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exam question answers

exam question answers - 1 2 3 Explain how a bank evolves...

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1) 2) 3) Explain how a bank evolves from a primitive goldsmith and the role played by asymmetric information and moral hazard in this evolution. In the beginning, people use gold for all transactions because of its value (valuable currently and believed to hold value in the future). But gold is very heavy and hard to carry around for transactions. There is also the risk of theft, when you are carrying around gold it is very obvious, it cannot be concealed very easily. Eventually, a creative entrepreneur comes up with a brilliant financial innovation, he offers to store the gold in his warehouse and give you a receipt. In exchange for this storage and security you pay a fee. While this is safer, it is still quite inconvenient to have to go to the warehouse, take out gold, make a purchase, and then put gold back in storage. Another financial innovation occurs, the receipts become alienable. Instead of constantly taking gold out of the warehouse, you just make transactions using the receipt. This can occur once the warehouse has been in business long enough for everyone to trust that the receipts are valuable, ie, you will get all the gold back. The warehouse now has a lot of gold just sitting there not doing anything. Now that receipts are traded, the gold is not taken out very often. The warehouse comes up with another financial innovation, they decide to lend the gold in the warehouse to make money off the interest. They can also just print more receipts that are not even backed by gold to make loans, so long as they do not overdo it. During this period, when receipts are used in transactions, the gold owners do not visit the warehouse regularly. The warehouse can break the trust that has been built up originally. There is less knowledge about the actions of the warehouse and the inventory, asymmetric information. The warehouse has an opportunity to take actions that the gold owners would not approve of without them knowing, in this way moral hazard is introduced into banking. 4) Can banking ever become completely deregulated? Why or why not? No, regulation and essential services provided by the banking system are intertwined. Complete deregulation can lead to financial instability. Because of the inherent moral hazard and asymmetric information present in banking, the likelihood of a bank failure without regulation is very high. This could trigger bank runs throughout other banks, even if they are well-managed. The only solution is regulation. 5) In what ways are banks unique?
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Banks are unique in the sense that they resolve the information asymmetry problems more efficiently that other capital providers (especially for smaller, lesser-known firms). The empirical evidence shows that there is a positive stock price reaction to bank loan announcements, which is not observed in the announcements of new issues of privately placed debts or public debts.
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