Financial Risk Management Regulatory Capital and Basel 3

Question 1

What are 'contingent convertible bonds' (CoCos) and what is their role in Basel III?

Accepted Answer

Hybrid instruments that automatically convert to equity or are written down when a bank's capital falls below a trigger level, absorbing losses on a going-concern basis

Answer

CoCos are designed to recapitalize a distressed bank automatically without government intervention; they qualify as Additional Tier 1 capital under Basel III when they have high-trigger (CET1 < 5.125%) conversion features.

Question 2

What is the purpose of the 'Internal Capital Adequacy Assessment Process' (ICAAP)?

Accepted Answer

A bank's own internal process to assess whether its capital is adequate for all material risks it faces, including those not covered in Pillar 1

Answer

ICAAP (Pillar 2 requirement) requires banks to self-assess their capital needs across all risks — credit, market, operational, concentration, strategic, and reputational — and demonstrate sufficiency to their supervisor.

Question 3

What is 'stress testing' under the Dodd-Frank Act (DFAST) for US banks?

Accepted Answer

A regulatory framework requiring large US banks to annually project their capital levels under baseline, adverse, and severely adverse macroeconomic scenarios

Answer

DFAST requires banks with $100B+ in assets to submit annual stress test results under Fed-prescribed scenarios, demonstrating they would remain adequately capitalized even in a severe recession.

Question 4

Under the Basel standardized approach for credit risk, what risk weight is typically applied to unrated corporate exposures?

Accepted Answer

100%

Answer

The Basel standardized approach assigns a 100% risk weight to unrated corporate claims, meaning a $100M unrated corporate loan requires $8M of regulatory capital (8% × 100% × $100M).

Question 5

What is the 'output floor' introduced in Basel IV (Basel III finalization)?

Accepted Answer

A requirement that RWA calculated under internal models must be at least 72.5% of the RWA calculated under the standardized approach, limiting capital savings from internal models

Answer

The 72.5% output floor prevents banks from using sophisticated internal models to generate RWA far below standardized levels, ensuring a minimum level of capital across all banks regardless of modeling sophistication.

Financial Risk Management Practice Test

Financial Risk Management Practice Test

Financial Risk Management Regulatory Capital and Basel 3