Question

Excess reserves act as insurance against deposit outflows. Suppose that on a yearly basis
Malcom Bank holds $12 million in excess reserves and $88 million in required reserves. Suppose
that Malcom Bank can earn 3.5% on its loans and that the interest paid on (total) reserves is
0.2%. What would be the cost of this insurance policy?

a. $0.40 million
b. $0.60 million
c. $0.75 million
d. $0.50 million

Answer 1

Cost of insurance policy = forgone interest income - interest paid on excess reserve

Forgone interest income = excess reserve × earn an interest rate

Forgone interest income = 12 million × 3.5% = 0.42 million

Interest paid on excess reserve = excess reserve × rate of interest paid = 12 million × 0.2% = 0.024 million

Cost of insurance policy = 0.42 - 0.024= 0.396 or 0.40 million ( rounded up)