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Problem Set 7

Chapter 18
Question 2.
Liquidity risk occurs because of situations that develop from economic and financial
transactions that are reflected on either the asset side of the balance sheet or the liability
side of the balance sheet of an FI. Asset-side risk arises from transactions that result in a
transfer of cash to some other asset, such as the exercise of a loan commitment or a line
of credit. The withdrawal of funds from a bank is an example of such a transaction.
Liability-side risk arises from transactions whereby a creditor, depositor, or other claim
holder demands cash in exchange for the claim. Another type of asset side liquidity risk
arises from the FIs investment portfolio. During the selloff, liquidity dries up and
investment securities can be sold only at fire-sale prices. A fire-sale price refers to the
price of an asset that is less than the normal market price because of the need or desire
to sell the asset immediately under conditions of financial distress.
Question 3.
Bank A is more liquid because it has more liquid assets than Bank B, although it has
less cash. Bank B probably earns a higher profit because the return on consumer loans
should be greater than the return on Treasury securities. However, comparing the loan
portfolios is difficult because it is impossible to evaluate the credit risk contained in
each portfolio.
Question 8.

Reserve requirements

= (0 x $6.0m) + ($42.1 - $6.0)(0.03) + ($225 - $42.1) (0.10)

= 0 + $1.083 + $18.29 = $19.373 million

After subtracting the average daily balance of vault cash of $7 million, the bank needs
to maintain a daily average of $12.373 million ($19.373 million - $7 million) during the
maintenance period.

The average daily balance over the maintenance period was $11 million. Therefore,
average reserves held were short $1.373 million.


For the 14-day period, the sum of its daily average is = $225 x 14 = $3,150. If $20
million is transferred on Friday, the total reduction is $120 million over two weekends
($20 x 3 days x 2 weekends), and the total 14-day balance is $3,030. The average daily
deposits will be $216.4286 million.
Reserve requirements = (0 x $6.0m) + ($42.1 - $6.0)(0.03) + ($216.4286 - $42.1) (0.10)
= 0 + $1.083 + $17.4329 = $18.5159 million. City Bank needs to maintain average
reserves of $11.5159 million ($18.5159 million - $7 million) during the maintenance
period. Since it had $11 million of reserves, extra reserves of $0.5159 per day will need
to be set aside.

Question 16

Cost of clearing checks = $0.10 x 75 x 12

Cost of managing each account =
Per check fee per account = $0.05 x 75 x 12 =
Fee received per account = $8 x 12
Total cost per account =
The average (imputed) interest cost of demand deposits = $89.00/1,500 = 5.93 percent.


If the bank has to keep 8 percent as reserves, its use of funds is limited to 0.92 x $1,500
per account, or $1,380. The average (imputed) interest cost = $89/$1,380 = 6.45


For an average imputed interest cost of 3 percent, the total cost per account = 1,500 x
0.03 = $45. This means that the per-check fee should be increased to $89 from $45.
Thus, the fee per check should be raised to $89/(75 x 12) = $0.10 (actually $0.0989) per

Question 17

Gross interest return = Explicit interest return + Implicit interest return

Interest earned by account holder $1,000 x (0.04/2) =
Implicit fee earned on checks $0.03 x 60 x 12 =
Average deposit maintained during the year (500) + (1,000)


Average interest earned = $41.60/750 = 5.55 percent


What is the average return if the bank lowers the minimum balance to $400?
If the minimum balance requirement is lowered to $400, the account holder earns an
extra $500 x (0.04/2) = $10 in interest. The average interest earned = $51.60/750 = 6.88


If the bank only pays interest on balances in excess of $400, the explicit interest earned
= $100 x 0.02 + $600 x 0.02 = $2 + $12 = $14. The implicit fee earned on checks =
$21.60, and the average interest earned = $35.60/$750 = 4.75%


How much should the bank increase its check-clearing fee to ensure that the average
interest it pays on this account is 5 percent? Assume that the minimum required balance
is $750.
Interest earned (both explicit and implicit) = $750 x 0.05 = $37.50. Fees to be earned
through check clearing = $37.50 - $20 = $17.50. Fee subsidy per check = 7.50/(60 x
12) = $0.0243. So, the bank should charge $0.05 - $0.0243 = $0.0257 per check.

Question 26
First, insurance companies can reduce their exposure by diversifying the distribution of
risk in the contracts they write. In addition, insurance companies can meet liquidity
needs by holding relatively marketable assets to cover claim payments.

Chapter 19
Question 2
Bank runs are costly to society since they create liquidity problems and can have a
contagion effect. Because of the first-come, first-serve nature of deposit liabilities,
bank depositors have incentives to run on the bank if they are concerned about the
bank's solvency. As a result of the external cost of bank runs on the safety and
soundness of the entire banking system, the Federal Reserve has put into place a safety
net to remove the incentives to undertake bank runs. The primary pieces of this safety
net are deposit insurance and other guaranty programs that provide assurance that funds
are safe even in cases when the FI is in financial distress. Other elements of the federal
safety net are access to the lender of last resort (discount window borrowing), reserve
requirements, and minimum capital guidelines.
Question 6
A risk-based insurance program should deter banks from engaging in excessive risktaking as long as it is priced in an actuarially fair manner. Such pricing currently is
being practiced by insurance firms in the property-casualty sector. However, since the
failure of commercial banks can have significant social costs, regulators have a special
responsibility towards maintaining their solvency, even providing them with some form
of subsidies. In a completely free market system, it is possible that banks located in
sparsely populated areas may have to pay extremely high premiums to compensate for a
lack of diversification or investment opportunities. Such banks may have to close down
unless subsidized by the regulators. Thus, a strictly risk-based insurance system may
not be compatible with a truly competitive banking system.
Question 8
Two ways of imposing stockholder discipline to prevent excessive risk taking are (a)
through a risk-based deposit insurance program, and (b) through increased capital
requirements and increased disclosure.
Risk-based deposit insurance premiums ensure that banks engaging in riskier activities
will have to pay higher premiums. One reason for the S&L crisis has been the fixedrate deposit insurance premiums that did not differentiate between risky and
conservative banks. As a result, stockholders of FIs in financial difficulties had nothing
to lose by investing in projects that had high payoffs because depositors were protected
by the FDIC insurance program.
Stockholder discipline also is increased if banks are required to hold more capital as
well as requiring more financial disclosures. The more capital a bank has, the less

likely the failure of a bank in the event of a decline in the market value of assets. This
protects not only the depositors but also the FDIC, which provides the insurance.
Greater disclosure also allows regulators and outside analysts to make more informed
judgments on the viability of the institution, raising the stock prices of better-managed
FIs and lowering the stock prices of those that are excessively risky.
Question 11
Capital forbearance refers to regulators permitting an FI with depleted capital to
continue operations. The primary advantage occurs in the short run through the savings
of liquidation costs. In the longer run, the likely cost is that the poorly managed FI will
become larger, more risky, but no more solvent. Eventually even larger liquidation
costs must be incurred.
Question 17

The purpose for implementing this strategy was to pass more of the failure resolution
cost to uninsured depositors.
Upon failure the good assets and the insured deposits are transferred to a takeover DI.
In addition an amount of uninsured deposits equal to the remaining amount of
uncovered good asset also are transferred to the assuming DI. Uninsured depositors lose
a portion of their deposits based on the difference between the estimated value of the
assets and the amount of insured deposits in the DI.


Because uninsured depositors assume all of the losses, they have a much stronger
incentive to monitor and control the actions of DI owners.