Questions
1. Which of the following is the primary reason indirect finance is more critical than direct finance in the
financial sector?
A) It provides greater security for individual investors.
B) It reduces the role of financial intermediaries.
C) It addresses issues of asymmetric information.
D) It allows direct transactions between savers and borrowers.
Answer: C
Explanation: Indirect finance involves financial intermediaries that reduce asymmetric information
issues by assessing borrower risk and matching investors with borrowers who may not directly connect
in a direct finance model.
2. Why are banks considered the most important source of external finance for businesses?
A) Banks specialize in issuing marketable securities.
B) Banks are heavily regulated, providing stability.
C) Banks control most financial intermediation processes.
D) They provide flexible loan options tailored to small and medium-sized businesses.
Answer: C
Explanation: Banks play a central role in financial intermediation by accepting deposits and issuing loans,
especially for businesses without direct access to securities markets.
3. Which of the following services of financial institutions directly supports the development of new
financial assets?
A) Portfolio management
B) Transforming financial assets
C) Assisting in asset creation
D) Exchanging assets on behalf of customers
Answer: C
Explanation: Assisting in asset creation allows financial institutions to help develop and structure new
financial instruments, catering to the needs of issuers and investors.
4. In addressing adverse selection, which method would a financial institution most likely employ to
safeguard against high-risk borrowers?
A) Issuing restrictive covenants
B) Government-required information disclosure
C) Monitoring borrower actions after the loan is issued
D) Limiting the investment advice provided to borrowers
Answer: B
Explanation: Requiring information disclosure before a transaction can help filter out high-risk
borrowers who are less likely to meet the institution’s standards.
5. Collateral is often a common requirement in debt contracts primarily to:
A) Reduce the risk associated with adverse selection.
B) Increase the complexity of legal documentation.
C) Protect the borrower from excessive lending.
D) Allow for higher loan amounts with lower interest rates.
Answer: A
Explanation: Requiring collateral reduces the lender's risk by securing the loan with the borrower’s
assets, thus mitigating issues tied to adverse selection.
6. Which role of financial institutions primarily helps individuals with lower incomes in portfolio
diversification?
A) Transforming financial assets
B) Reducing transaction costs
C) Providing maturity intermediation
D) Managing portfolios
Answer: B
Explanation: Financial intermediaries reduce transaction costs, which allows even individuals with
limited income to diversify their portfolios by accessing pooled investments like mutual funds.
7. What is the primary difference between adverse selection and moral hazard?
A) Adverse selection occurs after a transaction, while moral hazard occurs before.
B) Adverse selection impacts equity contracts, while moral hazard affects debt contracts.
C) Adverse selection arises before the transaction, while moral hazard occurs after.
D) Both adverse selection and moral hazard only apply to government-regulated loans.
Answer: C
Explanation: Adverse selection occurs before a transaction as borrowers select in, often leading to
higher-risk individuals being chosen, whereas moral hazard occurs after, where borrower actions may
deviate from expected behavior.
8. Which of the following best describes “maturity intermediation” as performed by financial
institutions?
A) Offering loans with lower interest rates than market securities.
B) Transforming short-term liabilities into long-term assets.
C) Converting illiquid assets to liquid forms.
D) Matching the maturity preferences of both savers and borrowers.
Answer: D
Explanation: Maturity intermediation involves financial institutions bridging the differing maturity
preferences between savers (who often prefer short-term) and borrowers (who often need long-term
loans).
9. Which of the following financial institution services directly reduces the risk of moral hazard?
A) Private collection of information on borrowers
B) Restrictive covenants in debt contracts
C) Allowing for checkable deposits
D) Issuing time deposits with fixed terms
Answer: B
Explanation: Restrictive covenants limit borrower actions, thus reducing moral hazard by ensuring
borrowers adhere to specific conditions throughout the loan’s term.
10. In the context of financial intermediation, economies of scale primarily:
A) Increase the costs associated with individual transactions.
B) Allow for lower per-transaction costs as the volume of transactions rises.
C) Encourage higher interest rates on individual loans.
D) Limit portfolio management options for small investors.
Answer: B
Explanation: Financial intermediaries achieve economies of scale by reducing the per-transaction cost as
they process higher volumes, which is beneficial for both the institution and its clients.
11. Which of the following features most clearly differentiates credit unions from commercial banks?
A) They are for-profit institutions.
B) They primarily focus on issuing mortgage loans.
C) They are cooperatives formed around specific groups.
D) They offer only savings deposits without checkable accounts.
Answer: C
Explanation: Credit unions are cooperative financial institutions typically serving a particular group, like
employees or union members, while commercial banks serve the broader public.
12. Which of these institutions was originally restricted primarily to mortgage lending but has since
diversified due to regulatory changes?
A) Mutual funds
B) Credit unions
C) Savings and Loan Associations
D) Investment banks
Answer: C
Explanation: Savings and Loan Associations (S&Ls) originally focused on mortgage lending but, over time,
regulatory changes allowed them to expand into broader financial services.
13. Why might a financial institution demand higher collateral from a borrower?
A) To reduce costs associated with information processing.
B) To minimize potential losses due to adverse selection.
C) To ensure the borrower has a stronger credit score.
D) To increase the frequency of portfolio turnover.
Answer: B
Explanation: Requiring collateral helps offset the risk associated with adverse selection by adding a layer
of security to loans extended to potentially high-risk borrowers.
14. How do financial institutions typically make profits from reducing transaction costs?
A) By investing exclusively in marketable securities.
B) By offering short-term loans at higher rates.
C) Through economies of scale and expertise development.
D) By reducing government regulation compliance costs.
Answer: C
Explanation: Financial institutions leverage economies of scale and develop expertise to reduce
transaction costs, making financial services accessible and profitable.
15. Which regulatory action helps address the issue of adverse selection in financial markets?
A) Imposing restrictive covenants on all debt contracts
B) Requiring private collection of borrower information
C) Implementing mandatory disclosure requirements
D) Allowing higher interest rates on consumer loans
Answer: C
Explanation: Mandatory disclosure requirements ensure transparency, reducing adverse selection by
providing investors with better insights into the creditworthiness of borrowers.
