Question

Describe and illustrate, using simplified bank balance sheets, how a bank could find itself with a liquidity crisis and a capital reserve crisis (two different crises). Describe and explain the actions it can take to move back to more prudent liquidity and capital reserve levels after such crises. (300 words max + tables if required)

Answer 1

Hi,

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Question:

Answer:

Before answering the question we will discuss some terminology and required Information to understand better :

Bank:

Banking is an industry that handles cash, credit, and other financial transactions. Banks provide a safe place to store extra cash and credit. The main functions of bank are - lending, accepting deposits, offering credit card and other third party products likes, insurance, MFs, etc, Agency Functions. The bank acts as an agent of its customers, General Utility Functions etc.

Balance Sheets:

Balance Sheet is the financial statement of a company which includes assets, liabilities, equity capital, total debt, etc. at a point in time. Balance sheet includes assets on one side, and liabilities on the other. For the balance sheet to reflect the true picture, both heads (liabilities & assets) should tally (Assets = Liabilities + Equity).

Balance Sheets of Bank:

A Bank's Balance Sheet. A balance sheet is an accounting tool that lists assets and liabilities.The net worth is the asset value minus how much is owed (the liability). A bank's balance sheet operates in much the same way. A bank's net worth is also referred to as bank capital.

Assets-

Assets are those resources or things which the company owns. They can be divided into current as well as non-current assets or long term assets.

Items of assets- Cash and cash equivalents, securities and loans.

Liabilities-

Liabilities are your company's obligations either money that must be paid or services that must be performed.

Items of liabilities- Checkable deposits, nontransaction deposit, Borrowings from Other Banks and Bank Capital.

Now come on the question:

liquidity crisis of bank-

A liquidity crisis is a financial situation characterized by a lack of cash or easily-convertible-to-cash (cash equivalents) assets on hand across many businesses or financial institutions simultaneously. The liquidity crisis may be by the widespread maturity mismatching among banks and other businesses and a resulting lack of cash and other liquid assets when they are needed or it can be triggered by large, negative economic shocks or by normal cyclical changes in the economy. You can see liquidity crisis at the time of financial or economic crisis, economic recession or downfall of economic growth. It may the cause of internal crisis of bank.

We can analyze it by using or Current Ratio formula (a useful tool of fundamental analysis)-

Current Ratio= Current Assets / Current Liabilities

if this ratio is bellow 1 then below suggests the company would struggle to pay its liabilities and might go bankrupt.

How to Solve It:

Banks maintain their liquidity primarily from deposits made by their customers. Customer should increase and maintain CASA ratio. Also Fed helm to the customer through the monetary policy. In this situation fed reduce discount rate, purchase government securities through OMO, reduce the reserve ratio.

Some time Fed also give the bailout package in the case of emergency (when bank fall in the dangerous zone and facing the problem of bankruptcy).

Capital reserve crisis;

Capital Reserve means the part of profit reserved by the company for a particular purpose such as to finance long-term projects or to write off capital expenses.

In case of bank, bank reserves are the minimal amounts of cash that banks must keep on hand in case of unexpected demand. Excess reserves are the additional cash that a bank keeps on hand and declines to loan out. The reserve is decided on the situation of economy of company specific problem. Like, in the case of financial or economic crisis or financial trouble of bank this ratio is increased by fed and vice-versa.

This is basically a tool use by Fed to provide safeguard to the banking System during the liquidity crisis.

How to manage it:

There is  norm is drafted by the Basel Committee is a committee of bank supervisors that is mandate for every bank globally. According to this committee every bank has to require to manage minimum capital requirement of some percentage of risk-weighted assets. The financial crisis of 2007-08 revealed shortcomings in the Basel norms.Basel-III was first issued in late 2009 and according to it  the total minimum capital requirement is 10.5% for bank.

A capital reserve is an account in the equity section of the balance sheet that can be used for contingencies or to offset capital losses. It is derived from the accumulated capital surplus of a company, created out of capital profit.

Fed also help through monetary policy like, reduce reserve ratio, bailout package, OMO etc.

Bank should also focus on it manage it though capital raising, expansion of CASA ratio, deposits and profit etc.

Thank You