Question

The initial T-accounts of Bank A and Bank B are as follows:

Bank A
Assets		Liabilities
Reserves	$55 mil	Deposits	$495 mil
Loans	$495 mil	Bank	$55 mil

Bank B
Assets		Liabilities
Reserves	$55 mil	Deposits	$528 mil
Loans	$495 mil	Bank	$22 mil

a. Suppose each of both banks needs to write off bad loans of $27.5 million, prepare new T-accounts for both banks. What problem is Bank B facing?

b. Given the return on assets (y%), the higher the bank capital is, the higher will be the return on equity for the owners of the bank. Do you agree? Use the information from the initial T-accounts of Bank A and Bank B to support your answer.

c. What conclusion could you draw from (a) and (b)?

Answer 1

Solution for A
			$ in Million
Bank A
Assets	Liabilities
Reserves	$	55	Deposits	$	495
Loans	$	467.5	Bank	$	27.5
			$ in Million
Bank B
Assets	Liabilities
Reserves	$	55	Deposits	$	528
Loans	$	467.5	Bank	$	-5.5
Problem faced by Bank B is : The Capital of the Bank has turned negative. So there is a risk that bank might go into liquidation
Solution for B
No. the higher the bank capital is, the lower will be the return on equity for the owners of the Bank.
Verification
Equity of Bank A	55
Equity of Bank B	22
Equity of Bank A is higher
Equity Multiplier = Total Assest/Equity
Bank A (55+495)/55	10
Bank B (55+495)/22	25
Return on Equity = Return on Asset * Equity Multipliers
Bank A = y% *10 = 10y%
Bank B = y%*25 = 25y%
From point a and b, we can derive at higher the capital is, lower will be the return on equity for the owners of the bank