Banking Risk Management 4 — Questions and Answers
Question 1: What is 'Expected Shortfall' (ES), also called Conditional VaR (CVaR)?
- The average loss in all scenarios within a confidence interval
- The average loss in scenarios that exceed the VaR threshold (Correct answer)
- The maximum loss observed in historical data
- The probability-weighted loss across all future scenarios
Correct answer: The average loss in scenarios that exceed the VaR threshold
Expected Shortfall (ES) measures the average loss in the tail of the distribution beyond the VaR threshold, capturing tail risk better than VaR alone.
Question 2: Which regulation requires large U.S. bank holding companies to submit annual capital plans and stress test results to the Federal Reserve?
- Dodd-Frank Act stress testing (DFAST)
- Comprehensive Capital Analysis and Review (CCAR)
- Both DFAST and CCAR (Correct answer)
- Basel III Pillar 2
Correct answer: Both DFAST and CCAR
Both DFAST (public stress test disclosure) and CCAR (capital plan approval process) apply to large U.S. bank holding companies under Fed oversight.
Question 3: A bank holding mortgage-backed securities experiences losses when homeowners prepay their mortgages faster than expected as rates fall. This is known as:
- Extension risk
- Prepayment risk (Correct answer)
- Duration risk
- Convexity risk
Correct answer: Prepayment risk
Prepayment risk occurs when borrowers refinance or pay off mortgages early during falling rate environments, shortening the expected cash flow duration.
Question 4: In the context of credit risk, what does 'Loss Given Default' (LGD) represent?
- The probability that a borrower will default within one year
- The total exposure at the time of default
- The percentage of exposure a lender loses if the borrower defaults (Correct answer)
- The expected number of defaults in a portfolio per year
Correct answer: The percentage of exposure a lender loses if the borrower defaults
LGD is the proportion of the total exposure that a lender cannot recover after a borrower defaults, expressed as a percentage.
Question 5: Which of the following best describes 'model risk' in banking?
- Risk that regulatory models are updated without notice
- Risk of loss resulting from errors or misuse of quantitative models (Correct answer)
- Risk that competitors use superior financial models
- Risk that stress test assumptions are too conservative
Correct answer: Risk of loss resulting from errors or misuse of quantitative models
Model risk is the potential for adverse consequences from decisions based on flawed, misused, or incorrectly implemented quantitative models.
Question 6: A community bank heavily concentrated in commercial real estate (CRE) loans is most exposed to which supervisory concern?
- Cybersecurity risk
- Concentration risk in a cyclical asset class (Correct answer)
- Foreign exchange risk
- Underwriting model risk
Correct answer: Concentration risk in a cyclical asset class
Supervisors closely monitor CRE concentration because real estate values are cyclical and a downturn can cause simultaneous losses across a concentrated portfolio.
Question 7: Which pillar of the Basel framework requires banks to publicly disclose their risk exposures, capital adequacy, and risk management practices?
- Pillar 1 — Minimum Capital Requirements
- Pillar 2 — Supervisory Review Process
- Pillar 3 — Market Discipline (Correct answer)
- Pillar 4 — Systemic Risk Surcharge
Correct answer: Pillar 3 — Market Discipline
Pillar 3 (Market Discipline) mandates public disclosure of risk and capital information so that market participants can assess a bank's risk profile.
Banking Risk Management 4
What is 'Expected Shortfall' (ES), also called Conditional VaR (CVaR)?