Reference no: EM133034376

Question - Consider the following balance sheet for a hypothetical financial institution, Bank A and Bank B:

Bank A's Balance Sheet

Assets 100

Liabilities 80

Capital 20

Bank B's Balance Sheet

Assets 100

Liabilities 90

Capital 10

1. Suppose the value of assets may drop by 20% with a probability of 10%. (otherwise, stay the same, i.e.,it is the only risk). Calculate the probability of being in insolvency for each bank.

2. For simplicity, suppose banks can also issue bonds. Calculate the risk premiums for the bonds issued by each bank that give the same expected rate of return as the risk-free bond whose interest rate is 4%. (Further assume that 1. if a bank becomes insolvent, the bond holders will get nothing, 2. issuing new bonds won't affect the probability of being in insolvency calculated from (1))

3. Following the financial crisis, regulatory capital requirements for the banking system increased in the new Basel Accords. What would be the effect on the financial market.