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Chapter 1 Why are financial institutions special? (Answers)
- A loan covenant is: A. a legal clause in a borrowing contract that requires the lender to avoid certain actions B. a legal clause in a borrowing contract that requires the lender to take certain actions C. a legal clause in a borrowing contract that requires the borrower to take certain actions D. a legal clause in a borrowing contract that requires the borrower to either take certain actions or avoid certain actions
- When a DI makes a shift from an 'originate-to-hold' banking model to an 'originate-to-distribute' banking model, the change is likely to result in: A. increased operating costs B. increased interest rate and liquidity risk C. decreased monitoring costs D. decreased fee income 3.In the traditional 'originate-to-hold' banking model, where a DI takes short-term deposits and uses them to make loans, the bank usually holds these loans until maturity. This exposes the bank to increased: A. operating costs B. interest rate and liquidity risk C. monitoring costs D. All of the listed options are correct. 4.FIs perform their intermediary function in two ways: A. They specialise as brokers between savers and users and they directly control the quantity of outside money in the economy. B. They serve as asset transformers by purchasing primary securities and issuing secondary securities and by purchasing secondary securities and issuing primary securities. C. They serve as asset transformers by purchasing secondary securities and issuing primary securities and they directly control the quantity of outside money in the economy.
D. They specialise as brokers between savers and users and they serve as asset transformers by purchasing primary securities and issuing secondary securities.
- Price risk refers to: A. the risk that the sale price of an asset will be lower than the purchase price of that asset. B. the risk that the purchase price of an asset will be lower than the sale price of that asset. C. the risk that the sale price of an asset will be higher than the purchase price of that asset. D. None of the listed options are correct.
- Economies of scale is the concept that: A. a cost reduction in trading and other transaction services results from increased efficiency when FIs perform these services. B. a profitability decrease in trading and other transaction services results from increased efficiency when FIs perform these services. C. a cost reduction in trading and other transaction services results from stable efficiency when FIs perform these services. D. None of the listed options are correct.
- Which of the following statements is true? A. Primary securities are securities issued by corporations and backed by the real assets of those corporations. B. Secondary securities are securities issued by corporations and backed by the real assets of those corporations. C. Dominant securities are securities issued by corporations and backed by the real assets of those corporations. D. Preliminary securities are securities issued by corporations and backed by the real assets of those corporations. 8.Secondary securities are securities issued by FIs and backed by: A. the real assets of the FI B. primary securities C. guarantees
C. positive externality D. negative externality
- Net regulatory burden is defined as the difference between the: A. private costs of regulations and the private benefits for the producers of financial services B. public costs of regulations and the public benefits for the producers of financial services C. private costs of regulations and the public benefits for the producers of financial services D. public costs of regulations and the private benefits for the producers of financial services
- The part of the money supply directly produced by the government or central bank is called: A. inside money B. outside money C. direct money D. indirect money 15.The part of the money supply produced by the private banking system is called: A. inside money B. outside money C. indirect money D. None of the options listed. The private banking system does not produce part of the money supply. 16.Which of the following are reasons for the specialness of financial intermediaries? A. higher average information costs B. lower price risk and superior liquidity attributes for financial claims to household savers. C. higher average transaction costs D. All of the listed options are correct. 17.Which of the following statements is true?
A. In a world without financial intermediaries the level of fund flows between household savers and the corporate sector is likely to be as high as it is with financial intermediaries. B. In a world without financial intermediaries funds would directly flow from surplus units to deficit units. C. In a world without financial intermediaries lenders (households) would need to monitor the actions of the firms to which they have lent their funds. D. In a world without financial intermediaries funds would directly flow from surplus units to deficit units and lenders (households) would need to monitor the actions of the firms to which they have lent their funds.
The following are protective mechanisms that have been developed by regulators to promote the safety and soundness of the banking system except: A. encouraging banks to rely more on deposits rather than debt or capital as a cushion against failure B. encouraging banks to limit lending to a single customer to no more than 10 per cent of capital C. the provision of deposit insurance D. the periodic monitoring of banks 19.Which of the following statements is true? A. Household savers are likely to be attracted to direct investments in corporate securities because of lower monitoring costs compared to using financial intermediaries. B. Household savers are likely to be attracted to direct investments in corporate securities because of lower liquidity costs compared to using financial intermediaries. C. Household savers are likely to be attracted to direct investments in corporate securities because of lower price risk compared to using financial intermediaries. D. None of the listed options are correct. 20.Which of the following statements is true? A. Agency costs arise whenever economic agents enter into a contract in a world of incomplete information. B. Monitoring costs are part of overall agency costs.
A. Transaction costs are low to the household since FIs are more efficient in monitoring and gathering investment information. B. To receive the benefits of diversification that households may not be able to achieve on their own. C. The FI can benefit from combining funds and negotiating lower asset prices and transaction costs D. All of the listed options are correct. 25.Which of the following statements is true? A. The more diversified a financial intermediary, the higher the probability that it will default on its obligations and the more risky and illiquid the claims. B. The less diversified a financial intermediary, the higher the probability that it will default on its obligations and the more risky and illiquid the claims. C. The more diversified a financial intermediary, the lower the probability that it will default on its obligations and the more risky but also the more liquid the claims. D. The more diversified a financial intermediary, the higher the probability that it will default on its obligations and the more risky but also the more liquid the claims. 26.Negative externalities exist in the depository sector when: A. the fear of DI insolvency leads to bank deposit runs B. lending activity is impaired or constrained C. there are delays in disbursements from insolvent DIs D. All of the listed options are correct. 27.Which of the following is an adequate definition of broad money? A. Currency plus bank current deposits of the private non-bank sector B.'M1' plus borrowings from the private sector by non-bank financial institutions less the latter's holdings of currency and bank deposits C.'M3' plus non-deposit borrowings from the private sector by all financial intermediaries (AFIs), less the holdings of currency and bank deposits by RFCs and cash management trusts D. None of the listed options are correct. 28.What does APCA and APRA stand for?
A. Australian Payments Clearing Association; Australian Prudential Regulatory Association B. Australian Payments and Cheques Association; Australian Payments and Regulatory Authority C. Australian Payments Cheques Association; Australian Prudential Regulatory Association D. Australian Payments Clearing Association; Australian Prudential Regulatory Authority 29.Which of the following are areas of institution-specific specialness? A. money supply transmission B. payment services C. intergenerational transfers D. All of the listed options are correct. 30.Which of the following are types of regulation that seek to enhance the net social welfare benefits of financial intermediaries ‘services? A. exit regulation B. issuer protection regulation C. credit allocation regulation D. All of the listed options are correct. 31.Which of the following statements is true? A.Bank failures may destroy household savings and restrict a firm's access to credit. B.Bank failures may create doubts in savers' minds regarding the stability and solvency of financial intermediaries in general. C. Bank failures may threaten the stability of the financial system. D. All of the listed options are correct. 32.Which of the following statements is true? A.Bank loans that represent more than 5 per cent of a banking group's capital must be reported quarterly to APRA. B.Bank loans that represent more than 10 per cent of a banking group's capital must be reported quarterly to APRA.
D. The private banking system controls both inside and outside money.
- Safety and soundness regulations include all of the following layers of protection except: A. the provision of guaranty funds B. requirements encouraging diversification of assets C. the creation of money for those FIs in financial trouble D. requiring minimum levels of capital 38.The following are protective mechanisms that have been developed by regulators to promote the safety and soundness of the banking system except: A. encouraging banks to rely more on deposits rather than debt or capital as a cushion against failure B. encouraging banks to limit lending to a single customer to no more than 10 per cent of capital C. the provision of deposit insurance D. the periodic monitoring of banks 39.Which of the following statements is false? A. A financial intermediary specialises in the production of information. B. A financial intermediary reduces its risk exposure by pooling its assets. C. A financial intermediary benefits society by providing a mechanism for payments. D. A financial intermediary acts as a lender of last resort. 40.Which function of an FI reduces transaction and information costs between a corporation and an individual and may encourage a higher rate of savings? A. brokerage services B. asset transformation services C. information production services D. money supply management 41.In its role as a delegated monitor, an FI:
A. keeps track of required interest and principal payments on loans it originates B. works with financially distressed borrowers in danger of defaulting on their loans C. holds portfolios of loans that they continue to service D. All of the listed options are correct. 42.Which of the following is not a major function of financial intermediaries? A. brokerage services B. asset transformation services C. information production D.management of the nation's money supply 43.Advantages of depositing funds into a typical bank account instead of directly buying corporate securities include all of the following except: A. monitoring done by the bank on your behalf B. increased liquidity if funds are needed quickly C. increased transactions costs D. less price risk when funds are needed 44.Many households place funds with financial institutions because many FI accounts provide: A. lower denominations than other securities B. flexible maturities versus other interest-earning securities C. better liquidity than directly negotiated debt contracts D. All of the listed options are correct. 45.The reason FIs can offer highly liquid, low price-risk contracts to savers while investing in relatively illiquid and higher risk assets is: A. because diversification allows an FI to predict more accurately the expected returns on its asset portfolio B. significant amounts of portfolio risk are diversified away by investing in assets that have correlations between returns that are less than perfectly positive
50.Why is the failure of a large bank more detrimental to the economy than the failure of a large steel manufacturer? A. The bank failure usually leads to a government bailout. B. There are fewer steel manufacturers than there are banks. C. The large bank failure reduces credit availability throughout the economy. D.Since the steel company's assets are tangible, they are more easily reallocated than the intangible bank assets. 51.Which of the following statements is true regarding the percentage share of assets of financial institutions in Australia as of end June 2013? A. The largest percentage of assets is held by money market corporations. B. The largest percentage of assets is held by credit unions. C. The largest percentage of assets is held by permanent building societies. D. The largest percentage of assets is held by banks.
- Agency costs are costs relating to the risk that the owners and managers of firms that receive savers' funds will take action with those funds’ contrary to the best interests of the saver. TRUE
- Due to the costs of monitoring, liquidity and price risk savers often prefer to hold the financial claims issued by FIs rather than those issued by corporations. TRUE
- In the principal-agent relationship between savers and a borrowing firm the savers are the agents and the borrowing firm is the principal. FALSE
- By acting as a delegated monitor, financial intermediaries reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds. TRUE
- FIs are better able to manage the risk of mismatching maturities of assets and liabilities than household savers. TRUE 57.FIs play a significant role in the transmission of monetary policy. TRUE
- An example of negative externality is the costs faced by small businesses in a one-bank town if the local bank fails. TRUE
- In most countries regulators require financial intermediaries to hold a minimum level of cash reserves against their deposits. There is no such regulation in Australia. TRUE
- The risk that the sale price of an asset will be less than the purchase price of an asset is called liquidity risk FALSE 61.In an attempt to enhance the net social welfare benefits of the services provided by financial intermediaries, safety and soundness regulation requires a DI to hold a minimum level of cash reserves against deposits. FALSE
- Because the average maturity of assets and the average maturity of liabilities are often different on an FI's balance sheet, the FI is exposed to liquidity risk FALSE
- None of the commercial banks in Australia defaulted during the global financial crisis. TRUE
- None of the commercial banks in the US defaulted during the global financial crisis.
A. funds two-year maturity assets with one-year maturity liabilities B. funds one-year maturity assets with two-year maturity liabilities C. funds two-year maturity assets with two-year maturity liabilities D. None of the listed options are correct.
A decrease in interest rates means that the discount rate on cash flows is: A. decreased and thus the market value of an FI's assets and liabilities decreases. B. increased and thus the market value of an FI's assets and liabilities decreases. C. increased and thus the market value of an FI's assets and liabilities increases. D. decreased and thus the market value of an FI's assets and liabilities increases.
An increase in interest rates means that the discount rate on cash flows is: A. decreased and thus the market value of an FI's assets and liabilities decreases B. increased and thus the market value of an FI's assets and liabilities decreases C. increased and thus the market value of an FI's assets and liabilities increases D. decreased and thus the market value of an FI's assets and liabilities increases
Market risk is defined as the risk: A. incurred by granting loans to companies that do not hold a large market share B. incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates and other asset prices C. that a sudden surge in liability withdrawals may require FIs to liquidate assets at less than fair market prices D. that an FI loses market share
The market risk of an FI increases with: A. increasing volatility of asset prices B. increasingly large unhedged short positions in bonds, equities and other commodities C. increasingly large unhedged long positions in bonds, equities and other commodities D. All of the listed options are correct.
Why are depository institutions and life insurance companies more exposed to credit risk than, for instance, money market managed funds and general insurance companies? A. Because the average maturities of their assets are longer than those of money market managed funds/general insurance companies. B. Because the average maturities of their assets are shorter than those of money market managed funds/general insurance companies. C. They are not exposed to more risk. D. Because they are not specialised in credit risk management.
Non-performing loans are defined as loans that: A. are either in default or close to being in default and are at least 90 days in arrears B. have been written off and loans that are at least 80 days in arrears C. are either in default or close to being in default and are at least 60 days in arrears D. have been written off and loans that are at least 60 days in arrears
What does systematic credit risk mean? A. The risk of default of the borrowing firm that arises from the borrowing firm's specific projects. B. The risk of default associated with microeconomic conditions affecting some borrowers. C. The risk of default associated with general macroeconomic conditions affecting all borrowers. D. The risk of default associated with general macroeconomic conditions affecting some borrowers.
The major difference between firm-specific credit risk and systematic credit risk is that: A. FIs can diversify systematic credit risk, while firm-specific credit risk cannot be diversified. B. FIs can diversify firm-specific credit risk, while systematic credit risk cannot be diversified. C. None of the listed options are correct, as FIs can diversify both types of credit risk. D. None of the listed options are correct, as FIs cannot diversify either type of credit risk.
… can be reduced by diversification. A. Firm-specific credit risk B. Systematic credit risk C. Firm-specific and systematic credit risks D. None of the listed options are correct.
scale'? A. the use of several inputs to produce one common output B. the ability to generate cost savings by producing more than one output with the same inputs C. the ability to lower average operating costs by expanding its output of financial services D. the ability to lower average operating costs by lowering its output of financial services
Which of the following are typical operational risk sources? A. employee fraud B. back-office failures C. general technological glitches D. All of the listed options are correct.
In which of the following situations is an Australian FI exposed to a depreciation of the euro against the Australian dollar? A. The FI holds €00 million in assets and €70 million in liabilities. B. The FI holds €100 million in assets and €100 million in liabilities. C. The FI holds 70 million in assets and €100 million in liabilities. D. The FI does not hold any assets or liabilities in euros, but considers doing so in the future.
An Australian FI that invests €50 million in three-year maturity loans and partially funds these loans with €30 million one-year deposits is exposed to the following risks. A. A depreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone. B. An appreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone. C. A depreciation of the euro against the Australian dollar plus credit risk plus reinvestment risk, such as decreasing interest rates in the Eurozone. D. A depreciation of the euro against the Australian dollar reinvestment risk, such as increasing interest rates in the Eurozone.
Sovereign risk refers to the risk that repayments from: A. local borrowers are interrupted because of interference from foreign governments B. foreign borrowers are interrupted because of interference from local governments C. foreign borrowers are interrupted because of interference from foreign governments D. None of the listed options are correct.
Which of the following is an effective measure for claimholders if a foreign government prohibits repayment of debt
obligations to an international lender? A. The claimholder can recover its outstanding debt through local courts. B. The claimholder can recover its outstanding debt through international courts C. The claimholder cannot do anything. D. The claimholder has limited recourse through normal legal channels but may exert leverage if it has control over future loans or supply of funds.
Unanticipated diseconomies of scale and scope are a result of: A. technology risk B. interest rate risk C. foreign exchange risk D. credit risk
The major source of risk exposure resulting from issuance of standby letters of credit is: A. technology risk B. interest rate risk C. credit risk D. off-balance-sheet risk
Politically motivated limitations on payments of foreign currency may expose the FI to: A. sovereign or country risk B. interest rate risk C. credit risk D. foreign exchange risk
The risk that a debt security's price will fall, subjecting the investor to a capital loss is: A. credit risk B. political risk C. currency risk D. market risk
The risk that interest income will increase at a slower rate than interest expense is: A. credit risk B. political risk C. currency risk D. interest rate risk
