Question

6. Banks and solvency

The following table shows the balance sheet for Main Street Bank

 

Compute the value of the bank's capital and enter it in the balance sheet. Then answer the question that follows. 

Answer 1

A bank's net worth, or capital, is the difference between the value of all its assets and the value of all its liabilities. Therefore, Main Street Bank's capital is as follows:

Bank's capital (net worth) = 5,320,000 - 5,270,000 = $50,000

Suppose it turns out that a borrower defaults on a $40,000 loan, and the collateral offered to get the loan is worthless. This will decrease the loans outstanding portion of Main Street Bank's balance sheet, and it will decrease the bank's capital to $10,000. In this situation, the bank is solvent.

Explanation:

If Main Street Bank wrongly identifies a borrower as creditworthy and lends him or her $40,000, and the loan cannot be recovered, then it is considered a bad loan. Since the $40,000 loan is not worth anything, $40,000 must be removed from the bank's assets on its balance sheet. Since the bank has suffered a $40,000 capital loss, that amount must be subtracted from the bank's capital, decreasing this amount from $50,000 to $10,000. Because the bank's capital is positive, Main Street Bank is still solvent.