A Bank Is Using the RAROC to Evaluate Large Business

question 15

Multiple Choice

A bank is using the RAROC to evaluate large business loans. The benchmark rate of return is 7.55 percent. The one-year loan interest rate is 8.00 percent and the bank must pay 7.40 percent to raise the funds. The cost to service the loan is 0.3 percent. If the loan defaults,92 percent of the money lent will be lost. Based on historical default rates,the extreme worst-case loss scenario is about 5 percent. Should the bank make the loan? Why or why not?

• A)Yes,because the RAROC is 7.11 percent.
• B)No,because the RAROC is 7.11 percent.
• C)Yes,because the RAROC is 6.52 percent.
• D)No,because the RAROC is 6.52 percent.
• E)No,because the RAROC is more than 7.55 percent.

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Definitions:

Moral Hazard

The tendency of individuals or entities to take riskier actions when they do not bear the full consequences of those actions, often due to having some form of insurance or protection.

Health Insurance

An insurance plan that covers the medical and surgical costs of the policyholder.

Consumers

Individuals or entities that use goods and services produced within an economy.

Government Tax Subsidy

Financial assistance from the government, often in the form of reduced taxes, to encourage or support particular economic activities.