Using the example (simplified) bank balance sheet below show and explain why the Leverage And Capital Ratios are changed as a result of a 6m write-down in mortgages.

After the written-down of £6m on mortgages, the mortgages have converted £120m into £114m so that the new total assets change to £299m. In addition, due to the decrease of total assets, the total equity also turned into £10m In order to make the total equity equal to total assets.

As we know, the formula of leverage ratio and capital ratio is:

Leverage ratio= Total Equity/Total Assets *100%  

Capital ratio= Total Equity/Risk-adjusted assets *100%

So, as the changing of total equity and total assets, the leverage ratio also change at the same time.

Due to the changing of mortgages, the risk-adjusted assets of mortgages also change so that the total risk-adjusted assets turned into £191m compared with previously figure £194m. Therefore, capital ratio has changed attributable to changing of total risk-adjusted assets.

In a word, the leverage ratio and capital ratio are changed as a result of a £6m write-down in mortgages.

Part B:

In the event that this write-down in mortgage assets was widespread; explain what measures all banks would have to take in order to rebuild their capital ratios back to the required minimum of 8%.

Answer:

1. The first method is by increasing total equity (with no change in risk-adjusted assets)

1. As we know, the capital ratio = total equity/ risk-adjusted assets *100%

From the table, we can see the current capital ratio=5.24%.the target capital ratio =8%.given the risk-adjusted assets £191, we suppose to find how much total equity is need to achieve capital ratio of 8%? Assume X=total equity.

8%=X/£191m*100% X=£15.28m.

In conclusion, total equity most increase to £15.28m to achieve the capital ratio of 8% with no change in risk-adjusted assets.

2. From the table we can see, given the bank has£10 in total equity. From 1 X is given £15.28m. X-£10m=£15.28m-£10m=£5.28m.

In conclusion, bank needed additional equity £5.28m from the existing equity of £10m to achieve the total equity of £15.28m so that the capital ratio of 8% can be achieved.

2. The second method is by decreasing risk-adjusted assets (with no change in equity)

1. With no change in equity, we calculate the total risk-adjusted assets. Using £10m in equity

The total risk-adjusted assets=£10m/8% *100%=£125m.

In conclusion, assume total equity is fixed; the total risk-adjusted assets have to decrease to £125m in order to achieve the capital ratio of 8%

2. Form the table, we can see, current risk-adjusted asset =£191m and the target risk-adjusted asset =£125m. The change of risk-adjusted asset =new risk-adjusted assets-old risk-adjusted assets=£125m- £191m=-£66m. In conclusion: the total risk-adjusted assets must reduce by £66m in order to get £125m so that the capital ratio of 8% can be achieved.
3. We now have to change the composition of Assets to make risk-adjusted assets=£125m

Because the risk weight of loans and advances is 100%. We need to make it smaller, old loans and advances=£125m, new loans and advances=old loans and advances +changes in composition of assets=£125m+ (-£66m) =£59m.

In conclusion, to achieve the value of risk-adjusted asset=£125m, we need to reduce the loans and advances by£66m in order to get the new loans and advances =£59m

4. In order to achieve liabilities=assets, we also need to change the value of cash in tills.

New cash in tills balance= current cash in tills + change in composition of assets=£5m+£66m=£71m.

In conclusion, to achieve the value of risk-adjusted asset=£125m, we not only need to reduce the loans and advances, but also need to increase the cash in tills by £66m in order to get the new cash in tills =£71m.

By reduce the loans & advances and increase the cash, which will reduce the lending. The liquidity ratio will increase lead to the credit crisis.

[C]New balance sheet with the capital ratio of 8%

Part C:

Explain how, in rebuilding capital ratios, aggregate demand will change, as a result the economy as a whole, could slide into recession.

Answer：

The bank starts to rebuild the capital ratios by reducing the risk-adjusted assets. Under the reducing the risk—adjusted assets, it will change the composition of the assets by reducing the loans & advances and increasing cash in tills. It will cause the overflow of the liquidity. Bank is suddenly reducing profitability. Loans become lesser and lesser to firms, individuals and so on. The bank refused to give loans to others in order to rebuild the capital ratio to achieve a higher figure, which will cause the credit crisis. Assuming the entire bank do that, the aggregate will fall due to the falling of the consumption of domestically produced goods & services and the investment. All of these are depend on loans. For people, they want to take loans from banks by buying cars and house. They also want to pay the educational fees. For the firms, they are in trouble they cannot finance the loans. Sometimes, they don’t have enough money to buy the new equipment and pay the salary to their employees, so they take loans from banks, the issue is they cannot take enough loans from banks so as to firms are tending to make less investment. Due to rebuilding capital ratio, banks don’t want to give loans to others, the Cd will fall down. As a result, the economic will go into the recession. The economic will experience a huge fall in terms of their aggregate demand.

Also, the banks start to rebuild the capital ratio by increasing the equity. Through increasing retained profit, it can delay the payment of dividends and increase its loans rates & bank charges, or by laying off staff and closing underperforming branches so that it will cause the increasing of the unemployment rate and reducing spending. Everything is tending to fall. Spending lesser and lesser, the aggregate demand will fall. Thus, GDP will fall leading to the recession.