BMO Risk Management & Mitigation 2 — Questions and Answers
Question 1: A bank's Value at Risk (VaR) model at the 99% confidence level predicts a maximum daily loss of $5 million. What does this mean?
- The bank will lose exactly $5M on 1% of trading days
- There is a 1% chance the daily loss will exceed $5M (Correct answer)
- The bank cannot lose more than $5M on any given day
- The expected daily loss is $5M
Correct answer: There is a 1% chance the daily loss will exceed $5M
VaR at 99% confidence means there is a 1% probability that losses will exceed the stated threshold on any given day.
Question 2: Which risk mitigation strategy involves transferring risk to a third party through contractual agreements?
- Risk avoidance
- Risk retention
- Risk transfer (Correct answer)
- Risk reduction
Correct answer: Risk transfer
Risk transfer shifts the financial burden of a loss to another party, commonly via insurance policies or derivative contracts.
Question 3: BMO's credit risk team notices that a corporate borrower's debt-to-EBITDA ratio has risen from 3x to 6x over 12 months. The most appropriate immediate action is to:
- Immediately call the loan and demand repayment
- Place the loan on the watchlist and request updated financials (Correct answer)
- Increase the interest rate on the loan retroactively
- Transfer the loan to another bank
Correct answer: Place the loan on the watchlist and request updated financials
A deteriorating leverage ratio warrants closer monitoring via watchlisting and gathering current financial data before taking more drastic action.
Question 4: What is the primary purpose of a bank's Internal Capital Adequacy Assessment Process (ICAAP)?
- To calculate minimum regulatory capital requirements
- To assess whether the bank holds sufficient capital for all material risks (Correct answer)
- To determine dividend payout ratios
- To evaluate employee compensation structures
Correct answer: To assess whether the bank holds sufficient capital for all material risks
ICAAP is a self-assessment process where banks evaluate their capital adequacy relative to their overall risk profile, going beyond minimum regulatory requirements.
Question 5: A trader at BMO enters into an interest rate swap where the bank pays fixed and receives floating. If interest rates fall significantly, the bank faces:
- A gain because floating receipts are higher
- A loss because fixed payments exceed floating receipts (Correct answer)
- No impact since swaps are off-balance-sheet
- A gain because fixed payments decrease
Correct answer: A loss because fixed payments exceed floating receipts
When rates fall, the floating leg the bank receives decreases while fixed payments remain constant, resulting in a net loss.
Question 6: Which of the following best describes concentration risk in a loan portfolio?
- Risk arising from too many small, diversified loans
- Excess exposure to a single borrower, sector, or geography (Correct answer)
- The risk that interest rates will rise unexpectedly
- Losses caused by operational failures in the lending process
Correct answer: Excess exposure to a single borrower, sector, or geography
Concentration risk occurs when a portfolio is overly exposed to a single entity, industry, or region, amplifying potential losses from that segment.
Question 7: Under Basel III, what is the Net Stable Funding Ratio (NSFR) designed to measure?
- A bank's ability to absorb sudden credit losses
- The proportion of long-term assets funded by stable long-term funding (Correct answer)
- The ratio of trading book assets to total assets
- A bank's exposure to foreign exchange risk
Correct answer: The proportion of long-term assets funded by stable long-term funding
NSFR ensures that a bank's long-term assets are supported by stable funding sources over a one-year horizon, reducing structural liquidity risk.
BMO Risk Management & Mitigation 2
A bank's Value at Risk (VaR) model at the 99% confidence level predicts a maximum daily loss of $5 million.
What does this mean?