As a financial institutions and markets analyst for More Gaine Securities, Inc.,

Question

As a financial institutions and markets analyst for More Gaine Securities, Inc., a highly reputable financial institutions' securities underwriter, you must prepare an analysis of the financial condition of a broad range of financial institutions of various sizes, localities, and product lines. Using the "probability of insolvency" model discussed in class where E(ROA) is the expected value of after-tax earnings on assets, ?2 is the variance of ROA, and K/A is the firm's equity capital plus contingency and loan loss reserves to total assets, discuss, based upon your economic assumptions, what financial ratios you might use to assess the level and expected future course, over the next few years, of each of these indicators of financial soundness. As a preliminary to this discussion, clearly state your assumptions about general economic growth and cyclical movements, interest rates (level and term structure), and potential developments in individual industries and regional economies (e.g., agriculture, energy, Asian Markets). Primarily, discuss how the federal regulatory agencies' capital adequacy policy, in the form of risk-based capital adequacy standards and Prompt Corrective Action, might affect financial institution soundness, costs of moral hazard and portfolio choices.

NOTE: the maximum probability of insolvency = ?2/[E(ROA) + K/A]2

Explanation / Answer

Being a Market Analyst, I would first go after quality of Assets (Liquidity of Assets). Because this is where Big giants makes fool out of Economy. They (Large companies Like Lehman Brothers, Merryl etc.... ) usally have Assets Worth of Billions of Dollars. And thus they Showed ROA , Asset ratio to Lenders and keep on borrowing money. But here the catch is ROA doesnt show the quality of assets , means what is the liquidity of assets, how easily assets can be liquidated. So we can assess the Market risk with the liquidity ratios - CUrrent ratio, Quick Ratio (Acid test) so that we can have an idea about the true health of COmpany. We can also go for ROE which shoes the actual performance of the company.

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