Question

The bank you own has the same balance sheet as given initially in number 7:

Suppose that the return on assets (ROA) is 4%.   Calculate the return on equity (ROE).   Suppose your bank capital increases to $40 while deposits fall to $60.

Assuming the ROA is fixed, what happens to ROE?  

Explain the benefits and costs of a bank increasing its capital.

Assets Reserves Loans Liabilities $25 Deposits $75 Bank Capital $80 $20

Answer 1

The solution to the above question have been given in the images below:-

The benefits and the cost of a bank increasing its capital are:-

BENEFITS- By increasing its capital, the bank reduces the probability of banking crisis, ensures the bank stay solvent as the increased capital can be used to repay its depositors, customers and the other claimants in case the bank doesn't have enough liquidity and also there is a less chance for the banks to go out of funds.

COST- By increasing its capital, the cost will be that it will have a lower Return on equity(ROE) for the same ROA. It also increases the bank lending rates, raises the cost for the banks and eventually for the consumers.