Consider the following balance sheets for two hypothetical banks A and B:
• Bank A:
– Assets: Cash = $1,000, Loan to Bank B = $500
– Liabilities: Deposits = $1,400
• Bank B:
– Assets: Mortgage–backed securities = $800
– Liabilities: Deposits = $200, Loan from Bank A =$500
(a) What is the equity (net worth) for each bank?
(b) What is the leverage ratio for each bank?
(c) Suppose house prices fall sharply and the mortgage backed securities held by Bank B fall in value to only $500. What happens to bank B’s net worth? The shortfall in Bank B’s net worth means that it cannot repay the loan it received from Bank A. Assume that Bank B pays as much as it can, while still making good on its deposits. What happens to the net worth of Bank A?
(d) Explain how what happened in part (c) is related to systemic risk. Discuss how tighter capital requirements, which reduce the leverage ratios, could avoid systemic risk in part (c).