Suppose ABC Bank borrowed funds partly from "wholesale" depositors (large cash pools too large to be covered by deposit insurance) and partly from "retail" depositors (with accounts small enough to be backed by deposit insurance) in order to finance its mortgage lending to 655 people like Katrin. ABC Balance Sheet Assets Llabilities Reserves = $10 million "retail" deposits = $50 million Mortgages = $190 million "wholesale" deposits = $140 million Interbank loans to other banks = $0 Discount loans from the Fed = $0 Interbank loans from other banks = $0 Net Worth $10 million a) What is ABC initial leverage ratio? Now suppose that the "Katrins" start defaulting on ABC mortgages. b) What happens to the value of mortgages and the net worth of ABC bank? What change in the value of mortgages would make ABS bank insolvent? c) What is the "collateral" for $140 million the wholesale depositors have lend ABC Bank? How will the "Wholesale" depositors respond to the change in the net worth of ABC bank? d) What are three ways ABC Bank can attempt to obtain reserves in order to pay the wholesale depositors? e) If there is a run on ABC bank what could happen to other banks, thus causing a financial crisis? f) If many banks are selling MBS ("fire sales") what happens to the net worth of banks? g) What can The Fed (the US central bank) do to stop the fire sales and stop the bank run? h) Given your answers to question 6), what values for leverage ratios for households would make mortgage defaults less likely? Given your answers to a) to g) above what values for leverage ratios for banks would make bank runs and financial panics less likely? Suppose ABC Bank borrowed funds partly from "wholesale" depositors (large cash pools too large to be covered by deposit insurance) and partly from "retail" depositors (with accounts small enough to be backed by deposit insurance) in order to finance its mortgage lending to 655 people like Katrin. ABC Balance Sheet Assets Llabilities Reserves = $10 million "retail" deposits = $50 million Mortgages = $190 million "wholesale" deposits = $140 million Interbank loans to other banks = $0 Discount loans from the Fed = $0 Interbank loans from other banks = $0 Net Worth $10 million a) What is ABC initial leverage ratio? Now suppose that the "Katrins" start defaulting on ABC mortgages. b) What happens to the value of mortgages and the net worth of ABC bank? What change in the value of mortgages would make ABS bank insolvent? c) What is the "collateral" for $140 million the wholesale depositors have lend ABC Bank? How will the "Wholesale" depositors respond to the change in the net worth of ABC bank? d) What are three ways ABC Bank can attempt to obtain reserves in order to pay the wholesale depositors? e) If there is a run on ABC bank what could happen to other banks, thus causing a financial crisis? f) If many banks are selling MBS ("fire sales") what happens to the net worth of banks? g) What can The Fed (the US central bank) do to stop the fire sales and stop the bank run? h) Given your answers to question 6), what values for leverage ratios for households would make mortgage defaults less likely? Given your answers to a) to g) above what values for leverage ratios for banks would make bank runs and financial panics less likely
