Your bank is providing a $30,000,000 loan to an A- A-rated corporate client. Refer to the information below.

Bank’s objective – ROE 18% before tax

Current Loan Interest rate: 6%

Average unused interest charge $ Nil

Application fee: $ Nil

Marginal cost of non-equity funds: 0.25%

Annual loan service fees: $100,000

Capital ratio: 10.5%

Average Demand deposits with bank $6,500,000

Interest paid on Demand deposits 0.7%

Average Term deposits $4,000,000

Interest rate on Term deposits 1.55%

Reserve requirements on deposits Demand deposit – 12%, Term deposit – 10%

Cost of providing services (by Loan Dept.) $120,000

Loan risk weighting 150%

1. What interest rate would you need to charge to achieve the bank’s objective (show workings)?

2. Using your newly calculated interest rate, assume that the cost of non-equity funds increases by 0.75%, and APRA also increases the capital ratio to 11%. Re-calculate the resulting new loan interest rate.

3. Explain two reasons as to why APRA may have increased the capital ratio. In your answer, describe how this decision has resulted in different interest rates in parts a. and b.