Suppose you are the CFO of a bank. Customers\' deposits, on which you pay an int

Question

Suppose you are the CFO of a bank. Customers' deposits, on which you pay an interest rate of 5%, account for 90% of you loanable funds, and the rest 10% of the funds come from the federal funds market, where you can borrow funds at 8%. All banks, including yours, are currently charging an interest rate of 8% on their loans. To increase your bank's market share and profit, you decide to lower the interest on your loans to 7.5%. Since in the current economic situation it is hard to get more deposits, you can only obtain additional funds from the federal funds market. Assume that costs other than the cost of funds are insignificant and can be ignored.

a.What is the bank's current average cost of a dollar in loans?

b.What is the bank's current marginal cost of a dollar in loans?

Suppose you are the CFO of a bank. Customers' deposits, on which you pay an interest rate of 5%, account for 90% of you loanable funds, and the rest 10% of the funds come from the federal funds market, where you can borrow funds at 8%. All banks, including yours, are currently charging an interest rate of 8% on their loans. To increase your bank's market share and profit, you decide to lower the interest on your loans to 7.5%. Since in the current economic situation it is hard to get more deposits, you can only obtain additional funds from the federal funds market. Assume that costs other than the cost of funds are insignificant and can be ignored.

a.What is the bank's current average cost of a dollar in loans?

b.What is the bank's current marginal cost of a dollar in loans?

Explanation / Answer

a.

Suppose Loanable fund amount of bank is = L

Loanable fund comes from deposit is 90% = .9L

Loanable fund comes from federal fund market is 10% = .1L

Interest paid on deposit amount is 5% which is =5*.9L/100 = .045L

Interest paid on federal fund amount is 8% which is =8*.1L/100 = .008L

Total Interest paid= (.045+.008)L = .053L

Average Interest rate = .053L*100/L = 5.3%

b.

Since additional amount is taken from federal fund due to tougher market scenario. In this amount, a bank pays 8% interest rate. Therefore, for any increase in loanable fund bank has to pay 8% interest rate. Marginal cost of additional loan is 8%.

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