Credit Risk Management Trivia 5 — Questions and Answers
Question 1: What credit risk term describes a borrower who is current on payments but whose underlying financials suggest elevated future default risk?
- Substandard
- Special mention (Correct answer)
- Doubtful
- Watch list
Correct answer: Special mention
'Special mention' (or 'criticized') assets are loans where borrowers show potential weaknesses that, if uncorrected, may weaken the credit or jeopardize repayment.
Question 2: In the Merton structural model of credit risk, default occurs when the firm's asset value falls below what threshold?
- The firm's equity market capitalization
- The face value of the firm's debt (Correct answer)
- The firm's book value of assets
- The firm's cash flow from operations
Correct answer: The face value of the firm's debt
In the Merton model, default is triggered when the market value of the firm's assets falls below the face value of its outstanding debt at maturity.
Question 3: What is a 'covenant-lite' loan, and why does it concern credit risk managers?
- A loan with below-market interest rates that reduces lender returns
- A leveraged loan with fewer financial maintenance covenants, giving lenders less early warning of deterioration (Correct answer)
- A loan with collateral that is difficult to value accurately
- A loan to a startup company with limited operating history
Correct answer: A leveraged loan with fewer financial maintenance covenants, giving lenders less early warning of deterioration
Covenant-lite loans lack traditional maintenance covenants (like leverage ratio tests), so lenders lose early warning signals and the ability to intervene before default becomes likely.
Question 4: Which regulatory concept requires banks to hold additional capital above minimums based on their systemic importance to the financial system?
- Countercyclical capital buffer
- Capital conservation buffer
- G-SIB surcharge (Correct answer)
- Pillar 2 add-on
Correct answer: G-SIB surcharge
The Global Systemically Important Bank (G-SIB) surcharge requires the largest, most interconnected banks to hold 1-3.5% additional CET1 capital above Basel III minimums due to their systemic risk.
Question 5: What is 'concentration risk' in a loan portfolio, and how is it typically managed?
- Risk of too many small loans; managed by consolidating into fewer large facilities
- Risk of excessive exposure to a single borrower, industry, or geography; managed through diversification limits (Correct answer)
- Risk that loan interest rates are too concentrated at one tenor; managed through rate swaps
- Risk that loan documentation is insufficient; managed through enhanced due diligence
Correct answer: Risk of excessive exposure to a single borrower, industry, or geography; managed through diversification limits
Concentration risk arises when a portfolio has outsized exposure to a single counterparty, sector, or region, and is managed through exposure limits, diversification, and credit risk transfers.
Question 6: Which financial crisis revealed major flaws in credit rating agency models for structured credit products?
- The 1997 Asian Financial Crisis
- The 2001 dot-com bubble
- The 2008 Global Financial Crisis (Correct answer)
- The 1998 Russian debt default
Correct answer: The 2008 Global Financial Crisis
The 2008 Global Financial Crisis exposed that rating agencies dramatically underestimated default correlations in mortgage-backed securities, leading to widespread AAA downgrades and massive investor losses.
Question 7: In credit analysis, what does 'subordination' provide in a structured finance transaction?
- Priority access to collateral for the most senior tranche
- Credit enhancement through junior tranches absorbing losses before senior tranches (Correct answer)
- Legal subordination of the SPV to the originating bank
- Reduced regulatory capital requirements for the originator
Correct answer: Credit enhancement through junior tranches absorbing losses before senior tranches
Subordination provides credit enhancement by having junior (lower-priority) tranches absorb losses first, protecting senior tranche holders until junior tranches are fully depleted.
Credit Risk Management Trivia 5
What credit risk term describes a borrower who is current on payments but whose underlying financials suggest elevated future default risk?