Deck 18: The Financial System: Opportunities and Dangers

Question 1

Reducing risk by holding many imperfectly correlated assets is called:

A)diversification.
B)moral hazard.
C)risk aversion.
D)leveraging.

Answer 1

diversification.

Question 2

Funds flow directly between savers and investors in financial _____ and flow indirectly between savers and investors through financial _____.

A)stocks; bonds
B)intermediaries; markets
C)bonds; stocks
D)markets; intermediaries

Answer 2

markets; intermediaries

Question 3

A dislike of randomness in economic circumstances is called:

A)rational expectations.
B)risk aversion.
C)adverse selection.
D)moral hazard.

Answer 3

risk aversion.

Question 4

Adverse selection concerns hidden knowledge about _____, while moral hazard concerns hidden knowledge about _____.

A)systematic risk; idiosyncratic risk
B)attributes; actions
C)equity finance; debt finance
D)financial markets; financial intermediaries

Question 5

Stocks are:

A)loans to a firm.
B)assets plus liabilities of a firm.
C)leverage in a firm.
D)shares of ownership in a firm.

Question 6

All of the following are examples of financial intermediaries except:

A)commercial banks.
B)stock exchanges.
C)pension funds.
D)insurance companies.

Question 7

A document representing an interest-bearing debt of the issuer, usually a corporation or government, is called:

A)equity.
B)stock.
C)a bond.
D)capital.

Question 8

Institutions that stand between savers and investors, helping to direct financial resources to their best use, are called:

A)financial markets.
B)financial intermediaries.
C)financial regulators.
D)financial capitalists.

Question 9

The allocation of resources between those who want to save and those who want to borrow is accomplished through:

A)the velocity of money.
B)fiscal policy.
C)the financial system.
D)foreign trade.

Question 10

Obtaining funds for a business by issuing ownership shares through the stock market is called _____ finance.

A)money
B)liability
C)debt
D)equity

Question 11

Purchasers of bonds issued by companies are _____ of the company, while purchasers of shares of stock issued by a company are _____ of the company.

A)creditors; debtors
B)debtors; creditors
C)creditors; partial owners
D)partial owners; debtors

Question 12

A bond (or debt instrument) is a(n):

A)ownership claim by the shareholder of a firm.
B)loan to a firm.
C)ongoing relationship between customers and a firm.
D)legal restriction on products a firm may produce.

Question 13

A situation in which one party to an economic transaction has more knowledge about the transaction than the other is called:

A)risk aversion.
B)asymmetric information.
C)systematic risk.
D)learning by doing.

Question 14

The financial system refers to the:

A)mechanism that transfers wealth from consumers to corporations.
B)institutions that facilitate the flow of funds between savers and investors.
C)technology that allows money to circulate in the economy.
D)government regulations that govern the terms of borrowing and lending.

Question 15

Risk that affects many businesses at the same time is called _____ risk, while risk associated with individual businesses is called _____ risk.

A)asymmetric; symmetric
B)symmetric; asymmetric
C)systematic; idiosyncratic
D)idiosyncratic; systematic

Question 16

Issuing bonds is called _____ financing, while issuing stocks is called _____ financing.

A)debt; equity
B)equity; debt
C)capital; investment
D)private; public

Question 17

Obtaining funds for a business by borrowing through the bond market is called _____ finance.

A)money
B)liability
C)debt
D)equity

Question 18

Two types of problems that arise due to asymmetric information are:

A)systematic risk and idiosyncratic risk.
B)risk aversion and diversification.
C)illiquidity and insolvency.
D)moral hazard and adverse selection.

Question 19

Financial intermediaries that sell shares to savers and use their funds to buy diversified pools of assets are called:

A)pension funds.
B)insurance companies.
C)mutual funds.
D)commercial banks.

Question 20

Diversification allows savers to largely eliminate:

A)risk aversion.
B)idiosyncratic risk.
C)systematic risk.
D)risk premiums.

Question 21

Adverse selection may cause lenders to be offered opportunities to finance only:

A)the most desirable business ventures.
B)less desirable business ventures.
C)risk-free business ventures.
D)diversified business ventures.

Question 22

Banks help mitigate the problem of adverse selection in lending by:

A)developing expertise in evaluating the business prospects of loan applicants.
B)making loans to many different types of borrowers.
C)adjusting the amount of the loan to fit the requirements of the borrower.
D)monitoring the business after a loan is made to the business.

Question 23

The precipitous fall in the price of assets that takes place when financial institutions must sell their assets quickly in the midst of a crisis is called a(n):

A)insolvency.
B)subprime sale.
C)speculative bubble.
D)fire sale.

Question 24

Governments can reduce the problem of moral hazard by:

A)requiring licences be obtained before starting a business.
B)prosecuting fraud and malfeasance.
C)keeping interest rates low.
D)reducing corporate income tax rates.

Question 25

The asset price that experienced a boom prior to the 2008-2009 recession in the United States was the price of:

A)oil.
B)residential real estate.
C)technology stocks.
D)food.

Question 26

Which of the following is an example of moral hazard?

A)The healthiest people buy life insurance.
B)The sickest people buy health insurance.
C)A person with health insurance rides a motorcycle without wearing a helmet.
D)A person with life insurance exercises daily and eats healthy foods.

Question 27

Which of the following is an example of adverse selection?

A)A careful driver buys extra insurance protection when renting a car.
B)The sickest people buy health insurance.
C)A person with health insurance rides a motorcycle without wearing a helmet.
D)A person with life insurance exercises daily and eats healthy foods.

Question 28

The mortgage defaults during the 2008-2009 financial crisis in the United States severely reduced the capital positions of:

A)major investment banks.
B)government-sponsored enterprises involved in the mortgage market.
C)a large insurance company (AIG).
D)all of the above.

Question 29

Subprime borrowers are borrowers:

A)who obtain loans at interest rates below the prime rate.
B)most likely to make their loan payments on time.
C)with risky credit profiles.
D)who borrow to purchase smaller homes.

Question 30

A well-functioning financial system does all of the following except:

A)foster economic growth by directing savings to its most productive use.
B)allocate risk among market participants.
C)eliminate systematic risk through diversification.
D)direct resources from savers to borrowers.

Question 31

A rise in the price of an asset above its fundamental value is called a(n):

A)financial panic.
B)insolvency.
C)liquidity crisis.
D)speculative bubble.

Question 32

One avenue by which a loss of confidence in one financial institution spreads to another financial institution is through:

A)a steep decline in asset prices driven by fire sales to restore liquidity.
B)a sharp decline in interest rates to compensate for added risk.
C)an increase in government deposit-insurance coverage.
D)a rapid slowdown in the withdrawal of deposits.

Question 33

The risk that imperfectly monitored agents will act in dishonest or otherwise inappropriate ways is called:

A)adverse selection.
B)moral hazard.
C)systematic risk.
D)risk aversion.

Question 34

When a borrower uses borrowed funds to engage in activities that are detrimental to the profitability of the business venture that was financed, there is a problem of:

A)adverse selection.
B)moral hazard.
C)systematic risk.
D)risk aversion.

Question 35

Governments can reduce the problem of adverse selection by:

A)requiring disclosure about investment projects and a firm's finances.
B)providing loans from public funds.
C)keeping interest rates low.
D)reducing corporate income tax rates.

Question 36

An asset-price bubble bursts if there is:

A)a panic cycle of asset sales and falling asset prices.
B)a statement from the central bank stating that the bubble is over.
C)an excess demand for an asset that raises asset prices.
D)a sharp decrease in interest rates that pricks the asset-price bubble.

Question 37

Falling house prices can generate widespread insolvency of financial institutions by:

A)reducing the value of collateral assets.
B)reducing the value of liabilities.
C)increasing the value of assets.
D)increasing capital.

Question 38

Banks help mitigate the problem of moral hazard in lending by:

A)requiring lengthy applications for loans.
B)making loans to many different types of borrowers.
C)adjusting the amount of the loan to fit the requirements of the borrower.
D)monitoring the business after a loan is made to the business.

Question 39

A major disruption in the financial system that impedes the economy's ability to intermediate between those who want to save and those who want to borrow and invest is called a:

A)moral hazard.
B)speculative bubble.
C)financial crisis.
D)stagflation.

Question 40

The housing price boom prior to the 2008-2009 recession in the United States was fuelled by all of the following except:

A)unusually large increases in building material costs.
B)lax lending standards.
C)government policies promoting homeownership.
D)homebuyers' expectations of never-declining home prices.

Question 41

Conventional monetary policy was limited during the 2008-2009 U.S. financial crisis because the central bank could not:

A)sell enough bonds through open market operations.
B)print a sufficient quantity of money.
C)reduce the target interest rate below zero.
D)adjust the discount rate quickly enough.

Question 42

A credit crunch reduces aggregate demand by:

A)increasing the exchange rate.
B)increasing interest rates.
C)reducing consumption and investment spending.
D)reducing the money supply.

Question 43

Ideally, the purpose of providing funds to insolvent banks beyond required insurance payouts is to:

A)transfer funds from taxpayers to financial institutions.
B)give taxpayers ownership in a commercial bank.
C)reward political loyalty.
D)prevent bank failures from multiplying.

Question 44

To the extent that risky mortgage-backed securities that were sold to buyers who were not fully aware of the risks contributed to the U.S. financial crisis of 2008-2009, blame for this action lies with:

A)homebuyers.
B)mortgage brokers.
C)investment banks.
D)the Federal Reserve.

Question 45

Since the financial crisis and recession of 2008-2009, regulators in Canada require financial institutions to periodically undergo a stress test. Stress tests are:

A)exams for bankers that are very difficult.
B)interviews with bank officials about their lending practices.
C)tests to evaluate the financial health of the Bank of Canada.
D)tests to evaluate the financial health of financial institutions if hypothetical events such as a housing price drop occurs.

Question 46

Conventional monetary and fiscal policies during a financial crisis are aimed at _____, while acting as a lender of last resort or injecting government funds into the financial system during a financial crisis is aimed at _____.

A)increasing output; reducing inflation
B)expanding aggregate demand; restoring confidence in the financial system
C)increasing corporate wealth; increasing household wealth
D)expanding aggregate supply; reducing the national debt

Question 47

When the central bank acts as a lender of last resort, it:

A)requires the borrower to put up collateral.
B)is able to confiscate some of the borrower's assets.
C)requires voting rights on the borrower's board of directors.
D)takes over ownership of the borrower.

Question 48

The effect of the financial crisis of 2008-2009 on the real economy in the United States was a(n) _____ in aggregate demand, a(n) _____ in output, and a(n) _____ in the unemployment rate.

A)increase; increase; increase
B)decrease; decrease; decrease
C)decrease; increase; increase
D)decrease; decrease; increase

Question 49

Conventional fiscal policy was limited during the 2008-2009 financial crisis because of:

A)concerns about increasing the government's budget deficit and debt.
B)difficulties paying out tax rebates.
C)the inability of the government to reduce spending below zero.
D)the inability of the government to raise taxes above 100 percent of income.

Question 50

The 2008-2009 recession in Canada was much smaller than in the U.S. for all of these reasons, except:

A)Canada had stiffer regulations on banks and mortgages.
B)Canada had a much smaller shadow-banking sector.
C)Canadian banks did not engage in any mortgage lending.
D)Canadian banks were better capitalized than U.S. banks.

Question 51

In the United States during the 2008-2009 period, the conventional monetary policy response was to _____ the target federal funds rate, while the conventional fiscal policy response was to _____ taxes and to _____ government spending.

A)increase; increase; increase
B)decrease; decrease; decrease
C)increase; increase; decrease
D)decrease; decrease; increase

Question 52

Conventional monetary and fiscal policies used in a recession are aimed at:

A)increasing aggregate supply.
B)increasing aggregate demand.
C)decreasing aggregate supply.
D)decreasing aggregate demand.

Question 53

If banks fear failure and become more conservative in making loans, then the sharp decline in bank lending is called a credit:

A)crunch.
B)hazard.
C)bubble.
D)swap.

Question 54

The principal purpose of a central bank acting as a lender of last resort is to:

A)prevent the failure of insolvent financial institutions.
B)maintain the liquidity of the financial system.
C)provide adequate funds to finance the government's spending.
D)keep interest rates as low as possible.

Question 55

A bank with assets worth less than liabilities is said to be _____, while a bank without adequate funds immediately available to make promised payments is said to be _____.

A)inflated; inverted
B)inverted; inflated
C)insolvent; illiquid
D)illiquid; insolvent

Question 56

To the extent that low interest rates contributed to the U.S. financial crisis of 2008-2009, the blame for this policy lies with:

A)the Federal Reserve.
B)investment banks.
C)rating agencies.
D)mortgage brokers.

Question 57

During the 2008-2009 U.S. financial crisis, the Federal Reserve served as a lender of last resort by providing liquidity to:

A)both banks and shadow banks with reliable collateral.
B)any insolvent domestic borrower in the economy.
C)state and local governments.
D)households that were underwater on their mortgages.

Question 58

To the extent that the undervaluation of the riskiness of mortgage-backed securities contributed to the U.S. financial crisis of 2008-2009, blame for this mistake lies with:

A)mortgage brokers.
B)investment banks.
C)rating agencies.
D)government policymakers.

Question 59

To the extent that mortgage defaults contributed to the U.S. financial crisis of 2008-2009, blame for these actions lies with:

A)homebuyers who borrowed more than they could afford to repay.
B)mortgage brokers who encouraged households to borrow excessively.
C)government policymakers who pursued policies to encourage homeownership.
D)all of the above.

Question 60

An illiquid bank can become insolvent when it:

A)refuses to make promised payments.
B)sells additional stock to obtain funds.
C)sells assets at fire-sale prices to meet liquidity demands.
D)can extend the due dates of its liabilities.

Question 61

Prior to the U.S. financial crisis of 2008-2009, financial regulation in the United States consisted of a _____ system of regulators, which the Dodd-Frank Act sought to improve upon by _____ the number of regulatory bodies.

A)coordinated; increasing
B)coordinated; decreasing
C)fragmented; increasing
D)fragmented; decreasing

Question 62

How do deposit insurance and the "too big to fail" policy increase moral hazard?

Question 63

The benefit of stricter capital requirements for shadow banks is _____, while the cost is _____.

A)the end of risk-taking behaviour; the development of more profitable opportunities
B)increased monitoring of risk-taking behaviour; higher executive compensation
C)enhancing financial stability; impeding financial intermediation
D)lower inflation; higher unemployment

Question 64

The Volcker rule restricts excessive risk-taking by commercial banks by:

A)prohibiting banks from making certain kinds of speculative investments.
B)increasing the amount of capital banks must hold.
C)decreasing the deposit insurance coverage of depositors in commercial banks.
D)limiting the compensation that bank executives can be paid.

Question 65

The government making loans that are secured by collateral of dubious value to prop up the financial system is an example of:

A)a giveaway of public funds.
B)risky lending.
C)a capital injection.
D)conventional monetary policy.

Question 66

Identify whether each of the following situations is a case of adverse selection or moral hazard. Explain.
a.Jasper knows, but the car rental company does not know when he is trying to rent a car during a blizzard in Winnipeg, that Jasper grew up in a tropical climate and has no idea how to drive in cold weather and snowy conditions.
b.Joan has received a loan from the bank to finance the purchase of more inventory for her quilt shop, but she intends to use the money (without telling the bank) to go on a safari in Africa.
c.Some companies sell annuities, which are policies that make periodic payments as long as the purchaser lives. Jane is trying to buy an annuity. Jane knows, but the annuity issuers do not know, that people in Jane's family routinely live to age 100.

Question 67

What are the problems that hinder any direct transaction between the lender and borrower? What role do banks play in mitigating those issues?

Question 68

Two policies that are intended to make the financial system more stable by restricting the size of financial institutions are:

A)to offer cheaper loans to large financial institutions and to make larger capital injections available for larger banks.
B)to lower the cost of deposit insurance for large banks and to provide incentives for large banks to make speculative investments.
C)to restrict mergers among large banks and to require higher capital requirements for large banks.
D)to allow large banks to be more highly leveraged and to increase deposit insurance coverage for depositors at large banks.

Question 69

Proponents of restricting the size of financial institutions believe this policy will _____, while opponents believe this policy will _____.

A)allow firms to take advantage of economies of scale; increase the volatility of the financial system
B)reduce the number of financial institutions; give institutions the incentive to take excessive risks
C)eliminate the need for deposit insurance; encourage imprudent risk taking
D)make the financial system more stable; lead to higher costs

Question 70

The phrase _____ describes a financial institution so central to that financial system that policymakers will not allow it to enter bankruptcy.

A)"no bank left behind"
B)"too big to fail"
C)"don't fail, don't bail"
D)"laissez-faire bank"

Question 71

Which of the following policies are intended to reduce the likelihood of future financial crises?

A)restricting the size of financial firms
B)limiting excessive risk taking
C)reforming regulatory agencies
D)all of the above

Question 72

There are systematic risks and idiosyncratic risks. Which risks can be mitigated by whom and how?

Question 73

Deposit insurance is an example of _____ used to prop up the financial system.

A)a giveaway of public funds
B)risky lending
C)a capital injection
D)conventional monetary policy

Question 74

"The less healthy a person is, the more likely he or she is to purchase insurance." This is a fact stated by an employee of a health insurance company. Is this issue related to adverse selection? If yes, how?

Question 75

Sovereign debt refers to debt issued:

A)without collateral.
B)with no rating by a credit-rating agency.
C)by governments.
D)with a promise to repay in a foreign currency.

Question 76

Provide one example from the 2008-2009 U.S. financial crisis of how the following types of policies were used to respond to the crisis:
a.conventional monetary and fiscal policy
b.lender of last resort
c.injections of government funds

Question 77

All of the following are examples of U.S. shadow banks except:

A)Bear Stearns.
B)AIG.
C)Bank of America.
D)Lehman Brothers.

Question 78

The government purchasing ownership stakes in a faltering financial institution in order to prop up the financial system is an example of:

A)a giveaway of public funds.
B)risky lending.
C)a capital injection.
D)conventional monetary policy.

Question 79

The purpose of the U.S. Financial Services Oversight Council, which was created by the Dodd-Frank Act, is to:

A)replace the existing U.S. regulatory agencies with one agency to enforce all financial regulations.
B)oversee U.S. private credit rating agencies.
C)determine appropriate levels of executive compensation for firms in the U.S. financial system.
D)coordinate activities of the various U.S. regulatory agencies.

Question 80

The potential problem faced by the rest of Europe in the event of a Greek debt default is:

A)the inability of the European Central Bank to conduct open market operations.
B)the risk of banks holding Greek debt becoming insolvent.
C)an increase in the number of U.S. dollars traded per euro in the foreign exchange market.
D)the strain on the European banking system, while banks in the rest of the world would be unaffected.