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Faculty of Economics and Business
Part A: Multiple-choice questions
(17 multiple-choice questions)
1. Regarding the selection of instruments of macroprudential policy, four requirements are
listed. Which of the following is not amongst the requirements?
1. The instrument must be effective in preventing the build-up of systemic risk, i.e.
must be procyclical.
2. The instrument must offer limited opportunities for arbitrage.
3. The instrument must be aimed at the roots, not only at the symptoms of systemic
risk.
4. The instrument must be distortionary to the lowest possible extent to the financial
system and the economy.
=> 1
2. In the analysis of the subprime crisis, we encountered the notion of “credit enhancement”.
What is the correct description of this term?
1. In securitisation, some tranches will have no default risk such that the average
probability of default of the portfolio of all tranches decreases.
2. The larger the number of securities in the underlying pool that will be securitised,
the larger is the fraction of the tranches that ends up with higher credit ratings
than the average.
3. The larger the number of securities in the underlying pool that will be securitised,
the larger is the fraction of the tranches that ends up with higher credit ratings
than the average and this fraction increases when default rates are more
correlated.
4. Credit enhancement refers to the fact that after the subprime crisis, the bad credits
were written off such that the average quality of the loans in the banks’ lending
portfolios increased again.
=> 2
3. A Structured Investment Vehicle (SIV)
1. invests in Asset-Backed Commercial Papers (ABCP) and finances itself via credit
lines from the sponsoring bank.
2. is exposed to funding liquidity risk as it finances itself via issuing Asset-Backed
Securities (ABS) that have a long maturity.
3. buys pools of credit contracts such as mortgages from banks in order to sell these
contracts to investors.
4. is potentially unstable since it is exposed to a so-called maturity mismatch.
=> 4
4. Consider two mortgages of exactly the same size and assume also that each of them has a
probability of default PD and that default risks are uncorrelated. These two mortgages are
then pooled into one portfolio and that this portfolio subsequently is sliced into a so-called
senior and a junior tranche. The probability of default of the senior tranche then is
1. 1 – ((1 – PD) * (1 – PD)).
2. (1 – PD) * (1 – PD).
3. ((1+PD) * (1+PD)) – 2*PD – 1.
4. (PD * PD) – PD.
=> 3
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5. In their analysis of the causes of financial crises, the lectures mentioned the effects of an
unanticipated decline in the value of the domestic currency. Such unanticipated decline in
the value of the domestic currency worsens balance sheets through the
1. decrease in the domestic-currency value of assets that are denominated in the
foreign currency which then decreases net worth.
2. increase in the domestic-currency value of assets that are denominated in the foreign
currency which then decreases net worth.
3. increase in the domestic-currency value of debts that are denominated in the foreign
currency which then decreases net worth.
4. decrease in the domestic-currency value of debts that are denominated in the foreign
currency which then decreases net worth.
=> 3
6. Which of the following problems was mentioned in the discussion of the East-Asian crisis
of 1997-1998?
1. The fact that the liberalisation of the capital account prior to the crisis restricted
capital inflows into the crisis countries.
2. The fact that the inflation rates in the crisis countries prior to the crisis were below
the inflation rate of the United States such that deflation risks in the US caused
hefty capital inflows into the crisis countries.
3. The balance sheets of firms and banks worsened due to the maturity mismatch that
created the fear that appreciations of the currencies of the crisis countries
would massively increase the domestic-currency value of debt that was
denominated in foreign currency.
4. The fact that the basket peg of the crisis countries ensured that the exchange rate of
these countries remained constant against the US dollar prior to the outbreak of
the crisis.
=> 4
7. Assume that checkable deposits (D) are at 10000 and that the currency ratio (c) is at 20
percent. The money supply M = M2 then is at
1. 10000/1.2
2. 12000
3. 50000
4. a level that cannot be calculated on the basis of the above information.
=> 4
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8. Assume that the central bank buys €1,000,000 in government bonds from the banking
sector. At the same time, the central bank increases the required reserve ratio from 1 percent
to 4 percent. According to the simple model, this means that the money supply M1 after the
increase of the required reserve ratio will increase by ________ rather than by _________ as
in the original situation, i.e. the situation with the lower required reserve ratio.
1. €25,000,000; €100,000,000.
2. €100,000,000; €25,000,000.
3. €4,000,000; €1,000,000.
4. This question cannot be answered as we do not have information on the level of the
deposits.
=> 1
9. The banking system of country DEF is characterised by the following statistics. The
amount of deposits is at 1000, the currency ratio is at 20 percent, the excess reserves amount
to 200 and the money multiplier is at 2. The required reserve ratio then is
1. at 10 percent.
2. at 20 percent.
3. at 25 percent.
4. impossible to determine on the basis of the information that is given.
=> 2
10. Which of the following statements on price stability is correct?
1. Stable inflation rates and stable inflation expectations reduce real interest rates
according to the Fisher parity.
2. Central banks that focus on keeping inflation low do not focus on a nominal anchor,
but do focus upon a real anchor.
3. Price stability has the disadvantage of hindering the central role that relative prices
play in the allocation of the factors of production.
4. Price stability increases the benefits of holding cash.
=> 4
11. The Single Resolution Mechanism (SRM) implies that the ECB now is also responsible
for the supervision of
1. all significant banks in Europe.
2. all banks in the euro area.
3. all significant banks in the euro area.
4. This question does not make sense.
=> 4
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12. You are given the following three statements on the Federal Reserve System:
I. The Federal Reserve System has a regional representation.
II. The Federal Reserve Banks supervise and regulate financial institutions.
III. Open-market operations are conducted in a centralised manner by the individual
Federal Reserve Banks.
How many of the above statements are correct?
1. 0
2. 1
3. 2
4. 3
=> 3
13. Which of the following is not an advantage of central bank independence?
1. Independent central banks are more likely to focus on longer-run objectives.
2. Independent central banks coordinate their decisions with politicians in a stricter
manner.
3. Independent central banks are less likely to directly purchase government bonds.
4. Independent central banks are more likely to focus on stability of prices.
=> 2
14. Suppose that you read the following statement: “Assume that everything else remains
constant and that the overnight interbank interest rate in the market for reserves is below the
ECB’s deposit interest rate.” This statement
1. implies that the deposit interest rate will have to increase.
2. implies that the overnight interbank interest rate will need to decrease further.
3. implies that the lending rate will be steeply downward sloping in terms of the
remaining term to maturity.
4. does not make sense.
=> 4
15. Price stability in the mandate of the European System of Central Banks is
1. defined as “…a year-on-year increase in the Harmonised Index of Producer Prices
(HIPP) for the euro area, close to but below 2%”.
2. given a numerical value by the Board of Governors.
3. not to be achieved by the European Systemic Risk Board.
4. to be obtained via monetary policy that is implemented in a decentralised manner by
the national bank supervisors.
=> 3
16. If the central bank targets a reserve aggregate, it is likely to lose control over _________
because _________ (everything else held constant in the market for reserves).
1. the interest rate; of fluctuations in the demand for reserves
2. the required reserve ratio; of changes in the excess reserves
3. the lending rate; bond prices are inversely related to interest rates
4. the interest rate; of fluctuations in the business cycle over the medium-term
=> 1
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17. Use the Taylor rule as it was described in the lectures. Assume that the following holds:
the equilibrium real interest rate is at 1 percent, the output gap is at 1 percent, the inflation
target is at 2 percent and the nominal interest rate target of the central bank is at 3.5 percent.
We then know that
1. the inflation rate is at 1 percent.
2. the inflation rate is at 1.5 percent.
3. the inflation rate is at 2 percent.
4. the inflation rate cannot be calculated via the above information.
=> 3
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Part B: Open questions
(4 open questions: the points for each (sub-)question are mentioned between
parentheses, total points for the open questions: 40)
You may want to leave part (c) of the first open question until the end of the exam as it
may take somewhat more time.
1. This first open question deals with the valuation of bonds. (a) Write down the formula for
the price at time t of a bond with a yearly coupon rate of 6 percent, that matures in 4 years
and that has a face value of €100. Use the quantitative information that you have received
and carefully mention the name of all the symbols for which you have obtained no
numerical information. (3 points) (b) Suppose that we receive the information that the price
of this bond would be at €105 at time t. Would the yield to maturity at time t exceed the
coupon rate? If yes, explain why? If no, explain why (3 points) (c) Consider a zero-coupon
bond with face value F that will mature in one year from now and a consol with a yearly
coupon payment C. Assume that both the zero-coupon bond and the consol have a yield of 5
percent. What is the numerical relation between C and F that is required in order to ensure
that the price of the zero-coupon bond exceeds the price of the consol? (4 points). [Total: 10
points]
Answer:
(a) (3 points)
(2 points) Pt = 6/(1+i) + 6/(1+i)2 + 6/(1+i)3 + 6/(1+i)4 + 100/(1+i)4,
(1 point) where Pt denotes the price of the bond at time t and i is the yield to
maturity.
(b) (3 points in total)
(1 point) No
(2 points) the yield to maturity at time t will be below the coupon rate. Why? The
bond sells at €105 at time t, i.e. sells at a price that is above par (the par value, i.e. the
face value, is at 100).
(c) (4 points) So, i = 0.05 for the two bonds. The price of the zero-coupon bond will be
denoted by PZ and the price of the consol will be denoted by PC. PZ > PC implies
F C
1+i
>
. This inequality requires F>C
. Thus, we have the condition
1+i i
i
1+0.05
1.05
F>C
=C
=21 C . Hence, the price of the zero-coupon bond will
0.05
0.05
exceed the price of the consol if the face value of the zero-coupon bond is more than
21 times the amount of the yearly coupon payment of the consol.
Note: there was no deduction of points if the result of the ratio 1.05/0.05 was not
given.
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2. Banks are heavily regulated. One of these regulations focusses on ensuring that banks
have enough reserves to be able to satisfy deposit withdrawals. (a) Explain briefly how this
is regulated. You obviously have to use the relevant terminology (2 points). (b) In the euro
area, but also elsewhere, depositors themselves are also directly protected by a different
layer of regulation that is different from the type of regulation that you discussed under (a).
What is this element of regulation? As always you have to briefly explain your answer in
which you also need to discuss the embedded danger of moral hazard (3 points). You are
given the following balance sheet of bank Lendalot.
Assets
Reserves
Loans
Liabilities
400 Deposits
2400 Capital
2800
2000
800
2800
The bank Lendalot is confronted with a deposit outflow of 400. At the same time, a new
client arrives who wants a loan of 200. What is the minimum amount of new deposits that
the bank Lendalot must attract to both have enough required reserves to fulfil its legal
requirements (20% of deposits) as well as have enough excess reserves to provide the loan
of 200? You need to assume that there are no other options for increasing reserves. (5 points)
[total: 10 points]
Answer.
(a) (2 points) Banks are required to keep a certain amount of their deposits as reserves.
These are the so-called required reserves that are to be calculated by multiplying the
total amount of deposits by the so-called required reserve ratio.
(b) (3 points: 1 point for the guarantee and 2 points for the link to moral hazard) In the euro
area, deposits are protected, i.e. guaranteed, up to €100,000. Such deposit-guarantee
system should convince depositors that their deposits are safe at all times (at least up
to €100,000) which then should minimise the risk of bank runs when for instance a
bank fails or is rumoured to be on the verge of collapse. However, such guarantee
can create moral-hazard behaviour at the level of the depositor when he/she – due to
the deposit guarantee – focusses solely on the deposit interest rate that is offered by
the bank without being concerned anymore about the risk profile of the bank at
which the deposits are held. Alternative answer: The bank may also have moral
hazard behaviour as the bank knows that its clients are protected by the guarantee
and then may be less concerned to take on excessive risks.
(c) (5 points) The outflow of 400 means that the deposits decrease to 1600 and that the
reserves decrease to 0. The required amount of new deposits (x) can most easily be
obtained from the following equation (other ways can be used as well): x =
0.2*(1600 + x) + 200 => x = 320 + 0.2*x + 200 => 0.8*x = 520 => 520 * 1.25 =
650.
A check (this check was not required for obtaining the full points for this part of the
question): After obtaining new deposits to the amount of 650 and putting the funds
that are obtained via the new deposits into the reserves, the reserves increase from 0
to 650. The required reserves are at 0.2*(1600 + 650) = 0.2*2250 = 450 such that
indeed excess reserves of 650 – 450 = 200 remain for providing the new client with a
loan. Thus the minimum required amount of deposits is at 650.
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3. In 1988, the world community created the so-called Basel I agreement. (a) Describe in not
more than two sentences (not two lines) the main goal of Basel I (2 points). Basel I
distinguished between four risk weights:
- 0%, No risk: (e.g. cash or equivalents)
- 20%, Low risk (e.g. claims maturing in a year or less)
- 50%, Moderate risk (e.g. residential mortgages)
- 100%, Standard risk (e.g. commercial loans)
The Park Bank has the following items on the asset side of its balance sheet: €200 million in
cash, €300 million in money-market loans, €700 million in corporate bonds that mature in
six months and €1800 million in long-term loans to various companies that all have a AAArating. Assume furthermore that the Park Bank holds an amount of capital that exactly
matches the requirements of Basel I. (b) What is the amount of capital that Park Bank holds?
(5 points) (c) Suppose that the Soft Bank (i.e. not the Park Bank) fails to satisfy the
minimum capital requirements. Specify three ways in which the Soft Bank can move
towards satisfying the international standards in this area (3 points) (total: 10 points)
Answer:
(a) (2 points) Basel I introduced minimum capital requirements to ensure that banks possess
sufficient capital (are sufficiently capitalised) to withstand adverse developments
such as economic recessions, bankruptcy of major borrowers, etc. Indeed, when the
value of assets needs to be revised downwards, the bank capital will also decrease.
(b)
(1 point) Basel I imposed the requirement that capital (C) should at least be at 8% of the
risk-weighted assets (RWA).
(2 points) The RWA of Park Bank are (200*0) + (300*0.2) + (700*0.2) + (1800*1) = 0 + 60
+ 140 + 1800 = 2000.
(2 points) Park Bank holds exactly the required 8% and thus C = 0.08*2000 = 160 or Park
Bank holds C to the tune of €160 million.
(c)
(3 points): If the bank falls short of meeting its capital requirements, the strategies are:
 raising capital by issuing new equity
 reducing the amount of dividends to stockholders and thus increasing the amount of
retained earnings which go directly into capital
 reducing the size of the bank by selling off loans and reduce liabilities. This keeps
the level of capital the same, but the capital requirements (which are calculated in
relation to the level of risk-weighted assets) can be met.
 Other strategies were evaluated upon the embedded logic.
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4. Why may the pro-cyclical behaviour of interest rates (rising during business cycle
expansions and falling during recessions) lead to pro-cyclical movements in the money
supply? Assume that the concept of “money supply” can be seen as M = M1 and assume that
the central bank does not employ any of the so-called tools of monetary policy. You are to
phrase your answer in terms of the money multiplier. (a) You first have to define this
multiplier (in terms of the so-called deposit ratios) and denote all the symbols that you have
used. (6 points) (b) Subsequently, you have to discuss two channels that cause the procyclical behaviour of interest rates to lead to pro-cyclical movements in the money supply in
which you focus on a business cycle expansion. You should give an intuitive explanation
and thus not an answer like “the ratio goes down because the denominator is now larger” (4
points) [total: 10 points]
Answer.
(a)
(3 points): The money multiplier m is defined as m = (1+c) / (r+e+c)
(3 points): c is the currency ratio (c = C /D, C = currency in circulation and D = deposits), r
is the required reserves ratio (r = RR /D, where RR = required reserves) and e is the
excess reserves ratio (e = ER /D, where ER = excess reserves)
(b)
(2 points): The rise in interest rates in a business cycle expansion increases the opportunity
cost of holding excess reserves (ER) such that banks have a larger incentive to lend which
increases the money supply as the new lending increases deposits, which in turn increases
reserves, increasing lending, increasing deposits, etc. Thus, the excess reserves ratio e
falls and this drop increases the money multiplier m and then M.
(2 points): The rise in interest rates in a business cycle expansion also increases the
opportunity cost of holding currency (c) such that the public desires to hold less currency
and thus holds more deposits which allows banks to lend more (that generates larger
future amounts of deposits given that larger level of deposits increases reserves, lending,
deposits, reserves, etc) and this causes an expansion in the money supply. Thus, the
currency ratio c decreases and this increases the money multiplier m and then M.
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