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Chapter 12 Problems and Solutions

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					Chapter 12 Problems and Solutions
  1. Explain why one bank might want to borrow from another bank.

  Answer: Banks borrow from other banks when their reserves run low. Bankers prefer
  to deal with deposit outflows by borrowing, rather than by selling securities or loans,
  because they do not want to shrink the size of their balance sheets. Furthermore, a
  bank that has a good lending opportunity does not want to turn it down for lack of
  funds.

  2. Why are checking accounts no longer an important source of funds for
     commercial banks in the United States?

  Answer: Checkable deposits make up only 10 percent of banks’ total liabilities. As a
  result of financial innovations, consumers can keep their funds in accounts that pay a
  higher rate of interest than checking accounts and have funds automatically
  transferred to their checking accounts when their balances are low. This has reduced
  the importance of checking accounts as a source of funds for commercial banks.

  3. Why would bankers be pleased with a reduction in the reserve requirement?

  Answer: Holding reserves is costly for banks, so bankers prefer to hold less reserves.

  4. Suppose you have decided to invest in a bank, and are trying to choose which one
     would make the best investment. You have asked your investment adviser for
     information on each bank you are considering, including its return on equity.
     Should you invest in the bank with the highest ROE? Why or why not?

  Answer: ROE is the bank’s net profit after taxes divided by the bank’s capital. It is a
  measure of bank profitability and leverage. If you invest in the bank with the highest
  ROE, you will face higher risk due to higher leverage.

  5. Banks hold more liquid assets than most businesses do. Explain why.

  Answer: Banks are required to meet depositors’ demands for cash. In order to be able
  to do this, they need to hold assets that are relatively liquid. Most businesses do not
  need to be able to come up with cash on short notice, so they do not need to hold as
  many liquid assets.

  6. The volume of commercial and industrial loans made by banks has declined over
     the past few decades. Explain why. What item has counterbalanced the decline
     in the value of loans on banks’ balance sheets?

  Answer: The rise of the commercial paper market has enabled businesses to raise
  funds directly, so they do not need to borrow from banks. An increase in mortgage
  lending has counterbalanced the decline in commercial and industrial loans.
7. Explain how a bank uses liability management to respond to a deposit outflow.
   Why do banks prefer liability management to asset management?

Answer: Banks can respond to another outflow by borrowing from another bank or
from the Federal Reserve or by issuing large-denomination time deposits. Banks
prefer liability management to asset management because asset management shrinks
the size of a bank’s balance sheet, while liability management does not.

8. Banks carefully consider the maturity structure of both their assets and their
   liabilities. What is the significance of the maturity structure? What risks are
   banks trying to manage when they adjust their maturity structure?

Answer: Banks adjust their maturity structure to manage interest rate risk. Banks’
assets tend to be long-term, while their liabilities are generally short-term. If the
short-term interest rate rises, banks will have to pay a higher level of interest on their
liabilities, but the interest income from their assets will stay the same. This will
reduce the banks’ profits. Banks try to match the interest rate sensitivity of their
assets and liabilities in order to manage this risk.

9. Define ROA, ROE, and leverage and show how the three are related. Using these
   concepts together with the information in Tables 12.2 (page 290) and 12.5 (page
   313), determine the amount of equity capital in the U.S. and Japanese banking
   systems in 2001. Comment on the difference.

Answer: Return on assets (ROA) is a bank’s net profit after taxes divided by the
bank’s total assets. Return on equity (ROE) is a bank’s net profit after taxes divided
by the bank’s capital. One measure of leverage is the ratio of bank assets to bank
capital. ROA times leverage equals ROE. Therefore, capital equals ROA times
assets divided by ROE.
For the U.S. in 2001, capital = (0.0169)*($6, 454,543 million)/(0.1860) = $586,461
million.
For Japan in 2001, capital = (-0.0076)*(¥772 trillion)/(-0.1796) = ¥33 trillion.
Japanese banks had much higher leverage than U.S. banks.

10. Define credit risk. Banks face both firm-specific and economy-wide credit risk.
    How do they manage each?

Answer: Credit risk is the risk that a bank’s loans will not be repaid. Banks manage
firm-specific credit risk by carefully evaluating potential borrowers and by
diversifying their loans. Diversifying loans by lending to different geographic areas
helps banks to manage economy-wide credit risk.

11. A bank has issued a one-year certificate of deposit for $50 million at an interest
    rate of 2 percent. With the proceeds, the bank has purchased a two-year Treasury
      note that pays 4 percent interest. What risk does the bank face in entering into
      these transactions? What would happen if all interest rates were to rise 1 percent?

   Answer: The bank faces the risk that the short-term interest rate will rise, increasing
   the amount of interest the bank has to pay on the CD, but leaving the interest income
   that the bank receives from the Treasury note unchanged. With an interest rate of 2
   percent for the CD and 4 percent for the Treasury note, the bank’s annual interest
   income is 4% * $50 million = $2 million and the bank’s annual interest expenses are
   2% * $50 million = $1 million. The bank makes a profit of $2 million – $1 million =
   $1 million. If the interest rate rises 1 percent, the bank’s profit falls to (4% * $50
   million) – (3% * $50 million) = $500,000.

   12. You live in a small town and are having coffee with the owner of the local bank.
       The bank, which has only a single branch, has been accepting deposits from you
       and your neighbors for decades. In the course of your conversation, the banker
       states, “We are an integral part of this community, so we lend only to the people
       who live here.” Is this strategy a sound one? What advice would you give the
       banker?

   Answer: This is not a sound strategy. If the local economy suffers, then a large
   portion of the bank’s borrowers will default. The bank should diversify its assets by
   lending to people from different geographic locations.

   13. You are managing a bank with $1 billion in assets, 3 percent of which are
       reserves; 15 percent, securities; 74 percent, loans; and 8 percent required bank
       capital. Twenty percent of the bank’s liabilities are transactions deposits; 70
       percent, nontransactions deposits; and 10 percent, borrowings.
       a. Construct the bank’s balance sheet.
       b. If the reserve requirement on transactions assets is 10 percent, what are the
           bank’s required reserves? Its excess reserves?
       c. In the event of a $20 million withdrawal, what options are available to you to
           meet the demand for funds? List them in preferential order, and explain your
           preferences.

Answer:
      a.
                             The bank’s balance sheet
                 Assets                             Liabilities
      Reserves    $30 million       Transactions deposits       $200 million
      Securities  $150 million      Nontransactions deposits $700 million
      Loans       $740 million      Borrowings                  $100 million
      Capital     $80 million

      b. Required reserves = $200 million * 10% = $20 million
         Excess reserves = $30 million - $20 million = $10 million
       c. The bank can manage the withdrawal by adjusting its assets or liabilities. The
          bank will prefer to adjust its liabilities since doing so does not shrink the size
          of its balance sheet. The bank can adjust its liabilities by borrowing from
          other banks or by attracting new deposits (issuing large-denomination time
          deposits). If the bank were to adjust its assets, it could sell securities or loans,
          or use some of its capital to meet the withdrawal. It could also refuse to
          renew a loan that has come due.

   14. Define operational risk and explain how a bank manages it.

   Answer: Operational risk is the risk that a bank will become physically incapable of
   operating (because its computer systems have failed or its building has become
   inaccessible). This risk can be managed by having backup sites that are far away
   from the bank’s primary location.

   15. On the Federal Reserve Board’s web site,
       http://www.federalreserve.gov/releases/, under statistical releases, you will find a
       weekly release called H.8, “Assets and Liabilities of Commercial banks in the
       United States.” Download the most recent release and construct a table that
       matches Table 12.1 (page 288) using the data in the release.
       a. Compare your table to Table 12.1. What are the differences in the data? How
           can you explain them?
       b. Find the current level of nominal GDP in the United States and use it as a
           scale for the numbers in your table. Describe what you find.

Answer:

            I.          Balance Sheet of U.S. Commercial Banks, May 2004
Assets in billions of dollars (numbers in parentheses are percentage of the total assets)
Cash Items (including reserves)                                                336.5 (4.4)
Securities                                                                    1922.3 (25.0)
     U.S. Government and agency                              1187.0 (15.4)
     State and Local Government and other                      735.4 (9.6)
Loans                                                                         4900.3 (63.7)
     Commercial and Industrial                                877.1 (11.4)
     Real Estate (including Mortgage)                        2378.2 (30.9)
     Consumer                                                 647.5 (8.4)
     Interbank                                                313.8 (4.1)
     Other                                                     683.7 (8.9)
Other Assets                                                                   599.8 (7.8)
Total Commercial Bank Assets                                                      7686.8

Liabilities in billions of dollars (numbers in parentheses are percentage of the total
liabilities)
Checkable Deposits                                                                 676.7 (9.6)
Nontransaction Deposits                                                           4337.6 (61.4)
     Savings Deposits and Time Deposits                         3245.9 (45.9)
     Large, Negotiable Time Deposits                            1091.7 (15.4)
Borrowings                                                                        1527.4 (21.6)
     From banks in the U.S.                                      431.8 (6.1)
     From nonbanks in the U.S.                                  1095.6 (15.5)
Other Liabilities                                                                  503.0 (7.1)
Total Commercial Bank Liabilities                                                    7066.6
Bank Assets – Bank Liabilities = Bank Capital                                         642.1

Source: Data are for May 26, 2004, seasonally adjusted, from Board of Governors of the Federal
Reserve System statistical release H.8. “Assets and Liabilities of Commercial Banks in the United
States,” available at www.federalreserve.gov/releases/h8/current.

        a.   Because the data in this table and the data in Table 12.1 are only a month
             apart, there aren’t any significant differences between the two. However,
             changes in the interest rate could change the composition of both the assets
             and liabilities of U.S. banks.

        b. In May 2004, nominal GDP, as estimated by the Bureau of Economic
           Analysis was $11,459.6 billion. Bank assets were equivalent to 67.1 percent
           of GDP. Cash was 2.9 percent of GDP, the value of securities held by banks
           was 16.8 percent of GDP, and the value of loans by banks was 42.8 percent of
           GDP. Bank liabilities were equal to 61.7 percent of GDP. The value of
           checkable deposits was 5.9 percent of GDP, the value of nontransaction
           deposits was 37.9 percent of GDP, and the value of bank borrowing was 13.3
           percent of GDP. Bank capital was equivalent to 5.6 percent of GDP.

				
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