01 Why Are Financial Institutions Special

1. Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial institutions.

2. Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users.

3. How can economies of scale help explain the existence of financial intermediaries?

4. Do you think the lemons problem would be more severe for stocks traded on the New York Stock Exchange or those traded over the counter? Explain your reasons.

5. Which firms are more likely to use bank financing rather than to issue bonds or stocks to finance their activities? Why?

6. What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?

7. How can the existence of asymmetric information provide a rationale for government regulation of financial markets?

8. Rich people often worry that others will seek to marry them only for their money. What kind of the asymmetric information problem is this example? Why?

9. What is the free-rider problem? How does it aggravate adverse selection and moral hazard problems in financial markets?

10. Why are FIs among the most regulated sectors in the world? When is the net regulatory burden positive?

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FM3036 Practice Problems 2 of 2

11.

a. You are in the market for a used car. At a used car lot, you known that the blue book value for the cars you are looking at is between $20,000 and

$24,000. If you believe the dealer knows as much about the car as you, how much are you willing to pay? Why? Assume that you only care about the expected value of the car you buy and that the car values are symmetrically distributed.

b. Now, you believe the dealer knows more about the cars than you. How much are you willing to pay? Why? How can this be resolved in a competitive market?

12. You wish to hire Ricky to manage your Dallas operations. The profits from the operations depend partially on how hard Ricky works, as follows:

Lazy Worker Hard Worker

Probabilities

Profit = $10,000

60% 20%

Profit = $50,000

40% 80%

If Ricky is lazy, he will surf the Internet all day, and he views this as a zero cost

opportunity. However, Ricky would view working hard as a “personal cost” valued at $1,000. What fixed-percentage of the profits should you offer Ricky? Assume Ricky only cares about his expected payment less any “personal cost.”

13. Many people argue that the deregulation in financial institutions is one of the reasons for the recent financial crisis. Please explain why that is the case.

14. Some blames the financial engineering as one of the reasons for the recent financial crisis. Please explain why that is the case.

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