Question

1) A bank with a leverage ratio of 15 has a cost of debt of 2%pa and a portfolio of assets with an expected yield of 4%pa. What are the expected ROA net of debt funding costs and the expected ROE of the bank, using the approach to defining leverage taken in the lecture slides? Show your workings.

2) What will the ROA and ROE actually be if the yield on assets turns out to be 3%? Show your workings. (1 mark)

3) What will the ROA and ROE actually be if the yield on assets turns out to be 1%? Show your workings.

4) What is the unweighted bank’s capital (or E/A) ratio (i) for a leverage ratio of 20 and (ii) for a leverage ratio of 30? Show your workings. (1 mark)

5) Redo the above calculations in parts 1) and 3) for a leverage ratio of 25. What affect does the higher leverage ratio have on your answers? Show your workings.

6) What is the relationship between a bank’s capital ratio and the risks and returns faced by (i) its shareholders and (ii) its creditors? Explain your answers.

just need to answer question 5 and 6

Answer 1

5) What approach has been used to define leverage ?

6) Bank Capital is the net worth of the bank. It also represents the equity value available to shareholders. Bank capital is highly regulated and banks are required to maintain capital in accordance with the Basel Accords.

net worth = (bank assets - bank liabilities)

This net worth / capital is a buffer against any unexpected losses that may be incurred by a bank and to avoid potential insolvency.

Under the Basel III, minimum total capital ratio = 12.9%. A capital ratio below this indicates that the bank may be unable to bear losses and remain liquid. Low capital could lead to less supply of credit for healthy borrowers, thereby denying bank a source of income. Low capital would also lead to shareholders losing faith in the bank.

A healthy capital ratio assures shareholders and regulatory authorities of bank's financial strength and ability to absorb a level of loss.