Banking Risk Management 5 — Questions and Answers
Question 1: A bank's chief risk officer (CRO) reports a Key Risk Indicator (KRI) that has breached its threshold. What is the primary purpose of a KRI in risk management?
- To assign blame for risk events after they occur
- To provide early warning signals of increasing risk exposure (Correct answer)
- To calculate regulatory capital requirements
- To rank borrowers by creditworthiness
Correct answer: To provide early warning signals of increasing risk exposure
KRIs are forward-looking metrics designed to signal rising risk levels before they materialize into actual losses.
Question 2: Under the Dodd-Frank Act, systemically important financial institutions (SIFIs) are required to prepare which document to demonstrate they can be wound down without taxpayer bailout?
- Capital Conservation Plan
- Living Will (Resolution Plan) (Correct answer)
- Recovery and Resolution Directive
- Contingency Funding Plan
Correct answer: Living Will (Resolution Plan)
SIFIs must file Living Wills—formal resolution plans showing regulators how the firm could be safely wound down during severe financial distress.
Question 3: A bank issues a loan at a fixed rate funded by variable-rate deposits. If interest rates rise, the bank's net interest income will most likely:
- Increase, because loan rates adjust upward
- Decrease, because funding costs rise while loan income stays fixed (Correct answer)
- Remain unchanged due to natural hedging
- Increase, because deposits become more valuable
Correct answer: Decrease, because funding costs rise while loan income stays fixed
When a fixed-rate loan is funded by variable-rate deposits, rising rates increase funding costs without a corresponding increase in loan income, compressing NIM.
Question 4: The 'unexpected loss' component in credit risk modeling is important because:
- It is covered by loan loss reserves (ALLL)
- It represents the deviation from average losses that capital must absorb (Correct answer)
- It is excluded from regulatory capital calculations
- It only applies to consumer loan portfolios
Correct answer: It represents the deviation from average losses that capital must absorb
Unexpected loss is the volatility around average (expected) losses, and banks must hold regulatory capital precisely to absorb these tail outcomes.
Question 5: Which of the following is an example of reputational risk in banking?
- A spike in nonperforming loans due to economic recession
- Negative media coverage following an anti-money-laundering compliance failure (Correct answer)
- An increase in credit card charge-offs during a holiday season
- A rise in mortgage prepayments as interest rates fall
Correct answer: Negative media coverage following an anti-money-laundering compliance failure
Reputational risk arises when events—such as AML failures publicized in the media—damage customer trust and the institution's public image.
Question 6: What does the term 'risk-weighted assets' (RWA) mean in the context of bank capital requirements?
- Total assets adjusted for market volatility over 12 months
- Bank assets multiplied by risk weights reflecting each asset's credit risk (Correct answer)
- Non-performing assets weighted by collateral value
- Off-balance-sheet items excluded from capital calculations
Correct answer: Bank assets multiplied by risk weights reflecting each asset's credit risk
RWA is calculated by multiplying each asset by a regulatory risk weight (e.g., 0% for government bonds, 100% for corporate loans) to reflect credit risk in capital ratios.
Question 7: A bank uses a Monte Carlo simulation to estimate potential trading losses over the next 10 days. This tool is most closely associated with measuring which type of risk?
- Operational risk
- Liquidity risk
- Market risk (Correct answer)
- Compliance risk
Correct answer: Market risk
Monte Carlo simulation is commonly used in market risk management to model the distribution of potential portfolio losses by simulating thousands of possible price paths.
Banking Risk Management 5
A bank's chief risk officer (CRO) reports a Key Risk Indicator (KRI) that has breached its threshold.
What is the primary purpose of a KRI in risk management?