Question

A DI has assets of $17 million consisting of $7 million in cash and $10 million in loans. It has core deposits of $13 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 $1 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 to the firm from this strategy after the drain? (Enter your answer in dollars not in millions.)
a-2. What will be the total asset size of the firm after the drain? (Enter your answer in millions.)
b-1. If the cost of issuing new short-term debt is 4.6 percent, what is the cost of offsetting the expected drain if the DI increases its liabilities? (Enter your answer in dollars not in millions.)
b-2. What will be the total asset size of the DI from this strategy after the drain? (Enter your answer in millions.)
  

a-1.	Cost of the drain	$
a-2.	Total asset size	$16	million
b-1.	Cost of the drain	$
b-2.	Total asset size	$17	million

Answer 1

a-1) Calculation of cost of drain

Net interest margin= Avg. yield of loans - Avg. cost of deposits = 5%-2% = 3%

Cost of the drain = Net interest margin * core deposit

= 3% * $1 million

= $30,000

a-2) Calculation of total asset size of firm

Total asset size from drain = Total assets - Net drain of core deposits

   = $17 million - $1 million

= $16 million

b-1) Calculation of cost of offsetting the expected drain if the DI increase its liabilities

  Cost of new-short term debt = 4.6%

Cost of deposits = 2%

  Extra cost =4.6% - 2% = 2.6%

  Cost of off-setting = 2.6% * $ 1million

= $26,000

b-2) Calculation of total asset size of Di after b-1 strategy

  Total asset size from drain = $16 million + $1 million

  =$17 million