Question

Recall that Carson Company relies heavily on commercial banks for loans. When the company was first established with equity funding from its owners, Carson Company could easily obtain debt financing because the financing was backed by some of the firm’s assets. However, as Carson expanded, it continually relied on extra debt financing, which increased its ratio of debt to equity. Some banks were unwilling to provide more debt financing because of the risk that Carson would not be able to repay additional loans. A few banks were still willing to provide funding, but they required an extra premium to compensate for the risk.

a. Explain the difference in the willingness of banks to provide loans to Carson Company. Why is there a difference between banks when they are assessing the same information about a firm that wants to borrow funds?

b. Consider the flow of funds for a publicly traded bank that is a key lender to Carson Company. This bank received equity funding from shareholders, which it used to establish its business. It channels bank deposit funds, which are insured by the Federal Deposit Insurance Corporation (FDIC), to provide loans to Carson Company and other firms. The depositors have no idea how the bank uses their funds. Yet the FDIC does not prevent the bank from making risky loans. So who is monitoring the bank? Do you think the bank is taking more risk than its shareholders desire? How does the FDIC discourage the bank from taking too much risk? Why might the bank ignore the FDIC’s efforts to discourage excessive risk taking?

Answer 1

a) The banks willingness to provide loan can be assessed from the perspective of the debt to equity ratio on the balance sheet. At the beginning the bank had low debt on its balance so its ability to pay back the debt was high but as the debt on the balance sheet increases the company’s ability to repay the debt can be questionable as to whether it will able to repay the debt or not and that is the reason why many banks are not willing to provide loan to the company. There is difference in the bank’s opinion because different bank has different risk structure and different way to handle a scenario so some banks might not take this risk and provide loan while some banks who has strong balance sheet can choose to take the risk but will charge high interest rate for the loan.

b) Federal deposit insurance corporation is one of the agencies which was set up with the objective to maintain stability and public confidence in the system. The FDIC protects the deposits of the consumer up to a certain amount so in case the banks defaults on its obligation to pay back the deposit the FDIC will pay to the depositors. Banks do take risk and depositors are not normally aware as to how much risk they are taking and how is their money being invested especially the retail investors. Banks come under the jurisdiction of the federal reserve and federal reserve regulates the banks. The bank has to maintain a certain level of reserve ratio and they have to invest certain portion of their capital in high quality securities like T bills. The banks also have to meet the Basel norms regarding the capital requirement. There is also the asset liability management committee in every bank which decides as to how much risk exposure the bank can take and how the risk is going to be managed. The FDIC acts from the consumer perspective and discourages excessive risk-taking culture and only insures a certain amount of deposit.