Exam questions 2016

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Macquarie University *

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Finance

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Apr 27, 2024

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Question 1 [13 marks] The 2014 Financial System Inquiry suggested that the three main criteria for a well- functioning financial system are efficiency , resilience and fairness . a) In relation to Australia’s banks, what do you think is meant by “ efficiency” ? [3 marks] b) Australian bank loans to customers are mostly secured by mortgage over real property such as houses and apartments. For these loans why is there a concern about “ resilience ”? [3 marks] c) How can a mutual bank, that is, a bank without shareholders, demonstrate that it is “ resilient ”? [2 marks] d) The Reserve Bank sets short term interest rates in Australia. Sometimes when the Reserve Bank reduces interest rates the banks do not “pass through” the full reduction to the interest rates they charge to their mortgage customers. Some commentators have described this as “ unfair ”. Do you agree? Explain your answer with reasons. [5 marks] Answer a) Efficient  Australian banks borrow from customers and make loans to other customers  This process should be as simple and cost-efficient as possible  Cost efficiency relates to the costs of the banks and the costs to customers in dealing with the banks  Competition between banks can help to improve efficiency  Loans should be allocated to customers who use the funds for the greatest economic benefit for Australia  Australia is a net importer of capital. Efficiency means that the banks have ready access to overseas funding on attractive terms

b) Resilience  One risk to banks is that individual customers may default on their loan repayments  This can be managed by good loan underwriting, capping LVRs and insurance for customers with high LVRs. And the bank has the security of the asset  The main resilience risk is a systemic issue, e.g. economic recession, that leads to increased loan defaults at a time of falling property prices  Best defence here is a strong capital position to absorb the losses and allow the banks to continue operating  A strong capital position should also allow the banks to be able to continue raising funds (including from overseas) to continue making loans even during the difficult economic conditions c) Mutual banks  Shareholder banks raise capital from shareholders and price their products to generate a return on capital for their shareholders  Mutual companies meet capital requirements through building retained earnings. Customers are charged for a contribution to the build-up of retained earnings as the business grows over time.

d) Fairness – passing through interest rate reductions  Bank lending rates are dependent on their borrowing rates which depend on their funding sources – see slide below  Funding from Australian sources should relate to the RBA interest rates  But wholesale funding from overseas does not link directly to RBA  Banks need to consider borrowing rates as well as lending rates  In setting mortgage interest rates there are considerations other than funding costs – see slide below  Perceptions of fairness might be enhanced by more transparent disclosures from banks

Question 2 [13 marks] a) Describe the main methods / channels used by life insurance companies and general insurance companies to distribute their products to customers. [5 marks] The main channels for life insurance is: Shareholders, LI company, Regulator, Financial planners, Super funds. The main channels for General Insurance is: Shareholders, Regulators, Brokers. For domestic general insurance individual can buy directly from the company through phone, website or in office. For business related insurance, it is sold by broker who advise on the needs for the company. For life insurance, super funds provide a basic level of insurance through group insurance. Mostly it is sold by financial regulators who provide needs and advise that align to the customer needs. LI can also be bought directly from the company. b) For each of the distribution methods / channels you identified in part (a) indicate the size of the distribution costs incurred by the insurance companies and briefly explain the reasons for any differences. [5 marks] - Need to pay heavy commissions for financial planners. 60% of premium in year 1 and 20% of later premiums - It is a heavily regulated process with claims cost, analysis and SOA which requires a lot of initial cost c) Reinsurance companies often pay a reinsurance commission to the direct insurance company on the business reinsured. Explain how reinsurance commission works. [3 marks] Answer a) Distribution channels

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