Understanding Asymmetric Information and Moral Hazard in Bank Loans and Securities Markets, Quizzes of Banking and Finance

Download Understanding Asymmetric Information and Moral Hazard in Bank Loans and Securities Markets and more Quizzes Banking and Finance in PDF only on Docsity! TERM 1 Inc. or Dec. volume of Bank Loans - new reg. make it easier for shareholders to replace company directors DEFINITION 1 With new regulations that make it easier to replace comp. directors, captive boards who are not properly supervising comp. managers are easier to replace. This ensures that boards of directors are more able to protect shareholders interests. Stocks become more attractive to savers. Fewer companies rely on bank loans forfinancing's. The volume of bank loans decreases.DEC loans. TERM 2 Inc. or Dec. volume of Bank Loans - A new law makes it a felony to default on a bank loan. DEFINITION 2 The cost of bank loans inc for potential borrowers. Fewer comp take bank loans to fund project that they are uncertain about. (comp. try to fin through the bond market) Volume of bank loans decreases.On the other hand, only good creditors will take the more risky loans. Banks can therefore be more confident about loan applicant's credit. This has potential to INC THE VOLUME OF BANK LOANSDEC or INC loans. TERM 3 Inc. or Dec. volume of Bank Loans - All the economy's small firms are bought by large firms. DEFINITION 3 Large firms have rating agencies for bonds. These ratings decrease adverse selection and make it more likely that firms will obtain financing through the bond market rather than bank loans. The VOL of bank loans will DEC.DEC loans. TERM 4 Inc. or Dec. volume of Bank Loans - Mutual funds reduce their min balance for shareholders. DEFINITION 4 Reducing min. balances for shareholders in mutual funds rather than deposit funds in banks. Banks will have fewer funds available to loan out. The VOL of bank loans DEC.DEC loans TERM 5 You advertise a position for hire at $50,000 but an applicant offers to work for 40,000. Should you jump at this offer? DEFINITION 5 Moral Hazard is more pronounced at the lower salary. (goofing off and monitoring the empl.) The work ethic may be lower in the lower salary volunteer. The willingness to accept the offer indicates an adverse selection problem. The firm must consider both moral hazard and adverse selection problems before jumping at the offer of paying a lower salary. TERM 6 Suppose you have $1,000 to lend and offer it for 10% int. Someone promises to pay 20% if you lend to him. Should you jump at this offer? DEFINITION 6 The person offering to pay 20% may be engaged in a higly risky venture that pays high returns if successful, but has high probability of failure and default. In the case of default, the person will not be able to pay 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. TERM 7 Asymmetric Information (Adverse Selection) DEFINITION 7 -exist when one party to a transaction has more info about the transact. that the other-leads to adverse selection where those most eager to make deals are least desirable to other party TERM 8 Lemons Problem DEFINITION 8 -Asymmetric information exists when buyers cannot observe quality but each seller knows the quality. buyers don't know quality, price is averaged for bad/good Owners of good qual. don't sell bc price is low Market is flooded with bad qual. If buyers know most are bad qual., price falls If the qual. of bad varies, owners of "better" qual. won't sell Vicious circle develops and market collapses TERM 9 Lemons in Securities Market DEFINITION 9 -Firms selling know more about likely returns than buyers- This asymmetry leads to adverse selection-Adverse selection affects both the stock and the bond market TERM 10 Lemons in Stock Markets DEFINITION 10 -savers forecast on past performance and future plans-firms have more info about earnings-firms know if their stock is over or undervalued- saver know new stock offered are bad qual., then market price is pushed down and causes market to break TERM 21 Venture-Capital Firms DEFINITION 21 -substantial interest in company, but don't purchase majority, and fund company for expansion and pogression TERM 22 Friendly Take-Over Firms DEFINITION 22 -deals made to give s/h market price or premium to sell and this firm will provide their own board, managers stay for better production TERM 23 Hostile Take-Over Firms DEFINITION 23 -buys as many shares to get majority and force s/h to sell (moral hazard causes stock to drop) then this firm buys dropped price TERM 24 SOX - SarbanesOxley Act DEFINITION 24 -An Act To protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes CEO and Outside Auditors must review accounts Criminal Penalties are increased TERM 25 4 ways Banks reduce Adverse Selection DEFINITION 25 Screening Borrowers - targeting better clients Collateral and Net Worth - makes loans more secure Covenants and Monitoring - compensating balance which keeps a certain amount restricted to your account and reduces mor.hazd. Interest Rates and Credit Rationing - prime rate is the rate the bank charges on business loans w lowest default risk. Higher interest rates for borrowers w bad credit