Question

You have the following information on the Bank of Morrisland as of 04/17/2020: it currently holds a total of $250 million in checking account deposits. It has borrowed $20 million from the Federal Reserve as discount loans. It has raised another $80 million by borrowing through the REPO funding. It has also borrowed 100 million dollars through the overnights (Federal funds) market. The bank’s current net worth (bank capital) is 40 million dollars. The bank currently holds $100 million in treasury securities and another $100 million in municipal bonds. The bank has made $65 million loans to consumers and $75 million loans to corporations. The bank has made another $110 million loans in residential mortgages. The bank has also issued two commercial loan commitments to Superior Industries: one worth of $40 million to be honored on October 1, 2020 and another worth of $35m to be honored on January 1, 2021. Assume that the required reserve ratio is 10%.

a. (8 pts.) What does the bank’s balance sheet look like?

b. (4 pts.) If the bank has a return on assets of 2%, calculate its return on equity.

c. (8 pts.) What is the bank’s leverage ratio? Is it a well-capitalized bank? Is it a well-capitalized bank according to Basel Accord?

d. (6 pts.) Following a trouble in the mortgage market, the bank found that the present value of residential mortgages has declined to 70 million dollars. As a result, regulators forced the bank to sell these mortgages to recognize the fair market value. In the meantime, hearing the news depositors pull out 25 million dollars from the bank. What does the bank’s balance sheet look like? How do these events affect its capital position?

e. (4 pts.) Find out how much capital injection is required in this scenario so that the bank can reach a 10% capital ratio.

Answer 1

(a) Bank Balance Sheet

*All figures in $ million
Assets	Liability & Equity
Treasury sec.	100	Deposits	250
Municipal bonds	100	Discount loans	20
Loans(consumers)	65	Repo funding	80
Loans(corporations)	75	Overnight market	100
Residential mortgages	110	Equity	40
Commercial loans commitment	40
Total	490	Total	490

**In commercial loan commitment $35m is ignored as it is due in next financial year, therefore will not be included in this year balance sheet

(b) Return on equity = Return on assets * (Assets/equity) = 2% * (490/40) = 24.5%

(c) Leverage ratio = equity/total assets = 40/490 = 0.0816 = 8.16%

Yes the bank is well capitalized as it has a leverage ratio in excess of 3%

(d) Loss in residential mortgages = 110 - 70 = $40m

This amount will be reduced from the equity: value of equity remaining = 40 - 40 = 0 (entire equity of the bank wiped out)

Decrease in deposits will result in decrease in Treasury assets by same amount

*All figures in $ million
Assets	Liability & Equity
Treasury sec.	75	Deposits	225
Municipal bonds	100	Discount loans	20
Loans(consumers)	65	Repo funding	80
Loans(corporations)	75	Overnight market	100
Residential mortgages	70	Equity	0
Commercial loans commitment	40
Total	425	Total	425

The entire capital of the bank has been wiped out. This will raise solvency issues in the bank & it will be required to be bailed out