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Sample/practice exam 15 November, answers

Principle of Banking (Trường Đại học Ngoại thương)

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1. The presence of adverse selection problem keeps bond and stock markets from
effectively channeling funds from savers to borrowers. What does statement mean?
Explain briefly.
This statement means that:
- In stock markets, adverse selection happens when high and low quality stock are
difficult to distinguish. This will discourage lenders to enter the markets because
they do not know whether a stock has high profit potential or high risk
- In bond markets, adverse selection happens when default risk is significant. A
firm may know that its true default risk is higher or lower than the public thinks
and then makes decision whether to issue bonds or securities to maximize its
benefits.
2. Why do large corporations find it easier to raise funds in securities markets while
small businesses rely mostly on bank loans ?
It is one of eight basic facts that only large, well-established corporations have
access to direct finance, which means large corporations often raise funds by
issuing securities while small businesses often take out bank loans. This is because
lender slack the information needed to verify the quality of small newly-
established businesses. In contrast, large well-established firms make lenders more
confident about their quality.
3. Would each of the following events increase or decrease the volume of bank
loans? Explain
a. New regulations make it easier for shareholders to replace company directors.
With new regulations that make it easier to replace company directors, captive
boards who are not properly supervising company managers are easier to re-place.
This ensures that boards of directors are more likely to protect shareholder
interests and to supervise management, which reduces the moral hazard problem.
Stocks become more attractive to savers. Fewer companies need to rely on bank
loans for financings. The volume of bank loans decreases.
b. A new law makes it a crime to default on a bank loan.
If it becomes a felony to default on a bank loan, the cost of bank loans in-creases
for potential borrowers. Fewer companies will take out bank loans to finance
investment projects when they are uncertain about the outcome of their projects.
In-stead, companies will try to obtain financing through the bond market. The
volume of bank loans decreases. On the other hand, banks are more likely to give
loans when more severe consequences are attached to defaulting. Making it a
felony to default will solve some of the adverse selection and moral hazard
problems. Only the better credit risks will still be interested in taking out a loan.
Banks can therefore be more confident about loan applicants’ credit. This has the
potential to increase the volume of bank loans. The net impact on bank loans from
the new law is unclear.
c. All the economy’s small firms are bought by large firms.
Large firms are more likely to have a bond rating provided by rating agencies.
These ratings decrease adverse selection and make it more likely that firms will

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obtain financing through the bond market rather than bank loans. The volume of
bank loans will decrease
d. Mutual funds reduce their minimum balances for shareholders.
Reducing the minimum balance for shareholders in mutual funds encourages more
small savers to purchase shares in mutual funds rather than deposit funds in banks.
Banks will have fewer funds available to loan out. The volume of bank loans
decreases.
4. Suppose you have $1000 to lend and offer it for 10-percent interest. Someone
promises to pay 20 percent if you lend to him. Should you jump at this offer?
The person offering to pay 20 percent may be engaged in a highly risky venture
that pays high returns if successful, but has a high probability of failure and
default. In the case of default, the person will not be able to pay any interest and
may, in fact, not be able to repay any of the principal, the initial loan of $1,000.
Thus, the promise to pay a higher interest rate should be regarded with caution. It
is likely that adverse selection is a problem here.
5. Suppose I am a good borrower. I need $10,000 to invest in a project that will pay a
safe 6% rate of return next year. Suppose my neighbor is a bad borrower, his
$10,000 project has very low chance of success but the expected rate of return is
20%. The local bank charges 10% interest rate on all its loans.
a. Will I be willing to borrow at this rate? Will my neighbor be willing to borrow
at this rate?
I may be unwilling to borrow at this rate because the interest rate is much
higher than my investment’s rate of return. Meanwhile, my neighbor may be
willing to borrow at this rate because the interest rate is much lower than his
project’s rate of return. Hay may gain a lot of profit if his project is successful.
b. Assume all potential borrowers are either like me or like my neighbor. Explain
why the bank will end up issuing no loans and no projects will be funded
If all potential borrowers are like me, they may be unwilling to take out loans
from the bank because of high interest rate. If all potential borrowers are like
my neighbor, the bank may be unwilling to make loans to them because of
their highly risky projects. As a result, the bank will end up issuing no loans
and no projects will be funded
c. How could the bank reduce with this adverse selection problem?
The bank could reduce this adverse selection problem by require the borrowers
to put up collaterals for the loans. If the borrowers default, the bank will get the
collaterals.
6. What kind of moral hazard problems do banks worry about?
The borrowers may not use the loans they receive efficiently. They may invest
in dangerous projects and may be unable to repay the loans to banks. Some

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measures to prevent moral hazard are monitoring the borrowers’ activities and
restricting risky behavior, requiring collateral, periodic auditing of the
borrowers, etc.
7. Suppose an all you can eat buffet costs $10. The buffet discovers that most of its
customers are sumo fighters. Is this a problem of adverse selection or moral hazard
for the restaurant? Explain.
This is a problem of both adverse selection and moral hazard for the restaurant.
Adverse selection happens because the restaurant did not know in advance that
most of its customers would be sumo fighters while they charged only $10 for
average customer. Moral hazard happens because the restaurant cannot know
whether the sumo fighter will eat buffet within the cost of $10 or more. In other
words, the restaurant cannot know they will gain profit or get loss.
8. Why might you be willing to make a loan to your neighbor by putting funds in a
savings account earning a 5% interest rate at the bank and having the bank lend her
the funds at a 10% interest rate rather than lend her the funds yourself?
We will avoid the asymmetric information. Bank is one of the financial
institutions that prevent the lender from risk of borrower’s default. In other words,
we will not lose our money when lending our neighbor funds through the bank’s
system. The bank will help us to monitor the loans and get the collateral from the
borrower when she is not able to pay her debt. We also save an amount of money
in legal fees, fees for a credit check, and so on and always receive the payment at
the interval terms
9. Why do property and casualty insurance companies have large holdings of
municipal bonds but life insurance companies do not?
Because the assets of the property and casualty insurance companies are
essentially reserves against sudden claims, they have to be liquid. Thus, these
companies get more municipal bonds which have high liquidity.
10. Life insurance companies tend to invest in long-term assets such as loans to
manufacturing firms to build factories or to real estate developers to build shopping

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malls and skyscrapers. Automobile insurers tend to invest in short-term assets such
as Treasury bills. What accounts for these differences?

Automobile insurers generally need to have funds readily available when a policy
holder makes a claim, and Treasury bills are highly liquid. Life insurance
companies have liabilities with a much longer horizon. A life insurance policy is
expected to pay off in 30 years, say, so that assets with longer horizons correspond
to their longer-term liabilities. In general, insurers can limit their risks by matching
the terms of their liabilities with the terms of their assets.
11. List three types of financial intermediaries, give examples.

-Commercial bank:Commercial banks accept deposits and provide security and

convenience to their customers

Ex: Vietcombank, BIDV, Agribank

-Insurance company: Insurance companies pool risk by collecting premiums from a

large group of people who want to protect themselves and/or their loved ones against
a particular loss, such as a fire, car accident, illness, lawsuit, disability or death.
Insurance helps individuals and companies manage risk and preserve wealth.

Ex: Prudential Vietnam, Manulife Vietnam

-Investment company: An investment company is a corporation or a trust through

which individuals invest in diversified, professionally managed portfolios of securities
by pooling their funds with those of other investors

.Ex: American Century

12. What explains the widespread use of deductibles in insurance policies?

Deductibles reduce the moral hazard problem because a policyholder will also suffer
losses when a claim is made. Thus the policyholder will have the incentive not to
engage in activities that make a claim more likely, and this will subject the insurance
company to smaller losses

13. Why might insurance companies restrict the amount of insurance a policyholder
can buy?

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The Insurance Companies might restrict the amount of insurance a policyholder can
buy to restrict the amount of risk that insurance company can bear

14. Explain why shares in closed-end mutual funds typically sell for less than the
market value of the stocks they hold.

Being permanent capital vehicles, the supply of shares is relatively fixed so attempts
to explain closed-end fund discounts have concentrated on the factors affecting
demand for shares. One possible reason is that they are frequently not that widely
traded and are thus not very liquid; this illiquidity then reduces their price

15. Will finance companies be replaced by commercial banks?

Finance companies tend to provide credit to borrowers that exhibit higher risk. They
can charge the borrowers a higher interest rate and therefore havethe potential to earn
a higher return on the loans (if the borrowers repay the loans). Commercial banks are
exposed to default risk, but not to the same degree. Their loan portfolios are
monitored by regulators. Thus, they are unlikely to replace finance companies.

16. “Closed end funds tend to hold stocks that are less liquid than stocks held by open
end funds”. Comment on this.

The greater popularity of the open-end funds is explained by the greater liquidity of
their redeemable shares relative to the nonredeemable shares of closed end funds.

17. Is investment banking a good career for someone who is afraid of taking risks?
Why or why not?

18. Should financial institutions be regulated in order to reduce their risk? Offer at least
one argument for regulation and one argument against regulation.

Regulation may be able to reduce failures of financial institutions, which may stabilize
the financial system. The flow of funds into financial institutions will be larger if the
people who provide the funds can trust that the financial institutions will not fall.
However, regulation can also restrict competition. In some cases, it results in subsidies

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to financial institutions that are performing poorly. Thus, regulation can prevent firms
from operating efficiently.

19. When a securities firm serves as an underwriter for an IPO, is the firm working for
the issuer or the institutional investors that may purchase shares? Explain the
dilemma.

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