What are the three causes for the emergence of the shadow banking system?

ECON 2411: Principles of Money and Banking
Instructor: Hoonsik Yang
Problem Set 2 – Fall 2015Instructions
• Partial credit will be given provided you show intermediate steps and are solving parts of the problem
correctly.
• Due: 10/30 Friday at 3:30PM; Please refer to the syllabus for the late penalty.
• Double check if you have written your name.

Questions
1. (10 points)
(a) The current price of a stock is $70. If dividends are expected to be $1 per share for the next four
years, and the required return is 20%, then what should be the price of the stock be in 4 years
when you plan to sell it?
(b) Next day, you heard a commentary from ECONOMICS channel saying that due to the unexpected
success of the firm’s investment, the dividends are expected to be $2 per share for the next four
years (and it did not change the expected dividends after that four years). What will be the price
of this stock now if rational expectation theory is right?
2. (10 points) What specific procedures do financial intermediaries use to reduce asymmetric information
problems in lending? Explain three of them.
3. (10 points) The profits from your asset portfolio depends on how your fund manager works.

Lazy
Hard working

Profit Probabilities
Profit = $20,000
80%
40%

Profit = $70,000
20%
60%

Your manager views being lazy as a "leisure" valued at $5000. If you offer 10% of the profit from your
portfolio to the manager, will he/she work hard? What if it is 50% of the profit?
4. (15 points) Bank of Storrs has the following balance sheet.
Assets
Reserves $ 50 mil.
Loans $ 450 mil.

Liabilities
Deposits $ 300 mil.
Bank Capital $ ? mil.

(a) How much bank capital does Bank of Storrs have?
(b) Suppose that a required reserve ratio is 10%. How much excess reserves does the bank have?
(c) How much reserves Bank of Storrs will have if the bank suffers a deposit outflow of $30 million?
Will it be more or less than what is required? If less, what should they do to have enough reserves?
List four options.
5. (10 points) Using the t-accounts of Bank of Storrs and Columbia bank, describe what happens when
Hoonsik writes a $100 check on his account at Bank of Storrs to pay his friend Frederic, who in turn
deposits the check in his account at Columbia bank.
1

6. (10 points) Bank of Storrs has the following balance sheet.
Assets
Reserves $ 50 mil.
Loans $ 450 mil.

Liabilities
Deposits $ 400 mil.
Bank Capital $ 100 mil.

Suppose that the bankers in Bank of Storrs find that $50 million of their loans have become worthless.
How the bank balance sheet will look like as a result?
7. (10 points) How can a bursting of an asset-price bubble in the stock market help trigger a financial
crisis?
8. (10 points) What is debt-deflation? Why the net worth of borrowers decline? (Use the definition in
the textbook. It can mean slightly different things depending on the context.)
9. (15 points) Read "The run on shadow banking and a framework for reform" in HuskyCT (reading
materials) and answer the following questions.
(a) What are the three causes for the emergence of the shadow banking system?
(b) Suppose that I lend you $200 for a day, and you give me a set of bonds with a market value of
$202 as collateral. How much is the haircut in this case? If I find out that you are more likely to
default than I originally expected, will the haircut increase or decrease?

2