Consider the simple FI balance

Consider the simple FI balance sheet in Table 7–2 .Before deposit withdrawals, the FI has $10 million in cash assets and $90  million in nonliquid assets (such as small business loans). These assets were funded with $90 million in deposits and $10 million in owner’s equity. Suppose that depositors unexpectedly withdrew $15 million in deposits (perhaps due to the release of negative news about the profits of the FI) and the FI receives no new deposits to replace them. To meet these deposit withdrawals, the FI first uses the $10 million it has in cash assets and then seeks to sell some of its nonliquid assets to raise an additional $5 million in cash. Assume that the FI cannot borrow any more funds in the short-term money markets, and because it cannot wait to get better prices for its assets in the future (as it needs the cash now to meet immediate depositor withdrawals), the FI has to sell any nonliquid assets at 50 cents on the dollar. Thus, to cover the remaining $5 million in deposit withdrawals, the FI must sell $10 million in nonliquid assets, incurring a loss of $5 million from the face value of those assets. The FI must then write off any such losses against its capital or equity funds. Because its capital was only $10 million before the deposit withdrawal, the loss on the firesale of assets of $5 million leaves the FI with only $5 million in equity.

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