Chapter 13
Financial Industry Structure
Conceptual and Analytical Problems
1 For many years you have been using your local, small-town bank. One day you hear
as a retail bank customer, what are the costs and benefits of such a merger? (LO1)
Answer: The benefits are that you will have access to a larger network of ATMs and
try to use its market power to charge higher fees. However, with many financial
services available at low cost on the Internet, such local market power may be
limited.
2 Why have technological advances hindered the enforcement of legal restrictions on
bank branching? (LO1)
Answer: Most people don’t go into a physical bank building to withdraw cash from
combined with electronic and mobile banking, has made the location of bank
buildings even less relevant.
3 How did the financial crisis of 2007-2009 affect the degree of concentration in the
U.S. banking industry? (LO1)
Answer: The spate of bank failures along with mergers between large banks and
40 percent of deposits.
4 Banks have been losing their advantage over other financial intermediaries in
attracting customers’ funds. Why? (LO2)
Answer: Other financial firms now exist that provide individuals with services
are still very liquid and can easily be converted into a means of payment. Banks no
firms provide individuals with low-cost access to the financial markets.
5 An industry with a large number of small firms is usually thought to be highly
benefits to consumers of the current structure of the U.S. banking industry? (LO1)
Answer: When the banking industry consisted of a large number of small firms, the
industry was less competitive than it is today. A bank in a small town or rural area
banks. Costs to consumers have fallen as a result of increased competition, but the
level of personal service that consumers receive has declined.
6 *What was the main rationale behind the separation of commercial and investment
banking activities in the Glass-Steagall Act of 1933? Why was the Act repealed?
(LO1)
Answer: The Glass-Steagall Act was enacted in the wake of widespread bank failures
during the Great Depression. It was widely believed that many commercial banks
the act sought to protect depositors from excessive risk taking by these banks.
While the Act sought to protect depositors, it also limited the ability of financial
environment of the late 1990’s and the act was repealed.
7 Explain what the phrase “too big to fail” means in reference to financial institutions.
too-big-to-fail problem? (LO1)
Answer: The phrase “too big to fail” refers to firms that are so big relative to the
to save the system.
The bailouts of systemically important financial institutions in the financial crisis
8 Discuss the problems life insurance companies will face as genetic information
becomes more widely available. (LO2)
Answer: Insurance companies can’t predict when a particular person will die, but
when they pool together a group of individuals with uncorrelated risks, they can
they may still want coverage for accidental death. Overall coverage would probably
fall.
9 When the values of stocks and bonds fluctuate, they have an impact on the balance
life insurance companies than for property and casualty companies? (LO2)
Answer: Property and casualty insurance companies have a different investment
horizon compared to life insurance companies. Because property and casualty
companies face the risk that they will have to sell stocks or bonds when prices are low
in order to pay policyholders’ claims.
10 Compare and contrast the structures of bank holding companies, financial holding
companies and universal banks. (LO1)
Answer: Bank holding companies typically own several banks, while financial
holding companies own banks and other financial intermediaries (such as investment
holding a portfolio of firms lowers the risk to firm owners.
11 What are the benefits of collaboration between a large appliance retailer and a finance
company? (LO2)
Answer: The appliance retailer has customers walk in the door who will need
collaboration.
12 Why did government-sponsored enterprises (GSEs) such as Freddie Mac and Fannie
more vulnerable to the house-price declines that precipitated the crisis. (LO2)
Answer: High leverage ratios resulted from the implicit guarantee behind these
enterprises. Although their debt was not guaranteed by the government, there was
institutions.
The fall in house prices increased the rate of mortgage defaults, reducing the value of
problems.
13 Consider two countries with the following characteristics. Country A has no
restrictions on bank branching and banks in Country A are permitted to offer
investment or insurance services. (LO1)
a. In which country do you think the banking system is more concentrated?
cheaper?
Explain each of your choices.
Answer:
a. Country A is likely to have a more concentrated banking system, as fewer banks
b. The experience in the United States with the McFadden Act would suggest that
the banking system would be more competitive in Country A. Although banking
operated.
c. In Country A, banks can take better advantage of economies of scale and scope
and so banking products are likely to be cheaper.
14 You examine the balance sheet of an insurance company and note that its assets are
company? Explain your answer. (LO2)
Answer: This is more likely to be a property and casualty insurance company. This
longer maturity, as most of their payments will be made well into the future.
15 *Statistically, teenage drivers are more likely to have an automobile accident than
adult drivers. As a result, insurance companies charge higher insurance premiums for
explain whether you think this insurance company will be profitable. (LO2)
Answer: This insurance company is unlikely to be profitable because of the problem
of adverse selection. The insurance premium based on the average risk of an accident
sufficient to cover the claims of a teenage-only pool and so the company would not be
profitable.
16 Use your knowledge of the problems associated with asymmetric information to
explain why insurance companies often include deductibles as part of their policies.
(LO2)
Answer: The presence of deductibles helps to reduce moral hazard. In the case of car
17 Suppose you have a defined-contribution pension plan. As you go through your
working life, in what order would you choose to have the following portfolio
Answer: You should choose (b), (c) and (a). Early in your working life, investing in
stocks makes sense as they generally earn a relatively high rate of return and are
18 As an employee, would you prefer to participate in a defined-benefit pension plan or
a defined-contribution pension plan? Explain your answer. (LO2)
Answer: If you are a risk-averse person and plan to stay in the same job for a
significant portion of your working life, you may prefer a defined benefit plan. The
investment decisions about your retirement savings, you may prefer a
defined-contribution plan.
19 In the aftermath of the financial crisis of 2007-2009, there have been calls to
re-instate the separation of commercial and investment banking activities that were
removed with the repeal of the Glass-Steagall Act. Do you think this is a good way to
reduce systemic risk? (LO1)
Answer: Separating commercial and investment banking activities into different
institutions may remove some conflicts of interest for banks across their different
systemic risk might be through capital and liquidity requirements.
20 Suppose a well-known financial holding company agreed to be the underwriter for a
new stock issue. After guaranteeing the price to the issuing company but before
holding company and (b) the issuing company? (LO1)
Answer: Because the financial holding company relies on its reputation to place the
with the issuing firm. The issuing firm will not be directly affected in that its funds
from this issue are already guaranteed. It may, however, suffer indirect adverse
21 Consider three possible health insurance programs with the following characteristics:
paying less.
Program B: Participation in the program is voluntary and the policy premium is the
Which of the three programs is least likely to be viable? Explain your answer. (LO2)
Answer: Program B is the least likely to be viable due to adverse selection. If you
can purchase health insurance at the same price regardless of your health status, in the
viable, while the ability to price discriminate on the basis of health status makes
Program A less likely to fail.
22 Suppose a U.S. bank is considering providing its services abroad. List one possible
banking facility (IBF)? (LO1)
Answer: Once possible advantage of acquiring a controlling interest in a foreign bank
relates to information costs. By retaining existing local staff and records of existing
by the U.S. bank.
Data Exploration
1. One aspect of the 2007-2009 financial panic was a run on some money market mutual
the run peaked. Why did this run end? (LO1)
Answer: The run on MMMFs occurred in September, 2008; the data plot is below.
been larger. Soon after the intervention, fund deposits began to rise again.
Institutional Money Funds (WIMFSL), Billions of Dollars, Weekly, Seasonally
Adjusted
2008-07-14 2333.1
2008-07-21 2327.2
2008-10-13 2267.2
2008-10-20 2314.5
2008-10-27 2326.1
2. When did the financial crisis of 2007-2009 peak and why? Plot weekly data for
dropdown box.) Explain the pattern. (LO1)
Answer: The data plot is below. The gap between the one-week LIBOR rate and the
massive increase in the supply of liquidity.
ICE Benchmark Administration Limited (IBA), 1-Week London Interbank Offered Rate (LIBOR), based on U.S.
Dollar© [USD1WKD156N], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/USD1WKD156N.
3. How did competition from money market mutual funds affect traditional savings
institutions that provided mortgages at fixed interest rates? Beginning in 1981, plot
first half of the 2000s? (LO1)
Answer: The data plot is below. When interest rates rose in the 1980s, revenues from
savings institutions to these mutual funds.
In the first half of the 2000s, short-term interest rates fell to very low levels, so
4. Mutual funds allow small savers to pool their resources and purchase diversified
code: MFTCMAHDFS) as a percentage of GDP (FRED code: GDP). Explain the
pattern. (LO2)
Answer: The plot below shows that mutual funds have become increasingly
important. The combination of diversification at low cost and tax protection offered
employers, helped sustain the rising trend, as have more recent variations on the
original IRA.
* indicates more difficult problems