ECO2115 Part I : Answering this question is compulsory. Question 1 (50 points) L

Question

ECO2115

Part I: Answering this question is compulsory. Question 1 (50 points)
Lupcon Bank has the following balance sheet:

Assets

Liabilities

Reserves

$60 million

Chequable deposits

$600 million

Commercial loans

$165 million

Capital

$25 million

Residential Mortgages

$400 million

Assume that the desired reserve ratio is 5%.

(10 points) Does Lupcon Bank hold any excess reserves? Is this a good liquidity management strategy? In your answer, address the benefits and the costs of holding reserves, from a perspective of the bank.

(10 points) A bank is classified as well capitalized if its ratio of capital to assets exceeds 5%. Is Lupcon Bank well capitalized? Does the manager of Lupcon Bank pursue a good capital adequacy management strategy? In your answer, address the benefits and the costs of holding a high (low) amount of bank capital.

(10 points) Suppose that Lupcon Bank receives bad news that a number of its mortgage borrowers default. As a result, the value of the bank’s mortgages falls by $20 million. That is, the market value of the mortgages becomes $380 million, instead of $400 million. What is the total value of Lupcon Bank’s assets now? What does Lupcon Banks’ balance sheet look like? How do these events affect its capital position?

(10 points) A bank regulator, who monitors the performance of Lupcon Bank, requires Lupcon Bank to increase its capital to $35 million. Describe the two ways the additional capital can be raised.

(10 points) Suppose that the bank is successful in raising the additional capital. That is, Lupcon Bank now has $35 million. What does the Lupcon Bank’s new balance sheet look like? Given this balance sheet, which adjustment(s) of the asset holdings can you advise to Lupcon Bank?

Assets

Liabilities

Reserves

$60 million

Chequable deposits

$600 million

Commercial loans

$165 million

Capital

$25 million

Residential Mortgages

$400 million

Explanation / Answer

1. Desired reserve ratio is 5%. Given it holds deposits of $600 million, the required reserves=5%*$600m=$30m

This implies the bank has excess reserves of $30m. This is a conservative liquidity management strategy. The bank holds twice as much as the desired reserves.

Benefits- the bank has additional capacity to absorb losses in it's assets (loans and advances).

Costs- The additional $30m held as reserves are essentially idle assets in the bank's balance sheets and aren't earning any return for the bank. This potential opportunity cost could decrease the profitability of the bank as this additional reserve isnt lent out anywhere.

2. Lupcon has only 4% of capital of assets ratio ($25m/$(400+165+65)). This is considerably less than the safety threshold of 5%. Thus the bank does not seem to pursue an adequate capital management strategy. Benefits and cost of holding additional capital are similar to point 1. Holding higher capital ensures the bank has sufficient buffer to withstand any market losses such as loan defaults. But holding lesser capital implies, those assets can be loaned out and not lie idle in the balance sheet.

3. New balance sheet looks like below

The total capital of the bank decreases even further to $5 million which will futher impact the capital to assets ratio which is already below the required 5% threshold

4. Additional capital can be raised in below ways:

a. Additional share issue

b. Owners/promoters pledge more capital

c. Bank sells some of it's existing loans/mortgages to another bank and receives cash proceeds today

Assets Liabilities Reserves $(60-20=40) million Chequable deposits $600 million Commercial loans $165 million Capital $25 million less loss in mortages which decreases retained earnings -$20 million Residential Mortgages $400 million Net capital $5 million

Related Questions

Navigate

• Browse (All)
• Browse E
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.