Chapter 01 - Why Are Financial Institutions Special?
1-1
Solutions for End-of-Chapter Questions and Problems
1. What are five risks common to financial institutions?
Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets
and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating cost risks.
2. Explain how economic transactions between household savers of funds and corporate users
of funds would occur in a world without financial institutions.
In a world without FIs the users of corporate funds in the economy would have to directly
approach the household savers of funds in order to satisfy their borrowing needs. This process
would be extremely costly because of the up-front information costs faced by potential lenders.
Cost inefficiencies would arise with the identification of potential borrowers, the pooling of
small savings into loans of sufficient size to finance corporate activities, and the assessment of
risk and investment opportunities. Moreover, lenders would have to monitor the activities of
borrowers over each loan's life span. The net result would be an imperfect allocation of resources
in an economy.
7. What are five general areas of FI specialness that are caused by providing various services
to sectors of the economy?
First, FIs collect and process information more efficiently than individual savers. Second, FIs
provide secondary claims to household savers which often have better liquidity characteristics
than primary securities such as equities and bonds. Third, by diversifying the asset base FIs
provide secondary securities with lower price-risk conditions than primary securities. Fourth, FIs
provide economies of scale in transaction costs because assets are purchased in larger amounts.
Finally, FIs provide maturity intermediation to the economy which allows the introduction of
additional types of investment contracts, such as mortgage loans, that are financed with shortterm deposits.
11. How do financial institutions help individual savers diversify their portfolio risks? Which
type of financial institution is best able to achieve this goal?
Money placed in any financial institution will result in a claim on a more diversified portfolio.
Banks lend money to many different types of corporate, consumer, and government customers.
Insurance companies have investments in many different types of assets. Investments in a mutual
fund may generate the greatest diversification benefit because of the fund’s investment in a wide
array of stocks and fixed income securities.
12. How can financial institutions invest in high-risk assets with funding provided by low-risk
liabilities from savers?
Diversification of risk occurs with investments in assets that are not perfectly positively
correlated. One result of extensive diversification is that the average risk of the asset base of an