Banking Exam Credit Risk and Analysis 4 — Questions and Answers
Question 1: Which of the following is a primary purpose of credit stress testing?
- To maximize loan portfolio yield
- To assess portfolio resilience under adverse economic scenarios (Correct answer)
- To determine the bank's dividend payout ratio
- To price individual loans competitively
Correct answer: To assess portfolio resilience under adverse economic scenarios
Stress testing evaluates how a credit portfolio would perform under severe but plausible adverse conditions, informing capital planning and risk limits.
Question 2: A borrower has a high debt-to-income (DTI) ratio. What does this signal to a lender?
- The borrower has substantial assets
- The borrower may struggle to manage additional debt obligations (Correct answer)
- The borrower has excellent credit history
- The borrower's collateral is highly valuable
Correct answer: The borrower may struggle to manage additional debt obligations
A high DTI means a large portion of income is already committed to debt payments, leaving less cushion for new obligations.
Question 3: In a leveraged buyout (LBO) scenario, what is the primary credit concern for senior lenders?
- Excessive equity contributed by the sponsor
- High debt load reducing cash flow available for debt service (Correct answer)
- Insufficient revenue diversification
- Low interest rate exposure
Correct answer: High debt load reducing cash flow available for debt service
LBOs are highly leveraged transactions where thin cash flow margins leave little buffer for debt service if business performance declines.
Question 4: What is 'credit migration risk'?
- The risk of borrowers moving to competing banks
- The risk that a borrower's credit rating deteriorates over time, increasing default probability (Correct answer)
- The risk of geographic concentration in a portfolio
- The risk of interest rate changes affecting loan pricing
Correct answer: The risk that a borrower's credit rating deteriorates over time, increasing default probability
Credit migration risk is the probability that a borrower's rating will deteriorate, affecting the value of the exposure even before default.
Question 5: A bank originates a loan with a personal guarantee from the business owner. What credit risk benefit does this provide?
- It eliminates all credit risk on the loan
- It provides an additional repayment source if the business defaults (Correct answer)
- It reduces the loan's interest rate automatically
- It transfers risk to another financial institution
Correct answer: It provides an additional repayment source if the business defaults
A personal guarantee gives the lender recourse against the guarantor's personal assets, creating a secondary repayment source beyond business cash flows.
Question 6: Under CECL (Current Expected Credit Loss) accounting, banks must recognize loan loss reserves based on:
- Losses already incurred and confirmed
- Lifetime expected credit losses at loan origination (Correct answer)
- Quarterly regulatory stress test results
- Historical average charge-off rates only
Correct answer: Lifetime expected credit losses at loan origination
CECL replaced the incurred-loss model, requiring banks to estimate and reserve for expected credit losses over the full remaining life of a loan at origination.
Question 7: Which of the following best describes 'credit enhancement' in structured finance?
- Increasing the interest rate to compensate for risk
- Mechanisms that improve the credit quality of a security, such as overcollateralization or subordination (Correct answer)
- Requiring additional borrower documentation
- Shortening the loan maturity to reduce exposure
Correct answer: Mechanisms that improve the credit quality of a security, such as overcollateralization or subordination
Credit enhancements like overcollateralization, cash reserves, and tranching absorb losses before senior investors are affected, improving their credit quality.
Banking Exam Credit Risk and Analysis 4
Which of the following is a primary purpose of credit stress testing?