Question

5)   A financial institution has the following balance sheet.

Assets (millions)		Liabilities
Cash	$15	Deposits	115
Securities	50	Equity	35
Loans	85
Total	150	Total	150

a)   If the bank regulators require banks to maintain at least 10% of its capital structure as equity, what is the largest loss the bank could take on the securities and still be in compliance?

b)         Explain why this requirement caused so many problems in

Answer 1

a)
Maxim Loss with at least 10%

(Equity- Loss)/(Total assets - Loss) = 10%
(35 - Loss)/(150 - Loss) = 10%
35 - Loss = 15 - 0.1 Loss
0.9 Loss = 35-15
Loss = 20/0.9 = 22.22

b) Problems created by this capital requirement are
1. Profits of Banks are reduced due to lower lending and this causes recovery in case of recession very difficult.
2. Net profit margin or spread of Banks decreases.
3. Lower lending decreases money supply and is detrimental for growth.

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