Question 1

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

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Question 2

"A fire-sale can make illiquid institutions insolvent." Explain how.

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Question 3

Suppose Bank A has a leverage ratio of 20 and Bank B has a leverage ratio of 10. Explain the meaning of these ratios and what would happen to each of these banks if the value of their assets fell by 6 percent.

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Question 4

Provide one example from the 2008-2009 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.

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Question 5

Provide one argument in favor of and one argument against each of the following proposals to prevent future financial crises.

a. require shadow banks to hold more capital,
b. give the FDIC resolution authority over shadow banks,
c. impose higher capital requirements on larger banks,
d. prohibit banks from making speculative investments.

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Question 6

In each case identify whether the situation 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 Wisconsin, 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 take 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 .

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Question 7

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

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Question 8

Why was the recession of 2008-2009 sometimes also referred as the subprime crisis?

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Question 9

What is the difference between systematic and idiosyncratic risk? Which type of risk can be almost eliminated through diversification?

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Question 10

What were the mistakes of the following parties which finally led to the recession of 2008-2009?
a. Homebuyers
b. Government policymakers
c. Investment banks.

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Question 11

How does TED spread indicate the confidence level the people in an economy have in the banking system?

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Question 12

By definition, "shadow banks are a diverse set of financial institutions that perform some functions similar to banks, but do so outside the regulatory system that applies to traditional banking." In the recession of 2008, the government financially rescued many shadow banks. Was this a moral hazard? If yes, then why did the government do this?

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Question 13

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

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Question 14

Every government in the world tries to avoid financial crisis. Similarly, every economist is also trying to find a foolproof way to remove the word "financial crisis" from the dictionary. What makes financial crisis so undesirable? Explain.

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Question 15

Provide specific examples from the 2008-2009 financial crisis of each of the five stages of a financial crisis:

a. asset-price booms and busts,
b. insolvencies of financial institutions,
c. falling confidence in the financial system,
d. credit crunch,
e. recession.

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Question 16

What are the benefits of a well-functioning financial system? What are the costs of a financial crisis?

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Question 17

What was the effect of the recession of 2008-2009 on output and prices? Give one example of conventional monetary policies and fiscal policies used by the government to fix the problem.

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Question 18

Use the aggregate demand-aggregate supply model to graphically illustrate the impact of a financial crisis on output and prices in an economy in the short run. Explain the factors that cause changes from the initial equilibrium to the new short-run equilibrium.

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Question 19

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

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Question 20

a.  What is the difference between an illiquid bank and an insolvent bank?

b. Would the Federal Reserve’s lender of last resort function be the most appropriate remedy for an illiquid or an insolvent bank? Explain.

c. Would the FDIC's resolution authority be the most appropriate remedy for an illiquid or an insolvent bank? Explain

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Quiz 20: The Financial System: Opportunities and Dangers