BA4819&5819 FINANCIAL INSTITUTIONS AND MARKETS

SOLUTION FOR MINI EXAM 4

05/01/2021
Time allowed: 40 minutes (including uploading time)

1) (40 points) Asymmetric information is a situation that arises when one party’s
insufficient knowledge about the other party involved in a transaction makes it impossible
to make accurate decisions when conducting the transaction. It has two specific forms:
adverse selection and moral hazard. Moral hazard occurs when one party has an incentive
to behave differently once an agreement is made between parties.
a. (10 points) Briefly explain why there is moral hazard in equity contracts.

Moral hazard in equity contracts is a principal agent problem. It is result of

separation of ownership by stockholders (principals) from control by managers
(agents). Managers may act in own rather than stockholders’ interest.

b. (15 points) Briefly discuss how monitoring can be used to solve the moral hazard
problem in equity contracts and briefly explain the problem(s) associated with
monitoring.

The stockholders may engage in a type of information production, the monitoring

of firm’s activities: auditing the firm frequently and checking on what the
management is doing. However, the monitoring can be costly. There will be time
and money spent by the stockholders to monitor the activities of the managers.
Moreover, there will be free-rider problem which will negatively affect the
monitoring activity. The free rider problem occurs when people who do not pay
for the monitoring activities (who do not monitor) will take the advantages of
monitoring (managers will be monitored and there will be less moral hazard
behavior since others monitor them).

c. (15 points) Briefly discuss the importance of financial intermediation as a tool to

solve moral hazard problem in equity contracts.

Financial intermediaries have the ability to avoid the free-rider problem. One
financial intermediary that helps to reduce the moral hazard behavior is the
venture capital firm. Because verification of earnings and profits is important in
eliminating moral hazard, venture capital firms usually have several of their own
partners participate as members of the board of directors of the firm in order to
monitor the activities of the firm. Since the equity in the firm is only marketable to
the venture capital firm other investors cannot free ride.
2) (20 points) Financial innovation in mortgage markets, agency problems in mortgage
markets and the role of asymmetric information in the credit rating process are accepted
as central factors of the Global Financial Crises (GFC). Briefly discuss how these factors
lead to GFC. Make sure that you mention conepts like securitization, collateralized debt
obligations, and subprime mortgages.
Financial engineering developed new financial products to further enhance and distribute
risk from mortgage lending. By lowering transaction costs, computer technology enabled
the bundling mortgages into standard debt securities (process called securitization). This
made it possible for banks to offer subprime mortgages. Subprime mortgages are the ones
made to borrowers who do not qualify for loans at the usual market rate of interest
because of a poor credit rating or because the loan is larger than justified by the income.
Financial engineering led to structured credit products that pay out income streams from a
collection of underlying assets, designed to have particular risk characteristics that appeal
to investors with differing preferences. Collateralized debt obligations are examples of
these structured credit products.
In a CDO, the securities (or tranches) are created based on default priorities. The first
defaults go to the lowest rated tranches. The highest rated tranches suffer defaults if most
of the assets default. Unfortunately, it can be difficult to determine exactly what each
tranche is worth and who has the rights to what cash flows.
In this new system mortgage originators did not hold the actual mortgage, but sold the
note in the secondary market. Mortgage originators earned fees from the volume of the
loans produced, not the quality. Also, unqualified borrowers bought houses they could not
afford through either creative mortgage products or outright fraud (such as inflated
income)
Furthermore, agencies consulted with firms on structuring products to achieve the highest
rating, creating a clear conflict. Moreover, the rating system was hardly designed to
address the complex nature of the structured debt designs. The result was meaningless
ratings that investors had relied on to assess the quality of their investments.
3) (40 points) Banks hold both required reserves and excess reserves. The Central Banks ask
banks to deposit certain percentage of their deposits as required reserves in the Central
Bank accounts but having excess reserves is banks’ decision.
a. (10 points) Briefly discuss why banks hold excess reserves.

Excess reserves are the most liquid assets. Banks can also earn interest on these
reserves. The excess reserves are used as a buffer against liquidity problems. They
can be employed to meet obligations by banks.

b. (20 points) State what other options the banks have if they do not have enough
reserves. Please state each method and associated costs with each method.

1) The banks can borrow from other banks. The cost is the interest rate paid on
these borrowings such as federal funds rate
2) The banks can borrow from the Fed (Central Bank) through the discount
window. The cost is the interest rate paid on these borrowings such as discount
rate.
3) The banks can sell the securities in their securities portfolios. The costs will be
the brokerage fees and other transaction cost. Also there will be foregone
interest income.
4) The banks can call some of their loans back or sell some of their loan portfolio
in the secondary market. The costs for calling back loans will be losing the
customers for the future thus there will be opportunity costs. The costs for
selling the loan portfolio will be the discount on the value of the loans. Since
they are not that liquid banks may need to decrease their prices to sell them.

c. (10 points) Briefly explain why bank capital is a tradeoff between safety and
return.

Capital is the difference between assets and liabilities. Capital protects liability
suppliers from asset devaluations or write-offs. That is why capital is also called
shock absorber. Bank capital helps to prevent bank failure.

At the same time the amount of capital affects returns for the owners of the bank.
Return on equity is calculated by dividing net income total equity (total capital).
As total capital increases return on equity decreases.