Solutions for End-of-Chapter Questions and Problems: Chapter One
1. What are five risks common to all financial institutions?
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. This process would be
extremely costly because of the up-front information costs faced by potential lenders. Cost
inefficiencies would arise with the identification of potential borrowers, the pooling of small
savings into loans of sufficient size to finance corporate activities, and the assessment of risk and
investment opportunities. Moreover, lenders would have to monitor the activities of borrowers
over each loan's life span. 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 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. In this sense, depositors have delegated the FI to act as a monitor on
their behalf. Further, 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. 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.
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 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 short-term 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. Because the FI invests
1. What are five risks common to all financial institutions?
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. This process would be
extremely costly because of the up-front information costs faced by potential lenders. Cost
inefficiencies would arise with the identification of potential borrowers, the pooling of small
savings into loans of sufficient size to finance corporate activities, and the assessment of risk and
investment opportunities. Moreover, lenders would have to monitor the activities of borrowers
over each loan's life span. 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 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. In this sense, depositors have delegated the FI to act as a monitor on
their behalf. Further, 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. 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.
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 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 short-term 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. Because the FI invests
