Banking Exam Financial Risk Management 5 — Questions and Answers
Question 1: Which of the following is NOT one of the three pillars of the Basel III framework?
- Minimum capital requirements
- Supervisory review process
- Market transparency and disclosure
- Mandatory government guarantees (Correct answer)
Correct answer: Mandatory government guarantees
The three pillars of Basel III are minimum capital requirements (Pillar 1), supervisory review (Pillar 2), and market discipline through disclosure (Pillar 3); government guarantees are not a pillar.
Question 2: A bank has a high proportion of fixed-rate long-term mortgages funded by short-term variable-rate deposits. When interest rates rise, what happens to the bank's net interest margin?
- NIM increases because loan rates reset higher
- NIM decreases because funding costs rise while loan income stays fixed (Correct answer)
- NIM is unaffected because rate changes offset each other
- NIM increases because depositors withdraw funds
Correct answer: NIM decreases because funding costs rise while loan income stays fixed
When rates rise, variable-rate deposit costs increase immediately while fixed-rate mortgage income remains unchanged, compressing the net interest margin.
Question 3: What distinguishes 'systemic risk' from 'systematic risk' in financial risk management?
- Systemic risk is portfolio-specific; systematic risk affects the entire financial system
- Systematic risk is portfolio-specific; systemic risk refers to risk that cannot be diversified away
- Systemic risk is the risk of collapse of an entire financial system; systematic risk is non-diversifiable market-wide risk (Correct answer)
- There is no meaningful distinction between the two terms
Correct answer: Systemic risk is the risk of collapse of an entire financial system; systematic risk is non-diversifiable market-wide risk
Systemic risk refers to the risk of a cascading collapse of the entire financial system (e.g., 2008 crisis), while systematic risk is non-diversifiable risk driven by macroeconomic factors affecting all assets.
Question 4: A bank uses an interest rate swap to convert fixed-rate loan income to floating-rate. If the bank is paying fixed and receiving floating, what is the bank's position called?
- Receiver swap
- Payer swap (Correct answer)
- Currency swap
- Total return swap
Correct answer: Payer swap
A payer swap means the bank pays fixed and receives floating, effectively converting fixed-rate asset income into floating-rate income to hedge liability repricing risk.
Question 5: What is the key difference between Expected Loss (EL) and Unexpected Loss (UL) in bank credit risk management?
- EL is covered by loan pricing and provisions; UL is covered by regulatory capital (Correct answer)
- EL is the worst-case loss scenario; UL is the average annual loss
- EL applies only to wholesale loans; UL applies only to retail portfolios
- EL is measured at 99% confidence; UL is measured at 95% confidence
Correct answer: EL is covered by loan pricing and provisions; UL is covered by regulatory capital
Banks price EL into loan spreads and set loan loss provisions for it, while economic and regulatory capital is held to absorb unexpected losses beyond the expected level.
Question 6: Which regulatory requirement mandates that U.S. banks with over $100 billion in assets undergo annual company-run and supervisory stress tests?
- Sarbanes-Oxley Act (SOX)
- Dodd-Frank Act Stress Testing (DFAST) (Correct answer)
- Gramm-Leach-Bliley Act
- Community Reinvestment Act (CRA)
Correct answer: Dodd-Frank Act Stress Testing (DFAST)
DFAST requires large U.S. banks to conduct annual stress tests using regulatory-specified scenarios to demonstrate capital adequacy under stress.
Question 7: In the context of market risk, what does 'convexity' measure for a bond portfolio?
- The sensitivity of bond duration to changes in interest rates (Correct answer)
- The credit spread differential between corporate and government bonds
- The likelihood of early bond redemption by the issuer
- The correlation between bond prices and equity returns
Correct answer: The sensitivity of bond duration to changes in interest rates
Convexity measures the rate of change of duration as interest rates change, capturing the curvature of the price-yield relationship that duration alone misses.
Banking Exam Financial Risk Management 5
Which of the following is NOT one of the three pillars of the Basel III framework?