Multiple Choice Questions
1. Empirical evidence points to the fact that:
A) Financial crises, though newsworthy, have no impact on economic growth.
B) Financial crises have a negative impact on economic growth only for the year of the crisis.
C) Financial crises have a negative impact on economic growth for years.
D) Financial crises can have a positive impact on economic growth as weak borrowers are weeded out.
Answer: C LOD: 1 Page: 349
A-Head: Regulating the Financial System.
2. There is a tradeoff that a bank faces that can impact its likelihood of failure; this tradeoff is:
A) The more competitive the banking environment, the more likely the bank will fail.
B) The greater the regulation from government the more likely the bank will fail.
C) The more profitable the bank, the less liquid the bank will be and the more likely it will fail.
D) The larger the bank in asset size the more likely it will fail.
Answer: C LOD: 2 Page: 351
A-Head: The Sources and Consequences of Runs, Panics and Crises.
3. Rumors of a bank failing, even if not true, can become a self-fulfilling prophecy because:
A) Customers will not want to obtain loans from this bank.
B) The rumors will cause people to not want to deposit in this bank.
C) Regulators will scrutinize the bank heavily looking for something wrong.
D) Depositors will rush to the bank to withdraw their deposits and the bank under normal situations would not have this amount of liquid assets on hand.
Answer: D LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
4. What matters most during a bank run is:
A) The number of loans outstanding.
B) The solvency of the bank.
C) The liquidity of the bank.
D) All of the above.
Answer: C LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
5. Contagion is:
A) The failure of one bank spreading to other banks through depositors withdrawing of funds.
B) The phenomenon of one bank loan that defaults will cause other bank loans to default.
C) The rapid contraction of investment spending that occurs when interest rates are increase by the Federal Reserve.
D) The rapid inflation that results from the printing of money.
Answer: A LOD: 1 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
6. A bank run involves:
A) Illegal activities on the part of the bank's officers.
B) A bank being forced into bankruptcy.
C) A large number of depositors withdrawing their funds during a short time span,.
D) A bank's return on assets being below the acceptable level.
Answer: C LOD: 1 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
7. The federal government is concerned about the health of the banking system for many reasons, the most important of which may be:
A) Banks are where government bonds are traded.
B) A significant number of people are employed in the banking industry.
C) Many people earn the majority of their income from interest on bank deposits.
D) Banks are of great importance in enabling the economy to operate efficiently.
Answer: D LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
8. When healthy banks fail due to widespread bank panics, those who are likely to be hurt are:
A) Government regulators.
B) Households and small businesses.
C) FDIC
D) The Federal Reserve.
Answer: B LOD: 1 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
9. It is difficult for depositors to know the true health of banks because:
A) Regulations prohibit this information from being made public.
B) The financial statements of banks are too difficult for most people to understand.
C) Most of the information on bank loans is private and based on sophisticated models.
D) Banking is competitive and financial records of banks are not divulged to prevent competitor banks from having an advantage.
Answer: C LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
10. Bank failures tend to occur most often during periods of:
A) Stock market run ups when, like many companies, banks tend to be overvalued.
B) During periods of high inflation when the fixed rate loans of many banks cause their real returns to decrease.
C) Recessions when many borrowers have a difficult time repaying loans and lending activity slows.
D) During times of wars and other civil unrest.
Answer: C LOD: 2 Page: 353
A-Head: The Sources and Consequences of Runs, Panics and Crises.
11. Bank panics seem to begin with:
A) Rumors.
B) Wars.
C) Real economic events.
D) a and c
E) b and c
Answer: D LOD: 1 Page: 353
A-Head: The Sources and Consequences of Runs, Panics and Crises.
12. Deflation can cause widespread bank crises:
A) Because the value of borrowers net worth falls but not their liabilities.
B) Borrowers default rates increase.
C) Bank balance sheets deteriorate as the level of economic activity decreases.
D) Information asymmetry problems increase during deflationary periods.
E) All of the above.
Answer: E LOD: 2 Page: 354
A-Head: The Sources and Consequences of Runs, Panics and Crises.
13. The reasons for the government to get involved in the financial system include each of the following, EXCEPT:
A) To protect the bank's monopoly position.
B) To protect investors.
C) To ensure the stability of the financial system.
D) To protect bank customers from monopolistic exploitation.
Answer: A LOD: 1 Page: 354
A-Head: The Government Safety Net.
14. The government is obligated to protect small investors because:
A) Large investors can better afford losses.
B) Many small investors cannot adequately judge the soundness of their bank.
C) There is inadequate competition to ensure a bank is operating efficiently.
D) Banks are often run by unethical managers who will often exploit small investors.
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Answer: B LOD: 1 Page: 354
A-Head: The Government Safety Net.
15. The government, often through the Federal Reserve, will regulate bank mergers, sometimes denying the proposed merger. Often the reason given for the denial is to protect small investors. What are small investors being protected from?
A) With a larger bank the bank is likely to take greater risk and may fail.
B) In order to pay for the merger, the bank may seek higher returns putting the depositors' funds at greater risk.
C) Mergers can increase the monopoly power of banks and the bank may seek to exploit this power by raising prices and earning unwarranted profits.
D) Bank runs hurt larger banks more than smaller banks.
Answer: C LOD: 2 Page: 354
A-Head: The Government Safety Net.
16. The financial system is inherently more unstable than most other industries due to:
A) In most other industries customers disappear at a faster rate; in banking they disappear slowly so the damage is done before the real problem is identified.
B) Banks deal in paper profits, not in real profits.
C) A single firm failing in banking can bring down the entire system; this isn't true in most other industries.
D) a and b
Answer: C LOD: 2 Page: 355
A-Head: The Government Safety Net.
17. The government's role of lender of last resort is directed to:
A) Large manufacturing firms that employ thousands of people.
B) Depositors, this is role the government plays when they insure depositors' balances in banks that fail.
C) Developing countries that are trying to build their financial systems.
D) Banks that experience sudden deposit outflows.
Answer: D LOD: 1 Page: 356
A-Head: The Government Safety Net.
18. The government provides deposit insurance; this insurance protects:
A) Large corporate deposit accounts, but only the amounts that exceed the $100,000 deductible.
B) Depositors for up to $100,000 should a bank fail.
C) The deposits of banks in their Federal Reserve accounts.
D) The deposits that people have but only for federally chartered banks.
Answer: B LOD: 1 Page: 357
A-Head: The Government Safety Net.
19. The government's providing of deposit insurance and functioning as the lender of last resort has significantly:
A) Decreased the incentive for bank managers to take on risk.
B) Increased the amount of regulation of banks required.
C) Increased the incentive for banks to take on risk.
D) b and c
E) a and b
Answer: D LOD: 2 Page: 359
A-Head: The Government Safety Net.
20. One of the unique problems that banks face is:
A) They hold liquid assets to meet illiquid liabilities.
B) They hold illiquid assets to meet liquid liabilities.
C) They hold liquid assets to meet liquid liabilities.
D) Both banks' assets and liabilities are illiquid.
Answer: B LOD: 1 Page: 355
A-Head: The Government Safety Net.
21. The inter-bank loans that appear on banks' balance sheets represent what proportion of bank capital?
A) Nearly ten percent.
B) Almost three-fourths.
C) Nearly half.
D) Less than two percent.
Answer: C LOD: 1 Page: 355
A-Head: The Government Safety Net.
22. The fact that banks often make loans to other banks means:
A) One bank failing will not have a large impact on the financial industry.
B) The banking industry is really self-regulating.
C) One bank's failure can be contagious and spread to other banks.
D) b and c
Answer: C LOD: 2 Page: 355
A-Head: The Government Safety Net.
23. If your stockbroker gives you bad advice and you lose your investment:
A) The government will reimburse you similar to reimbursing depositors if a bank fails.
B) The government will not reimburse you for the loss; you are not protected from bad advice by your stockbroker.
C) These losses would be covered under FDIC.
D) Your investment would only be covered if the stockbroker was employed by a bank.
Answer: B LOD: 2 Page: 357
A-Head: The Government Safety Net.
24. The best way for a government to stop the failure of one bank from turning into a bank panic is to:
A) Make sure solvent institutions can meet the withdrawal demands of depositors.
B) Declare a bank holiday until solvent banks can acquire adequate liquidity.
C) Limit the withdrawals of depositors.
D) Provide zero-interest rate loans to all banks regardless of net worth.
Answer: A LOD: 2 Page: 356
A-Head: The Government Safety Net.
25. The need for a lender of last resort was identified as far back as:
A) The start of the Great Depression in 1929.
B) 1913, when the Federal Reserve was created.
C) 1873, by British economist Walter Bagehot.
D) in 1776 by the first U.S. Secretary of the Treasury, Alexander Hamilton.
Answer: C LOD: 1 Page: 356
A-Head: The Government Safety Net.
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26. The creation of the Federal Reserve in 1913:
A) Provided the opportunity for lender of last resort but not the guarantee that it would be used.
B) Guaranteed the Federal Reserve would always act as lender of last resort.
C) Eliminated bank panics in the U.S.
D) Was in response to the Great Depression in the U.S.
Answer: A LOD: 2 Page: 356
A-Head: The Government Safety Net.
27. If the lender of last resort function of the government is to work to minimize a crisis, it must be:
A) Reserved only for those banks that are most deserving.
B) Used on a limited basis.
C) Credible, with banks knowing they can get loans quickly.
D) Only available during economic downturns.
Answer: C LOD: 2 Page: 357
A-Head: The Government Safety Net.
28. The first test of the Federal Reserve as lender of last resort occurred:
A) With the attack on Pearl Harbor by the Japanese.
B) With the widespread failures of Savings and Loans in the 1980's.
C) With the introduction of flexible exchange rates in the U.S. in 1971.
D) With the stock market crash in 1929.
Answer: D LOD: 1 Page: 356
A-Head: The Government Safety Net.
29. One lesson learned from the bank panics of the early 1930's is:
A) The lender of last resort function almost guarantees that bank panics are a thing of the past.
B) The mere existence of a lender of last resort will not keep the financial system from collapsing.
C) Only the U.S. Treasury can be a true lender of last resort.
D) The financial system will collapse without a lender of last resort.
Answer: B LOD: 2 Page: 357
A-Head: The Government Safety Net.
30. During a bank crisis:
A) Officials at the Federal Reserve find it easy to sort out solvent from insolvent banks.
B) It is important for regulators to be able to distinguish insolvent from illiquid banks.
C) It is easy to determine the market prices of bank's assets.
D) A bank will go to the central bank for a loan before going to other banks.
E) a and d
Answer: B LOD: 2 Page: 357
A-Head: The Government Safety Net.
31. A moral hazard situation arises in the lender of last resort function because:
A) A central bank finds it difficult to distinguish illiquid from insolvent banks.
B) A central bank usually will only make a loan to a bank after it becomes insolvent.
C) A central bank usually undervalues the assets of a bank in a crisis.
D) The central bank is the first place a bank facing a crisis will turn.
Answer: A LOD: 2 Page: 357
A-Head: The Government Safety Net.
32. When the Federal Reserve was unable to stem the bank panics of the 1930s, Congress responded by:
A) Taking over the lender of last resort function and assigning this function to the U.S. Treasury.
B) Ordering the printing of tens of billions of dollars of additional currency.
C) Creating the FDIC and offering deposit insurance.
D) Declaring a bank holiday and closing banks for 30 days.
Answer: C LOD: 1 Page: 357
A-Head: The Government Safety Net.
33. With deposit insurance:
A) Depositors do not need to involve themselves with the risk taking by bank managers.
B) The deposits of a bank customer are insured up to some stated maximum value.
C) There is a creation of potential moral hazard by bank managers.
D) All of the above.
Answer: D LOD: 2 Page: 357
A-Head: The Government Safety Net.
34. One reason customers do not care about the quality of their bank's assets is:
A) Most people cannot distinguish an asset from a liability.
B) The quality of a bank's assets changes almost daily.
C) They assume the bank only has high quality assets.
D) With deposit insurance, there isn't any real reason to care; their deposits are protected even if the bank fails.
Answer: D LOD: 2 Page: 357
A-Head: The Government Safety Net.
35. On November 20, 1985, the Bank of New York needed to use the lender of last resort function due to:
A) A run on the bank started by a rumor that the president of the bank embezzled tens of millions of dollars from the bank.
B) A computer error caused the bank's records to wipe out the balances of all of its customers.
C) A rumor that the bank was about to be taken over by FDIC due to insolvency.
D) A computer error that made it impossible for the bank to keep track of its Treasury bond trades.
Answer: D LOD: 1 Page: 357
A-Head: The Government Safety Net.
36. The payoff method used by the FDIC to address the insolvency of a bank is when the FDIC:
A) Pays the owners of the bank for the losses they would otherwise face.
B) Pays off all depositors the balances in their accounts so no depositor suffers a loss, though the owners of the bank may suffer losses.
C) Pays off the depositors up to the current $100,000 limit, so it is possible that some depositors will suffer losses.
D) Takes all of the assets of the bank, sells them pays off the liabilities of the bank in full and then replenishes their fund with any remaining balance.
Answer: C LOD: 2 Page: 357
A-Head: The Government Safety Net.
37. Under the purchase and assumption method of dealing with a failed bank, the FDIC:
A) Finds another bank to take over the insolvent bank.
B) Takes over the day to day management of the bank.
C) Sells the failed bank to the Federal Reserve.
D) Sells off the profitable loans of the failed bank in an open auction.
Answer: A LOD: 2 Page: 358
A-Head: The Government Safety Net.
38. Considering the methods available to the FDIC for dealing with a failed bank, the depositors of the failed bank should:
A) Be indifferent between the two since it really does not matter to them which method is used.
B) Prefer the purchase and assumption method since the deposits over $100,000 will also be protected.
C) Prefer the payoff method because they will have access to their funds earlier.
D) Prefer the payoff method since a lot less paperwork is involved for the depositor.
Answer: B LOD: 2 Page: 358
A-Head: The Government Safety Net.
39. Under the purchase and assumption method, the FDIC usually finds they:
A) Can sell the failed bank for more than the bank is actually worth.
B) Can sell the bank at a price equaling the value of the failed banks assets.
C) Have to sell the bank at a negative price since the bank is insolvent.
D) Cannot sell the bank and almost always have to revert to the payoff method for dealing with a failed bank.
Answer: C LOD: 2 Page: 358
A-Head: The Government Safety Net.
40. Many states had their own insurance fund to protect depositors. One problem with these state funds is:
A) They are monopolies in their own state and extract extremely high prices for the insurance they provide.
B) State funds are highly inefficient they cannot achieve the economies of scale a federal fund can achieve.
C) State funds do not have regulators as knowledgeable as the regulators at FDIC.
D) No state fund is large enough to withstand a run on all of the banks it insures.
Answer: D LOD: 2 Page: 359
A-Head: The Government Safety Net.
41. Deposit insurance only seems to be viable at the federal level. This is likely due to the fact that:
A) No state fund is large enough to withstand a run on all banks it insures.
B) A run on the banks within a state may be contained before it spreads countrywide.
C) The U.S. Treasury backs the FDIC and can therefore withstand virtually any crisis.
D) All of the above.
Answer: D LOD: 2 Page: 359
A-Head: The Government Safety Net.
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42. The limit on FDIC insured deposits is currently $100,000. In inflation adjusted dollars, the real limit since the inception of FDIC has:
A) Decreased by 10%.
B) Stayed constant.
C) Increased by 20%.
D) Decreased by 50%
E) None of the above.
Answer: E LOD: 2 Page: 361
A-Head: The Government Safety Net.
43. The most recent increase has deposit accounts insured for up to $100,000. The feeling among many economists is that the last increase was:
A) Warranted because it saved taxpayers tens of millions of dollars.
B) A disaster because it gave many shaky institutions an opportunity to use high interest rates to attract more insured deposits.
C) Overdue because it was needed to keep pace with inflation.
D) Needed to reduce the risk of moral hazard.
Answer: B LOD: 2 Page: 360
A-Head: The Government Safety Net.
44. In the ten years after the FDIC limit was increased to $100,000:
A) More than four times the number of banks and savings and loans failed than did during the first 46 years of FDIC's existence.
B) Less than one-fourth the number of banks and savings and loans failed than during the first 46 years of FDIC's existence.
C) The cost to taxpayers of failed institutions in that period was negligible because FDIC was in place.
D) a and c
Answer: A LOD: 2 Page: 360
A-Head: The Government Safety Net.
45. Which of the following statements is most correct?
A) The higher the deposit insurance limit the lower the risk of moral hazard.
B) The higher the deposit insurance limit the greater the risk of moral hazard.
C) Deposit insurance limits do not impact moral hazard, they impact adverse selection.
D) Increasing the deposit insurance limits above $100,000 would increase coverage for over 50 percent of all depositors.
Answer: B LOD: 2 Page: 360
A-Head: The Government Safety Net.
46. One argument for not raising the deposit insurance limit above $100,000 is:
A) It would mainly benefit large banks.
B) Over 50% of all depositors would get an increase in coverage.
C) It mainly benefits a small percentage of depositors who are capable of monitoring the risks their banks take.
D) It would likely raise the interest rates banks would have to offer to depositors.
Answer: C LOD: 2 Page: 360
A-Head: The Government Safety Net.
47. Since the 1920's, the ratio of assets to capital has almost tripled for commercial banks. Many economists believe this is the direct result of:
A) Lower quality management in banks.
B) The increase in branch banking.
C) Allowing banks to offer non-bank services.
D) Government provided deposit insurance.
Answer: D LOD: 2 Page: 359
A-Head: The Government Safety Net.
48. The moral hazard problem caused by government safety nets:
A) Is greater for larger banks.
B) Is greater for smaller banks.
C) Is pretty constant across banks of all sizes.
D) Only exists for banks with high leverage ratios.
Answer: A LOD: 2 Page: 359
A-Head: The Government Safety Net.
49. The government's too big to fail policy applies to:
A) Certain highly populated states where a bank run impacts a large percent of the total population.
B) Large banks whose failure would certainly start a widespread panic in the financial system.
C) Large corporate payroll accounts held by some banks where many people would lose their income.
D) Banks that have branches in more than two states.
Answer: B LOD: 1 Page: 359
A-Head: The Government Safety Net.
50. The government's too big to fail policy:
A) Increases the scrutiny of the bank's risk by large corporate depositors.
B) Reduces the risk faced by depositors with accounts less than $100,000.
C) Reduces the risk faced by depositors with accounts exceeding $100,000.
D) Reduces the moral hazard problem of insuring large banks.
E) c and d
Answer: C LOD: 2 Page: 359
A-Head: The Government Safety Net.
51. If the government did not offer the too big to fail safety net:
A) Large banks would be more disciplined by the potential loss of large corporate accounts.
B) The moral hazard problem of insuring large banks would increase.
C) The moral hazard problem of insuring large banks would decrease.
D) a and b
E) a and c
Answer: E LOD: 2 Page: 359
A-Head: The Government Safety Net.
52. You hold an FDIC insured savings account at your neighborhood bank jointly with your father. Each of you has contributed equally into the account. The current balance in the account is $120,000. If the bank fails each of you will receive:
A) $60,000.
B) $50,000
C) $100,000
D) $120,000.
Answer: A LOD: 2 Page: 362
A-Head: The Government Safety Net.
53. You hold an FDIC insured savings account at your neighborhood bank. Your current balance is $125,000. If the bank fails you will receive:
A) $125,000.
B) $100,000.
C) $62,500.
D) $75,000.
Answer: B LOD: 1 Page: 362
A-Head: The Government Safety Net.
54. You have two savings accounts at an FDIC insured bank. You have $75,000 in one account and $40,000 in the other. If the bank fails, you will receive:
A) $75,000
B) $40,000
C) $115,000
D) $100,000
Answer: D LOD: 2 Page: 362
A-Head: The Government Safety Net.
55. You have savings accounts at two separately FDIC insured banks. At one of the banks your account has a balance of $50,000. At the other bank the account balance is $60,000. If both banks fail, you will receive:
A) $100,000.
B) $60,000
C) $110,000
D) $50,000
Answer: C LOD: 2 Page: 362
A-Head: The Government Safety Net.
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56. Governments employ three strategies to contain the risks created by government safety nets. These include each of the following, EXCEPT:
A) Government supervision.
B) An excise tax on bank profits.
C) Government regulation.
D) Formal bank examination.
Answer: B LOD: 1 Page: 360
A-Head: Regulation and Supervision of the Financial System.
57. The purpose of the government's safety net for banks is to do each of the following, EXCEPT:
A) Protect the integrity of the financial system.
B) Eliminate all risk that investors face.
C) Stop bank panics.
D) Improve the efficiency of the economy.
Answer: B LOD: 2 Page: 360
A-Head: Regulation and Supervision of the Financial System.
58. Governments supervise banks mainly to:
A) Reduce the potential cost to taxpayers of bank failures.
B) Be sure the banks are following the regulations set out by banking laws.
C) Reduce the moral hazard risk.
D) All of the above.
Answer: D LOD: 1 Page: 360
A-Head: Regulation and Supervision of the Financial System.
59. Commercial Banks are regulated by a combination of agencies including each of the following, EXCEPT:
A) The Federal Reserve.
B) Office of Thrift Supervision.
C) State authorities.
D) Federal Deposit Insurance Corporation.
Answer: B LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
60. Savings banks and savings and loans are regulated by a combination of agencies which includes:
A) Federal Reserve System.
B) Office of the Comptroller of the Currency.
C) Office of Thrift Supervision.
D) The Internal Revenue Service.
Answer: C LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
61. Credit Unions are regulated by a combination of agencies which includes:
A) State Authorities.
B) The Federal Reserve.
C) The Federal Deposit Insurance Corporation.
D) a and c
Answer: A LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
62. Banks can effectively choose their regulators by deciding:
A) To be a private or public corporation.
B) To be a member of the Federal Reserve or not.
C) To purchase FDIC insurance or to forego the coverage.
D) To be chartered at the national or state level.
Answer: D LOD: 1 Page: 362
A-Head: Regulation and Supervision of the Financial System.
63. The fact that banks can be either nationally or state chartered creates:
A) Situations where some banks go unregulated.
B) Situations where banks operating in more than one state can escape regulation.
C) Regulatory competition.
D) a and b
Answer: C LOD: 2 Page: 362
A-Head: Regulation and Supervision of the Financial System.
64. One negative consequence of regulatory competition is:
A) It is expensive.
B) Financial institutions are over regulated at a cost to customers.
C) Financial institutions often seek out the most lenient regulator.
D) It minimizes competition.
Answer: C LOD: 2 Page: 362
A-Head: Regulation and Supervision of the Financial System.
65. A long standing goal of financial regulators has been to:
A) Prevent banks from growing too big and powerful.
B) Minimize the competition that banks face.
C) Encourage banks to grow as large as possible.
D) Discourage small rural banks.
Answer: A LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
66. Bank mergers require government approval because banking officials want to make sure:
A) That the merger will create a larger, more solid bank.
B) That the merger will not create a monopoly in any geographic region.
C) That if a merger has a small community bank taken over by a larger regional bank, that the customers of the small town will still be well-served.
D) a and c
E) b and c
Answer: E LOD: 2 Page: 363
A-Head: Regulation and Supervision of the Financial System.
67. Which of the following statements is most correct?
A) Financial regulators do everything possible to encourage competition in banking.
B) Financial regulators work to prevent monopolies but also work to minimize the strong competition in banking.
C) Financial regulators discourage competition in banking.
D) Financial regulators prefer banks to have monopoly power in their geographic markets.
Answer: B LOD: 2 Page: 363
A-Head: Regulation and Supervision of the Financial System.
68. Banking regulations:
A) Prevent banks from holding more than 10 percent of their assets in common stock of companies.
B) Prevent banks from owning corporate jets.
C) Prevent banks from owning common stocks of corporations.
D) b and c
Answer: C LOD: 2 Page: 364
A-Head: Regulation and Supervision of the Financial System.
69. One reason that financial regulations restrict the assets that banks can own is to:
A) Combat the moral hazard that government safety nets provide.
B) Limit the growth rate of banks.
C) Prevent banks from being too profitable.
D) Keep banks from spending lavishly on perks for executives.
Answer: A LOD: 1 Page: 364
A-Head: Regulation and Supervision of the Financial System.
70. Financial regulators set capital requirements for banks. One characteristic about these requirements is:
A) Every bank will have to hold the same level.
B) The riskier the asset holdings of a bank, the more capital they will be required to have.
C) The more branches a bank has, the more capital they must have.
D) The amount of capital required is inverse to the amount of assets the bank owns.
Answer: B LOD: 2 Page: 364
A-Head: Regulation and Supervision of the Financial System.
71. The Basel Accord is:
A) The basic set of guidelines the Federal Reserve applies in regulating domestic banks.
B) A set of guidelines for basic capital requirements for internationally active banks.
C) An agreement between state and federal regulators to try to have one standard set of guidelines for all banks.
D) A set of guidelines applied only to international banks operating with U.S. boundaries.
Answer: B LOD: 2 Page: 366
A-Head: Regulation and Supervision of the Financial System.
72. Banks are required to disclose certain information. This disclosure is done to:
A) Enable regulators to more easily assess the financial condition of banks.
B) Allow financial market participants to penalize banks that carry additional risk.
C) Allow customers to more easily compare prices for services offered by banks.
D) All of the above.
Answer: D LOD: 1 Page: 365
A-Head: Regulation and Supervision of the Financial System.
73. The supervision function of banks includes:
A) Requiring bank officers to attend classes on an annual basis.
B) On site examinations of the bank.
C) Extensive background checks of all bank officers.
D) All of the above.
Answer: B LOD: 1 Page: 365
A-Head: Regulation and Supervision of the Financial System.
74. One reason a bank officer may be reluctant to write off a past-due loan is:
A) It will increase their liabilities.
B) It will decrease the banks assets and capital.
C) It will increase their liabilities and assets, requiring more capital to be held.
D) Bank officers are not reluctant to write-off past due loans.
Answer: B LOD: 2 Page: 366
A-Head: Regulation and Supervision of the Financial System.
75. The acronym CAMELS, which is the criteria used by supervisors to evaluate the health of banks, includes the following, EXCEPT:
A) Asset quality.
B) Losses.
C) Management.
D) Earnings.
Answer: B LOD: 1 Page: 366
A-Head: Regulation and Supervision of the Financial System.
76. The CAMELS ratings are:
A) Made public monthly to the financial markets so people can judge the relative quality of banks.
B) Published once a quarter in banking journals issued by the Federal Reserve.
C) Included in the annual report of publicly owned banks.
D) Not made public.
Answer: D LOD: 1 Page: 366
A-Head: Regulation and Supervision of the Financial System.
77. In the 1980's, regulators let a large number of insolvent savings and loans continue to operate. They allowed this because:
A) They didn't know they were insolvent.
B) To close them down may have bankrupted the deposit insurance fund.
C) Regulators did not want to admit they might have been wrong.
D) a and c
E) b and c
Answer: E LOD: 2 Page: 368
A-Head: Regulation and Supervision of the Financial System.
78. In the 1980's, many managers of insolvent institutions actually made a bad situation worse by:
A) Closing their institution before regulators did.
B) Offering higher interest rates on deposits depleting healthy institutions of these funds.
C) Dramatically reducing the loans they were making.
D) Cutting the interest rate they would pay for deposits.
Answer: B LOD: 1 Page: 368
A-Head: Regulation and Supervision of the Financial System.
79. Forbearance in the regulations of savings and loans had regulators:
A) Closing many institutions that were actually quite healthy.
B) Taking a far more stringent interpretation of banking regulations.
C) Deliberately ignoring or taking a loose interpretation of regulations.
D) Ultimately saving the deposit fund for savings and loans from insolvency.
E) b and d
Answer: C LOD: 2 Page: 369
A-Head: Regulation and Supervision of the Financial System.
80. A regulatory change that has resulted from the savings and loan crisis is:
A) Assets are now accounted for at market value.
B) The deposit insurance premiums charged are the same for all institutions.
C) Assets are now accounted for at book value rather than market value.
D) Regulators put institutions whose capital levels are less than two percent of assets on a watch list.
Answer: A LOD: 2 Page: 369
A-Head: Regulation and Supervision of the Financial System.
81. As a result of the failure of many financial institutions in the 1980's:
A) Deposit insurance premiums are now risk based.
B) Regulators must immediately close institutions whose capital falls below two percent of assets.
C) Assets must be accounted for at book value rather than market value.
D) a and c
E) a and b
Answer: E LOD: 2 Page: 369
A-Head: Regulation and Supervision of the Financial System.
Short Answer Questions
82. The text points out that there is an inverse relationship between the fiscal cost of a bank crisis and real GDP growth. What are some of the reason that can explain this inverse relationship?
Answer: One obvious cost is that funds that have to be used to "clean-up" the crisis must be diverted from some other use, so there is the opportunity cost that is faced. Another reason is that the process of channeling funds from savers to borrowers is disrupted or inefficient. If savers become leery of banks, they may not save or they may not channel these funds through banks so the economy is not as efficient as it could be. Also, investment projects that should be funded will not be, and those that shouldn't be may receive funding since financial intermediation is not working as it should. Another, and perhaps the largest cost, is that if investment is curtailed the ability to produce output in the future will be harmed leading to a lower standard of living not just for the current year but for many years.
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A-Head: The Sources and Consequences of Runs, Panics and Crises.
83. Why is it generally assumed that there is a trade-off between a bank's profitability and its safety?
Answer: The assets that tend to bring the bank the highest return tend to be the least liquid. Highly liquid assets have relatively low returns. So if a bank seeks high profits it is likely to invest in relatively illiquid assets. On the other hand, a bank needs to be liquid, especially in situations where customers may desire to withdraw their deposits. If a bank does not have liquid funds or if they cannot convert illiquid assets to a liquid form without taking significant losses, they may fail.
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A-Head: The Sources and Consequences of Runs, Panics and Crises.
84. Why do bank runs usually have people rushing to their bank instead of waiting for the lines to taper off so they do not have to wait so long?
Answer: Banks promise to satisfy depositors' withdrawal requests on a first come first served basis. As a result, people thinking the bank has limited cash (which is usually true) want to get theirs before the bank runs out and rush to the bank to be first in line. LOD: 1 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
85. What is the difference between a bank that is insolvent and one that is illiquid?
Answer: A bank that is insolvent is in a position where the bank's assets are less than their liabilities, so they have negative bank capital. A bank that is illiquid may be solvent, meaning it has assets that are exceed its liabilities, but it may not have sufficient reserves, marketable assets and capital to meet all of the depositors' demand for withdrawals.
LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
86. Why is it that a run on a single bank can turn into a wide scale financial panic, or what the text identified as contagion?
Answer: The reason for the spread of panic or contagion is information asymmetries. It is due to the fact that most depositors cannot tell a healthy from an unhealthy bank. As a result, the safest thing for individuals to assume is their bank is unhealthy and to withdraw their funds.
LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
87. How do banks potentially make economic downturns more severe and how do economic downturns contribute to the increased failure of banks?
Answer: When an economy begins to slow some people lose their jobs and or their incomes are reduced. As a result, these individuals may default on their loans which reduces the value of a bank's assets and also reduces the bank's capital, especially if the loans are in default. As bank capital is reduced lending will also be reduced which will further slow the economy as consumer durable good spending will fall, as will investment spending. But the slowing of the economy will also continue to push more loans into default and further reduce bank capital leading to even more bank failures. LOD: 2 Page: 353
A-Head: The Sources and Consequences of Runs, Panics and Crises.
88. Why is the financial industry inherently more unstable than most other industries?
Answer: In most other industries the failure of one participant does not put the other participants and the industry at risk. The same cannot be said of the financial industry. The failure of one bank or financial institution, through contagion, can put the entire system at risk. This is due to information asymmetries which can have depositors assuming their bank is going to also fail and seek to withdraw their funds. This then leads to liquidity risk, because most banks would lack the liquidity to withstand the run.
LOD: 2 Page: 353
A-Head: The Government Safety Net.
89. In 1873, British economist Walter Bagehot proposed the central bank function as the lender of last resort. Specifically, he suggested the central bank lend freely to banks which have good collateral at high rates of interest. Why the requirements of good collateral and a high rate of interest?
Answer: The requirement of good collateral is to ensure the loans are going to solvent banks. The high interest rates will penalize a bank for not holding adequate reserves to meet the liquidity needs. If the interest rate charged is low, the bank will have a strong incentive to seek higher returns through illiquid assets knowing it can count on the central bank in times of liquidity need.
LOD: 2 Page: 356
A-Head: The Government Safety Net.
90. Does the lender of last resort function guarantee an end to bank runs? Explain.
Answer: The Great Depression is evidence to the fact that just because a central bank has the function of lender of last resort, there is no guarantee that banks will use it or the central bank will lend freely. The experience in the early years of the Great Depression showed that banks did not take advantage of borrowing from the Fed. LOD: 2 Page: 357
A-Head: The Government Safety Net.
91. How does the lender of last resort potentially create a moral hazard problem?
Answer: The lender of last resort function provided by a central bank will have a bank turning to the central bank for a loan after all other options are exhausted. The bank manager knows that the central bank will want to avoid a widespread bank panic and will be generous in evaluating the value of the bank's assets and to grant a loan even if they suspect the bank may be insolvent. Knowing this, bank managers will tend to take too many risks.
LOD: 2 Page: 357
A-Head: The Government Safety Net.
92. You have a retirement account in a bank that has failed. The balance in your account is $180,000. Does it make a difference to you if FDIC uses the payoff method or the purchase and assumption method for resolving this insolvency? Explain.
Answer: It does make a difference. Under the payoff method, the FDIC simply pays off the depositors the balance in their account up to the legal limit which is currently $100,000. You would potentially lose $80,000. Under the purchase and assumption method, FDIC will find a firm to take over the failed bank and your account will stay intact.
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A-Head: The Government Safety Net.
93. Imagine a situation where the deposits at state chartered banks would be insured by a state insurance fund and deposits at nationally chartered banks would be insured by FDIC. How would you expect both depositors and banks would react?
Answer: Depositors would quickly learn that no state insurance fund can withstand a run on all banks in their state. As a result, they would seek to withdraw their funds and place them in a nationally chartered institution. The owners of the state chartered banks would then seek to change their charter to a national one and pick up FDIC insurance. The reason people do not fear FDIC running out of funds is that they are backed by the U.S. Treasury and as a result can withstand any crisis.
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A-Head: The Government Safety Net.
94. Explain why the ratio of assets to capital increased dramatically for commercial banks from the 1920s to the present.
Answer: The answer to this question is simply deposit insurance. Without deposit insurance a bank would have to make sure their assets were highly liquid and that they maintained adequate capital to withstand either the shock of assets losing value or a run on the bank. With deposit insurance, the bank manager knows that the insurance fund will protect most depositors and so feels comfortable assuming more risk. One, the additional return from the greater risk will belong to the bank's owners. The potential loss from the greater risk will be borne primarily by the insurance fund. This is a classic moral hazard problem.
LOD: 2 Page: 359
A-Head: The Government Safety Net.
95. You are the head of finance for a very large corporation located in a relatively small town. At a local chamber of commerce meeting, the president of the local bank asks you why you keep the corporation's bank accounts in a very large mid-western bank and not in his local bank. From a risk reduction perspective, how could you answer his question?
Answer: You might employ the concept of too big to fail. As the text points out, the likelihood of bank regulators allowing a large bank to actually fail is very remote. A small bank failure, while certainly disruptive to the bank's depositors and owners, is not likely to cause wide scale panic. If you had your company's funds in this bank and it failed, your company may only recover up to the legal limit. On the other hand, the failure of a large bank might cause wide scale panic, so realizing this, you decide to place your company's funds into a bank that you believe is in the too big to fail category and thus protecting your company's deposits.
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A-Head: The Government Safety Net.
96. You get married and, in doing some basic financial planning, your spouse suggests that the two of you open separate accounts so that if your total deposits exceed $100,000, your funds will be protected by FDIC. How would you respond to the suggestion?
Answer: You could respond by saying that it isn't necessary until the amount you have exceeds $200,000 since currently FDIC insurance will protect a joint account up to $100,000 for each person on the account. Once you have more than $200,000 in accounts, you may want to open another account at a different institution.
LOD: 2 Page: 362
A-Head: The Government Safety Net.
97. What is the link between the safety net provided by the government to the financial industry and the relatively heavy regulation of the same industry by the government?
Answer: The link is that the safety net provided, like FDIC insurance, too big to fail, and lender of last resort, while very valuable also creates strong moral hazard and adverse selection problems. As a result, to minimize these problems governments have developed different strategies to manage the risks created by the safety net.
LOD: 2 Page: 360
A-Head: Regulation and Supervision of the Financial System.
98. What potential problems are created by regulatory competition?
Answer: Regulatory competition often allows a financial institution to select who will regulate it by selecting who charters it. One problem is that this will encourage the institution to select the regulator(s) that they believe will be the most lenient.
LOD: 2 Page: 362
A-Head: Regulation and Supervision of the Financial System.
99. Explain how bank regulators seem to face a bit of a paradox regarding preventing monopoly power by banks and spurring competition.
Answer: One of the goals of banking regulators is to prevent any bank from growing so large that they effectively become a monopoly in their geographic market. Monopolies are inefficient and are seldom of benefit to consumers. On the other hand, while we usually think of competition as being beneficial to consumers because it results in low prices and new products, within the financial industry competition can cause banks to seek other ways to earn profits, which may expose the bank to greater risk, and threaten the integrity of not just one institution but the entire system.
LOD: 2 Page: 363
A-Head: Regulation and Supervision of the Financial System.
100. Why are banks restricted in the assets that they can own; for example, why do you think banks are prohibited from owning common stock?
Answer: There are a few reasons for this, one, many of these assets are relatively illiquid and can cause wide swings in the value of assets. If the value of these assets were to decrease significantly, the institutions' capital would be negatively impacted putting the institution and the system at risk. Another reason is the problem of moral hazard. The government is providing a safety net, which by itself would cause a bank to want to seek a higher return by taking on more risk. To combat this problem, regulators restrict the institution in the types of assets it can hold.
LOD: 2 Page: 364
A-Head: Regulation and Supervision of the Financial System.
101. If we lived in an economy where interest rates are highly volatile, would you expect the maximum asset to capital ratio that a regulator would allow to increase or decrease and why?
Answer: An environment where interest rates are highly volatile says that the value of a firm's assets would also be volatile. For example, if interest rates significantly rise unexpectedly, the value of a bank's assets would fall unexpectedly. This would put a strain on the capital of the bank, especially in the sense that the bank's capital is the cushion that it would fall back on should it face a liquidity crisis. The bank could find itself insolvent if interest rates rise a lot and their capital were inadequate. As a result, we would expect regulators to insist on a lower asset to capital ratio.
LOD: 3 Page: 364
A-Head: Regulation and Supervision of the Financial System.
102. We saw in the text that the government also regulates nondepository financial institutions, such as insurance companies. Consider a property casualty insurance company; why would the government need to regulate them?
Answer: The insurance company takes premiums from people and makes the promise to pay claims should certain events occur. In the case of property insurance, often times these events could be widespread and quite severe, like a hurricane or an earthquake. When a loss like this occurs, it is similar to a liquidity crisis for banks, the insurance company faces a run in the sense that it will need to be liquid and quickly. Regulators then want to ensure at least three things, one is that the insurance company is solvent, meaning its assets exceed its liabilities. It also want to make sure that the assets are liquid and that the value stated reflects market value, and third, that the company has adequate capital to withstand fluctuations in asset value should it have to get liquid at a time when asset prices may be depressed.
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A-Head: Regulation and Supervision of the Financial System.
103. What was the primary motivation behind the creation of the Basel Accords?
Answer: Globalization in the sense that foreign banks could enter a market and compete with domestic banks. The problem was that often times the foreign banks would be operating under different regulatory restrictions that would provide them with a competitive advantage. The Basel Accords are an attempt to place minimum capital requirements on financial institutions that are internationally active.
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A-Head: Regulation and Supervision of the Financial System.
104. Identify at least two problems a borrower would face if banks were not required to disclose the information that they are currently required to make available.
Answer: One problem that quickly comes to mind would be all of the hidden fees that a bank could charge for a checking account or a loan application. In addition, the customer would face very high search cost in the sense that they would have to ask a lot of questions of each institution to uncover these hidden costs.
Another problem is the way that interest is calculated for savings accounts and loans. For example, is the interest being paid on a savings account based on the average balance or is it based on the balance that exist at the beginning or end of the month? Also, the interest rate charges on the loan, is it expressed as an annual rate or is it calculated using some other formula. The disclosure laws that banks face are designed to reduce these costs to customers and make the comparing of prices across banks easier.
LOD: 2 Page: 365
A-Head: Regulation and Supervision of the Financial System.
105. You head up an agency where one of the services your agency provides is examination of financial institutions. Over time you notice that you are experiencing high personnel turnover and the turnover is a result of the largest bank in your area hiring the examiners at much higher salaries than they were earning. Do you see any problem here and if so, how do you address it?
Answer: In economics there is a concept called "regulatory capture" where the firm being regulated actually captures the regulator in potentially a number of ways. In this case, the examiner, knowing that the firm may hire her, potentially could extend leniency that would otherwise not be extended, or could look the other way on a number of questionable practices, hoping to land one of the high paying jobs within the firm. One way to address the problem is to move examiners around to different institutions. This does have a tradeoff to it, in that an examiner does have specific information regarding the firm and this can be valuable in examining the institution. Another way to treat the problem is to make sure that examiners are well paid and are earning salaries that are commensurate with what their skills would command in the private sector.
LOD: 3 Page: 367
A-Head: Regulation and Supervision of the Financial System.
106. The CAMELS criteria to evaluate the health of banks by supervisors is not made public. Make a case for one making this information public and a case for keeping it private.
Answer: The case for making it public would be to encourage the managers of banks to do whatever is necessary to earn a high rating to keep depositors and to attract investment capital. This information would go a long way toward treating the moral hazard problem. The case for keeping it private is to avoid a run on the bank. If a bank is having difficulty, regulators may have the opportunity to work with the management to solve the problem and avoid a bank run which is likely to push the institution into insolvency and end up costing some depositors and taxpayers more than it would have if they work the problems out without public scrutiny.
LOD: 3 Page: 366
A-Head: Regulation and Supervision of the Financial System.
Essay Questions
107. Discuss the ramifications of the FDIC reducing deposit insurance limits to $25,000.
LOD: 3 Page: 360
Answer:
If deposit insurance limits were reduced to $25,000 a few things would happen. First, many people would have more at risk by saving at their banks. The result may be for people to either keep less on deposit at the bank, this will reduce the funds available to banks or will require the banks to offer higher interest rates to depositors to attract funds since the depositors will now face greater risk, increasing the cost of acquiring funds. Another likely outcome is that banks may actually put out more information to the public advertising how safe and well run their particular bank is, this would be done to again attract depositors who now are seeking a relatively safe place to put their funds. There may be less of a moral hazard incentive on the part of bank managers. Any decrease in bank return or any increase in risk has the manager facing the widespread withdrawal of funds by depositors who face a higher cost of bank failure. There could also be more innovation. For example, savers could still get the U.S. government to guarantee their principal by purchasing U.S. Treasury securities. We would likely see greater use of saving vehicles where all funds are placed in treasury securities and savers have convenient ways to access these funds, (much like many current money market accounts.) Banks, seeking to attract deposits would have to offer products and or higher returns to compete with the Treasury securities.
A-Head: The Government Safety Net.
108. We saw in the text that government regulations, specifically deposit insurance, compounded the savings and loan crisis. But how did government regulation actually "sow the seeds" of the crisis?
LOD: 3 Page: 368
Answer:
Savings and loans originally were chartered to make home mortgage loans and accept deposits. Basically, they were regulated in what they could pay to depositors and they were limited in the form their assets could take. Their assets were long term and relatively illiquid, while their liabilities were short term and subject to withdrawal, meaning the regulations that savings and loans faced made them ripe for liquidity risk. When nominal market interest rates increased in the 1970's above the interest rates that savings and loans could offer to depositors, depositors began to withdraw their funds and the savings and loans were plunged into a liquidity crisis. At the same time the rising interest rates was severely decreasing the market value of their assets and many of these institutions were insolvent. Most were allowed to continue to operate by regulators who did not want to face either the wiping out of the insurance fund for these institutions or the admission that regulations and the regulators contributed heavily to this problem.
A-Head: Regulation and Supervision of the Financial System
109. FDIC used to charge banks the same rate for insurance on deposits. From what you have learned, what problems did this create for not only the FDIC but for well run banks?
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Answer:
For FDIC the immediate problem is adverse selection. The average rate would have attracted more low quality, or in this case, high risk banks. Now FDIC could get around the adverse selection problem by simply asking for a regulation requiring all banks purchase insurance through them. This is similar to an insurance provider providing group insurance to an employer but insisting they get most if not all of the employees to purchase coverage and it not be voluntary. FDIC cannot escape the problem of moral hazard, however, here the presence of insurance will have some banks wanting to take on more risk. In fact, the well-managed (low risk) banks will be at a disadvantage, actually subsidizing the high risk banks. The only way to address the problem of cross-subsidization is through a premium that is risk based so that the lower risk company will pay a lower premium which would in theory allow it to offer lower rates on loans and or higher rates to depositors.
A-Head: The Government Safety Net.
110. On a regular basis Congress is asked to consider raising the insurance limit on FDIC coverage. From what you learned in Chapter 14, what do you think Congress should do?
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Answer:
This is an interesting problem. Most people who would not give the matter a lot of thought would probably think this is a good idea and that it would help a lot of savers. The reality is that most savers do not have the current limit of $100,000 in a bank. Large investors or businesses who may have more than $100,000 in a bank have the tools to adequately assess the financial health of their bank and the risk they are taking. Perhaps more important, we saw the disaster brought by the last increase in coverage. There is no escaping the fact that deposit insurance creates moral hazard problems and the more insurance the greater the problem. If the goal of the insurance is to protect the savings of relatively "small" savers, even the current limit of $100,000 is likely more than enough. It is difficult to make a case for raising the limit, and given the moral hazard and regulatory problems that come with a higher limit, it probably isn't a good idea. A stronger case could be made to make sure that the financial institutions that are operating are following current regulations and have adequate capital.
A-Head: Regulation and Supervision of the Financial System.
