Question

            ASSETS                                                                        LIABILTIES

CASH               10                                                        DEPOSITS        30

LOANS             40                                                        EQUITY            20

A bank with the balance sheet above is met with a sudden drop in deposits of $20 due to financial problems.  The bank can sell a portion of their loan portfolio for $0.50 on the dollar.  The bank earns 8% on their loans, and pays 4% on their deposits.  The bank can borrow money at 6%.  

2.  What does the bank’s balance sheet look like if it addresses the drop in deposits using stored liquidity?  

3.  What does the bank’s balance sheet look like if it addresses the drop in deposits using purchased liquidity?   

4.  Which method impacts income less (which method produces a smaller drop in income)?  

Answer 1

2. They would need to use the $10 in cash and have to sell $20 loan at $10. This would result in liabilities being in excess of assets and lead to loss in equity value

Asset	Liabilities
Cash	0	Deposits	10
Loan	20	Equity	10

3. They would need to borrow at 6%

Asset	Liabilities
Cash	10	Deposits	10
Loan	40	Equity	20
		Borrowings	20

4. The return from internal funding - 1.6 from Loans - 0.4 from deposits = 1.2

Return from external funding = 3.2 from loans - 0.4 from deposits - 1.2 from borrowings = 1.6

External funding would be the better option