1. Why are secured loans an important method of lending for financial

QUESTION

1. Why are secured loans an important method of lending for financial institutions?
2. If more customers want to borrow funds at the prevailing interest rate, a financial institution can increase its profits by raising interest rates on its loans. Is this statement true, false, or uncertain? Explain your answer.
3. Why is being nosy a desirable trait for a banker?
4. A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?
5. Because diversification is a desirable strategy for avoiding risk, it never makes sense for a financial institution to specialize in making specific types of loans. Is this statement true, false, or uncertain? Explain your answer.
Answer:1 Secured loans are an important method of lending for financial institutions because if the borrowerdefaults, the financial institution can take title to the collateral, sell it off, and use the proceeds tooffset any losses on the loan. Thus the financial institution can worry less about the adverse selectionproblem because it has some protection even if the borrower was a bad credit risk. Answer:2 Uncertain. In some cases, raising rates may generate more income and thus increase profits.However, the higher interest rates do increase adverse selection in which the risk-prone borrowersare more likely to seek out the loans. Thus the rate of default might go up and bank profits couldsuffer. Answer:3 In order for a banker to reduce adverse selection she must screen out good from bad credit risks bylearning all she can about potential borrowers. Similarly in order to minimize moral hazard, shemust continually monitor borrowers to ensure that they are complying with restrictive loancovenants. Hence it pays for the banker to be nosy. Answer:4 Compensating balances can act as¦

collateral. They also help establish long-term customerrelationships, which make it easier for the bank to collect information about prospective borrowers,thus reducing the adverse selection problem. Compensating balances help the bank monitor theactivities of a borrowing firm so that it can prevent the firm from taking on too much risk, therebynot acting in the interest of the bank. Answer:5 False. Although diversification is a desirable strategy for a bank, it may still make sense for a bankto specialize in certain types of lending. For example, a bank may have developed expertise inscreening and monitoring a particular kind of loan, thus improving its ability to handle problems ofadverse selection and moral hazard.

ANSWER:

CLICK REQUEST FOR  AN EXPERT SOLUTION