Question

City Bank is considering making a \(\$ 50\) million loan to a company named Sheet-oil that wants to commercialize a process for turning used blankets, pillowcases, and sheets into oil. This company's chances for success are dubious, but City Bank makes the loan anyway because it believes that the government will bail it out if Sheet-oil goes bankrupt and cannot repay the loan. City Bank's decision to make the loan has been affected by: a. Liquidity. b. Moral hazard. c. Token money. d. Securitization.

Short answer

City Bank's decision is affected by moral hazard.

Step-by-step solution

Understanding the Concepts

Before analyzing the situation, it's crucial to understand what each term in the options means. Liquidity refers to the ability to quickly convert assets into cash without significant loss. Moral hazard is the risk that a party engages in risky behavior knowing that it is protected, often by another party (e.g., insurance or government bailout), from the consequences of that behavior. Token money involves money that has limited intrinsic value but is used as a medium of exchange. Securitization is the process of pooling various types of debt instruments to sell as bonds.

Identifying Relevant Factors in the Scenario

City Bank is considering lending to a company despite its dubious chances of success. This decision is based on the belief that a government bailout will protect the bank from the negative consequences if the company fails to repay the loan.

Connecting the Scenario to the Concepts

City Bank's decision is influenced by its belief in external support (i.e., government bailout), which aligns with the concept of moral hazard where the bank takes on risky behavior because it expects not to face the direct consequences.

Selecting the Most Appropriate Answer

Given that the bank's decision is directly affected by the expectation of a government bailout, this behavior exemplifies moral hazard. Therefore, the best choice is 'b. Moral hazard.'

Key concepts

Risk Management

In the world of finance, risk management plays a crucial role. Banks and companies constantly evaluate the risks associated with different investment or lending opportunities. The goal is to balance potential returns with the possibility of losses.

• Risk management involves assessing, monitoring, and controlling financial risks.
• It requires a proactive approach to identify potential threats and develop strategies to mitigate them.

In the context of the City Bank scenario, effective risk management would mean thoroughly evaluating the likelihood of Sheet-oil's success and considering the repercussions if the company fails. However, the expectation of a government bailout may make banks complacent in their risk assessment, leaning into the moral hazard as the safety net deters them from taking necessary precautions.

Government Bailouts

Government bailouts are a significant factor in economic behavior and decision-making within financial institutions. A bailout refers to the assistance provided by a government to prevent a company, sector, or industry from failing financially.

• Bailouts can come in the form of loans, cash injections, or purchasing equity stakes in the troubled entity.
• The aim is to stabilize critical economic segments and avoid broader economic fallout.

In our scenario, City Bank proceeds with the risky loan knowing that a government bailout is a possibility. This expectation influences their decision to take on more risk than they might have otherwise considered without the safety net of state intervention.

Economic Behavior

Economic behavior refers to how individuals, companies, and governments make decisions about allocating resources. This decision-making process considers costs, benefits, and the likelihood of different outcomes.

• Understanding economic behavior helps to predict and influence market trends and financial practices.
• Various factors, such as incentives, regulatory environments, and expected support mechanisms, shape these behaviors.

In the context of the moral hazard present in the City Bank case, the bank's economic behavior is swayed by its expectation of government intervention. Instead of making decisions based purely on the financial health and prospects of Sheet-oil, the bank's actions are shaped by external expectations, illustrating how potential safety nets alter rational economic decision-making.

Financial Decision Making

Financial decision making involves choosing the best course of action among various financial options, with a focus on maximizing returns while minimizing risks. This includes decisions like investments, loans, capital expenditures, and managing financial resources efficiently.

• Effective decision making requires comprehensive analysis and understanding of both current information and future projections.
• Decisions must strike a balance between short-term gains and long-term sustainability.

In our example, City Bank makes a financial decision to fund a risky venture based on the assumption of a government safety net. This decision might not optimally balance risk and reward if the bank overly relies on potential external bailout options, which can undermine diligent financial assessment and planning.