Credit Risk Management Professional 2 — Questions and Answers
Question 1: Which regulatory framework introduced the Internal Ratings-Based (IRB) approach for calculating credit risk capital requirements?
- Basel I
- Basel II (Correct answer)
- Dodd-Frank Act
- Sarbanes-Oxley Act
Correct answer: Basel II
Basel II introduced the IRB approach, allowing banks to use internal models to estimate PD, LGD, and EAD for capital calculations.
Question 2: A bank's loan portfolio has an expected loss (EL) of $5M and unexpected loss (UL) of $20M. What is the primary purpose of economic capital in this context?
- To cover the expected loss of $5M
- To cover the unexpected loss of $20M (Correct answer)
- To cover both EL and UL combined
- To fund loan origination costs
Correct answer: To cover the unexpected loss of $20M
Economic capital is held to absorb unexpected losses; expected losses are typically covered by loan loss provisions and pricing.
Question 3: In credit portfolio management, what does 'concentration risk' specifically refer to?
- Risk from holding too many small loans
- Excessive exposure to a single borrower, sector, or geography (Correct answer)
- Risk from high credit quality borrowers defaulting simultaneously
- Volatility in net interest margins
Correct answer: Excessive exposure to a single borrower, sector, or geography
Concentration risk arises when a portfolio has disproportionate exposure to a single counterparty, industry, or region, amplifying potential losses.
Question 4: Which metric measures the percentage of exposure recovered after a borrower defaults, net of collection costs?
- Probability of Default (PD)
- Exposure at Default (EAD)
- Recovery Rate (RR) (Correct answer)
- Loss Given Default (LGD)
Correct answer: Recovery Rate (RR)
Recovery Rate is the proportion of the outstanding balance recovered post-default; LGD equals 1 minus the recovery rate.
Question 5: A credit analyst uses a Merton structural model to assess default risk. What is the model's core assumption?
- Default occurs when cash flow falls below a threshold
- A firm defaults when its asset value falls below its debt obligations (Correct answer)
- Default probability is derived solely from credit ratings
- Default is triggered by regulatory capital breaches
Correct answer: A firm defaults when its asset value falls below its debt obligations
The Merton model treats equity as a call option on the firm's assets, with default occurring when asset value drops below the debt face value at maturity.
Question 6: Under the Advanced IRB approach, which parameter does the bank estimate internally rather than using supervisory estimates?
- Risk weight functions
- Probability of Default (PD) only
- PD, LGD, and EAD (Correct answer)
- Regulatory correlation factors
Correct answer: PD, LGD, and EAD
Under Advanced IRB, banks estimate PD, LGD, and EAD internally, while under Foundation IRB only PD is estimated internally.
Question 7: A syndicated loan is restructured and the lead bank accepts a debt-for-equity swap. Which credit risk concept does this action directly address?
- Counterparty credit risk mitigation
- Loss Given Default reduction (Correct answer)
- Probability of Default increase
- Exposure at Default growth
Correct answer: Loss Given Default reduction
A debt-for-equity swap converts debt to ownership, reducing the outstanding claim and thereby lowering Loss Given Default on the restructured exposure.
Credit Risk Management Professional 2
Which regulatory framework introduced the Internal Ratings-Based (IRB) approach for calculating credit risk capital requirements?