Bank Administration

Chapter 6
Solution for Selected Problems

Problem #1. Abstracting from real resource costs such as salaries for loan officers, processing
costs, and other noninterest expenses, if the risk-free rate of interest is 8 percent
and the risk (probability) of default is .05, what is the profitable loan contract rate.
What is the default-risk premium in this case? How would your answers change if
the portfolio risk premium was .005? What if this premium was - .005?

r* = 1.08 / (1- 0.05) - 1 = 0.1368 = 13.68%

and the default-risk premium equals

0.1368 - 0.08 = 0.0568 or 5.68%

If the portfolio risk premium is .005, the profitable loan contract rate increases by 60 basis points
to:

1.08 / (1 - 0.05 - 0.005) – 1 = 0.1428 or 14.28%

If the portfolio risk premium is - 0.005, then the loan rate will decline by 59 basis point to

0.1309 = 1.08 / (1 - 0.05 + 0.005) – 1 = 0.1309 or 13.09%

In these two cases, the default-risk premiums are 6.28% and 5.09%, respectively.

Problem #2. If a loan contract rate is 15 percent and the risk-free rate is 10 percent, what can
you say about the components of the RHS of equation 6-8?

Nothing. All you know is that the default-risk premium is 0.05 = 0.15 - 0.10.

Problem #3. Although banks can raise some funds at close to the risk-free rate (r), their base
cost-of-funds rate typically is the federal-funds rate, a CD rate, or LIBOR. Federal
funds and Eurodollar CDs (at markups over LIBOR) are attractive because they
are not subject to reserve requirements or deposit-insurance fees. Charging fees
and requiring compensating balances are also part of bank business lending.
Suppose a bank faces the following situation:
Base cost of funds (domestic CD rate) = 7.00%
Loan-origination and processing fee = 0.25%
Compensating-balance requirement = 10%
Reserve requirements = 10%
Deposit-insurance fees = 0.125%
Probability of default = 1.00%
Portfolio-risk premium = 0.25 %
Adjust equation (6-3) to account for all of these factors and calculate the bank's profitable

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loan rate.
Equation (6-3) is: r* = (1 + r) / (1 - d) - 1 which can be rewritten as

r* = (r + d) / (1 - d)

Including the default risk premium from equation (6-12), we have:

r* = [(1 +r) / (1 – d – p) ] – 1 which can be rearranged to

r* = (r + d + p)/(1 - d - p).

Let f = fees,
b = balance requirements,
rr = reserve requirements,
dif = deposit-insurance fees, and
p = portfolio risk premium.

The base cost of funds or CD rate is r(cd) replaces r.

Of these factors f and b are favorable to the bank while rr, dif, and p are risk or regulatory
burdens that need to be priced.

What do we do have to do to take account of all of these factors? Let's work through this in steps.

First, with r(CD) = 0.07, d = 0.01, and p = 0.0025, then

r* = [(r + d + p) / (1 – d – p)] = [(0.07 + 0.01 + .0025) / (1 – 0.01 – 0.0025)] =

r* = (.0825 / 0.9875) = .0835 or 8.35%.

Adding the noninterest income (f),

r* = [(r + f + d + p) / (1 – d – p)] = [(0.07 + 0.0025 + 0.01 + .0025) / (1 – 0.01 – 0.0025)]

r* = [.0850 / 0.9875] = .0861 or 8.61%.

Since the compensating balance (if effective) is a cost to the borrower, it raises the loan rate to

r* = [(r + f + d + p) / (1 – d – p - b )] =
[(0.07 + 0.0025 + 0.01 + .0025) / (1 – 0.01 – 0.0025 – 0.01)]
0.0850 / 0.8875 = .0958 or 9.58%.

Wow! What a boom to the lender and bust to the borrower! Implicit pricing at its best -- from the
bank's point of view.

Note how this works. You borrow $1 million but the bank only let's you use $900,000 = .10($1

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million). By the way, in today's competitive markets, compensating balances have, for the most
part, been competed away.

Now, what about the costs of regulation, rr and dif? Assuming rr and dif apply to the
compensating balance, we have:

r* = {(r + f + d + p) / [1 – d – p – b + b (rr + diff)]} =

r* = {(0.0850 / [0.8875 + 0.1(0.1) + .00125 (0.1)]} =

r*= 0.0850 / 0.8976 = 0.0947 or 9.47%.

If the bank can pass these costs of regulation onto the borrower, the rate will be .0958.

To summarize, the relevant formula is:

r* = [r(CD) + f + d + p] / [1 - d - p - b + b(rr + dif)].

If f = b = 0 and r(CD) = r, then

r* = (r + d + p) / (1 – d - p).

Adding +1 and -1 to the numerator and rearranging gives:

r* = [(1 + r) - (1 - d - p)] / (1 - d - p)

r* = [(1 + r) / (1 - d - p)] - 1,

and we are back to equation (6-7), or (6-1) if p = 0.

Problem #4. Given the following information, calculate risk-adjusted loan and bond returns.
Investment in which asset will add the most value to die bank?
Risk-free rate = 5%
Bond yield (including unrealized gains) = 8.2%
Bond yield (excluding unrealized gains) = 8.0%
Gross loan yield = 10%
Net loan charge-off rates: Period Rate
t 1.4%
t-1 1.3
t-2 1.2
t-3 1.1
t-4 1.0
If the average duration of the bond portfolio exceeds the average duration of the
loan portfolio how would that affect your decision to allocate assets? What role
would nomnterest operating expenses play?

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Using IDC's approach described in the text,

the risk-adjusted return equals the loan rate minus the risk-free rate minus the average
charge-off rate minus the standard deviation of the average charge-off rate.

Thus, the risk-adjusted return on loans = [0.10 - 0.05 - 0.012 - 0.0017 = 0.0363. or 3.63%.

Since the risk-adjusted returns on bonds are 3.2% (including unrealized gains) and 3.0%
(excluding unrealized gains), loans are preferred to bonds, other things equal.

If the duration of the bond portfolio exceeds that of the loan portfolio, then (assuming short-term
funding) bonds have more interest-rate risk, which would make loans an even better deal.

However, since loans are more costly to make and monitor, operating expenses also must be
factored into the asset-allocation decision.

Problem #5. Consider a risky bond (or bank loan) with a face value of $1,000 that promises
semiannual payments of $100 for 5 years. If sold at par, the bond has a yield to maturity of 10
percent. If the risk-free rate on five-year debt is 7.5 percent, what is the value of the loan
guarantee that would make the risky bond a risk-free instrument?

It takes two steps:

First, find the present value (PV) of the risky bond's cash flow discounted at the risk-free
rate, that is,

Price = PV($50 every six months for ten years discounted at 3.75%) + PV($1,000 in 10
periods discounted at 3.75%) = $1,102.66.

This price represents the value of the risky bond's cash flows if the cash flows were guaranteed
or free of default risk.

The second step is to rearrange either (6-4a) or (6-5) as:

Risk-free loan - Risky loan = Loan guarantee.

Entering the relevant values, we solve for the implied value of the loan guarantee as:

$1102.66 - $1,000 = $102.66.

The implied price of the loan guarantee as a percentage of the no-guarantee (risky) price is

[($102.66 / 1000) x 100] = 10.266%.

The point of this exercise is that by estimating the price of the bond as if its cash flows were risk-

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free and subtracting the actual market price of the bond, we derived the implied market value of
the loan guarantee. The ratio of the implied value of the loan guarantee to the price of the bond
without the guarantee provides a relative measure of risk.

Problem #6. A lender has a choice of two risky loans for each of the following experiments. If
the loans are held in 60/40 proportions, what are the expected returns from
diversified and undiversified portfolios? Assume the states are equally likely and
explain.

State State State

Loan 1 2 1 2 1 2
A $4 $2 $8 $4 $5 $3
B $2 $1 $0 $6 $2 $6

Expected return (60/40)

Experiment State 1 State 2
#1 $3.2 = (0.6 X 4) + (0.4 X 2) $1.6 = (0.6 X 2) + (0.4 X 1)
#2 $4.8 = (0.5 X 4) + (0.5 X 2) $4.8 = (0.6 X 8) + (0.4 X 0)
#3 $3.8 = (0.5 X 2) + (0.5 X 1) $4.2 = (0.6 X 3) + (0.4 X 6)

Expected return (60/40)

Experiment A alone B alone
#1 $3 = (0.5 X 4) + (0.5 X 2) $1.5 = (0.5 X 2) + (0.5 X 1)
#2 $6 = (0.5 X 8) + (0.5 X 4) $3 = (0.5 X 0) + (0.5 X 6)
#3 $4 = (0.5 X 5) + (0.5 X 3) $2 = (0.5 X 2) + (0.5 X 6)

In experiment #2, the portfolio return is state independent, resulting in a riskless portfolio due to
the negative correlation between the outcomes for A and B. In experiment #1, the outcomes for
A and B move together (positive correlation) while in #3 they move as in #2 but do not quite
create a riskless portfolio.

Problem #8—Solution only

Alpha Project

E(Y) (0.003)(1,000,000) + (0.002)(1,000,000) = 5,000

RAROC = (5,000 / 30,000) = .167 or 16.7% > 10% accept

Beta Project

E(Y) = (0.001)(10,000,000) + (0.001)(10,000,000) = 20,000

RAROC = (20,000 / 100,000) = .20 or 20% > 10% accept

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Gamma Project

E(Y) = (0.01 X 5,000,000) + (0.005 X 5,000,000) = 75,000

RAROC = (75,000 / 50,000) = 1.5 or 150% > 10% accept

Solution for Problem #9

Average cost of fund:

[(45,000,000 X 0.03) + (45,000,000 X 0.05) + (10,000,000 X 0.10)] / 100,000,000] = 4.6%

RAROC = [loan rate of return / (unexpected loss rate X portion of loan lost on default)]

Alpha project RAROC = [0.01 / (0.01 X .1)] = 10% > 4.6% accept

Delta project RAROC = [0.2 / (0.04 X 0.8)] = 6.25% > 4.6% accept

Pi Project RAROC = [0.3 / (0.10 X 0.9)] = 3.33% < 4.6% reject

Solution for Problem #10

∆ L = -D [∆ r / (1+r)] L

-2.5 [0.005 / (1+ 0.10)] 1,000,000 = 11,363.64

E(Y) = (loan spread + annual loan fee) X amount of loan

E(Y) = (0.0025 + 0.00075) 1,000,000 = 3,250

RAROC = (3,250 / 11,363.64) = .286 or 28.6%

Solution for Problem #11

Current ALLL = $354 million

Additional ALLL needed above your estimate = $140 million
Loans = $24.5 billion
Non-performing loan = $1.5 billion
The required ratio of ALLL to non-performing loans = 0.70
Non-criticized loans = $20 billion
Special mention loans = $1.529 billion
Sub-standard loans = $2.472 billion
Doubtful loans = $519 million
Loss loans = $38 million

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 Year t-1 Net loan losses / Total loans
Q1 0.8
Q2 1.06
Q3 0.93
Q4 2.29
Average loan loss ratio 1.27

Method 1:

Required ALLL = (total loans) (average loan loss ratio)

= ($24.5 billion) (0.0127) = $311, 150,000

Need ALLL = Estimated ALLL + Additional ALLL

= $311, 150,000 + $140,000,000 = $451, 150,000

PLL = $451,150,000 - $354,000,000 = $97,150,000

Method 2:

Required ALLL = (non-performing loan ration) (non-performing loans)

= (0.7) ($1.5 billion) = $1.050 billion

PLL = $1.050 billion - $354 million = $696 million

Method 3:
Weight Required ALLL
Non-criticized loans $20 billion 0.01 $200
million
Special mention loans $1.529 billion 0.05 $76.45 million
Substandard loans $2.472 billion 0.20 $494.4 million
Doubtful loans $519 million 0.50 $259.5 million
Loss loans $38 million 1.00 $38 million
Total ALLL needed $1,068.35 million

PLLL = $1,068.35 million - $354 million = $714.3 million.

Ratio of ALLL to total loans = ($1.06835 billion / 24.5 billion) = 4.36%.