Question 1

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

Accepted Answer

From the standpoint of diversification, specialization in lending may seem counterintuitive. However, when considering the adverse selection problem, specialization in lending makes perfect sense. Adverse selection refers to the tendency for borrowers with higher risk to apply for loans more frequently than borrowers with lower risk. As a result, lenders who specialize in a particular type of lending (such as mortgage lending or small business lending) are better equipped to screen borrowers and assess their risk levels, which mitigates the adverse selection problem.

Question 2

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 the borrowers with the riskiest investment projects seek bank loans in higher proportion compared to those with safer investments, leading to an imbalance in the quality of loans in the bank's portfolio. This can lead to higher default rates and can affect the bank's profitability and financial stability.

Question 3

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

Accepted Answer

Rationing credit refers to the practice of banks offering borrowers smaller loans than they have requested. This is often done as a way for banks to manage risk and ensure that they have enough funds to lend to other customers.

Question 4

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 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

If a bank has more rate-sensitive assets than liabilities, it means that the bank's assets will be affected more by changes in interest rates than its liabilities. Therefore, a decline in interest rates will reduce the spread between the interest earned on assets and interest paid on liabilities, resulting in a decrease in bank profits. On the other hand, a rise in interest rates will increase the spread, leading to an increase in bank profits.

Question 6

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.

Question 7

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 the cost of the bank's liabilities more than the interest income earned on its assets, resulting in a reduction in bank profits. Therefore, option B is correct. Option A is incorrect because an increase in interest rates will increase the interest income on its assets but also increase the cost of its liabilities, resulting in an uncertain impact on bank profits. Option C is incorrect because a decline in interest rates will reduce the interest income on its assets but also reduce the cost of its liabilities, resulting in an uncertain impact on bank profits. Option D is incorrect because even if interest rates decline, the bank's profits may still be affected.

Question 8

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.

Question 9

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

Accepted Answer

Interest-rate risk refers to the uncertainty about how changes in interest rates will affect investments, such as bonds or loans. It is the risk that changes in the interest rate will affect the value of the investment, whether positively or negatively. Default risk refers to the risk that a borrower will fail to make their scheduled payments. The problem of moral hazard refers to the risk that an individual or organization will behave in a riskier manner because they are not fully accountable for the consequences of their actions. Security risk refers to the risk of physical harm or damage to property.

Question 10

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

Accepted Answer

This situation describes moral hazard, which occurs when an individual or entity takes on more risks because they are protected from the consequences of their actions. In this case, the borrower, once they have the loan, may feel less inclined to choose a safe investment because they are less worried about losing their own money. Instead, they may choose a high-risk investment, knowing that the bank is on the hook for the loan.

Question 11

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

Accepted Answer

Long-term customer relationships lead to reduced costs of information collection because the company has already gathered information about the customer over time. This makes it easier to screen credit risks because the company can use the information they have gathered to make informed decisions.

Question 12

Credit risk management tools include ________.

Accepted Answer

Collateral is a commonly used credit risk management tool that mitigates the risk of default by providing an alternative source of repayment for loans or credit facilities. Deductibles are typically associated with insurance policies rather than credit risk management, while interest rate swaps and duration analysis are more related to market risk management.

Question 13

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 profits as the interest earned on assets will increase more than the interest paid on liabilities.

Question 14

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

A loan commitment is a contractual agreement between a bank and a borrower, in which the bank agrees to provide a specified amount of loan within a specified period at an interest rate that is tied to a market interest rate. This commitment helps the borrower to plan and arrange finances accordingly. Option A and B are not correct as they are not standard terms used in banking. Option D is also not correct as pre-credit loan line is not a commonly used term in the banking industry.

Question 15

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

In order for restrictive covenants to be effective, banks must also monitor and enforce them. This ensures that borrowers comply with the restrictions in the loan contract and reduces the possibility of moral hazard problems. Banks cannot simply trust borrowers to do the right thing, as this can lead to non-compliance and potential losses for the bank. Additionally, banks cannot rewrite the contract or extend the deadline without causing potential harm to their own financial position.

Question 16

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

Adverse selection refers to the problem of lenders not being able to distinguish between good and bad credit risks among potential borrowers. Bankers collect information such as credit history, income, and assets to screen out bad credit risks and mitigate adverse selection. The term "moral hazard" refers to the problem of borrowers taking on greater risks because they know they are protected by insurance or other forms of protection. "Moral suasion" refers to incentives and persuasion used by regulators or other authorities to encourage responsible behavior in financial markets. "Adverse lending" is not a commonly used term in finance.

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 to creditworthy borrowers due to a shortage of funds or other factors such as strict lending criteria or regulations. It is a common occurrence in financial markets and can lead to borrowers seeking alternative sources of financing, such as non-bank lenders or peer-to-peer lending platforms. The other options (coercive bargaining, strategic holding out, and collusive behavior) do not accurately describe the situation where a lender refuses to make a loan despite willing borrowers.

Question 18

If a bank's liabilities are more sensitive to interest rate movements than are its assets, then ________.

Accepted Answer

If a bank's liabilities (e.g. deposits, borrowings) are more sensitive to interest rate movements than its assets (e.g. loans, investments), an increase in interest rates will lead to an increase in the cost of funding for the bank while the interest it earns on its assets will not increase as much, resulting in a reduction in bank profits. Conversely, a decrease in interest rates will reduce the cost of funding for the bank while the interest earned on assets will remain the same, leading to a reduction in bank profits.

Question 19

Unanticipated moral hazard contingencies can be reduced by ________.

Accepted Answer

Long-term customer relationships can reduce unanticipated moral hazard contingencies as the lender can gain a better understanding of the borrower's behavior and financial situation, allowing for closer monitoring and communication. Screening and specialization in lending can reduce adverse selection, while credit rationing can reduce overall risk exposure, but these measures do not directly address unanticipated moral hazard contingencies.

Question 20

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

Accepted Answer

Collateral is the specific property that is promised to the lender as security for a loan. If the borrower defaults on the loan, the lender can seize the collateral to recover their losses. Deductibles are the amount that must be paid out of pocket before an insurance policy will cover a claim. Restrictive covenants are clauses in a contract that limit the ways in which a property can be used. Contingencies are conditions that must be met before a contract can be fully executed. None of these options accurately describe property promised to a lender as compensation for default.

Quiz 12: Banking and the Management of Financial Institutions

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