Consider a simple bank that has assets of 100, capital of 20 , and checking deposits of 80. Recall from Chapter 4 that checking deposits are liabilities of a bank.

a. Set up the bank's balance sheet.

b. Now suppose that the perceived value of the bank's assets falls by 10. What is the new value of the bank's capital? What is the bank's leverage ratio?

c. Suppose the deposits are insured by the government. Despite the decline in the value of bank capital, is there any immediate reason for depositors to withdraw their funds from the bank? Would your answer change if the perceived value of the bank's assets fell by 15? 20? 25? Explain.

Now consider a different sort of bank, still with assets of 100 and capital of 20, but now with short-term credit of 80 instead of checkable deposits. Short-term credit must be repaid or rolled over (borrowed again) when it comes due.

d. Set up this bank's balance sheet.

e. Again suppose the perceived value of the bank's assets falls. If lenders are nervous about the solvency of the bank, will they be willing to continue to provide short-term credit to the bank at low interest rates?

f. Assuming that the bank cannot raise additional capital, how can it raise the funds necessary to repay its debt coming due? If many banks are in this position at the same time (and if banks hold similar kinds of assets), what will likely happen to the value of the assets of these banks? How will this affect the willingness of lenders to provide short-term credit?