Econ 121 Midterm Exam – II
Instructor: Chao Wei
Provide a BRIEF AND CONCISE answer to each question. There are 25 points onthis exam.
- (6 points) Prepare the balance sheet of a bank that has $20 million in reserves, $40 million in securities, $140 million in loans, $180 million in deposits, and $20 million in equity capital.
- What are the bank’s excess reserves if the reserve requirement is 10% of deposits? (1 point)
Excess reserves = $20-$180*10% = $2 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: $170 million in deposits, and $20 million in equity capital.
Excess reserves = $10-$170*10% = -$7 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 $17 million, Securities $33 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 $17 million, Securities $40 million, loans $133 million. Liabilities side is the same as that in b.
After borrowing from other banks, the assets side of the balance sheet is: Reserves $17 million, Securities $40 million, loans $140 million. Liabilities side is: Deposits $170 million, Borrowing from other banks $7 million, Equities $20 million
After issuing equity shares, the asset side of the balance sheet is: Reserves $17 million, Securities $40 million, loans $140 million. Liabilities side is: Deposits $170 million, Equities $27 million. - The advantages of selling securities: very liquid market, low transaction cost (0.5 point);
The disadvantages of selling securities: forgone interest earnings, possible capital loss (0.5 point).
The advantages of borrowing from other banks: also a liquid market convenient to borrow; no need to forgo profitable opportunities due to lack of resources (0.5 point);
The disadvantages of borrowing from other banks: reduce the ratio of equity to the total asset, thus making the bank more risky (0.5 point).
- (5 points) GAP and Duration Analysis
(a) Suppose that you are the manager of a bank that has $15 million of fixed-rate assets, $30 million of rate-sensitive assets, $25 million of fixed-rate liabilities, and $20 million of rate-sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen to bank profits if the interest rate rises by 5 percentage points. (2 points)
GAP = Rate-sensitive assets – Rate-sensitive liabilities
= 30 – 20 = $10 million
Change in bank profits = 5%*(30-20) = $0.5 million
Given the GAP, bank profits will increase by $0.5 million if the interest rate rises by 5 percentage points.
(b) Suppose a bank has assets of $100 million with duration of 12 years, and liabilities of $93 million with duration of 6 years. What will happen to the net worth of the bank if the interest rate unexpectedly increases by 2% (3 points)?
Percentage change in asset value = -2%*12 = -24%;
Percentage change in liability value = -2%*6 = -12%
Absolute change in asset value = -100*24% = -$24 million
Absolute change in liability value = -93*12% = -$11.16 million
net change in net worth = -24-(-11.16) = -$12.84 million
The net worth of the bank will decline by $12.84 million. - (3 points) Quote from the Wall Street Journal Oct 23, 2008:
“Amazon.com Inc. reports a 48% increase in profit and a 31% revenue jump for the third quarter, but issued a cautious projection ahead of the key holiday season. The revised sales outlook comes just three months after the Seattle-based internet retailer had raised its revenue forecast for the year, showing how quickly the consumer spending environment has declined. Amazon shares fell more than 13% on the news.”
Please explain why Amazon shares declined despite increases in profits and revenues?
According to the efficient market hypothesis, prices reflect all publicly available information. Prices of Amazon shares already reflect the expectation of high revenue forecast made three months ago. The recent “cautious” projection of the key holiday season is bad news for the market. As a result, despite the increase in profits and revenue jump for the third quarter, Amazon shares fell due to revised outlook of the holiday season.
- (5 points) Joe deposits $1 million dollars in a bank called Magna, which pays commission to Ace Mortgage Brokers to make loans on its behalf. Ace mortgage brokers make mortgage loans to John without verifying his income or employment records. George the government regulator is assigned the duty to monitor Magna’s loan activities. Describe all the moral hazard problems for the five parties involved and identify the principal and the agent for each moral hazard problem.
1) Joe the principal and Magna the agent. Magna tends to take on too much risk using Joe’s deposits.
2) Magna the principal and Ace the agent. Ace tends to make risky loans for commission instead of carefully checking borrowers’ background on Magna’s behalf.
3) Ace the principal and John the agent. John tends to take out risky mortgage loans from Ace and thus having a high chance of bankruptcy.
4) Joe the principal and George the government regulator. George is hired to monitor Magna on behalf of Joe. But George tends to shirk his duties since it is not his own deposits being misused by Magna. - (4 points)
(a) Briefly explain the intentions of regulators when they introduced the deposit insurance into the banking system (1 point).
Regulators originally wanted to instill confidence in the banking system by insuring deposits, thus preventing bank runs like those in the 1930s.
(b) Describe the moral hazard and adverse selection problems brought by the deposit insurance system (1point for each problem).
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.
(c) What are the up and down sides of a partial deposit insurance (that is, only a fraction of deposits is insured) (1 point)?
The up side is that the depositors will have stronger incentives to monitor the banks when part of their deposits is at stake. The down side is that bank runs cannot be prevented with partial deposit insurance. - (2 points)Credit rationing takes two forms. The first occurs when a bank refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate. The second occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like.
Explain why the first form is a tool to help solve adverse selection problems, while the second form is a tool to deal with the moral hazard problems.
Since the bank cannot fully observe information about a borrower, adverse selection problem is present. The borrower who is willing to pay the highest interest rate often happen to be the one who is willing to take on the highest risk. By refusing to make a loan of any amount to a borrower despite higher interest rate offered, the bank can safeguard against such type of adverse selection problem.
Since the bank cannot fully monitor the borrowers’ actions after making the loan, moral hazard problem is present. The borrower tends to take on too much risk using the loan. By restricting the size of the loan, the bank can safeguard the moral hazard problem by limiting its exposure to risk.