Question

In: Finance

Which of the following statements involving the promised return on a loan is NOT true?

		Credit risk may be the most important factor affecting the return on a loan.
		Compensating balances reduce the effective cost of loans for the borrower because the deposit interest rate is typically greater than the loan rate.
		Compensating balances represents the portion of the loan that must be kept on deposit at the bank.
		Compensating balance requirements provide an additional source of return for the lending institution.
		Increased collateral is a method of compensating for lending risk.

Expert Solution

Answer: Compensating balances reduce the effective cost of loans for the borrower because the deposit interest rate is typically greater than the loan rate.

Simple Promised Return on a Loan / Loan Rate:

BR= Base Lending Rate

Reflects the FI’s weighted-average cost of capital, or its marginal cost of funds

Prime Lending Rate– BR set by the banks themselves, and are used to price long-term loans. It is loosely linked to market interest rates.

LIBOR (London Interbank Offered Rate) – Commonly used in pricing short-term or variable rate loans.

m = Credit Risk Premium / Margin

Reflects the default probability of the borrower and the loss given default.

Direct/Indirect Fees as part of the Promised Return on a Loan:

of = Loan Origination Fee

Covers the cost of processing the application

b = Compensating Balance Requirement

Compensating Balances are the % of a loan that a borrower is required to hold on deposit at the lending institution. It adds as an additional source of return on lending for the FI.

RR = Reserve Requirement

Set by the Federal Reserve on the FI’s demand deposits

Factors that may affect the promised return an FI receives on a loan

A. The collateral backing of the loan.

B. Fees relating to the loan.

C. The interest rate on the loan.

D. The credit risk premium on the loan.

jeff jeffy answered 2 years ago

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Which of the following statements involving the promised return on a loan is NOT true?

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