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1.2 Financial intermediaries, such as commercial banks and mutual funds, channel funds from savers

to borrowers. Financial intermediaries are important to the financial system because they match savers and borrowers by reducing transactions costs and information costs.

1.3 Financial intermediaries are able to take advantage of economies of scale, such as standardized legal contracts, specialized loan officers, and sophisticated computer systems, to reduce transactions and information costs. If everyone were perfectly honest, the differences in transactions costs between financial intermediaries and small savers would decline, but not disappear. Evaluating loans would be easier, but still necessary because perfectly honest people may propose business ideas that have too low a chance of succeeding, and loans would still need to be processed. Additionally, financial intermediaries would still have economies of scale in sophisticated computer systems such as automated teller machine networks.

1.4 The Internet has reduced information and transactions costs. The Internet allows many financial transactions to be conducted online, thereby reducing their costs. The Internet also makes it much easier for investors to gather information on firms, thereby reducing information costs.

1.5 Writing bank records in ledgers would not have had significant economies of scale because bank workers would have written in ledgers one by one and there would be little average cost reduction in workers writing in 20 ledgers versus writing in only 10 ledgers. The computer, however, significantly increased economies of scale in recording bank records. One computer could store thousands of bank records nearly as easily as it could store 10, and the bank would need to purchase the software for entering the records would only once (for a given version of the software.)

2.1 Adverse selection is the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment. Moral hazard is the risk that people will take actions after they have entered into a transaction that will make the other party worse off. The “lemons problem” refers to the adverse selection problem that arises from asymmetric information. Because potential investors have difficulty in distinguishing good borrowers from bad borrowers, these investors offer good borrowers terms they are reluctant to accept. Because banks specialize in gathering information, they are better able to overcome this problem.

2.2 The Securities and Exchange Commission (SEC) is a federal government agency that regulates

U.S. stock and bond markets. The SEC’s primary role is to reduce adverse selection by requiring

the disclosure of financial and accounting information from all publicly traded firms. The SEC

was founded in 1934 in an attempt to alleviate the asymmetric information problem that became apparent following the stock market crash of 1929. The SEC has been successful in reducing the cost of asymmetric information, but it has not eliminated it completely.

2.3 Relationship banking is the ability of banks to assess credit risks on the basis of private information about borrowers. Banks have less risk because of the additional information they collect about the borrower. The borrower gets a lower interest rate because he or she is a lower risk to the bank.

2.4 The principal-agent problem is an example of moral hazard and occurs when managers (agents) follow their own self interest rather than the interest of the shareholders (principals).

2.5 Venture capital firms raise funds from investors to invest in start-up firms. Private equity firms raise funds to acquire shares in established firms with the intention of reducing moral hazard problems. Crowd-funding raises small amounts of investment funds for startup firms from large numbers of people on social networking sites. So, crowd-funding plays a role that is more similar to the role played by venture capital firms than to the role played by private equity firms.

2.7 The asymmetric problem in this used car example is adverse selection. It is likely that only a lemon would be put up for sale after being driven just 2,000 miles. A buyer could deal with the problem by having a mechanic inspect the car or by getting a warranty from the dealer (or a buyer might simply trust the dealer’s reputation for selling reliable cars).

2.9 a. Banks would be reluctant to lend to startups for two key reasons: 1) There is substantial risk that startups would fail, particularly during sluggish economic times, and 2) banks want to continue to recover from the consequences of the financial crisis and recession by improving the quality of their loans (loaning to borrowers who are likely to pay back the loans).

b. Startups might have an easier time obtaining equity investments from small investors through crowd-funding sites than obtaining loans from banks because: 1) Small investors are not investing large amounts of money, 2) the social networking sites reach large numbers of people, and 3) small investors may enjoy funding innovative, new ideas even though the returns on their investments are low.

2.11 a. Securitization is the process of combining (bundling) loans, such as mortgages, into securities that can be sold on financial markets.

b. When the loans are bundled together and sold off, the bank that issued the loan doesn’t bear the cost if the borrower fails to pay back the loan. The bank that issues the loan makes its money by originating and selling the loans on the secondary market. This process creates a moral hazard problem.

c. The investors did not know that the securities contained bad commercial real estate loans. It is highly unlikely that these securities had high enough interest rates to compensate investors for the additional risk because during this period the market consistently underestimated the risk involved with mortgage-backed securities.

2.13 Moral hazard is less likely to be a problem in scenario (b), because when a manager receives a percentage of the firm’s profits, the manager’s objective will be closer to the shareholders’ objective of maximizing the firm’s profits.

2.14 a. Stock options provide an incentive for the managers to make decisions that increase the stock’s value, which is what shareholders want.

b. The exercise price is the price at which the buyer of an option has the right to buy or sell the underlying asset. In this case, the exercise price was the price that the KB Home CEO could buy stock. By backdating the options to an earlier date when the stock price was lower, the CEO is able

to purchase shares of the company at a cheaper price and then resell the stock at the current higher price.

c. The information problem involves the principal-agent problem, which is the moral hazard problem of managers pursuing their own interests rather than those of shareholders.

3.1 The owners’ personal funds and profits are the primary sources of funds for small- to medium-sized firms. Loans—particularly mortgage loans—from financial intermediaries are the most important source of external funds for small- to medium-sized firms. See Figure 9.1 on page 270 of the text.

3.2 The bond market is the most important method of debt financing for corporations. See Figure 9.2, panel (a) on page 271 of the text.

3.3 The three key features are: 1) Loans from financial intermediaries are the most important external source of funds for small to medium sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms. 2) The stock market is a less important source of external funds to corporations than is the bond market. There is less moral hazard involved with bonds than with stocks. 3) Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral and restrictive covenants is to reduce moral hazard.

3.5 Being honest would not eliminate the need for financial intermediaries. In a world of perfect honesty, adverse selection would be reduced and moral hazard would be largely eliminated. But adverse selection occurs not just because of dishonesty; it also occurs when one side of a transaction unavoidably has more information than does the other side of the transaction. Also, financial intermediaries experience economies of scale in making loans; these economies of scale would still exist even in a world of perfect honesty.

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