Question

(1.) Suppose you are a manager of a bank with the following balance sheet:

Assets (in millions)		Liabilities (in millions)
Reserves	$30	Checkable Deposits	$200
Securities	$150	Time Deposits	$600
Loans	$820	Borrowings	$100

Suppose you are required to hold 10.00% of checkable deposits as reserves with the central bank. If you were faced with an unexpected withdrawal of $30 million from time deposits, would you rather:

• I. Draw down $10 million of excess reserves and borrow the remain $20 million from other banks? or

• II. Draw down $10 million of excess reserves and sell securities of $20 million?

Explain your choice.

Answer 1

The choice would depend upon the market interest rates. It would be sensible to draw down $10 million of excess reserves since it carries no explicit cost. Hence the choice is between borrowing from the other banks or selling securities would depend upon the interest rate charged by other banks. If the interest rate charged by other banks is higher than the returns on securities, it would be preferable to sell the securities rather than taking more loan since it would entail a lower cost. However if the return on securities is higher than the cost of borrowing, the bank should borrow the money. This is also a better option since the loan can be paid off as and when the bank has enough money on hand, but if securities are purchased again there will be a transaction cost to it too.,