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Answers to Chapter 1
Questions:
1. a. primary
2. a. money market
b. money market
8. Financial institutions consist of:
Commercial banks - depository institutions whose major assets are loans and major liabilities are deposits.
Commercial banks’ loans are broader in range, including consumer, commercial, and real estate loans, than other
depository institutions. Commercial banks’ liabilities include more nondeposit types of nondeposit sources of funds,
such as subordinate notes and debentures, than other depository institutions.
9. If there were no FIs then the users of funds, such as corporations in the economy, would have to approach the
savers of funds, such as households, directly in order to fund their investment projects and fill their borrowing needs.
10. There are at least three reasons for this. First, once they have lent money in exchange for financial claims,
suppliers of funds need to monitor or check the use of their funds. They must be sure that the user of funds neither
absconds with nor wastes the funds on projects that have low or negative returns. Such monitoring actions are often
extremely costly for any given fund supplier because they require considerable time, expense, and effort to collect
this information relative to the size of the average fund supplier’s investment.
11. A suppler of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring the fund
user’s actions in a timely and complete fashion after purchasing securities. One solution to this problem is for a large
number of small investors to place their funds with a single FI serving as a broker between the two parties. The FI
12. In addition to information costs, FIs help small savers alleviate liquidity risk. Liquidity risk occurs when savers
are not able to sell their securities quickly and at their fair market values. Commercial banks, for example, are able
13. As long as the returns on different investments are not perfectly positively correlated, by spreading their
investments across a number of assets, FIs can diversify away significant amounts of their portfolio risk. Thus, FIs
can exploit the law of large numbers in making their investment decisions, whereas due to their smaller wealth size,
14. If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by
15. Because they are sold in very large denominations, many assets are either out of reach of individual savers or
would result in savers holding highly undiversified asset portfolios. For example, the minimum size of a negotiable
16. Other services provided by FIs that benefit the overall economy include:
Money Supply Transmission - Depository institutions are the conduit through which monetary policy actions impact
the rest of the financial system and the economy in general.
17. As nancial institutions perform the various services described above, they face many
types of risk. Specically, all FIs hold some assets that are potentially subject to default or
credit risk (such as loans, stocks, and bonds). As FIs expand their services to non-U.S.
18. FIs provide various services to sectors of the economy. Failure to provide these services, or a breakdown in their
efficient provision, can be costly to both the ultimate suppliers (households) and users (firms) of funds as well as the
19. A major event that changed and reshaped the financial services industry was the financial crisis of the late
2000s. As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic
increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of
“originate and hold” to “originate to distribute.” In the traditional model, banks take short term deposits and other
20. The boom (“bubble”) in the housing markets began building in 2001, particularly after the terrorist attacks of
9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by
providing liquidity to FIs. For example, the Federal Reserve lowered the short-term interest rate that banks and other
financial institutions pay in the Federal funds market and even made lender of last resort funds available to non-bank
