Consider the following balance sheets of two banks. These two banks have equal a

Question

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. Which bank has a higher leverage ratio? Producer Bank Consumer Bank Suppose both banks' assets increase by 20% to $120,000. Assume that the liabilities of both banks remain the same. Consumer Bank's capital increases by, and Producer 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. Now suppose all the items in the balance sheets of both banks return to their initial values. Suddenly, 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. Consumer Bank's capital decreases by, and Producer Bank's capital decreases by. Therefore, if the value of assets is falling, a higher leverage ratio means a percentage decrease in capital. Under this second scenario, which bank is closer to insolvency? Producer Bank Consumer Bank

Explanation / Answer

Answer

Leverage Ratio = Total Debt/ Total Equity

Consumer Bank = 80,000/20,000 = 4:1

Producer Bank = 95,000/5,000 = 19:1

Producer Bank has a higher leverage ratio.

Suppose both bank’ assets increase by 20%. Consumer Bank’s capital increases by $20,000, and Producer bank’s capital increases by $20,000. Therefore if the value of assets is rising and liabilities do not change, a higher leverage ratio results in a greater percentage increase in capital. (20,000/5,000* 100 = 400% for Producer Bank and 20,000/20,000 * 100 = 100%)

Assuming that the liabilities remain the same. Consumer Bank’s capital decreases by $5,000 and Producer Bank’s capital decreases by $5,000. Therefore, if the value of assets is falling, a higher leverage ratio means a greater percentage decrease in capital. (5,000/5,000* 100 = 100% for Producer Bank and 5,000/20,000 * 100 = 25%)

Under the second scenario which bank is closer to insolvency?

Answer: Producer Bank

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