BUS307 COMMERCIAL BANKING

MURDOCH UNIVERSITY Final Examination
Trimester J Offshore, 2020
BUS307 COMMERCIAL BANKING
Exam Type: OPEN BOOK, TAKE HOME EXAM
Exam Duration: Must be completed within 48 hour window and uploaded on to LMS
STUDENT DETAILS
Surname: ______________________ Given Name: ___________________
Student No: ____________________ Signature: ______________________
INSTRUCTIONS
The examination consists of 8 questions worth 100 marks.
There are three theory questions worth a total of 20 marks which require short
answers.
Question 8 – Essay/theory question. This question is worth 15 marks.
Selected formulae are provided at the end of the Examination Paper.
Please answer questions on the exam paper in the spaces provided.
You must attempt all questions. The total mark is 100.
Examiners Use Only

EXAMINATION AIDS ALLOWED
Provided by the University
NIL
Provided by Candidate
CALCULATOR LEVEL 3 – FINANCIAL
IMPORTANT DECLARATION:
In downloading and completing this examination, you declare that the content
within the submitted examination file is your own work.
_______________________________________________________________
SECTION A – 65 MARKS
ANSWER ALL QUESTIONS IN THE SPACES PROVIDED ON THE EXAMINATION
PAPER. SHOW ALL WORKINGS.
QUESTION 1a [10 Marks]
The market value of the assets of a corporation is currently $15 million. The firm has on issue
a debt outstanding that has a par value of $13.2 million and a due date of exactly five years.
No intermediate interest payments are required. The risk-free (continuous) rate is 5.5% and
the standard deviation of returns of the firm’s assets is 60%.
Fortunately, for the bank loan officer, she learns that a dividend of $1.2 million will be paid
within days. (Hint: It can be assumed that the dividend will be paid immediately.)
What should be the today’s equity value and debt value and the fair interest rate required
by the debt holders? State any simplifying assumptions made in your calculations.
QUESTION 1a [10 Marks] (continued)
QUESTION 1a [10 Marks] (continued)
QUESTION 1 b [5 Marks]
Considering the formulae below, what are the most important variables in driving the
computed fair interest rate. Justify your answer.
D = Xe-rt -[Xe-rt N(-d2 ) – Ae-t N(-d1)]
d
A X
r t
1 t
2
2
=
ln + ( –  +  )

d d t
2 = 1 -
QUESTION 2 [ 15 Marks]
Suppose a borrower knows at time t = 0 that it will have available at time t = 1 an opportunity
to invest $85 in a risky project that will pay off at time t = 2. The borrower knows that it will
be able to invest in one of two mutually exclusive projects, S or R, each requiring a $85
investment. If the borrower invests in S at time t = 1, the project will yield a gross payoff of
$155 with a probability of 0.8 and $45 with a probability of 0.2 at time t = 2. If the borrower
invests in R at time t = 1, the project will yield a gross payoff of $170 with a probability of 0.6
and $25 with a probability of 0.4 at time t = 2. The borrower’s project choice is not observable
to the bank.
The riskless, single-period interest rate at time t = 0 is 10%. It is not known at time t = 0 what
the riskless, single period interest rate at time t = 1 will be, but it is common knowledge that
this rate will be 8% (with probability 0.65) or 15% (with probability 0.35). Assume universal
risk neutrality and that the borrower has no assets than the project on which you (as the
lender) can have a claim.
Suppose you are this borrower’s bank and both you and the borrower recognize that this
borrower has two choices: (1) it can do nothing at time t = 0 and simply borrow at the spot
market at interest rate prevailing for it at time t = 1, or (2) it can negotiate at time t = 0 with
you (or some other bank) for a loan commitment that will permit it to borrow at
predetermined terms at time t = 1.
What advice should you give this borrower? Assume a competitive loan market in which each
bank is constrained to earn zero expected profit.
HINTS: Determine the loan commitment fee, and NPV of the spot loan and loan commitment.
QUESTION 2 continued
QUESTION 2 continued
QUESTION 2 continued
QUESTION 3a [15 Marks]
Use this balance sheet information to answer the following questions:

The bank has granted a special loan that has 3 years to maturity and has repayments of
$357.875 million at the end of year 1, no payment at the end of year 2 and $357.875 million
payment at the end of year 3. The loan is trading at par and the yield to maturity is 5 percent
per annum.
The yield curve is flat and the interest rate is 5%. The financial institution decides to use a 3-
year swap. The swap is composed of a three-year bond with a fixed coupon rate of 5 percent
paid annually and a floating-rate bond with duration of approximately zero.
Using this swap, determine the notional principal of the swap and advise the financial
institution on whether it should be a fixed or floating payer. Present an explanation including
pertinent assumptions of how the swap you have recommended works.
QUESTION 3a [15 Marks] continued
QUESTION 3a [15 Marks] continued
QUESTION 3a [15 Marks] continued
QUESTION 3b [5 Marks]
What impact does the suspension of loan repayments as the coronavirus crisis hits borrowers
have on your analysis? No calculations are required.
QUESTION 4 [15 Marks]

The ALCO committee believes that
R
R
 +
1
= 0.01 would be a reasonable estimate of relevant
interest rate movements.
If the 90-day bank bill futures are quoted at 96.0 and there is no basis risk, calculate the
number of future contracts to macro-hedge the bank’s balance sheet.
Show all calculations and specifically state whether a short or long position is recommended.
QUESTION 4 continued
QUESTION 4 continued
QUESTION 4 continued
SECTION B – 20 MARKS
ANSWER ALL QUESTIONS IN THE SPACES PROVIDED ON THE EXAMINATION
PAPER.
Review the following article and use the information to respond to questions
where applicable.
Banks around the world are suspending loan repayments as coronavirus hits
borrowers
Published Apr 1, 2020, 5:21 pm SGT
Singapore
The Monetary Authority of Singapore said individuals can apply to defer principal and interest
repayment of residential property loans.
With a global recession on the horizon as the coronavirus pandemic continues to ravage
economies around the world, banks in various countries have scrambled to offer relief for
those whose lives, jobs and businesses have been upended in the crisis.
Homeowners with hefty mortgage repayments and borrowers who have taken large sums of
bank loans to sustain their businesses risk falling into default as world economies take a sharp
dive amid nation-wide lockdowns and a halt in most international travel.
Pre-empting a potential tide of defaults from affected borrowers, Singapore’s central bank on
Tuesday (March 31) offered loan relief for individuals and companies.
Individuals can apply to their banks to defer both principal and interest repayment of
residential property loans until Dec 31, the Monetary Authority of Singapore said. Small and
medium-sized firms can defer principal payments on secured term loans also up to the end
of the year.
Singapore isn’t the only country offering generous mortgage deferrals amid the coronavirus
crisis. Here are some other nations whose banks have sprung into action:
Malaysia
Malaysia’s central bank last week said banking customers would be allowed to delay repaying
their existing loans for six months from Wednesday.
The moratorium – part of Bank Negara’s measures to help borrowers under strain due to the
coronavirus outbreak – will automatically apply to all ringgit-denominated loans and financing
not in arrears of more than 90 days, The Star reported. It will not apply to credit card balances.
The central bank said banks should allow customers to convert their outstanding credit card
balances into term loans of not more than three years.
Following the announcement, several Malaysian banks said they would not be compounding
interest for their customers during the six-month moratorium period. RHB Banking Group,
Public Bank Bhd, Malayan Banking Bhd (Maybank), CIMB Bank Bhd, OCBC Bank (M) Bhd, HSBC
Malaysia, AmBank Group, Affin Bank Bhd, United Overseas Bank (Malaysia) Bhd and Citi
Malaysia were among those banks offering non-compounded interest for retail customers
and small and medium-sized enterprises.
Thailand
Banks in Thailand announced a coronavirus debt-relief package in early March, offering
companies a year-long grace period to repay their loans.
The package came in tandem with state relief measures, and the grace period on loan
repayments applied to companies in the tourism sector, exporters, importers and retailers,
the Nikkei Asian Review reported.
Britain
Several banks in Britain have offered repayment holidays on mortgages and loans in an effort
to stem a potential tide of defaults from borrowers affected by the coronavirus crisis. Among
those lenders were the Royal Bank of Scotland, Lloyds and TSB, the Guardian reported early
last month.
RBS Group, in which the British government has a majority stake, said it would grant a threemonth break on mortgage and loan repayments for customers under strain due to the virus
situation. It also offered to temporarily raise affected customers’ credit card limits and scrap
fees on credit card cash advances, among other measures.
Italy
Italy announced in early March it would suspend all mortgage repayments across the nation,
as the country went under lockdown to contain the coronavirus outbreak.
Italy’s banking lobby group ABI said lenders would offer debt holidays to small firms and
families, BBC reported. It’s not the first time debt payments were halted in Italy. A similar
relief measure was granted to some small businesses and households during the financial
crisis.
Italian banks own the biggest pile of non-performing loans – about 142 billion euros – among
European Union countries, according to a Bloomberg report. The Italian banking association
in February asked for a one-year suspension of rules that force them to identify past-due loans
as being in “default” to free up more money for lending.
United States
As the coronavirus crisis worsens in the United States, the country’s two mortgage giants
Fannie Mae and Freddie Mac have instructed lenders to grant their customers more flexibility
in either lowering or halting home loan repayments for up to 12 months.
Their action effectively grants relief to half of all American home loans, according to a
Fortune.com report last week. Other mortgage lenders across the country are expected to
follow suit in the coming weeks and months.
The Trump administration was also mulling a nation-wide plan to let homeowners affected
by the virus situation delay their mortgage repayments, Bloomberg reported earlier last
month. But the government would have to decide on a mechanism for borrowers to catch up
with their postponed payments, as well as to determine how to advance money to mortgage
servicers so that investors in mortgage-backed securities get their guaranteed payments.
Canada
Canada’s six biggest banks last month said they would allow homeowners to delay their
mortgage repayments for up to six months, as part of a coronavirus-relief plan.
The lenders – Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce,
National Bank of Canada, Royal Bank of Canada and Toronto-Dominion Bank – also offered
other debt relief measures including credit card repayment deferrals and extensions on
mortgages’ amortisation periods, the Financial Post reported. Borrowers were advised to
reach out to their banks to apply for the deferrals.
Borrowers in good standing who had been affected by the pandemic could apply at any time,
with deferrals available for an indefinite period, Bloomberg reported. Under the plan,
payments are skipped for a period of time, and accrued interest accrued is added to the
mortgage’s outstanding balance. The additional interest is incorporated into future monthly
payments when they resume, or upon renewal at the end of the mortgage’s term.
Sources: Bloomberg, The Star, Nikkei Asian Review, Guardian, BBC, Fortune.com, Financial
Post
QUESTION 5 [10 Marks]
Given that banks are suspending loan repayments what impact would these strategies have
on the risks facing the bank. Be specific.
QUESTION 6 [5 Marks]
Banks screen and monitor borrowers to minimize adverse selection and moral hazard.
How can banks ensure that their screening and monitoring will be effective given the
coronavirus crisis?
QUESTION 7 [5 Marks]
In selected countries credit cards are attracting special treatment. What characteristics make
credit cards unique? You may consider the 5Cs – capacity, character, collateral, capital and
conditions in your answer.
SECTION C – 15 MARKS
ANSWER THE QUESTION IN THE SPACE PROVIDED ON THE EXAMINATION
PAPER.
QUESTION 8 [15 Marks]
Using Lopez et al. (2018) article (below) as a starting point, briefly detail strategies that the
bank can employ to mitigate the impact of negative interest rates. Evidence of
supplementary references that identify other strategies will attract a higher grade. Use the
space provided, at the end of the article, for your response.
_____________________________________________________________________
Bank performance under negative interest rates
Jose A. Lopez, Andrew Rose, Mark Spiegel 02 October 2018
Many countries have now adopted negative nominal interest rates. The column uses data on
5,000 banks affected by this policy to conclude that, while their net income has not fallen,
strategies to increase non-interest income are unlikely to be sustainable. Therefore, we cannot
assume that bank performance and lending will carry on at current levels over extended
periods of negative policy rates.
The decision of the Danmarks National bank to lower its policy rate below zero in July 2012
was an important extension of monetary policy. We have had non-standard monetary
policies, such as quantitative easing and forward guidance, since the Global Crisis of 2008, but
negative nominal interest rates in Denmark represented an unprecedented leap across the
mythical zero lower bound (ZLB). Of course, the ZLB has subsequently proven to be quite
porous, as Switzerland, Sweden, the euro area, and Japan have also enacted negative rates.
However, before this exploration into negative territory there were concerns that financial
institutions – deposit-taking banks in particular – would be dramatically and negatively
affected by negative policy rates.
A number of earlier studies found that banks experienced difficulties when rates were low,
though positive. For example, Borio et al. (2017) found that banks were less profitable at low
rates of interest, and that the sensitivity of profitability to rate reductions grows as interest
rates fall. Claessens et al. (2018) found similar results, driven by reductions in net interest
margins. Borio and Gambacorta (2017) also found that bank lending becomes less responsive
to reductions in policy rates as those rates approach zero, suggesting that the financial
channel of the monetary transmission mechanism is weaker at this point.
Now that banks have actually experienced negative rates in a number of countries, we can
assess their relative ability to cope with the challenges of crossing the ZLB. In particular, we
can observe how banks responded to these policies, and the implications of those responses
for the financial transmission channel of monetary policy.
Our research into this question (Lopez et al. 2018) suggests that banks were able to cope
relatively well with negative interest rates, although we should question the sustainability of
their strategies over longer periods if rates remain negative. Our analysis examines annual
balance sheet data from more than 5,000 banks in the EU and Japan between 2010 (before
negative nominal rates) and 2016 (the most recent year available for all the banks).
A large sample of banks across 14 currencies allows us to examine a variety of countries that
‘went negative’ at different times and for different reasons. We also compare the fortunes of
these banks with institutions in similar countries that did not experience negative rates during
our sample period.
The off-setting roles of interest and non-interest income
Overall bank net income – total bank income minus expenses – appears not to be affected by
negative nominal interest rates, at least compared with low positive rates. This finding
supports results in earlier studies, largely based on samples of banks from a single currency
regime. For example, the research done by Basten and Mariathasan (2018) on Swiss banks.
Moreover, relative to earlier studies, our sample has more small banks (by asset size) and
more banks that are rely heavily on deposit funding (high-deposit banks). Banks in both of
these categories claim to have greater exposure to losses under negative interest rates.
But more detailed income and balance sheet data reveals notable effects below this headline
income figure. Figure 1 shows our model-implied ratios of net interest and net non-interest
income, relative to total assets, for banks in our sample during periods of positive policy rates
(the blue bars) and negative rates (the orange bars).
Figure 1 Income ratios for all banks in the sample (%)
Source: Lopez et al. (2018).
• Banks experienced significant declines in net interest income. This is the income from
loans and bond holdings minus expenses such as interest paid on deposits and other
outstanding debt; as shown in the figure, the decline was from 0.02% of total assets to
-0.03%. Notably, banks did not substantially reduce deposit expenses, consistent with
the assumption that nominal deposit rates are sticky at zero. The reduction in interest
income under negative interest rates was different across bank size. Large banks
(greater than $10 billion in assets) appear to be more capable of lowering their deposit
expenses, whereas changes in small bank deposit expenses were insignificant.
• Banks mitigated the losses on net interest income by generating significant increases in net
non-interest income. As shown in the figure, this income ratio rose to 0.04% under
negative policy rates, from -0.01% under positive rates. These increases were due
almost entirely to increased non-interest income, from fees and from other sources
such as capital gains and gains on securities. Here again, large banks were better able
to reduce their non-interest expenses, such as salaries, than their smaller counterparts.
These results suggest that banks adjusted their operations to offset the expected decline in
interest income under negative rates by generating additional non-interest income. This is
especially true of specially smaller and more deposit-dependent banks. These adjustments
maintained their income levels, but it is an open question whether this is sustainable.
In particular, capital gains on securities when policy rates drop below the zero bound are
unlikely to endure just because rates remain negative. As noted in the report by the
Committee on the Global Financial System (CGFS 2018), banks are likely to continue to make
structural changes in their operations to respond to the effect of negative rates on bank
profitability. The health and viability of banks and other financial firms are key drivers of the
macroeconomy and monetary policy, and the results suggest that it is best to be guarded in
our optimism about their continued viability under negative rates.
Questions of sustainability
Our results mirror those in earlier studies of low rates, and suggest that banks have fared
reasonably well under negative nominal interest rates. But the increased non-interest income
enjoyed by banks under negative rates may be unsustainable. Capital gains on securities
following negative interest rate surprises are unlikely to endure for long.
Nevertheless, concerns about the financial channel of the monetary transmission have not
been realised, which argues against the need to adjust our long-term monetary policy
assumptions. We would recommend caution, however, in concluding that bank performance
and lending is sustainable over extended periods of negative or low-for-long policy rates.
QUESTION 8 [15 Marks]
QUESTION 8 [15 Marks]
QUESTION 8 [15 Marks]
Normal Distribution Table

Selected Formulae
You may use the formulae provided below to assist you in answering the
questions. You should show all workings to gain credit for partly correct answers
in your examination.
( ) 
 

+
= –
n
i i
PMT
PVA
1
1
1
n
n
t
t
t
n
n
t
t
t
r
FV
r
C
r
n FV
C r
t
Duration
(1 ) (1 )
(1 ) (1 )
1 1
+
+
+
 +
+
 +
=
= =
A DL
L A
DG = D – A
r
r
D
L A
E D
A L .
1


+


= – –


D A
L A
D B D
B. = ( A – L).
D P b
D A
L A
D
N
F F
A L
F
. .
( – ).
=
1
0, 1
0,
1, (1 )
(1 )
(1 )
–
–
–
+
+
+ =
n
n
n
n
n n
i
i
i
( )n
n
i
FV
PV
+
=
1
D = Xe-rt -[Xe-rt N(-d2 ) – Ae-t N(-d1)]
d
A X
r t
1 t
2
2
=
ln + ( –  +  )

d d t
2 = 1 -
2
r1,H = r1,Le
END OF EXAMINATION

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