Econ 121 Midterm Exam – II
Instructor: Chao Wei
Provide a BRIEF AND CONCISE answer to each question. There are 25
points on this exam.
1. (6 points) Prepare the balance sheet of a bank that has $19 million in
reserves, $40 million in securities, $140 million in loans, $180 million
in deposits, and $19 million in equity capital.
a. What are the bank’s excess reserves if the reserve requirement
is 10% of deposits? (1 point)
Excess reserves = $19 - $180*10% = $1 million
b. 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: $9 million in reserves, $40 million in securities,
$140 million in loans;
Liabilities side: $170 million in deposits, and $19 million in
equity capital.
Excess reserves = $9 - $170*10% = -$8 million
c. 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 $32 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 $132
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 $8 million, Equities $19 million
After borrowing from the Fed, the asset side of the balance
sheet is: Reserves $17 million, Securities $40 million, loans
$140 million. Liabilities side is: Deposits $170 million,
Discount Loan (or: borrowing from the Fed) $8 million,
Equities $19 million.
d. What are the advantages and disadvantages of using each of the
following two methods to make up reserve deficiency: (1) sell
securities; (2) borrow from other banks (2 points)
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).
2. (3 points) GAP Analysis.
Suppose that you are the manager of a bank that has $18 million of
fixed-rate assets, $30 million of rate-sensitive assets, $28 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.
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.
3. (3 points) Suppose that the First National Bank has the following
balance sheet (in million dollars):
Assets: Reserves 10; Loans 90;
Liabilities: Deposits 90; Bank capital 10.
Suppose that the Second National Bank has the following balance
sheet (in million dollars)
Assets: Reserves 10; Loans 90;
Liabilities: Deposits 95; Bank Capital 5.
a. If net profits of the First and Second National Banks are both $1
million dollars, then what are the return on asset (0.5 point) and the
return on equity for each bank (0.5 point)?
For the First National Bank,
ROA = 1/100 = 1%
ROE = 1/10 = 10%
For the Second National Bank
ROA = 1/100 = 1%
ROE = 1/5 = 20%
b. Suppose that both banks suffer a loan loss of $6 million, How will
their balance sheets look like now? (0.5 point for each balance sheet)
For the First National Bank,
Assets: Reserves 10; Loans 84;
Liabilities: Deposits 90; Bank Capital 4.
For the Second National Bank,
Assets: Reserves 10, Loans 84;
Liabilities: Deposits 95, Bank Capital -1.
c. Based on your answer to b, what has happened to the Second
National Bank? Explain your answer.
The Second National Bank has gone bankrupt due to the loan loss.
(0.5 point) This is because its assets are now insufficient to cover all
the liabilities to outside creditors (0.5 point).
4. (4 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 Bob without
verifying his income or employment records. George the government
regulator is assigned the duty to monitor Magna’s loan activities.
Briefly 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.
5. (5 points) Questions on adverse selection, moral hazard and
collateral.
(a) Give an example of adverse selection on the securities market.
(One of the examples is sufficient.)(1 point)
Examples include: (1) Investors often could not distinguish good
firms from bad firms if the firms are relatively unknown. As a result,
good firms tend to be undervalued, while bad firms are often
overvalued. Consequently, good firms would not be willing to raise
funds on the securities market, and investors would not like to invest
in securities issued by unknown firms. (2) The borrowers who are
most eager for loans, who would be willing to promise to take out
loans at any interest rates are often very risky borrowers.
(b) Give an example of moral hazard on the securities market. (One of
the examples is sufficient.)(1 point)
Examples include: (1) Borrowers take on too much risk; (2)
Borrowers default or engage in activities not in the interest of lenders.
(c) Explain why collateral is a useful tool to reduce adverse selection
and moral hazard problems.(2 points)
By requiring collateral, the lender is able to seize collateral in case of
default. Those borrowers who are most likely to default thus would
not take out loans from the lender, fearful of the loss of collateral. As
a result, adverse selection problem is reduced.
With the collateral at stake, the borrower typically would avoid
activities which might lead to the loss of collateral. As a result, moral
hazard is reduced.
(d) Mortgage loans are typically secured by collateral. That is, if you
fail to make your mortgage payments, the lender can take title to your
house, auction it off, and use the receipts to pay off the loan. Please
briefly explain why the prevalence of collateral (house) in mortgage
loan contracts still could not prevent the subprime mortgage crisis. (1
point)
Collateral is not a perfect tool, especially when the market value of
collateral declines. As the market value of collateral declines, it is
much less costly for borrowers to walk away from their obligations, as
happened in the subprime mortgage crisis.
6. (4 points) Describe two ways in which financial intermediaries help
lower transaction costs in the economy. (Two of the three ways below
are sufficient. Two points for each.)
Financial intermediaries help lower transaction costs through the
following ways:
a. Economies of scale. Financial intermediaries bundle investors’
funds together to reduce transaction cost for each investor.
b. Expertise. Financial intermediaries are also better able to develop
expertise to lower transaction costs.
c. Diversification. By bundling funds together, financial
intermediaries can diversify the risk exposure of investors.