Problem Set 3 - Financial Stability

1) Asymmetric Information Concepts:

For each of the following examples determine whether the described market failure is a case of adverse
selection, moral hazard, or neither.

a) Some of the people applying for mortgages over-report their income, causing a bank to demand
higher interest rates. This causes some of the honest borrowers to delay their purchase of a home.

b) Many companies publish quarterly reports, and would benefit from all such reports being very
detailed. However, firms are reluctant to publish details that their competitors are not also publishing.
As a result, the reports end up being superficial and of little use to investors.

c) A firm applied for a bank loan using a more conservative business plan than they might end up
pursuing. The terms of the loan assume a risk of default that is too low.

2) Adverse Selection Model:

There is a lender with profit function π(L, r) = (1 + r)(1 − δ)L − L1+β , where L is quantity of lending,
r is the interest rate, δ is the default rate, and β > 0 describes the cost of raising funds. Loan demand
Ld is a linear decreasing function of r. The default rate is an increasing, convex function of r.

a) At some interest rate r̄ where L is maximized, If Ld (r̄) ≤ Lmax , does the loan market clear, or does
credit rationing occur?

b) What happens to Lmax if the cost of raising funds (β) increases? (I.e what happens to Ls as β
changes?)

c) If the lender has competitors with a higher cost of raising funds, but who face the same demand
curve, such that Ld (r̄) > Lmax for a competitor, do the competitor’s markets clear or does rationing
occur?

d) If unserved borrowers from one lender can try another lender, what will happen to the demand
curve faced by the lender in part a)? Can this change the equilibrium?

3) Moral Hazard and Collateral:

A lender is offering loans to firms that can choose multiple strategies once they receive funding. The
strategies offer trade offs of rate of return versus the risk of failure. Consider a firm’s strategy to result
in returns r3 > r2 > r1 and default rates δ3 > δ2 > δ1 . While all of the firms promise to pursue strategy
one, the lender knows this will depend on the interest rate offered (r). Loan demand is linear and
decreasing in r. Loan supply follows:
 1
s (1 + r)(1 − δi ) β
L =
1+β

a) Write the condition under which a firm will switch from strategy one to strategy two (call this r1̄ ),
and the condition under which a firm will switch from strategy two to strategy three (call this r2̄ ).

1
b) Assume loan demand exceeds loan supply at r1̄ , but supply exceeds demand at r2̄ . Draw the supply
and demand diagram.

c) Now allow the lender to require collateral (of share c). Write an equation describing the loan contract
that would incentivize all borrowers to use strategy one.

4) Bank Balance Sheets:

Consider the following bank balance sheet with duration measures for each category:
ASSETS LIABILITIES
Type Crore Dur. Type Crore Dur.
Reserves 5 0 Checkable Deposits 25 0
Securities Non-Transaction Deposits
Short-Term 12 1 Savings & Small CD 16 1
Long-Term 20 3 Negotiable CD 21 3
Loans Borrowings
Variable & Short-Term 24 3 Central Bank 15 1
Long-Term Fixed 30 7 Interbank 12 1
Physical Capital 5 0 Subtotal 89
Total Assets 96 Bank Capital 7 -

a) If the statutory reserve ratio and liquidity ratio are 5% and 20% respectively, is the bank currently
in compliance?

b) Assuming risk weights of 0% for reserves, short-term securities and physical capital, 50% long-term
securities, and 100% for all other assets, what is the bank’s current capital ratio?

c) Perform a duration analysis for an increase in interest rates by 1%. Also, determine how far interest
rates have to increase (to the nearest tenth of a percent) before the bank is insolvent.

d) In a single month, 3 crore of checkable deposits and 4 crore of small CDs are withdrawn. To prevent
bank failure, the bank sells 2 crore of short-term securities to the open market, sells 3 crore of long-term
loans to other banks, and borrows an additional 1 crore from the central bank. After these measures are
taken, is the bank in compliance with the required ratios from part a)? (Hint: Make sure to properly
account for the effect on reserves.)

e) Assuming the same scenario from part d), do a new duration analysis. In terms of the amount
interest rates have to increase to cause insolvency, is the bank more or less sensitive to interest rate
risk after these measures are taken?

5) Banking Regulation:

a) Various bailouts that occurred during the global financial crisis were criticized because they tended to
increase consolidation of the banking industry. Explain how these regulatory interventions could result
in investors being biased toward the major banks, and the dangers posed by major banks knowing that
they will be bailed out in the event of a crisis.

b) As an alternative to bailouts, consider an extended receivership, where the government nationalizes