Question

One reasonable way for a significantly undercapitalized bank to raise capital is sell unproductive risky assets and use the proceeds to pay down debt. Regulators look at how much equity capital a bank has relative to risky assets.   True or False?

Answer 1

Undercapitalization is a situation in which a business has insufficient funding, or capital, to support its operations. Although undercapitalization can affect any business, it is particularly common and problematic for small businesses. In fact, undercapitalization is one of the warning signs of major financial trouble for small businesses, as well as a significant cause of small business failure. Undercapitalization also acts to limit the growth of many small businesses, because without sufficient capital they cannot afford to make the investments necessary for expansion. In this way, undercapitalization can pose a problem even for profitable small businesses

Without sufficient capitalization, companies are unprepared to ride out slow periods in the business cycle, or to fend off a new competitor, or to work through any number of shocks that buffet all businesses from time to time.

There are a number of factors that determine how much capitalization any small business needs. Businesses that offer a service usually require fewer funds than those that manufacture a product. Similarly, businesses in which the owners perform most of the work tend to need less up-front capital than businesses with employees. A company's initial capitalization also depends on the entrepreneur's ability to invest personal funds and institute a sound business plan.

In order to avoid future problems with undercapitalization, entrepreneurs need to perform a realistic assessment of their expenses and financial needs. Some of the major expenses facing a new business include facility rental; salaries and wages; equipment and tools; supplies, utilities; insurance; advertising; and business licenses. Based upon this information, the entrepreneur should prepare a cash flow projection on a monthly basis for the first year. The difference between the funds the entrepreneur is able to contribute, the amount of income the business is expected to generate, and expenses the business is projected to incur provides a rough estimate of the business's financial needs. Ideally, an entrepreneur will secure the necessary equity from various sources to make up the difference and provide the business with sufficient capitalization.

In the current banking system the capital requirement is actually doing two different things. One is that it's there as a buffer too absorb potential losses, the other is that it is acting to regulate the amount of lending that a bank can do - in conjunction with the central bank reserve requirements - and as a consequence also ends up partially regulating the money supply expansion for the entire economy.

The capital adequacy of banks is tightly regulated worldwide in order to better ensure the stability of the financial system and the global economy. It also provides additional protection for depositors. In the United States, banks are regulated at the federal level by the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board and the Office of the Comptroller of the Currency (OCC). Additionally, state-chartered banks are subject to state regulatory authorities. Regulation and solvency of banks is considered to be critical because of the unique importance of the banking industry to the functioning of the economy as a whole.

Monitoring the financial condition of banks is also important because banks have to deal with a mismatch in liquidity between their assets and liabilities. On the liabilities side of a bank's balance sheet are very liquid accounts, such as demand deposits. However, a bank's assets primarily consist of rather illiquid loans. While loans can be (and frequently are) sold by banks, they can only quickly be converted to cash by selling them at a substantial discount.

Answer 2

9. False.

a. Price of Bank asset:

Maturity =10yrs.

Coupon= 10% p.a. distributed semiannually

FV= 100

YTM=8% p.a.

MV or PV = 113.59 [use any financial calculator online]

b. Price of Bank Liability:

Maturity =3yrs.

Coupon= 8% p.a. distributed semiannually

FV= 100

YTM=7% p.a.

MV or PV = 102.66 [use any financial calculator online]

27. True. With the suggestion mentioned is appropriate. Assuming a long term liquidity requirement.

But in case there is short term liquidity requirement then it would be false. Bank can look towards other lines of credit which would come with more benefit than selling of assets.