FIN 311

Assignment 8 Chs 15, Addendum to 15 and 12

Ch. 12 problems
1) Fine-Tuned Savings Association finds that it can attract the following amounts of deposits if it
offers new depositors and those rolling over their maturing CDs at the interest rates indicated
below:

Expected Volume of New Rate of Interest Offered

Deposits Depositors
$10 million 4.00%
15 million 4.35
20 million 4.60
24 million 5.00
26 million 5.35

Management anticipates being able to invest any new deposits raised in loans yielding 5.50
percent. How far should this thrift institution go in raising its deposit interest rate in order to
maximize total profits (excluding interest costs)?

Rate Exp. Diff.

Total Marginal Marginal Total
Expected Offered Marginal In Marg.
Interest Interest Revenue Profits
Inflows on New Cost Rate Rev and
Cost Cost Rate Earned
Funds Cost
$10 4.00% 0.4000 0.4000 4.00% 5.50% +1.50% $0.1500
$15 4.35% 0.6530 $0.253 5.05% 5.50% +0.45% $0.1730
$20 4.60% 0.920 0.2680 5.35% 5.50% +0.15% $0.1800
$24 5.00% $1.200 $0.280 7.00% 5.50% -1.50% $0.120
$26 5.35% $1.391 $0.191 9.55% 5.50% -4.05% $0.039

Fine-Tuned Savings Association should raise its deposit rate to 4.60 percent, attracting $20
million in new deposits; because up to that point the marginal revenue rate is greater than the
marginal cost rate and total profits are also rising. At 5.0 percent, the marginal cost rate is greater
than the marginal revenue rate and total profits fall from a high of $0.18 million back down to
$0.12 million.

2) R&R Savings Bank finds that its basic transaction account, which requires a $1,000 minimum
balance, costs this savings bank an average of $4.65 per month in servicing costs (including
labor and computer time) and $1.83 per month in overhead expenses. The savings bank also tries
to build in a $0.75 per month profit margin on these accounts. What monthly fee should the bank
charge each customer?
Further analysis of customer accounts reveals that for each $100 above the $1,000
minimum in average balance maintained in its transaction accounts, R&R Savings saves about 5
percent in operating expenses with each account. (Note: If the bank saves about 5 percent in
operating expenses for each $100 held in balances above the $1,000 minimum, then a customer
maintaining an average monthly balance of $1,500 should save the bank 25 percent in operating
costs.) For a customer who consistently maintains an average balance of $1,350 per month, how
much should the bank charge in order to protect its profit margin?

Following the cost-plus-profit approach, the monthly fee to be charged by the bank should be:

Operating Planned profit

Unit price charged Estimated overhead
expense per unit margin from
the customer for = + expense allocated to the +
of deposit each service
each deposit service deposit-service function
service unit sold

= $4.65 + $1.83 + $0.75 = $7.23 per month.

The appropriate fee for a customer maintaining an average balance of $1,200 per month would
be:

[$4.65 – {0.175 × ($4.65)}] + $1.83 + $0.750 = $3.836 + $1.83 + $0.750 = $6.416 per month.

3) Lucy Lane maintains a savings deposit with Monarch Credit Union. This past year Lucy
received $10.75 in interest earnings from her savings account. Her savings deposit had the
following average balance each month:

January $450 July $450

February 350 August 425
March 300 September 550
April 550 October 600
May 225 November 625
June 400 December 500

What was the annual percentage yield (APY) earned on Lucy’s savings account?

Lucy’s account had an average balance this year of:

[$450 × 31 days + $350 × 28 days + $300 × 31 days + $550 × 30 days + $225 × 31 days
+ $400 × 30 days + $450 × 31 days + $425 × 31 days + $550 × 30 days + $600 × 31 days
+ $625 × 30 days + $500 × 31 days] ÷ 365 days

= $452.055

Then the APY must be:

APY= 2.38 percent.

Ch. 15 problems
4) Please calculate Red River National Bank’s total risk-weighted assets, based on the following
items that the bank reported on its latest balance sheet. Does the bank appear to have a capital
deficiency?

Cash $ 80 million
Domestic interbank deposits 145 million
U.S. government securities 275 million
Residential real estate loans 413 million
Commercial loans 587 million
Total assets $1,500 million
Total liabilities $1,375 million
Total capital $125 million

Off-balance-sheet items include:

Standby credit letters that back municipal

general obligation bonds $ 93 million
Long-term unused loan commitments to
private companies 216 million

The risk-weighted assets of Red River National Bank would be calculated as follows:

Solution:

The credit-equivalent amount of each off-balance-sheet (OBS) items:

Standby credit letters that back municipal

general obligation bonds $93 million × 0.20 = $18.6 million
Long-term unused loan commitments to $216 million × 0.50 = $108.0
private companies million

On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items:

0 Percent Risk-Weighting Category

Cash $80.00 million
U.S government securities $275.00 million
Total $355.00 million × 0.00 = $0 million

20 Percent Risk-Weighting Category

Domestic interbank deposits $145.00 million
 Standby credit letters that back municipal
general obligation bonds 18.60 million
Total $163.60 million × 0.20 = $32.72 million

50 Percent Risk-Weighting Category

Residential real estate loans $413.00 million × 0.50 = $206.50 million

100 Percent Risk-Weighting Category

Commercial loans $587.00 million
Long-term unused loan commitments to
private companies $108.00 million
Total $695.00 million × 1.00 = $695.00 million
Total risk-weighted assets held by this bank $934.22 million

Red River's overall capital-to-assets ratio is:

Total Capital = $125 million = 0.1338 or 13.38 percent

Total Risk-Weighted Assets $934.22 million

Based on the risk weighted assets, it does not appear that Red River has a capital deficiency as
the capital to risk-weighted assets ratio is above the minimum requirement of 8 percent. In fact
Red River is in a position to generate more assets by utilizing some part of the extra capital of
5.38 percent.

5) Suppose Red River National Bank, whose balance sheet is given in problem 4, reports the
forms of capital shown in the following table as of the date of its latest financial statement. What
is the total dollar volume of Tier 1 capital? Tier 2 capital? Calculate the Tier 1 capital-to-risk-
weighted- assets ratio, total capital-to-risk-weighted-asset ratio, and the leverage ratio.
According to the data given in Problems 5 and 6, does Red River have a capital deficiency?
What is its PCA (total capital to risk-weighted assets , Tier 1 capital to risk-weighted assets, and
Tier 1 capital to average total assets) capital adequacy category?

Red River National Bank has the following Tier 1 and Tier 2 capital items and totals:

Tier 1 Capital Tier 2 Capital

Common stock (par value) $7 million Allowance for loan losses $32 million
Surplus $28 million Subordinated debt capital $15 million
Undivided profits $37 million Intermediate-term preferred stock $6 million
 Total Tier 1 capital $72 million Total Tier 2 capital $53 million

Hence, the Tier 1 capital-to-risk-weighted- assets ratio is calculated as follows:

Tier 1 capital = $72 million = 0.07707 or 7.71%

Total risk-weighted assets $934.22 million

Total capital-to-risk-weighted-asset ratio is calculated as follows:

Total capital = $72 million + $53 million = 0.1338 or 13.38 %

Total risk-weighted assets $934.22 million

The leverage ratio is calculated as follows:

Tier 1 capital = $72 million = 0.048 or 4.80%

Total assets $1,500 million

This bank has sufficient Tier 1 capital and since its Tier 2 capital amount is less than 100 percent
of Tier 1 capital amount, it satisfies the requirements of Basel I. Also, its PCA capital adequacy
category would be “well capitalized” as it has a ratio of capital to risk-weighted assets of more
than 10 percent and a ratio of Tier 1 (or core) capital to risk-weighted assets of more than 6
percent. However, its leverage ratio (Tier 1 capital to average total assets) does not meet the
required standard of at least 5 percent.

6) Richman Savings Association has forecast the following performance ratios for the year
ahead. How fast can Richman allow its assets to grow without reducing its ratio of equity capital
to total assets, assuming its performance holds reasonably steady over the period?

Profit margin of net income over operating revenue 12.00%

Asset utilization (operating revenue ÷ assets) 7.38%
Equity multiplier 11.4x
Net earnings retention ratio 55.00%

Internal capital growth rate = Profit margin of net income over operating revenue × Asset
utilization × Equity multiplier × Net earnings retention ratio

= 0.0553 or 5.553 percent

Its assets cannot grow any faster than 5.53 percent over the period without reducing its ratio of
equity capital to total assets.
Ch 15 Addendum

Consider the following information:

EAD
(loan
amount
PD LGD )
3.50% 25% $5m.

a.Find out the expected loss for this loan:

EL = 0.035*0.25*5 = $0.04375m. , or $43,750

b.Find the unexpected loss for this loan:

UL = SQRT(PD –PD**2*LGD*EAD) = $0.1829447, or $182,945

c.How much economic capital does the bank need to have in excess of the expected
(average) loss for this loan?

Economic capital = UL = $182,945

d.Calculate the return on risk-adjusted capital (RORAC) for this loan if the bank charges
4% interest on this loan:

$0.04*5,000,000 / $182,945 = 109.32%