The Bank Balance Sheet

Question 1

What is the capital ratio?

Answer 1

Bank’s capital / Total assets

Question 2

What is the capital ratio requirement?

Answer 2

Must be at least 8%

If the capital ratio is less than 8%, the bank is undercapitalised

Question 3

How can capital be increased?

to improve the capital ratio

Answer 3

• Issuing stock
• Cut dividend payments which will increase the retained earnings (capital)
• Decrease the amount of its assets, by selling

Question 4

What is the effect of deterioration in balance sheets?

Answer 4

Causes a decline in the economy

• If the bank has less capital (net worth) they have fewer resources to lend
• Lending will therefore decline (deleveraging)
• Deleveraging will lead to a decline in investment spending, which will lead to a decline in economic activity

Higher interest rates can be charged as there is less to lend
This increases the problem of asymmetric information

The bank has less “skin in the game” (less to lose) so may make risky decisions which could lead to failure

Question 5

How does simultaneous failure of banks cause a decline in the economy?

Answer 5

• Information is not being produced in financial markets by banks
• Therefore the bank’s financial intermediation role to prevent asymmetric information problems is lost