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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 181
A credit risk specialist argues that Basel IRB capital for retail mortgages should be lower than the Standardised Approach because IRB better captures diversification and granularity. However, Basel IV's output floor partially undermines this argument because:
Select an option first.
Correct answer: B — Even if IRB correctly models lower risk for high-quality mortgages, the output floor prevents capital from falling below 72.5% of the SA capital, regardless of the model's accuracy.
Explanation: Output floor paradox: even a well-calibrated, accurate IRB model for retail mortgages that correctly quantifies low risk cannot allow regulatory capital to fall below 72.5% of the SA capital. The floor is a blunt instrument — it provides a risk-insensitive backstop for all portfolios, not just those where model risk is genuinely high. A is wrong; C is incorrect; D is wrong.
Question 182
Under the ECB's supervisory guidance on credit risk (ECB's 'Dear CEO' letter on NPLs), banks with high NPL ratios are expected to:
Select an option first.
Correct answer: B — Develop credible, time-bound NPL reduction strategies with specific provisioning and coverage targets, meet minimum coverage ratios that increase with NPL age, and report progress to supervisors.
Explanation: ECB NPL guidance: banks with NPL ratios above supervisory thresholds must develop NPL management strategies covering: (1) NPL reduction targets (strategic plans); (2) governance (dedicated workout functions); (3) provisioning (increasing coverage with age under backstop rules); (4) reporting. A is too aggressive; C forces asset sales; D is too extreme.
Question 183
In the context of climate-related credit risk, a 'transition risk stress scenario' for a bank's corporate loan portfolio would typically involve:
Select an option first.
Correct answer: B — A sudden repricing of carbon-intensive assets (due to unexpected carbon taxation or regulation), causing credit deterioration for energy companies, fossil fuel producers, and high-emission industries in the loan portfolio.
Explanation: Transition risk stress: regulatory or technology shock causes rapid repricing of carbon assets. Example: sudden $150/tonne carbon price → profitability of coal, oil, gas companies collapses → PDs spike → banks with concentrated energy sector exposure face large credit losses. A is physical risk (different scenario); C is also physical risk; D is operational risk.
Question 184
The 'wrong-way risk' multiplier in Basel SA-CCR for specific wrong-way risk exposures is:
Select an option first.
Correct answer: B — A supervisory add-on that increases the EAD of a derivative when there is identified specific wrong-way risk between the reference entity and the counterparty's creditworthiness — regulators may require the derivative to be treated as if the exposure equals the full notional.
Explanation: Specific wrong-way risk (SWWR): identified when the reference asset/underlying has adverse correlation with the counterparty's credit quality. Example: buying CDS protection on a bank's own reference portfolio from that bank. SA-CCR: SWWR exposure = full notional × (1 − recovery rate), overriding the standard EAD calculation. A is wrong; C is arbitrary; D is too narrow.
Question 185
A CRO presents to the board that the bank's 'through-the-cycle' credit loss estimate for the corporate loan book over the next recession is $500m, while the current IFRS 9 provisions (PIT, forward-looking) are $300m. The $200m difference represents:
Select an option first.
Correct answer: B — The potential additional provision charge expected as the economy deteriorates and Stage 1/2 loans migrate to Stage 3 — a key input to the bank's capital planning and stress testing process.
Explanation: The TTC estimate ($500m) exceeds current PIT provisions ($300m): the gap ($200m) reflects the expected future provision build-in a recession. This informs: (1) stress test loss estimates; (2) capital adequacy under adverse scenarios; (3) ICAAP capital planning. It is NOT additional capital required now (C) or distributable (D). A is possible but the more useful interpretation is B.
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Question 186
The 'systemic risk contribution' concept in macroprudential policy suggests that G-SIBs should:
Select an option first.
Correct answer: B — Internalise the social cost of their systemic importance through additional capital surcharges — reflecting that their potential failure imposes externalities on the financial system and economy beyond their individual shareholders.
Explanation: Internalising systemic externalities: without surcharges, G-SIBs would take excessive risk (the gains are private, the systemic failure costs are socialised). The G-SIB surcharge creates an incentive to reduce systemic footprint. It doesn't eliminate the TBTF problem entirely but reduces the probability of G-SIB failure and its cost. A, C, D are incorrect policy approaches.
Question 187
In a 'reverse stress test' for credit risk, the process involves:
Select an option first.
Correct answer: B — Starting from a predefined failure outcome (e.g., CET1 falls to 0%, the bank cannot fund itself) and working backwards to identify what combination of credit events, macro scenarios, and correlations would produce that failure — surfacing previously unidentified vulnerabilities.
Explanation: Reverse stress testing: (1) define the failure state (what does insolvency look like?); (2) work backwards: what PD spike, LGD increase, concentration defaults would get us there?; (3) assess plausibility of these scenarios; (4) identify vulnerabilities. This uncovers 'unknown unknowns' that forward stress tests miss. A is reverse; C is sensitivity analysis; D is supervisory stress test.
Question 188
The 'credit risk adjustment' to RAROC accounts for:
Select an option first.
Correct answer: B — Deducting expected credit losses and the cost of economic capital (allocated capital × hurdle rate) from the revenue generated by a credit activity, producing a true risk-adjusted return.
Explanation: RAROC = (Revenue − Expected Loss − Operating Cost − Allocated Capital × Hurdle Rate) / Economic Capital. The credit risk adjustment means: (1) revenue is reduced by ECL (EL must be priced in); (2) economic capital is the denominator (not total exposure). This shows whether the activity earns above the cost of equity capital after all credit costs.
Question 189
The 'PD-LGD correlation' is important in credit portfolio models because:
Select an option first.
Correct answer: B — When PD increases (recession), LGD also tends to increase (falling collateral values) — this positive correlation amplifies credit portfolio tail losses beyond what assuming independent PD and LGD would produce.
Explanation: PD-LGD correlation (procyclical amplification): in recessions, (1) PD rises as borrowers are stressed; (2) LGD rises as collateral values fall and recovery processes are impaired. Both moving in the same direction simultaneously amplifies actual credit losses vs models that assume PD and LGD are independent. Basel prescribes downturn LGD to partially address this. A underestimates the impact; C and D are wrong.
Question 190
Under the new EU Banking Package (CRR3/CRD6 implementing Basel IV), the F-IRB 'input floor' for LGD requires:
Select an option first.
Correct answer: B — A supervisory LGD floor (e.g., 25% for unsecured corporates, 10-40% depending on collateral type) below which banks cannot set their LGD estimate, even if their internal data supports a lower number.
Explanation: Basel IV LGD input floors: minimum LGD estimates regardless of bank's internal data: unsecured senior corporate = 25%, unsecured subordinated = 25%+, secured by CRE = 15%, secured by financial collateral = 0%. These floors prevent banks from using extremely low LGD estimates from limited (potentially unrepresentative) default data. A has no constraint; C uses Foundation IRB SA LGD (only for unsecured); D is incorrect.
Question 191
A bank calculates its 'effective expected positive exposure' (Effective EPE) for a portfolio of interest rate swaps with a single netting set. The effective EPE is higher than the simple average EPE because:
Select an option first.
Correct answer: B — Effective EPE is a non-decreasing profile — it doesn't allow exposure to fall as swaps mature, reflecting the fact that capital must be held for the maximum exposure reached up to each maturity date, not the average of instantaneous exposures.
Explanation: Effective EPE: EEE(t) = max(EEE(s), EE(t)) for s < t — non-decreasing. This constraint reflects that capital cannot be reduced below the highest exposure previously encountered in the simulation. Simple EPE allows exposure to decline (e.g., as near-term swaps mature). Basel IMM uses Effective EPE × α=1.4 for EAD. A and C are wrong; D is incorrect.
Question 192
A credit committee is reviewing a request to grant an exception to standard credit policy for a 'relationship-driven' deal that does not meet minimum financial covenant requirements. The most appropriate governance response is:
Select an option first.
Correct answer: B — Escalate the exception to the appropriate level in the credit authority matrix, document the exception and its rationale clearly, track it in an exceptions register, and monitor the account more closely post-approval.
Explanation: Exception management best practice: (1) proper escalation (senior credit officer, credit committee); (2) full documentation of exception rationale, risks, and mitigants; (3) exceptions register (allows portfolio-level monitoring of exception rate and performance of exception approvals); (4) enhanced monitoring. A substitutes revenue for credit quality; C is inflexible (legitimate exceptions exist); D removes independent oversight.
Question 193
The 'credit concentration adjustment' in the supervisory formula for securitisation capital (SEC-SA under CRR2) is designed to:
Select an option first.
Correct answer: B — Increase capital for securitisation tranches backed by concentrated collateral pools (fewer, larger exposures) where idiosyncratic default risk is not fully diversified — reflected through a higher effective number of loans (N) in the formula.
Explanation: SEC-SA: uses parameters including pool credit quality, LGD, effective maturity, and tranche thickness. The 'number of effective exposures' N adjusts for concentration: N = (Σ EAD)² / Σ EAD² (Herfindahl-based). Lower N (more concentrated) = higher capital. A and C are wrong; D is incorrect.
Question 194
A credit risk model developed for large corporate credits uses 'shadow ratings' (internal ratings mapped to external rating scale). The primary challenge of this approach is:
Select an option first.
Correct answer: B — Validating shadow ratings requires comparing predicted default rates to actual defaults for large corporates — but large corporate defaults are very rare, making statistical validation over short time periods difficult.
Explanation: Shadow rating validation challenge: large corporates have very low PDs (e.g., 0.05-0.5%/year). To observe even 5 defaults at 0.1% PD, you need 5,000 borrower-years of data. With a portfolio of 100 large corporates, that's 50 years of data. Statistical significance is very hard to achieve. External data (rating agency default studies) must supplement sparse internal data. A is wrong; C is wrong; D is incorrect.
Question 195
Under IFRS 9, the concept of 'reasonable and supportable information' in ECL models requires:
Select an option first.
Correct answer: B — Incorporating all forward-looking macroeconomic information and borrower-specific information that is available without undue cost or effort — including economic forecasts, sector outlooks, and borrower-level signals.
Explanation: IFRS 9 reasonable and supportable information: banks must use all relevant available information — not just historical data. Includes: macroeconomic forecasts (GDP, unemployment, property prices), sector-specific data, borrower-specific forward-looking signals. 'Without undue cost or effort' is a practical constraint. A restricts to audited history; C is too strict; D reverts to incurred loss model.
Question 196
A bank's 'credit risk escalation policy' requires that loans deteriorating to watch-list status be escalated to:
Select an option first.
Correct answer: B — A senior credit officer or dedicated special mention committee for enhanced monitoring, with formal escalation to the CRO and credit committee if deterioration continues.
Explanation: Escalation framework: Stage 1 (pass) → standard monitoring. Watch-list/Stage 2 → escalate to senior credit officer/Special Mention Committee → enhanced monitoring, action plan. Non-performing/Stage 3 → escalate to CRO, credit committee, potentially workout team. Regulatory notification (C) required only for material events. A and D are incorrect.
Question 197
The 'fundamental review of the trading book' (FRTB) treatment of 'default risk' in the trading book requires:
Select an option first.
Correct answer: B — A separate 'Default Risk Charge' (DRC) calculated using a one-year, 99.9% confidence level jump-to-default simulation — capturing the risk of sudden default not captured by gradual spread widening in the ES model.
Explanation: FRTB DRC: captures JTD (jump-to-default) risk in the trading book over a 1-year horizon at 99.9% confidence. Separate from the ES calculation (which captures gradual spread moves but underestimates sudden default). DRC uses a two-factor correlation model. A is wrong (ES doesn't fully capture JTD); C is SA shorthand; D is incorrect.
Question 198
Under the 'internal ratings-based' approach, the 'maturity adjustment' in the Basel capital formula increases capital for longer-maturity exposures. The economic rationale is:
Select an option first.
Correct answer: B — Over a longer horizon, there is more time for credit migration to occur — a currently good credit may migrate to a poorer rating (and higher spread) before maturity, creating MTM losses even without default.
Explanation: Maturity adjustment economic rationale: for a 5-year loan vs 1-year loan to the same borrower, the 5-year has more time for credit migration (e.g., A to BB) which affects mark-to-market value and economic risk even before default. The adjustment captures this additional migration risk. A, C, D are incorrect.
Question 199
The 'Basel III net stable funding ratio' (NSFR) requires that 'available stable funding' must exceed 'required stable funding' by at least 100%. A bank failing this test would most likely need to:
Select an option first.
Correct answer: B — Lengthen its funding profile by issuing longer-term bonds, reducing reliance on short-term wholesale funding, or reducing the amount of illiquid long-term assets on its balance sheet.
Explanation: NSFR remediation: to increase NSFR, either: (1) increase available stable funding (issue long-term debt, grow retail deposits, increase equity); or (2) reduce required stable funding (reduce illiquid long-term assets, shorten asset duration). A is wrong; C addresses capital, not liquidity; D may reduce RSF temporarily but moves risk rather than eliminating it.
Question 200
A portfolio credit risk analyst calculates that adding a new $10m credit to a diversified portfolio increases portfolio credit VaR by $500,000. The 'marginal credit VaR' per unit exposure is:
Select an option first.
Correct answer: B — $50,000
Explanation: Marginal credit VaR = $500,000 / $10m = $50,000 per $1m of exposure = 5% of the exposure. This can be compared to the standalone credit VaR of the position to assess the diversification benefit of adding this credit to the portfolio. D is 5% = $500k/$10m (percentage form). A is the total, not per unit; C and D need clarification — B ($50k per $1m) is the per-unit marginal VaR.
Question 201
In the context of 'climate stress testing' for credit risk, a 'disorderly transition' scenario involves:
Select an option first.
Correct answer: B — A sudden, unexpected policy tightening on carbon emissions causing rapid repricing of fossil fuel assets, stranded asset losses, and credit deterioration across carbon-intensive sectors.
Explanation: Disorderly transition: an abrupt policy shock (e.g., sudden introduction of $150/tonne carbon tax, unexpected renewable energy mandate) that catches energy and carbon-intensive companies off-guard. Asset stranding occurs when proven fossil fuel reserves become uneconomical. Banks with concentrated energy sector exposures face sudden credit deterioration. A is orderly transition; C is physical risk; D is orderly transition.
Question 202
A bank's 'credit risk model governance' framework should include which validation frequency?
Select an option first.
Correct answer: B — Models should be validated on an ongoing basis — annual full validation, continuous performance monitoring (monthly backtesting, portfolio-level calibration checks), and triggered reviews when material model failures or regulatory changes occur.
Explanation: Model governance best practice: (1) initial full validation before use; (2) annual full validation (AUROC, calibration, segmentation); (3) ongoing monthly/quarterly monitoring (default rate tracking, rating stability); (4) triggered reviews (significant portfolio changes, economic regime shift, regulatory change); (5) independent validation (separate from development). A, C, D represent inadequate governance.
Question 203
The 'leverage ratio' under Basel III complements the risk-based capital ratio by:
Select an option first.
Correct answer: B — Providing a non-risk-sensitive backstop that prevents banks from achieving very low risk-weighted capital ratios by using sophisticated models to assign very low risk weights to large portfolios.
Explanation: Leverage ratio backstop: Tier 1 / Total Exposure ≥ 3%. It is deliberately non-risk-sensitive — treats all assets equally. This prevents gaming: a bank cannot use internal models to assign extremely low risk weights to its entire balance sheet, potentially achieving very low RWA while maintaining high actual leverage. A is wrong; C is NSFR/LCR; D is capital structure, not leverage ratio.
Question 204
A bank's 'credit risk appetite for leveraged lending' is tested when:
Select an option first.
Correct answer: B — A loan is proposed to a company with Debt/EBITDA of 7× in a cyclical industry, requiring consideration of whether the leveraged lending risk appetite permits loans above the bank's maximum leverage threshold and at what terms.
Explanation: Leveraged lending credit risk appetite: banks set maximum Debt/EBITDA limits (e.g., max 6×) for leveraged lending. A 7× request: (1) is it within policy?; (2) if exception, is it escalated properly?; (3) does the sector cyclicality justify concern?; (4) are mitigants (strong EBITDA, asset coverage, sponsor support) sufficient? A is too broad; C and D are unrelated to leveraged lending appetite.
Question 205
A 'CDS on loan' (LCDS) differs from a standard bond CDS in that:
Select an option first.
Correct answer: B — LCDS references syndicated secured loans with physical settlement typically requiring delivery of the specific loan — loan recovery rates are usually higher, resulting in lower LCDS spreads than bond CDS for the same issuer.
Explanation: LCDS (Loan CDS): references secured leveraged loans with higher recovery rates (~60-70%) vs senior unsecured bonds (~40%). Lower LGD → lower LCDS spread for same issuer. Physical settlement requires delivery of the specific loan instrument, making it more complex. A reverses the reference; C and D are incorrect.
Question 206
The 'effective notional' in a CDO tranche represents:
Select an option first.
Correct answer: B — The portion of the reference portfolio's notional that the tranche is exposed to — determined by tranche thickness (detachment minus attachment point) multiplied by portfolio notional.
Explanation: Tranche notional = (Detachment% − Attachment%) × Portfolio Notional. A 5-10% tranche on a $500m portfolio: notional = (10%−5%) × $500m = $25m. This $25m is the maximum loss the tranche holder can suffer. A is the full portfolio; C is market value; D is the synthetic structure's CDS notional.
Question 207
In CLO analysis, a 'CCC bucket' concentration limit restricts:
Select an option first.
Correct answer: A — The maximum notional of loans rated CCC or below, typically capped at 7.5% of the portfolio.
Explanation: CCC bucket: CLOs typically permit a maximum of 7.5% of the portfolio in loans rated CCC or below (triple-C and defaulted). Excess above the haircut threshold means only a fraction of CCC loans count toward par for OC tests, effectively penalising CCC concentration. B, C, D are not standard CCC bucket definitions.
Question 208
The 'excess spread' in a CLO waterfall acts as a credit enhancement because:
Select an option first.
Correct answer: B — Interest income from the portfolio exceeding note coupon payments and expenses is initially trapped and used to build the OC cushion before flowing to equity — absorbing small losses before principal is impaired.
Explanation: CLO excess spread: the difference between portfolio interest income and note/expense payments. In a healthy CLO, this flows to equity. In a stressed CLO, it is diverted to senior note repayment (OC test mechanic) or trapped in a principal account. This makes excess spread the first line of credit defence — it absorbs losses before any note principal is impaired. A, C, D are wrong.
Question 209
An 'interest rate swap' embedded in a CLO structure converts:
Select an option first.
Correct answer: B — Fixed-rate loans in the CLO portfolio to a floating rate (SOFR + spread) — necessary when some loans pay fixed rates but CLO notes pay floating SOFR-based coupons.
Explanation: CLO interest rate hedge: most leveraged loans pay SOFR + credit spread (floating). CLO notes also pay floating (SOFR + note spread). However, if some loans are fixed-rate, the CLO needs an interest rate swap to convert fixed income to floating, matching the floating note liabilities. A, C, D are not the purpose of the embedded swap.
Question 210
The 'market value test' in a CLO (less common than OC test) requires:
Select an option first.
Correct answer: B — The market value of the loan portfolio to exceed a specified multiple of the outstanding note balance — if market value falls, the CLO manager must sell loans and repay notes.
Explanation: Market value CLO: repayment depends on portfolio market value (not cash flow). If portfolio MV / Note balance < trigger → sell assets → repay notes. More common in pre-2008 structured vehicles; cash flow CLOs (most modern CLOs) use OC tests based on par value, not market value. A, C, D are incorrect.
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