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

A bank's CFO proposes to raise its return on equity by replacing $2 billion of common equity with senior debt while keeping assets unchanged. Which is the most likely consequence from a capital structure perspective?

Replacing equity with debt raises leverage, which boosts return on equity when the bank is profitable. However, it shrinks the loss-absorbing buffer, raising the probability of distress and typically the cost of debt. Risk therefore increases rather than stays the same.

  1. ALower leverage and lower probability of default
  2. BHigher leverage, higher ROE if profitable, but a greater probability of distress and lower loss-absorbing capacityCorrect
  3. CNo change in risk because assets and earnings are unchanged
  4. DLower cost of debt because senior debt becomes safer

Explanation

Swapping equity for debt raises leverage. Earnings spread over less equity lifts ROE in good states, but the thinner buffer raises default probability and tends to increase the debt funding cost. Risk is not unchanged because the loss-absorbing buffer shrinks.

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