Econ 121 Midterm Exam – II
Answer Key
Instructor: Chao Wei
1. (10 points)
a. The bank’s excess reserves is 3 (=18-150*0.1) million (1 point).
b. The assets side of the revised balance sheet: Reserves $8 million,
Securities $40 million, Loans $140 million. On the liabilities side:
Deposits $140 million, Equity $48 million (2 point). The bank
needs $6 million additional reserves (1 point).
c. After selling securities, the assets side of the balance sheet is:
Reserves $14 million, Securities $34 million, Loans $140 million.
Liabilities side is the same as that in b (1 point). Advantages:
Securities market is highly liquid. Securities can be sold at small or
little transaction cost (0.5 point). Disadvantages: The bank is
forgoing interest earnings of securities. The transaction can involve
capital loss and potential capital gain is also subject to taxes (0.5
point).
After calling in loans, the assets side of the balance sheet is:
Reserves $14 million, Securities $40 million, loans $134 million.
Liabilities side is the same as that in b (1 point). Advantages: It is
an opportunity to drop risky borrowers (0.5 point). Disadvantages:
The bank risks offending customers, and potentially jeopardizes
the repayment of entire loan made to the customer if some portion
of the loan has been lent out to him (0.5 point).
After borrowing from other banks, the assets side of the balance
sheet is: Reserves $14 million, Securities $40 million, loans $140
million. Liabilities side is: Deposits $140 million, Borrowing from
other banks $6 million, Equities $48 million (1 point). Advantages:
(1) There is no need to reduce interest-bearing assets. (2) Return on
equity will be higher if return on assets is the same as before (0.5
point). Disadvantage: The bank now has smaller equity-Asset ratio,
and subject to higher risk of insolvency if there are large loan
losses (0.5 point).
2. (10 points)
a. These agencies have much smaller capital to asset ratios
compared to the banks. Describe how a small capital-toasset ratio affects the probability of insolvency.
The company’s capital serves as a buffer against risks of
substantial loss of assets. The company’s own capital is
equal to its assets minus liabilities. In case of substantial
losses of assets, a small capital-to-asset ratio increases the
probability of insolvency, that is, the company does not have
sufficient assets to pay off all holders of its liabilities.
b. These agencies borrow at a rate that is above the U.S.
Treasury rate but well below the highest rated private
corporations, suggesting that the market perceives there is
little default risk. Provide an explanation for the low default
risk in light of your answer to the first part of this question.
Is there a moral hazard problem created by the U.S.
government? Explain your answer.
The reason that they have a low default risk is because the
investors perceive strong government ties of these two
companies. Investors might believe that the U.S.
government will bail them out in case of failing, given its
strong government ties and the “too-big-to-fail” size of their
business.
This can lead to a moral hazard problem where the company
insures mortgages that have a higher probability of failing in
order to earn higher returns knowing that the government
will pay off any debt the company might owe in case of
bankruptcy.
3. Gap Analysis:
Gap = Rate-sensitive Assets – Rate-Sensitive Liabilities
= $30m - $15m
= $15m
Net profits increase by $0.6m (=15*0.04).
4. (12 points) There will be three moral hazard problems. Each problem
is worth 2 points and remedy for each problem is worth 2 points as
well.
a. Joe as depositor versus Bank Magna. Magna is the borrower. There
is a moral hazard problem in that Magna might take too much risk
using Joe’s deposits. To reduce moral hazard problem, Joe should
closely monitor Magna’s operations to make sure its investment
portfolio is not too risky. Since Joe is also the shareholder, he also
needs to make sure that other shareholders have a huge stake in the
bank so that the bank has enough net worth to buffer against
probabilities of bankruptcy.
b. Joe as shareholder versus Bank Magna. There is a typical principleagent problem. Joe’s interests may not coincide completely with those
of management. Management may claim too high bonus or engage in
fraudulent accounting to make profits of its own, sometimes at Joe’s
cost. To reduce this moral hazard problem, Joe should closely monitor
the company’s operation. He can also support the management to take
a large stake in the company by becoming shareholders.
c. Net Worth Corporation versus Bank Magna. As a borrower, Net
Worth Corporation might take on too much risk using bank loan. To
reduce the problem of moral hazard, Magna should monitor Net worth
closely, and require collateral or compensating balance from Net
Worth Corporation.
5. Percentage change in market value of assets = -2%*4 = -8%
Percentage change in market value of liabilities = -2%*6 = -12%
percentage change in market value of net worth
= 100*(-8%) – 90*(-12%) = 2.8
The market value will increase by 2.8 million if interest rates rise by 2
percentage points.
The bank can engage in trading with financial instruments to reduce
its exposure to the interest rate risk.
The answers to 6 can be readily found in the textbook.