Question

1. The following table presents the balance sheet of bank A at the end of the financial year (in million pounds).

Assets		Liabilities and capital
Reserves	4	Deposits	74
OECD government bonds	13	Long term debt	16
Commercial loans	53	Equity	8
Mortgages	28
TOTAL	98	TOTAL	98

The net income for the year is 0.8134 million pounds. Answer the following questions:

1. Calculate and interpret the Return-on-Assets, Return-on-Equity, and Equity Multiplier ratios.   
2. Due to a severe economic crisis, mortgages worth £2 million default. Show how the balance sheet would look like after recoding this event.  
3. What is a ‘fire sale’ and how can it affect bank stability?   d. Explain the trade-off between liquidity and profitability and its importance in bank management.

Answer 1

Hi,

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Question:

Answer:

a). Answer:

Return-on-Assets= Total Net Income/Total Assets

Net Income =  0.8134 million pounds

Total Assets =98 million pounds

Return-on-Assets =  0.8134/98 = 0.0083 = 0.83%

Return-on-Assets = 0.83%

Return-on-Equity = Net Income/Share's holder equity

Return-on-Equity =  0.8134/8 = 0.1016 = 10.16%

Return-on-Equity = 10.16%

Equity Multiplier ratios = Equity multiplier = Total assets / Total stockholder's equity

= 98/8 = 12.25

Equity Multiplier ratios = 12.25

b). Answer:

Mortgages worth £2 million default.

So, it will reduced the total assets by £2 million.

New total assets = 98 - 2 = £96 million.

Liabilities will not affected.

​​​​​​​c). Answer:

Fire Sales: It is a sale of goods or assets at a very low price, typically when the seller is facing bankruptcy.When banks purchase these type that is available at heavy discounted price then its creat a high risk for the banks. Risk may be default risk or may be company securities don't able to bounce back (in case of equity). When a seller get bankrupt then its harms heavily to the balance sheet of the banks. In case on stock or shares when its not bounce back or falling down more then the bank lose money and its heavily affect to the balance sheet of the banks also. This type of bad banking activity/practices harm to the assets and damage to the balance sheet that is dangerous for the bank stability.

​​​​​​​d). Answer:

Trade-off between liquidity and profitability:

Liquidity refers to the  how quickly you can get your hands on your cash. Profitability refers to the degree to which a business or activity yields profit or financial gain. Both have adverse relation. Higher liquidity means lower the risk liquidity but lower profitability also and vice-versa. When a company or bank increases its liquidity ratio then its decrease the liquidity risk but at the same time its decrease the profitability. When a company or bank decreases its liquidity ratio then its increase the liquidity risk but at the same time its increase the profitability. So, liquidity must should be balance to manage and balancing the liquidity risk and profitability.

Thank You