Leverage
Consider the following balance sheets of two banks. These two banks have equal amounts of assets but are leveraged differently. Assume that there is no regulatory capital requirement.
Balance Sheet of Arch Bank
Assets
Liabilities and Net Worth
Outstanding Loans
$100,000
Deposits (Liabilities)
$80,000
Capital (Net worth)
20,000
Total
$100,000
Total
$100,000
Balance Sheet of Medes Bank
Assets
Liabilities and Net Worth
Outstanding Loans
$100,000
Deposits (Liabilities)
$95,000
Capital (Net worth)
5,000
Total
$100,000
Total
$100,000
a. Which bank has a lower leverage ratio?
b. Suppose both banks' assets increase by 10% to $110,000. Assume that the liabilities of both banks remain the same. Arch Bank's capital increases by _____% and Medes Bank's capital increases by _______%. Therefore, if the value of assets is rising and liabilities do not change, a higher leverage ratio results in a _____ percentage increase in capital.
c. Now suppose all the items on the balance sheets of both banks return to their initial values. Suddenly, the banks realize that loans they made are riskier than they thought, and the total value of their assets declines by 5% to $95,000. Again, assume that the liabilities of both banks remain the same. Arch Bank's capital decreases by __________%, and Medes Bank's capital decreases by ______%. Therefore, if the value of assets is falling, a higher leverage ratio means a ________ percentage decrease in capital.
d. Under this second scenario, which bank is closer to insolvency?
Leverage
Consider the following balance sheets of two banks. These two banks have equal amounts of assets but are leveraged differently. Assume that there is no regulatory capital requirement.
| Balance Sheet of Arch Bank | |||
| Assets | Liabilities and Net Worth | ||
| Outstanding Loans | $100,000 | Deposits (Liabilities) | $80,000 |
| Capital (Net worth) | 20,000 | ||
| Total | $100,000 | Total | $100,000 |
| Balance Sheet of Medes Bank | |||
| Assets | Liabilities and Net Worth | ||
| Outstanding Loans | $100,000 | Deposits (Liabilities) | $95,000 |
| Capital (Net worth) | 5,000 | ||
| Total | $100,000 | Total | $100,000 |
a. Which bank has a lower leverage ratio?
b. Suppose both banks' assets increase by 10% to $110,000. Assume that the liabilities of both banks remain the same. Arch Bank's capital increases by _____% and Medes Bank's capital increases by _______%. Therefore, if the value of assets is rising and liabilities do not change, a higher leverage ratio results in a _____ percentage increase in capital.
c. Now suppose all the items on the balance sheets of both banks return to their initial values. Suddenly, the banks realize that loans they made are riskier than they thought, and the total value of their assets declines by 5% to $95,000. Again, assume that the liabilities of both banks remain the same. Arch Bank's capital decreases by __________%, and Medes Bank's capital decreases by ______%. Therefore, if the value of assets is falling, a higher leverage ratio means a ________ percentage decrease in capital.
d. Under this second scenario, which bank is closer to insolvency?
Related textbook solutions
Related questions
Use the information presented in Midwestern Mutual Bank's balance sheet to answer the following questions.
| Bank's Balance Sheet | |||
| Assets | Liabilities and Owners' Equity | ||
| Reserves | $175 | Deposits | $575 |
| Loans | $700 | Debt | $225 |
| Securities | $875 | Capital (owners' equity) | $950 |
Suppose the owners of the bank borrow $100 to supplement their existing reserves. This would increase the reserves account and (increase or decrease) the (capital, debt, deposits, loans, reserves) account.
This would also bring the leverage ratio from its initial value of (1.84, 1.95, 3.94, 5.35) to a new value of (1.84, 1.95, 3.94, 5.35).
Suppose that Big Bucks Bank has the simplified balance sheet shown below. The reserve ratio is 20 percent.
a. What is the maximum amount of new loans that Big Bucks Bank can make? $.
Show in columns 1 and 1' how the bank's balance sheet will appear after the bank has lent this additional amount.
| Assets | Liabilities and net worth | |||||||
| (1) | (2) | (1' ) | (2' ) | |||||
| Reserves | $22,000 | $ | $ | Checkable deposits | $100,000 | $ | $ | |
| Securities | 38,000 | | | |||||
| Loans | 40,000 | | ||||||
b. By how much has the supply of money changed? $.
c. How will the bankâs balance sheet appear after checks drawn for the entire amount of the new loans have been cleared against the bank? Show the new balance sheet in columns 2 and 2'.
d. Using the original figures, revisit questions a, b, and c based on the assumption that the reserve ratio is now 15 percent. What is the maximum amount of new loans that this bank can make? $.
Show in columns 3 and 3' (below) how the bankâs balance sheet will appear after the bank has lent this additional amount.
By how much has the supply of money changed? $.
| Assets | Liabilities and net worth | |||||||
| (3) | (4) | (3' ) | (4' ) | |||||
| Reserves | $22,000 | $ | $ | Checkable deposits | $100,000 | $ | $ | |
| Securities | 38,000 | | ||||||
| Loans | 40,000 | | ||||||
How will the bankâs balance sheet appear after checks drawn for the entire amount of the new loans have been cleared against the bank? Show the new balance sheet in columns 4 and 4' in the table above.
The money supply expansion process
Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 20%. The Federal Reserve buys a government bond worth $750,000 from Raphael, a client of First Main Street Bank. He deposits the money into his checking account at First Main Street Bank.
Complete the following to reflect any changes in First Main Street Bank's balance sheet (before the bank makes any new loans).
a) The Assets side of First Main Street Bank's balance sheet (before the bank makes any new loans), this (increases/decreases) First Main Street Bank's (building and furniture/net worth/checkable deposits/reserves/loans) by ($150,000/$600,000/$750,000/$1,800,000). On the Liabilities side, First Main Street Bank's balance sheet, (increases/decreases) First Main Street Bank's (building and furniture/net worth/checkable deposits/reserves/loans) by ($150,000/$600,000/$750,000/$1,800,000).
b) Complete the following table to show the effect of a new deposit on excess and required reserves when the required reserve ratio is 20%.
Hint: If the change is negative, be sure to enter the value as a negative number.
| Amount Deposited | Change in Excess Reserves | Change in Required Reserves |
|---|---|---|
| (Dollars) | (Dollars) | (Dollars) |
| 750,000 |
c) Now, suppose First Main Street Bank loans out all of its new excess reserves to Megan, who immediately writes a check for the full amount to Larry. Larry then immediately deposits the funds in his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Raphael, who writes a check to Susan, who deposits the money in her account at Third Fidelity Bank. Finally, Third Fidelity lends out all of its new excess reserves to Becky.
Fill in the following table to show the effect of this ongoing chain of events at each bank. Enter each answer to the nearest dollar.
| Increase in Checkable Deposits | Increase in Required Reserves | Increase in Loans | |
|---|---|---|---|
| (Dollars) | (Dollars) | (Dollars) | |
| First Main Street Bank | |||
| Second Republic Bank | |||
| Third Fidelity Bank |
d) Assume this process continues, with each successive loan deposited into a checking account and no banks keeping any excess reserves. Under these assumptions, the $750,000 injection into the money supply results in an overall increase of ($370,000/$3,000,000/$3,750,000) in checkable deposits.
