Question

A shadow bank’s sole assets comprise USD10bn “cash” (electronic bank deposits) and USD200bn 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

Answer-

The correct Option is B.

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

The sole asset with cash amount of USD 10 bllion is insufficient to pay off debt but will be able to pay off debt by liquadating the securities which is USD 180 billion (10 % loss in securities = USD 200 billion x 90 % =  $ 180 USD). The overnight repo is the only debt for the bank which shows that the bank is solvent ( ie. it will be able to pay off the debt ). The 10 % haircut means the lender will lend only 90 % of loan and it increases leverage for the bank by 10X )

The other Options are incorrect.

Option A is incorrect as it has inadequate cash of just USD 10 billion.

Options C and D are inorrect as both options mention balance sheet insolvent but its balance sheet is solvent as it has USD 180 billion worth of securities.