DARNELL: Hi, Felix. I would like to ask you about leverage. The Professor was talking about the advantages and disadvantage of banks usingleverage. From what I understand, high bank leverage was one of the key ingredients in the housing bubble and the financial crisis thatfollowed. What I do not understand is that, if leverage is so risky, why wouldn't the government just forbid banks from using leverage at all andthus eliminate the possibility of such a crisis in the future?FELIX: Darnell, this is not an easy question. Regulators and bankers are still searching for strategies that would benefit both investors and bankcustomers. I'll try to help you understand the trade-off of using leverage versus abandoning it completely. But first, let's make sure youunderstand what leverage is.DARNELL: In banking, leverage means that banks can useIncrease the potential return onreservesto purchase assets that offer higher returns and thusdepositsreservesstockholders' equityFELIX: Consider a bank that has $8,000,000 in deposits anes. Suppose it lends out $7,200,000. What are the bank's totaldepositsassets and stockholders' equity?DARNELL: This bank has$8,200,000 in assets, and stockholders' equity is sFELIX: Now, suppose the bank's deposits carry an average annual interest rate of 4%, whereas its loans yield 8%. This means that the bank earns$7,200,000 x 0.08 = $576,000 on loans and must pay only $8,000,000 x 0.04 = $320,000 in interest on deposits. To sum up, the bank"borrowed" dollar deposits from its customers to return $576,000 – $320,000 = $256,000per year in profit for its stockholders.DARNELL: I see. This implies that the bank offers a return ofon its equity of $200,000. Quite impressive!FELIX: Yes, the investors should be excited to get such a return! However, what if there is an increase in defaults, so that the bank's assets (loans)fall in value by, say, 10%, or $7,200,000 x 0.1 = $720,0002 The value of loans outstanding would decline to$7,200,000 – $720,000 = $6,480,000 and total assets would be $1,000,000 + $6,480,000 = $7,480,000 consequentily, the stockholders'equity will decline to $7,480,000 – $8,000,000 = -$520,00QDARNELL: But this means that the bank's shareholders lostof the original equity of $200,000!FELIX: Now, let's see whether it would really help if the bank used no leverage, that is, if it operated without borrowing from customer deposits. Allit would be able to loan out is its equity of $200,000, which would earn just $200,000 x 0.08 = $16,000. Given a 4% interest rate on deposits,the bank's profit would be $16,000 – $320,000 = -$304,000 with such low expected returns, the bank would not exist in the first place, asinvestors would undoubtedly go somewhere else. Thus leverage is essential to a bank's profitability, but it also carries significant risk.

Leverage in banking terms imply that the optimal utilization of the deposits for the disbursing of…

Answered: leverage

Business

Economics

leverage

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

See similar textbooks

Related questions

Q: International banking facilities are Foreign branch offices of large domestic banks. Departments of…

A: When banks have to make transactions in some other currency zone, many hurdles can appear, which are…

Q: The creation of the Federal Reserve in 1913 Multiple Choice guaranteed the Federal Reserve would…

A: The monetary policies are those policies which are enacted by the central bank of a country to…

Q: Over the last 15 years the Federal Reserve has substantially changed the way it operates. What is…

A: The Federal Reserve System is the central bank of the United States. Five general functions are…

Q: Congress purposely established the Fed back in 1913 as an independent agency of government, thus…

A: The Federal Reserve, also known as the Fed, is Country U's central bank. The Country U Congress…

Q: The Federal Reserve Bank of New York has a great deal of influence over financial markets to this…

A: The Federal Reserve System or the Federal Reserve are other names for the Fed. It serves as both the…

Q: Money Creation and the Federal Reserve: Around the World The popularity of Swiss bank accounts was…

A: Long-term Stability of Switzerland's Economy: Switzerland has a reputation for economic stability.…

Q: Consider the scenario where you are the Chairperson of the Federal Reserve Bank. The US economy is…

A: inflation is the situation where general average price level increases over period of time .…

Q: Systemic risk refers to risks the federal government faces when it increases its debt O risks to the…

A: In a market, risk refers to the possibility of having loss in a specific situation when making an…

Q: To support economic growth, the Indonesian government is committed to making the Islamic economy a…

A: Following are five key ways that conventional and Islamic commercial banks differ: 1. The oversight…

Q: Assess whether it is beneficial to be in a Monetary Union

A: A monetary union is a collection of nations that uses a single currency and has a single central…

Q: Financial institutions such as banks pays lower interest rates to depositors and charge higher…

A: Democratic government is a type of government in which there is both public and private sector…

Q: Some charge that the Crisis of 2008 was caused by the greed of Wall Street firms and other bankers.…

A: The crisis of 2008 was a very serious crisis and the economy all around the world had to face the…

Q: The main reason people hold money (in terms of what counts in M1) is to Group of answer choices…

A: The M1 measure of money includes the liquid forms of money such as cash, demand deposits, traveler’s…

Q: A large state's senator recently made a speech condemning the continuous deficits in the federal…

A: Monetary and fiscal policies are both macroeconomic instruments used to steer or boost the economy.…

Q: the quantity of money supplied exceeds the quantity of money demanded then what can you say about…

A: *Answer: .

Q: explain the implications of The O-Ring Model

A: O-Ring Model:- This relates to the idea that even the tiniest elements of a complicated…

Q: The charging of interest rates is often viewed with contempt. Do interest rates serve any useful…

A: The interest rate is the sum of the principal that a loan owes for the utilization of money. The…

Q: Commercial banks were accused of being too speculative in the pre-Depression era because they were…

A: The Glass-Steagall Act: a law passed in 1933 as part of the New Deal that separated commercial and…

Q: Annuity The market forces in financial markets are determining that all asset yields (interest…

A: This approach involves the central bank (Reserve Bank of Australia) issuing more bonds to increase…

Q: Market interest rates are established by the banks or any financial institutions. True or false?

A: Answer - Market Interest rate - It is the interest rate given on the deposits or other investments…

Q: The difference between a spot rate and a forward rate is termed the Forward Neutral Forward…

A: The distinction between the spot rate and the forward rate is known as the basis. No matter what the…

Q: As the interest rates decline, the amount of money the public holds rise. True or False

A: Interest rate play an important role in the people's decision to hold money.

Q: Can you thoroughly explain the broken window fallacy?

A: Earlier to Broken window fallacy given by Frederic bastiat, the economist was of the opinion that…

Q: Distinguish between Market and Inflation-Free Interest Rates?

A: The Market interest Rate, also called the nominal interest rate (i) is the rate which is not…

Q: characteristic of paper money? Question 23 options: It is valuable because it is generally…

A: Functions of money . a store of value . a unit of account . a medium of exchange

Question

DARNELL: Hi, Felix. I would like to ask you about leverage. The Professor was talking about the advantages and disadvantage of banks using
leverage. From what I understand, high bank leverage was one of the key ingredients in the housing bubble and the financial crisis that
followed. What I do not understand is that, if leverage is so risky, why wouldn't the government just forbid banks from using leverage at all and
thus eliminate the possibility of such a crisis in the future?
FELIX: Darnell, this is not an easy question. Regulators and bankers are still searching for strategies that would benefit both investors and bank
customers. I'll try to help you understand the trade-off of using leverage versus abandoning it completely. But first, let's make sure you
understand what leverage is.
DARNELL: In banking, leverage means that banks can use
Increase the potential return on
reserves
to purchase assets that offer higher returns and thus
deposits
reserves
stockholders' equity
FELIX: Consider a bank that has $8,000,000 in deposits an
es. Suppose it lends out $7,200,000. What are the bank's total
deposits
assets and stockholders' equity?
DARNELL: This bank has
$8,200,000 in assets, and stockholders' equity is s
FELIX: Now, suppose the bank's deposits carry an average annual interest rate of 4%, whereas its loans yield 8%. This means that the bank earns
$7,200,000 x 0.08 = $576,000 on loans and must pay only $8,000,000 x 0.04 = $320,000 in interest on deposits. To sum up, the bank
"borrowed" dollar deposits from its customers to return $576,000 – $320,000 = $256,000per year in profit for its stockholders.
DARNELL: I see. This implies that the bank offers a return of
on its equity of $200,000. Quite impressive!
FELIX: Yes, the investors should be excited to get such a return! However, what if there is an increase in defaults, so that the bank's assets (loans)
fall in value by, say, 10%, or $7,200,000 x 0.1 = $720,0002 The value of loans outstanding would decline to
$7,200,000 – $720,000 = $6,480,000 and total assets would be $1,000,000 + $6,480,000 = $7,480,000 consequentily, the stockholders'
equity will decline to $7,480,000 – $8,000,000 = -$520,00Q
DARNELL: But this means that the bank's shareholders lost
of the original equity of $200,000!
FELIX: Now, let's see whether it would really help if the bank used no leverage, that is, if it operated without borrowing from customer deposits. All
it would be able to loan out is its equity of $200,000, which would earn just $200,000 x 0.08 = $16,000. Given a 4% interest rate on deposits,
the bank's profit would be $16,000 – $320,000 = -$304,000 with such low expected returns, the bank would not exist in the first place, as
investors would undoubtedly go somewhere else. Thus leverage is essential to a bank's profitability, but it also carries significant risk.

Expert Solution

This question has been solved!

Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.

This is a popular solution!

SEE SOLUTION Check out a sample Q&A here

Step 1

Step 2

Step 3

Step 4

Trending now

This is a popular solution!

Step by step

Solved in 4 steps

SEE SOLUTION Check out a sample Q&A here

Knowledge Booster

Learn more about

Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, economics and related others by exploring similar questions and additional content below.

Similar questions

In order to slow money creation, a country might privatize a SOE (state owned enterprise), thereby eliminating the cash subsidies it receives to cover its operational losses. True ☐ False ☐
Suppose an investment bank is buying $100 million in long-term mortgage-backed securities and finances the investment by borrowing 75% and paying for the other 25% out of equity. What is the bank's leverage?
A Credit Union is a bank owned by its depositors who are called members and they have something in common. Suppose that the Credit Union member share in common is that most of them work for the oil industry in a particular town in Texas. If the price of oil declines dramatically leading to mass layoffs in the oil industry then we may expect that Many Credit Union borrowers may default on their loans Many Credit Union depositors may withdraw their savings the Credit Union may face insolvency risk d. all of the above b. O O O
If the slope of the nominal yield curve is steeper that the slope of the real yield curve, market predicts that boom is coming and inflation rate will go down in the future. recession is coming and inflation rate will go down in the future. boom is coming and inflation rate will go up in the future. recession is coming and inflation rate will go up in the future.
The video claims that a HECs-style government loan would lead to "the taxpayer... propping [up] "zombie" firms and the loan [would not] be repaid." What is meant by this? Lifeless firms would continue to operate, generating profits followed by defaulting on the government loan Firms will continue to have no customers, meaning they have no means to repay the government Firms will file for bankruptcy so they don't have to repay the government None of the options
Let's assume that the table below presents the credit cards market in Oregon at different interest rates in 100 million of dollars. What is the equilibrium interest rate in this hypothetical market? Interest Rate Quantity Supplied Quantity Demanded8% 800 1300 11% 900 1200 14% 1000 1150 17% 1100 1100 20% 1200 105022% 1300 1000
Using two teams, initiate an argument that agrees (Pro) with the Fed actionand an argument that opposes (Con) the Fed action.
Over the last 10 years the Federal Reserve has substantially changed the way it operates. What is different about how the Federal Reserve now conducts policy? options: it discusses its policy in public and asks for guidance from Congress it gives the public forward guidance on what it will do It is more secretive about interest rate and other policy changes it places fewer regulations on commercial banks
The interest rate is the opportunity cost of holding money. Select one: True False
The U.S. fiduciary monetary system :puts capital controls in place .is one where money is not convertible to a fixed quantity of gold .controls the private banking system .is the one agency responsible for providing coins and paper currency.
In a less-developed economy, cattle is widely accepted as payment for goods and services. Nearly all goods and services are priced in terms of cattle; however, cows vary in quality, become less valuable with age, and are difficult to move over long distances. Which of the following functions of money do cattle provide? Select the two correct answers. portability uniformity medium of exchange unit of account store of value
The actions taken by the RBA in Australia to influence interest rates, aggregate demand, economic activity, and prices in the economy is known as: