ECON 2210-KPU Copyright: Rabia Aziz Spring Homework Assignment Ch 8,9
1 Assume that the Supreme Court of Canada rules that lenders in mortgage contracts may not include the house as collateral. How will the announcement affect the market for mortgage loans? Explain your reasoning with the help of the concepts of adverse selection and moral hazard and how these problems are affected by the presence of (or as in this case lack of) collateral. Draw the Demand supply diagram to show the effect on interest rates in this market.
- You wish to hire Trump J to manage your Alberta operations for your company. The profits from the operations depend partially on how hard Trump J works. Probabilities Profit = $5,000 Profit = $90,000 Lazy 90% 10% Hardworker 20% 80% If Trump J is lazy, he will surf the Internet all day and he views this as a zero cost opportunity. However, Trump views working hard as a “personal cost” valued at $1000. What fixed percentage of profits should you offer Trump J for him to work hard? Assume Trump J only cares about his expected payment less any “personal cost”.
- The Basel Accord requires that the banks need to hold capital at a level equal to 8% of the riskadjusted assets on the balance sheet. The assets and their risk weights are: Asset 1998 Basel Accord Risk Weights Asset Risk Weight Bonds issued by OGDC countries 0.00% Claims on industrial country banks 20.00% Residential Mortgages 50.00% Consumer and corporate Loans 100.00% Risk weight on cash and Reserves in 0% Consider a Bank with the following Balance sheet. Find the amount of the bank capital the Basel weights require. Then assuming that borrowing is zero, find the level of deposits and the leverage ratio of the bank. Assets Liabilities Reserves 2,000 Deposits ________________ Securities Government Bonds, Canada 1,000 Borrowing 0 Loans Industrial Country Banks 2,000 Mortgages 6,000 Consumer 10,000 Capital __________________ ECON 2210-KPU Copyright: Rabia Aziz Spring
4.Oldhat Financial starts it’s day of operations with $20 million in capital. A total of $125 million in chequable deposits are received. Bank borrows 5 million from the overnight funds market. The bank makes a $40 million commercial loan and another $60 million in mortgages with the following terms: 200 standard 30-year fixed rate mortgages with a nominal annual rate of 5.25% each for 300,000. Assume that desired reserves are 8%. a. Complete the Bank’s balance sheet below: Assets Liabilities b. What is the leverage ratio for Oldhat Financial? Is it well capitalized? c. Calculate the risk-weighted assets of Oldhat Financial after the first day. d. Calculate the risk-weighted capital ratio after the first day.
- What type of bank regulations are designed to reduce adverse selection problems? Will they completely eliminate adverse selection problems? 6. Explain the rationale for capital requirements.
Effects of Interest Rates on the Mortgage Market
Money and Banking
If the Supreme Court of Canada rules that lenders may not use the house as collateral in mortgage contracts, the mortgage loan market would increase significantly. This increase may be triggered by issues of adverse selection and moral hazard among borrowers. Adverse selection would occur when some borrowers benefit from the mortgage loans because of possessing information that lenders may not have. For example, two borrowers, one with a house as their fixed asset and another with a commercial property, may seek a mortgage. However, the individual with the commercial property may know that by filling in accurate information about their property, the bank may use it as collateral; therefore, the person decides to lie. This decision leads to adverse selection because the bank will treat both borrowers the same despite one party having an asset that can be used as collateral.
Moral hazard, whereby borrowers provide misleading information or change behavior after receiving the loan, may also occur. For example, after hearing about the Supreme Court’s deliberation, borrowers may use loans for unintended purposes because they cannot bear the risk of losing their houses for failure to repay the loans.
When the interest rates are high, people are unwilling to take mortgage loans. However, at higher rates, banks are willing to lend more. Therefore, the demand for mortgage shifts to the left from D0 to D1 while the supply shifts to the right, from S1 to S2. Conversely, at lower rates, people may take more mortgage loans. Banks, on the other hand, may offer fewer loans. Therefore, in such a scenario, the demand for mortgage loans shift to the right from D0 to D1 while the supply shifts to the left from S0 to S2.
When Trump works hard, he is likely to generate total profits of:
(20%*$5,000) + (80%*$90,000) = $73,000
However, Trump views working hard as a personal cost at $1,000. Therefore, for Trump to work hard, I will offer him 13.7% (1000/73,000) of the profits.
Basel Capital Requirement
Step 1: Calculate the risk-adjusted weights of the assets in the balance sheet
|Reserves 2,000 of 0.00%||0|
|Government bonds, Canada 1,000 of 0.00%||0|
|Industry country banks 2,000 of 20.0%||400|
|Mortgages 6,000 of 50.00%||3,000|
|Consumer 10,000 of 100%||10,000|
|Sum of adjusted weights||13,400|
Amount of bank capital required: 8% of 13,400= $1,072
Finding the level of deposits and leverage ratio of the bank
If the bank requirement is $1,072 and capital employed is calculated by deducting current liabilities from total assets, then the deposits equal $19,928 ($21,000- $1,072)
Leverage ratio= tier 1 capital/ average total consolidated assets
Tier 1 capital= reserves ($2,000)
Therefore, leverage ratio= 2,000/$21,000
Leverage ratio= 9.52%
|Commercial loan $40million||Capital $20 million|
|Mortgage loan $60 million||Checkable deposits $125 million|
|Bank borrowing $5 million|
|Reserves (8%*125million) $10 million|
Leverage ratio=Tier 1 capital/average total consolidated assets
Tier 1 capital= Reserves ($10 million)
Average consolidated assets= $100 million ($60+$40 million)
Therefore, leverage ratio= 10% (10million/100million)
The institution is well capitalized because it has a leverage ratio of above 5%
Mortgages (50%)= 50%* 60million
Commercial loan (100%) =100%*40million
Therefore, the risk weighted assets are $70 million
Risk-weighted capital ratio= (tier 1 capital + tier 2 capital/risk weighted assets)/risk weighted assets
Risk-weighted capital ratio= 14.29% ($10 million/$70 million
Chartering banks is one of the bank regulations established to reduce adverse selection problems. This regulation minimizes risks by screen loan proposals from risk-prone entrepreneurs on behalf of the bank. Such regulations may not completely eliminate these problems because risk-prone entrepreneurs can easily hide information during the chartering process.
Capital requirements are essential because they help sustain the bank’s operating losses and meet financial obligations whenever clients withdraw their deposits.