Question

2. Consider the following two banks:

Bank of Huxley                                                                     Bank of Slavin

$100 million in assets                                                             $200 million in assets

$5 million in equity capital                                                    $15 million in equity capital

Assume that the loan quality in the respective portfolios of each institution are comparable and that each bank is generating a return on assets of 1%. All things being equal, in which institution would you rather hold common stock? What steps could the other, less appealing institution take to make it more attractive to potential investors in its common stock? Which of the two institutions is more likely to attract the attention of bank regulators and why?     

Answer 1

Assuming equity capital face value is $ 1.
Particulars	Huxley	Slavin
No. of equity shares	5 Million	15 Million
Return on assets	1 Mn	2 Mn
	(100 Mn * 1%)	(200 Mn*1%)
Earnings per share = Return on assets / No. of equity shares	0.20	0.13
Rank	1	2
Based on EPS, Bank of Huxley is better investment.

Bank of Slavin can take steps to ensure more efficient utilization of its assets in order to generate a higher return, which in turn increases the EPS.

As per capital adequacy ratio norms, banks are required to have capital to risk weighted assets ratio of 8%.

The calculation of ratio is as follows:

Particulars	Huxley	Slavin
Capital (In Millions)	5	15
Assets (In Millions)	100	200
Capital to asset ratio (Capital / Assets)	5.00%	7.50%

Based on the above, Bank of Huxley has a very low Capital adequacy ratio of 5% compared to Bank of Slavin which has 7.5%.

Hence, Bank of Huxley is more likely to attract the attention of regulators owing to lower Capital Adequacy Ratio.