Question

A group of college friends decide to start their own bank, LSU Community Bank, in rural Pennsylvania. In order to get started they put in a total of $10 million of their own money and borrow $40 million from a venture debt lender. (This is known as venture debt lending.) They accept $160 million in deposits from households and businesses in the community, and, in turn, make $90 million in loans. They also purchase $95 million of mortgage-backed securities and keep the remainder of their assets as reserves at the Philadelphia Federal Reserve District Bank. a. Show LSU Community Bank's balance sheet. b. What is LSU Community Bank's reserve-deposit ratio? c. What is LSU Community Bank's asset to equity ratio? d. Suppose the housing market tanks and the market value of the bank's mortgage-backed securities falls by 10%. i. Show LSU Community Bank's new balance sheet. ii. By what percentage does the value of the bank's assets fall? iii. By what percentage does the value of the bank's capital fall?

Answer 1

LSU Community Bank's balance sheet: Assets-Reserves: $10 million, Mortgage-backed Securities: $95 million, Loans: $90 million. Liabilities-Deposits: $160 million. Equity-Initial investment: $10 million. The reserve-deposit ratio is 6.25% and the asset to equity ratio is 19.5. The market value of the bank's mortgage-backed securities falls by 10%. The value of the bank's assets falls by 10.5% and the value of the bank's capital remains the same.

Step-by-step explanation:

a. LSU Community Bank's balance sheet:

Assets:

• Reserves: $10 million
• Mortgage-backed Securities: $95 million
• Loans: $90 million

Liabilities:

• Deposits: $160 million

Equity:

• Initial investment: $10 million

b. LSU Community Bank's reserve-deposit ratio:

The reserve-deposit ratio can be calculated by dividing the total reserves by the total deposits. In this case, the reserve-deposit ratio is $10 million divided by $160 million, which equals 0.0625 or 6.25%.

c. LSU Community Bank's asset to equity ratio:

The asset to equity ratio can be calculated by dividing the total assets by the equity. In this case, the asset to equity ratio is ($10 million + $95 million + $90 million) divided by $10 million, which equals 19.5.

d. Suppose the housing market tanks and the market value of the bank's mortgage-backed securities falls by 10%:

i. LSU Community Bank's new balance sheet:

Assets:

• Reserves: $10 million
• Mortgage-backed Securities: $85.5 million
• Loans: $90 million

Liabilities:

• Deposits: $160 million

Equity:

• Initial investment: $10 million

ii. By what percentage does the value of the bank's assets fall?

The value of the bank's assets falls by ($95 million - $85.5 million) divided by $95 million, which equals 0.105 or 10.5%.

iii. By what percentage does the value of the bank's capital fall?

The value of the bank's capital remains the same at $10 million, so there is no percentage change.