54) Which of the following are accurate statements concerning the role that restrictive covenants
play in reducing moral hazard in financial markets?
A) Covenants reduce moral hazard by restricting borrowers’ undesirable behavior.
B) Covenants require that borrowers keep collateral in good condition.
C) Covenants require periodic accounting statements and income reports.
D) All of the above.
E) Only A and B of the above.
55) Although restrictive covenants can potentially reduce moral hazard, a problem with
restrictive covenants is that
A) borrowers may find loopholes that make the covenants ineffective.
B) they are costly to monitor and enforce.
C) too many resources may be devoted to monitoring and enforcing them, as debtholders
duplicate others’ monitoring and enforcement efforts.
D) all of the above.
E) only A and B of the above.
56) Governments in developing countries sometimes adopt policies that retard the efficient
operation of their financial systems. These actions include policies that
A) prevent lenders from foreclosing on borrowers with political clout.
B) nationalize banks and direct credit to politically favored borrowers.
C) make it costly to collect payments and collateral from defaulting debtors.
D) do all of the above.
E) do only A and B of the above.
57) Economies of scale
A) in the financial markets does not explain why financial intermediaries developed and have
become such an important part of our financial structure.
B) can be used to an advantage by reducing transaction cost.
C) both A and B of the above.
D) neither A nor B of the above.
58) Liquidity services are services that
A) make it easier for customers to conduct transactions.
B) conducts transactions for the customer.
C) increase transaction costs.
D) all of the above.
59) Adverse selection
A) is a problem created by asymmetrical information after the transaction.
B) can be solved by eliminating asymmetrical information.
C) occurs when people who do not pay for information take advantage of the information other
people have to pay for.
D) all of the above.
60) The free-rider problem
A) occurs when people who do not pay for information take advantage of the information other
people have to pay for.
B) suggests that the private sale of information will only be a partial solution to the lemons
problem.
C) prevents the private market from producing enough information to eliminate all the
asymmetric information that leads to adverse selection.
D) all of the above.
61) Bad firms
A) do not have an incentive to make themselves look good.
B) will slant the information they are required to transmit to the public.
C) both A and B of the above.
D) neither A nor B of the above.
62) A bank
A) has the ability to profit from the information it produces.
B) avoids the free-rider problem by primarily making private loans rather than by purchasing
securities that are traded in the open market.
C) becomes an expert in determining good firms from bad firms.
D) all of the above.
63) Net worth
A) is the difference between current assets and current liabilities.
B) is the difference between assets and liabilities.
C) is total assets divided by total liabilities.
D) is total assets plus total liabilities.
64) Economies of scope refer to cost savings that arise when the
A) size of financial transactions increase.
B) size of financial transactions decrease.
C) number of different activities undertaken increases.
D) number of different activities undertaken decreases.
65) The problem with monitoring as a tool to solve the ________ problem is that it can be
expensive in terms of time and money, as reflected in the name economists give it,costly state
verification.
A) principal-agent
B) adverse selection
C) audit
D) regulation
66) A financial institution can achieve cost savings by engaging in multiple activities. These are
called economies of
A) scope.
B) scale.
C) complexity.
D) information.
67) A financial institution can achieve cost savings in its credit card operations if it increases the
number of cardholders. This is an example of economies of
A) scope.
B) scale.
C) complexity.
D) information.
68) Which combination of activities within a single financial institution is least likely to lead to
conflicts of interest?
A) Auditing and management advisory services
B) Commercial banking and investment banking
C) Assessment of credit quality and consulting
D) Consumer lending and business lending
69) Conflicts of interest pose a problem because they
A) lower the quality of information.
B) increase problems of asymmetric information.
C) make the financial system less efficient.
D) do all of the above.
70) An advantage of providing multiple financial services within one financial institution is that
it
A) lowers information costs.
B) develops broader long-term relationships with customers.
C) both A and B of the above.
D) none of the above.
71) A conflict of interest occurs when
A) a financial firm sells a service to its customers for a price that exceeds the cost of producing
the service.
B) lenders prefer higher interest rates and borrowers prefer lower interest rates.
C) riskier borrowers are the ones who are more likely to apply for loans.
D) people expected to provide reliable information to the public have incentives not to do so.
72) A conflict of interest between providing impartial research about companies issuing
securities and selling those same securities arises in
A) investment banking.
B) commercial banking.
C) accounting firms.
D) mutual funds.
73) If potential revenues from underwriting greatly exceed brokerage commissions, there is
________ incentive for investment bank analysts to report ________ information about firms
issuing securities.
A) stronger; unbiased
B) stronger; favorable
C) weaker; unbiased
D) weaker; favorable
74) Spinning is the practice of
A) investment banks allowing executives of potential client companies to buy underpriced initial
public offerings of other companies’ securities.
B) investment bank analysts providing misleading information about a company to encourage
more investors to purchase the company’s securities.
C) accounting firms encouraging its audit clients to also purchase its management advisory
services.
D) credit rating agencies providing higher ratings on a company’s securities in order to develop a
long-term relationship with the company.
75) Investment banks are guilty of conflict of interest when they
A) pressure their analysts to produce research favorable to their client firms.
B) permit executives of client firms to alter analysts’ research on their firms.
C) prohibit analysts from making negative or controversial comments about client firms.
D) all of the above.
76) Investment banks serve two client groups,
A) home buyers and mortgage lenders.
B) people saving for retirement and pension funds.
C) issuers of securities and investors in those securities.
D) mutual funds and investors with relatively small amounts to invest.
77) Auditors attempt to reduce information asymmetry between a firm’s managers and its
A) customers.
B) owners.
C) employees.
D) competitors.
78) Conflicts of interest in the Arthur Andersen accounting firm intensified when ________
became the firm’s largest source of profits and large clients pressured ________ office managers
to give favorable audits.
A) consulting; regional
B) consulting; national
C) auditing; regional
D) auditing; national
79) The potential conflict of interest when a single accounting firm provides both auditing and
consulting services is that the firm can
A) charge higher fees to its audit clients and lower fees for its consulting services so it can
expand its consulting business.
B) charge higher fees to its consulting clients and lower fees for its audit services so it can
expand its auditing business.
C) provide unjustifiably favorable audit reviews for firms that are large clients for its consulting
services.
D) pressure its clients into paying high fees for both auditing and consulting services.
80) The conflict of interest in credit-rating agencies arises because ________ pay to have
securities rated and, as a result, the agencies’ ratings may be biased ________.
A) security issuers; downward
B) security issuers; upward
C) investors; downward
D) regulators; upward
81) During the 2007-2009 financial crisis, housing prices began to fall and subprime mortgages
began to default. Which of the following statements is true about the rating of subprime
mortgage products?
A) The rating agencies were way ahead of the market, giving many of the subprime products
junk ratings from the start.
B) Rating agencies were not involved. Subprime mortgages could not be structured, by law.
C) Many AAA-rated subprime products had to be downgraded over and over again until they
reached junk status.
D) None of the above are true.
82) Since firms issuing new securities pay to have these securities rated, the credit-rating
agencies have incentive to ________ to attract more business.
A) give favorable ratings
B) give impartial ratings
C) lower the fees they charge
D) practice spinning
83) The Sarbanes-Oxley Act of 2002 dealt with conflicts of interest in
A) investment banks.
B) accounting firms.
C) credit-rating agencies.
D) all of the above.
84) The Global Legal Settlement of 2002 dealt with conflicts of interest in
A) accounting firms.
B) investment banks.
C) credit-rating agencies.
D) all of the above.
85) Which of the following provisions of legislation to deal with conflicts of interest does not
increase the flow of information in financial markets?
A) Requiring a firm’s chief officers to certify its financial statements and other disclosures
B) Requiring investment banks to make their analysts’ recommendations public
C) Requiring disclosure of off-balance-sheet transactions
D) Increasing resources available to the Securities and Exchange Commission to supervise
financial markets
86) The Global Legal Settlement includes what key element?
A) It directly reduces conflicts of interest.
B) It provides incentives for investment banks to not exploit conflicts of interest.
C) It has measures to improve the quality for information in financial markets.
D) All of the above.
87) China is in an early state of development, with a per capita income that is still less than
________, one-fifth of the per capita income in the United States.
A) $5,000
B) $10,000
C) $25,000
7.2 True/False
1) American businesses get more funds from direct financing than from indirect financing.
2) American businesses use stock to finance about 10 percent of their external financing.
3) One reason why indirect financing is used is to minimize adverse selection problems.
4) Issuing marketable securities is the primary way businesses finance their operations.
5) Because of the adverse selection problem, lenders may refuse loans to individuals with low
net worth.
6) The concept of adverse selection helps to explain why indirect finance is more important than
direct finance as a source of business finance.
7) The problem of adverse selection helps to explain why direct finance is more important than
indirect finance as a source of business finance.
8) The concept of adverse selection helps explain why collateral is an important feature of many
debt contracts.
9) One way of describing the solution that high net worth provides to the moral hazard problem
is to say that it makes debt contracts incentive compatible.
10) Net worth is the difference between a firm’s assets and its liabilities.
11) Economies of scale means that the percentage return on a financial transaction rises as the
size of the transaction rises.
12) Agency theory focuses on how government agencies regulate financial intermediaries and
markets.
13) The principal-agent problem is an example of the adverse selection problem that can result
from asymmetric information.
14) The financial system is one of the most heavily regulated sectors of the economy.
15) Collateralized debt is also called secured debt.
16) Most legal work in the U.S. involves the writing and enforcement of contracts, not
ambulance chasing, criminal law, and frivolous lawsuits.
17) The Sarbanes-Oxley Act of 2002 was passed in response to scandals in the investment
banking industry.
18) The Sarbanes-Oxley Act of 2002 provides for oversight of accounting firms but makes no
provisions for increasing the flow of information to financial markets.
19) The Sarbanes-Oxley Act of 2002 and the Global Legal Settlement of 2002 both have the
potential to reduce economies of scope.
20) The Global Legal Settlement of 2002 arose out of a lawsuit brought by New York Attorney
General Eliot Spitzer against the ten largest investment banks.
21) The Sarbanes-Oxley Act of 2002 established a Public Company Accounting Oversight Board
(PCAOB), overseen by the SEC, to supervise accounting firms and ensure that audits are
independent and controlled for quality.
22) Due to criticisms of rating agencies following the default of many subprime products, the
SEC prohibited credit rating agencies from structuring the same products that they rate.
23) China is in an early state of development, with a per capita income that is still less than
$10,000, one-fifth of the per capita income in the United States.
1) What are economies of scale in financial transactions? How can financial intermediaries
achieve these economies?
2) How does the U.S. differ from other countries with respect to the source of funding for
nonfinancial business?
3) Explain how the “lemons” problem could cause financial markets to fail.
4) Distinguish between adverse selection and moral hazard.
5) What facts about financial structure can be explained by adverse selection?
6) What facts about financial structure can be explained by moral hazard?
7) What factors usually cause an increase in moral hazard?
8) What factors usually cause an increase in adverse selection?
9) What is the principal-agent problem?
10) What is the free-rider problem? Describe some situations that this problem creates.
11) The U.S. has more lawyers per capita than any other country in the world. It is also among
the richest countries in the world. Explain why these two facts may not be mere coincidence.
12) Why should we be concerned about conflicts of interest in the financial services industry?
13) What conflicts of interest can arise in investment banking?
14) What conflicts of interest can arise in accounting firms?
15) What conflicts of interest can arise in credit-rating agencies?
16) Evaluate the major provisions of Sarbanes-Oxley and the Global Legal Settlement as
remedies for conflict of interest problems.
17) What issues do critics cite when discussing why Sarbanes-Oxley has led to a decline in U.S.
capital markets?