Question

The First Knox National Bank is concerned about its use of leverage. a) Is it right to be worried if it faces a loss on its portfolio of loans equal to 10%? [let R=10%].

  First Knox National Bank

Assets Liabilities

Reserves $100m. Deposits  $1000m

Loans     $950m. Equity (capital) $50m.

b) Can the loss to depositors be calculated? If it can, please compute it.

c) If the depositors are insured (by the FDIC), explain the potential role of moral hazard in this case.

Answer 1

Bank's Leverage Ratio is calculated by dividing Banks Assets by its Equity capital.

So, Leverage Ratio is 21:1, for every 21$ of assest we put 1$ of equity.

a). If the Bank faces a loss of 10% on its portfolio of loans then with a 21% leverage ratio , the investment only needs to be drop 4.76% (1/levereage ratio)in order to be wiped out. we are paying the loss form our own funds and not the borrowed money.

Hence, bank need not be worried about the given loss percentage.

b) Yes, loss to depositors can be calculated by Capital Adequacy Ratio.

Capital / Risk Weighted Assets :- 50/1050 = 4.76%

C) The moral hazard exiests only when there is risk to depositor, if they are fully insured by FDIC the risk is transferred to third party and hence if Banks failed with no loss to depositor the role of morale hazard does not come into exsistance.