Chapter 3: Banking

Question 1

Explain the business model of a Retail Bank. (3)

Answer 1

1) The bank attracts deposits from individuals.
2) The bank uses those deposits to make loans to other individuals.
3) The interest the bank pays on deposits is less than the interest it demands on loans.

Question 2

Give two possible definitions of a Commercial Bank.

What is another term often used interchangeably with Commercial Bank?

Answer 2

1) The US definition of a commercial bank is all banks that take deposits and grant loans.
2) Elsewhere commercial banking refers to the above activity focused on companies/commercial entities.

Commercial banking is often referred to as corporate banking, since business clients are predominantly corporate entities.

Question 3

Give three standard features of bank loans.

Answer 3

The standard features of banks loans are the loan is normally:

1) For a set period that is generally less than five years.
2) At a set rate of interest.
3) Set with a defined repayment schedule.

Question 4

What is an unsecured loan?

Answer 4

A loan where the lender agrees to lend without requiring a security.

Question 5

What is a mortgage?

Answer 5

A mortgage is a form of loan used to buy property. As they tend to involve large sums of money, the loans are generally repaid over longer periods.

Question 6

Give four standard features of a mortgage.

Answer 6

Mortgages are typically:

1) For a set period
2) At a variable rate of interest
3) Have a defined repayment schedule
4) Secured on the property the loan is used to buy

Question 7

Give three standard features of an overdraft.

Answer 7

Overdrafts are generally:

1) Flexible - ability to draw, repay and draw again up to the overdraft limit
2) At a variable rate of interest
3) Unsecured and repayable on demand

Question 8

What are the three key characteristics of credit cards?

Answer 8

Credit cards generally have the following characteristics:

1) Flexible - able to be used up to the credit limit
2) Variable rate of interest which tends to be expensive
3) Repayments of a minimum amount are required each month

Question 9

Give four standard characteristics of loans from pawnbrokers and payday loans.

Answer 9

Loans from pawnbrokers and payday loans are:
1) Easily available - the decisions tend to be made immediately
2) Very expensive in comparison to other forms of borrowing
3) For pawned items, repayment is required to regain possession of the pawned item.
4) Payday loans are very short term with repayment required at the next payday

Question 10

What is the effective annual rate of interest?

Answer 10

The effective annual rate of interest takes the quoted rate and adjusts it to take into account the frequency of interest charges.

When interest is charged more frequently than annually, the effective annual rate will be greater than the quoted rate.

Question 11

What two things should be considered when comparing the cost of borrowing?

Answer 11

When comparing the cost of borrowing, it is sensible to:

1) Look at the annual quoted percentages
2) Look for the effective annual rates to make a true comparison, including the impact of how often the interest is charged.

Question 12

What is secured borrowing?

What is an advantage of secured borrowing to borrower?

Answer 12

Secured borrowing is where the lender has the right to take something that belongs to the borrower if the borrower fails to meet the terms of the loan.

Since secured borrowing is safer to the lender because of the security, it is also cheaper for the borrower.

Generally unsecured loans are more expensive because the risk to the lender is greater.

Question 13

How might companies be able to borrow money more cheaply?

Answer 13

Companies that need to borrow money generally may be able to borrow more cheaply by offering some of their assets as security.

The company’s assets might include land and buildings.

Question 14

What are Investment Banks?

Answer 14

Investment banks are specialists in ‘capital-raising’, and particularly in large-scale capital-raising, starting at around £5m and upwards to £100bn.

Another major line of business for investment banks is mergers and acquisitions (M&A). This is where investment banks advise companies on their business strategy, in particular on how the companies can grow by buying other businesses.

Question 15

What is capital?

What two forms does capital take?

Answer 15

Capital is long-term finance and is required by companies and many governments.

Broadly capital comes in two forms - equity and debt (bonds or loans)

Question 16

What determines whether a company is more likely to borrow money through a loan from the bank or by issuing bonds?

Answer 16

The choice of loans or bonds is often a matter of how keen the banks are to lend money.

When banks have plentiful funds, they tend to be willing and able to lend at competitive interest rates.

When banks are less willing to lend, companies that want to borrow have little choice other than the bond marker.

Question 17

When would debt be considered a more appropriate way to raise capital?

Answer 17

If the company is raising finance for something that can be easily sold, then borrowing might be more appropriate - because the asset being purchased can be used as security.

Question 18

When would equity be considered a more appropriate way to raise capital?

Answer 18

When finance is being raised for items that are inherently more risky, such as a pharmaceuticals company raising capital to research a cure to cancer, equity is a more logical choice.

The outcome of the research is uncertain, and, if it does not work out, paying interest and then repaying the money may become difficult for the borrowing company.

By raising equity, there is no obligation to repay and there is no obligation to pay dividends.

Question 19

What are the three main roles of a Central bank?

Answer 19

1) Banker to the Banks
2) Banker for the Government
3) Regulatory Role

Question 20

Explain the the Central Bank’s role as Banker to the Banks. (3)

Answer 20

1) The Central Bank holds the cash reserves of various banks
2) When someone who is a customer at one bank transfer money to someone at a different bank, the money moves across the two banks via their accounts at the Central bank.
3) Central Banks also occasionally have to act as lender of last resort to banks that are in temporary financial difficulties.

Question 21

Explain the Central Bank’s role as banker for the government. (4)

Answer 21

1) Accumulate the nation’s tax receipts
2) Make payments to the various government departments
3) Hold the country’s foreign currency reserves
4) Issue notes and coins on behalf of the government and manage government debt.

Question 22

Explain the Central Bank’s regulatory role. (2)

Answer 22

1) Licenses banks to operate and oversee their activities.
2) Responsible for setting the interest rate to control inflation.