The following tables show the balance sheets of two banks: Big Bank and Small Bank....
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Accounting
The following tables show the balance sheets of two banks: Big Bank and Small Bank. is a levered bank, while is an unlevered bank. Assume that both banks offer an annual rate of 4% on checking deposits and charge an annual rate of 8% on loans. For Small Bank, the annual interest cost on deposits is, and the annual return on loans is. Hence, Small Bank earns a net profit of, which represents a rate of return of on stockholders' equity. For Big Bank, the annual interest cost on deposits is, and the annual return on loans is. Hence, Big Bank earns a net profit of, which represents a rate of return of on stockholders' equity. Suppose that the value of loans in both banks declines by 10%. The amount of loans outstanding for Big Bank decreases from $250,000 to, which represents a loss of stockholders' equity. The amount of loans outstanding for Small Bank decreases from $500,000 to, which represents a loss of of stockholders' equity. Therefore, provides a higher rate of return to its investors, and exposes its investors to greater risk in the event of a decline in the value of loans
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