Question

TD Bank starts with $200 in bank capital. It then accepts $800 in deposits. It keeps 12.5% of deposits in reserves. It uses the rest of its assets to make bank loans.

1. Show the balance sheet of TD Bank. You may type directly into the following T account.

TD Bank
Assets		Liabilities

2. What is TD Bank’s leverage ratio.
3. Suppose that 20 percent of the borrowers from TD Bank default and these bank loans become worthless. Show the bank’s new balance sheet.
4. By what percentage do the bank’s total assets decline? By what percentage does the bank’s capital decline? Which change is larger and why?

Answer 1

a. Pls see table below. The bank loans out 87.5% of deposits, i.e., $700 plus the initial cash it had brought in as capital

Assets	Amount	Liabilities	Amount
Reserves	100	Deposits	800
Loans	900	Capital	200
Total	1,000	Total	1,000

b. leverage = liabilities / capital = 800 / 200 = 4

c. if 20% of loans have gone bad, it amounts to 20% * 900 = 180 reduction in loans and capital. Pls see revised balance sheet

Assets	Amount	Liabilities	Amount
Reserves	100	Deposits	800
Loans	720	Capital	20
Total	820	Total	820

d. total assets declined by 18%, which is (1000 - 820) / 1000, whereas capital declined by 90%, which is (200 - 20) / 200. The reason for a larger decline in capital is that the deposits cannot be used to absorb the loss the bank has suffered due to bad loans, hence all the impact is absorbed by capital.