Dr. Valerie R. Bencivenga/Dr.

Beatrix Paal
Eco 304L

Practice Assignment: Financial Crisis (Right Answers)

Multiple choice
1. A
2. B
3. B
4. D
5. C
6. B
7. C
8. B
9. D
10. C
11. A

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12. C

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13. A

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14. C

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15. A

o.
16. D
17. B rs e
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18. D
19. B
20. D
o

21. B
aC s

22. B
vi y re

23. A
24. C
25. B
ed d

26. B
ar stu

27. B
28. D
29. B
30. C
is

31. D
Th

32. D
33. B
34. A
35. A
sh

36. A
37. C
38. D
39. B
40. C

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 Problems
1.a. leverage ratio = 130/20 = 6.5

b.
A L
Reserves 10 100 Deposits (FDIC-insured)
Loan to another bank 5 5 Borrowed from Bank #2
Corporate bonds 5 5 Bond-holders
Common risky asset 80
Unique risky asset 30 20 0 Equity

This bank is insolvent since it’s equity is zero.

When the bank’s holdings of the common risky asset are sold, revenue from the sale will be 76 (since
it’s illiquid). Therefore the bank’s assets total 96 in value. This is not enough to pay off depositors, so
the FDIC will have to spend 4 so depositors can get all of their money back.

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Bond-holders and Bank #2 don’t get anything back …

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A L

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Reserves 10 100 Deposits (FDIC contributes 4)

o.
Loan to another bank 5 5 Borrowed from Bank #2
Corporate bonds rs e 5 5 Bond-holders
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Common risky asset 80
Unique risky asset 30 20 0 Equity
o
aC s
vi y re
ed d
ar stu
is
Th
sh

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 c.
A L
Reserves 10 100 Deposits (FDIC-insured)
Loan to Bank #1 0 5 5 Borrowed from other banks
Corporate bonds 5 5 Bond-holders
Common risky asset 76 80
Unique risky asset 30 20 11 Equity

Now Bank #2’s assets are valued at 121 (down from 130). Therefore, its equity falls from 20 to 11, and
its leverage ratio rises from 130/20 = 6.5, to 121/11 = 11.

d.
A L
Reserves 10 100 Deposits (FDIC-insured)
Loan to Bank #1 0 5 5 Borrowed from other banks
Corporate bonds 5 5 Bond-holders
Common risky asset 76 80

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Unique risky asset 30 20 11 Equity

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Bank #2’s assets and liabilities both fall by 5 due to selling the corporate bonds and repaying other

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banks. Now Bank #2’s assets are 116, and its liabilities are 105.

o.
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Bank #2’s equity is still 11, and so its leverage ratio falls to 116/11 = 10.55. No, this action does not
ou urc
reduce leverage enough.

e.
o

A L
aC s

Reserves 20 10 100 Deposits (FDIC-insured)

vi y re

Loan to Bank #1 0 5 5 Borrowed from other banks

Corporate bonds 5 5 Bond-holders
Common risky asset 76 80
ed d

Unique risky asset 30 20 11 21 Equity

ar stu

Now Bank #2’s leverage ratio is 126/21 = 6. Yes, this action successfully reduces leverage to under 7.
is
Th
sh

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 2.
Assets Liabilities
Reserves 10 Deposits 100
Loans 90
US Treasuries 30
Equity 30

Assets Liabilities
Reserves 10 Deposits 100
Loans 90
US Treasuries 30
Risky asset 40 with prob .75
0 with prob .25
Equity 30
= 40 with prob .75
or 0 with prob .25

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The bank’s assets start out at 130 (equity 30). With probability .75, the bank’s assets will go to 140 (equity 40,

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i.e., an increase of 10 in equity). With probability .25, the bank’s assets will go to 100 (equity 0, i.e., a drop in

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equity of 30).

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The expected gain to selling 30 of US Treasuries, and paying 30 for the risky asset is
rs e
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.75(gain of 10 in equity) + .25(loss of 30 in equity)
= .75 x 10 minus .25 x 30
= 7.5 – 7.5
o

=0
aC s
vi y re

There is no expected gain to selling US Treasuries, and buying the risky asset. All the bank is buying is risk!!
The owners of this bank, even if risk-neutral, will not want to make invest in the risky asset.
ed d

Assets Liabilities
ar stu

Reserves 10 Deposits 100

Loans 90
US Treasuries 20
Equity 20
is
Th

Assets Liabilities
Reserves 10 Deposits 100
sh

Loans 80 90
US Treasuries 20
Risky asset 40 with prob .75
0 with prob .25
Equity 20
= 30 with prob .75
or 0 with prob .25

The bank’s assets start out at 120 (equity 20). This bank is not as well-capitalized as the other bank.
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 With probability .75, the bank’s assets will go to 130 (equity 30, i.e., an increase of 10 in equity). With
probability .25, the bank’s assets will go to 90 (equity 0, i.e., a drop in equity of 20). Equity cannot go
negative! This limits the amount equity can drop. Here it can only drop 20! That is the key difference
compared to the other bank.

The expected gain to selling 20 of US Treasuries and 10 of loans, and paying 30 for the risky asset is

.75(gain of 10 in equity) + .25(loss of 20 in equity)

= .75 x 10 minus .25 x 20
= 7.5 – 5
= 2.5

This is a positive expected gain in equity! The reason is that limited liability limits the amount equity can
fall, and this bank didn’t start out with much!

This bank’s owners will want to undertake the investment. Why should you care? If the investment fails, and

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the bank must be shut down by the FDIC, the FDIC will have to pay 10 to reimburse depositors. If a lot of

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banks undertake such risky investments, when they have little equity, the taxpayers will be on the hook

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when the FDIC runs out of funds!!!

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o.
rs e
ou urc
o
aC s
vi y re
ed d
ar stu
is
Th
sh

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