91Ó°ÊÓ

Why are deposit insurance and other types of government safety nets important to the health of the economy?

Why might more competition in financial markets be a bad idea? Would restrictions on competition be a better idea? Why or why not?

Consider a failing bank. How much is a deposit of $290,000 worth to the depositor . if the FDIC uses the payoff method? The purchase-and-assumption method? Which method is more costly to taxpayers?

Oldhat Financial starts its first day of operations with \($11$million in the capital. A total of \)$120$million in checkable deposits are received. The bank makes a \($30$million commercial loan and another \)$40$million in mortgages with the following terms: $200$standard, $30$-year, fixed-rate mortgages with a nominal annual rate of $5.25\%$, each for $$200,000$. Assume that required reserves are $8\%$.

a. What does the bank balance sheet look like?

b. How well capitalized is the bank?

c. Calculate the risk-weighted assets and risk-weighted capital ratio after Oldhat’s first day.

Go to the St. Louis Federal Reserve FRED database, and find data on the residual of assets less liabilities, or bank capital (RALACBM027SBOG), and total assets of commercial banks (TLAACBM027SBOG). Download the data from January 1990 through the most recent month available into a spreadsheet. For each monthly observation, calculate the bank leverage ratio as the ratio of bank capital to total assets. Create a line graph of the leverage ratio over time. All else being equal, what can you conclude about leverage and moral hazard in commercial banks over time?

Why can government safety nets create both an adverse selection problem and a moral hazard problem?

Early the next day, the bank invests $\backslash (35$million of its excess reserves in commercial loans. Later that day, terrible news hits the mortgage markets, and mortgage rates jump to $13\%$, implying a present value of Oldhat’s current mortgage holdings of \)$99838$ per mortgage. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What does Oldhat’s balance sheet look like? How do these events affect its capital position?

To avoid insolvency, regulators decide to provide the bank with \(27 million in bank capital. Assume that bad news about mortgages is featured in the local newspaper, causing a bank run. As a result, \)40 million in deposits is withdrawn. Show the effects of the capital injection and the bank run on the balance sheet. Was the capital injection enough to stabilize the bank? If the bank regulators decide that the bank needs a capital ratio of 10% to prevent further runs on the bank, how much of an additional capital injection is required to reach a 10% capital ratio?

How could higher deposit insurance premiums for banks with riskier assets benefit the economy?

What are the costs and benefits of a too-big-to-fail policy?