1) When the liabilities of a bank decline in value but the asset value remains t

Question

1) When the liabilities of a bank decline in value but the asset value remains the same the value of the bank’s equity must decline. True or False? 2)A bank has borrowed $10 million from investors at 10% for 10 years. After two years interest rates begin to increase. This would depress the value of the bank’s liabilities which would boost the value of the bank’s equity. True or False? 3)A bank has made many bad loans to real estate developers. Bank managers are now writing down the value of these loans by 50%. This will increase the value of the bank’s insured deposits. True or False? 4)It is not possible for a bank to be solvent but illiquid. True or False?

Explanation / Answer

1. In balance sheet both debt and equity must be equal. When there is a decline in the value of liabilities either the value of assets must decline or the equity must rise. Therefore, the given statement is false.

2. If the interest rate of any liability increases, then there would be an additional flow of cash as now the bank would have to pay additional interest. So this statement is false as it would not affect the equity but would affect assets.

3. If the bank writes down the value of advances given by it to real estate developers then the amount of assets would fall and there would be no increase in the value of deposits. Therefore, this statement is false.

4. Yes it is possible for a bank to be solvent but illiquid as liquidity is defined by the cash it holds for day to day working. It might be possible that the cash has all been invested and it does not have cash to give to those depositers who want to withdraw. So here the bank is solvent but illiquid.

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