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EC3028  Money and Banking

Mock Set Exercises

Question 1

Using T-accounts, please record the following transactions.

a)   A new bank is incorporated with initial capital $5m.

b)   The bank issues checking deposits to customers for $20m.

c)   The bank issues bonds for $25m.

d)   The bank must maintain a reserve requirement of 10% of assets at all times.

e)   The cash available after setting aside the required reserves is loaned out to customers.

f)   After one year, the loan portfolio suffers default losses for 5% of its value.

g)   Discuss ways in which banks manage their credit risk.

h)   Unsatisfied by its performance, the bank decides to sell the entirety of its remaining loan portfolio. The bank finds a buyer willing to buy it at a 2% discount to its current book value. Record the transaction and any Profit or Loss registered from the sale.

i)    The bank now updates the cash held as required reserves.

j)    The bank decides to invest all the available cash in a safe Government zero coupon bond,   with 2 years to maturity and a Yield-to- Maturity (YTM) of 2%. At what price will the bank purchase these securities? How many units will the bank purchase?

k)   Immediately  after  the  purchase,  the  Yield-to- Maturity  (YTM)  rises  to  3%  What happens           to the price of the bond?

l)    Record any Profit and Loss from the bond portfolio using T-accounts.

m)  Discuss interest rate risk and the ways in which banks manage such risk.

Solution 1

a)   Equity (L) +5m, Cash (A) +5m

b)   Deposits (L) +20m, Cash (A) +20m

c)   Bonds (L) +25m, Cash (A) +25m

d)   Reserves = 10%*(5+20+25) = 5m

Cash (A) -5m, Required Reserves (A) +5m

e)   Cash (A) -45m, Loans (A) +45m

f)    Losses = 5%*45 = 2.25m

Loans (A) -2.25m, Equity (L) -2.25m

g)   Students are expected to discuss for example credit screening, evaluation of loan to value and loan to income ratios, cash flow monitoring, sharing information among banks, etc.

h)   Current book value = 45-2.25 = 42.25m. Discount = 2%*42.25 = 0.85m

Sale value = 42.25 – 0.85 = 41.4m

Loans (A) -42.25m, Cash (A) +41.4m, Equity (L) -0.85m (loss)

i)    Assets are now Cash=41.4m + Required Reserves=5m. Assets = 46.4m.

Because assets have shrunk, also the reserve requirement has shrunk. 10%*46.4m = 4.64m

This means the bank can take 0.36m out of required reserves.

Required Reserves (A) -0.36m, Cash (A) +0.36m

j)    Cash = 41.4+0.36 = 41.76m.

Price = 100*exp(-0.02*2) = 96.07.

Units purchased = 41.76m/96.07 = 0.4346m

Cash (A) -41.76m, Bonds (A) +41.76m

k)   Price = 100*exp(-0.03*2) = 94.17.

l)    Revenue from sale = units x price = 0.4346*94.17 = 40.93m PnL = 40.93m-41.76m=-0.83m

Bonds (A) -0.83m, Equity (L) -0.83m

m) Students are expected to discuss duration hedging, interest rate risk to assets and interest rate risk to income, rate sensitive assets, rate sensitive liabilities and interest rate gap analysis.

Question 2

Use the supply and demand analysis of the market for  reserves to visually illustrate and explain how the following monetary policy decisions may affect the interbank market rate as well as the amount of reserves in equilibrium.

[Note: most marks will be awarded on the basis of a correct explanation of the economic intuition of each scenario.]

a)   Assuming that the current interbank market rate is equal to the discount rate, central bank, central bank raises the reserve requirements .  [7 points]

b)   Assuming that the current interbank market rate is equal to the interest rate paid on reserves, central bank lowers the discount rate.  [7 points]

c)   Assuming that the current interbank market rate is at a level between the interest rate paid on reserves and the discount rate, central bank sells some treasury bonds to the commercial banks.  [7 points]

d)   Assuming that the current interbank market rate is at a level between the interest rate paid on reserves and the discount rate, central bank undertakes forward guidance by promising to keep the discount rate fixed till unemployment goes below a certain threshold.  [7 points]

e)   Assuming that the current interbank market rate is equal to the discount rate, central bank raises the discount rate (by a small amount and/or by a large amount) . [7 points]

Solution 2

Each  answer  should  be  accompanied  with  the  relevant  figures  and  much  more detailed explanations:

a)   No change in the interbank market rate but the borrowed reserves increase.

[7 points]

b)   No change either in reserves or in the interbank rate.

[7 points]

c)   Non-borrowed reserves (as well as total reserves) go down and interbank rate goes up.

[7 points]

d)   No change in anything .

[7 points]

e)   It depends.

[7 points]

Question 3

a)   What are the long-term determinants of exchange rates? Discuss in the context of the recent currency crises in Turkey [10 points]

[Word limit: 300 words]

b)   Discuss the benefits and costs of public ownership of central banks by giving examples from central banks around the world for each of your arguments.  [10 points]

[Word limit: 300 words]

c)   Discuss how COVID- 19 may have affected the central bank policies around the world by providing at least two recent examples and giving references to the appropriate sources.  [15 points]

[Word limit: 300 words]

Solution 3

a)   Following long-term determinants should be explained: Relative prices (i.e., inflation rates), trade barriers, domestic consumption preferences, productivity differentials across countries.

[5 points]

Students are also expected to discuss these reasons in the context of recent currency crises in Turkey and explain which one of these determinants may have played a role.

[5 points]

b)

•    Arguments for public ownership:

–   Central banks act in the ultimate public interest.

–   Private   ownership   bias   central   banks  toward   self-serving   profit-making interests, hence increasing risk-taking and balance sheet troubles.

–   The global financial crisis highlighted concerns that the profit-making target of private  shareholders  could  hamper  them  from  saving  the  financial  sector during financial crises.

[5 points]

•    Arguments for private ownership:

–   guarantees central bank independence

–   restricts the distribution of dividends per share

–   private owners are required to recapitalize the central bank  in the case of losses which  lifts this burden off the fiscal budget.

[5 points]

c)    A general discussion of why and how covid- 19 led the central banks to provide ample liquidity to the commercial banking system and to ease credit conditions.  [5 points]    

Discussion of the monetary policy change due to covid- 19 in the context of two specific examples (with appropriate references) would be worth 5 points each. [10 points]