2. (6 points) A bank has book value of $5 million in liquid assets, $95 million

Question

2. (6 points) A bank has book value of $5 million in liquid assets, $95 million in loans, 590 million in millton in equity. Some loans default so that the bank writes off $5 milhon bad Assets Liquid Assets Loans Liabilities and equity Deposits Equity 90 10 95 5, 21e %. The proportion of bad loans out of original amount of loans is Workout: loans reduce, equity reduces. The proportion of equity reduction out of original amount of Since equity is 50 % Workout: Based on the above results, does credit risk of loans have an enlarged or compressed effect on equity? Workout:

Explanation / Answer

1. bad loans/total loans = 5/95*100= 5.26%

2. Equity reduction = Orginal equity less write off of bad loans = 10-5= 5 .

Percentage = 5/10*100 = 50%

3. Yes, the credit risk of loans have an enlarged effect on equity. Since only 5.26% of default on loan has caused equity errosion of around 50 % which is quite impactful. This is because the majority of the asset is loan and if the value of this asset reduces , it will start reducing the equity even more and may start going in negative if there are more write off. Hence, a slight change in the loan amount can impact the equity heavily.

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