Question

A shadow bank’s sole assets comprise $10bn “cash” (electronic bank deposits) and $200bn securities. The securities act as collateral for an overnight repo (currently attracting a zero haircut) which is the shadow bank’s only debt. The following day the securities lose 10% of their value and this prompts the creditor to impose a 10% haircut on a fresh repo. Which of the following statements best describes the shadow bank's new situation?

a. it has enough capital and cash liquidity to stay out of trouble

b. it remains balance sheet solvent but has insufficient cash to pay off its debt

c. it can avoid default since cash assets are adequate but is technically balance sheet insolvent

d. it has inadequate cash liquidity and is balance sheet insolvent

Answer 1

Statement 'C' describe the position of shadow bank.

Since total assets of bank is lower than its liablities hence it is balance sheet insolvent.However it has enough cash to provide for 10% haircut on fresh repo.

the securities have lost their value and not the cash so it can be said that though the securities has lost the value and it could probably dent ther overall balance sheet value but still has got ample liquidity in form of cash.

So statement C is true and rest of the statements are false as they advocates whether the firm is iliquid or is balance sheet solvent.