Response to the following problem:
A DI has assets of $10 million consisting of $1 million in cash and $9 million in loans. It has core deposits of $6 million. It also has $2 million in subordinated debt and $2 million in equity. Increases in interest rates are expected to result in a net drain of $1 million in core deposits over the year.
a. The average cost of deposits is 2 percent and the average cost of loans is 5 percent. The DI decides to reduce its loan portfolio to offset this expected decline in deposits. What is the cost and what will be the total asset size of the firm from this strategy after the drain?
b. If the cost of issuing new short-term debt is 3.5 percent, what is the cost of offsetting the expected drain if it increases its liabilities? What will be the total asset size of the DI from this strategy after the drain?