2. (6 points) A bank has book value of S5 deposits, and $10 million on in equity

Question

2. (6 points) A bank has book value of S5 deposits, and $10 million on in equity. Some loans default so that the bank writes off $5 mii million in liquid assets, S$95 million in loans, $90 million in So Assets Liquid Assets Loans Liabilities and equity Deposits Equity 90 95 10 The proportion of bad loans out of original amount of loans is S, 24%. Workout: Since loans reduce, equity reduces. The proportion of equity reduction out of original amount of equity is 50 % 5 Workout: Based on the above results, does credit risk of loans have an enlarged or compressed effect on equity? Workout:

Explanation / Answer

Bad loans = $5 Mn

Original amount of loans = $95 Mn

Proportion of bad loans out of original amount of loans = $5 Mn/ $95 Mn= 0.05263 = 5.26%

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Amount by which loans reduce = $5 Mn

Equity also decreases by an equal amount as the loan is written off

Total Equity = $10 Mn

Proportion of equity reduction out of total equity = $5 Mn/ $10 Mn = 0.5 = 50%

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As can be seen from the calculations above, the credit risk of loans have an enlarged effect on equity. For a 5.26% default, Equity suffers by 50%.

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