The average interest earned on the loans is 6 percent and the average cost of deposits is 5 percent. Rising interest rates are expected to reduce the deposits by $3 million. Borrowing more debt will cost the bank 5.5 percent in the short term.
-What will be the cost of using a strategy of reducing its asset base to meet the expected decline in deposits? Assume that the bank intends to keep $2 million in cash as a liquidity precaution.
A)$10,000.
B)$15,000.
C)$30,000.
D)$40,000.
E)$50,000.

Question

The average interest earned on the loans is 6 percent and the average cost of deposits is 5 percent. Rising interest rates are expected to reduce the deposits by $3 million. Borrowing more debt will cost the bank 5.5 percent in the short term.
-What will be the cost of using a strategy of reducing its asset base to meet the expected decline in deposits? Assume that the bank intends to keep $2 million in cash as a liquidity precaution.
A)$10,000. 
B)$15,000. 
C)$30,000. 
D)$40,000. 
E)$50,000.

Quizplus · Accepted Answer

First, let's calculate the amount of deposits that the bank is going to lose due to rising interest rates:

$3,000,000 x 5% = $150,000

Now, let's calculate the amount of interest earned on loans:

Total loans = $20,000,000 
Interest earned = $20,000,000 x 6% = $1,200,000

The bank intends to keep $2,000,000 in cash, so the remaining asset base is:

$20,000,000 - $2,000,000 = $18,000,000

If the bank reduces its asset base by $150,000, the new asset base will be:

$18,000,000 - $150,000 = $17,850,000

Now, let's calculate the cost of borrowing more debt at 5.5%:

Cost of new debt = $150,000 / 5.5% = $2,727,272.73

Therefore, the cost of using a strategy of reducing its asset base to meet the expected decline in deposits is:

Cost of new debt - Interest earned on loans = $2,727,272.73 - $1,200,000 = $1,527,272.73

However, the question asks for the cost of this strategy after keeping $2 million in cash as a liquidity precaution. Therefore, we need to subtract this amount from the cost we just calculated:

$1,527,272.73 - $2,000,000 = -$472,727.27

This means that the strategy of reducing its asset base actually results in financial gain for the bank. However, this would only be a short-term strategy and would not be sustainable in the long run.

The Average Interest Earned on the Loans Is 6 Percent