Question 1

If borrowers with the most risky investment projects seek bank loans in higher proportion to those borrowers with the safest investment projects, banks are said to face the problem of ________.

Accepted Answer

Adverse selection occurs when those with higher risk are more likely to apply for loans, leaving the bank with a pool of borrowers who are more likely to default. This is different from adverse credit risk, which is the risk of default once the loan has been given, and moral hazard, which is the risk that the borrower will act in a way that is not in the best interest of the bank once the loan is received. Lemon lenders is not a relevant term in this context.

Question 2

Property promised to the lender as compensation if the borrower defaults is called ________.

Accepted Answer

Collateral is property or an asset that is pledged as security against a loan. In the event that the borrower is unable to repay the loan, the lender can seize the collateral and sell it to recover the amount owed.

Question 3

When banks offer borrowers smaller loans than they have requested, banks are said to ________.

Accepted Answer

When banks offer borrowers smaller loans than they have requested, this is called rationing credit. This means that the bank is limiting the amount of credit it is willing to extend to the borrower, usually based on the borrower's creditworthiness and the bank's own risk assessment.

Question 4

All else the same, if a bank's liabilities are more sensitive to interest rate fluctuations than are its assets, then ________ in interest rates will ________ bank profits.

Accepted Answer

If a bank's liabilities are more sensitive to interest rate fluctuations than its assets, an increase in interest rates will increase its interest expenses faster than its interest income, leading to a reduction in profits. Therefore, option B, an increase in interest rates will reduce bank profits, is the correct answer.

Question 5

If a bank has ________ rate-sensitive assets than liabilities, a ________ in interest rates will reduce bank profits, while a ________ in interest rates will raise bank profits.

Accepted Answer

When a bank has more rate-sensitive assets than liabilities, a decline in interest rates will result in a decrease in profits since the income from these assets will decrease more than the cost of liabilities. On the other hand, when there are more rate-sensitive liabilities than assets, a decrease in interest rates will result in increased profits. This is because the cost of funding liabilities will decrease more than the income from assets.

Question 6

Banks face the problem of ________ in loan markets because bad credit risks are the ones most likely to seek bank loans.

Accepted Answer

Adverse selection refers to the problem of asymmetric information where bad credit risks are more likely to seek loans than good credit risks. This poses a problem for banks as they may end up lending to bad credit risks, which increases the likelihood of loan defaults and losses for the bank.

Question 7

In order to reduce the ________ problem in loan markets, bankers collect information from prospective borrowers to screen out the bad credit risks from the good ones.

Accepted Answer

The problem being referred to is adverse selection, which is the tendency for those with the highest risk of default to be the most likely to seek and receive loans. To mitigate this problem, bankers gather information about prospective borrowers to separate the good risks from the bad ones. Moral hazard refers to the risk that borrowers will take on more risk than they would if they were using their own money. Moral suasion refers to efforts by government officials to persuade market participants to adopt certain policies or behaviors. Adverse lending is not a commonly used term in finance.

Question 8

Unanticipated moral hazard contingencies can be reduced by ________.

Accepted Answer

Long-term customer relationships can help reduce unanticipated moral hazard contingencies. This is because a lender who has a long-term relationship with a borrower is likely to have a better understanding of the borrower's behavior and risk profile, which can help them anticipate potential moral hazard issues and take steps to mitigate them. Screening and credit rationing can also help reduce moral hazard, but they do not specifically address unanticipated contingencies. Specialization in lending may not necessarily reduce moral hazard contingencies.

Question 9

Provisions in loan contracts that prohibit borrowers from engaging in specified risky activities are called ________.

Accepted Answer

Provisions in loan contracts that prohibit borrowers from engaging in specified risky activities are called restrictive covenants. Due-on-sale clauses and liens are related to other aspects of loan contracts. Proscription bonds are not a commonly used term in loan agreements.

Question 10

Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks face the ________.

Accepted Answer

The moral hazard problem arises when borrowers, once they have received a loan, may undertake riskier investment projects. This means that they may not have the same incentives to carefully evaluate and monitor their investment decisions, as the bank is the one risking its funds. As a result, banks face the risk of not getting paid back, which is commonly referred to as credit risk. The other answer choices (A, B, and C) are related to problems that banks face before extending a loan, such as the risk of adverse selection (lending to borrowers who are more likely to default), the lemon problem (lending to borrowers who have poor credit quality), and adverse credit risk problem (lending to borrowers who have high credit risk).

Question 11

Credit risk management tools include ________.

Accepted Answer

Collateral is a credit risk management tool used to secure a loan or credit exposure. It provides a lender with an asset that can be seized and sold if the borrower defaults, thus reducing the lender's credit risk.

Question 12

Risk that is related to the uncertainty about interest rate movements is called ________.

Accepted Answer

Interest-rate risk is the risk related to uncertainty about interest rate movements. Default risk is the risk of a borrower not being able to repay their debt. The problem of moral hazard refers to the risk that a party may act in their own self-interest rather than in the interest of the other party. Security risk refers to the risk of loss or damage to physical or digital assets.

Question 13

From the standpoint of ________, specialization in lending is surprising but makes perfect sense when one considers the ________ problem.

Accepted Answer

Specialization in lending seems counterintuitive from a diversification standpoint because diversification aims to spread out risk. However, it makes sense when considering the adverse selection problem, as specialization allows lenders to better assess and manage the risk associated with specific borrowers or sectors.

Question 14

How can specializing in lending help to reduce the adverse selection problem in lending?

Accepted Answer

The answer of How can specializing in lending help to...

Question 15

Long-term customer relationships ________ the cost of information collection and make it easier to ________ credit risks.

Accepted Answer

Long-term customer relationships reduce the cost of information collection as the company has already collected data and information about the customer. This makes it easier to screen or evaluate credit risks as the company has more information to base their decision on. Therefore, the correct answer is A - reduce; screen.

Question 16

To reduce moral hazard problems, banks include restrictive covenants in loan contracts. In order for these restrictive covenants to be effective, banks must also ________.

Accepted Answer

Restrictive covenants are useless if banks do not monitor and enforce them. Without effective monitoring and enforcement, borrowers may be able to take advantage of the moral hazard problem, putting the banks at risk. Therefore, the answer is A, that banks must monitor and enforce the restrictive covenants to reduce moral hazard problems.

Question 17

When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or even a higher rate, the bank is said to engage in ________.

Accepted Answer

Credit rationing occurs when lenders refuse to make loans even if there are willing borrowers, often due to constraints on the supply of credit. This can be caused by factors such as regulatory restrictions or a shortage of funds available for lending. Coercive bargaining refers to using threats or other forms of pressure to force a desired outcome in a negotiation, and strategic holding out involves one party delaying an agreement in order to gain a better outcome. Collusive behavior refers to two or more parties conspiring to manipulate a market, which is not applicable in this scenario.

Question 18

If a bank has ________ rate-sensitive assets than liabilities, then ________ in interest rates will increase bank profits.

Accepted Answer

If a bank has more rate-sensitive assets than liabilities, then an increase in interest rates will lead to an increase in the yield on the bank's assets. This means that the bank will earn more interest income, leading to higher profits.

Question 19

A bank's commitment to provide a firm with loans up to pre-specified limit at an interest rate that is tied to a market interest rate is called ________.

Accepted Answer

The description provided in the question is that of a loan commitment. It is an agreement by a bank to extend credit up to a certain amount for a specified period of time, subject to certain conditions. The interest rate on this credit is usually tied to a market interest rate, such as LIBOR. The other options presented in the question (A, B, and D) do not accurately describe this type of loan agreement.

Question 20

In one sense ________ appears surprising since it means that the bank is not ________ its portfolio of loans and thus is exposing itself to more risk.

Accepted Answer

Specialization in lending without diversifying a portfolio of loans means a bank is focusing on a narrow range of loan types, which increases its exposure to risk if that particular loan category performs poorly.

Quiz 12: Banking and the Management of Financial Institutions