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:

a. liquidity.

b. moral hazard.

c. token money.

d. securitization

Short answer

The correct answer is option b) moral hazard.

Step-by-step solution

Step 1. Explanation for the correct answer

The City Bank is giving out loans to the Sheetoil company, and there is a chance of the company being unsuccessful. So the chances of the repayment of the loan which they approved are very low or risky. So it ends up as a moral hazard for the bank, which results in a high risk because of a low chance of success.

Step 2. Explanation for incorrect options

The giving out of loans in this scenario is not affected by the matter of liquidity. Liquidity refers to the easy convertibility of resources and other assets. But here, it is about the risk and repayment. So, option “a” is also incorrect.

Token money is referred to the intrinsic value of money that is lower than its face value.Anything which is accepted or received as money is also said as token money. Here bank gives them money and receives it in the form of money. So, option “c” is also incorrect.

Securitization refers to the process by which the assets are pooled into interest-bearing securities. Here pooling of securities is not required as they have decided to give out loans and securitization only is a matter when they defer payment or are not able to pay the loan. So, option “d” is also incorrect.