Chapter
8
Financial Institutions—
An Overview
Solutions to End-of-Chapter Questions and Problems
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Investment banks are more willing to guarantee purchases of firms’ securities through a
firm commitment underwriting arrangement is they feel confident that the firms’ shares
will sell in the marketplace; shares of firms with proven track records are more likely to
meet this criterion. In contrast, investment banks are more likely to offer best effort
deals, which entail minimal guarantees, to new businesses with less clear-cut prospects.
In the past, when new businesses were starting up in larger relative numbers, such best
effort deals were more commonplace.
A specialist is required to keep share prices for stocks from swinging too widely, which
requires the specialist to execute limit orders when necessary. This takes away some
flexibility for the specialist to be able to trade amounts of any given share that it might
otherwise desire to trade. As a result, a specialist has an incentive to hold a variety of
shares to maintain fullest possible trading flexibility, even though the specialist gains
from limit-order commissions that brokers must pay to compensate somewhat for the loss
of flexibility.
Depression often is associated with suicides, which is the ultimate moral hazard problem
for life insurance policies. Consequently, many insurers refuse to insure people who
have been treated for depression, even though depression is a very commonplace illness.
This has provoked considerable controversy in recent years, given that evidence indicates
that depression is treatable, which reduces the risk of suicide. Some insurers instead
include clauses exempting beneficiaries of suicides from collecting policy benefits.
The problem is that the PBGC has created adverse selection and moral hazard problems.
The adverse selection problem arises because pay-as-you-go pensions are the most likely
to be inadequately funded, and they thereby have strong incentives to seek federal
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insurance. In addition, the extension of federal insurance for all tax-deferred pensions
has encouraged many pension plans to reduce their funding levels, because they know
that even if they fail the government will cover their liabilities. This is the moral hazard
problem associated with the PBGC.
Naturally, there are two sides to take on this issue. One is to agree with those who argue
that expanding federal regulations of hedge funds would not have much effect, on the
basis of the ease with which hedge funds could move outside U.S. legal jurisdiction. The
other is to take the stand that those who wish to maintain shares in U.S.-based hedge
funds could stand to benefit from regulatory oversight that diminishes the potential for
significant losses.
Because bank deposits are insured, meaning that banks have to incur insurance costs.
The insurance costs result in relatively lower net returns on bank deposits relative to
comparable mutual funds. In addition, with the absence of insurance, mutual funds
involve higher risk as compared to bank deposits so that savers demand higher returns.
If this prediction is correct, the rates of return on underlying mortgages will decline after
the baby-boom generation retires, and this will cause the returns on FNMA mortgagebacked securities to decline as well. Those who hold these securities would experience
reduced returns as a result.