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
candidates who would do the best job — that is, there are difficulties in screening
candidates in the face of asymmetric information. Probationary periods when the
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
working hard due to problems with monitoring. Salaries based on performance can
mitigate the problem by providing the employee with the incentive to work hard
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
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
health standards. Because of this, some people may not want to eat out at all. Also,
restaurants don’t have an incentive to follow health regulations if diners can’t
distinguish restaurants that meet the health standards from those that don’t. However,
publishing the names of restaurants cited for health code violations allows people to
identify unsanitary restaurants and thus holds restaurants accountable for following
health regulations.

3. In 2009, Bernard Madoff was sentenced to 150 years in prison for executing what
was likely the largest Ponzi scheme in history. What problem associated with
asymmetric information was central to 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
monitor his behavior to ensure that he was using their funds as they expected. Perhaps
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Chapter 11 - The Economics of Financial Intermediation

they assumed that earlier investors had carried out this monitoring and so they did not
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
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
include in their funds and monitor these companies on behalf of individual investors.
By making these choices, the mutual funds affect prices, guiding 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
purchase equity because there is no way to discipline managers who fail to act in the
interests of the shareholders. Companies in those countries are more likely to issue
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.
By using standardized forms for gathering information about potential borrowers and
for issuing loans, financial intermediaries can take advantage of economies of scale.

7. The Internet can have a significant influence on asymmetric information problems.

(LO2)
a. How can the Internet help 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
evaluating a company before deciding whether to purchase its stock or doing a
“Google” search on someone before going out on a date.
b. Not all of the information available is accurate, which can make the problem of
adverse selection worse.

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Chapter 11 - The Economics of Financial Intermediation

c. The Internet provides information to reduce adverse selection, but isn’t very
helpful in reducing moral hazard, although in some circumstances it might
provide a less costly means of monitoring.

8. The financial sector is heavily regulated. Explain how government regulations help
solve information problems, increasing the effectiveness of financial markets and
institutions. (LO1)

Answer: The government requires firms to disclose information. For example,

public financial statements prepared according to standard accounting practices are
required by the Securities and Exchange Commission. Investors can feel more secure
in assessing the financial health of a firm given this government-mandated and
standardized information, thus reducing problems associated with adverse selection.
Since they know they are required to disclosure certain information, firms may be less
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
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? (LO2)

Answer: The ultimate collateral behind the mortgage-backed securities were the
houses purchased with the mortgages underlying these securities. When house prices
fell, the value of the collateral was not sufficient to cover the investments. If the
collateral is riskier than thought, the loans are mispriced. The lender should ask for a
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
explain how it reduces the value of a borrower's collateral. How might a lender who
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
value of the borrower’s assets will decline, decreasing the net worth of the borrower.
If the lender properly anticipates the deflation, and thus the falling net worth of the
borrower, a higher interest rate should be charged, or additional collateral should be
required. At the margin, low net worth borrowers will find financing unavailable.

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Chapter 11 - The Economics of Financial Intermediation

11. 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
would like the policy to specify collateral. In this case, the land upon which the
structure is to be built might be an option for either a home construction project or a
business structure. For a business, other options might be requiring collateral in terms
of inventory or a requiring the borrowing firm to purchase a certificate of deposit.
Second, you would likely release only a portion of the total loan when construction
begins. Third, as construction proceeds, you could conduct periodic inspections to be
sure that all relevant building codes and other design specifications were being
followed prior to releasing additional funding.

12. *Your parents give you $3,000 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 $3,000 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
acquire fractions of shares in the large number of companies included in the fund. If
you opt to buy individual shares, you will be limited to a handful of companies.
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
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
the adverse selection problem by making it easier for investors to distinguish between
firms of different levels of creditworthiness. Demand for bonds should rise, raising
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
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

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Chapter 11 - The Economics of Financial Intermediation

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
they are dealing with and there is an equal probability of either type of firm, they
will be only be willing to lend if they receive at least the average rate of 9 percent.
b. No. The type A firms would not be willing to pay this interest rate and so would
withdraw from the market, leaving only type B firms. This is an example of an
adverse selection problem. Only the less desirable firms are willing to borrow.

15. Suppose you are the financial advisor to a firm that is in good financial health. What
suggestions would you make to the firm’s management about obtaining borrowed
funds if both financially healthy and financially unhealthy firms are trying to borrow
in the bond market? (LO2)

Answer: One suggestion would be to provide as much information as possible about

the firm to potential investors in order to identify itself as a financially healthy firm.
Ideally, the information should come through someone other than the firm for
credibility, so this suggestion might be difficult to implement.

Another suggestion would be to utilize the services of a financial intermediary rather

than issuing debt directly in the bond market. 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.

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,
when he or she borrows money there is an incentive to take on excessive risk. The
downside is limited to the collateral posted while the upside is unlimited. The
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
system is well developed on Utopia. Everything else being equal, how would you

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Chapter 11 - The Economics of Financial Intermediation

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. Although overcoming information problems is a key function of financial
intermediaries, they also reduce transaction costs and therefore would still have a role
in this economy. For example, financial intermediaries could pool savings from small
depositors to make a large loan more cheaply than a group of islanders trying to
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
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? (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
the shareholders. You should find out if there is a separation between ownership and
management and if so, if there is any evidence of a pattern of lavish and unnecessary
spending by the management. If there is evidence of a clear disconnect between the
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
borrowers and the accuracy of that information for predicting default should reduce
your concerns about adverse selection. The ability to spread your lending across a
group of borrowers rather than lend to just one would also reduce the risk associated
with choosing one poor-quality borrower. Moral hazard concerns might be alleviated
by a commitment from the peer-to-peer lending site you use to report missed
payments by borrowers to credit bureaus. You might also consider the time you have
available to monitor the loan yourself for signs of trouble.

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Chapter 11 - The Economics of Financial Intermediation

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
your credit card balance in a timely manner so that you incur no interest cost. Your
roommate pays for everything in cash, reserving the credit card only for an
emergency that never happened. After two years, you both look for a new credit card.
Explain why you are offered a new card at a much lower interest rate than your
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 applied 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
the contrary, that you represent a high default risk. After two years of establishing a
credit history through borrowing and timely repayments, your behavior provides the
credit card company with information that allows them to revise that assessment. In
contrast, even though your roommate behaved in a safe manner, her behavior did not
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
for new investment projects in a country that experiences a large increase in financial
market uncertainty? (LO2)

Answer: You would likely see a rise in the share of projects financed from retained
earnings, as the increased market uncertainty would raise the cost of external
financing (either direct or indirect), making it relatively less attractive or even
unattainable.

22. Use a core principle from Chapter 1 to explain why, everything else being equal, a
software company might find it more expensive to issue debt than a furniture store?
(LO1)

Answer: According to Core Principle 2, risk requires compensation. The furniture

store’s capital is more likely to be tangible while that of the software company is
likely to be predominantly intangible. Tangible capital can be re-sold and so can
serve as collateral, reducing the risk of lending and so lowering the cost of issuing
debt for the furniture store.

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