1.4.1 Role of Banks in the Economy — Practice Questions

Seven original multiple-choice questions on the role of banks in the economy: channelling savings towards investment, providing credit, interest rates and collateral.

7 questions Edexcel B A-Level Multiple choice Model answers included

Not read the notes yet? Start with the 1.4.1 Role of Banks in the Economy revision notes.

1. 1. A firm that hires out party marquees borrows £45,000 from its bank. It agrees that, if it fails to repay, the bank may take and sell the firm's two delivery lorries. In this agreement, the lorries are

   Definition in context

   Select one answer

   A Collateral.

   B Credit.

   C A personal guarantee.

   D Trade credit.
   Show model answer

   Answer: A (Collateral.). Collateral is an asset a borrower promises to a lender, which the lender can take and sell if the loan is not repaid. The lorries belong to the firm and back the loan, so this is a secured loan. That lowers the bank's risk, which makes it more willing to lend and usually means a lower interest rate.

   Why the other options are wrong

   • B — The credit is the £45,000 itself: money lent that has to be paid back later. The lorries are not lent to anyone; they are the security behind the credit.
   • C — A personal guarantee is a promise by the owner to repay from their own money. The lorries belong to the firm, not to the owner personally.
   • D — Trade credit is when a supplier lets a business take goods now and pay later. No supplier is involved here; the lender is a bank.

2. 2. In one year, a small bank holds £5 million of savers' deposits and pays them 2% interest. It lends £4 million of this to local firms at 7%. Ignoring all its other costs, the interest the bank receives minus the interest it pays for the year is

   Calculation

   Select one answer

   A £180,000

   B £200,000

   C £250,000

   D £280,000
   Show model answer

   Answer: A (£180,000). Banks make most of their profit from the gap between the interest they charge borrowers and the interest they pay savers.
   Interest received from firms: £4 million × 7% = £280,000.
   Interest paid to savers: £5 million × 2% = £100,000.
   £280,000 − £100,000 = £180,000.
   Note that the bank pays interest on all £5 million of deposits, including the £1 million it has not lent out.

   Why the other options are wrong

   • B — This applies the 5-point gap to the £4 million lent: £4 million × 5% = £200,000. It forgets that the bank also pays 2% on the £1 million of deposits it has not lent, which costs a further £20,000.
   • C — This applies the 5-point gap to all £5 million of deposits. Interest is earned only on the £4 million lent.
   • D — This is the interest received from firms only. The bank also pays £100,000 to its savers, which has to come off.

3. 3. Table 1 shows four businesses asking the same bank, on the same day, to borrow the same amount.
   Using Table 1, the bank will probably charge the highest rate of interest to

   Data interpretation

   Table 1: Four requests to borrow from the same bank

   	Time trading	Security offered	Credit requested
   Business 1	15 years	Its own premises	Five-year loan
   Business 2	15 years	None	Five-year loan
   Business 3	Just starting	None	Overdraft
   Business 4	Just starting	Its machinery	Five-year loan

   Select one answer

   A Business 1.

   B Business 2.

   C Business 3.

   D Business 4.
   Show model answer

   Answer: C (Business 3.). The rate a bank charges rises with the risk that it will not be repaid, and depends on the borrower's track record, any collateral, and the type of credit.
   Business 3 is worst on all three counts: it has no track record, offers no security, and wants an overdraft, which usually costs more than a loan. So it is the riskiest borrower and pays the highest rate.

   Why the other options are wrong

   • A — Business 1 is the safest borrower in the table: fifteen years of trading, a loan secured on its own premises. It should be offered the lowest rate, not the highest.
   • B — Business 2 offers no security, which raises its rate, but it has fifteen years of trading behind it and wants a loan rather than an overdraft. Business 3 offers no security either, and is worse on track record and type of credit.
   • D — Business 4 is new, which raises its rate, but it offers its machinery as collateral, so the bank can recover some of its money. Business 3 offers nothing.

4. 4. Over two years, the interest rates banks pay on savings and charge on loans both fall from about 6% to about 2%. Through the reward for saving and the cost of borrowing, the most likely result is that

   Applied reasoning

   Select one answer

   A Households save less and firms invest less.

   B Households save less and firms invest more.

   C Households save more and firms invest less.

   D Households save more and firms invest more.
   Show model answer

   Answer: B (Households save less and firms invest more.). The interest rate is the reward for saving and the cost of borrowing.
   Lower rates → saving earns little → households save less.
   Lower rates → borrowing is cheaper → more projects are worth borrowing for → firms invest more.

   Why the other options are wrong

   • A — Saving falls, but investment does not. This treats the lower rate as bad news for firms too, when for a borrower it is a lower cost.
   • C — Both directions are reversed. A lower rate makes saving less rewarding and borrowing cheaper, not the other way round.
   • D — Investment rises, but saving does not. A lower rate makes saving less rewarding, so households save less, not more.

5. 5. Rather than lending £10,000 directly to one local firm, a saver deposits it with a bank that lends to thousands of firms. The main reason the saver's money is safer at the bank is that

   Applied reasoning

   Select one answer

   A A bank lends only to firms that offer collateral.

   B A bank pays savers more than a firm would pay.

   C A bank's checks mean none of its borrowers fail.

   D A failed loan is a small part of a bank's lending.
   Show model answer

   Answer: D (A failed loan is a small part of a bank's lending.). A saver who lends to a single firm could lose everything if that firm fails. A bank spreads its lending across thousands of borrowers, so one failure is a small loss set against all the loans that are repaid, and the saver's deposit is not tied to any one firm.

   Why the other options are wrong

   • A — Banks also make unsecured loans, with no collateral, and charge a higher rate for them. Collateral lowers the risk on a loan, but it is not why the deposit is safe.
   • B — A bank usually pays savers less than it charges borrowers; that gap is how it makes its profit. And a higher return would not make the money safer anyway.
   • C — A bank checks how likely a borrower is to repay, but checks lower the risk; they cannot remove it. Some borrowers always fail, which is why spreading the lending matters.

6. 6. A printing firm wants to borrow £50,000 for a machine it expects to add £4,000 a year to its profit before interest. Its bank offers an unsecured loan at 9% a year, or a loan secured on the firm's premises at 6% a year. Considering only the first year's interest, the extra profit from the machine

   Calculation

   Select one answer

   A Covers the interest on both loans.

   B Covers the interest on neither loan.

   C Covers the interest on the secured loan only.

   D Covers the interest on the unsecured loan only.
   Show model answer

   Answer: C (Covers the interest on the secured loan only.). Unsecured loan: £50,000 × 9% = £4,500 of interest, more than the £4,000 the machine adds.
   Secured loan: £50,000 × 6% = £3,000 of interest, less than £4,000.
   So the machine is worth borrowing for only on the secured loan. The higher the rate, the more a project has to earn to be worth borrowing for, and collateral is what brings the rate down.

   Why the other options are wrong

   • A — At 9%, the interest is £4,500, which is £500 more than the machine adds. The project does not cover the cost of the unsecured loan.
   • B — At 6%, the interest is £3,000, which the £4,000 of extra profit covers. This answer may have included repaying the £50,000 itself, which the stem leaves out.
   • D — This has the two loans the wrong way round. The secured loan is the cheaper one, because collateral lowers the bank's risk, so it is the one the machine can pay for.

7. 7. A bank has more deposits than it is currently lending. It still turns down a gift shop's loan request, because the shop's cash-flow forecast shows it could not keep up the repayments. The best explanation is that

   Applied reasoning

   Select one answer

   A It must keep all its deposits available as cash.

   B Its profit comes mainly from loans that are repaid.

   C Lending more would raise the interest it pays savers.

   D Unused deposits earn the bank more than loans do.
   Show model answer

   Answer: B (Its profit comes mainly from loans that are repaid.). A bank makes its profit from the gap between the interest it charges borrowers and the interest it pays savers. A loan only earns that if it is repaid. A borrower who cannot keep up the repayments could cost the bank the money it lent, so the bank wants to lend, but only to borrowers it expects to pay it back.

   Why the other options are wrong

   • A — If a bank had to keep every deposit as cash, it could not lend at all. Banks lend deposits on to borrowers; that is how savings are channelled into investment.
   • C — The interest a bank pays savers depends on its deposits, not on how much it lends. Making the loan would not change that cost.
   • D — Deposits sitting idle earn the bank nothing, while it still pays interest on them. A sound loan earns more than an unused deposit, which is why the bank wants to lend.