FRM Part II · FRM Exam Part II · Liquidity and Leverage
A bank has assets of $500 million and equity of $25 million. Assuming liabilities are unchanged in value, by what percentage decline in asset value is its equity wiped out?
A 5% fall in asset value eliminates the equity. Equity of $25 million divided by assets of $500 million is 5%, the inverse of the leverage multiple of 20. Any larger loss makes the bank insolvent.
- A2%
- B4%
- C5%Correct
- D20%
Explanation
Equity is wiped out when asset losses equal equity: 25/500 = 5%. The 20% figure uses equity relative to liabilities incorrectly inverted (500/25 = 20 is the leverage multiple, not a loss percentage). The 4% option wrongly uses equity over assets plus equity.
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