September 2017 - Q6(i)

[AKS01]

Hi,

This question is around two small banks offering loans to retailers and large organisations. It states that they borrow from the governments to raise funds in order to offer these loans.
The first part of the question says: Suggest how a regulatory framework set by the government may limit what these banks are able to do in terms of investment

Looking at the mark scheme, it states:

• Restrictions on the types of assets that can be invested in
• In this case, banks would be restricted (authorised) to issuing loans – any other (in particular higher risk investments) wouldn’t be allowed, i.e. they are lending institutions not speculators

I don't think I fully understand this. I thought this point was around what assets the bank can invest in (e.g. bonds, property, equity) ... not what they are issuing?

Can you also explain what is meant by the point below:

• Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
• Again this would relate to only issuing loans but may also limit loans as a proportion of total assets, i.e. requiring free assets in terms of cash or government bonds.

Thanks in advance

 

[Aman Sehra]

Hi,

I don't think I fully understand this. I thought this point was around what assets the bank can invest in (e.g. bonds, property, equity) ... not what they are issuing?

If we were to invest in a bond, then we would give a lump sum, and then get a return, in the form of coupons and a redemption. Issuing a loan is similar - a bank could issue a loan (ie give a lump sum to a company/person), and then get repayments back, which include interest.

Hi,
Can you also explain what is meant by the point below:

• Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
• Again this would relate to only issuing loans but may also limit loans as a proportion of total assets, i.e. requiring free assets in terms of cash or government bonds.

The first point is around the fact that certain assets may not be permissible to demonstrate solvency. For example, gold or art.
The second point relates to the fact that issuing loans means that we are expecting to get some income. This present value of this income is seen as an asset. However, there could be rules stating a maximum % that loan income can be, of total assets held. It may be a requirement to hold a certain % of assets in cash, or government bonds.

Aman
ActEd Tutor

 

[AKS01]

Thanks Aman, that makes a lot more sense!