379 $
© 2014 Pearson Canada Inc.$
Explain using an example the statement that "given the return on assets, the lower the bank
capital, the higher the return for the owners of the bank."
Answer: The students must explain this in the following lines: Assuming that we have two
identical banks that earn net profit after taxes $50 and their total assets are $100 for each, then
the banks' ROA is equal to 50 percent. If bank A has bank capital equal to $40 and bank B has
bank capital equal to $20, their respective ROE is 1.25 and 2.5. Thus, the bank with the lower
bank capital—bank B—has the higher ROE. The shareholders of bank B earn double the profits
for every dollar they invest in bank B than bank A.
Diff: 3 Type: SA Page Ref: 304 - 306
Skill: Applied
Objective List: 13.2 Specify how banks make profits by accepting deposits and making loans
Explain the relationship between return on assets and return on equity. What incentives does
this relationship give a bank manager? Is this the desired outcome preferred by regulators?
Discuss.
Answer: For a given return on assets, the greater the amount of capital, the lower is the return on
equity. Bank managers who seek to increase the return on equity must increase the asset base,
purchase riskier assets, or reduce the amount of capital by paying dividends or buying back
stock.
Regulators (and depositors) prefer higher capital for bank safety. Managers typically prefer
lower equity than regulators, resulting in regulatory bank capital requirements.
Diff: 2 Type: SA Page Ref: 305 - 306
Skill: Recall
Objective List: 13.2 Specify how banks make profits by accepting deposits and making loans