In workout one, a bank has made loans to customers. The customers use their own assets such as property as security in case they cannot pay back the loan.

What happens to the bank's balance sheet if there is a recession? If 10% of loans default and the bank is only able to recoup 50% of the assets from defaulted loans? Well, here we have our initial balance sheet and we can see that the bank has total assets of 100 split between liquid assets of 20 so that might be cash. And the loans of 80, and they're very illiquid. How have they been financed? They've been financed through liabilities and equity of deposits of 95 and equity of 5.

Now that equity, that's going to be used to absorb any losses and we'll see that coming up.

So underneath, we've got the balance sheet for after the recession and we start with those liquid assets. Nothing happened to them, they just stay as they were.

But next up we had the loans. Now the loans, we've lost 10% of them. So I go up to the 80 and I'm going to multiply by 90% or 1 minus the 10%.

Oh dear. So we've lost a huge amount of those loans.

However, we were told that 50%, the bank was able to recoup 50% of the assets from defaulted loans. Well, how much loans were lost? They were initially worth 80. They've gone down to 72. We've lost 8 worth of the loans, but we can get back 50% of that while multiply that by 50%, and the repossessed assets come to 4. So the bank's total assets, which were worth 100, they've now gone down to 96. Oh dear. Well, what happens to the bottom half of the balance sheet? Well, the deposits, that's deposits from customers putting their income and their savings in the bank. We have to try and pay that back. So we can't reduce that. That's got to be worth the same 95. It always was, but hang on. My total assets are 96. My total liabilities and equity has to be 96. Equity is going to be the plug and our equity, which was worth 5 further up, has now gone down to, oh dear it's gone down to 1. Total liabilities and equity sum of the items above.

So what's happened overall? The bank lost some of its loans through default, but was able to repossess some of the assets and get them back. Ultimately, 4 of value was lost. The loans were worth 80. They're now worth 76 ish. That 4 of losses could potentially have impacted the deposits, but they didn't the equity of the bank, that's what that's there for. That's to absorb any losses. So while nots great, the bank is doing okay.

Let's go down to workout two.

We're back to the same starting position, but now we're asked what happens to the bank's balance sheet if customers withdraw 10 of deposits very quickly.

So same balance sheet here, but then we have to work out that balance sheet after deposit withdrawal.

Well, the first thing we need to look at is the deposits line. That deposits, which was worth 95, has now just gone down by 10 and it's happened very quickly. What's the other half of that transaction? Well, because the deposits have been withdrawn very quickly, we've had to use liquid assets. Our liquid assets, which were 20, some of that's now been paid out to the customers. So that's gone down by 10. But that's okay. We only used liquid assets that time. That means we have not had to sell any of the loans. Loans are very illiquid. It would be very difficult to sell them and the value would reduce.

So the total assets is now 90.

The equity is still the plug between the total assets and the deposits.

It was 5. It's still 5 now. Total liabilities and equity comes to 90. So our liquid assets have worked in exactly the way they're designed. Deposits are withdrawn, liquid assets are taken out. We don't have to touch the illiquid loans.