ECON 1100 Lecture Notes - Lecture 11: Open Market Operation, Reserve Requirement, Money Supply
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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?