A bank manager advises all of his loan officers that the average cost of funds for the bank over the past year has been 6%. The bank has borrowed $1 million at 5%, another $1 million at 6% and another $1 million at 7%

Future borrowing costs are expected to continue at 7%. The manager however, instructs his loan officers that they are authorized to make loans at interest rates that are equal to or greater than the bank's average cost of borrowing. How would you evaluate the bank manager's decision?

The bank manager has made an error. The marginal cost of borrowing money is 7% so he should have instructed his loan officers to lend out the money as long as it earned the bank 7% or better. If it only lends out money at 6% or better it would lose money on every dollar earned if these loans were contracted at anything less than 7%.