Chapter 11 – The Economics of Financial Intermediation
Chapter 11
The Economics of Financial Intermediation
Conceptual and Analytical Problems
1. Describe the problem of asymmetric information that an employer faces in hiring a
new employee. What solutions can you think of? Does the problem persist after the
person has been hired? If so, how and what can be done about it? Is the problem
more or less severe for employees on a fixed salary? Why or why not? (LO2)
Answer: Prior to hiring a new employee, an employer may have difficulty identifying
After someone has been hired, the employer may not know whether that person is
A fixed salary makes it difficult to create the proper incentives for employees to do
their best and so the problem is likely to be more severe.
2. In some cities, newspapers publish a weekly list of restaurants that have been cited
for health code violations by local health inspectors. What information problem is
this feature designed to solve, and how? (LO2)
Answer: This solves both adverse selection and moral hazard. People who dine out at
restaurants may have a difficult time identifying restaurants that don’t meet certain
3. What problem associated with asymmetric information was central to Bernard
Madoff’s success in cheating so many investors for so long? (LO2)
Answer: The Madoff fraud is an example of a moral hazard problem that arises from
the absence of perfect monitoring. Investors with Bernard Madoff did not adequately
11-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 11 – The Economics of Financial Intermediation
4. Financial intermediation is not confined to bank lending but is also carried out by
non-bank firms such as mutual fund companies. How do mutual funds help
overcome information problems in financial markets? (LO1)
Answer: Mutual funds, like other financial intermediaries, are specialists at screening
and monitoring. They assess companies when deciding what stocks and bonds to
5. In some countries it is very difficult for shareholders to fire managers when they do a
poor job. What type of financing would you expect to find in those countries? (LO3)
Answer: When shareholders can’t fire managers, people will be less willing to
6. Define the term economies of scale and explain how a financial intermediary can take
advantage of such economies. (LO1)
Answer: Economies of scale occur when average costs fall as production increases.
7. The Internet can have a significant influence on asymmetric information problems.
(LO2)
a. How can the Internet help to solve information problems?
b. Can the Internet compound some information problems?
c. On which problem would the Internet have a greater impact, adverse selection or
moral hazard?
Answer:
a. The Internet provides people with a wealth of information, whether they are
c. The Internet provides information to reduce adverse selection, but isn’t very
8. The financial sector is heavily regulated. Explain how government regulations help
to solve information problems, increasing the effectiveness of financial markets and
institutions. (LO1)
11-2
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 11 – The Economics of Financial Intermediation
Answer: The government requires firms to disclose information. For example, public
financial statements prepared according to standard accounting practices are required
9. One of the solutions to the adverse selection problem associated with asymmetric
information is the pledging of collateral. However, the collateral may be riskier than
initially thought. As an example, explain why the collateral did not work adequately
to mitigate the mortgage securitization problems associated with the financial crisis of
2007-2009? (LO3)
Answer: The ultimate collateral behind the mortgage-backed securities were the
houses purchased with the mortgages underlying these securities. When house prices
10. *Deflation causes the value of a borrower’s collateral to drop. Define deflation and
explain how it reduces the value of a borrower’s collateral. How might a lender who
anticipates deflation alter the terms of a loan? (LO3)
Answer: Deflation is a fall in the overall price level. A borrower’s liabilities will
remain the same since loan repayment is usually specified in nominal terms. But, the
11. In 2002 the trustworthiness of corporate financial reporting was called into question
when a number of companies corrected their financial statements for past years.
What impact did their action have on the financial markets? (LO3)
12. You are in charge of setting policies for implementing construction loans at a bank
once the loan officer has approved the borrowers’ applications. (Construction loans
finance the development of a structure during the building process and are later
converted to mortgages.) How would you protect your bank’s interests? (LO3)
Answer: The loan officer has addressed the adverse selection problem, so you are
seeking a solution to a moral hazard problem. To protect the bank’s interests, you first
11-3
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 11 – The Economics of Financial Intermediation
13. *Your parents give you $2,000 as a graduation gift and you decide to invest the
money in the stock market. If you are risk averse, should you purchase some stock in
a few different companies through a web site with low transaction fees or put the
entire $2,000 into a mutual fund? Explain your answer. (LO1)
Answer: As a small investor, a mutual fund is the best way to reduce risk by
diversifying your investment. By purchasing shares in a mutual fund, you can
14. Suppose a new website was launched providing up-to-date, credible information on
all firms wishing to issue bonds. What would you expect to see happen to the overall
level of interest rates in the bond market? (LO1)
Answer: You would expect interest rates overall to fall. The web site would reduce
15. Suppose two types of firms wish to borrow in the bond market. Firms of type A are
in good financial health and are relatively low risk. The appropriate premium over
the risk-free rate for lending to these firms is 2 percent. Firms of type B are in poor
financial health and are relatively high risk. The appropriate premium over the
risk-free rate for lending to these firms is 6 percent. As an investor, you have no other
information about these firms except that type A and type B firms exist in equal
numbers. (LO2)
a. At what interest rate would you be willing to lend if the risk-free rate were 5
percent?
b. Would this market function well? What type of asymmetric information problem
does this example illustrate?
Answer:
a. The appropriate interest rate for type A firms’ bonds is 7 percent while that for
type B firms’ bonds in 11 percent. As investors don’t know which type of firm
11-4
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 11 – The Economics of Financial Intermediation
b. No. The type A firms would not be willing to pay this interest rate and so would
16. Consider again the low-risk type A firm described in Problem 15. If you were the
financial advisor to such a firm, what suggestions would you make to the firm’s
management about obtaining borrowed funds? (LO3)
Answer: One suggestion would be to provide as much information as possible about
Another suggestion would be to utilize the services of a financial intermediary. If the
firm has been banking with the same institution for a while, that institution will have
evidence of the firm’s quality from its existing accounts and would likely be willing
to lend to the firm at a more favorable rate.
17. Consider a small company run by a manager who is also the owner. If this company
borrows funds, why might a moral hazard problem still exist? (LO3)
Answer: Even when the owner and the manager of the firm are the same person,
18. *The island of Utopia has a very unusual economy. Everyone on Utopia knows
everyone else and knows all about the firms they own and operate. The financial
system is well developed on Utopia. Everything else being equal, how would you
expect the mix on Utopia between internal finance (where companies use their own
funds such as retained earnings) and external funding (where companies obtain funds
through financial markets) to compare with other countries? What role would
financial intermediaries play in this economy? (LO1)
Answer: As Utopia doesn’t suffer from asymmetric information problems to the same
degree as other countries, you would expect external finance to be more important.
11-5
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 11 – The Economics of Financial Intermediation
19. You and a friend visit the headquarters of a company and are awestruck by the
expensive artwork and designer furniture that graces every office. Your friend is very
impressed and encourages you to consider buying stock in the company, arguing that
it must be really successful to afford such elegant surroundings. Would you agree
with your friend’s assessment? What further information (other than the usual
financial data) would you obtain before making an investment decision? (LO3)
Answer: The luxurious surroundings could be a result of the principal-agent problem,
where managers who do not own the company they run have different objectives than
20. Under what circumstances, if any, would you be willing to participate as a lender in a
peer-to-peer lending arrangement? (LO1)
Answer: Your willingness will likely be influenced by how well you believe the
problems associated with asymmetric information can be dealt with. For example,
11-6
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.