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The Banking Industry
1. HSBC has over $1 trillion in assets and operates in about 100 countries. It calls it-
self “the world’s local bank.” What business strategies does this phrase suggest?
Why might these strategies be successful?
ANSWER: Banks’ basic functions are to take in deposits and make loans, which re-
quires information gathering. HSBC is an international money-center bank with the abil-
ity to raise funds globally. Calling itself the world’s local bank suggests that HSBC’s strat-
2. Suppose that Melvin’s Bank purchases Gertrude’s Bank, making Gertrude a sub-
sidiary of Melvin. Does this acquisition benefit the stockholders of Melvin’s Bank?
Does the answer depend on the motives for the purchase? Explain. (Hint: Review
the motives for bank consolidation discussed in Section 8.2.)
ANSWER: The motives for consolidation are economies of scale, diversification, and
empire building. If the motive for consolidation is either economies of scale or diver-
3. Securitization has spread from mortgages to student loans and credit card debt.
However, few loans to businesses have been securitized. Explain why.
ANSWER: Securitization relies on a bundling or pooling of loans that share similar
characteristics, such as credit scores for mortgage loans or car loans. Pooling based
on specific characteristics allows savers to gauge the default risk of the securities
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4. Suppose that loan sharks propose legislation to promote their industry. They want
a legal right to break the kneecaps of loan defaulters.
a. Suppose you were hired as a lobbyist for the loan sharks. What arguments
could you make to support their proposal?
ANSWER: The loan shark lobbyist may work with the motto “Thank you for taking out
a very high interest loan” (as in the movie Thank You for Smoking). The argument for
the proposal of breaking kneecaps may hinge on the fact that banks and other fi-
nancial institutions do not provide access to credit for low-income, low-credit-score
b. How would you respond to these arguments if you oppose kneecap breaking?
ANSWER: The market for loans to people with low credit scores seems to have been
5. Consider the example in Chapter 7 of two firms that want to issue bonds (see Fig-
ure 7.2). Assume as before that a firm makes the promised payment on a bond only
if its project succeeds.
a. Suppose the government guarantees the firms’ bonds: it makes the promised
payment if either firm defaults. Can both firms sell bonds? What payments must
they promise?
ANSWER: The case in Chapter 7 distinguishes between symmetric information,
where savers and firms know which firm is safe and which firm is risky, and asym-
With symmetric information and the assumptions given in Figure 7.2, safe firms issue
bonds with a promised payment of $110, but risky firms are not able to issue a bond
With asymmetric information the same scenario holds. The government guarantee
CHAPTER 8 The Banking Industry A-53
b. What is the average cost to the government of guaranteeing a bond, assum-
ing it does so for each firm?
ANSWER: Guaranteeing the bond for the safe and the risky firm means that the gov-
ernment faces a 1/6 chance of having to come up with the promised payment to
c. What is the average profit on an investment project, assuming both firms fi-
nance their projects with government-guaranteed bonds?
ANSWER: The profit for the safe firm is $125 – $110 = $15. The profit for the risky
d. Which is higher, the average cost of a bond guarantee (part (b)) or the aver-
age profit on a project (part (c))? In light of this comparison, do the guarantees
promote economic efficiency? Explain why or why not. (Hint: How do the guar-
antees affect the adverse selection problem?)
ANSWER: The average cost of the bond guarantee (b) is lower than the average ex-
pected profit. The government guarantees make sure that both firms have access to
6. Discuss several reasons why the government guarantees student loans but not
auto loans.
ANSWER: Government involvement in the student loan market has recently shifted
from providing guarantees to providing loans to students. No such government in-
volvement exists in the market for car loans. Economic justifications for any govern-
ment involvement in markets is based on the idea of market failure. Asymmetric
information that leads to moral hazard and adverse selection problems is the type of
ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
7. The text Web site provides data on 82 countries from a 2002 study on government
bank ownership. For each country, the data include (a) the percentage of bank assets
at government-owned banks in 1970, (b) the average growth rate of bank loans as a
percentage of GDP from 1960 to 1995, and (c) the average growth rate of real GDP
per person from 1960 to 1995.
a. Make a graph with variable (a) on the horizontal axis and (b) on the vertical axis
and plot each country. What might explain the relationship between these vari-
ables?
ANSWER: Based on the graph, it is not easy to see a clear relationship between the
percentage of bank assets at government-owned banks in 1970 and the average
b. Make a graph with (a) on the horizontal axis and (c) on the vertical axis. What
might explain the relationship between these variables?
8. Many states allow payday lending but impose restrictions on the practice. For ex-
ample, a state may limit the amount someone can borrow or the number of times a
loan can be rolled over. Find out whether payday lending is legal in your state, and,
if so, what restrictions exist. How stringent are these restrictions compared to those
in other states?
9. The Web site of the Community Financial Services Association, the payday lenders’
organization, has a page on “Myths and Realities” about payday lending. Do you
agree with the CFSA about what’s a myth and what’s reality? Do some research to
answer this question, starting with the CFSA site and that of the Center for Respon-
sible Lending (both linked to the text Web site).
ANSWER: The CFSA, an organization of payday lenders states that one of the myths
about payday lending is the high interest rate quoted by opponents. The site states
that the fee for a two-week $100 loan is $15, a simple 15 percent. However, when the
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10. What are the current interest rates on 1-year certificates of deposit at a commer-
cial bank and a credit union located near you? Is one institution’s rate higher than the
other’s? What might explain the difference?
ANSWER: Often interest rates offered by credit unions are higher than the rates of-
fered by a commercial bank. Credit unions do not have to generate profits for share-
holders, a separate stakeholder group. Credit unions are therefore able to pay higher
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