Select only one answer for each question. Provide explanation and calculation where relevant
to support your answers. For numerical questions select the answer that is nearest to yours.
- Analysis of adverse selection indicates that financial intermediaries, especially banks,
a. have advantages in overcoming the free-rider problem, helping to explain why indirect
finance is a more important source of business finance than is direct finance.
b. despite their success in overcoming free-rider problems, nevertheless play a minor role
in moving funds to corporations.
c. provide better-known and larger corporations a higher percentage of their external funds
than they do to newer and smaller corporations which rely to a greater extent on the new
issues market for funds.
d. must buy securities from corporations to diversify the risk that results from holding nontradable loans.
e. none of the above. 9 marks - In 2020 Harry takes out a £35,000 loan to buy a car as a 40th birthday present for himself. He
will pay the loan back when he is 45. Harry takes out term insurance for the whole period for
the whole amount of the loan. Harry lives in Hackney, London. Use the following information to
determine what the insurance company should charge. Show the calculation step by step in
handwriting.
• Claim processing costs are £200.
• Interest rates are 6%.
• Average delay between receipt of premium and payment of claim is 3.5 years.
• Administration costs are 2% of the pure premium.
• The insurer adds 1 year to the probability of dying due to the risk of living in Hackney.
• Charge for uneconomic use of capital is 0.5% of the pure premium.
• Sales commission is 0.3% (30 basis points) of the final premium
a. £146.0
b. £183.7
c. £225.0
d. £340.6
e. £501.2
18 marks - If a bank finds that its ROE is too low because it has too much bank capital, what can it do to
raise its ROE?
a. It can reduce the bank’s dividends to shareholders.
b. It can issue common stocks.
c. It can keep its capital constant, but increase the amount of its assets.
d. It can give out fewer loans.
e. It can sell off securities and then use the proceeds to reduce its liabilities.
9 marks
3
Turn over - A bank has excess reserves of £1,000 and sight deposits of £80,000 when the reserve
requirement is 20 percent. If the reserve requirement is lowered to 10 percent, the bank’s
excess reserves will be
a. £1,000
b. £8,000
c. £9,000
d. £16,000
e. £17,000
9 marks - Consider a bank with the following balance sheet:
Assets Liabilities
Required Reserves £9 million Sight deposits £90 million
Excess reserves £2 million Bank capital £6 million
T-bills £46 million
Commercial loans £39 million
The bank makes a loan commitment for £15 million to a commercial customer. Calculate the
bank’s risk-weighted assets before and after the agreement.
a. Total risk-weighted assets before the agreement are £54 million; total risk-weighted assets
after the agreement are £39 million.
b. Total risk-weighted assets before the agreement are £39 million; total risk-weighted assets
after the agreement are £54 million.
c. Total risk-weighted assets before the agreement are £39 million; total risk-weighted assets
after the agreement are £39 million.
d. Total risk-weighted assets before the agreement are £54 million; total risk-weighted assets
after the agreement are £85 million.
e. Total risk-weighted assets before the agreement are £85 million; total risk-weighted assets
after the agreement are £100 million.
9 marks - Eternity Financial starts its first day of operations with £11 million in capital. A total of £120
million in sight deposits are received. The bank makes a £70 million commercial loan. To be
classified as well capitalised, a bank’s capital ratio must exceed 5%. What is Eternity’s capital
ratio? How well capitalised is the bank?
a. The capital ratio is 8.40%; the bank is well capitalised.
b. The capital ratio is 7.75%; the bank is well capitalised.
c. The capital ratio is 5.83%; the bank is well capitalised.
d. The capital ratio is 2.40%; this triggers increased regulatory restrictions on the bank.
e. The capital ratio is 0.09%; this triggers increased regulatory restrictions on the bank.
9 marks
4
Turn over - Off-balance-sheet activities
a. generate fee income with no increase in risk.
b. increase bank risk but do not increase income.
c. generate fee income but increase a bank’s risk.
d. generate fee income and reduce risk.
e. increase bank risk and decrease income.
9 marks - “The one-year lending rate will be cut to 4.35 percent from 4.6 percent effective Saturday,” the
People’s Bank of China said on its website on Friday. Which of the following statements is
correct?
a. This is an expansionary monetary policy.
b. This is a contractionary monetary policy.
c. This will discourage private sector borrowing.
d. This encourages commercial banks to hold more cash reserves.
e. Banks are likely to raise their own interest rates in line with the Central Bank’s lending rate.
9 marks - Consider an open market purchase of £5 billion of Treasury bonds by the Central Bank. The
required reserve ratio is 10%. The bank does not want to hold excess reserves and the public
does not want to hold currency. What is the impact of the purchase on the bank from which the
Central Bank bought the securities?
a. The reserves decrease by £5 billion.
b. The bank's securities increase by £5 billion.
c. The value of deposits will increase by £50 billion.
d. The simple deposit multiplier will be 100.
e. None of the above.
9 marks
10.Analysis of the transmission mechanisms of monetary policy provides four basic lessons for a
central bank’s conduct of monetary policy. Which of the following is NOT one of these lessons?
a. Rising interest rates indicate a tightening of monetary policy, whereas falling interest rates
indicate an easing of monetary policy.
b. Monetary policy can be highly effective in reviving a weak economy even if short-term
interest rates are already near zero.
c. Avoiding fluctuations in the level of unemployment is an important objective of monetary
policy, thus providing a rationale for interest-rate stability as the primary long-run goal for
monetary policy.
d. Other asset prices beside those on short-term debt instruments contain important
information about the stance of monetary policy because they are important elements in
various monetary policy transmission mechanisms.
e. Both A and C.
Sample Solution