ECO2115

Part I: Answering this question is compulsory. Question 1 (50 points) Lupcon Bank has the following balance sheet:

Assets		Liabilities
Reserves	$60 million	Chequable deposits	$600 million
Commercial loans	$165 million	Capital	$25 million
Residential Mortgages	$400 million

Assume that the desired reserve ratio is 5%.

(10 points) Does Lupcon Bank hold any excess reserves? Is this a good liquidity management strategy? In your answer, address the benefits and the costs of holding reserves, from a perspective of the bank.

(10 points) A bank is classified as well capitalized if its ratio of capital to assets exceeds 5%. Is Lupcon Bank well capitalized? Does the manager of Lupcon Bank pursue a good capital adequacy management strategy? In your answer, address the benefits and the costs of holding a high (low) amount of bank capital.

(10 points) Suppose that Lupcon Bank receives bad news that a number of its mortgage borrowers default. As a result, the value of the banks mortgages falls by $20 million. That is, the market value of the mortgages becomes $380 million, instead of $400 million. What is the total value of Lupcon Banks assets now? What does Lupcon Banks balance sheet look like? How do these events affect its capital position?

(10 points) A bank regulator, who monitors the performance of Lupcon Bank, requires Lupcon Bank to increase its capital to $35 million. Describe the two ways the additional capital can be raised.

(10 points) Suppose that the bank is successful in raising the additional capital. That is, Lupcon Bank now has $35 million. What does the Lupcon Banks new balance sheet look like? Given this balance sheet, which adjustment(s) of the asset holdings can you advise to Lupcon Bank?