Skip to content

FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank increases its leverage by replacing equity with deposits while keeping assets and asset returns unchanged. Holding other things constant, what is the most likely effect?

Substituting deposits for equity raises leverage, which magnifies both expected return on equity and its volatility, and it also raises default risk because the loss-absorbing buffer is thinner. Return on assets is unchanged since the assets and their returns are the same.

  1. AReturn on equity rises in expectation and its volatility rises, as does default riskCorrect
  2. BReturn on equity falls and its volatility falls
  3. CReturn on equity rises and its volatility falls
  4. DReturn on assets rises because funding costs decline

Explanation

Higher leverage spreads the same asset income over a smaller equity base, magnifying expected ROE and its variability. The thinner buffer also raises the probability of insolvency. Return on assets depends on the asset side and is unchanged.

Did you get it right without looking?

One question tells you little. A timed set on Capital Structure in Banks shows your real accuracy, how long you take and where you lose marks.

Practise Capital Structure in BanksFree diagnostic mock

More Capital Structure in Banks questions