Help me answer this technical-ish question

The below relates to a plain vanilla commercial bank:

This is an oversimplification, but a bank's balance sheet is made up of the following components: Assets - cash, securities, net loans (gross loans to customers minus loan loss reserves), goodwill and fixed assets Liabilities - deposits, senior and subordinated debt Equity - preferred equity (including TARP if applicable) and common equity

A few major differences between banks' balance sheets and other types of companies: loans and deposits make up the majority of banks' balance sheets and the loan to deposit ratio is often close to 1:1. Banks are far more levered than most companies - equity/assets is typically in the 6% to 10% range. Equity levels are drastically reduced when loans go bad - think of it this way, since loans are frequently 10x equity, a bank becomes at risk of failure if only 1 in every 10 loans goes bad.

The two most important questions regarding the balance sheet: (1) is the bank growing or shrinking its balance sheet? (2) what are the bank's capital adequacy ratios? During a recession, most banks shrink their balance sheets to maintain acceptable capital ratios.

The most common way for a bank to shrink its balance sheet is through a reduction in loans. A bank can: 1) Sell loans to healthier banks 2) Sell non-performing loans to distressed asset buyers 3) Quit making new loans and let existing loans run off the books as they are repaid 4) Asset quality also typically deteriorates when the economy goes south causing an increase in the loan loss reserve and thereby a decrease in net loans.

Cash and securities will typically increase during a recession. Banks value liquidity during crises and will reinvest repaid loan proceeds in cash and Treasuries, and not new loans to customers.

Loan loss reserves will increase and equity will decrease as bad loans are written off.

Regarding capital adequacy ratios - bank regulators typically look at the tier 1 capital ratio and the leverage ratio. Analysts typically look at tangible equity / tangible assets and tangible common equity / tangible assets.

Regardless of the ratio used, during a recession capital adequacy ratios often deteriorate rapidly. Since leverage is so high, banks cannot shrink their loan portfolios fast enough to keep up with charge-offs caused by loan losses.

Finally, preferred equity became a much more prevalent form of financing during the recession thanks to Uncle Sam and TARP.