Suppose a bank with $10 million in total assets had 60 percent of its assets in loans and that one of those loans was for $250,000.  Assume the bank also had a 10 percent capital to asset ratio.  Use this information to fill in the blank in the balance sheet below, then consider the following questions:

• If the loan for $250,000 had to be written off as a total loss, what would be the impact or percentage change in the bank’s loan portfolio? 
• What would be the percentage impact on the bank’s capital?

Hint: Remember the balance sheet must balance, that is, assets must equal liabilities plus capital. Also, the sum of the parts must equal the total. For instance, individual assets components should equal total assets.

Simple Balance Sheet for Small Bank
	($000)
Total loans	$6,000
Other assets	$4,000
Total assets	$10,000
Total liabilities	$9,000
Total capital	$1,000

The percentage change in loans if the $250,000 loan had to be written off as loss is?
A. 2.50%
B. 2.78%	The correct answer is 4.17%.  To calculate the percentage change in loan from charging off the $250,000 divide the $250,000 by the $6,000,000 amount for total loans.
C. 4.17%
D. 5.49%

 

The percentage change in capital from writing off the loan is?
A. 25.0%
B. 30.0%	The correct answer is 25%.  To calculate the percentage change in capital from the $250,000 charge off, divide $250,000 by the total capital amount of $1,000,000. In this example, the loan is charged-off directly against capital.  At your bank, the charge-off would be subtracted from the allowance for loan and lease losses (ALLL), the reserve the bank holds to absorb loan losses.
C. 16.0%
D. 40.0%

In this example, the loan losses that are small relative to a bank’s total loans translate into large capital losses.  Small Bank could only sustain losses on three additional loans of this size before its capital is depleted.  Yet, its loan portfolio would have shrunk by around 17 percent (four loans of $250,000 each or $1 million divided by $6 million).

The Small Bank example illustrates another point.  Simply because of their size and potential capital exposure, large loans are always a major source of credit risk and should receive increased attention and scrutiny.  Because of this, it is essential that the board be involved in decisions regarding the bank’s most significant credit exposures.