) The Federal Deposit Insurance Corporation Improvement Act of 1991
A) instructed the FDIC to come up with risk-based deposit insurance premiums.
B) expanded the FDIC’s ability to use the “too-big-to-fail” policy.
C) instructed the FDIC to wait longer before intervening when a bank gets into trouble.
D) did all of the above.
43) What is the primary argument for not giving depositors greater incentive to monitor financial
institutions?
A) Experts do not believe that depositors are capable of monitoring banks and imposing
discipline on them.
B) Banks could be subject to more frequent runs by nervous depositors.
C) Both A and B are correct.
D) Neither A nor B is correct.
44) Which of the following is least likely to accompany financial consolidation and the
development of large, complex banking organizations?
A) More financial institutions will be considered too big to fail.
B) The government safety net will be extended to include nonbanking activities.
C) Moral hazard problems will become less important.
D) Banks will have greater incentives and opportunities to take on more risk.
45) What accounts for the problems facing China’s four largest banks?
A) Large loans to inefficient, state-owned enterprises
B) Closing of unprofitable branches and laying off unproductive employees
C) Selling shares in the bank overseas to raise capital
D) All of the above
46) World Bank research on the effects of deposit insurance concludes that
A) adoption of deposit insurance will promote stability and efficiency in the banking systems of
emerging-market economies.
B) adoption of explicit government deposit insurance is associated with a higher incidence of
banking crises.
C) adoption of deposit insurance has the greatest benefits in countries that have weaker
institutional environments.
D) none of the above are true.
47) Just prior to the global financial crisis, mortgage loans known as NINJA loans were issued to
borrowers. What is a NINJA loan?
A) A loan issued by a Japanese bank, thus avoiding U.S. regulation.
B) A loan document originated by a mortgage banker named Bruce Lee.
C) A loan issued to borrowers with no income, employment, nor assets to speak of.
D) A loan issued with a “martial arts” clause.
48) Which of the following categories is not part of the Dodd-Frank legislation of 2010?
A) capital requirements
B) consumer protection
C) “Volcker Rule”
D) derivatives
49) In an effort to control the use of derivatives by financial institutions, the Dodd-Frank
legislation of 2010 requires ________.
A) standardized derivatives products
B) over-the-counter trading (instead of exchange trading) of derivatives products
C) an increase in counterparty risk
D) all of the above
50) An SIV, or structured investment vehicle, is an off-balance-sheet entity that shields a
sponsoring institution from risk. What happened to some of these SIVs when they ran into
financial problems?
A) The SIV sued the sponsoring institution to pay, in full, all liabilities of the SIV.
B) The SIV still remained off-balance-sheet, but investors did sue sponsoring institutions.
C) Nothing! The SIV status as off-balance-sheet remained, a nice example of a financial
structure that worked during the financial crisis.
D) Troubled SIVs became an asset of the sponsoring institution — the off-balance-sheet status
was meaningless.
51) What role did the credit-rating agencies play leading up to the start of the financial crisis in
2007?
A) Inaccurate ratings provided by credit-rating agencies helped promote risk taking throughout
the financial system.
B) The credit-rating agencies were the first to see signs of trouble, and they developed more
stringent standards as the housing bubble evolved.
C) Solid ratings provided by credit-rating agencies helped limit risk taking throughout the
financial system.
D) The credit-rating agencies were largely uninvolved with the financial crisis.
1) To understand banking regulation in the United States, it is helpful to understand the concepts
of asymmetric information, adverse selection, and moral hazard.
2) Because asymmetric information problems in the banking industry are a fact of life throughout
the world, bank regulation in other countries is similar to that in the United States.
3) The failure of one bank can hasten the failure of others in what is referred to as a contagion
effect.
4) To be classified as a well-capitalized bank, a bank’s leverage ratio must exceed 8 percent.
5) Once a bank has been chartered, it is required to file periodic call reports that reveal the bank’s
assets and liabilities, income, ownership, and other details.
6) “Truth in lending” was mandated under the Consumer Protection Act of 1969 and requires all
lenders to reveal the annual percentage rate, or APR, on loans.
7) Probably the most important feature of FDICIA is its prompt corrective action provisions
which require the FDIC to intervene earlier and more vigorously when a bank gets into trouble.
8) According to some economists, Congress made a mistake when it passed the FDICIA of not
requiring the FDIC to assess risk-based insurance premiums.
9) The “too-big-to-fail” policy reduces the adverse selection problem in bank regulation.
10) A better capitalized bank has more to lose when it fails and is less likely to take less risk.
11) When the payoff method is used to resolve a failed bank, both large and small depositors are
protected from suffering losses.
12) In the years just prior to the global financial crisis, mortgage loans were issued to borrowers
with no income or employment.
13) The Dodd-Frank legislation of 2010 finally resolved the status of GSEs such as Freddie Mac.
14) Prior to the global financial crisis, inaccurate ratings provided by credit rating agencies
helped promote risk taking throughout the financial system.
18.3 Essay
1) What do we learn about the causes of banking crises by comparing crises throughout the
world to those that have occurred in the United States?
2) What is the asymmetric information problem and how does it contribute to our understanding
of the structure of bank regulation in the United States and other countries?
3) Why did the United States experience a banking crisis in the 1980s?
4) How has bank regulation in the United States changed since the late 1980s? What accounts for
these changes?
5) How have bank capital requirements changed since the banking crisis of the 1980s? Explain.
6) Describe the CAMELS rating system used by bank examiners.
7) Why does the safety net created by deposit insurance increase the adverse selection and moral
hazard problems in banking? How do bank regulations attempt to overcome these problems?
8) Discuss some of the problems of Basel 2 that the global financial crisis revealed.
9) Discuss the role of mark-to-market accounting during the global financial crisis. Did it help or
hurt credit markets and bank lending?
10) Discuss the role of NINJA loans in the global financial crisis.
11) Why is international financial regulation becoming more important in recent years?
12) Describe 2 of the 5 different categories of regulation found in the Dodd-Frank legislation of
2010.
13) How can we change the way the credit-rating system works to avoid the problems
encountered with ratings prior to the Global Financial Crisis?
14) Describe the difference between macroprudential and microprudential regulation.
15) One way to avoid the too-big-to-fail problem with banks is to break-up large, systemically
important financial institutions. What are the downsides to this solution?
16) How does Dodd-Frank claim to eliminate the too-big-to-fail problem?
17) Discuss the advantages and problems of using market-value accounting for bank capital
requirements.
18) Discuss some of the recent banking crises throughout the world.