New PDF release: A methodology for cost factor comparison and prediction

By Alvin J. Harman

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47 default risk, not the true measure of risk facing financial institutions. The constraint is not binding to the left of C but to the right, any additional risky funds must be allocated solely to the long-term government bond. We thus obtain the locus SPP’CK1. Now, the capital adequacy constraint results in the bank holding more long-term bonds, rather than lending. In the example illustrated, there is little change in the total riskiness of the bank’s portfolio, though there can be large changes in the amount of lending.

G. g. by banks going bankrupt or contracting their lending portfolio, will find it difficult getting taken on by an alternative bank. , its collateral requirements. For simplicity, we shall ignore these other determinants. To simplify matters, we formulate the bank’s problem within a two period model. The bank has an initial net worth, at. It can obtain funds at an interest cost of ρ, which is also the interest it receives on T-bills63. Let M be the bank’s investment in Tbills, and τ be the effective tax rate imposed on deposits, the end-of–the-period net worth of the bank, taking account of the possibility of bankruptcy, is: 62 at+1 = max {Y = max {Y + M (1+ρ) + M (1+ρ) - (1+ρ)(1+τ)B, 0 } if B > 0 , 0 } if B =0 62 A more comprehensive approach would entail using dynamic programming; the bank chooses a sequence of portfolios for each discrete time.

T+1 =λ(M). 84 Even when the shadow price of liquidity exceeds the tax, there will be limited holdings of T bills. Capital adequacy requirements imply that the capital leverage ratio at/(M+N) may be required by regulation to be greater than some lower bound α* and this requirement will restrain the bank from holding too much in the form of T-bills. 85 Besides T-bills, as we have already noted, the bank can also hold long-term government bonds. However, if capital markets—and risk regulation—worked “perfectly” the higher interest rate on long term bonds would simply compensate for the higher risk associated with such bonds.

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A methodology for cost factor comparison and prediction by Alvin J. Harman

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