Reference no: EM131311278

A customer of a bank requests an immediate $5 million loan. Assume the bank is holding no excess reserves. The "prudent-banker" rule states that the bank should only make a loan if it is holding sufficient excess reserves to fund the loan, and the amount of the loan should not exceed the bank's excess reserves. The idea behind the "prudent-banker" rule is that when the bank makes a loan it creates a checkable deposit that is anticipated to immediately clear against the bank's reserve position for the full amount. Since the bank faces a fractional reserve requirement, the check clearing will cause the bank to be deficient in meeting its reserve requirement. Holy horrors, the bank is now in big trouble!

a) Explain how modern bank-management principles and the existence of various markets and financial institutions make the "prudent-banker" fable a legacy from the past. Carefully describe the two main approaches to managing a bank's reserve position and use T-accounts to explain how they operate. Finally, explain how the total pool of bank reserves can be shifted between banks and why the reserve requirement does not limit an individual bank's ability to expand its assets and liabilities.

b) While the reserve requirement does not limit a bank's ability to grow in size (expand its asset and liabilities), the capital requirement does impose a limit. What is a capital requirement and how does it act to limit a bank's ability to grow? Explain the actions a bank could take to expand its capital, and thus, be able to grow in size.