Homework Assignment #5: Answer Key

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1 Homework Assignment #5: Answer Key Write out solutions to the following problems from your textbook. Be sure to show your work on an math and use figures or graphs where appropriate. Chapter 11: #1 Describe the problem of asymmetric information that an employer faces in hiring a new employee. What solutions can you think of? Does the problem persist after the new person has been hired? If so, how? What can be done about it? Is the problem more or less severe for employees on a fixed salary? Why or why not? Answer: This is pretty much a never ending list. Potential employers always face a severe information problem. They never know the true skills and abilities of the potential employee, only the potential employee knows that. Firms try to resolve this several different ways. 1) Requiring resumes 2) Academic Transcripts 3) Testing...etc. all of these tools are used to try and gauge the true ability of the worker. Once hired the asymmetric information problem is not over. Employers have difficulty in knowing how hard their employees are working. Only the worker knows their true effort. To resolve this most companies have managers whose main responsibility is to monitor the workers and ensure that objectives are being made. The problem is greater for hourly workers who have an incentive to work slowly and get more hours. A salaried worker will have an incentive to complete the required tasks and hope to go home early. #2 In some cities, newspapers publish a weekly list of restaurants that have been cited for health code violations by local health inspectors. What information problem is this feature designed to solve? How? Answer: The problem here is that customers never see the kitchen. They do not know how clean the kitchen is or if the food is properly handled. This reports are meant to give out general information about the behind the scenes action in a restaurant. #4 In some countries it is very difficult for shareholders to fire managers when they do a poor job. What type of financing would you expect to find in those countries? Answer: As stated in the book, one of the benefits of being a stockholder is the ability to hire the board of directors which can then control the future of managers. Without this benefit, stocks look a little less attractive. More importantly, the implied freedom for the manager means that he/she is free to think about their own objective and not about the shareholders. This setup increases the moral hazard problem between managers and stockholders. So, we should suspect a greater amount of bond financing in places with this arrangement. 1

2 #15 Consider a small company run by a manager who is also the owner. If this company borrows funds, why might a moral hazard problem still exist? Answer: There is still the incentive to do things that maximize expected income which might bring about added risk that the bank would not forecast when making the loan to the company. Chapter 12: #2 Banks hold more liquid assets than most businesses do. Explain why? Answer: Mostly because of reserve requirements. They are told to hold some liquidity at the bank. Also, providing liquidity is a general purpose for a bank, so to ensure their customers of quality service, and bank will hold some amount of liquidity for withdrawals and new loans. #5 On the Federal Reserve Board s Website find the H.8 release. Download the most recent release and construct a table that match Table 12.1 using the information in the release. Answer: Table for week ending April Assets Dollars(bil US$) % of Category Cash Items 1, % Securities 2, % US Government and agency 1, % Loans 6, % Commerical and industrial % Real Estate 3, % Consumer % Interbank % Other % Other Assets 1, % Total Commerical Bank Assets 11,842.7 Liabilities Deposits 7, % Large, negotiable time deposits 1, % Borrowings 1, % From banks in the US % From nonbanks in the US 1, % Other Liabilities % Total Commerical Bank Liabilities 10,574.0 Bank Assets- Bank Liabilities = Bank Capital 1,268.7 #7 Banks carefully consider the maturity structure of both their assets and their liabilities. What is the significance of the maturity structure? What risks are banks trying the manage when they adjust their maturity structure? Answer:The banks are trying to manage interest rate risk when considering the maturity structure of their assets and liabilities. A typical bank will have a long term average maturity on their assets which are made up of bonds and loans. At the same time their liabilities, 2

3 such as checking and savings accounts, are of much shorter maturity and fluctuate as interest rates move. The interest rate on assets is typically more rigid and does not fluctuate much with short term interest rate movements. As interest rate tend to rise bank will attempt to lengthen the maturity of their liabilities and most be put under competitive pressures to pay out higher interest on their deposits. #11 Consider the balance sheet of Bank A and Bank B. If reserve requirements were 10 percent and both banks had equal access to the interbank market and funds from the Federal Reserve, which bank do you think faces the greatest liquidity risk? Explain your answer. Bank A(in millions) Bank B(in millions) Assets Liabilities Assets Liabilities Reserves $50 Transaction Deposits $200 Reserves $30 Transaction Deposits $200 Loans $920 NonTransaction Deposits $600 Loans $920 NonTransaction Deposits $600 Securities $250 Borrowings $100 Securities $50 Borrowings $100 Answer: It is pretty obvious that Bank B faces greater liquidity risk. Both banks have $800 in deposits. The gives Bank A a reserve $50 ratio of $800 = 6.25%. Bank B has a reserve ratio of $30 $800 = 3.75%. Both banks are currently under the reserve requirement. In addition Bank B also has a much smaller position in securities which means that it will be harder to adjust their Asset distribution to get bank in line with the reserve requirement. Chapter 14: #4: Discuss the regulations that are designed to reduce moral hazard created by deposit insurance. Answer: The government uses a mix of regulations in an attempt to reduce the moral hazard problem of deposit insurance. The moral hazard problem of deposit insurance comes from the fact that protected depositors have no incentive to monitor the behavior of their banks. Knowing this, bank managers take on riskier asset positions. Thus, the deposit insurance creates its own moral hazard problem. We have seen this behavior by looking at balance sheets over time. The proportion of bank capital has fallen significantly over time. More and more bank assets are tied into securities markets which are more risky than simply holding the assets in the bank. The primary regulation that the government uses to solve this problem in a minimum capital requirement. There are also disclosure requirements that forces banks to release information about their balance sheet. #6: Distinguish between illiquidity and insolvency. Why is it difficult for a lender of last resort to tell the difference between the two? Does the distinction matter? Answer: An illiquid bank is one that has bank capital but is just suffering from a lack of reserves. An insolvent bank is one who 3

4 has negative bank capital. It has negative net worth. The government has a hard time determining which banks are solvent and insolvent because it is in the interest of the bank to hold some of the info about its balance sheet back as private information. The government only wants to give loans to solvent institutions which are simply illiquid and their shortage of reserves appears to be a temporary phenomena. Since government officials will also be anxious to keep the crisis from getting any worse, they will typically be generous with the lending requirements for banks. The problem is that bank managers know this and some will take advantage of the situation. The government looks like it will bail out a bank no matter why it is having trouble. This creates incentives for managers to take a highly risky position in the bank. Thus the asymmetric information creates a moral hazard problem for bank managers which will tend to be too risky. #7: Why do regulators insist that banks hold a minimum level of capital? Answer: This rule is basically to help some of the problems discussed in the previous 2 problems. Capital requirements turn bank managers, more or less, into stock holders of their bank. So, their interest are more lined up with that of keeping the bank solvent and not just increasing interest income. #11: For each of the following events, state whether you think the immediate problem a typical bank is most likely to encounter is one of illiquidity or of insolvency. Explain your choice in each case. 1. (a) The government announces it is abolishing its deposit insurance program. Answer: This is clearly an issue of illiquidity. If the government removes the FDIC program, depositors will face substantially more risk, and some of them may remove their deposits from banks. Note this has nothing to do with the profitability of the bank, this was an outside shock hitting the depositors. (b) The economy falls into recession and job losses are rampant. Answer: This is more of a problem with insolvency. If the economy is in a recession with job losses, this would mean that businesses are having tough times and may struggle with outstanding loans. In addition the job losses also mean the firms are not likely to expand factories. Thus investment is going to suffer and the banks will struggle to find new loans. This hits the assets portion of their balance sheet and hits the ability of their deposits to generate interest income. (c) The central bank triples the reserve requirements, effective immediately. Answer: On the surface this appears to be a problem with illiquidity, but in reality this will end up to be an insolvency problem. If the reserve requirement is tripled, banks 4

5 would have to cut out some of the interest earning components of their assets. This makes it harder for banks to make profits and thus hits their solvency. 5

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