Question

QUESTION 3 a) If a bank is falling short of meeting its capital requirements by $1 million, what three things can the bank do to rectify the situation? (3 marks) b) What are the two basic causes of financial crises in emerging market economies? (3 marks) c) An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Deliberate on the following; i. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. (3 marks) ii. Based on the liquidity preference framework, how would your answer in (i) above be reflected by the interest rate, if the liquidity effect is smaller than the income and prose-level effects? (3.5 marks) [12.5 marks]

Answer 1

SOLUTION

1 THREE THINGS THE BANK CAN DO WHEN THE BANK IS FALLING SHORT OF MEETING ITS CAPITAL REQUIREMENT

If a bank is falling short of meeting its capital requirement by $1 million , the three things the bank can do as follows

1 It can raise $ I million of capital by issuing new stock.

2 It can cut its dividend payments by $ 1 million , thereby increasing its retained earnings by $ 1 million

3 It can decrease the amount of assets so that the amount of capital relative to its assets increases , thereby meeting the capital requirements.

2 TWO BASIC CAUSES OF FINANCIAL CRISIS IN EMERGING MARKET ECONOMICS

Financial markets are weaker in emerging markets than an in industrial countries in two respects

* Financial disclosure laws are weaker, implying the most financing takes the form of debt instead of equity. In the event of default the bankruptcy courts awards creditors a smaller share of the proceeds from the investment projects.

* When risky projects are financed by debt, creditors impose a celling on debt to ensure entrepreneurs with a profitable project prefer repayment to sacrificing the specified fraction of output. The larger the expected bankruptcy award, due to the larger expected level of output and a greater creditor protection , the higher will be the debt ceiling.

3 DELIBRATING AN IMPORTANT WAY IN WHICH THE FEDERAL RESERVE THE MONEY SUPPLY BY SELLING BONDS TO THE PUBLIC

1) EFFECT THE ACTION IN INTEREST RATES, USING DEMAND AND SUPPLY BONDS

Interest rate levels are a factor of a supply and demand of credit : an increase in the demand of money or the credit will rise the interest rates , while a decrease in the demand for credit will decrease them and as the supply of the credit increases , the price of the borrowing decreases. Hence, when the riskiness of the bonds rises, the increased riskiness of bonds lowers the demands for bonds. The demand curve will therefore shift to the left, and the equilibrium bond price falls and the interest rates will increase.

2) HOW THE LIQUIDITY EFFECT IS SMALLER THAN THE INCOME AND PROSE LEVEL EFFECTS

Liquidity preference suggest investors should demand a higher interest rate on premium on securities with long - term maturities that carry on a greater risk because all other factors are being equal , investors prefer cash or other highly liquid holdings.

The demand for liquidity holds more speculative power, investments that are more liquid are easier to cash in for full value. Cash is commonly accepted as the most liquid asset. According to this theory , interest rates of short term securities are lower because the investors are not sacrificing liquidity for greater time frames than medium or longer term securities .

Hence, enabling the liquidity effect to be smaller than the income and prose level effects