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A financial institution is considering a loan application for $2 million. It expects to charge 1/5 % origination fee and 10 basis points as service fee. The institution has estimated a risk premium to be around 0.25%. The market interest rate for similar loans is 11%. The 98th (worst case) loss rate for borrowers has been historically 2%, and the proportion of loans of this type that cannot be recovered on default has been 85%. Using the RAROC, should the financial institution make the loan? Assume cost of funds to be 11.5%.

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Lelia Lubowitz
Lelia LubowitzLv2
29 Sep 2019

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Please show work and how you arrived at your conclusion.
The assignment may be submitted as an Excel spreadsheet or an electronic (Word or PDF) document.

2. A financial institution is planning to give a loan of $5 million to a firm. It expects to charge an up-front fee of 0.20%
and a service fee of 5 basis points. The loan has a maturity of 8 years. The cost of funds for the financial institution is 10%.
The FI has estimated a risk premium of 0.15%. The current market interest rates for this type of loan is 10.1%.
The 99th (extreme case) loss rate for borrowers of this type has historically run at 4%.
The dollar proportion of loans of this type that cannot be recaptured on default has historically been 85%.
Using the RAROC model, would you recommend that the FI make this loan? Why?

Skip Stephens recently graduated from college with a degree Ibusiness administration. While attending college, Skip built up alarge amount of debt, which currently includes student loans,outstanding credit card balances, bank loans, and so forth. Nowthat he has a good-paying job, Skip wants to clean up his debtposition to improve his credit reputation so that he can qualifyfor a mortgage when he is ready to purchase a house in a fewyears.

As a result of a conversation with a financial planner, Skipdecided that he should consolidate his debt into a single loan.Consolidation will help him monitor his debt better as he pays itoff, and such an action probably will also decrease the interestrate that he is now paying. It took some effort, but Skip was ableto find a financial institution that seems willing to offer him thetype of loan he needs. The firm, which is named Syndicated Lending,is a new firm that specializes in loans to riskier borrowers, so itappears to be the right fit for Skip. Much of Syndicated’s businessis conducted electronically via the Internet. Although the companyhas a Website that gives some information about loans thatSyndicated offers, there is not much information about interestrates, application fees, and other charges associated with gettinga loan. When Skip clicked on the “Interest Rate” icon onSyndicated’s Website, a message appeared that said to contact thecompany directly. After many attempts, Skip was able to speak to a“real” person at Syndicated. When he asked why more information wasnot available on the Website, the employee stated that the companydecided not to post interest rates because managers believed it wasunfair to publicize low rates to lure customers, knowing that mostborrowers are unable to qualify for such loans. In other words,managers felt that it was unethical to use the “bait andswitch”1 tactics used by competitors. The employee gaveSkip some general information about the loans that Syndicatedoffers, but she would not tell him interest rates because thecompany had a policy of not quoting a rate until a thorough creditcheck was completed. As a result, to get an interest quote, Skipwould have to fill out and submit a loan application and he wouldhave to pay a $100 application/credit check fee.

Skip decided that he wanted more information about Syndicatedbefore deciding whether to apply for a loan, so he talked withpeople in the local area, searched chat boards and consumer opinionWebsites on the Internet, and so forth. Although much of theinformation he collected was positive, many people complained thatSyndicated was a “shady” organization that has a reputation ofchanging interest rates without notice and that it is not acustomer-friendly firm. Some of the people whom Skip talked withwent so far as to call Syndicated an unethical “loan shark” thatcould get away with unannounced interest rate hikes and otherchanges in loan agreements because the company knows that itscustomers cannot borrow from any other financial institution in thelocal area.

Now Skip is wondering whether it is wise to apply for aconsolidated loan from Syndicated, even though it appears that hecan improve his credit rating and lower his interest payments. Whatshould Skip do? Does it seem as though Syndicated follows unethicallending practices? Is it unethical to use “bait and switch” tacticslike those that Syndicated accuses other institutions of using?Should interest rates be posted on the company’s Website?

8. Which of the following would require a higher return under a risk-adjusted return on capital (RAROC) approach to capital allocation?

a)traditional commercial lending activities

b)government securities

c) home mortgages

d) 2 and 3.

9. Trend analysis often involves

a) comparison of past firm performance to current industry performance

b)averaging past years' performance to remove the effects of accounting changes

c) graphically portraying performance measures over time

d) all of the above

e) 1 and 3

10. Transaction risk is the risk of a loss _______ and translation risk is the risk of a loss _______

a) in the value of a firm’s equity with assets denominated in one currency and liabilities in another; with changes in exchange rates for foreign transactions

b) with changes in exchange rates for foreign transactions; in the value of a firm’s equity with assets denominated in one currency and liabilities in another

c) in the value of a firm’s assets with equity denominated in one currency and liabilities in another; with changes in exchange rates for foreign transactions

d) none of the above

11. The special-purpose vehicle (SPV)

a) allows sales accounting treatment of under generally accepted accounting principles (GAAP)

b) usually reduces the credit rating of the structured securitization

c) monitors reports by the loan servicer on the pool performance

d) all of the above

12. The major financing source for a bank comes from

a) loans

b) deposits

c) equity

d) none of the above

13. The provision for loan losses would likely be

a) increased during economic downturns

b) decreased during economic downturns

c) increased during an economic expansion

d) none of the above

e) 2 and 3

14. The Internet

a) may allow banks to cross-sell products, reduce transaction costs, and improve market presence, service, and quality provided to customers

b) may make customers more loyal to the bank by increasing the convenience and access to a broad variety of services, thereby reducing the probability of customers’ switching institutions

c) has increased costs for financial institutions due to lack of economies of scale

d) 1 and 2

15. Pillar 2 of Basel II

a) includes capital charges for credit risk on a case-by-case basis

b) is mutually enforced by Pillars 1 and 3

c) provides for supervisory review of banks internal assessments of capital allocation and adequacy

d) all of the above

e) 2 and 3

16. Types of loan sales include

a) the novation, which transfers all rights and obligations of the selling bank to the buyer

b) the assignment, which gives the buyer the right to take action against the borrower if payments are not made

c) the participation, in which the bank continues to service the loan

d) all of the above

17. The difference between the book value of capital and the market value of capital for the same institution is influenced by

a) changes in interest rates

b) changes in reserve requirements

c) changes in historic asset costs

d) none of the above

e) all of the above

18. Financial institutions are required to maintain liquid assets for the purpose(s) of

a) meeting repayment obligations to customers holding maturing liabilities

b) meeting repayment obligations to customers holding maturing liabilities. meeting regulatory requirements for reserves

c) meeting the dividend payment requirements of outstanding common stock

d) all of the above

e) 1 and 2

19. The process of securitization typically involves

a) removing loans from a bank's balance sheet and selling them to investors

b) bank origination of loans.

c) an insurance company surety bond or a bank letter of credit

d) all of the above

20. Generally, as the maturity of an asset or liability rises it has a higher risk premium due to greater maturity risk and greater

a) default risk

b) default risk

c) liquidity risk

d) all of the above

e) 2 and 3

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