Consider the following balance sheets for two hypothetical banks A and B: • Bank

Question

Consider the following balance sheets for two hypothetical banks A and B:

• Bank A:

– Assets: Cash = $1,000, Loan to Bank B = $500

– Liabilities: Deposits = $1,400

• Bank B:

– Assets: Mortgage–backed securities = $800

– Liabilities: Deposits = $200, Loan from Bank A =$500

(a) (5 points) What is the equity (net worth) for each bank?

(b) (5 points) What is the leverage ratio for each bank?

(c) (7 points) Suppose house prices fall sharply and the mortgage backed securities held by Bank B fall in value to only $500. What happens to bank B’s net worth? The shortfall in Bank B’s net worth means that it cannot repay the loan it received from Bank A. Assume that Bank B pays as much as it can, while still making good on its deposits. What happens to the net worth of Bank A?

(d) (8 points) Explain how what happened in part (c) is related to systemic risk. Discuss how tighter capital requirements, which reduce the leverage ratios, could avoid systemic risk in part (c).

Explanation / Answer

A) Since, Assets = Liabilities + Shareholder's Equity
Shareholder's Equity = Assets - Liabilities

Bank A: Total assets = 1000 + 500 = 1500
Liabilities = 1400
Hence, Shareholder's Equity = 1500 - 1400 = 100

Bank B: Total assets = 800
Liabilities = 500 + 200 = 700
Hence, Shareholder's Equity = 800 - 700 = 100

B) leverage ratio = Total Liabilities/Net Equity
Bank A: leverage ratio = 1400/100 = 14:1
Bank B: leverage ratio = 700/100 = 7:1

C) Since the price of the MBS reduces by 300, Bank B’s net worth reduces by 300 to -200
Subsequently, Bank A’s net worth declines by -200. The reason is the following: the equity holders of bank B do not pay back the debts due to bank A on their own money’s . Moreover, depositors are senior to bank A on bank B’s assets.Therefore bank B needs to default on its loan due to bank A, repaying only 300 instead of 500.

D) Systemic risk occurs because the default of bank B, could potentially cause that of another bank A (in the case of question 3, bank B is only "damaged", that is its net worth is reduced).

Even if bank A was right in thinking that mortgage-backed securities were toxic, and therefore did not invest in them, it did not necessarily know it was exposed to the housing market through the loan it had made to bank B.

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