Wiggle S&L has currently $120 deposit from one-year savings account and made 30 year fixed interest rate mortgage loans of $100. . Also, the bank owns government securities whose market value is $60. Both loan and deposit interest rates are fixed at 5%.

1. What is the market value of the loan and the deposit? Assume that the market interest rate is also 5% and the depositor will not withdraw the money for 1 year and the probability of default for the loan is zero. (Hint: The value of the loan is identical to the present value of a 30 year bond with 5% coupon rate.)

2. If the loan and the deposit are the only asset and liability of the Wiggle S&L, what is the value of the banks capital?

3. Now suppose that the market interest rate has increased from 5% to 10% overnight due to an unexpected inflation. How will the value of loan and deposit change? (Assume that both the deposit and contracts are not indexed. Therefore, deposit and loan interest rates do not change despite the change in market interest rate.) What is the banks capital?

4.

Based on this example, provide a rationale for the capital requirement regulations such as Basel II.