please solve the questions, everything in red should be included in the answer please keep language simple
Question 5
This question has two parts. Each part has equal weight. Where there are sections within the part, each section carries equal weight.
Part 1. Using the bank balance sheet to explain the following terms:
a) Capital adequacy
b) Liquidity management
c) Asset management
d) Off balance sheet activity
Part 2. How can changes to the bank regulatory regime help to reduce the risk of banking crisis?
a) The answer should explain the importance of banking capital as a buffer against a decline in asset value and say something about the general principals of capital adequacy. A good answer will also consider the tension between profit-maximisation and capital adequacy.
b) The answer should explain what liquidity is and should give some examples of liquid and illiquid assets. A good answer would also relate liquidity to the nature of liabilities.
c) There should be a discussion of the range of assets that are held by banks and an overview of the relationship between risk and return. A good answer will consider credit risk and diversification.
d) There should be a clear understanding of on-balance sheet and off-balance sheet. There should be some examples of off balance sheet activity. A good answer will consider the regulatory advantage of having activity off the balance sheet.
The second section is more open but the answer should consider the way that maturity and liquidity transformation makes banks vulnerable to credit risk and losses of confidence. The reforms should address this fundamental weakness and therefore can include measures to increase capital or make capital more aligned with the risk or liquidity of the assets; measures to increase the liquidity of the assets; measures to address the maturity of the liabilities; measures to reduce the risk of assets held (this may also include a discussion of bonus payments and other incentives to increase risk, including the owner ship structure). There may also be some coverage of other banking activities, such as the trading activity that is conducted by investment banks and how this may spill-over to conventional banks.
Question 6
Please answer the following questions. Each question is equally weighted.
a) Provide an overview of the main participants in the bond markets and an assessment of what each is trying to achieve by their purchase or sale of bonds.
b) Use supply and demand to explain how (assuming everything else remains constant) the government bond yield would be expected to response to
i) an increase in inflation expectations
ii) an expansion in government spending
iii) a rise in risk aversion
iv) a reduction in liquidity in the secondary market
The main participations are the government and corporations. The main buyers are the usual pension and insurance companies. The government is trying to raise finance. This is debt. A regular bond is a fixed interest, so there is less concern about changing interest rates. The liquidity should ensure that cost of funds is lower than a less liquid debt alternative. Pension and insurance funds are generally trying to match assets to liabilities. Assuming no default, funds will be delivered at a set day in the future. The supply and demand should show a decrease in demand for rising inflation expectations and higher yields; an expansion in supply and higher yields when government spending rises; an increase in demand for relatively low risk government bonds and lower yields; and, a reduction in demand and an increase in yield for less liquidity. A good answer will explain the mechanism fully and will address the link between the price and the yield. It will also have clear and well-labelled diagrams.
Question 3
Consider a stylised bank with £500m deposits, £200m borrowed from other financial institutions, £100m in cash or cash-equivalents, and £400m of loans. The loans are split equally between safe loans that charge an interest rate of 1% and risky loans that charge an interest rate of 10%. There is no interest on the cash or cash-equivalents. The bank pays a set amount of £10m for the deposits with the cost of maintaining branches and pays 1% when borrowing from another institution:
i) Draw the bank balance sheet (2 marks)
ii) Calculate the amount of capital/equity (1 mark)
iii) Calculate the annual profit ( 2 marks)
iv) What options do the managers of the bank have when deciding what to do with the profits? (5 marks)
v) How does the balance sheet change if a recession causes 10% of the risky loans to default? (5 marks)
vi) What options do the managers of the bank have for rebuilding the capital/equity of the bank (5 marks)
vii) Why is having sufficient capital/equity important? (5 marks)
Draw the bank balance sheet
ii) Calculate the amount of capital/equity £200m
iii) Calculate the annual profit £10m
iv) What options do the managers of the bank have when deciding what to do with the profits? Keep in bank or pay as dividends.
v) How does the balance sheet change if a recession causes 10% of the risky loans to default? Risky loans become £180m, Capital is £180m and Profits are 8M
vi) What options do the managers of the bank have for rebuilding the capital/equity of the bank? Retain profits, issue more equity.
vii) Why is having sufficient capital/equity important? It will provide a buffer against a possible decline in the value of the assets.
Question 5
Please answer the following questions.
a) Provide an overview of the main participants in the bond markets and an assessment of what each is trying to achieve by their purchase or sale of bonds. (15 marks)
b) Use supply and demand to explain how (assuming everything else remains constant) the government bond yield would be expected to respond to:
i) A fall in inflation expectations (2 marks)
ii) An increase in the government deficit (2 marks)
iii) A boom in emerging market economies (2 marks)
iv) A large increase in risk aversion (2 marks)
v) A downgrading of the government credit rating (2 marks)
a. Describe the main participants (sellers are government and corporations; buyers are funds (particularly insurance and pension and banks).
b. List of objectives
a. Explain the advantage of bonds for pension funds and banks
b. Describe some differences between government and corporate bonds (liquidity, size and risk).
a. Will link the types of bond to the types of use.
B) Supply and demand diagrams must be provided, labelled and the price – yield/return relationship made clear.
A clear written explanation must accompany the diagram.
Question 4
Evaluate the effect of ‘quantitative easing’ on the real economy and on financial assets.
i. should include a. A description of quantitative easing
ii. Comments about its effect on real economy and financial assets
iii. An explanation about how QE policy differs from ‘normal’
iv. More details in the assessment of the effect of quantitative easing.
v. Evaluate the relative effect on real and financial sides of the economy
vi. Consider interactions between the two
vii. State why this is important
