Question 1: Credit and liquidity risk

Consider a bank that invests an amount y in illiquid assets at t=0. At t=2, each unit invested in the illiquid asset will yield R>1 and so investment y will return yR.

Banks assets are funded with short-term debt s, long-term debt l and equity e so that: y = s + l + e. The gross interest rate that short-term creditors receive from t=0 to t=1 is 1, the gross interest rate

that they receive from t=1 to t=2 is rs > 1, and the long-term creditors receive rl at t=2.

A fraction of short-term creditors do not rollover their debt at t=1 (i.e. s withdraw), where has (approximation) a Normal distribution N(,). The bank can repay such creditors by using cash or liquidating the illiquid asset. When one unit of the illiquid asset is liquidated at t=1, it yields R where<1and1/>rl >rs.

Supposey=100,e=10,s=70,l=20,rl=1.2,rs =1.1,=0.6,=0.5and=0.1.

Table 1: Banks balance sheet

Assets Liabilities

Short-term debt s=70 y=100 Long-term debt l=20

Equity e=10

1. a) For what values of R is the bank fundamentally insolvent? For what values of R is the bank fundamentally solvent?

2. b) Suppose R =1.5 (so an investment of 100 would return 150 at t=2). What is the probability that the bank will be solvent at t=2?

3. c) Suppose that at t=1, we learn that R =1.2 and =0.9. The central bank decides to introduce an asset purchase program. What is the minimum price the central bank needs to buy the risky asset to prevent the bank from failing? How much cash does the central need to conduct the asset purchase program at that price?