AQA A-level Economics: Banks, credit creation and financial regulation (7136) – Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs – examination boards hold copyright in their own papers. Use these alongside the official past papers from your board or school.

These questions cover sub-sections 4.2.4.2 and 4.2.4.4 of the AQA A-level Economics (7136) specification, version 1.3 (3.2.4.2 and 3.2.4.4 on the AQA website). All banks, countries and figures are invented. Learn the content first from the study guide or the revision notes. Hub: AQA A-level Economics. Checklist: printable checklist.

Questions

1. Distinguish between a commercial bank and an investment bank. [2]

2. Bank R is an invented commercial bank. Its balance sheet (£m) shows assets of reserves 30, short-term lending to other banks 50, bonds 120, loans 280 and other assets 20. Its liabilities are customer deposits 380 and wholesale borrowing 70. The remaining item is capital.

(a) Explain whether customer deposits are an asset or a liability of Bank R. [2] (b) Calculate Bank R’s capital. [2]

3. Explain two conflicts between the objectives of a commercial bank. [4]

4. A bank receives a new deposit of £200m. It keeps 20% liquid and lends the rest, and each loan is spent and redeposited in a bank that behaves the same way.

(a) Calculate the amount lent in the first and second rounds. [2] (b) Explain why the amount lent falls with each round. [2]

5. Explain how a bank that carries out both retail and investment banking might increase systemic risk. [6]

6. Bank S has liquid assets of £35m and £220m of deposits repayable on demand. Most of its assets are long-term loans.

(a) Calculate the shortfall if 20% of those deposits are withdrawn. [3] (b) Explain why this shortfall might lead to failure, referring to borrowing short and lending long. [3]

7. Bank T has assets of £400m, of which £240m are loans, and capital of £30m. Five per cent of its loans default and nothing is recovered.

(a) Calculate Bank T’s capital after the defaults. [2] (b) Calculate the percentage fall in the value of its assets that would eliminate its capital. [1] (c) Explain why a bank with more capital is less likely to fail. [2]

8. State the main role of each of the PRA, the FPC and the FCA in the UK. [3]

9. Bank U has £50m to invest. Option 1 is safe and returns 4%. Option 2 has a 55% chance of a 14% return and a 45% chance of a 12% loss.

(a) Calculate the expected return, in £m, of each option if Bank U bears its own losses. [3] (b) Calculate Option 2’s expected return if a rescue means Bank U never makes a loss. [1] (c) Explain what your answers show about moral hazard. [2]

10. Assess whether higher liquidity and capital requirements are enough to keep a banking system stable. [9]

11. In Country B (invented), a large bank fails. Bank lending to firms falls by £6bn and investment falls by the same amount. The multiplier is 1.4 and GDP was £300bn.

(a) Calculate the fall in aggregate demand, in £bn and as a percentage of GDP. [3] (b) Evaluate the likely effects on the real economy of the failure of a large bank. [9]

Answers

1. A commercial bank takes deposits and lends to households and firms [1]. An investment bank serves large clients, for example advising on takeovers, raising finance or trading assets, earning fees and trading income [1]. [2] Examiner insight: “Distinguish” needs both sides stated. A description of only one type of bank leaves the comparison incomplete.

2. (a) A liability [1], because Bank R owes the money back to depositors on demand [1]. (b) Total assets = 30 + 50 + 120 + 280 + 20 = £500m [1]. Capital = 500 − 380 − 70 = £50m [1]. [4] Examiner insight: A reason is needed after “liability”. Saying that deposits are money held at the bank, not owed by it, is a common error.

3. Liquidity v profitability: cash and liquid assets earn little, so holding more of them lowers profit [1]; long loans earn more but cannot be turned into cash quickly [1]. Security v profitability: safe borrowers pay lower interest, so a safer loan book earns less [1]; risky lending earns more but risks default and failure [1]. [4] Examiner insight: Each conflict needs both objectives named and the reason they pull apart. Two conflicts that are really the same pair add little, so choose two different pairs.

4. (a) Round 1: 0.80 × 200 = £160m [1]. Round 2: 0.80 × 160 = £128m [1]. (b) In each round the bank keeps back 20% of the new deposit [1], so the amount available to lend shrinks each time, towards zero [1]. [4] Examiner insight: The question asks for rounds, not a multiplier, and a multiplier calculation is not required. Show the working for each round.

5. Systemic risk is the danger that trouble at one institution spreads through the system [1]. Trading losses in the investment arm reduce the shared capital [1], which threatens retail deposits [1]. Ordinary savers and the payment system are then exposed [1]. Because the bank is large and interconnected, its failure would hit other banks [1], so the government may feel it must rescue it, creating moral hazard and a cost to taxpayers [1]. [6] Examiner insight: A chain from cause to consequence gains credit. Listing “bigger, riskier” without linking the two arms of the bank does not.

6. (a) Withdrawals = 0.20 × 220 = £44m [1]. Liquid assets = £35m [1]. Shortfall = 44 − 35 = £9m [1]. (b) Deposits can be withdrawn immediately, but loans are long-term [1], so the bank must sell loans quickly, probably below their value (about £10m of loans sold at 90p yields £9m) [1]. The losses reduce capital, and if depositors fear failure the run grows and the bank may become insolvent [1]. [6] Examiner insight: Show the withdrawal figure before the subtraction. A shortfall stated alone does not show how you reached it.

7. (a) Loss = 0.05 × 240 = £12m [1]. Capital = 30 − 12 = £18m [1]. (b) 30 ÷ 400 = 7.5% [1]. (c) Capital absorbs losses before depositors and other creditors are affected [1]. A larger cushion means a bigger fall in asset values is needed before the bank is insolvent [1]. [5] Examiner insight: Part (c) needs the mechanism: losses fall on capital first. “Capital makes banks safer” is an assertion, not an explanation.

8. PRA: supervises individual firms such as banks and sets standards on capital and liquidity [1]. FPC: monitors and acts to reduce risks to the financial system as a whole [1]. FCA: regulates conduct, such as treatment of customers and the working of markets [1]. [3] Examiner insight: Match each body to a different focus (firm, system, conduct). Describing all three as “regulating banks” does not show the difference between them.

9. (a) Option 1: 0.04 × 50 = £2.0m [1]. Option 2: 0.55 × 7 + 0.45 × (−6) = 3.85 − 2.70 [1] = £1.15m [1]. (b) 0.55 × 7 + 0.45 × 0 = £3.85m [1]. (c) Without a rescue, Option 1 is better (2.0 against 1.15) [1]. With a rescue, Option 2 becomes better (3.85), so the bank takes more risk because losses fall on someone else [1]. [6] Examiner insight: Moral hazard needs the comparison before and after the rescue, and a statement of who bears the loss.

10. Knowledge: higher liquidity requirements reduce the risk of runs [1], and higher capital requirements increase the cushion against losses [1]. Analysis: banks can then survive withdrawals and defaults without selling assets at a loss, so the chain to a credit crunch is less likely [1]. Banks are also less likely to take risks when more of their own capital is at stake, which reduces moral hazard [1]. Further analysis: lower failure risk reduces contagion between banks [1]. Evaluation: requirements raise banks’ costs, so lending may fall or become dearer, which slows growth [1]. They do not remove confidence-driven runs or herd behaviour, and banks may hold risky assets that meet the rules [1]. Supervision by the PRA, system-wide action by the FPC and conduct rules also matter [1]. Judgement: requirements are necessary but not sufficient, and their value depends on how well they are set and enforced [1]. [9] Examiner insight: A judgement that names a condition (“sufficient only if…”) is stronger than a repeat of earlier points.

11. (a) Fall in aggregate demand = 6 × 1.4 = £8.4bn [1]. Percentage = 8.4 ÷ 300 [1] = 2.8% [1]. (b) Chain: failure reduces confidence and capital in other banks [1], so lending tightens and a credit crunch follows [1]. Firms cut investment [1], households reduce credit-financed spending [1], aggregate demand falls [1], output falls and unemployment rises [1]. Lower incomes cause defaults and weaken banks further [1]. Evaluation: the effect is smaller if firms find other finance, if regulators and the government act quickly, or if banks hold strong capital [1]. It is larger when banks are interconnected or confidence is slow to return, and the multiplier may be bigger or smaller than assumed [1]. [12] Examiner insight: Use Country B’s figures in part (a) and refer back to them in part (b). Generic points that ignore the data are less convincing.

Where marks are usually lost

• Putting deposits on the asset side of a balance sheet.
• Giving a result without the calculation step that leads to it.
• Mixing up liquidity (meeting payments) and capital (absorbing losses).
• Writing “moral hazard” without saying who bears the cost.
• Naming the PRA, FPC and FCA but not giving each a distinct role.
• Treating a credit multiplier calculation as required.
• Writing a one-sided answer to an assess or evaluate question.
• Stopping at bank failure without a chain to the real economy.

Next steps

• Review with the revision notes and the study guide.
• Return to the AQA A-level Economics hub and tick off the printable checklist.
• Take the free 10-minute diagnostics.
• Book a free trial class.

Official syllabus

AQA, AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, sections 4.2.4.2 and 4.2.4.4.