Choose the statement that is incorrect. A) A financial institution\'s net worth
ID: 1204171 • Letter: C
Question
Choose the statement that is incorrect.
A) A financial institution's net worth is the market value of what it has lent minus the market value of what it has borrowed.
B) If a financial institution's net worth is positive, the institution must be solvent and liquid.
C) A financial institution can be solvent but illiquid.
D) A financial institution is illiquid if it has made long-term loans with borrowed funds and is faced with a sudden demand to repay more of what it has borrowed than its available cash.
Explanation / Answer
The Net worth of a financial institution = Total Asset – Total Liabilities.
For financial institution, the money is deposited is the liabilities and the money it has lent in the market is the asset.
So for a financial institution, the net worth will be total money lent in the market – total money deposited or borrowed
The solvency of a financial institution is its ability to pay off long term liabilities to the creditors.
Illiquid means the assets cannot be converted to equivalent cash easily, and can’t be sold easily in market without any loss of its value.
So based on the above definitions,
Option A is true,
Option B is false, as for a financial institution the net worth is positive if assets are more than liabilities. But assets means the lending for financial intuition. If the financial institution borrowed money for short term and longer term period but lent the money for longer period only. In this case if his assets are more than liabilities, the net worth is positive. Also it can pay the long term liabilities making it solvent. But it will face difficulties in paying short term liabilities which make it as illiquid.
Option C is true, as per above example.
Option D is true, as this is the example for illiquid condition.
So the answer for incorrect statement is Option B.