Posted: November 25th, 2015

Bank capital and solvency risks

Bank capital and solvency risks:
given balance sheet,Retail deposits rate
Bonds and other long term loans rate
Short term wholesale loans rate.
1. What is the probability that the bank is insolvent a year ahead?
2. What is the expected – or average ‐ return on the equity over the year? (remember the shareholders have limited liability so this calculation is not straightforward and you definitely cannot do it with a pocket calculator!).
3. Devise a fair scheme to pay the holders of all the debt of the bank if the bank is insolvent. (Take note of the fact that there are three types of debt and each has been promised a different interest rate and each has provided a different amount of debt).
4. Assuming that there was no change in the return promised on all types of funding or in the returns on assets, how much of the deposits of the bank would need to switched to equity funding for the chances of insolvency to be halved?
5. Could the situation described in question 4 be an equilibrium? If it is not an equilibrium what might change?