Adverse selection is a problem associated with equity and debt contracts arising from

verse selection is a problem associated with equity and debt contracts from the lenders relative lack of information about the borrowers potential returns and risks o investment activities. the lenders inability to legally require sufficient collateral to cover a 100 percent loss if the borrower defaults the borrowers lack of incentive to seek a loan for highly risky investments None of the above When a $40 check written on the First National Bank of Flagstaff is deposited in an account at the Coconino County Bank, then the liabilities of the First National Bank of Flagstaff increase by $40 the reserves of the First National Bank of Flagstaff decrease by $40 the liabilities of the Coconino County Bank fall by $40 the assets of the Coconino County Bank fall by $40 l 1. Loans are the largest category of bank assets provide most of the banks revenues. earn the highest return of all bank assets. do each of the above e, do only (a) and (b) above 12. Banks hold primary reserves, secondary reserves, and because they all provide for liquidity and against the high cost of a deposit outflow and bank failure. deposits Securities loans bank capital none of the above 13 Banks attempt to screen good from bad credit risks to reduce the incidence of loan defaults. To do this specialize in lending to certain industries or regions. write restrictive covenants into loan contracts. expend resources to acquire accurate credit histories of their potential loan customers. do all of the above 14. All of the following were reasons for the Federal Reserve Act of 1913 except the need for a Lender of Last Resort. the introduction of the free banking principle. the rigidity and inelasticity of the money supply an inefficient check collection system. all were reasons for the Act of 1913 15 Federal deposit insurance was created under the Constitution the National Currency Act of 1863 &lor the National Banking Act of 1864. the Federal Reserve Act of 1913 d. the Glass-Steagall (Banking) Act of 1933 e. none of the above

Answer

9. a) the lender’s relative lack of information about the borrower’s potential returns and risks of his investment activities. Adverse selection refers to situation where one side of market cannot observe quality of goods on the other side of market. For this reason it is also called hidden information problem. In this scenario, lender is not able to know the actual creditworthiness of the borrower. 10. b) the reserves of the First National Bank of Flagstaff decrease by $ 40. This is because deposits are the reserves of banks and when it transfers from one bank to another then reserves of bank decreases. 11. d) do each of the above.

Each bank provide loans of the amount left after keeping reserve requirement. Loans are the largest assets of the banks. They lend money on higher interest rate and give less interest rate to their depositors.

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