1.4.1 and 1.4.2 The Role of Banks in the Economy and Risk and Liability

Question 1

Banks

Answer 1

Financial investments, channeling funds from savers to borrowers, in particular to home-buyers and to businesses that want to borrow for investment or just keep the business going

Question 2

interest payments

Answer 2

Reward savers for parting with their money and ensure that borrowers pay for their loan together with any risks involved

Question 3

working capital

Answer 3

The money needed by businesses to cover costs of production

Question 4

why are banks important

Answer 4

• Provide efficient payment systems
• Provide a safe place for saver’s funds and usually pay interest on savings account
• Offer loans to borrowers (individuals or businesses), in return for investment payments

Question 5

why banks are the best for distributing money

Answer 5

• Without banks savers would have to keep cash until they needed it or run huge risks by lending directly to borrowers
• Savers would have little knowledge of which borrowers could be relied on
• Banks have long experience in dealing with both savers and borrowers and can evuate risks and set interest rates that reflects those risks

Question 6

bank role in providing credit

Answer 6

• Individuals can afford to buy homes that are worth several times their annual income, and still have enough disposable income to meet all their needs
• For businesses, banks lend the funds needed to help them undertake big investment projects, which is vital to the economy
• Banks also provide businesses with working capital - the funds they need to finance day to day payments
• Banks may help the government to cover its deficits

Question 7

how do banks facilitate economic growth

Answer 7

• Banks can led more money than they have in deposits → they know everyone will not withdraw their savings as the same time (although in a banking crisis this may not be the same for all banks)
• This means that they are key players in the economic growth process
• All of us gain from bank’s activities because they facilitate investments that raise standards of living in the long run

Question 8

borrowing and interest rates

high risk borrowers

Answer 8

• Their interest rate will depend on the degree of risk involved in lending to them
• Interests rates are always highest on credit card loans
• To get a low rate of interest on a loan from a bank, borrowers have to be able to convince the bank that there is little risk involved → If they pay what they owe, they will get a better deal from the bank

Question 9

banks and credit worthiness

Answer 9

• Anyone who has failed to pay back a loan will have a poor reputation and will be asked to pay high rates of interest if they want to borrow
• If the borrower can offer collateral, then the interest rate will be lower

Question 10

collateral and banks

Answer 10

• Collateral is the assets that can be used to repay the bank if the borrower does not have enough money to cover both interests and repayments
• The collateral damage for mortgage loans will be the property itself, which can be sold to pay back the bank
• If a business owns its premises, this will serve as collateral
• Banks seek to minimise the risks in this way

Question 11

risk

Answer 11

Anticipate probabilities and put a value on them

Question 12

uncertainty

Answer 12

We do not know the likelihood of a particular event occuring, cannot measure it or predict it

Question 13

Sole traders and partnerships + unlimited liability

Answer 13

The owners have a legal duty for all debts and can have all of their personal possessions seized pay their debts

Question 14

Limited companies + limited liability

Answer 14

Liability is limited to the business itself and not owners/shareholders. Company may lose assets but the personal wealth of the owners is protected

Question 15

how can risk be reduced

Answer 15

Risks can be greatly reduced when businesses make sure they are as well informed as possible about the kinds of things that might go wrong

Question 16

what is limited liability

Answer 16

• Applies to both private limited companies and public limited companies
• Private limited companies are usually small with a limited number of shareholders; shares cannot be bought by outsiders
• Public limited companies are listed on the stock exchange so that anyone can buy their shares, including banks, pension funds and insurance companies

Question 17

positive impacts of a business with limited liability –> importance

Answer 17

• Limits the risk to shareholders as they only lose the value of their investment, not total assets
• Investors liability/financial commitment is limited to the total amount invested or promised in share capital
• Investors personal belongings are protected
• Banks prefer to loan to them as they are seen as less risky

Question 18

problems with a business having unlimited liability

Answer 18

• Business owners are responsible for the total amount of debt to the business
• Owner may lose their personal belongings if the value of these is needed to cover the debts of the business
• Seen as high risk

Question 19

sole traders

Answer 19

• Individual who runs an unincorporated business by themselves (sole proprietor)
• Cheap and easy to set up
• they are made personally liable for the debts of the business and owns all of its profits –> UNLIMITED liability

Question 20

advantages and disadvantages of being a sole trader

Answer 20

• quick and easy to set up
• simple to run as the owner has complete control over decision making
• minimal paper work
• easy to close/shut down
• full personal liability
• harder to raise finance, as they usally have limited funds of their own
• the business is the owner, so if the owner is ill etc the business suffers
• can pay a higher tax rate than a company

Question 21

partnerships

Answer 21

• Association of 2 or more people
• Partners are liable for the debts of the business –> UNLIMITED liability
• General partners are fully liable but limited partners are limited to the amount of investment they made in the partnership
• Operation governed by a partnership agreement they determine
• Concerns equal profit share, salary and benefit entitlement, new partners etc

Question 22

advantages and disadvantages of partnerships

Answer 22

• simplest way for two or more people to run a business together
• minimal paperwork once partnership agreement set up
• business benefits from the expertise and efforts of more than one owner
• partners can provide specialist skills
• greater potential to raise finance - partners each provide investment
• full personal liability
• a poor partner decision damages the interest of the other partners
• harder to raise finance than a company
• partners are bound by the decisions of others
• complicated to sell/close
• partners may disagree

Question 23

limited company

Answer 23

• Profit and losses are the company’s and it has its own debt and obligations; separate legal entities
• Company endures despite what happens to its managers –> owned by shareholders and director-run in the shareholders interests
• shareholders own a share, not company assets, so not reliable for company debts –> LIMITED liability
• can have LTD or PLC

Question 24

advantages and disadvantages of limited companies

Answer 24

• limited liability protects shareholders
• easier to raise finance through share sales
• stable form of structure – business still exists even when shareholders change
• greater admin costs
• public disclosure of company info
• directors legal duties

Question 25

if a sole trader needs to borrow for their business, why should they become limited

Answer 25

• Businesses that need to borrow should become limited companies to protect themselves → if the business goes bankrupt they can only take the share capital of the business, not all the owners possessions
• They register with the companies house which makes the business a separate legal entity
• If a business cannot pay its debts it will go into liquidation but the owners only lose the money they put into the business

Question 26

not for profit organisations

Answer 26

• trade in order to benefit the community –> social aims and profit
• eg job creation and training, community services, fair trade with developing countries
• social enterprise: including community development trust, housing associations, worker owned operatives, sports clubs