Suppose you were in charge of prudential regulation and encountered this bank:

Assets Liabilities
Loans to SMEs $ 60 Retail Deposits $40
T-bills $30 Seven-year long-term bonds: $40
Cash $10
Equity
Paid in capital: $5
Retained earnings: $15

The loans, bonds and deposits are all floating rate. The bank pays fixed for seven years on a interest rate swap with a notional of $40 to secure its funding costs.

What would you tell the bank?

Question

Suppose you were in charge of prudential regulation and encountered this bank:

Assets                                                  Liabilities
Loans to SMEs     $ 60                       Retail Deposits $40
T-bills                     $30                       Seven-year long-term bonds: $40
Cash                       $10
                                                            Equity
                                                            Paid in capital: $5
                                                            Retained earnings: $15

The loans, bonds and deposits are all floating rate. The bank pays fixed for seven years on a interest rate swap with a notional of $40 to secure its funding costs.

What would you tell the bank?

BlackTom AI · Accepted Answer

Question restatement: You are regulating a bank with the following balance sheet and risk details. Assets: Loans to SMEs $60, T-bills $30, Cash $10. Liabilities: Retail deposits $40, Seven-year long-term bonds $40. Equity: Paid-in capital $5, Retained earnings $15 (total equity $20). All loans, bonds, and deposits are floating rate. The bank pays fixed for seven years on an interest rate swap with notional $40 to hedge funding costs. The task is to decide what you would tell the bank.

Option 1: Keep up the good work.
- Assessment: This is a cautious, overly optimistic assessment given the information. While the balance sheet is asset-liability matched in total (assets = liabilities + equity), there is still important risk management detail to consider. The bank has a mix of floating-rate assets and liabilities, and it uses a swap with notional $40 to fix funding costs. The swap hedge can be effective, but effectiveness depends on basis risk, gap risk, and the adequacy of liquidity buffers. Saying “keep up the good work” glosses over these potential vulnerabilities and the need for ongoing stress testing, governance, and capital planning. As a regulator, you would expect a more explicit risk management posture rather than complacency.

Option 2: The bank is a disaster and needs to be liquidated. It is poorly capitalized, while facing unacceptable levels interest rate and liquidity risk.
- Assessment: This is an alarmist stance not warranted by the provided data. The bank’s equity is $20 on assets $100, i.e., 20% of asset value, which is a solid level in many regulatory frameworks, and there is a hedging instrument (the swap) intended to stabilize funding costs. The statement about “unacceptable” liquidity risk cannot be conclusively made from the data alone; we would need liquidity ratios (e.g., LCR) and cash flow projections under stress. Liquidation would be extreme given the information. A regulator would require a targeted plan to address risk concentrations rather than an immediate liquidation mandate.

Option 3: Improve your core capital ratios, or I will shut you down.
- Assessment: This is a plausible, measured regulatory stance. Core capital (equity relative to risk-weighted assets) is a common concern, and the bank has a reasonable equity base of $20 on total assets of $100. In real-world terms, regulators would want to assess risk-weighted assets and ensure capital adequacy, liquidity, and risk management practices are robust. The conditional “or I will shut you down” reflects typical enforcement language. However, it should be paired with a concrete remediation plan, timelines, and supervisory expectations, not just a threat.

Option 4: Close out the swap, because you are taking reckless interest rate risk.
- Assessment: This is potentially misguided without a full hedging analysis. The bank pays fixed for seven years on a swap with notional $40 to hedge funding costs, which can be prudent given floating-rate exposure. Closing out the swap could crystallize losses, remove a hedge, and potentially expose the bank to higher funding costs if rates move unfavorably. A regulator would consider whether the hedge is effective, the swap’s counterparty risk, and whether the bank has adequate liquidity to withstand discontinuation. Labeling the position as “reckless” ignores the intended risk management purpose and could be counterproductive without a detailed risk assessment.

Summary of reasoning: Option 1 is overly optimistic and ignores risk-management specifics; Option 2 is an extreme claim not supported by capital adequacy in the given figures; Option 3 presents a sensible, standards-aligned supervisory stance emphasizing capital adequacy and remediation; Option 4 prematurely rejects the hedging strategy and risks destabilizing the bank’s funding profile. Each option involves different interpretations of capital adequacy, liquidity, and hedging effectiveness, and a prudent regulator would require a formal assessment of capital adequacy (including risk-weighted assets), liquidity coverage, stress testing outcomes, and the hedge’s effectiveness before deciding on actions.

IFEPIA7022_001_2025_3 - Economics of Finance EOF Final - Dec 16, 2025

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