Attempt all questions

Provide detailed answers and justify whatever you suggest.

Q1. A 20-year old university student, David, lived at home and worked full-time in a local
supermarket during the vacations. He had a part-time job at the same supermarket during term-
time.

David applied successfully to his bank for a loan of $2,500, in order to buy and insure a second-
hand motorbike. But as soon as he told his mother about the loan, she complained to the bank.
She said its decision to lend her son the money had been "ill-judged and irresponsible" and that
it had taken advantage of her son's inexperience.

David’s mother told the bank that her son had planned to go travelling for a year after he
graduates. She was concerned that the loan repayments would not only prevent him from saving
money for his travels, but also leave him short of cash. She also believed that, by lending him the
money, the bank had actively encouraged her son to buy a powerful motorbike.

David’s mother wants that bank should write-off the loan and take the motorbike in
exchange. The bank disagreed.

David’s mother has brought the dispute to you. Give your comments (keeping in view the banker
customer relationship and class discussions) whether David’s mother’s claim is valid or the bank
is right in disagreeing. Do provide justifications for your comments. (6 marks)

Answer:

In this scenario the banker is right and should not agree to this claim. David is a 20 year old
student and hence is above 18 years old and falls under the mature category. He possesses an
ability to understand what is right and wrong for him and also legally allowed to take any kind of
decision he wants for his good. Being a 20 year old also makes him eligible of being a customer
of the bank as he is not a minor. Moreover David also does a part time job and earns something
which ensures that he is credible and also in a position to save money and repay the bank loan in
the near future. The loan David took was a type of consumer financing where he was allotted
money to buy a bike for his own use. Hence the bank performed its duties and lent the specified
amount to David as he was totally eligible for the loan. His mother however wants the bank to
settle the loan against the bike he purchased. This claim of his mother is wrong. The reason is
that the bank has a responsibility to offer loan to everyone eligible and hence does not has a duty
to know about the personal life as to if David was about to go out for his studies or not. Thus the
bank did right by not agreeing to his mother’s claim as bank just fulfilled the duties. Also bank is
said to have a security known as the good faith. According to this the bank always makes a
decision in the favor of the customer and always wishes good on his part. Hence the bank
possesses this security in this case as it advanced the loan to David while he was in need for his
betterment which can’t be settled for a motorbike as it goes against the bank operations.

Hence David mother’s claim on the bank is inappropriate as it lent the loan on certain conditions
and cannot write it off against the motorbike. Also David is a student of sound mind and mature
enough to make appropriate decisions for him, thus in this case the bank stands correct in its
position.

Q2. Mr J was a young, single man with some learning difficulties. He lived independently but
relied on his family and his community support worker, Mrs Y, for help in managing his
finances.

Mr J had only been in work for a few months - as a warehouse assistant - when the factory that
employed him closed down. He realised there was no real likelihood of finding immediate
employment, so he decided to start his own business as a handyman. He approached his bank and
asked for a loan in order to buy a small van and some tools.

As his literacy skills were limited, Mr J had not prepared any kind of business plan. However,
the lending officer told him this would not be necessary and that the computer showed he was
"good for the credit". So the bank gave Mr J £4,000 as a personal loan.

Excited by the prospect of his new venture, Mr J went ahead and bought a small second-hand
van and some tools.

Unfortunately, however, he was unable to find any work as a handyman. His current account
quickly became overdrawn and he was unable to meet the loan repayments. Without any prior
discussion with Mr J, the bank passed his details to its debt recovery section, who in due course
wrote to him.

Extremely alarmed by the tone and content of this letter, Mr J panicked. Within a couple of days
he had managed to sell his van - at a significant loss - to try and pay back some of what he owed.

Mr J then asked his community support worker, Mrs Y, for advice. With Mr J's consent, she
complained on his behalf to the bank, saying it should not have lent the money in the first place.
When the bank refused to uphold the complaint, Mrs Y referred it to you to resolve the dispute.(6
marks)

Answer:

The bank in Mr. J’s scenario must accept the complaint and provide settlement for this issue.
This is because it has been clearly stated in the scenario that the Mr. J possesses some learning
difficulties. Hence he does not qualify to be a customer. This is because the customer must be a
person who should understand and remember the terms and conditions specified under the
contract. The bank should have rejected the loan offer in the first place as he is a dependent
person and also unable to remember his duties and rights of being a customer. The bank should
have evaluated Mr. J and assessed if he is eligible for the loan or not and then advanced the loan.
Moreover he is a dependent person. He totally depends on his family and his community workers
for his financing. This also raises another reason why the bank shouldn’t have advanced the loan
to him. This clearly states that Mr. J does not belong to a financially strong background and does
not ensure the timely repayment of the loan to the bank. Moreover the scenario also states that
the bank did not carry on a background check for the customer and lent a loan on the basis of
very limited information. Also when Mr. J applied for the loan he had no job and hence he did
not have a source of income to pay back the loan. On the other hand the banks always check the
feasibility reports of the customer to assess his/her cash projections which the bank did not
perform before providing the loan. Also the use of sentence “the computer showed that he was fit
for credit” shows that how inappropriately his eligibility for applying the loan was checked.

Hence Mr. J and his community work supporter in this case have the full right to approach the
bank and call for settlement. This is because the bank did not carry out a thorough check on his
background and his ability to payback. Moreover the bank should have analyzed his learning
difficulties and his credit standing before advancing the loan. The banker should always make
sure that the person has all the essential abilities to become a customer and his low literacy
should have alarmed the banker about his limited understanding on the terms and conditions.

Q3. Suppose there are two investors. One has a project to build a factory; the other has a project
to visit a casino and gamble. Which investor has a greater incentive to issue bonds? Which
investor’s bonds are better deals for savers? Justify your answer.( 3 marks)

Answer:

The investor with a project to build a factory has a greater incentive to issue bonds in the market
than that of the investor who plans to visit a casino. This is because the customers will feel
confident when purchasing the bonds of the investor who plans to invest into a factory as it will
guarantee that the investor is credible and reliable. Moreover it will reduce the problem of
adverse selection as the savers will be confident to purchase the security that exists due to limited
information and the fear that persisted might go away due to the productive use of money in a
factory. On the other hand the person issuing bonds to visit the casino might provide greater
moral hazards to the savers. When the funds of savers will be used up in casinos there is no
productive use of them and hence the investor will be using the savers just for entertainment
purposes and to overcome any financial shortages he/she might be facing. Hence the savers will
be better off if they buy bonds of the first investor as there will be less fear, more confidence and
less moral hazard associated.
Q4. . Suppose an owner of a corporation needs $ 1 million to finance a new investment. If his
total wealth is $ 1.2 million, would it be better to use his own funds for the investment or to issue
stock in the corporation? What if the owner’s wealth is $1 billion? Justify your answer.(3 marks)

Answer:

If the owner has a wealth of $1.2 million then he should issue stocks. This is because businesses
needs a good amount of cash flow and running finance inside the business to carry on the day to
day operations. Hence putting all the amount and leaving a little amount behind will be an
alternative with a very high risk and if the investment leads to a loss then the owner will lose a
big chunk of his/her wealth. Hence in this case stocks should be issued to divide the risk and
manage the funds by issuing stocks. Issuing the stocks will also help the owner to generate
additional wealth and help aid in the finance of new project as well as his personal income
growth. However in the other case if the owner’s wealth is $1 billion then the owner can use
his/her funds to finance the new investment. This is because $1.2 million makes a small
proportion of the owner’s wealth and if for instance the investments provides a loss it will be
manageable for the owner to bear the risk and accept it. Hence in the first case the owner should
issue stocks while in the second case he/she should utilize their own wealth.

Q5. What are the reasons we see active trading in stock markets as compared to an almost
stagnant bond market in Pakistan?(4 marks)

Answer:

Stock and bonds markets come under the category of the financial markets. In Pakistan however
stock market and stock exchange is very visible and active whereas the bond market is nearly
invisible. Pakistanis by nature possess a personality of being risk takers. They want higher
returns for their investments and hence feel no hindrance while dealing with risky instruments.
Moreover people are more motivated to buy the shares. The reason for this is that there always
exists an option of secondary market. Where owner of shares can sell the shares anytime and get
quick returns on their investments. Moreover shares bring two benefits with it. People can get a
return in the form of dividends by the company they bought shares in and also they can earn the
capital gains by selling the shares in the secondary market.

Hence all these factors simultaneously motivates Pakistanis to invest in the stock market rather
than the bond market and due to their risk taking personality they prefer quick returns and are
ready to bear the higher risks.

Provide short answers to the following (2 marks each)

Q6. What is the major source of earning for banks and how do banks generate it?

Answer:
The major source of earning by the bank is through its major functions that it provides its
customers. The banks earn the most through the banking spread. It is the amount that comes as a
result of a difference between the rate at which the deposit was kept and amount at which a loan
was lent to the customers. If for instance a bank earned a deposit and promised to pay a 15%
interest rate on it to the saving surplus unit and then lent the same amount to borrower and
charged an interest rate of 18%. In this way the bank earned an additional 3% interest rate which
is then referred to as the banking spread of the bank. This banking spread is easier to be earned
under the saving accounts. As savers have a nature of not making frequent withdrawals that will
give bank enough time to use their money in the productive options and earn more banking
spread out of it. Moreover savers are apparently more in number so more deposits will bring
more opportunities for the bank to earn banking spread.

Q7. Why the loans given by banks are called as private loans?

Answer:

These types of loans are the ones that exist between a single lender and a single borrower. This
falls under the category of the consumer financing under which individuals are provided with the
loans according to their needs. These types of loans are the opposite of that of the commercial
loans. Private loans are the ones that are tailor made and hence their terms and conditions are
flexible and vary from one individual to the other. Banks experience different kinds of
conditions, among which some can be more credible or less credible in nature. For them a bank
might not generate a specific policy. Customers with more credible background brings less risk
to the bank and hence less risk premium is charged for those kinds of customers. Whereas the
ones that bring more risk needs to compensated through charging more risk premium. These
kinds of loans require individual evaluations and hence produces individual terms and
conditions.

Q8. What is “fractional reserves banking system”? Discuss

Answer:

Fractional reserve system is a kind of a system that sets a reserve requirement for the commercial
banks to be kept with every central bank. This is set by the SBP or State Bank of Pakistan. It
alters with the economic conditions. If the economy needs the money supply to be increased in
the economy the state bank decreases it so less fraction of money is kept at the central bank and
more money is available for the customers approaching the commercial banks. If however
monetary policy suggests lower money supply then the reserve amount can be increased. The
term used for keeping a reserve system under the banks is referred to as the statutory liquidity
and the ratio of it determines the amount to be kept with the central bank.

Q9. Under what conditions the customer cannot sue his banker even if banker has not maintained
his account’s secrecy.
Answer:

The customer possesses a right for his account secrecy to be maintained. However under some
conditions a customer might not be in a rightful position to sue the bank for disclosing his/her
account details. If for instance there has been an order from a court which has proper
documented orders and the orders follow the formal and legal channel then the bank is allowed
to provide the account details to them. It should be however ensured that the process is
documented and is done through legal means. Moreover not just the court the law enforcement
agencies and authorities might also demand the account details of an individual. Certain
scenarios for instance can include the tax authorities that can access your account and even holds
a right to debit the individual’s account. This is known as account detachment under which a
customer’s account is debited by a certain amount. A customer might not be informed about it as
well in some scenarios. Hence under these cases a customer loses the right to sue the banker on
disclosure of account details.

Good luck!