Question

Suppose that you are managing a bank specializing in commercial mortgages with the balance sheets as below. Say now that the property market conditions deteriorate, and you realize that you may have to write-off loans up to £12m. How will the bank’s balance sheet look like? Is your bank facing a risk of being considered as insolvent? Why? What is the minimum amount of capital you need to ensure that your bank will not be considered as insolvent?

Assets Reserves Loans Commercial mortgages 60m Liabilities Deposits Bank Capital £10m £110m £50m £10m

Answer 1

If the bank needs to write off the bad loans it will write off from the Capital and Reserves account. It is a contra-asset account where the non-performing loans and the provisions for the same are deducted from the total loans. The same effects the capital and reserves of the liability side. If we need to write off the loans the bank balance sheet would look like as below:

Assets	Amount	Liabilities	Amount
Reserves	10	Deposits	110
Loans	50	Bank Capital	10
Commercial Loans	60	(write - off)	-12
(write - off)	-12
Total	108	Total	108

As per the basel 3 norms, a bank should always maintain a minimum of 4.5% of common equity tier 1 capital of the risk weighted assets and a minimum of 6% capital of the risk weighted assets in tier 1 and a minimum total capital of 8% of Risk weighted assets.

So as per the balance sheet given above the bank should maintain a total capital of 9.6 (when the assets were 120) after the write down the assets have become 108, which requires the bank to maintain a minimum capital of 8.64.

So to compensate the write off the bank needs to generate an equity of 10.64. (10 - 12 + 10.64) = 8.64 of total capital.

8.64 = (initial capital (10) - Write off (12) + Additional Equity (10.64)