This question tells a sad tale of Merrill Lynched, an 'investment bank". Investment banks have a higher maximum asset to equity ratio of 20 (versus the 10 requirement imposed on regular banks). This allows them to earn a potentially higher rate of profits. The initial balance sheet (in million of dollars) is as follows

Aseets	Liabilities
Reserves 100	Deposits 1000
Loans 800	Bank bonds 200
Securities 400	Bank capital ?

a) what is bank capital? Does it satisfy the regulations?

b) Merrill makes a healthy 8% return on both loans and securities (sub-prime mortgages) but only has to pay out 5% both depositors and bondholders. (Assume zero return on reserves.) Merrill pays no taxes because they are very clear. What is Merrill's earnings (i.e. net profit after taxes), ROA and ROE?

c) Merrill identifies 50 of reserves as excess reserves and decideds to lend that out leaving 50 as reserves. How much does this improve the ROE?

d) Investment banks get the Shrub Administration to raise the maximum equity multiplier to 33.

Merrill wants to maximize its return on equity and also grow the company by buying more securities by issuing bank bonds; reserves and deposits are the same as before. (Merrill figured this was a safe move because unlike loans, securities are usually liquid, and unlike deposits, bond funding cannot be quickly withdrawn.) Continuing from part(c), redraw the balance sheet for EM=33. What is the maximum ROE?

Merrill suffered an electronic bank run on Monstrous Monday Sept 14/08 in which fearful demand depositors suddenly started withdrawing. Merrill can't sell the loans. The securities turn out to be backed by sub-prime mortgages and only receive 10 cents on the dollar in the crisis. (Merrill can't get a loan from other banks or an Advance from the Fed.)

e) after what quantity of withdrawals is Merrill insolvent?

f) what is the loss to bondholders and depositors if Merrill had received regulatory forbearance and contunued to payout to as many withdrawers as possible by continuing to liquidate securities in insolvency.

This question adds a simple dynamic analysis to the above question. Suppose the initial spreadsheet for Merrill Lynched(above) represents its situation at the end of last year. The earning(i.e. net profit after tax) in part (b) are for the current year.

a) Draw the balance sheet if all the earning are paid out as dividends to equity holders.

b) Draw the balance sheet if all of the earnings are invest in Securities at the end of the year. What is the new equity multiplier?