Banking Exam Financial Risk Management 3 — Questions and Answers
Question 1: What is the primary purpose of a bank's Asset-Liability Committee (ALCO)?
- Approving individual large loans
- Managing the balance sheet to optimize risk-return and ensure liquidity (Correct answer)
- Setting regulatory capital minimums
- Auditing internal controls
Correct answer: Managing the balance sheet to optimize risk-return and ensure liquidity
ALCO oversees the bank's balance sheet structure, balancing interest rate risk, liquidity risk, and profitability across assets and liabilities.
Question 2: Which stress testing approach involves regulators prescribing standardized adverse scenarios for banks to model?
- Sensitivity analysis
- Reverse stress testing
- Supervisory stress testing (Correct answer)
- Monte Carlo simulation
Correct answer: Supervisory stress testing
Supervisory stress testing, like the Federal Reserve's DFAST/CCAR, requires banks to use regulator-specified scenarios to assess capital adequacy under stress.
Question 3: A borrower's credit rating is downgraded from investment grade to below investment grade. This triggers which specific risk event?
- Basis risk
- Fallen angel risk (Correct answer)
- Spread risk only
- Prepayment risk
Correct answer: Fallen angel risk
A 'fallen angel' refers to a bond or borrower downgraded from investment grade to speculative grade, triggering forced selling by institutional investors and sharp price declines.
Question 4: In market risk management, 'basis risk' refers to:
- The risk that a hedge does not perfectly offset the underlying exposure (Correct answer)
- The risk of loss from changes in the absolute level of interest rates
- The probability that a counterparty defaults before settlement
- The risk that collateral becomes illiquid
Correct answer: The risk that a hedge does not perfectly offset the underlying exposure
Basis risk occurs when the hedging instrument and the hedged position do not move in perfect correlation, leaving a residual unhedged exposure.
Question 5: What is the Liquidity Coverage Ratio (LCR) designed to ensure?
- Banks maintain enough capital to absorb ten years of losses
- Banks hold sufficient high-quality liquid assets to survive a 30-day stress scenario (Correct answer)
- Banks limit lending to no more than 80% of deposits
- Banks maintain a minimum return on equity
Correct answer: Banks hold sufficient high-quality liquid assets to survive a 30-day stress scenario
The LCR requires banks to hold enough high-quality liquid assets (HQLA) to cover total net cash outflows over a stressed 30-day period.
Question 6: Which of the following is an example of operational risk in banking?
- A borrower missing a loan payment
- Rising interest rates compressing the net interest margin
- A rogue trader executing unauthorized transactions (Correct answer)
- A decline in equity market prices reducing securities portfolio value
Correct answer: A rogue trader executing unauthorized transactions
Operational risk includes losses from failed internal processes, systems, human error, or external events — unauthorized trading is a classic example.
Question 7: What is 'repricing risk' in the context of interest rate risk management?
- The risk that loans are prepaid before maturity
- The risk arising from differences in the timing of rate changes on assets versus liabilities (Correct answer)
- The risk that a borrower's credit quality deteriorates
- The risk of mark-to-market losses on the trading book
Correct answer: The risk arising from differences in the timing of rate changes on assets versus liabilities
Repricing risk occurs when assets and liabilities mature or reprice at different times, exposing a bank to changes in net interest income when rates shift.
Banking Exam Financial Risk Management 3
What is the primary purpose of a bank's Asset-Liability Committee (ALCO)?