Question

A DI has assets of $24 million consisting of $8 million in cash and $16 million in loans. It has core deposits of $20 million. It also has $2 million in subordinated debt and $2 million in equity. Increases in interest rates are expected to result in a net drain of $3 million in core deposits over the year.

a-1. The average cost of deposits is 2 percent and the average yield on loans is 5 percent. The DI decides to reduce its loan portfolio to offset this expected decline in deposits. What is the cost of the firm from this strategy after the drain? (Enter your answer in dollars not in millions.) Cost of the drain=?

$ a-2. What will be the total asset size of the firm from this strategy after the drain? (Enter your answer in millions.) Total asset size= ?million

b-1. If the cost of issuing new short-term debt is 3.5 percent, what is the cost of offsetting the expected drain if the DI increases its liabilities? (Enter your answer in dollars not in millions.) Cost of the drain= ?

b-2. What will be the total asset size of the DI from this strategy after the drain? (Enter your answer in millions.) Total asset size=? million

Answer 1

Solution a
Assuming that the decrease in loans is offset by an equal decrease in deposits, the cost of the drain = (0.05 – 0.02) x $3 million = $90,000. The average size of the firm will be $21(24-3) million after the drain.

Solution b
The average size of the firm will be $21(24-3) million after the drain.
Solution c
Cost of the drain = (0.035 – 0.02) x $3 million = $45,000
Solution d
The average size of the firm will be $24(21+3) million after the drain