Part B:

1. In Round 2 you are asked to grow your banks balance sheet through the expansion of assets funded by liabilities. Specifically, you can now leverage (increase the liabilities of) your bank up to a multiple of 12x total shareholders equity. Using Balance Sheet t=1: Start of Round 2 make decisions regarding your Round 2 asset allocations and sources of funds. Here are your new alternatives for Round 2:

Assets

• Consumer Loans will earn on average 10% per annum and require a 4% loan loss reserve
• Residential Mortgages will earn on average 5% per annum and require a 2% loan loss reserve
• Commercial and Industrial (C&I) Loans will earn on average 4% per annum and require a 1% loan loss reserve

Liabilities

• Deposits, net of the expenses to attract them, are forecasted to cost 2% per annum
• Borrowed Funds, mainly through the interbank market, are forecasted to cost 1% per annum

Again, we are consolidating all Treasury securities in Round One into a single balance item for Rounds 2-5. All securities going forward will be one-year Treasury bills.

1. To complete Balance Sheet t=2: Start of Round 2 take the following steps:

• First, copy your completed Balance Sheet t=1: End of Round 1 into the balance sheet below. Again, going forward we will assume all investments in "Securities" are held to maturity as one-year Treasury bills.
• Next, decide on the amount of your bank's leverage, that is, how much, either through deposits or borrowed funds, you choose to raise up to 12x the existing shareholder's equity at the end of Round One.
• Then, allocate all of your liabilities and shareholders' equity among the asset alternatives taking into account the following probability of return and cost outcomes in Round 2.

Below are the possible return and cost outcomes in period 2 and their probabilities:

Outcomes	1	2	3	4	5	6	7
Outcome Probability	16.67%	25%	25%	13.89%	13.89%	2.78%	2.78%
Cash	0%	0%	0%	0%	0%	0%	0%
Securities (T-bills)	0.25%	0.25%	0.25%	0.25%	0.25%	0.25%	0.25%
Consumer Loans	Net 6%	Net 7%	Net 5%	Net 8%	Net 4%	Net 8%	Net 2%
Residential Mortgages	Net 2%	Net 3%	Net 1%	Net 4%	Net 0.5%	Net 4%	Net 0%
C&I Loans	Net 3%	Net 4%	Net 2%	Net 5%	Net 1%	Net 5%	Net 0.5%
Deposits	2%	2%	2%	2%	2%	2%	2%
Borrowed Funds	1%	1%	1%	1%	1%	0.50%	3%

• Outcome 1: No Change
• Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated
• Outcome 3: Moderate economic decline: slightly higher loan losses than estimated
• Outcome 4: Strong economic expansion: even fewer loan losses than estimated
• Outcome 5: Strong economic decline: even higher loan losses than estimated
• Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds
• Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of borrowed funds

Balance Sheet t=2: Start of Round 2
Assets			Liabilities and Shareholders Equity
Cash	Deposits
Securities (T-Bills)	Borrowed Funds
Consumer Loans*	Total Liabilities
Residential Mortgages*	Common Stock
C&I Loans*	Retained Earnings
Total Shareholders Equity
Total Assets	Total Liabilities and Shareholders Equity

*Loan figures are net of loan loss provisions.

Again, make sure Total Assets = Total Liabilities and Shareholders' Equity

2. In a single type-written page (approximately 250 words, double-spaced) provide the rationale for your Round 2 asset allocation and funding source decisions. Include in your assessment the risks associated with your allocation.

Bank Portfolio - Round 2

As shown in the FINA 340 course website, you begin to diversify the composition of your assets, choosing among types of loans with varying levels of risk and return. You can also grow your assets further by adding debt with alternative sources of liabilities, including deposits and borrowed funds. Note that different assets and liabilities have different returns and default rates based on the state of the world. Importantly, the responses in this worksheet are what determine your evaluation on the assignment.

Refer to: 1) the instructions in this worksheet, 2) the simulation handbook for previous versions of the exercise provided to you by your instructor (in PDF), and 3) information in the text, Cecchetti, S. G. and Schoenholtz, K (5e). Money, Banking, and Financial Markets.

In Round 2 of the Simulation, you are asked to apply the Outcome, determined by chance, to your bank's portfolio. Use the embedded Excel worksheet below. To enter your values, place the cursor onto the table. Next, right click the mouse. Choose "Worksheet Object, Edit." You will want to save your work and make sure it appears in the Word document

1. Refer to your Round 1 Bank Balance Sheet. With the Outcome determined by chance, complete the spreadsheet by opening it and using the drop down menu to determine your Bank's Outcome from Round 1.

In Round 2 you are asked to grow your bank's balance sheet through the expansion of assets funded by liabilities. Specifically, you can now leverage (increase the liabilities of) your bank up to a multiple of 12x total shareholder's equity.

Refer to your End of Round 1 Bank Balance Sheet (above). Now add Leverage to your bank's Balance Sheet. Use the embedded Excel worksheet below to complete. To enter your values, place the cursor onto the table. Next, right click the mouse. Choose "Worksheet Object, Edit." You may use a rounded value in cell C2 to determine your Total Equity at the End of Round 1.

Allocate your bank's Assets in proportion to the Liabilities you added through Leverage.

Make sure your Balance Sheet totals correctly.

1. In the space below, provide the rationale single spaced, for your Start of Round 2 asset allocation and funding source decisions. Include in your assessment how you might solve the problem of either adverse selection or moral hazard in your allocation (refer to Chapter 11)

4. Refer to Chapter 12, Equation (3), ROE. Assume you wish to attain a return on equity, ROE, of 14% on Shareholders Equity by the end of Round 2. Use the Total Shareholders Equity balance from the Balance Sheet above. How much net profit after tax will your bank need to earn to attain the goal? Show your work below.