Congratulations! You have been headhunted by a bank. You have $80mn in deposits,
ID: 1203972 • Letter: C
Question
Congratulations! You have been headhunted by a bank. You have $80mn in deposits, $10mn of borrowings from the interbank market, $10mn in reserves, $20mn in government securities and $70mn in commercial loans. The reserve requirement is 10% of deposits and the minimum equity capital requirement is 10% of non-reserve assets. What is your capital ratio and how does it compare with the regulatory requirement of 10%? What are reserves and why are they typically necessary? Suppose that the interest rate on government securities is 1%, the interest rate you charge on loans is 6%, the interest paid on your borrowings is 4% and that your customer deposits (and your deposits at the Fed) earn no interest. What is your profit in $ terms (excluding any non-interest costs and revenues)? What is your % return on equity (ROE)? Now suppose one of your corporate borrowers defaults on $30mn of loans that have to be totally written off. What happens to your balance sheet; what are your options? (4 marks each = max 20 marks)Explanation / Answer
(a) Capital ($) = Assets - liabilities = Reserves + Government securities + loans - Deposits - Borrowings
= (10 + 20 + 70 - 80 - 10) million
= 10 million
Capital ratio = Capital / (Government securities + Loans) = $10 million / $(20 + 70) million
= $10 million / $90 million
= 0.1111, or 11.11%
This is higher than required ratio of 10%.
(b) Reserves are kept by a source of fund by the banks and are a part of cash asset. Reserves are kept so that bank can operate its daily activities without turning to debt capital everytime it needs funding, and in particular, when demand for deposit withdrawal is higher than expected, banks use their reserves to manage heavy withdrawals.
(c) Total interest received ($ million) = 20 x 1% + 70 x 6% = 0.2 + 4.2 = 4.4
Total interest paid ($ million) = 10 x 4% = 0.4
Profit = Interest received - Interest paid = $(4.4 - 0.4) million = $4 million
(d) Equity = Total liabilities + Capital = Deposits + Borrowings + Capital
= $(80 + 10 + 10) million = $100 million
ROE = Profit / Equity = $4 million / $100 million = 0.04, or 4%
NOTE: First 4 sub-questions are answered.