Provide a BRIEF AND CONCISE answer to each question. There are 25 points on this exam.
(4 points) Prepare the balance sheet of a bank that has $20 million in reserves, $40 million in securities, $140 million in loans, $150 million in deposits, and $50 million in equity capital.
What are the bank’s excess reserves if the reserve requirement is 10% of deposits? (1 point)
Excess reserves = $20-$150*10% = $5 million
Suppose that checks drawn on the bank’s accounts withdraw $10 million. Show what the revised balance sheet looks like? (0.5 point) How much additional reserve does the bank need? (0.5 point)
Assets side: $10 million in reserves, $40 million in securities, $140 million in loans;
Liabilities side: $140 million in deposits, and $50 million in equity capital.
Excess reserves = $10-$140*10% = -$4 million
Suppose that the bank chooses one of the following transactions to make up its reserve deficiency: (1) sell securities; (2) call in loans; (3) borrow from other banks; (4) issue equity shares.
For each of the above 4 options, show what the balance sheet looks like after each transaction. (0.5 point for each transaction).
After selling securities, the assets side of the balance sheet is: Reserves $14 million, Securities $36 million, Loans $140 million. Liabilities side is the same as that in b.
After calling in loans, the assets side of the balance sheet is: Reserves $14 million, Securities $40 million, loans $136 million. Liabilities side is the same as that in b.
After borrowing from other banks, the assets side of the balance sheet is: Reserves $14 million, Securities $40 million, loans $140 million. Liabilities side is: Deposits $140 million, Borrowing from other banks $4 million, Equities $50 million
After issuing equity shares, the asset side of the balance sheet is: Reserves $14 million, Securities $40 million, loans $140 million. Liabilities side is: Deposits $140 million, Equities $54 million.
(4 points) If you were a banker who believed that interest rates were about to decline, use gap and duration analysis to explain what you would try to do with your bank’s balance sheet and why it makes sense to do so. (2 points each for gap/duration analysis, 1 point on “what” and 1 point on “why” respectively).
If I were a banker, I would rearrange the balance sheet to:
a. Decrease rate-sensitive assets and increase rate-sensitive liabilities to make the GAP negative, because when GAP is negative, if the interest rate declines, the bank profits will increase.
b. Lengthen the duration of assets and shorten the duration of liabilities. When the interest rate declines, market values of both assets and liabilities increase. By lengthening the duration of assets and shortening the duration of liabilities, one can make the increase in the value of liabilities smaller than the increase in the value of assets, thus contributing to an increase in the bank’s net worth.
(5 points) Suppose that the First National Bank has the following balance sheet (in million dollars):
Assets: Reserves 10; Loans 35;
Liabilities: Deposits 35; Bank capital 10.
Suppose that the Second National Bank has the following balance sheet (in million dollars)
Assets: Reserves 5; Loans 40;
Liabilities: Deposits 40; Bank Capital 5.
a. If net profits of the First and Second National Banks are both $1 million dollars, then what are the return on asset (1 point) and the return on equity for each bank (1 point)?
b. Suppose that both banks suffer a loan loss of $6 million, How will their balance sheets look like now? (1 point for each balance sheet)
For the First National Bank,
Assets: Reserves 10; Loans 29;
Liabilities: Deposits 35; Bank Capital 4.
For the Second National Bank,
Assets: Reserves 5, Loans 34;
Liabilities: Deposits 40, Bank Capital -1.
c. Based on your answer to b, what has happened to the Second National Bank? Explain your answer. (1 point)
The Second National Bank has gone bankrupt due to the loan loss. This is because its assets are now insufficient to cover all the liabilities to outside creditors.
(4 points) If lower money growth is associated with lower future inflation and if announced money growth turns out to be extremely low but is still higher than the market expected, what do you think would happen to long-term bond prices?
Because inflation is higher than expected, expectations of future short-term interest rates will be higher, and as a result, long-term interest rates would rise. The increase in long-term interest rates implies that long-term bond prices will fall.
(4 points) Briefly explain the intentions of regulators when they introduced the deposit insurance into the banking system (1 point). Describe the moral hazard and adverse selection problems brought by the deposit insurance system (1.5 points for each problem).
Regulators originally wanted to instill confidence in the banking system by insuring deposits, thus preventing bank runs like those in the 1930s.
However, the deposit insurance has brought about moral hazard and adverse selection problems.
Moral hazard: insured depositors (principal) no longer have the incentives to monitor their banks (agents). Banks, especially large banks, are inclined to take on more risks given that they are now monitored by bureaucrats at FDIC, instead of depositors who are supposed to have keen interest in their operation.
Adverse selection: This moral hazard problem further leads to adverse selection problem as crooks would want to open banks due to lack of monitoring.
(4 points) Below is a quote from Wall Street Journal Oct 14.
”Some of private equity's founding fathers are considering going public -- with good reason. Buyout barons like Kohlberg KravisRoberts's Henry Kravis, Carlyle Group's David Rubenstein and Blackstone Group's Steve Schwarzman have transformed their cottage boutiques into global megafund complexes that scoop up businesses with borrowed money in hopes of later selling them for a profit. It is only natural they would want to cash in some of their chips on franchises they have built up over decades
But none apparently wants to be the first to disrobe in public. One reason is that valuing private-equity firms is especially difficult given their earnings volatility….
As a result, the first firm coming to market may command a lower valuation until investors grow comfortable with how they make money. So the private-equity firm pioneering an IPO might pave the way for others to reap greater rewards.”
a. What information asymmetry problem is involved here (1 point)?
Adverse selection problem is involved here since the public has difficulty distinguishing good firms from bad ones due to the difficulty in valuing these firms with volatile earnings.
b. Use economic theory to explain why none of the buyout barons would want to be the first to disrobe in public (3 points).
Since investors cannot distinguish good business (peaches) from bad ones (lemon), they may price each firm as average. As a result, good business may be undervalued due to lack of information on this particular type of business. That is why these buyout barons would not want to be the first to disrobe in public.