Question

City Bank is considering making a \(\$ 50\) million loan to a company named SheetOil 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 SheetOil goes bankrupt and cannot repay the loan. City Bank's decision to make the loan has been affected by: LO34.7 a. Liquidity. b. Moral hazard. c. Token money. d. Securitization.

Short answer

The decision is influenced by moral hazard.

Step-by-step solution

Understand the Problem

City Bank is making a decision to loan money to a company despite recognizing the company's questionable chances for success. The belief that the bank will be bailed out by the government is influencing this decision.

Define the Key Concepts

Let's break down the terms: - Liquidity refers to the ease with which an asset can be converted into cash. - Moral hazard is a situation where one party takes risks because they do not bear the full consequences of their actions. - Token money is currency that has little intrinsic value. - Securitization is the process of turning loans into tradeable securities.

Match the Scenario to a Concept

City Bank believes it will not face the negative consequences of the loan if SheetOil fails because of a potential government bailout. This describes a situation where the bank is taking a risk without bearing the potential consequences, matching the definition of moral hazard.

Identify the Correct Option

Based on the understanding from the previous steps, the situation City Bank is in closely matches the definition of moral hazard. City Bank's decision is influenced by its belief that it will not suffer a loss due to an external party (the government) stepping in.

Key concepts

Banking Risks

Banking is like walking on a tightrope. Each step, or decision, needs careful consideration to maintain balance. Banks face numerous risks that can affect their stability and profitability. One major category of these risks is credit risk. This is the risk that borrowers do not repay their loans.
Interest rate changes present another challenge. If a bank issues loans with low interest rates and rates rise sharply, it might lose money.
Operational risks, like those from system failures or fraud, also need managing.

• Credit Risk: Failure to repay loans affects bank revenue.
• Interest Rate Risk: Losses may occur if market rates increase.
• Operational Risk: Includes technological failures or unexpected disasters.

Effective risk management is crucial for banks to survive and thrive. This includes a thorough evaluation of potential loans and strategic decision-making to minimize exposure to unnecessary risks.

Government Bailouts

Government bailouts act like a financial safety net. They are used when a company or bank faces failure and the government steps in to save it, using taxpayer money. The purpose of these bailouts is to prevent widespread economic instability or market collapse. They're a contentious topic because they create an environment where institutions may engage in risky behaviors, expecting that a government rescue will save them.

• Prevention of Economic Collapse: Ensures major firms do not fail, stabilizing the market.
• Encouragement of Risk-Taking: Because of the safety net, some firms may take unnecessary risks.

While bailouts can save jobs and keep markets stable, they also reinforce irresponsible behavior by removing the direct consequences of failure. Hence, they must be used carefully and sparingly, ensuring taxpayer funds are protected and institutions remain accountable for their decisions.

Loan Decision-Making

Loan decision-making is a critical component of banking operations. This process involves assessing why, how, and to whom loans should be given. Banks must evaluate the creditworthiness of each applicant. This means checking their ability to repay by looking at their credit history, income, and overall financial health.

• Assess Creditworthiness: Review of income, credit scores, and past payment history.
• Potential Interest Earnings vs. Risks: Balancing potential earnings with security and repayment certainty.

Banks also think about the political and economic environment. An unstable market might deter extensive lending due to added risks. A successful loan benefits both parties; the borrower gets necessary funds, and the lender earns interest over time. Nevertheless, thorough assessments and calculated risks are key to sustainable and profitable banking practices.