ECON 2035- LSU Ratikan Exam 3
Review Questions Fully Solved.
Asymmetric Information - Answer A situation where one party to a transaction has more or
better information than the other (e.g., a borrower knows their own risk better than the bank).
Adverse Selection - Answer An asymmetric information problem that occurs before a
transaction. High-risk borrowers are the ones most likely to seek loans, potentially leading to a
market of only "lemons."
Moral Hazard - Answer An asymmetric information problem that occurs after a transaction.
The risk that a borrower engages in activities that are undesirable from the lender's point of
view (e.g., taking high risks with borrowed money).
Transaction Costs - Answer The time and money spent carrying out financial transactions
(e.g., legal fees, time spent researching a company).
Economies of Scale - Answer The reduction in cost per unit as the number of transactions
increases. Financial intermediaries use this to lower transaction costs.
Information Costs - Answer The costs associated with gathering information on a borrower
to reduce asymmetric information.
Collateral - Answer Property pledged to a lender to guarantee payment of a loan. If the
borrower defaults, the lender keeps the collateral.
Credit Rationing - Answer When lenders refuse to make loans even though borrowers are
willing to pay the stated interest rate (or even a higher one), usually to avoid adverse selection.
Principal-Agent Problem - Answer A type of moral hazard where the "agents" (managers)
pursue their own interests rather than the interests of the "principals" (owners/shareholders).
Relationship Banking - Answer The ability of banks to collect private information over time
about a borrower through multiple interactions, reducing asymmetric information.
Restrictive Covenant - Answer A provision in a loan contract that restricts the borrower's
actions to ensure they can repay the loan (e.g., "you must keep $\$50,000$ in cash at all
times").
, Akerlof's Expected Value Problem ("The Lemons Problem") - Answer The theory that if
buyers cannot distinguish quality, they will only offer an "average" price. High-quality sellers will
leave the market, leaving only low-quality "lemons."
Backward-Bending Supply Curve of Loans - Answer A graph showing that at a certain point,
raising interest rates actually decreases the supply of loans because the risk of adverse selection
and default becomes too high for the bank.
Asset - Answer Anything of value owned by the bank (e.g., loans, reserves, securities).
Liability - Answer Anything the bank owes to others (e.g., checkable deposits, borrowings).
Balance Sheet - Answer A financial statement showing Assets on one side and Liabilities +
Bank Capital on the other. They must always balance.
Bank Capital (Equity) - Answer The difference between a bank's total assets and its total
liabilities (Assets - Liabilities). It acts as a safety cushion against insolvency.
Checkable Deposits - Answer Bank accounts that allow the owner to write checks or use
debit cards; they are a primary liability for banks.
Reserves - Answer Funds that a bank keeps in the form of vault cash or deposits at the
Federal Reserve.
Required Reserves - Answer The minimum amount of reserves a bank is legally required to
hold.
Excess Reserves - Answer Any reserves held beyond the legal requirement (Total Reserves -
Required Reserves).
Liquidity Risk - Answer The risk that a bank will not have enough cash to meet deposit
outflows (people wanting their money back).
Interest Rate Risk - Answer The risk that changes in market interest rates will reduce a bank's
profit or capital.
Leverage - Answer The use of borrowed money to buy assets, which magnifies both
potential gains and potential losses.
Review Questions Fully Solved.
Asymmetric Information - Answer A situation where one party to a transaction has more or
better information than the other (e.g., a borrower knows their own risk better than the bank).
Adverse Selection - Answer An asymmetric information problem that occurs before a
transaction. High-risk borrowers are the ones most likely to seek loans, potentially leading to a
market of only "lemons."
Moral Hazard - Answer An asymmetric information problem that occurs after a transaction.
The risk that a borrower engages in activities that are undesirable from the lender's point of
view (e.g., taking high risks with borrowed money).
Transaction Costs - Answer The time and money spent carrying out financial transactions
(e.g., legal fees, time spent researching a company).
Economies of Scale - Answer The reduction in cost per unit as the number of transactions
increases. Financial intermediaries use this to lower transaction costs.
Information Costs - Answer The costs associated with gathering information on a borrower
to reduce asymmetric information.
Collateral - Answer Property pledged to a lender to guarantee payment of a loan. If the
borrower defaults, the lender keeps the collateral.
Credit Rationing - Answer When lenders refuse to make loans even though borrowers are
willing to pay the stated interest rate (or even a higher one), usually to avoid adverse selection.
Principal-Agent Problem - Answer A type of moral hazard where the "agents" (managers)
pursue their own interests rather than the interests of the "principals" (owners/shareholders).
Relationship Banking - Answer The ability of banks to collect private information over time
about a borrower through multiple interactions, reducing asymmetric information.
Restrictive Covenant - Answer A provision in a loan contract that restricts the borrower's
actions to ensure they can repay the loan (e.g., "you must keep $\$50,000$ in cash at all
times").
, Akerlof's Expected Value Problem ("The Lemons Problem") - Answer The theory that if
buyers cannot distinguish quality, they will only offer an "average" price. High-quality sellers will
leave the market, leaving only low-quality "lemons."
Backward-Bending Supply Curve of Loans - Answer A graph showing that at a certain point,
raising interest rates actually decreases the supply of loans because the risk of adverse selection
and default becomes too high for the bank.
Asset - Answer Anything of value owned by the bank (e.g., loans, reserves, securities).
Liability - Answer Anything the bank owes to others (e.g., checkable deposits, borrowings).
Balance Sheet - Answer A financial statement showing Assets on one side and Liabilities +
Bank Capital on the other. They must always balance.
Bank Capital (Equity) - Answer The difference between a bank's total assets and its total
liabilities (Assets - Liabilities). It acts as a safety cushion against insolvency.
Checkable Deposits - Answer Bank accounts that allow the owner to write checks or use
debit cards; they are a primary liability for banks.
Reserves - Answer Funds that a bank keeps in the form of vault cash or deposits at the
Federal Reserve.
Required Reserves - Answer The minimum amount of reserves a bank is legally required to
hold.
Excess Reserves - Answer Any reserves held beyond the legal requirement (Total Reserves -
Required Reserves).
Liquidity Risk - Answer The risk that a bank will not have enough cash to meet deposit
outflows (people wanting their money back).
Interest Rate Risk - Answer The risk that changes in market interest rates will reduce a bank's
profit or capital.
Leverage - Answer The use of borrowed money to buy assets, which magnifies both
potential gains and potential losses.
