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.