Exercises 4 - C

Exercices 4
1 - How can the existence of asymmetric information provide a rationale for government
regulation of financial markets?
Because there is asymmetric information and the free-rider problem, not enough
information is available in financial markets. Thus there is a rationale for the government to
encourage information production through regulation so that it is easier to screen out good
from bad borrowers, thereby reducing the adverse selection problem. The government can
also help reduce moral hazard and improve the performance of financial markets by
enforcing standard accounting principles and prosecuting fraud.
2 - Suppose you are applying for a mortgage loan. The loan officer tells you that if you get
the loan, the bank will keep the house title until you pay back the loan. Which problem of
asymmetric information is the bank trying to solve?
The bank is trying to solve the moral hazard problem by placing a lien on the house title. In
general, the bank does not “keep the house title”, but it places a lien on it instead to prevent
the house owner to sell the house without its supervision. In this case, the bank wants to
make sure that you do not sell the house, get the money and never pay back the loan.
3 - Would you be more willing to lend to a friend if she put all of her life savings into her
business than you would if she had not done so? Why?
Yes. The person who is putting her life savings into her business has more to lose if the
business takes on too much risk or engages in personally beneficial activities that don’t lead
to higher profits. So she will act more in the interest of the lender, making it more likely that
the loan will be paid off.
4 - Which specific asymmetric information problem do credit-rating agencies help to reduce

in the bond market? Explain the effect of the subprime mortgage crisis on the
trustworthiness of these agencies and on the quality of information.
Credit rating agencies try to mitigate the problem of adverse selection. By compiling
information and evaluating default risks, credit rating agencies help investors to decide
which bonds have the highest risks of default and which ones are relatively safer
investments. The subprime mortgage crisis undermined the trustworthiness of these
agencies, since securities that were assigned good ratings were in fact bad investments.
5 - Define “financial frictions” in your own terms and explain why an increase in financial
frictions is a key element in financial crises.
Financial frictions are a set of conditions that prevent financial markets to effectively assign
funds to the best investment opportunities. In general they increase when information
asymmetries worsen, preventing lenders from ascertaining the best potential borrowers.
Financial frictions are a key element in financial crises because as the channeling of funds
through the financial market is interrupted or limited, the economy slows down. This could
Exercices 4
trigger an asset price decline, increase in uncertainty and the deterioration in financial
institutions´ balance sheets.
6 - How does a general increase in uncertainty as a result of a failure of a major financial

institution lead to an increase in adverse selection and moral hazard problems?
A failure of a major financial institution which leads to a dramatic increase in uncertainty in

financial markets, makes it hard for lenders to screen good from bad credit risks. The
resulting inability of lenders to solve the adverse selection problem makes them less willing
to lend, which leads to a decline in lending, investment, and aggregate economic activity.
7 - Describe two similarities and two differences between the U.S. experiences during the
Great Depression and those during the Great Recession financial crisis of 2007–2009.
Both the Great Depression and the Great Recession were preceded by sharp increases in
asset prices. During the two episodes, credit spreads widened, the availability of credit
shrank, and economic activity sharply declined. The two episodes differ in the source of
asset price increases: during the Great Depression, rising stock prices were the trigger,
whereas in the recent crisis a housing bubble was the primary trigger. During the Great
Depression, many bank failures lead to a bank panic, causing more banks to fail. During the
recent crisis, even though the banking system was hit hard and bank failures did occur, they
were much less pronounced, and no bank panic occurred. Finally, although both episodes
resulted in significant declines in GDP and increases in unemployment, this was much more
pronounced during the Great Depression, when unemployment peaked at 25% (as opposed
to the recent crisis, in which the unemployment rate reached 10.2%). In part, this is the
result of Federal Reserve policymakers trying much more aggressively to contain the
financial crisis and reverse the decline in economic activity during the recent crisis than was
true during the Great Depression.
8 - Provide one argument in favor of and one against the idea that the Fed was responsible
for the housing price bubble of the early 2000s.
Supporters of the idea that the Fed was responsible for the Great Recession financial crisis
argue that it helped to create the conditions for a housing market bubble by setting the
federal funds rate (a benchmark interbank loan rate discussed later in the text) at an
extremely low level. This action made funds cheaper to financial intermediaries and were
therefore more willing to lend to homeowners. Another argument in favor of such a
hypothesis is that the Fed was not stringent enough in its administrative task of regulating
and monitoring financial intermediaries. On the other side, supporters of the Fed´s policy
during this period cite other facts that contributed to the housing market bubble, in
particular, the lowering of lending standards and funds inflows from India and China coupled
with no attractive investment opportunities (so that eventually those funds ended up fueling
the housing market bubble). This is still an ongoing and very interesting debate.

Exercises 4 - C

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Exercices 4

4 - Which specific asymmetric information problem do credit-rating agencies help to reduce

6 - How does a general increase in uncertainty as a result of a failure of a major financial

A failure of a major financial institution which leads to a dramatic increase in uncertainty in

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