A) What is the return on equity for each bank? B) Suppose both banks get caught up in the euphoria of the housing market, only to find later that $5 million of their housing loans have become worthless. Explain in detail the consequences for both of these banks. C) Why has a shortfall of capital as a result of financial crisis led to deeper recessions?
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To calculate the return on equity (ROE) for each bank, we use the formula: ROE = Net Income / Shareholder's Equity Show more…
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7) Housing bust to financial crisis Suppose ABC Bank borrowed funds partly from "wholesale" depositors (large cash pools too large to be covered by deposit insurance) and partly from "retail" depositors (with accounts small enough to be backed by deposit insurance) in order to finance its mortgage lending to 655 people like Katrin. ABC Balance Sheet Assets Liabilities Reserves = $10 million "retail" deposits = $50 million Mortgages = $190 million "wholesale" deposits = $140 million Interbank loans to other banks = $0 Discount loans from the Fed = $0 Interbank loans from other banks = $0 Net Worth = $10 million a) What is ABC's initial leverage ratio? Now suppose that the "Katrins" start defaulting on ABC mortgages. b) What happens to the value of mortgages and the net worth of ABC bank? What change in the value of mortgages would make ABC bank insolvent? c) What is the "collateral" for the $140 million the wholesale depositors have lent ABC Bank? How will the "wholesale" depositors respond to the change in the net worth of ABC bank? d) What are three ways ABC Bank can attempt to obtain reserves in order to pay the wholesale depositors? e) If there is a run on ABC bank, what could happen to other banks, thus causing a financial crisis? f) If many banks are selling MBS ("fire sales"), what happens to the net worth of banks? g) What can the Fed (the US central bank) do to stop the fire sales and stop the bank run? h) Given your answers to question 6), what values for leverage ratios for households would make mortgage defaults less likely? Given your answers to a) to g) above, what values for leverage ratios for banks would make bank runs and financial panics less likely?
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Which of the following scenarios would result in a decrease in a bank’s capital ratio? Check all that apply. A bank purchased $4 million worth of stocks one year ago and sells them for $5 million today but doesn’t distribute the earnings as dividends to its shareholders. A bank that has not been performing strongly engages in a secondary stock offering in an attempt to raise $5 million. A bank sells off many of its assets, such as mortgage-backed securities, mortgage loans, and real estate development loans. A bank purchased $4 million worth of stocks one year ago and sells them for $4 million today.
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Humongous Bank is the only bank in the economy. The people in this economy have 20 million dollars in money, and they deposit all their money in Humongous Bank. a. Humongous Bank decides on a policy of holding $100\%$ reserves. Draw a T-account for the bank. b. Humongous Bank is required to hold $5 \%$ of its existing 20 million dollars as reserves, and to loan out the rest. Draw a T-account for the bank after it has made its first round of loans. c. Assume that Humongous bank is part of a multibank system. How much will money supply increase with that original 19 million dollars loan?
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