University of Amsterdam, Business School

Caput Commercial Banking Academic Year 2010/2011 Exam January 2011

Student name .. Student ID .. Signature ..

Instructions
The rules of this exam are as follows: Please write your full name, student ID and signature. Please keep all answers brief and to the point. Do not provide irrelevant informa- tion, but show all steps that are necessary to solve a problem. There are 12 pages in this exam including this page. Questions start on Page 2 and end on Page 9. The last three pages are empty and are to be used for rough work. Please return all the pages together with the text of the exam. This is a closed books closed notes exam. Ordinary calculators are permitted, but no computers or other devices. Dictionary is not allowed. Please answer in the space provided as far as possible. The exam includes four exercises. All exercises are compulsory (no options!) - so attempt all exercises you can. If a question seems unclear, interpret it as best you can and proceed. Do not contact me or anyone else seeking clarification. You have 2 hours (!) to complete the exam. Good luck! Score Exercise 1 (max 10 points) Exercise 2 (max 25 points) Exercise 3 (max 25 points) Exercise 4 (max 40 points) Total points: 100

Exercise 1
Bank XYZs debt obligations have a present value Euros 2b and a duration of 5 years. Half of this is a 10-year note with a duration of six years. The banks CFO has decided that the bank should target a debt duration of four years instead of five. Assume that it is possible to issue 4-year notes with a duration of three years. If the proceeds from issuing these notes are used to retire 10-year notes, there will be a reduction in the duration of the banks liabilities. Assuming a flat yield curve, how many Euros of 4-year notes should the bank issue?

Exercise 2
Consider an economy with a large number of penniless entrepreneurs. Each entrepreneur requires external funding equal to 50 to start a new project today. The project can be risky or risk-free. The risky project generates cash flows 100 with probability 3/5 (and 0 with prob 2/5). The risk-free project always generates cash flows of 60. Assume that everybody is riskneutral and the riskfree interest rate is 10%. (1) Calculate the NPV of each project. Are both projects credit worthy? Suppose there is asymmetric information. The bank does not know the riskiness of the project and it can not discover it by screening the project. The only thing the bank knows is that safe projects occur in 20% of all cases. The entrepreneur instead knows the projects riskiness. Entrepreneurs only start a project if they end up with a strictly positive expected payoff (taking into account what they have to pay back to the bank). There is perfect competition in the credit market, i.e. banks break-even in expectation. Suppose initially that the manager of the bank reasons as follows: The project is risky with probability 4/5 and it fails with probability 2/5. With probability 1/5 the project is risk-free. So, to break-even I have to charge an interest rate such that 4/5 3/5 50(1 + r) + 1/5 50(1 + r) = 50(1.1). (2) Is a loan applicant that would accept the resulting interest rate, credit worthy at that interest rate? (3) Does the bank break-even at that interest rate? Motivate your answer. Suppose now that the previous manager is fired and a new smart manager is hired. (4) Which interest rate will banks charge in equilibrium if a debt un-collateralized contract is signed between parties? (5) Is there any market imperfection at the equilibrium interest rate found in point (4)? Motivate your answer. (6) List at least three different instruments the bank can use to mitigate the problem of asymmetric information. Explain intuitively why they are useful. (7) Choose one of the instruments you have listed above and show analytically how it can be used to solve the problem of asymmetric information.

Exercise 3
Consider a bank that seeks to sell a loan to one of many riskneutral investors. The problem is that the bank is perfectly informed about the quality of the loan, while the investor is not. The investor knows that the loan can either be of low or high quality. A low quality loan generates income 1000 with probability 1/5 in one year and zero with probability 4/5. A high quality loan generates income H for sure, where H 200. Prior to the loan sale, the investor attaches probability to the event that the loan is of high quality. The bank enjoys a benefit equal to 40 when removing a loan from its book (stemming, say, from lower regulatory capital costs). This is true when the loan is high quality but also when is low quality. (a) Suppose that the bank can credibly communicate the quality of the loan with zero cost. What is the price at which the bank is able to sell a high quality loan and a low quality loan. What are the total gains from selling each loan for the bank? (b) Now suppose that the bank cannot credibly communicate the quality of the loan. What is the new equilibrium price at which the bank is able to sell the loan? (c) Suppose now that the true quality of the loan is high and the bank cannot credibly communicate the quality of this loan. Under which condition the bank is willing to sell the high quality loan, if the equilibrium price is the one found in point (b)? (d) What happens to the condition found in point (c) as 1? Explain your answer. (e) What happens to the condition found in point (c) if H = 200? Explain your answer.

Exercise 4
For each statement below say if it is true or false. Explain your answer using maximum 5 lines. The number of pints you get depends on the answer you give. 1. The effect of market yield changes on the banks equity value does not depend on the mismatch between the duration of the banks assets and liabilities. 2. For a non-zero-coupon bond, duration > maturity; an increase in the coupon in- creases duration. 3. The collateral is generally used to deal with moral hazard problems (for exam- ple, the entrepreneur can choose the level of effort which is private information) but not with adverse selection problems (for example, there are different types of entrepreneurs and the type is private information). 4. The deposit insurance and the lender of last resort are two instruments used to avoid bank runs. These two instruments are ex-ante efficient. 5. Capital adequacy regulation (Basel I) induced banks to transfer credit risks to third parties for example through securitization in order to relieve regulatory capital burden. 6. Suppose that a bank has the following balance sheet (market values, Euro b): Assets cash corporate loans t-bills 25 800 25 Liabilities deposits long-term debt common stock 700 125 25

Using this information say whether the following four sentences are true or false and motive your answer. 6a. The bank risk-weighted assets are 400. 6b. The banks total regulatory capital is 150. 6c. The bank satisfies the capital ratio imposed by Basel 1988. 6d. The bank can further increase the capital ratio by issuing additional long-term debt?