A Bank Is Using the RAROC to Evaluate Large Business

question 7

Multiple Choice

A bank is using the RAROC to evaluate large business loans. The benchmark rate of return is 7.55%. The 1-year loan interest rate is 8.00% and the bank must pay 7.40% to raise the funds. The cost to service the loan is 0.3%. If the loan defaults, 92% of the money lent will be lost. Based on historical default rates, the extreme worst-case loss scenario is about 5%. Should the bank make the loan? Why or why not?

• A) Yes, because the RAROC is 7.11%.
• B) No, because the RAROC is 7.11%.
• C) Yes, because the RAROC is 6.52%.
• D) No, because the RAROC is 6.52%.
• E) No, because the RAROC is more than 7.55%. (0.080 - 0.074 - 0.003)/(0.05 * 0.92) = 6.52%, but this is below the benchmark of 7.55%.

Comprehend the operational mechanics of banks including reserve requirements.

Recognize the various interest rates relevant in the banking ecosystem.

Understand the concept and implications of sub-prime lending.

Identify the structure and functions of the Federal Reserve System.

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