Explanation:
A broker-dealer's vulnerability to a liquidity crisis is strongly associated with its degree of asset encumbrance. We can determine this by calculating the proportion of instruments pledged as collateral against total instruments owned for each bank. Higher ratios mean the bank is more encumbered and has fewer unencumbered assets available to pledge if short-term financing is suddenly withdrawn.
The encumbrance ratios are calculated as follows:
Bank C has the highest proportion of its assets pledged as collateral (44.44%), leaving it with the lowest buffer of unencumbered assets. Therefore, Bank C is the most vulnerable to a liquidity crisis.
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Q.1 In recent years large dealer banks have increasingly resulted to financing a significant part of their assets using short-term finance solutions like overnight repurchase agreements. In these deals, creditors hold bank assets as collateral. The table below shows the year-end financing of six broker-dealer banks (amounts in sterling pounds).
Banks
| A | B | C | D | E | F | |
|---|---|---|---|---|---|---|
| Instruments owned | 896 million | 745 million | 630 million | 700 million | 962 million | 1.23 billion |
| Pledged as collateral | 229 million | 121 million | 280 million | 310 million | 151 million | 280 million |
Suppose repo creditors raise questions regarding the solvency of the abovementioned banks: Which bank will be most vulnerable to a liquidity crisis?
A
Bank A
B
Bank E
C
Bank F
D
Bank C