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Solutions for End-of-Chapter Questions and Problems: Chapter One 1.

What are five risks common to all financial institutions?

Five risks common to all financial institutions include default or credit risk of assets, interest rate risk caused by maturity mismatches between assets and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating risks. 2.

Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial institutions.

In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs. In this economy, the level of fund flows between household savers and the corporate sector is likely to be quite low. There are several reasons for this. Once they have lent money to a firm by buying its financial claims, households need to monitor, or check, the actions of that firm. They must be sure that the firm’s management neither absconds with nor wastes the funds on any projects with low or negative net present values. Such monitoring actions are extremely costly for any given household because they require considerable time and expense to collect sufficiently high-quality information relative to the size of the average household saver’s investments. Given this, it is likely that each household would prefer to leave the monitoring to others. In the end, little or no monitoring would be done. The resulting lack of monitoring would reduce the attractiveness and increase the risk of investing in corporate debt and equity. The net result would be an imperfect allocation of resources in an economy. 3.

Identify and explain three economic disincentives that would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial institutions.

Investors generally are averse to directly purchasing securities because of (a) monitoring costs, (b) liquidity costs, and (c) price risk. Monitoring the activities of borrowers requires extensive time, expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt securities would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra returns which may be available. Finally, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume. 4.

Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users.

FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in an asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also may offer advisory services which help reduce 1 © 2022 .

information costs, such as full-line firms like Merrill Lynch. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities. 5.

In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?

Funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI. 6.

Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process?

By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. This agglomeration of funds resolves a number of problems. First, the large FI now has a much greater incentive to collect information and monitor actions of the firm because it has far more at stake than does any small individual household. In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI have a greater incentive to collect information, the average cost of collecting information is lower. Such economies of scale of information production and collection tend to enhance the advantages to savers of using FIs rather than directly investing themselves. Second, the FI can collect information more efficiently than individual investors. The FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. Thus, a richer menu of contracts may improve the monitoring abilities of FIs. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate providers and users of funds in the economy. Thus, by acting as a delegated monitor and producing better and more timely information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy. 7.

What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?

First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price risk conditions than primary securities. Fourth, FIs 2 © 2022 .

provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with shortterm deposits. 8.

What are agency costs? How do FIs solve the information and related agency costs experienced when household savers invest directly in securities issued by corporations?

Agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from the failure to adequately monitor the activities of the borrower. If no other lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the lending agreement. That is, agency costs arise whenever economic agents enter into contracts in a world of incomplete information and thus costly information collection. The more difficult and costly it is to collect information, the more likely it is that contracts will be broken. Because the FI invests the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower because it has far more at stake than does any small individual household. 9.

How do large FIs solve the problem of high information collection costs for lenders, borrowers, and financial markets?

One way financial institutions solve this problem is that they develop of secondary securities that allow for improvements in the monitoring process. An example is the bank loan that is renewed more quickly than long-term debt. When bank loan contracts are sufficiently short term, the banker becomes almost like an insider to the firm regarding informational familiarity with its operations and financial conditions. Indeed, this more frequent monitoring often replaces the need for the relatively inflexible and hard-to-enforce covenants found in bond contracts. Thus, by acting as a delegated monitor and producing better and timelier information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy. 10.

How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy securities issued by corporations?

FIs provide financial or secondary claims to household and other savers. Often, these claims have superior liquidity attributes compared with those of primary securities such as corporate equity and bonds. For example, depository institutions issue transaction account deposit contracts with a fixed principal value (and often a guaranteed interest rate) that can be withdrawn immediately on demand by household savers. Money market mutual funds issue shares to household savers that allow those savers to enjoy almost fixed principal (deposit-like) contracts while often earning interest rates higher than those on bank deposits. Even life insurance companies allow policyholders to borrow against their policies held with the company at very short notice. 11.