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
Answer: Prior to hiring a new employee, an employer may have difficulty identifying
new employee can be terminated are a simple solution to this problem.
After someone has been hired, the employer may not know whether that person is
without constant monitoring.
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, media outlets publish a weekly list of restaurants that have been cited
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
identify unsanitary restaurants and thus holds restaurants accountable for following
health regulations.
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
need to incur the cost. They may also have assumed that the oversight of the SEC was
sufficient to safeguard their funds.
4. Financial intermediation is not confined to bank lending but is also carried out by
overcome information problems in financial markets? (LO1)
Answer: Mutual funds, like other financial intermediaries, are specialists at screening
resources in the economy to their most productive uses.
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
bonds or seek bank loans to obtain funding.
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?
moral hazard?
Answer:
a. The Internet provides people with a wealth of information, whether they are
evaluating a company before deciding whether to purchase its stock or doing a
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
institutions. (LO1)
Answer: The government requires firms to disclose information. For example, public
financial statements prepared according to standard accounting practices are required
willing to engage in excessively risky behavior, reducing problems associated with
moral hazard.
9. One of the solutions to the adverse selection problem associated with asymmetric
to mitigate the mortgage securitization problems associated with the financial crisis of
2007-2009? (LO2)
Answer: The ultimate collateral behind the mortgage-backed securities were the
larger down payment, charge a higher interest rate, or both.
10. *Deflation causes the value of a borrower’s collateral to drop. Define deflation and
anticipates deflation alter the terms of a loan? (LO2)
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
required. At the margin, low net worth borrowers will find financing unavailable.
Answer: Investors became less sure of their ability to distinguish good firms from bad
ones, so their willingness to purchase stocks and bonds decreased.
11. You are in charge of setting policies for implementing construction loans at a bank
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
sure that all relevant building codes and other design specifications were being
followed prior to releasing additional funding.
12. *Your parents give you $2,000 as a graduation gift and you decide to invest 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
Mutual funds offer investors a low-cost way to diversify a small sum across a wide
range of companies.
13. Suppose a new website was launched providing up-to-date, credible information on
level of interest rates in the bond market? (LO1)
Answer: You would expect interest rates overall to fall. The web site would reduce
bond prices and reducing interest rates.
14. 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
information about these firms except that type A and type B firms exist in equal
numbers. (LO2)
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
adverse selection problem. Only the less desirable firms are willing to borrow.
15. Consider again the low-risk type A firm described in Problem 14. If you were the
financial advisor to such a firm, what suggestions would you make to the firm’s
management about obtaining borrowed funds? (LO2)
Answer: One suggestion would be to provide as much information as possible about
suggestion might be difficult to implement.
Another suggestion would be to utilize the services of a financial intermediary. If the
to lend to the firm at a more favorable rate.
16. 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? (LO2)
Answer: Even when the owner and the manager of the firm are the same person,
owner/manager receives all the profits above the loan repayment.
17. *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
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.
identify those with surplus funds and those needing to borrow in the absence of an
intermediary.
18. 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
financial data) would you obtain before making an investment decision? (LO2)
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
objectives of the management and the best interests of the shareholders, buying stock
in this company is probably not your best option.
19. 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,
the ability to review credit scores and other financial information of potential
payments by borrowers to credit bureaus. You might also consider the time you have
available to monitor the loan yourself for signs of trouble.
20. Upon graduation, both you and your roommate receive your first credit cards with
identical features. You use your card extensively to make purchases, always paying
roommate, despite both of you working in similar jobs for the same income. (LO2)
Answer: This scenario illustrates the problem of adverse selection. When you and
your roommate apply for a credit card at graduation time, you likely had little or no
credit history, so the credit card company assumes, in the absence of information to
provide sufficient new information to the credit card company to warrant a revised
assessment to the same degree.
21. What would you expect to happen to the mix between internal and external financing
market uncertainty? (LO2)
Answer: You would likely see a rise in the share of projects financed from retained
unattainable.