FINA 465- EOC Ch.18

A NOW account requires a minimum balance of $750 for interest to be earned at an annual rate of 4 percent. An account holder has maintained an average balance of $500 for the first six months and $1,000 for the remaining six months. The account holder writes an average of 60 checks per month and pays $0.02 per check, although it costs the bank $0.05 to clear a check. a. What average return does the account holder earn on the account? Gross interest return = Explicit interest return + Implicit interest return Interest earned by account holder ($500 x 0.00 x 6/12) + ($1,000 x 0.04 x 6/12) = $20.00 Implicit fee earned on checks ($0.05-$0.02) x 60 x 12 = $21.60 Average deposit maintained during the year (6/12 x 500) + (6/12 x 1,000) = $750.00

*Ans: Average interest earned = ($20.00 + $21.60)/750 = 5.55 percent

27. What trends have been observed between 1960 and 2015 in regard to liquidity and liability structures of commercial banks? What changes have occurred in the management of assets that may cause the measured trends to be overstated?

*Ans: From Table 18-5, it is clear that commercial banks have reduced their composition of liquid assets to illiquid assets from 44 percent to 26.62 percent (liquid assets = cash and government and agency securities). However, this may be overstated because the illiquid assets, such as commercial and mortgage loans, are significantly different today from prior years because they can be securitized and sold in the secondary markets. As a result, they are not as illiquid as they were in the past, which may be one reason why banks held more liquid assets in prior years. Table 18-6 also shows that there has been a shift away from transaction accounts to time accounts, CDs, and borrowed funds. Although this reduces withdrawal risk, these funds are more expensive for commercial banks.

An FI has estimated the following annual costs for its demand deposits: management cost per account = $140, average account size = $1,500, average number of checks processed per account per month = 75, cost of clearing a check = $0.10, fees charged to customer per check = $0.05, and average fee charged per customer per month = $8. a. What is the implicit interest cost of demand deposits for the FI? Cost of clearing checks = $0.10 x 75 x 12 = $90.00 Cost of managing each account = $140.00 Per check fee per account = $0.05 x 75 x 12 = -$45.00 Fee received per account = $8 x 12 = -$96.00 Total cost per account = $89.00

*Ans: The average (imputed) interest cost of demand deposits = $89.00/1,500 = 5.93 percent.

Define the lagged reserve accounting system

-The lagged reserve accounting system occurs when the reserve maintenance period begins after the reserve computation period is completed. As long as these two periods do not overlap, the DI should have little uncertainty regarding the amount of reserves necessary to be in compliance with regulatory guidelines.

Define the reserve computation period

-The reserve computation period is a two-week period beginning every other Tuesday and ending on a Monday over which the required reserves are calculated. The actual reserve calculation is accomplished by multiplying the average daily net transaction accounts balance over this 14-day period times the required reserve ratio. The exact amount of this reserve calculation is not known with certainty until the end of the computation period.

Define the reserve maintenance period

-The reserve maintenance period is the 14-day period over which the average level of reserves must equal or exceed the required reserve target.

What are the benefits and costs to an FI of holding large amounts of liquid assets?

A major benefit to an FI of holding a large amount of liquid assets is that it can offset any unexpected and large withdrawals without reverting to asset sales or emergency funding. If assets have to be sold at short notice, FIs may not be able to obtain a fair market value. It is more prudent to anticipate withdrawals and keep liquid assets to meet the demand. On the other hand, liquid assets provide lower yields, so the opportunity cost for holding a large amount of liquid assets is high. FIs taking conservative positions by holding large amounts of liquid assets will therefore have lower profits.

How does the cost of MMMFs differ from the cost of MMDAs? How is the spread useful in managing the withdrawal risk of MMDAs?

MMMFs earn rates of return that are directly related to the money market conditions for the assets held by the funds. MMDAs can be priced to reflect these conditions, but they do not necessarily need to be priced in this manner. Since the two products compete for investor funds, FIs can control the rate of withdrawal of funds from the MMDAs by raising or lowering the explicit interest rate paid to depositors. Allowing the MMDA-MMMF spread to become increasingly negative will increase the rate of withdrawal from the MMDA accounts.

What is the "weekend game"? Contrast a DI's ability and incentive to play the weekend game under LRA as opposed to CRA.

Since Friday balances are carried over the weekend and are counted for Saturday and Sunday, they carry more weight in the reserve computations. Thus, DIs developed a strategy to send deposits offshore on Friday, thereby reducing their Friday closing deposit balances. When these deposits were bought back on Monday, average daily deposit balances were reduced, thereby decreasing reserve requirements. Although the ratio of weekends to total days in the reserve computation period is the same under LRA as under CRA (2/7 or 4/14), there is greater flexibility for DIs to play the weekend game under LRA. That is because the DI has complete information about reserve requirements on each day of the maintenance period. However, because of the uncertainty under CRA, there is greater incentive for DIs to play the weekend game under CRA than under LRA.

Rank these financial assets according to their liquidity: cash, corporate bonds, NYSE-traded stocks, and T-bills.

The liquidity ranking from most liquid to least liquid would be cash, T-bills, NYSE-traded stocks, and corporate bonds.

20. Rank the following liabilities, with respect, first, to funding risk and second to funding cost: Funding Risk Funding Cost a. Money market deposit account. 7 4 b. Demand deposits. 10 1 c. Certificates of deposit. 6 5 d. Federal funds. 4 7 e. Bankers' acceptances. 2 9 f. NOW accounts. 9 2 g. Wholesale CDs. 5 6 h. Passbook savings. 8 3 i. Repos. 3 8 j. Commercial paper. 1 10

The rankings above are not meant to be definitively precise, but are made to illustrate that the funding cost and the funding risk are inversely related.

Why are Treasury securities considered good examples of liquid assets?

Treasury securities are considered good examples of liquid assets because they can be converted into cash quickly with very little loss of value from current market levels.