The Financial System
1. When financial markets channel funds from savers to investors, who benefits?
Explain.
ANSWER: With a well-functioning financial system, both parties to the transaction
benefit when funds are channeled from savers to investors. Investors are able to con-
2. Suppose an owner of a corporation needs $1 million to finance a new investment.
If his total wealth is $1.2 million, would it be better to use his own funds for the in-
vestment or to issue stock in the corporation? What if the owner’s wealth is $1 billion?
ANSWER: The principle of diversification suggests that the owner of the corporation
will have a stronger interest in financing the new investment through issuing stock
3. Suppose you were required to put all your retirement savings in the securities of
one company. What company would you choose, and why? Would you choose the
company you work for? Would you buy stock or bonds?
ANSWER: Putting all retirement savings in the securities of one company violates the
principle of diversification. But if you were required to choose just one company, you
could choose one company that is already fairly diversified. Maybe you choose a
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4. Suppose there are two investors. One has a project to build a factory; the other has
a project to visit a casino and gamble on roulette. Which investor has a greater in-
centive to issue bonds? Which investor’s bonds are better deals for savers?
ANSWER: Gambling with other people’s money is very appealing. The potential gains
are big and no losses accrue to the gambler (plus roulette itself is probably a fun ac-
tivity for the gambler). Building a factory, however, is sure to require long, hard hours
5. Suppose a company raises funds by issuing short-term bonds (commercial paper).
It uses the funds to make private loans. Such a firm is called a finance company. Is
a finance company a type of bank?
ANSWER: No, a finance company is not a type of bank. Banks are defined as fi-
6. Firms such as Moody’s and Standard & Poor’s study corporations that issue bonds.
They publish “ratings” for the bonds—evaluations of the likelihood of default. Sup-
pose these rating companies went out of business. What effect would this have on
the bond market? What effect would it have on banks?
ANSWER: Published bond ratings are a tool to overcome the problem of asymmet-
ric information in financial markets in which savers and investors have a direct rela-
The recent financial crisis in the United States has shown that it is not enough to
7. National credit bureaus collect information on people’s credit histories. They are
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likely to know whether you ever defaulted on a loan. Suppose that a new privacy law
makes it illegal for credit bureaus to collect this information. What effect would this
have on the banking industry?
ANSWER: Just as ratings companies (see previous question) help to reduce asym-
metric information in financial markets, credit bureaus that provide individual credit
8. When a bank makes a loan, it sometimes requires borrowers to maintain a check-
ing account at the bank until the loan is paid off. What is the purpose of this require-
ment?
ANSWER: One reason for this requirement is that checking balances serve as col-
lateral for the bank. A second purpose is to reduce moral hazard problems. Moral
hazard is the risk that the bank loan will be used in a way that makes default on the
9. Microfinance institutions argue that (a) many traditional banks discriminate against
women in lending and (b) women have lower default rates than men on loans from
MFIs. Discuss how point (a) could explain point (b).
ANSWER: It is useful to think of bank loans and microfinance institutions as substi-
tutes. Because of bank practices, men traditionally have had easier access to bank
loans, being able to substitute the two sources of loans more easily than women.
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ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
10. The text Web site contains World Bank data on financial development. Using
these data, compare bank loans as a percentage of GDP in two groups of countries:
those in East Asia (8 countries) and those in sub-Saharan Africa (16 countries). For
each group, compute the average of the bank-loan variable for three time periods:
1976–1985, 1986–1995, and 1996–2007.
a. Which of the two regions has a higher level of bank loans? How has the level
of loans changed over time in each region?
ANSWER:
During all time periods East Asia (average of 8 countries) had a higher loan to GDP
b. What might explain the differences between East Asia and Africa that you found
in part (a)? How do you think these differences have affected the economies of
the two regions?
ANSWER: The difference might be explained by the soundness of the banking sys-
11. In the World Bank data, examine bank loans as a percentage of GDP in the United
States, Germany, and Japan. Is the level of bank loans relatively high or low in the
United States? What might explain this fact? (Hint: See the data on stock market cap-
italization in the three countries.)
ANSWER: Bank loans as a percentage of GDP are relatively low in the United States
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Date East Asia (loan/GDP) Sub-Saharan Africa
(loan/GDP)
12. Link at the Web site to Planet Rating, a French organization that calls itself “the
global microfinance rating agency.” What is the main function of Planet Rating? How
might its work help the microfinance industry to grow?
ANSWER: The main function of the Planet Rating is to provide information to savers
who consider lending funds to microfinance institutions (MFIs). The rating system
A SMALL RESEARCH PROJECT
13. Do you know someone (such as a parent) who is working and saving for retire-
ment? Does he or she have money in a 401(k) plan? What securities does the per-
son hold through the plan? Does he or she follow the principle of diversification?
ANSWER: The principle of diversification means that the assets owned as part of a
retirement plan (such as a 401(k) plan) are spread among many types of assets such
as stocks and bonds issued by various corporations and the government. Spreading
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