Week 1 Practice questions solution
Chapter 1 End-Chapter questions
Q3. Identify and explain three economic disincentives that probably would dampen
the flow of funds between household savers of funds and corporate users of funds
in an economic world without FIs.
Investors generally are averse to purchasing securities directly 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 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 that may be available. Third,
the price risk of transactions on the secondary markets would increase without the
information flows and services generated by high volume.
Q4. Identify and explain the two functions in which FIs may specialise that 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 the asset transformation function. The brokerage
function can benefit both savers and users of funds and can vary according to the
firm. FIs may only provide transaction services—such as discount brokerages—or they
also may offer advisory services which help reduce 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.
Q5. 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?
The 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 are therefore 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.
Q8. What are agency costs? How do FIs solve the information and related agency
costs when household savers invest directly in securities issued by corporations?
What is the ‘free-rider’ problem?
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 a failure to
adequately monitor the activities of the borrower. Because the cost is high, individual
investors may do an incomplete job of collecting information and monitoring under
the assumption that someone else is doing these tasks. In this case, the individual
becomes a free rider. But 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.
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.
Q9. How do large FIs solve the problem of high information collection costs for
lenders, borrowers and financial markets in general?
One-way FIs solve this problem is that they develop 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. The renewal process updates the financial
and operating information of the firm more frequently, thereby reducing the need for
restrictive bond covenants that may be difficult and costly to implement.
Q10. How do FIs alleviate the problem of liquidity risk faced by investors who wish
to invest in the securities of corporations?
Liquidity risk occurs when savers are not able to sell their securities on demand.
Banks, for example, offer deposits that can be withdrawn at any time. Yet the banks
make long-term loans or invest in illiquid assets because they are able to diversify
their portfolios and better monitor the performance of firms that have borrowed or
issued securities. Thus, individual investors are able to realise the benefits of investing
in primary assets without accepting the liquidity risk of direct investment.
Q12. How can FIs invest in high-risk assets with funding provided by low-risk
liabilities from savers?
Diversification of risk occurs with investments in assets that are not perfectly
positively correlated. One result of extensive diversification is that the average risk of
the asset base of an FI will be less than the average risk of the individual assets in
which it has invested. Thus, individual investors realise some of the returns of high-
risk assets without accepting the corresponding risk characteristics.
Q16. How do depository institutions such as banks assist in the implementation and
transmission of monetary policy?
The Reserve Bank of Australia (RBA) involves banks directly in the implementation of
monetary policy through changes in the reserve requirements and the official rate.
The open market sale and purchase of treasury securities by the RBA in the RBA’s
open market operations also involves the banks the implementation of monetary
policy in a less direct manner.
Q21. What is negative externality? In what ways does the existence of negative
externalities justify the extra regulatory attention received by FIs?
A negative externality refers to the action by one party that has an adverse effect on
some third party who is not part of the original transaction. For example, in an
industrial setting, smoke from a factory that lowers surrounding property values may
be viewed as a negative externality. For financial institutions, one concern is the
contagion effect that can arise when the failure of one FI can cast doubt on the
solvency of other institutions in that industry.
Q23. Why are FIs among the most regulated sectors in the world? When is net
regulatory burden positive?
FIs are required to enhance the efficient operation of the economy. Successful
financial intermediaries provide sources of financing that fund economic growth
opportunity that ultimately raises the overall level of economic activity. Moreover,
successful financial intermediaries provide transaction services to the economy that
facilitate trade and wealth accumulation.
Conversely, distressed FIs create negative externalities for the entire economy. That
is, the adverse impact of an FI failure is greater than just the loss to shareholders and
other private claimants on the FI’s assets. For example, the local market suffers if an FI
fails and other FIs may also be thrown into financial distress by a contagion effect.
Therefore, since some of the costs of the failure of an FI are generally borne by society
at large, the government intervenes in the management of these institutions to
protect society’s interests. This intervention takes the form of regulation.
However, the need for regulation to minimise social costs may impose private costs
on the firms that would not exist without regulation. This additional private cost is
defined as a net regulatory burden. Examples include the cost of holding excess
capital and/or excess reserves and the extra costs of providing information. Although
they may be socially beneficial, these costs add to private operating costs. To the
extent that these additional costs help to avoid negative externalities and to ensure
the smooth and efficient operation of the economy, the net regulatory burden is
positive.
Chapter 2 End Chapter questions
Q1. How have the risks and products sold by the financial services industry changed
since 1950?
The financial services industry today is very different from that in 1950. In 1950, the
financial institutions (FIs) were more specialised, each offering a distinct set of
products/services. Today, however, the activities and products of the various FI types
are more blurred, with many overlapping functions and risks. The risks faced by
modern FIs are becoming increasingly similar because of this.
Q3. What are the major sources of funds for banks in Australia? What are the major
uses of funds for banks in Australia?
Sources of funds:
• local deposits
• local wholesale funding (interbank funds)
• international wholesale funding
• equity (and other capital components).
Uses of funds:
• loans and advances:
– home mortgages
– commercial loans
– bank accepted bills
– commercial bills
– promissory notes
– corporate bonds and debentures
• interbank lending
• securities including:
– government securities
– other bank securities
– corporate bonds
– securitised assets
• foreign currency and foreign currency assets
• cash and deposits with the RBA.
Q5. Why did bank net interest margin fall from 2000 to 2013? Why wasn’t bank ROE
affected?
Australian bank net interest margins have been falling since the 1980s due to
deregulation of the financial markets and new technologies as well as regulatory
change and the focus on improvements in quality capital. However, their return on
equity has remained at a long-term average of 16 per cent. Total bank returns are
made up of interest income and fee income, and fee income has represented one-
quarter of bank operating income since 2004.
Past exam questions:
1. Which of the following is NOT a reason for the specialness of financial
intermediaries?
A. Lower average information costs.
B. Lower price risk and superior liquidity attributes of financial claims to household
savers.
C. No agency costs.
D. Lower average transaction costs.
E. All of the above.
Answer: C
2. Which of the following statements is true?
A. The RBA is responsible for market integrity and consumer protection across the
financial system.
B. APRA is responsible for prudential supervision.
C. ASIC is responsible for monetary policy and for overall financial system stability. D.
All of the above.
E. None of the given answers.
Answer: B
