Banking Laws

Essay Questions #6
Name
Professor Morey
Spring 2022
1 Using the prisoner’s dilemma show why a conservative bank would have to take great risks in the banking industry by offering liar loans, subprime loans, Adjustable ARM loans, etc.
A prisoner's dilemma is more like a psychological mind game, whereby an individual seems to think that they know quite well what the other is thinking; and, in the process, anticipate the next move by the other party. In so doing, the person ends up making a particular move, thinking and firmly believing that the other person will make the same move as well. The person will keep on pushing their limit to new heights in the process. The same is the case with banks. They end up taking more and more risks by offering various types of loans, believing that other banks in the industry are also doing the same, so they have to do even more to be better than the competition. They end up pushing their credit rates lower to attract more clientele, not minding whether the move will be good or bad for business.
2 Show how a leveraged bank can make higher profits during a boom than an unleveraged firm. Then, show how a leveraged bank can lose much more capital during a recession than an unleveraged bank.
In a financial setting, leverage is the balance between debt and equity. It is all about having some extra cash in hand to gain an advantage. In such a boom period, a bank can get a substantial amount of money from elsewhere at a friendly interest rate then use it to finance other customers who need financing. This substantial amount received from elsewhere acts as the extra cash needed for leverage. In such a way, they remain ahead of the competition and also be way ahead of an unleveraged firm. During a recession, however, the opposite happens. The people needing the financing might end up defaulting on the loans given to them by the leveraged bank. As a result, if the bank, for example, combined $50m of its funds to an extra $50 extra leverage, then a portion of the total $100m loaned out gets defaulted, the bank will have lost a significant percentage of its capital.
3 Explain how Greenspan was guilty of the law of small numbers.
The law of small numbers shows that small samples need to be representative of the larger sample from which the small samples were taken. Conversely, the law also asserts that people would often ignore the probability of extreme outcomes. Greenspan is guilty of this law because he reduced the funds rate to 1% in the hope that it would spur economic growth through increased spending. While it did, however, the impacts were disastrous, as he altered historical economic settings that had held strong for more than two decades.
4 Explain how the subprime loan market is a market for lemons.
This market has very scanty information since much of the available information concerning it is concealed. Anyone who uses a subprime loan market is faced with a tiered payment schedule and might end up paying back an amount whose interest is way higher t...