BEEM119
UNIVERSITY OF EXETER BUSINESS SCHOOL
May 2018
Economics of Banking Module Convenor: Dr Pradeep Kumar
Duration: TWO HOURS
Answer ALL SIX questions from Section A and ONLY FOUR questions from Section B. If you answer ALL FIVE questions in section B, only the first FOUR will be marked.
All questions in Section A are worth 8 marks each. All questions in Section B are worth 13 marks each.
Approved calculators are permitted. This is a closed note paper.
If some question is not clear to you, state your assumption and provide an answer under that assumption.
SECTION A
(Answer all questions)
1. Explain why the real interest rates on two identical 10-year government bonds, one issued in the United States and one in Brazil, can be different.
2. State whether the following statements are true or false. Briefly explain your answer.
a. No matter which action (by a bank or its customers) changes a bank’s balance sheet, total assets always equal total liabilities plus net worth.
b. While deposit insurance solves the problem of bank runs, it makes the problem of moral hazard worse.
c. The problem of adverse selection arises when borrowers have little incentive to behave prudently after acquiring a loan.
d. Changes in the discount rate is the Central bank’s preferred method to control the money supply.
3. Why is it often proposed that banks should be charged premiums for deposit insurance based on their levels of capital i.e. premiums should be higher if capital is lower? Are there any drawbacks to this proposal?
4. XY Bank¡¯s balance sheet is the following:
Show how the balance sheet changes in each of the following scenarios. Also, calculate the equity ratio and rate sensitivity gap for each of the following scenarios:
(a) The XY bank issues $10 of new stock and uses the proceeds to buy T-bills. (b) The XY bank replaces $15 of its loans with floating rate loans.
5. Suppose we also include traveller¡¯s checks in the money supply alongside currency in circulation (C) and deposits (D). Let T be the level of traveller¡¯s checks, so T/D is the ratio of traveller¡¯s checks to current account deposits. Derive the money multiplier in terms of C/D, R/D, and T/D.
2
Assets
Liabilities & Net Worth
Reserves
20
Current Deposits
10
T-bills
40
Savings Deposits
60
Loans
40
Net Worth
30
Total
$100
Total
$100
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Turn over
6. British banks reported increasing profitability and increasing return on equity each year up until the 2007-2009 financial crisis, even though the British banking industry is highly competitive. How can you reconcile an increase in profitability alongside an increase in competition?
SECTION B
(Answer only four questions)
7. Using the Panzar-Rosse methodology, derive an expression for the H-statistic. Also, explain why the H-statistic is always negative for a monopoly equilibrium.
8. Using the loanable funds theory, show in a graph how each of the following events affect the supply and demand for loans and the equilibrium real interest rate:
(a) Government proposal of a tax cut for all business earnings.
(b) In addition to (a), tax cuts lead to an increase in confidence of the foreign savers.
9. Derive an expression for the interest rate on loans in a monopoly model (Monty-Klein) of banking. Alongside deposits and loans, assume that there is also a market for treasury bills. Also, assume that the operating cost of a bank depends upon the volume of deposits and loans. Clearly state any other assumptions you make for the derivation. What is the main criticism of this theoretical model?
10. Describe the regression model used in the stochastic frontier analysis to compute cost efficiencies in the banking industry. Using the model, explain how elasticity of cost with respect to output measures the economies of scale of a bank.
11. A finance company raises most of its funds by issuing long-term bonds instead of collecting deposits. It uses most of these funds for floating rate loans. Answer the following:
a. How does the finance company¡¯s rate-sensitivity gap differ from those of most banks?
b. What deal could this finance company and a traditional bank make to reduce risk for both the institutions?
3
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End of Paper