Question

Consider the following balance sheet (in $millions): Assets consisting of Cash of $2 and Loans of $10; Liabilities consisting of Deposits of $8, Debt of $2 and Equity of $2 (Total Assets of $12). The average interest earned on the loans is 7% and the average cost of deposits is 6%. Rising interest rates are expected to reduce the deposits by $3 million. Borrowing more debt will cost the bank 6.5% in the short term.

A. What will be the cost of using a strategy of reducing its asset base to meet the expected decline in deposits? Assume that the bank intends to keep $2 million in cash as a liquidity precaution.

B. What will be the cost of using a strategy of liability management to meet the expected decline in deposits? Assume that the bank intends to keep $2 million in cash as a liquidity precaution.

Answer 1

Here,

Equity & Liabilities:

Equity = $ 2 Million

Debt = $ 2 Million

Deposits = $ 8 Million

Total Equity and Liabilities = $ 12 Millions.

Assets:

Cash = $ 2 Million

Loans = $ 10 Millions

Total Assets = $ 12 Millions.

Hint: From the structure of the Balance Sheet we can identify that it of the Banks. So, while solving this problem think from the angle of the bank which will help in solving this question with ease.

Further,

Average interest earned on the loans = 7%.

Average cost of deposits = 6%.

Now, Rising interest rates are expected to reduce the deposits by $ 3 Million.

Borrowing more debt will cost the bank 6.5% in the short term.

A. What will be the cost of using a strategy of reducing its asset base to meet the expected decline in deposits? Assume that the bank intends to keep $2 million in cash as a liquidity precaution.

Now, the company decided to reduced its asset base to meet the expected decline in the deposits of $ 3 Millions so Loans given by the company would be $ 7 Millions ($ 10 Millions - $ 3 Millions) as the company intends to keep $ 2 Million in cash as a liquidity precaution.

Now, to decide the cost of this stragtegy we have to determine the effect on net interest income.

Average interest earned on the loans = 7%.

Average cost of deposits = 6%.

Net Interest Income = 7% - 6% = 1%.

So, the cost of this strategy of asset management = $ 3 Million x 1% = $ 0.03 Millions.

B. What will be the cost of using a strategy of liability management to meet the expected decline in deposits? Assume that the bank intends to keep $2 million in cash as a liquidity precaution.

Now, the company has decided to borrow more debt to meet the expected decline in the deposits and maintain the asset base of $ 10 Millions and also intends to keep $ 2 Millions as cash. So, the company will borrow $ 3 Millions i.e. the amount equal to the decrease in deposits @ 6.5%.

Now, to decide the cost of this stragtegy we have to determine the effect on net interest income.

Average interest earned on the loans = 7%.

Average cost of new borrowing = 6.5%.

Net Interest Income = 7% - 6.5% = 0.5%.

So, the cost of this strategy of liability management = $ 3 Million x 0.5% = $ 0.015 Millions.