TUTORIAL 6

ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE

I. Review questions
1. What are eight basic facts about the global financial system?
2. Explain the problem of transaction cost in the financial market. How this problem
is solved?
3. Describe why asymmetric information leads to adverse selection and moral
hazard.
4. Explain adverse selection and moral hazard problem in debt and equity contracts
and various tools used to reduce them.

II. Multiple-choice questions

1. The largest source of external funds for U.S. firms is:
A. loans.
B. bonds.
C. stocks
D. trade debts

2. Asymmetric information occurs when

A. one party in a transaction has more information than another.
B. one party in a transaction has more influence than another.
C. each party in a transaction gains from the transaction.
D. each party has equal information

3. A bad credit risk seeks out loans more actively. This is a(n):
A. adverse selection problem.
B. moral hazard problem.
C. principal-agent problem.
D. liquidity problem

4. A borrower engages in activities that are undesirable from a lender's point of

view. This is the:
A. moral hazard problem.
B. liquidity problem.
C. transaction costs problem.
D. adverse selection problem.

5. The free-rider problem

A. will only occur if information costs are zero.
 B. is that people who do not pay for information take advantage of information other
people have paid for. Be careful by the point of view not of their own
C. will make more people willing to provide information services.
D. makes it easier for an investor to continue to buy securities at less than the true
value.

6. The principal-agent problem

A. occurs because owners have complete information about managers.
B. is a type of moral hazard.
C. eliminates costly state verification.
D. is not related to asymmetric information.

7. When interest rates are high, lenders may not want to make loans because of:
A. moral hazard.
B. the principal-agent problem.
C. adverse selection.
D. costly state verification.
8. A venture capital firm (vốn đầu tư mạo hiểm):

A. increases the size of the moral hazard problem.

B. pools resources to help entrepreneurs start new firms. -> High risk, High R(E)
C. allows equity shares of the new firm to be sold in the marketplace.
D. has no say in the management of the new firm.

9. Which of the following describes the "lemons problem?"

A. Sellers have more information than buyers and more transactions occur.
B. Buyers have more information than sellers and more transactions occur.
C. Sellers have more information than buyers and few transactions occur.
D. Buyers have more information than sellers and few transactions occur.

10. By taking advantage of economies of scale and developing expertise

(technology), financial intermediaries overcome the problem of: Financial
Innovation
A. adverse selection.
B. free-riding.
C. high transaction costs.
D. moral hazard.
11. Regulation of the financial system Asia Crisis 1997-collapse of fin. Sys.
A. occurs only in the United States.
B. protects the jobs of employees of financial institutions.
C. protects the wealth of owners of financial institutions.
D. ensures the stability of the financial system. Huge problem eco.

12. One purpose of regulation of financial markets is to => reduce asymmetric i4

not eliminate
A. limit the profits of financial institutions.
B. increase competition among financial institutions.
C. promote the provision of information to shareholders, depositors and the public. ->
Transparency of i4 diff. involves
D. guarantee that the maximum rates of interest are paid on deposits.

13. Property that is pledged to the lender in the event that a borrower cannot make
his or her debt payment is called
A. collateral. Tài sản thế chấp
B. points.
C. interest.
D. good faith money.

14. The predominant (chiếm ưu thế) form of household debt is (US)

A. consumer installment debt.
B. collateralized debt.
C. unsecured debt.
D. unrestricted debt.

15. Collateralized debt is also known as

A. unsecured debt.
B. unrestricted debt.
C. secured debt.
D. promissory debt.

16. Credit card debt is

A. secured debt.
B. restricted debt.
C. unrestricted debt.
D. unsecured debt. (không được đảm bảo)

17. If you default on your auto loan, your car will be repossessed because it has been
pledged as ________ for the loan. Mortgage loan => subprime (các khoản cho vay
dưới chuẩn) -> global fin. Crisis 2008 ; NINJA-no job, no income, no A-> still
borrow $ from bank-> risky-lose $
A. interest
B. collateral
C. dividend
 D. commodity

18. A ________ is a provision that restricts or specifies certain activities that a

borrower can engage in.
A. residual claimant
B. risk hedge
C. restrictive barrier
D. restrictive covenant (requirements/ conditions need to follow)

19. A clause in a mortgage loan contract requiring the borrower to purchase

homeowner's insurance is an example of a
A. proscriptive covenant.
B. prescriptive covenant.
C. restrictive covenant.
D. constraint-imposed covenant.

20. That only large, well-established corporations have access to securities markets
A. explains why indirect finance is such an important source of external funds for
businesses.
B. can be explained by the problem of moral hazard.
C. can be explained by government regulations that prohibit small firms from
acquiring funds in securities markets.
D. explains why newer and smaller corporations rely so heavily on the new issues
market for funds.

21. The concept of adverse selection helps to explain

A. why collateral is not a common feature of many debt contracts.
B. why large, well-established corporations find it so difficult to borrow funds in
securities markets.
C. why financial markets are among the most heavily regulated sectors of the
economy.
D. why stocks are the most important source of external financing for businesses.

22. As information technology improves, the lending role of financial institutions

such as banks should ________.
A. increase somewhat
B. decrease (services provide by diff. banks)
C. stay the same
D. increase significantly

23. Net worth (liability) can perform a similar role to ________.

A. diversification
B. collateral
C. intermediation
D. economies of scale
III. Practice exercises
Questions taken and apapted from Chapter 8 (Mishkin, 2019)

1. How does a mutual fund lower transaction costs through economies of scale?

2. Explain the principal-agent problem as it pertains to equity contracts:

3. What are the transaction costs problems facing financial organizations? Explain
how financial Intermediaries can help reduce these problems. -> Expertise, Eco.
Of scale, Implement of Tech., from office branch
Transactions cost ↓, Time↓,, Money↓, => cost per $ invested ↓,

Usually transaction costs increase the expense of investors. This is

especially notable for households and private investors. Since they
have limited funds available for investment, high transaction costs
cause people to invest in only a small share of all available options,
making their investments riskier. One solution for high transaction
cost is to bundle investors' funds and take advantage of economies of
scale. This led to the making of financial intermediaries like mutual
funds which sell shares to individuals and invest the proceeds in
bonds and stocks. Since many transactions occur together, transaction
costs for each of them become lower. Additionally, financial
intermediaries also provide the expertise that can be used to lower
transaction costs

4. Explain why dating can be considered a method to solve the adverse selection
problem.

When a couple dates, they are (explicitly or implicitly) extracting

information about the significant other. At the same time, they are
sharing information about themselves. This information flow helps
both individuals to make better decisions about a probable (or not)
future life together -> reduce adverse selection/ prob, In this way, one
can think that this process is formally no different from the one in
which the loan officer tries to choose the right borrower.

5. Why are financial intermediaries willing to engage in information collection

activities when investors in financial instruments may be unwilling to do so?
FI Debit Investor
Free-rider effect :< :>
 Private loan
 Investors in financial instruments who engage in information
collection face a free-rider problem (copy the situation), which means
other investors may be able to benefit from their information without
paying for it. Individual investors, therefore, have inadequate
incentives to devote resources to gathering information about
borrowers who issue securities. Financial intermediaries avoid the
free-rider problem because they make private loans to borrowers
rather than buy the securities borrowers have issued. Since they will
reap all the benefits from the information they collect, their
information collection activities will be more profitable. They thus
have a greater incentive to invest in information collection.

6.Suppose you have data about two groups of countries, one with efficient legal
systems and the other with slow, costly, and inefficient legal systems. Which group
of countries would you expect to exhibit higher living standards?
Economy vs Principal market ↑ -> lending process; Huyen Nhu Viettinbak

One would expect the group of countries with more efficient legal
systems to exhibit higher living standards. Legal systems are an
important part of the lending process, precisely because they are part
of the enforcement mechanisms of contracts that deal with the moral
hazard problem. Costly, slow, and inefficient legal systems do not
promote lending and thereby funding of investment opportunities.

7. What steps can the government take to reduce asymmetric information

(adverse and moral hazard prob)problems and help the financial system
function more smoothly and efficiently? Provide more i4 to lenders/
mentors => Transparency

The government can produce information about borrowers and

provide it to investors free of charge, it can require borrowers to
report honest information about themselves to investors, and it can set
and enforce rules that govern the behavior of financial institutions so
they do not take on too much risk. These prudential regulations for
banks include banning certain activities and asset categories
considered too risky, establishing minimum capital requirements, and
requiring disclosure of
financial information to regulators and investors.
8. Explain how the separation of ownership and control in American
corporations might lead to poor management. Engage in risky of investor
-> ST not LT

The separation of ownership and control creates a principal-agent

problem. The managers (the agents) do not have as strong an incentive
to maximize profits as the owners (the principals). Thus, the managers
might not work hard, might engage in wasteful spending on personal
perks, or might pursue business strategies that enhance their personal
power but do not increase profits.