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engineering
contemporary financial intermediation

Questions and Answers of Contemporary Financial Intermediation

Can you explain intuitively why capital can resolve asset substitution moral hazard?
Discuss intuitively how capital can help the bank to resolve “adverse selection” problems. It would be useful to start out by explaining first what we mean by “adverse selection,” and why it
Please address the following questions:a. What is a reverse LBO?b. What are the main reasons why customers of banks become higher-quality credits after reverse LBOs?c. Why are we observing such a
What is the extent of secured lending among C&I loans? What are the two main types of collateral?
What are the costs of collateral? Why is “outside” collateral so popular despite these costs?
What is “underinvestment moral hazard”? Explain the intuition underlying the claim that collateral can attenuate this moral hazard. What are the implications of this for the design of bank loan
What is a “contract receivable”? Why is it usually more risky than an “accounts receivable”?
What are the main sources of credit information for banks in conducting credit analysis?
What is the role of ratio analysis in credit assessment? What are its limitations?
Overheard was the following conversation between two friends:Tom: I find it offensive that a bank would tell me what to do and what not to do when it makes me a loan. After all, I own the asset
What are “affirmative covenants,” “restrictive clauses,” “negative covenants,” and “default provisions”? Discuss the role of each in the design of credit contracts.
You are a bank loan officer. ABC Corporation has requested a $2.1 million loan. The corporation has $2 million in retained earnings and an existing debt obligation that calls for a repayment of $4
Consider a firm that needs $350 to invest in a project that will yield a single cash flow one period hence. The firm knows the probability distribution of this cash flow, but no one else does. As a
Consider a firm that can invest $250 right now, at t = 0, in a project that will yield a single cash flow one period hence, at t = 1. This $250 investment will be raised by issuing unsecured debt at
Given below is an excerpt from a conversation. Critique it.a. Butterworth: I’ll let that pass because I want to address your question, Mike. You know over 70% of business loans are secured, and
What is the “lending function” and how can it be decomposed? What is the usefulness of the decomposition?
Suppose that you are the loan officer for the Midtown Community Bank and you know that within a particular risk class, there are two types of borrowers: low-risk borrowers and high-risk borrowers.
Suppose Midtown Community Bank has received a loan application at t = 0 from a firm that currently has no assets except for an investment opportunity available one period hence, at t = 1. The
Consider a borrower, Kiddie Toys, Inc., that can choose between two projects, S and R. Project S yields $150 with probability 0.8 and zero with probability 0.2, whereas project R yields $162 with
Suppose The Midtown Community Bank is faced with two types of borrowers that it cannot distinguish, G and B. The type-G borrower wishes to borrow $100 to invest in a single-period project that yields
Marvelous Computers, Inc. currently owes its creditors $120. It is run by an entrepreneur, Mr. Bill Doors, who could manage the firm for one period at a personal cost of $5. Mr. Doors has a unique
Consider Marvelous Computers managed by Mr. Bill Doors. The firm has two kinds of debt outstanding: senior debt under which it owes $100 to bondholders, and a subordinated bank loan that requires a
Having survived earlier travails, Marvelous Computers finds itself in trouble again. It now has three types of debt: a bank loan with the highest priority, senior debt owned by bondholders with the
Suppose a firm has no assets at t = 0, except an option to acquire an investment opportunity at t = 1 for $500 million.The outlay required for this investment will be raised entirely through a bank
What is credit rationing? Why would it ever be rational for a profit-maximizing bank to ration credit?
What are the three main types of financial distress? Why would lenders be willing to restructure debt when the borrower is experiencing mild financial distress? What kinds of accommodations are
What sort of restructuring are lenders willing to engage in when the firm is experiencing moderate financial distress and why?
What sort of incentives do lenders have to restructure debt when there is severe financial distress and why?
What is a “bridge loan” and how is it related to “merchant banking”?
What is DIP fi nancing and why might it be advantageous to existing creditors?
Discuss the kinds of coordination problems that can come up in loan workouts and how they might be solved.
You are a banker and are confronted with a pool of loan applicants, each of whom can be either low risk or high risk. There are 600 low-risk applicants and 400 high-risk applicants and each applicant
Imagine this is January 1, 2002. You are head of the loan department at the High Growth Bank of Los Angeles. Mr. Alex Walker, the founder and CEO of ABC, Inc., a small manufacturing firm, comes to
Consider a borrower that can choose between two projects, S and R, each of which will pay off a random amount one period hence. Project S will yield $250 with probability 0.9 and zero with
Consider a fi rm managed by an entrepreneur. The fi rm has two kinds of debt outstanding: senior debt under which it owes $150 to bondholders, and a subordinated bank loan that requires a repayment
Describe the bank’s spot-lending process, with particular emphasis on the roles of information-processing-capacity constraints and randomness in loan demand.
What is syndicated lending and what economic functions does it serve?
Why is a syndicated loan like a relationship loan and why is it like a transaction loan?
What roles do senior and junior lenders play in a syndicated loan?
What is project finance and what economic functions does it serve?
Why is leverage typically higher in project-financed ventures than in conventional financing?
Why is project financing typically used only for very large projects?
Why would securitization emerge in project financing? What are the parallels between this and the development of secondary market trading for syndicated loans?
What is an OBS contingent claim, and what are the major types of contingent claims observed today?
Defi ne a loan commitment and briefl y discuss the different types of loan commitments.
Provide discussion of the supply-and-demand-side motivations for loan commitments.
Discuss the risks faced by commercial banks in loan commitments, L/Cs, and interest rate swaps.
Critique the following excerpt from a conversation.Moderator : Hold it there people. Remember, I cannot be here forever. I thought we were discussing banking reform and deposit insurance. Does all
1. Suppose the North American Bank has originated a portfolio of loans. North American knows that the aggregate payoff on this portfolio will be $100 with probability 0.9 and $30 with probability
Suppose the North American Bank has two loans, each of which is due to be repaid one period hence. The cash flows are independent and identically distributed random variables. Each loan will repay
The North American Bank needs to raise $50 in financing at the beginning of the period to finance an investment that will yield a random payoff at the end of the period. This payoff has the following
4. Suppose there are three possible assets from which the North American Bank can choose two to securitize. Call these assets a, b, and c. The assets are quite similar and their cash-flow
What are the four basic components of a lending transaction? Why were these unified in the first place and why are they being decomposed now through securitization?
Discuss pass-through (both static and dynamic pool), ABBs, and pay-through, with particular focus on the differences between these contracts.
Why are pass-throughs more popular than pay-throughs, and why are REMICs now replacing pass-throughs?
What are I/O – P/O strips and how can they be used to hedge interest-rate risk?
What is asset-backed commercial paper? Why has it become popular? Why don’t corporations avoid banks and directly issue secured commercial paper?
Are there any “natural” limits to securitization? What are these? What sort of assets are most likely to be securitized and what assets are likely to be securitized?
Explain how a financial institution can use securitization as a tactical tool for balance sheet management and pricing, and as a strategic weapon for market penetration and diversification.
What does the anticipated future growth of securitization portend for the viability of banks and the ability of the Fed to control monetary aggregates?
Suppose bank A has two loans, each of which is due to be repaid one period hence and whose cash flows are independent and identically distributed random variables. Each loan will repay $250 to the
Given below is a conversation. Critique it.Moderator: O.K.! That’s one for you, Alex. But I don’t understand one thing. If banks are allowed to invest only in very safe assets, what happens to
What measures were used to cope with bank runs and panics prior to federal deposit insurance? Why were these not entirely satisfactory?
What is a bank run and how can you explain a run on economic grounds?
How does deposit insurance prevent runs and panics?
Explain the similarity between deposit insurance and a common stock put option and how this leads to moral hazard.
Why did deposit insurance work so well in the United States until 1980 despite the obvious moral hazard, and why did it fail after that?
Discuss the roles of bank managers, accountants, regulators, and politicians in the “great banking/S&L debacle.”
What is liability management and what are its main objectives?
What is the agency problem between the shareholders and managers of a bank in liability management?
Is moral hazard unethical, illegal, or neither? Can you outline a conceptual framework for defining unethical behavior by a depository institution?
What aspects of S&L/bank behavior would you consider unethical? For example, were junk bond investments unethical? Be sure to take an ex ante perspective and not use “20-20 hindsight.”
Why do you think unethical behavior became so rampant in the last decade and not prior to that? Did people change? Did morals decline in general? Did the environment change? Can you relate unethical
Consider a bank that receives a $1 deposit from each of 200 different depositors at t = 0. It invests $25 of shareholders’ equity in the bank and lends $200, keeping $25 as cash reserves. Out of
Why do you think shadow banking grew so much in the last two decades? What does it imply about systemic fi nancial risks?
1. Suppose there is a bank that can make a loan of $100 at t = 0. The loan will repay at t = 1. The loan finances a project that a borrower can invest in. The borrower can choose one out of three
What are the common myths related to the role of capital in banking? Why are these myths wrong?
Is the M&M capital structure irrelevance theorem applicable in banking? Why or why not?
What are the two main theories of bank capital structure? Provide an assessment of each based on empirical evidence.
Why do you think banks have so much more leverage than non-financial firms?
Suppose a bank can make a loan of $120 at t = 0. The loan will repay at t = 1 and it fi nances a project that a borrower can invest in. The borrower can choose from one of the three mutually

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