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Chapter 12

Money and Financial Systems (Millsaps College)

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Economics of Money, Banking, and Financial Markets, 11e (Mishkin)

Chapter 12 Financial Crises

12.1 What is a Financial Crisis?

1) A major disruption in financial markets characterized by sharp declines in asset prices and
firm failures is called a
A) financial crisis.
B) fiscal imbalance.
C) free-rider problem.
D) "lemons" problem.
Answer: A
AACSB: Application of Knowledge

2) A financial crisis occurs when an increase in asymmetric information from a disruption in the
financial system
A) causes severe adverse selection and moral hazard problems that make financial markets
incapable of channeling funds efficiently.
B) allows for a more efficient use of funds.
C) increases economic activity.
D) reduces uncertainty in the economy and increases market efficiency.
Answer: A
AACSB: Reflective Thinking

3) A serious consequence of a financial crisis is

A) a contraction in economic activity.
B) an increase in asset prices.
C) financial engineering.
D) financial globalization.
Answer: A
AACSB: Reflective Thinking

4) ________ are asymmetric information problems that act as a barrier to efficient allocation of
capital.
A) Asset prices
B) Credit imbalances
C) Financial frictions
D) Financial derivatives
Answer: C
AACSB: Application of Knowledge

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12.2 Dynamics of Financial Crises

1) Financial crises in advanced economies might start from a

A) debt deflation.
B) currency crisis.
C) mismanagement of financial innovations.
D) currency mismatch.
Answer: C
AACSB: Reflective Thinking

2) When financial institutions go on a lending spree and expand their lending at a rapid pace they
are participating in a
A) credit boom.
B) credit bust.
C) deleveraging.
D) market race.
Answer: A
AACSB: Application of Knowledge

3) When the value of loans begins to drop, the net worth of financial institutions falls causing
them to cut back on lending in a process called
A) deleveraging.
B) releveraging.
C) capitulation.
D) deflation.
Answer: A
AACSB: Application of Knowledge

4) When financial intermediaries deleverage, firms cannot fund investment opportunities

resulting in
A) a contraction of economic activity.
B) an economic boom.
C) an increased opportunity for growth.
D) a call for government regulation.
Answer: A
AACSB: Reflective Thinking

5) When asset prices rise above their fundamental economic values, a(n) ________ occurs.
A) asset-price bubble
B) liability war
C) decline in lending
D) decrease in moral hazard
Answer: A
AACSB: Application of Knowledge

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6) Most U.S. financial crises have started during periods of ________ either after the start of a
recession, a stock market crash, or the failure of a major financial institution.
A) high uncertainty
B) low interest rates
C) low asset prices
D) high financial regulation
Answer: A
AACSB: Reflective Thinking

7) If uncertainty about banks' health causes depositors to begin to withdraw their funds from
banks, the country experiences a(n)
A) banking crisis.
B) financial recovery.
C) reduction of the adverse selection and moral hazard problems.
D) increase in information available to investors.
Answer: A
AACSB: Reflective Thinking

8) In a bank panic, the source of contagion is the

A) free-rider problem.
B) too-big-to-fail problem.
C) transactions cost problem.
D) asymmetric information problem.
Answer: D
AACSB: Reflective Thinking

9) Debt deflation occurs when

A) an economic downturn causes the price level to fall and a deterioration in firms' net worth
because of the increased burden of indebtedness.
B) rising interest rates worsen adverse selection and moral hazard problems.
C) lenders reduce their lending due to declining stock prices (equity deflation) that lowers the
value of collateral.
D) corporations pay back their loans before the scheduled maturity date.
Answer: A
AACSB: Reflective Thinking

10) A substantial decrease in the aggregate price level that reduces firms' net worth may stall a
recovery from a recession. This process is called
A) debt deflation.
B) moral hazard.
C) insolvency.
D) illiquidity.
Answer: A
AACSB: Application of Knowledge

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11) A possible sequence for the three stages of a financial crisis might be ________ leads to
________ leads to ________.
A) asset price declines; banking crises; unanticipated decline in price level
B) unanticipated decline in price level; banking crises; increase in interest rates
C) banking crises; increase in interest rates; unanticipated decline in price level
D) banking crises; increase in uncertainty; increase in interest rates
Answer: A
AACSB: Reflective Thinking

12) The economy recovers quickly from most recessions, but the increase in adverse selection
and moral hazard problems in the credit markets caused by ________ led to the severe economic
contraction known as The Great Depression.
A) debt deflation
B) illiquidity
C) an improvement in banks' balance sheets
D) increases in bond prices
Answer: A
AACSB: Reflective Thinking

13) The ________, the difference between the interest rate on Baa corporate bonds and U.S.
Treasury bonds. rose sharply during the Great Depression.
A) credit boom
B) credit spread
C) adjustable-rate
D) default swap
Answer: B
AACSB: Application of Knowledge

14) Typically, the economy recovers fairly quickly from a recession. Why did this NOT happen
in the United States during the Great Depression?
Answer: The 25% decline in the price level from 1930-1933 triggered a debt deflation. The loss
of net worth increased adverse selection and moral hazard problems in the credit markets and
increased and prolonged the economic contraction.
AACSB: Reflective Thinking

12.3 The Global Financial Crisis of 2007-2009

1) ________ is a process of bundling together smaller loans (like mortgages) into standard debt
securities.
A) Securitization
B) Origination
C) Debt deflation
D) Distribution
Answer: A
AACSB: Application of Knowledge

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2) A ________ pays out cash flows from a collection of assets in different tranches, with the
highest-rated tranch paying out first, while lower ones paid out less if there are losses on the
underlying assets.
A) collateralized debt obligation (CDO)
B) adjustable-rate mortgage
C) negotiable CD
D) discount bond
Answer: A
AACSB: Application of Knowledge

3) The originate-to-distribute business model has a serious ________ problem since the
mortgage broker has little incentive to make sure that the mortgagee is a good credit risk.
A) principal-agent
B) debt deflation
C) democratization of credit
D) collateralized debt
Answer: A
AACSB: Ethical understanding and reasoning abilities

4) If mortgage brokers do not make a strong effort to evaluate whether the borrower can pay off
a loan, this creates a
A) severe adverse selection problem.
B) decline in mortgage applications.
C) call to deregulate the industry.
D) decrease in the demand for houses.
Answer: A
AACSB: Ethical understanding and reasoning abilities

5) Agency problems in the subprime mortgage market included all of the following EXCEPT
A) homeowners could refinance their houses with larger loans when their homes appreciated in
value.
B) mortgage originators had little incentives to make sure that the mortgagee is a good credit
risk.
C) underwriters of mortgage-backed securities had weak incentives to make sure that the holders
of the securities would be paid back.
D) the evaluators of securities, the credit rating agencies, were subject to conflicts of interest.
Answer: A
AACSB: Ethical understanding and reasoning abilities

6) The growth of the subprime mortgage market led to

A) increased demand for houses and helped fuel the boom in housing prices.
B) a decline in the housing industry because of higher default risk.
C) a decrease in home ownership as investors chose other assets over housing.
D) decreased demand for houses as the less credit-worthy borrowers could not obtain residential
mortgages.
Answer: A
AACSB: Reflective Thinking
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7) When housing prices began to decline after their peak in 2006, many subprime borrowers
found that their mortgages were "underwater." This meant that
A) the value of the house fell below the amount of the mortgage.
B) the basement flooded since they could not afford to fix the leaky plumbing.
C) the roof leaked during a rainstorm.
D) the amount that they owed on their mortgage was less than the value of their house.
Answer: A
AACSB: Reflective Thinking

8) If a borrower takes out a $200 million loan in a repo agreement and is asked to post $220
million of mortgage-backed securities as collateral, the "haircut" is
A) 5%.
B) 10%.
C) 20%.
D) 50%.
Answer: B
AACSB: Analytical Thinking

9) As "haircuts" increased during 2007-2009, financial institutions found that to borrow the same
loan amount now required ________ collateral.
A) less
B) no
C) more
D) default-free
Answer: C
AACSB: Reflective Thinking

10) Although the subprime mortgage market problem began in the United States, the first
indication of the seriousness of the crisis began in
A) Europe.
B) Australia.
C) China.
D) South America.
Answer: A
AACSB: Application of Knowledge

11) Which investment bank filed for bankruptcy on September 15, 2008 making it the largest
bankruptcy filing in U.S. history?
A) Lehman Brothers
B) Merrill Lynch
C) Bear Stearns
D) Goldman Sachs
Answer: A
AACSB: Application of Knowledge

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12) The global financial crisis of 2007-2009 not only led to a worldwide recession, but also a
________ in the European nations that use the euro currency.
A) currency devaluation
B) budget surplus
C) sovereign debt crisis
D) tax cut
Answer: C
AACSB: Application of Knowledge

13) The government passed the Economic Recovery Act in October 2008 to prevent the financial
crisis from continuing to worsen. A controversial component of this act was the
A) temporary decrease in the federal deposit insurance limit.
B) sale of new subprime mortgage assets.
C) borrowing of $150 million from AIG.
D) Troubled Asset Relief Program (TARP).
Answer: D
AACSB: Application of Knowledge

12.4 Response of Financial Regulation

1) Microprudential supervision focuses on the safety and soundness of

A) individual financial institutions.
B) the financial system as a whole.
C) the shadow banking system.
D) government credit agencies.
Answer: A
AACSB: Application of Knowledge

2) Microprudential supervision does all of the following EXCEPT

A) checking capital ratios of a bank.
B) checking a bank's compliance with disclosure requirements.
C) assessing the riskiness of an individual bank's activities.
D) focusing on financial system liquidity.
Answer: D
AACSB: Reflective Thinking

3) Macroprudential supervision policies try to prevent a leverage cycle by changing capital

requirements so that they ________ during an expansion and ________ during a downturn.
A) increase; decrease
B) increase; increase
C) decrease; increase
D) decrease; decrease
Answer: A
AACSB: Reflective Thinking

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4) In order to ensure that borrowers have an ability to repay residential mortgages, the new
consumer protection legislation requires lenders to do all of the following EXCEPT
A) verify the income of the borrower.
B) verify the borrower's job status.
C) check the credit history of the borrower.
D) verify that the borrower can read and understand a loan contract.
Answer: D
AACSB: Reflective Thinking

5) The new Consumer Financial Protection Bureau is an independent agency but is funded and
housed within
A) the Treasury Department.
B) the Federal Reserve.
C) the SEC.
D) the IRS.
Answer: B
AACSB: Application of Knowledge

6) The Dodd-Frank legislation of 2010 permanently increased the federal deposit insurance to
A) $40,000.
B) $100,000.
C) $200,000.
D) $250,000.
Answer: D
AACSB: Application of Knowledge

7) Firms that are designated as systemically important financial institutions (SIFIs) are subject to
all of the following additional Federal Reserve regulations EXCEPT
A) higher capital standards.
B) stricter liquidity requirements.
C) providing a plan for orderly liquidation if necessary.
D) interest rate ceilings on time deposits.
Answer: D
AACSB: Reflective Thinking

8) The Volcker Rule addresses the off-balance-sheet problem involving

A) trading risks.
B) selling loans.
C) loan guarantees.
D) interest rate risks.
Answer: A
AACSB: Analytical Thinking

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9) The Dodd-Frank bill created an agency to monitor markets for asset price bubbles and the
buildup of systemic risk. This agency is called the
A) Resolution Trust Authority.
B) Board of Governors.
C) Financial Stability Oversight Council.
D) Macroprudential Supervisory Agency.
Answer: C
AACSB: Application of Knowledge

12.5 Too-Big-To-Fail and Future Regulation

1) One suggested method of dealing with the too-big-to-fail problem is to reimpose the
restrictions that were in place under
A) Glass-Steagall.
B) McFadden.
C) the Edge Act.
D) the Federal Reserve Act.
Answer: A
AACSB: Application of Knowledge

2) One suggested method of reducing excessive risk-taking by SIFIs is to require them to hold
________ capital when credit is expanding rapidly and ________ capital when credit is
contracting.
A) less; more
B) more; no
C) more; less
D) less; no
Answer: C
AACSB: Application of Knowledge

3) Dodd-Frank addressed many of the issues that led to the financial crisis. Which of the
following was NOT addressed by Dodd-Frank regulations?
A) stricter consumer protection laws
B) privately owned, government-sponsored enterprises (GSEs) such as Fannie mae and Freddie
Mac
C) resolution authority over the large financial institutions
D) higher requirements on firms dealing in derivatives
Answer: B
AACSB: Application of Knowledge

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4) The global financial crisis showed the need for increased financial regulation, however, too
much or poorly designed regulation could
A) choke off financial innovation.
B) increase the efficiency of the financial system.
C) increase economic growth.
D) increase international financial integration.
Answer: A
AACSB: Reflective Thinking

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