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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 151
A 'risk-weighted return on capital' (RWROC) measure in banking equals:
Select an option first.
Correct answer: B — Net income attributable to a business line divided by the regulatory risk-weighted capital (RWA × minimum capital ratio) consumed by that business line.
Explanation: RWROC = Net income / (RWA × capital ratio). This is equivalent to ROE for regulatory capital, measuring how efficiently regulatory capital is used to generate returns. Complements RAROC (which uses economic capital). A is ROA; C is an incorrect ratio; D is a capital adequacy ratio.
Question 152
The 'Volcker Rule' in the US Dodd-Frank Act restricts banks primarily from:
Select an option first.
Correct answer: B — Proprietary trading (trading for the bank's own account) and owning or sponsoring hedge funds and private equity funds.
Explanation: Volcker Rule: prohibits bank holding companies from: (1) proprietary trading in securities, derivatives, commodity futures and options; (2) sponsoring or investing in hedge funds and private equity funds. Exceptions: market-making, hedging, government securities. A, C, D are not Volcker Rule restrictions.
Question 153
A 'core Tier 1 ratio' or 'Common Equity Tier 1' (CET1) ratio of 12% means:
Select an option first.
Correct answer: B — The bank's highest-quality capital (common equity and retained earnings) equals 12% of its risk-weighted assets.
Explanation: CET1 ratio = CET1 capital / Risk-weighted assets. CET1 = common equity (paid-in ordinary shares, retained earnings, other comprehensive income, less deductions). At 12%, the bank has substantial buffer above the 4.5% minimum and 7.0% conservation buffer floor. A uses total assets; C and D are incorrect.
Question 154
The primary reason Basel requires 'downturn LGD' for regulatory capital is:
Select an option first.
Correct answer: B — In recessions, collateral values fall and recovery processes are impaired, meaning actual LGDs in the worst scenarios are higher than long-run averages — capital must cover stress-period LGDs.
Explanation: Downturn LGD (Basel A-IRB requirement): must reflect 'economic downturn conditions'. In recessions: (1) property prices fall (secured LGD rises); (2) bankruptcy courts are overwhelmed (slower recovery); (3) distressed asset sales yield less. Long-run LGD understates stress-period LGDs. Capital must be adequate for downturn, not just average conditions.
Question 155
The 'Asset Quality Review' (AQR) conducted by the ECB in 2014 was primarily designed to:
Select an option first.
Correct answer: B — Independently verify the credit quality of bank loan portfolios and the adequacy of provisions, ensuring reported credit quality was accurate and comparable across European banks.
Explanation: ECB AQR (2014): comprehensive review of bank balance sheets by the ECB/national supervisors before the SSM took over. Involved: (1) data integrity checks; (2) credit file reviews (sampling loans); (3) collateral and provision adequacy; (4) complex asset revaluation. Identified €25bn of provisioning shortfalls. A is liquidity; C and D are different scopes.
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Question 156
A bank with a corporate loan has: PD=1%, LGD=45%, EAD=$50m, maturity=2.5yr. Under Basel SA (unrated corporate at 100% risk weight), the regulatory capital requirement is:
Select an option first.
Correct answer: C — $4,000,000
Explanation: SA: RWA = EAD × risk weight = $50m × 100% = $50m. Capital = RWA × 8% = $50m × 8% = $4m. Compare with IRB capital (much lower for high-quality corporates). A is EL only; B is 0.8% × EAD; D is 1% × EAD.
Question 157
Under the Foundation IRB approach, a corporate borrower with internally estimated PD=0.8% has LGD set by Basel at 45% for senior unsecured. EAD=$20m, maturity=2.5yr. The regulatory capital K under Foundation IRB is approximately:
Select an option first.
Correct answer: B — Approximately $800,000–$1,000,000 — the IRB formula produces higher capital than simple EL × 8× multiplier because of systematic risk.
Explanation: IRB capital > EL: the capital formula K = LGD × N[(N⁻¹(0.008) + √ρ × N⁻¹(0.999)) / √(1−ρ)] − 0.008 × 0.45 × maturity adjustment. For 0.8% PD, ρ ≈ 23.7%. K ≈ 4-5% of EAD ≈ $800k–$1m. A is EL only; C is full EAD; D is 8% flat (SA approach).
Question 158
A bank switches from Standardised Approach (SA) to Advanced IRB for corporate credit risk. For a portfolio of high-quality investment-grade corporate loans (PD~0.1%, LGD=45%), the expected impact on regulatory capital is:
Select an option first.
Correct answer: B — Significant capital reduction — IRB formula is much more sensitive to PD; at very low PD, IRB capital is lower than the 100% SA risk weight capital.
Explanation: IRB sensitivity: for very low PD corporate loans, the IRB formula produces capital significantly lower than SA 100% risk weight × 8% = 8%. A 0.1% PD investment-grade corporate under IRB might have K ≈ 1-2% of EAD vs 8% under SA — significant capital benefit for large IG portfolios. A, C, D are wrong.
Question 159
Under Basel IV, A-IRB has been removed for 'banks and large corporates'. The primary reason is:
Select an option first.
Correct answer: B — For large corporates and banks, internal LGD and EAD estimates vary widely across banks for the same exposure — limiting comparability and potentially understating capital through model optimisation.
Explanation: Basel IV IRB constraints: A-IRB removed for: (1) banks/financial institutions (model risk too high, LGD estimates unreliable); (2) large corporates (revenue > €500m) — insufficient default data to reliably estimate LGD/EAD. F-IRB (bank estimates only PD) retained. This reduces model variability and risk weight inconsistency (RWA variability problem). A, C, D are wrong.
Question 160
The 'expected credit loss' under IFRS 9 equals $100m while the bank's regulatory expected loss (EL = PD × LGD × EAD) under IRB equals $80m. Under Basel, the difference between accounting provisions and regulatory EL affects CET1 capital by:
Select an option first.
Correct answer: B — If IFRS 9 provisions ($100m) exceed regulatory EL ($80m), the excess ($20m) is added back to CET1 capital (up to 0.6% of credit RWA); if provisions are less than EL, the shortfall reduces CET1.
Explanation: IRB provision floor: if accounting provisions > regulatory EL → excess provisions up to a cap (0.6% RWA) can be added to Tier 2 capital, and nothing is deducted from CET1. If accounting provisions < regulatory EL → shortfall is deducted from CET1 (50%) and Tier 2 (50%). The interaction between IFRS 9 and Basel capital is an important practical topic.
Question 161
A bank's internal model for LGD estimates shows a 35% long-run average LGD and 55% downturn LGD for unsecured corporate loans. Basel requires the bank to use:
Select an option first.
Correct answer: B — The downturn LGD (55%) for regulatory capital calculations under A-IRB, to ensure capital is adequate under adverse economic conditions.
Explanation: Basel A-IRB: LGD must reflect 'economic downturn conditions'. The downturn LGD (55%) is used for capital calculation. Long-run average LGD (35%) is used for expected loss calculation and IFRS 9 provisioning (with forward-looking adjustments). A minimises capital (not allowed); C is arbitrary averaging; D has insufficient supervisory oversight.
Question 162
The 'transition provisions' in Basel IV allow banks to phase in the output floor over:
Select an option first.
Correct answer: B — A 5-year period from 2025 to 2030 — the floor starts at 50% and rises to 72.5% by 2028.
Explanation: Basel IV output floor phase-in (as finalised Dec 2017, delayed for COVID): starting January 2025: 50%; 2026: 55%; 2027: 60%; 2028: 65%; 2029: 70%; 2030: 72.5%. This allows banks time to adjust capital planning. A, C, D are incorrect timelines.
Question 163
Under the IFRS 9 'simplified approach' for trade receivables, the bank should:
Select an option first.
Correct answer: B — Always recognise lifetime ECL for trade receivables and lease receivables (and optionally for contract assets), without assessing significant increase in credit risk.
Explanation: IFRS 9 simplified approach (IFRS 9.5.5.15): for trade receivables, contract assets, and lease receivables, entities must (or may optionally) use the simplified approach — always recognising lifetime ECL. This avoids the complexity of tracking Stage 1→2→3 migration for short-duration receivables where 12-month vs lifetime distinction is less meaningful.
Question 164
The 'global systemically important bank' (G-SIB) assessment methodology uses five equally weighted categories. Which of the following is NOT one of the five categories?
Select an option first.
Correct answer: C — Profitability.
Explanation: G-SIB five categories (FSB/BCBS methodology): (1) Cross-jurisdictional activity; (2) Size; (3) Interconnectedness; (4) Substitutability/Financial infrastructure; (5) Complexity. Profitability (C) is not a G-SIB category — large profitable banks are not automatically more systemic.
Question 165
A bank's 'risk appetite framework' (RAF) at the board level should include:
Select an option first.
Correct answer: B — Qualitative statements of the bank's risk culture and appetite, quantitative limits (credit, market, liquidity, operational), risk tolerance ranges, and escalation procedures when limits are approached or breached.
Explanation: Comprehensive RAF: (1) qualitative: risk culture, acceptable business types, prohibited activities; (2) quantitative: limits for each risk category; (3) tolerance bands: amber/red zones triggering escalation; (4) escalation: who is notified when limits are reached. A is too narrow; C is one component; D is an output, not a RAF element.
Question 166
The 'incremental default risk charge' (IRC) for trading book credits under Basel aims to:
Select an option first.
Correct answer: B — Capture the default and migration risk of credit instruments in the trading book over a 1-year horizon at 99.9% confidence, supplementing the 10-day VaR which does not capture these risks adequately.
Explanation: IRC (now largely replaced by FRTB): captures jump-to-default (JTD) and migration risk in the trading book over 1 year at 99.9% — risks that a 10-day VaR misses for credit-sensitive instruments. The liquidity horizon assumed is 3 months (constant risk assumption). A is wrong; C is too narrow (spread risk captured by VaR/ES); D is too narrow.
Question 167
A bank is stress-tested by its regulator with a scenario involving GDP −4%, unemployment +3%, and property prices −25%. The bank calculates credit losses of $2bn against a capital buffer of $3bn. The regulator concludes:
Select an option first.
Correct answer: B — The bank has sufficient capital to absorb the scenario losses while maintaining capital above regulatory minimums — the stress test passes.
Explanation: Stress test pass: if capital buffer ($3bn) > stress losses ($2bn), the bank remains viable — capital is not depleted below regulatory minimums. The regulator assesses adequacy, not whether any losses occur. A is wrong (the question says losses < buffer); C and D are stress test consequences only if the test fails.
Question 168
In CRE (Commercial Real Estate) lending, the 'capitalisation rate' (cap rate) is used to:
Select an option first.
Correct answer: B — Value the property: Property value = NOI / Cap rate — a higher cap rate implies a lower property value for the same NOI.
Explanation: Cap rate = NOI / Property value. Rearranging: Value = NOI / Cap rate. If NOI = $1m and cap rate = 8%, property value = $12.5m. If cap rates rise (e.g., 8%→10%), property values fall. This inverse relationship drives collateral value sensitivity in CMBS. A is LTV; C is the loan coupon; D is a credit risk measure, not cap rate.
Question 169
Under Basel III, the 'leverage ratio exposure' measure includes which of the following off-balance-sheet items?
Select an option first.
Correct answer: B — Derivative exposures (via SA-CCR), securities financing transaction exposures, and off-balance-sheet commitments converted using specified credit conversion factors.
Explanation: Leverage ratio total exposure: (1) on-balance-sheet; (2) derivative exposures (SA-CCR); (3) SFT exposures (repo, reverse repo); (4) off-balance-sheet (credit lines × CCF). This comprehensive exposure measure prevents gaming via off-balance-sheet structures. A is too narrow; C and D are too restrictive.
Question 170
The 'climate risk' disclosure requirements increasingly imposed on banks by financial regulators primarily address:
Select an option first.
Correct answer: B — Both physical risks (damage to collateral from climate events) and transition risks (policy-driven repricing of carbon-intensive assets, stranded asset risk) that affect the credit quality and value of bank loan portfolios.
Explanation: Climate credit risk channels: (1) physical — flooding/fire damages property collateral, disrupts business operations → higher PD and LGD; (2) transition — carbon taxes, emission limits reprice fossil fuel companies → stranded asset risk → credit deterioration in energy-intensive sectors. Regulators require banks to assess and disclose both channels.
Question 171
An 'AIRB portfolio' bank calculates its '99.9th percentile conditional default rate' in the Vasicek model. This is used to set regulatory credit risk capital because:
Select an option first.
Correct answer: B — The 99.9% confidence level corresponds approximately to a 1-in-1000 year loss event, calibrated to survive a severely adverse economic cycle without breaching regulatory minimum capital ratios.
Explanation: Basel IRB 99.9th percentile rationale: calibrated to produce capital adequate for an 'economic downturn period' — approximately a 1-in-1000 year event. This is designed to ensure the bank can survive a severely adverse credit cycle (comparable to the Great Depression). Under the Vasicek model: Z = N⁻¹(0.999) = −3.09 (standard deviations below mean for the systematic factor).
Question 172
In credit portfolio management, a 'macro overlay' in the IFRS 9 ECL calculation allows banks to:
Select an option first.
Correct answer: B — Adjust model-derived ECL estimates for macroeconomic developments or known limitations of the model that are not yet captured in the quantitative inputs — such as the impact of a new regulation or geopolitical event.
Explanation: Macro overlay: IFRS 9 requires forward-looking information. When models lag current conditions (e.g., COVID-19 shock in March 2020 not yet in historical data), a management overlay is applied to the model output. This must be: (1) documented; (2) objective; (3) consistent with the bank's macro scenarios; (4) subject to governance challenge. A, C, D are too extreme or incorrect.
Question 173
A bank's Pillar 3 report for credit risk must disclose (under the EBA/BCBS Pillar 3 framework):
Select an option first.
Correct answer: B — Credit risk RWA by asset class, credit quality (rating distribution, NPLs, provisions, coverage ratios), credit mitigation techniques, geographic and sector concentrations, and IRB model parameters.
Explanation: Pillar 3 credit disclosures: granular, structured templates covering (1) credit quality by portfolio (EBA CR1-CR7); (2) credit risk mitigation (CR3); (3) IRB model parameters (CR6-CR10); (4) counterparty credit risk (CCR); (5) securitisation exposures; (6) macroprudential overlays. A is too narrow; C is confidential; D is insufficient.
Question 174
The 'procyclicality buffer' within the Basel capital framework specifically designed for credit risk is the:
Select an option first.
Correct answer: B — Countercyclical Capital Buffer (CCyB) — accumulating in credit booms and released in downturns to allow banks to absorb losses without cutting lending.
Explanation: CCyB: specifically designed to address credit cycle procyclicality. National macro-prudential authorities activate it when credit growth is excessive (building buffers in boom) and deactivate it in stress (releasing buffers to support lending in bust). CCB (A) is always on; G-SIB (C) is size/systemic importance-based; SRB (D) is for structural systemic risk.
Question 175
A bank conducting 'credit portfolio optimisation' to improve RAROC across its loan book might employ which of the following strategies?
Select an option first.
Correct answer: B — Selectively shedding or hedging low-RAROC exposures (e.g., using CDS, loan sales, or securitisation), reinvesting freed-up capital into higher-RAROC activities, and improving pricing on new origination to reflect true economic capital cost.
Explanation: Portfolio optimisation: (1) identify low-RAROC borrowers (charging insufficient spread for economic capital consumed); (2) use CDS/CLO/securitisation to reduce those exposures; (3) price new loans at RAROC-accretive levels. This improves overall portfolio risk-return without changing the business. A and C increase risk; D changes accounting treatment.
Question 176
Under Basel's 'supervisory formula approach' (SFA) for re-securitisation, the capital charge is:
Select an option first.
Correct answer: B — Higher than for standard securitisation tranches of the same rating — re-securitisation (CDO²) adds a layer of complexity and correlation risk that regulators penalise with additional capital.
Explanation: Re-securitisation penalty: CDO² layers CDO tranche risk on CDO tranche risk, creating extreme complexity and correlation amplification. Basel III imposes higher risk weights on re-securitisation positions to deter this risk and ensure adequate capital. 2008 crisis demonstrated catastrophic losses in CDO² structures that were assigned AAA ratings. A and C are wrong; D is incorrect.
Question 177
A bank's IRB model produces significantly lower RWA for residential mortgages than competitor banks using the same Standardised Approach. The Basel output floor would cap the benefit at:
Select an option first.
Correct answer: B — A minimum of 72.5% of the SA RWA — if the bank's IRB RWA would be, say, 30% of SA RWA, the output floor raises it to at least 72.5% of SA RWA.
Explanation: Output floor (Basel IV): minimum IRB RWA = 72.5% × SA RWA. If a bank's IRB model produces $10bn RWA on a portfolio that the SA would calculate as $25bn RWA, the floor raises IRB RWA to max($10bn, 72.5%×$25bn=$18.125bn). Prevents extreme divergence between IRB and SA capital. A is pre-Basel IV; C is 100% (not the floor); D has wrong direction.
Question 178
The 'double default' framework under Basel A-IRB provides capital relief when:
Select an option first.
Correct answer: B — A guaranteed exposure benefits from the recognition that BOTH the primary obligor AND the guarantor must default for a loss to occur — the joint probability is much lower than either individual PD.
Explanation: Double default capital relief: eligible guarantee where guarantor PD is uncorrelated with or negatively correlated with obligor PD. P(Loss) = P(obligor defaults) × P(guarantor defaults | obligor defaults). For IG guarantor (PD=0.1%) on HY borrower (PD=5%): approximate joint PD = 0.5% × 0.1% = 0.0005% (if independent). Capital significantly reduced. A is the event; C is concentration risk; D is CDS-specific.
Question 179
An institution receives a 'model risk' finding from its IRB model validation that 'the PD model shows significant instability across economic cycles, with predictions deteriorating sharply in recessions.' The most appropriate remediation is:
Select an option first.
Correct answer: B — Recalibrate the PD model using a longer historical period that includes multiple economic cycles, ensuring the model captures downturn PDs, or apply a scalar/floor to ensure conservative estimates during adverse conditions.
Explanation: Model risk remediation for cycle instability: (1) recalibrate using longer data period (multiple cycles); (2) apply TTC calibration methodology; (3) add a 'downturn PD floor' to ensure model doesn't produce unrealistically low PDs in benign periods. The goal is a TTC model that produces stable, conservative estimates. A reduces capital (wrong direction); C is an overreaction; D doesn't fix the problem.
Question 180
Under the FRTB 'Sensitivities-Based Method' (SBM) for credit spread risk in the trading book, the capital charge accounts for:
Select an option first.
Correct answer: B — Delta risk (sensitivity of positions to credit spread changes), Vega risk (sensitivity of option positions to credit spread volatility), and Curvature risk (non-linear sensitivity to large spread moves).
Explanation: FRTB SBM: structured approach calculating three risk components: (1) Delta — CS01 sensitivity weighted by risk weights; (2) Vega — vega of options on credit instruments; (3) Curvature — additional risk from non-linear options. These are aggregated across buckets and risk classes. A is too simple; C misses spread sensitivity; D is operational risk.
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