. Deposit Insurance and Capital Requirements: Consider a bank that is financed with equity from risk neutral shareholders and depositors. Depositors only alternative investment is cash holding. The bank has raised 9 Mio through deposits. Shareholders have 1 Mio equity invested in the bank. The bank can lend its funds as loans to risky borrowers. In this case its loan portfolio pays 16 Mio with a probability of 60% and zero otherwise. As an alternative investment strategy, the bank can also lend its funds to safer borrowers. In this case the overall return on the loan portfolio is only 14 Mio with a probability of 80% and zero otherwise. After the banks investment decision is publicly observable deposits need to be rolled over. 1. Assume that deposits are not insured. a) What is the repayment that depositors will require in order to be willing to roll over their deposits, if i) the bank invested in the risky loan portfolio (1.5point) ii) the bank invested in the safe loan portfolio (1.5point) b) What is the expected net profit for shareholders, if i) the bank invested in the risky loan portfolio (1.5point) ii) the bank invested in the safe loan portfolio (1.5point) c) Which initial loan portfolio should the bank invest into? (1point) 2. Assume deposits are fully insured and the bank does not have to pay any fee to the deposit insurance. a) What is the repayment that depositors will require in order to be willing to roll over their deposits, if i) the bank invested in the risky loan portfolio (1.5point) ii) the bank invested in the safe loan portfolio (1.5point) b) What is the expected net profit for shareholders, if i) the bank invested in the risky loan portfolio (1.5point) ii) the bank invested in the safe loan portfolio (1.5point) c) Which initial loan portfolio should the bank invest into? (1point) 3. Given that deposits are insured by how much can the bank increase the implicit subsidy from the deposit insurance by choosing the risky loan portfolio? (2 points) 4. Given that deposits are insured what is the critical amount of equity financing above which bank shareholders would prefer the safe strategy? (4 points)