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Chapter 7Why Do Financial Institutions Exist? Answers to End-of-Chapter Questions Financial intermediaries can take advantage of economies of scale and thus lower transaction costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for...

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Chapter 7 Why Do Financial Institutions Exist?

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Answers to End-of-Chapter Questions

1. Financial intermediaries can take advantage of economies of scale and thus lower transaction costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks’ large scale allows them to keep legal and computing costs per transaction low. Economies of scale which help financial intermediaries lower transaction costs explains why financial intermediaries exist and are so important to the economy. 2. When a couple dates, they are (explicitly or implicitly) extracting information about the significant other. At the same time, they are sharing information about themselves. This information flow helps both individuals to make better decisions about a probable (or not) future life together. In this way, one can think that this process is formally no different from the one in which the loan officer tries to choose the right borrower. 3. No. If the lender knows as much about the borrower as the borrower does, then the lender is able to screen out the good from the bad credit risks and so adverse selection will not be a problem. Similarly, if the lender knows what the borrower is up to, then moral hazard will not be a problem because the lender can easily stop the borrower from engaging in moral hazard. 4. Standard accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets, hence making them operate better. Standard accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets. In addition, they make it harder for managers to understate profits, thereby reducing the principal-agent (moral hazard) problem. 5. One would expect the group of countries with more efficient legal systems to exhibit higher living standards. Legal systems are an important part in the lending process, precisely because they are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem. Costly, slow and inefficient legal systems do not promote lending and thereby funding of investment opportunities. 6. One would expect corruption measures to be negatively correlated with living standards. Corruption usually deters investment, since it undermines the legal system. Countries in which corruption is prevalent have trouble encouraging individuals or companies to invest in them. Corruption affects living standards by undermining the efficiency of the legal system, thereby lowering investment, one fundamental ingredient to economic growth, the basis of higher living standards. 7. Because there is asymmetric information and the free-rider problem, not enough information is available in financial markets. Thus there is a rationale for the government to encourage information production through regulation so that it is easier to screen out good from bad borrowers, thereby reducing the adverse selection problem. The government can also help reduce moral hazard and improve the performance of financial markets by enforcing standard accounting principles and

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prosecuting fraud. 8. Yes. The person who is putting her life savings into her business has more to lose if the business takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off. 9. The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general, the bank does not “keep the house title”, but it places a lien on it instead to prevent the house owner to sell the house without its supervision. In this case, the bank wants to make sure that you do not sell the house, get the money and never pay back the loan. 10. True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less because the collateral can be sold to make up any losses on the loan. Thus adverse selection is not as severe a problem. 11. The free-rider problem means that private producers of information will not obtain the full benefit of their information producing activities, and so less information will be produced. This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem. 12. The conflict of interest discussed in the chapter is of underwriting and research in investment banking. A conflict of interest usually arises among banks when they own asset management companies, which invest their clients’ funds in securities that match their declared financial objectives. In Europe, asset management companies provide investors with more diversification and investing options than they would have by themselves. When the banks issue mutual funds to the general public and then steer their clients to the asset management companies that they own, there is a conflict of interest. Banks and asset management companies should not be related to one another, especially when banks are issuing mutual funds or hedge funds. 13. Credit rating agencies try to mitigate the problem of adverse selection. By compiling information and evaluating default risks, credit rating agencies help investors to decide which bonds have the highest risks of default and which ones are relatively safer investments. The subprime mortgage crisis undermined the trustworthiness of these agencies, since securities that were assigned good ratings were in fact bad investments. 14. The “Chinese wall” is a term used in audit firms when a client might need two different services from the same company. For example in PwC, client X might need accounts preparation services from the Transaction Services department and audit services from the Audit and Assurance department at the same time. This is legal in Europe but illegal in America. When faced with such a situation (where it is legal), the two departments must put up a proverbial Chinese wall between each other to prevent the sharing private information. 15. The principal–agent problem may occur in a multinational company where the owners or shareholders do not run the business on a day-to-day basis. The shareholders or the owners are the principal. The business is run by the agents—the board of directors, CEO, and CFO—which could conflict with the interest of the owners. This is a common problem for MNCs as most are public listed and run by the board, who are often not shareholders, so both principal and agent suffer from goal incongruence which is detrimental to the overall financial health of a company.

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Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition, Global Edition

16. a. Research analysts in investment banks might distort their research to please issuers of securities so underwriters in the investment bank can get their business. b. Investment banks might engage in spinning, a form of kickback in which they allocate hot, but underpriced, IPOs to executives in return for their companies’ future business. 17. When prospective employers ask job applicants to go through a job interview, they are trying to solve the adverse selection problem. Prospective employers want to know more about potential workers, much in the same way loan officers want to know more about potential borrowers. As it is the case with a loan transaction, the information asymmetry does not end here, since if hired, worker and employer will have to solve the moral hazard problem. Usually employers try to solve this problem with paying schemes that encourage workers to provide more effort. 18. Adverse selection occurs where one party in a transaction has complete knowledge of a situation that the other party lacks, which can be detrimental to the economy in the long run. In the subprime mortgage crisis, the banks awarded mortgages to people who were generally incapable to pay off the loans keeping in view what they earned. The mortgage sellers knew that the future homeowners could not afford to pay back later but still insisted that they take out the mortgage as they wanted the commission from each transaction. The reason why they could do so was because the mortgages were then securitized: once packaged and sold, they were not on the books of the banks. The problem of adverse selection also occurred with the investors of the securitized loans who thought that real estate prices would continue to rise and with that the demand for securitized mortgages. However, the banks knew very well that real estate prices would not rise indefinitely. 19. Sarbanes-Oxley requires CEOs and CFOs to certify the financial statements and disclosures of the firm and requires disclosure of off-balance sheet transactions and relationships with special purpose entities. This mandatory disclosure improves the quality of information, but has the disadvantage of being costly. Sarbanes-Oxley also substantially increases supervisory oversight with the PCAOB which can help stop conflicts of interest in the accounting industry. Also by making the audit committee independent of management, audits are likely to be more reliable, an important benefit. However, Sarbanes-Oxley may reduce economies of scope available to accounting firms by preventing them from providing auditing and consulting services to the same client. 20. Cecilia and Julia are free-riders. Even though they have provided no effort, they had accepted the reward of a good grade. Looking into the future, Lucia now has no incentive to work hard, if everybody gets the same grade regardless of their effort. One can expect that Lucia will either not participate or decide to provide no effort at all, with the result that the project will most probably be a failure. It is very difficult to completely eliminate the free rider problem, both in financial markets and in our everyday lives.

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Quantitative Problems

1. Sam is in the market for a used motorbike. At a used bike shop, Sam roughly knows that the price of a used motorbike is between $40,000 and $48,000. If Sam believes that the dealer knows as much about the bikes as him, how much do you think that Sam is willing to pay? Explain. Assume that he only cares about the expected value of the bike he buys and that the bike values are symmetrically distributed. Solution: Sam is willing to pay the average price. If the distribution of used motorbike values is symmetric, Sam will be willing to pay $44,000 for a randomly selected used motorbike. 2. Sam now decides to go to a different town to search for a used motorbike and believes that the dealer knows more about the used motorbikes than him. How much do you think that Sam is willing to pay? Discuss. How can this be resolved in a competitive market? Copyright © 2019 Pearson Education Ltd.

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Solution: Sam is willing to pay the average price upfront: $44,000. However, the dealer will know this, and only sell him a used motorbike worth between $40,000 and $44,000. Fortunately, Sam also knows this. So, Sam will only pay $42,000. And so on. This ends with Sam paying $40,000, and the bike being worth $40,000. This is alright for Sam, but the dealer can never sell motorbikes worth more than $40,000. The resolution, of course, is to get more information. This may include a test drive, mechanical inspection, warranty, etc. 3. You wish to hire Melissa to manage your Kansas operations. The profits from the operations depend partially on how hard Melissa works, as follows: Probabilities

Lazy Worker Hard Worker

Profit  $20,000

Profit  $100,000

65% 30%

35% 70%

If Melissa is lazy, she will surf the Internet all day, and she views this as a zero cost opportunity. However, Melissa would view working hard as a “personal cost” valued at $2,000. What fixedpercentage of the profits should you offer Melissa? Assume Melissa only cares about her expected payment less any “personal cost.” Solution: Let P be the percent of profits you pay Melissa. If Melissa is lazy, her expected payment is 0.65  20,000 P + 0.35  100,000 P = 48,000 P If Melissa works hard, her expected payment is 0.30  20,000 P + 0.70  100,000 P − 2,000 = 76,000 P − 2,000 To induce Melissa to work hard, you need 76,000 P − 2,000 > 48,000 P 28,000 P > 2,000 P > 0.0714 So, offer Melissa 7.14% of the profits, and this should induce her to work hard. 4. You own a house worth $800,000 on a river. If the river floods moderately, the house will be completely destroyed. This happens about once every 80 years. If you build a seawall, the river would have to flood heavily to destroy your house, and this only happens about once every 400 years. What would be the annual premium for an insurance policy that offers full insurance? For a policy that only pays 80% of the home value? What are your expected costs with and without a seawall? Do the different policies provide an incentive to be safer (build the seawall)?

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Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition, Global Edition

Solution: With full insurance: Without a seawall, the expected loss is 800,000  0.0125 = 10,000 With a seawall, the expected loss is 800,000  0.0025 = 2,000 The insurance company will charge the expected loss as a premium. Your expected cost under either scenario each year is the premium. With partial insurance: Without a seawall, the expected loss is 640,000  0.0125 = 8,000 With a seawall, the expected loss is 640,000  0.0025 = 1,600 The insurance company will charge the expected loss as a premium. Your expected cost each year is: Without a seawall: [0.0125 (640,000 − 800,000) + 0.9875 (0)] − 8,000 = −6,000 With a seawall: [0.0025  (640,000 − 800,000) + 0.9975 (0)] − 1,600 = −1,200 Unfortunately, neither insurance policy is better or worse. Although the premiums under the partial insurance policy are lower, the expected cost each year is the same as with full insurance. In either scenario, you will build the seawall if the annual cost of building and maintaining a seawall is less than $4,800/year.

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