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Free FRM Credit Risk Measurement and Management Practice Questions & Answers
400 exam-style Credit Risk Measurement and Management questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 361
An 'ICAAP' (Internal Capital Adequacy Assessment Process) requires banks to:
Select an option first.
Correct answer: B — Internally assess all material risks, including those not captured by Pillar 1, and determine whether the bank holds adequate capital to cover them under stress scenarios.
Explanation: ICAAP: banks' own forward-looking assessment of capital needs, covering all material risks (credit, market, operational, IRRBB, concentration, pension, reputational). Supervisors review the ICAAP and may impose Pillar 2 add-ons. A only covers Pillar 1; C is Pillar 3 disclosure; D is not an ICAAP requirement.
Question 362
'Credit risk appetite' at a bank is typically expressed through:
Select an option first.
Correct answer: B — A combination of quantitative limits (maximum exposure by sector, rating, maturity, geography) and qualitative statements on acceptable credit behaviours and business types.
Explanation: Credit risk appetite: a multi-dimensional framework combining quantitative limits (maximum exposures, concentration limits, minimum credit quality) with qualitative guidelines (industries to avoid, deal types to restrict). A is too simplistic (one number); C and D are measures of the bank's own credit quality.
Question 363
'Large exposure limits' under Basel restrict the maximum exposure to a single counterparty at:
Select an option first.
Correct answer: B — 25% of Tier 1 capital (with specific limits for G-SIB interbank exposures at 15%).
Explanation: Basel large exposure limits: maximum exposure to a single counterparty ≤ 25% of Tier 1 capital. For G-SIB-to-G-SIB exposures, the limit is 15% to reduce systemic interconnectedness. A, C, D are incorrect.
Question 364
Under the Basel IRB formula, the 'asset correlation' parameter (ρ) for corporate exposures is:
Select an option first.
Correct answer: B — Prescribed by regulators as a function of PD — lower-PD (higher-quality) borrowers have higher asset correlation.
Explanation: IRB correlation: ρ = 0.12×(1−e^(−50PD))/(1−e^(−50)) + 0.24×(1−above). At very low PD, ρ ≈ 0.24 (24%); at high PD, ρ ≈ 0.12 (12%). High-quality borrowers have more systematic/less idiosyncratic risk. The correlation is supervisory-prescribed, not bank-estimated. A, C, D are incorrect.
Question 365
A bank with a corporate loan: PD=0.5%, LGD=45%, EAD=$10m, Maturity=2.5yr. The regulatory capital (K) under Basel IRB is approximately (using the Basel formula, asset correlation ρ≈23.8%, confidence level 99.9%, maturity adjustment≈1):
Select an option first.
Correct answer: C — Approximately $700,000 (K ≈ 7% of EAD for a typical investment-grade corporate)
Explanation: For a 0.5% PD, IG corporate: Basel formula typically gives K ≈ 5-10% depending on exact parameters. K = LGD×N[(N⁻¹(PD)+√ρ×N⁻¹(0.999))/√(1-ρ)] − PD×LGD, adjusted for maturity. Approximate K ≈ 7% × $10m = $700,000. A is just EL; B is 2.25% × $10m; D is full EAD.
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Question 366
The Basel 'maturity adjustment' in the IRB capital formula accounts for:
Select an option first.
Correct answer: C — Both A and B — the maturity adjustment raises capital for maturities above 2.5 years and reduces it for shorter maturities.
Explanation: Maturity adjustment b(PD) = (0.11852 − 0.05478×ln(PD))². Capital multiplied by (1 + (M−2.5)×b(PD))/(1−1.5×b(PD)). A 3-year loan pays more capital than a 1-year loan. A and B together describe the adjustment; C correctly states both directions of adjustment.
Question 367
In the Basel framework, a 'past due' loan (90+ days overdue) is classified as:
Select an option first.
Correct answer: B — 'Non-performing' with a default classification, triggering the use of LGD estimates appropriate for defaulted assets and downturn conditions.
Explanation: Basel default definition: exposure is 90+ days past due on any material credit obligation OR unlikely to pay without recourse to collateral. Upon default classification: (1) LGD switches to 'downturn LGD', (2) PD=100%, (3) specific provisions required, (4) Stage 3 under IFRS 9. A, C, D are incorrect classifications.
Question 368
The 'specialised lending' category under IRB includes project finance, object finance, commodities finance, income-producing real estate, and high-volatility commercial real estate (HVCRE). These receive special treatment because:
Select an option first.
Correct answer: B — Their repayment depends primarily on the cash flows from specific assets or projects rather than the general creditworthiness of the borrower — making standard PD estimation from obligor financials less appropriate.
Explanation: Specialised lending (SL): unlike corporate loans, repayment depends on project/asset performance, not the corporate borrower's overall business. This makes PD estimation from corporate financial data less applicable. Basel allows slotting criteria (supervisory risk weights by risk category) as an alternative to the general IRB formula. A, C, D are incorrect.
Question 369
A bank adopting the 'Expected Credit Loss' (ECL) model under IFRS 9 must categorise assets into stages. Which of the following correctly describes Stage 2?
Select an option first.
Correct answer: B — Assets that have experienced a 'significant increase in credit risk' since origination — requiring recognition of lifetime expected credit losses (not just 12-month ECL).
Explanation: IFRS 9 stages: Stage 1 = performing (12-month ECL); Stage 2 = significant credit risk increase (lifetime ECL); Stage 3 = credit-impaired/defaulted (lifetime ECL + different interest recognition). The Stage 1→2 migration requires more sensitive forward-looking indicators than 90-day past due (which triggers Stage 2→3). A is Stage 1; C is Stage 3; D is 90+ days overdue (usually Stage 3).
Question 370
A bank estimates that its portfolio's 12-month ECL is $50m under IFRS 9. This implies that provisions must be set at:
Select an option first.
Correct answer: A — $50m (the 12-month ECL for Stage 1 assets) — reducing retained earnings.
Explanation: IFRS 9: Stage 1 assets require provisions equal to 12-month ECL = $50m. This deduction flows through the income statement and reduces retained earnings (and therefore CET1). Stage 2 and 3 require lifetime ECL provisions. B is the incurred loss model (superseded); C and D are incorrect.
Question 371
Under Basel, the 'Standardised Approach for Counterparty Credit Risk' (SA-CCR) was designed to replace simpler methods like the Current Exposure Method (CEM) because:
Select an option first.
Correct answer: B — SA-CCR is more risk-sensitive, capturing the effect of netting, collateral, and market volatility on derivative exposures more accurately than the CEM's fixed add-on factors.
Explanation: SA-CCR: replaces CEM and Standardised Method with a more risk-sensitive approach that recognises: (1) bilateral netting within netting sets, (2) collateral (via a supervisory formula), (3) market volatility (via supervisory delta and supervisory factors). A is not always true; C is wrong; D is not how SA-CCR works.
Question 372
The 'Standardised Approach for measuring Credit Risk Mitigation' (Basel SA) substitutes the guarantor's risk weight for the obligor's when:
Select an option first.
Correct answer: B — The guarantee is unconditional, irrevocable, and directly covers the credit obligation — and the guarantor is a recognised eligible protection provider with a lower risk weight than the obligor.
Explanation: SA guarantee recognition (substitution approach): the protected portion of the exposure receives the guarantor's risk weight instead of the obligor's — but only if the guarantee meets strict eligibility criteria: (1) direct, explicit, irrevocable, unconditional; (2) guarantor is eligible (sovereign, bank, other entity with lower risk weight). A and C are too broad; D is a collateral condition, not guarantee.
Question 373
The 'Economic Capital' framework in a bank serves what primary function?
Select an option first.
Correct answer: B — Providing a risk-sensitive, internal measure of capital adequacy that enables risk-adjusted performance measurement (RAROC) and optimal capital allocation across business lines.
Explanation: Economic capital: internally estimated capital based on the bank's own assessment of all risks (credit, market, operational, liquidity) at a chosen confidence level (e.g., 99.97% for AA rating). Used for RAROC = Risk-adjusted income / Economic capital, enabling comparison of risk-adjusted profitability across diverse business units. A is regulatory capital; C and D are separate decisions.
Question 374
A bank calculates a business line's RAROC as 14%. If the bank's cost of equity (hurdle rate) is 12%, the business line should:
Select an option first.
Correct answer: B — Continue operating and expand — the RAROC exceeds the cost of equity, indicating value creation for shareholders.
Explanation: RAROC > hurdle rate = value creation. If RAROC = 14% > 12% cost of equity, the business line earns a return above what equity providers require — it creates shareholder value. RAROC < hurdle rate = value destruction (consider exit). A is an arbitrary threshold; C and D don't follow from the comparison.
Question 375
'Stressed VaR' (SVaR) for credit risk was introduced to:
Select an option first.
Correct answer: B — Ensure that market risk capital for credit-sensitive positions (e.g., CDS, credit bonds) is calibrated to a period of significant credit market stress, reducing pro-cyclicality.
Explanation: SVaR (Basel 2.5, now FRTB): supplement to standard VaR calibrated to a 12-month historical window that includes a significant market stress period (e.g., 2008 financial crisis). For credit-sensitive positions, SVaR captures the potential loss during a credit crisis. Prevents capital from declining artificially in calm periods. A is wrong (SVaR supplements, not replaces); C and D are different frameworks.
Question 376
The 'Fundamental Review of the Trading Book' (FRTB) replaces VaR with Expected Shortfall (ES) at 97.5% for market risk capital because:
Select an option first.
Correct answer: B — ES captures the severity of losses beyond the VaR threshold (tail severity) and is a coherent risk measure — addressing VaR's inability to capture tail risk magnitude.
Explanation: FRTB: 97.5% ES replaces 99% VaR. ES = average loss given loss exceeds VaR → captures tail severity. ES is also sub-additive (coherent) — VaR fails sub-additivity under certain distributions. The 97.5% ES generates approximately equivalent capital to 99% VaR under normality but is more conservative for fat-tailed distributions. A reverses; C and D are wrong.
Question 377
Under Basel's credit risk framework, 'double default' treatment for guaranteed exposures provides:
Select an option first.
Correct answer: B — Capital relief recognising that both the obligor AND the guarantor must default for a loss to occur — the joint probability is much lower than either individual PD.
Explanation: Double default: P(Loss) = P(obligor defaults AND guarantor defaults) = PD_obligor × PD_guarantor × (1-correlation benefit). For an IG guarantor backing a speculative grade borrower: joint PD ≈ 0.5% × 5% = 0.025% — dramatically lower than either individual PD. Basel A-IRB provides capital relief for eligible guarantees. A, C, D are incorrect descriptions.
Question 378
'IFRS 9' replaced 'IAS 39' in credit loss provisioning primarily by:
Select an option first.
Correct answer: B — Moving from an 'incurred loss' model (provision only after evidence of impairment) to an 'expected credit loss' model (provision for anticipated future losses based on forward-looking estimates).
Explanation: IAS 39 incurred loss model: provision only when objective evidence of impairment exists (triggering too-little-too-late provisioning). IFRS 9 ECL model: provisions based on statistical expected losses from day 1 (Stage 1: 12-month ECL) with earlier cliff recognition through stages. This addresses the 'too little, too late' problem observed in the 2008 crisis. A, C, D are incorrect.
Question 379
In the context of credit risk stress testing, a 'severe adverse scenario' typically includes:
Select an option first.
Correct answer: B — GDP decline of 3-6%, significant unemployment increases, sharp credit spread widening, and falling asset prices — designed to test capital adequacy under plausible but severe conditions.
Explanation: Regulatory stress tests (Fed CCAR, EBA): define a 'severely adverse' scenario with macroeconomic parameters — e.g., GDP −5%, unemployment +5pp, equity −40%, HPI −25%, credit spreads +300bp. Banks apply this to their portfolio to estimate losses and check capital adequacy. A is a benign scenario; C and D are partial shocks, not severe adverse.
Question 380
'Pillar 3' disclosure requirements for credit risk include:
Select an option first.
Correct answer: B — Qualitative and quantitative information enabling market participants to assess the bank's credit risk profile, risk management approach, and capital adequacy — promoting market discipline.
Explanation: Pillar 3: mandatory public disclosure of material credit risk information: credit quality by asset class, NPL ratios, ECL provisions, IRB model parameters (PD, LGD, EAD by portfolio), credit mitigation techniques, geographic and sector concentrations. This enables investors and counterparties to make informed decisions. A, C, D are too narrow or incorrect.
Question 381
A bank observes that its IRB model produces PD estimates that systematically underestimate actual default rates in recessions. The most appropriate regulatory response is:
Select an option first.
Correct answer: B — Requiring the bank to apply a 'PD scalar' or a Pillar 2 add-on to correct for the systematic downward bias, ensuring capital is adequate for downturn conditions.
Explanation: If internal PD models have systematic bias (underprediction in downturns), supervisors can: (1) require a calibration correction (PD scalar), (2) impose a Pillar 2 capital add-on, or (3) require model recalibration. Option A reduces capital (wrong direction); C ignores the bias; D is a nuclear option not typically used for a single calibration issue.
Question 382
The 'correlation risk' between credit portfolios managed by different desks within the same bank is best addressed through:
Select an option first.
Correct answer: B — An enterprise-wide credit risk aggregation framework that captures cross-desk default correlations, enabling identification of systemic credit concentrations that individual desk-level risk management would miss.
Explanation: Enterprise credit risk aggregation: cross-desk correlations arise when different desks hold exposures to the same borrower, sector, or systematic risk factor. Without aggregation, the bank may appear diversified desk-by-desk but have dangerous portfolio-level concentrations. An enterprise risk system (credit limit management, portfolio analytics) addresses this. A, C, D fail to capture inter-desk correlation.
Question 383
The 'Vasicek model' used in Basel IRB assumes that the credit portfolio is infinitely granular, which means:
Select an option first.
Correct answer: B — The portfolio is perfectly diversified with respect to idiosyncratic default risk — no single obligor contributes meaningfully to total portfolio loss, so only systematic risk remains.
Explanation: Infinite granularity: in the limit of a very large, equally weighted portfolio of small exposures, idiosyncratic risk diversifies away completely. The remaining risk is purely systematic (the common factor Z). Basel IRB capitalises this systematic risk at a 99.9% confidence level. Real portfolios have concentration risk not captured by IRB (→ Pillar 2 add-on). A, C, D are incorrect.
Question 384
A bank's credit risk management team identifies that a corporate borrower's credit quality has significantly deteriorated — the borrower is now rated CCC. The bank should:
Select an option first.
Correct answer: B — Escalate to the credit committee, classify the loan as 'watch' or 'non-performing' as appropriate, increase provisions (IFRS 9 Stage 2 or 3), restrict additional credit, and develop a remediation/workout plan.
Explanation: Best practice credit risk management for a deteriorated credit: (1) escalate to senior credit officers and credit committee; (2) reclassify (Stage 2 or 3 / non-performing / substandard); (3) increase IFRS 9 ECL provisions; (4) restrict new credit to the borrower; (5) engage the borrower on remediation options (restructuring, additional security). A delays action; C may crystallise unnecessary loss; D is too slow.
Question 385
'Concentration risk' adjustment to Basel IRB capital arises from the 'granularity adjustment' because:
Select an option first.
Correct answer: A — The Basel IRB formula was designed for infinitely granular portfolios — real portfolios have single-name concentrations that add idiosyncratic risk not captured by the formula.
Explanation: Granularity adjustment (Basel II QIS and academic literature): the Vasicek/Basel formula assumes idiosyncratic risk is fully diversified. Real portfolios have large single-name exposures that contribute idiosyncratic risk beyond the systematic component. The granularity adjustment adds capital for this non-diversified idiosyncratic risk. B, C, D are incorrect.
Question 386
Under the 'Basel IV' framework (finalised in December 2017, phasing in through 2028), the key change to the IRB approach for credit risk is:
Select an option first.
Correct answer: B — Restricting the use of A-IRB for certain exposure classes (large corporates, banks, other financial institutions) where data limitations make reliable LGD and EAD estimation difficult.
Explanation: Basel IV IRB changes: (1) A-IRB restricted/removed for banks, large corporates (consolidated revenue > €500m), other FIs — must use F-IRB or SA; (2) Minimum PD floors (e.g., 0.05% for corporates); (3) LGD floors (e.g., 25% for unsecured corporates); (4) Output floor at 72.5% of SA. A is wrong; C is wrong (F-IRB retained); D has wrong direction.
Question 387
A credit risk model validator observes that the model's Gini coefficient was 0.75 on the development sample but only 0.55 on the validation sample. This indicates:
Select an option first.
Correct answer: B — Model overfitting — the model has been tuned too specifically to the development data and is not generalising well to new data.
Explanation: Gini coefficient drop from 0.75 (development) to 0.55 (validation) = 20-point degradation = overfitting. The model learned the noise of the development sample rather than the true underlying relationship. Remedies: regularisation, variable selection, larger development sample, simpler model specification. A is wrong; C and D underestimate the severity of a 20-point drop.
Question 388
The 'credit risk appetite' and 'credit risk capacity' of a bank differ in that:
Select an option first.
Correct answer: B — Credit risk appetite is the level of risk the bank actively chooses to take in pursuit of its strategy; credit risk capacity is the maximum risk the bank could absorb without breaching regulatory or stakeholder constraints.
Explanation: Risk appetite vs. capacity: capacity = absolute maximum (limited by capital, regulatory requirements, funding). Appetite = chosen level within capacity (strategic, risk-return optimised). Appetite should always be below capacity to maintain a buffer. C reverses who sets them; D is usually true but not definitionally required — they could theoretically be equal.
Question 389
In stress testing for credit risk, 'scenario design' should include which of the following principles?
Select an option first.
Correct answer: B — Scenarios that are severe but plausible, including historical replications and hypothetical forward-looking scenarios that capture current vulnerabilities, structural changes, and tail risks.
Explanation: Stress scenario design principles: (1) historical (2008 crisis, 2001 recession) — grounded in actual events; (2) hypothetical (pandemic, cyber crisis, real estate crash) — tailored to current vulnerabilities; (3) reverse stress tests — what would cause failure? A restricts to historical only; C and D are inappropriate for risk identification purposes.
Question 390
A senior credit risk officer argues that the bank's credit culture is a key determinant of portfolio quality over time. What does 'credit culture' encompass?
Select an option first.
Correct answer: B — The shared values, attitudes, behaviours, and informal norms around credit risk-taking — how credit decisions are actually made, what information is considered, and how conflicts between revenue generation and credit discipline are resolved.
Explanation: Credit culture: the informal and formal environment surrounding credit decisions. Strong credit culture: (1) independent credit review that can override relationship managers; (2) reward structures that don't solely incentivise volume; (3) management that visibly supports prudent credit standards even during competitive pressure; (4) transparent reporting of credit quality. A is too narrow (formal policies only); C and D are components, not the full definition.
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