Chapter 8 Financial Industry Structure
Chapter 8
Financial Industry Structure
Problems and Solutions
1. For many years, you have been using your local small-town bank. One day
you hear that the bank is about to be purchased by Bank of America. From
your vantage point as a retail bank customer, what are the costs and benefits
of such a merger?
Answer: The benefits are that you will have access to a larger network of ATMs and
you will be able to use your bank for a larger scope of financial services. However,
you will receive less personal service. Furthermore, the costs of the services you use
are likely to fall for two reasons. Economies of scale mean that larger banks have
lower per unit costs; and economics of scope mean that banks with a broader array of
services have lower costs as well. But the larger bank could use its monopoly power
to raise costs, as well.
2.Consider the impact of the merger in Question 1 from the point of view of a
small business owner. Is the purchase of your small community bank good or
bad? Explain your answer.
Answer: The small business owner had likely developed a relationship with the
community bank, allowing him to borrow funds more easily. Unless some care is
taken, information asymmetries could worsen. He will have to reestablish himself as a
good credit risk with Bank of America, but won’t be able to receive the same level of
personal service he experienced with the community bank.
3. Why have technological advances hindered the enforcement of legal
restrictions on bank branching?
Answer: Most people don’t go into a physical bank building to withdraw cash from
their accounts or make a deposit; instead they go to an ATM. ATMs do not qualify
as “branches” of a bank, so a bank can expand its customer base across a larger
geographic area without violating branching regulations. The advent of the Internet
and electronic banking has made the location of bank buildings even less relevant.
4. Banks have been losing their advantage over other financial intermediaries in
attracting customers’ funds. Why?
Answer: Other financial firms now exist to provide individuals with services typically
performed by banks. Money market mutual funds offer customers access to
financial instruments that pay a higher rate of interest than bank deposits, yet are still
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Money, Banking, and Financial Markets
Chapter 8 Financial Industry Structure
very liquid and can easily be converted into a means of payment. Banks no longer
have an advantage in screening loan applicants because of the ease with which
individuals can transmit information, so a customer who needs a loan can go online to
get price quotes instead of going to the local bank. Discount brokerage firms
provide individuals with low-cost access to the financial markets.
5. What has been the impact of the Internet on the structure of the banking
industry?
Answer: The Internet has rendered the physical location of a particular bank irrelevant,
allowing large banks to expand across the country, and reducing the number of small
local banks.
6. Describe the economies of scope that large financial holding companies hope
to realize. Do you believe they will be successful?
Answer: The companies hope to reduce costs by offering customers a wide range of
services. Enabling customers to complete all of their financial activities with one
institution should help to reduce costs, but the people who run the large companies are
probably more interested with increasing the size of their institutions.
7. Discuss the problems life insurance companies will face as genetic
information becomes more widely available.
Answer: Insurance companies can’t predict when a particular person will die, but
when they pool together a group of individuals with uncorrelated risks, they can
predict fairly accurately the outcome for the group as a whole. However, if the
companies have access to genetic information, they will be able to estimate with some
accuracy when each individual is likely to die. Companies won’t want to issue
insurance to individuals who will probably die soon, and individuals who are likely to
remain healthy won’t want to buy insurance. If the information were able to
completely eliminate the uncertainty about when someone will die, then there is no
longer anything left to insure.
8. How can the favorable tax treatment of pension funds encourage saving?
Answer: When people can reduce their taxes by contributing some of their income to
a pension fund, they are more likely to do so. These individuals will save more
money for their retirement.
9. Why would property and casualty insurers have balance sheets that differ
from those of life insurance companies?
Instructor’s Manual t/a Cecchetti:
Money, Banking, and Financial Markets
Chapter 8 Financial Industry Structure
Answer: Property and casualty insurance companies have a different time horizon
from life insurance companies. Property and casualty insurance companies often
have to make a large number of payments in the near future, so their assets are
primarily short-term securities; life insurance companies do not have to make most of
their payments until well into the future, so their assets consist of longer-term
securities.
10. Insurance companies will not provide fire insurance for the full value of your
house and its contents. Why not?
Answer: Providing fire insurance for the full value of one’s house and its contents
increases moral hazard; the individual would have less of an incentive to protect his
house from burning down and would not take appropriate precautions, such as having
smoke alarms and fire extinguishers. Remember, one of the solutions to the moral
hazard problem is to ensure that borrowers and the insured have something of their
own – some net worth – at stake.
11. What are the benefits of collaboration between a large appliance retailer and
a finance company?
Answer: The appliance retailer has customers walk in the door that will need
financing to make purchases. Meanwhile, the finance company has access to funds
in financial markets. So, there are economies of scope that they two can exploit
through collaboration.
12. Why might a person who changes jobs frequently have a lower retirement
income than someone who stays with the same employer for a long time?
Answer: Companies with defined-benefit pension plans base the size of the retirement
income of a former employee on the number of years the employee worked at the
company and on the employee’s final salary. Someone who does not stay with any
particular company for very long would have a lower retirement income.
13. How do insurance companies address the problem of adverse selection?
Answer: Insurance companies screen applicants and adjust their premiums
accordingly. Someone applying for life insurance will have to undergo a physical
examination, and someone with a poor driving record will have to pay a larger
premium for car insurance.
14. Earnings on the savings accumulated under a whole life insurance policy are
not taxed. Such a policy provides insurance that pays benefits when the
policyholder dies, plus savings the policyholder can cash in before death.
What would happen to the relative demand for whole life insurance if
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Chapter 8 Financial Industry Structure
Congress passed a law making the earnings on all savings exempt from taxes?
Would insurance companies be for or against such a law? Why?
Answer: If Congress passed a law making the earnings on all savings exempt from
taxes, then there would be no advantage to investing one’s savings in a life insurance
policy instead of in another type of account. Insurance companies would be against
this because less people would purchase whole life insurance.
15. California experiences periodic wildfires that destroy significant numbers of
homes. What would happen to the insurance market if the government
passed a law requiring that any insurance company operating in the state
must provide fire insurance to all those homeowners who ask for it?
Answer: If the insurance companies have reinsurance, then they are already willing to
provide insurance to all homeowners who ask for it. If the insurance companies do
not have reinsurance, they will stop selling insurance policies or will raise the
premiums dramatically.
16. Could the financial system operate without securities firms?
not?
Why or why
Answer: It would be difficult for the financial system to operate without securities
firms. Without the underwriting services of investment banks, firms would find if
very difficult to issue stock. Without brokerage firms, individual investors would
not have access to the financial markets. And without mutual funds, small investors
would not be able to create diversified portfolios (and so would not invest).
17. An industry with a large number of small firms is usually thought to be
highly competitive. Is that supposition true of the banking industry?
What are the costs and benefits to consumers of the current structure of the
U.S. banking industry?
Answer: When the banking industry consisted of a large number of small firms, the
industry was less competitive than it is today. This is because each small bank had a
monopoly within its geographic area. As large banks branch across the country and
the number of small local banks falls, consumers benefit by having access to a larger
network of ATMs and by being able to engage in a wider range of financial activities
through their banks. Costs to consumers have fallen as a result of increased
competition. However, the level of personal service that consumers receive has
declined.
18. Explain the following quotation:
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Chapter 8 Financial Industry Structure
“For the farmers who needed credit in the rural South in the early years of the
20th century, the alternatives were dismal. Few banks would even consider
making agricultural loans, and those who did charged extremely high interest
rates. Rural credit was fertile ground for loan sharks, and year after year,
farmers turned over their crops to help pay exorbitant interest charges on loans
made to keep their farms operating. Should a crop fail, the chances of a
farmer extricating himself and his family from a loan shark’s clutches were
virtually non-existent.” (Raghuram G. Rajan and Luigi Zingales. Saving
Capitalism from the Capitalists. New York: Crown Business, 2003, pg. 13.)
Answer: Banks were unwilling to make agricultural loans to local farmers because if
there were a bad growing season, then a large portion of the banks’ borrowers would
default. The only way farmers could borrow money was from loan sharks.
Because farmers had no other options, the loan sharks could charge very high interest
rates.
19. When the values of stocks and bonds fluctuate, they have an impact on the
balance sheet of insurance companies. Why is that impact more likely to be
a problem for life insurance companies than for property and casualty
companies?
Answer: Property and casualty insurance companies have a different investment
horizon from life insurance companies. Because property and casualty insurance
companies are likely to have to make a large number of payments in the near future,
they invest primarily in short-term assets, like money market instruments. Payments
from life insurance companies don’t occur until far into the future, so they invest in
longer-term instruments, including stocks and bonds. Life insurance companies face
the risk that they will have to sell stocks or bonds when prices are low in order to pay
policyholders’ claims.
20. Explain how assumptions about the rate of return on a firm’s pension fund
portfolio can affect a firm’s profitability. Why might government
regulators want to monitor those assumptions?
Answer: If the rate of return on a firm’s pension fund portfolio is high, the firm does
not need to contribute as much money to the fund in order to be able to make the
promised payments to its retired employees. When a firm expects the rate of return
on its pension fund to be high, it will invest less money in the fund (or even take
money out of the fund) in order to increase its profits. However, if the rate of return
is less than expected, then the firm will have difficulty meeting its obligations to
retired employees. Government regulators monitor assumptions about rate of return,
because many private, defined-benefit pension funds are insured by the government,
so if the firm can’t meet its obligations, then the government has to step in and make
payments to retirees.
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