Question

High Capital Bank

Assets Liabilities

Reserves. \$10 million Deposits \$90 million

Loans \$90 million Bank capital \$10 million

Low Capital Bank

Assets Liabilities

Reserves \$10 million Deposits \$96 million

Loans \$90 million Bank capital \$ 4 million

(a) If current profits are \$800,000 for each bank, what is the Return on Equity (ROE) for each bank?

(b) If the required reserve ratio is currently 10%, how much in excess reserves does each bank have?

(c) Suppose that the value of each banks’ loans decreases by \$5 million. Are both banks still solvent?

SOLUTION:

(a) Return on Equity on each Bank:

ROE for High Capital Bank = Net Profit / Equity *100

= 800,000 / 10,000,000 * 100

= 0.08 * 100

= 8%

ROE for Low Capital Bank = Net Profit / Equity *100

= 800,000 / 4,000,000 * 100

= 0.2 *100

= 20%

(b) Excess reserve for each Bank:

Excess reserve for High Capital Bank = actual reserve - 10% of deposits

= 10,000,000 - 10% of 90,000,000

= 10,000,000 - 9,000,000

= \$ 1,000,000 or 1 million

Excess reserve for High Capital Bank = actual reserve - 10% of deposits

= 10,000,000 - 10% of 96,000,000

= 10,000,000 - 9,600,000

= \$ 400,000 or 0.4 million

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