AIM 1: Discuss the scope of the Basel II Accord and how it applies to various bank subsidiaries or business relationships.

1、MainBank is a bank holding company with two subsidiaries, ElmBank and OakBank. ElmBank is an internationally active bank. OakBank is also an internationally active bank, and OakBank has an insurance subsidiary. The application of the Basel II framework in this situation should be to:

  I. ElmBank on a stand alone basis.

 II. MainBank on a consolidated basis.

III. OakBank’s insurance subsidiary on a stand alone basis.

IV. Oak Bank without consolidating the insurance subsidiary.

A) I and III only. 

B) III only.  

C) I and II only. 

D) I, II, III and IV. 

The correct answer is C

Related businesses such as insurance should be consolidated. The Accord calls on supervisors to look at not only the holding company, but also at each individual banking subsidiary to assure that the depositors of those subsidiaries are adequately protected by capital.

2、The Basel II Capital Accord corrected many of the deficiencies of Basel I. Which of the following statements is NOT accurate?

A) Basel I did not recognize the effects of diversification. 

B) Basel I did not recognize off-balance sheet activities. 

C) Basel II included a new role for supervisors. 

D) Basel II did not prevent the double counting of capital.

The correct answer is D

The Basel II Accord covers any holding company that may be the parent of other entities involved in banking activities, and it looks at the entire group on a consolidated basis. The idea is to include the risks held at any level of a multilevel banking group and to prevent the double counting of capital.

3、If an internationally active bank holding company has subsidiaries engaged in insurance activities:

A) those subsidiaries should be consolidated, and minimum capital requirements should be adjusted to reflect their risk. 

B) those subsidiaries should not be consolidated, and no adjustment to minimum capital requirements is necessary. 

C) those subsidiaries should be consolidated, but with no adjustment to minimum capital requirements. 

D) those subsidiaries should not be consolidated, but minimum capital requirements should be adjusted to reflect their risk.

The correct answer is A

All of the bank holding company’s related business operations should be consolidated, and the risk of those subsidiaries should be reflected in adjustments to capital requirements.

AIM 2: Define the types of capital, and discuss how each type is used to meet capital requirements under Basel II.

1、Tier 3 capital can be used to satisfy capital requirements resulting from:

A) market-risk charges only. 

B) credit-risk charges only. 

C) market-risk and credit-risk charges. 

D) only certain types of credit-risk charges.

The correct answer is A

Tier 3 capital can only be used to satisfy capital requirements resulting from market-risk charges and cannot be applied to credit-risk charges.

2、The balance sheet for James Bankholdings as of December 31, 2004 included the following items ($000):

Preferred Stock (noncumulative)                                  $800,000 

CommonStock                                                $1,200,000 

RetainedEarnings                                              $3,000,000 

Unrealized gains on long term Equity holdings                       $750,000

Based only on this information, estimate the Tier 1 and Tier 2 capital of James Bankholdings as of 12/31/04 (use $000):

      Tier 1                                  Tier 2

A) $5,000,000                                 $750,000

B) $4,200,000                               $800,000

C) $4,200,000                              $1,550,000

D) $5,000,000                                  $0

The correct answer is A

Tier 1 capital includes common stock, retained earnings and noncumulative preferred stock. Tier 2 capital would include the unrealized gains on long term investments.

3、Which of the following securities is included in Tier 1 capital?

  I. Common equity.

 II. Subordinated debt.

III. Hybrid instruments.

IV. Cumulative perpetual preferred stock.

A) I and II only.   

B) I and IV only.  

C) I, II, III, and IV.   

D) I only. 

The correct answer is D

Tier 1 capital, also called core capital, is composed of common equity, noncumulative perpetual preferred stock, and minority equity interest in consolidated subsidiaries, less goodwill and other deductions. Tier 2 capital, also called supplementary capital, is composed of hybrid instruments that are structured to be more or less permanent. These include cumulative perpetual shares and qualifying 99-year debt. Subordinated debt is a component of Tier 3 Capital.

 4、Tier 3 capital is allowed by the Basel Accord to cover:

  I. legal risks.

 II. credit risks.

III. market risks.

IV. operational risks.

A) I, II, and IV.  

B) III only.  

C) II and III only. 

D) I and II only. 

The correct answer is B

Tier 3 capital can be used to satisfy only market risks.

5、Tier 1 and tier 2 capital requirements differ from tier 3 capital requirements in that tier 1 and tier 2 are associated with:

A) credit-risk charges.

B) exchange-risk charges.

C) interest-rate risk charges.  

D) market-risk charges.

The correct answer is A

Tier 1 and tier 2 capital must first be applied to credit-risk charge amounts. Tier 1 and tier 2 capital can be used for market-risk charges only above those required by credit-risk charges. Tier 3 capital can only be used for market-risk charges.

6、Tier 1 capital is composed of all of the following EXCEPT:

A) common equity.  

B) non-cumulative perpetual shares. 

C) minority equity interest.  

D) cumulative perpetual shares. 

The correct answer is D

Cumulative perpetual shares is a component of tier 2 capital.

AIM 3: Describe the Basel II Accord’s requirements for calculating risk-weights using both the standardized and the internal ratings-based approaches when accounting for credit risk.

1、Which of the following assets requires a 0 percent risk weighting according to the Basel Accord?

A) Cash receivables.  

B) Cash. 

C) Residential mortgages. 

D) Industrial real estate investments.

The correct answer is B

Cash is the only asset that allows a zero percent risk weighting in the list.

2、An approach to assessing regulatory capital for operational risk that bases the capital charge upon a fixed percentage of an indicator (gross income) of operational risk exposure, where the percentage differs across business lines is the:

A) basic indicator approach.   

B) internal measurement approach.  

C) standardized approach.   

D) loss distribution approach. 

The correct answer is C

The standardized approach to measuring operational risk allows banks to divide activities along standardized business lines. The percentages of gross income differ across business lines in the standardized approach.

3、The standardized approach to estimating the risk arising from asset securitization:

A) requires a reduction of capital for unrated positions.   

B) is more commonly known as the external Ratings-Based Approach (RBA). 

C) treats securitized assets consistently regardless of credit rating until a default occurs.  

D) has stricter requirements than the IRB approach for transferring of risk through securitization.

The correct answer is A

Under the standardized approach, unrated positions entail a deduction of capital, so that issuers have no incentive to avoid ratings of high risk tranches. Note that the standardized approach gives riskier assets higher risk rates. Also, the RBA approach refers to the external ratings based approach used by banks getting an external assessment of its asset risks.

4、Under the new Basel Capital Accord there are two IRB approaches, foundation and advanced, to calculating risk weights in determining a bank’s minimum capital requirement for credit risk. For which of the following types of exposures is the foundation approach precluded?

A) Corporate exposures.  

B) Retail exposures.

C) Sovereign exposures.  

D) Bank exposures.

The correct answer is B

In general, a bank is expected to be more attuned to the risks associated with the retail loans they make, so there is no foundation alternative for retail exposures.

5、Under the IRB approach to credit risk, a bank that originates a securitization and retains a first loss position in that securitization must:

A) deduct the position from capital if it is of low credit quality.  

B) apply a higher risk weight to the position. 

C) deduct this position from capital.   

D) rid itself of the position within 90 days.

The correct answer is C

Under the IRB approach to credit risk, first loss provisions must de deducted from regulatory capital.

6、Under the Basel II Capital Accord, the standardized approach to credit risk requires that loans considered past due be risk weighted at:

A) 150%. 

B) 100%.  

C) 200%. 

D) 80%.

The correct answer is A

Under the Basel II Accord, loans considered past due are risk weighted at 150% to reflect their greater risk profile.

7、Under the IRB approach of the Basel II Accord, an unexpected loss:

A) should be part of the probability of default (PD) calculation.  

B) might occur as a result of an economic downturn.  

C) should be covered by loan loss provisions and interest margins.   

D) can be avoided by using historical default rates to estimate losses.

The correct answer is B

Losses predicted by historical default rates are expected and should be covered by loan loss provisions. Unexpected losses are unexpected variations from expected losses. An example would be the losses that arise during an economic downturn when many loans default at the same time.

8、Under the Basel II Accord, the standardized approach to credit risk weighting requires all of the following EXCEPT:

A) wherever possible, risk weights must be based on external risk assessments. 

B) past-due loans must receive a credit risk weighting of 150%.  

C) risk exposures with no external weighting must receive a risk weighting of 100%.  

D) sovereign credit risks must receive the same risk weighting as corporate credits domiciled in that sovereign. 

The correct answer is D

The standardized approach is based primarily on external risk assessments. If no such risk assessments are available, this approach requires a 100% risk weighting. Past due loans must be given a 150% risk weight. However, sovereign (government) credit risks would probably receive lower risk weights than corporate credits due to the added flexibility that governments have as opposed to corporations.

15、The advanced IRB approach to calculating risk weights for corporate, sovereign, and bank exposures requires the bank to abide:

A) only by supervisory-set probabilities of default (PD).  

B) by supervisory-set PD and losses given default (LGD).  

C) only by supervisory-set LGD.  

D) by supervisory-set documentation requirements.

The correct answer is D

The advanced IRB approach allows banks to set their own PD and LGD, as long as they meet rigorous standards of supervisory documentation requirements.

AIM 4: Discuss the concepts of expected loss, unexpected loss calibration, and downturn loss given default that are part of the IRB approach.

1、The Basel II Accord incorporates the concept of a downturn LGD. The rationale for using a downturn LGD is to:

A) provide a more conservative estimate of unexpected losses.  

B) assure that banks have adequate reserves to cover expected losses. 

C) force banks to use historical default rates in estimating unexpected losses.  

D) generate a more accurate estimate of default probability (PD).

The correct answer is A

A downturn LGD assumes several borrowers in similar areas simultaneously default, as a result of an economic downturn. This gives rise to an unexpected loss. If historical default rates are used, the loss estimate will probably be too low.

2、Name concentration represents a violation of which condition necessary for the ASRF IRB model?

A) The assumption that all borrowers in the same region and industry have a correlation of 0.5.  

B) Risk weights for each obligor depend upon the systematic risk specific to the portfolio.

C) Systematic risk is defined by a single factor.  

D) Portfolios are composed of granular assets.

The correct answer is D

Name concentration represents an excess exposure to a specific obligor in the portfolio making assets non-granular.

AIM 5: List the necessary conditions for the IRB credit risk weight function.

1、Which of the following are NOT conditions for the IRB credit risk weight function?

A) Calculation of risk weights should be independent of the specific portfolio.

B) Expected and unexpected losses are covered by capital.  

C) The model includes a single market risk factor. 

D) All idiosyncratic risk is diversified away.

The correct answer is B

Only unexpected capital losses are covered by capital. Expected losses are covered by earnings or reserves.

2、The portfolio invariance assumption of the IRB credit risk model does NOT include:

A) correlation with other assets in the portfolio. 

B) diversification indirectly by calibrating the risk weight equation for a well diversified bank.

C) calculation of risk independent of the specific portfolio.  

D) correlation with a systematic risk factor.

The correct answer is A

Correlation with other assets in the portfolio is not explicitly included in the risk estimation.

AIM 6: Explain the IRB credit risk weight function, the variables, and their interrelationships.

1、The conditional PD used in the IRB credit risk weight function is based on:

      I. An asymptotic risk factor.

     II. A systematic risk factor of 0.0999.

    III. A correlation weighted sum of the default threshold and the systematic risk factor.

    IV. A Merton based mapping of downturn PD’s.

A) One of the above.  

B) Two of the above. 

C) Three of the above.  

D) All the above.

The correct answer is B

Statements II and IV are true. The conditional PD is based on a systematic risk factor of 0.999 and a Merton based mapping of average PD’s.

2、Which of the following are not TRUE regarding the ASRF IRB model?

      I. Correlations are calculated for each asset class.

     II. Maturity effects are less dramatic for low PD assets.

    III. PD estimates should reflect the PD in economic downturns.

    IV. Long-term credits are riskier than short-term credits.

A) II and III.  

B) II only. 

C) I and II.  

D) III and IV.

The correct answer is A

Maturity effects are more dramatic for low PD assets, as they have more opportunity to deteriorate in quality. LGD estimates are downturn estimates; PD are estimates of a normal economy.

3、The maturity adjustment in the IRB credit risk weight function is:

      I. Based on a standard maturity of 2.5 years.

     II. Equal to zero for a maturity of one year.

    III. Higher for long-term credits.

    IV. Higher for high PD’s.

A) I and III.  

B) II and III. 

C) I and IV.  

D) II and IV.

The correct answer is A

Equal to one for a maturity of one year. Higher for low PD’s.

4、The IRB asset correlations for the credit risk weight function are:

      I. 12% to 24% for corporates, sovereigns, and banks.

     II. 3% to 16% for retail exposures.

    III. 15% for mortgages.

    IV. 8% for revolving retail exposures.

A) One of the above is false.  

B) I and III are false. 

C) II and IV are false. 

D) All of the above are true. 

The correct answer is A

The asset correlation for revolving retail exposures is 4%.

5、High asset correlation in the IRB credit risk weight function is associated with:

      I. large corporate loans.

     II. larger firm size.

    III. retail loans.

    IV. higher PD assets.

A) I and II.  

B) II and III.  

C) I, II, and IV.  

D) I only.

The correct answer is D

Larger firm size only applies to corporates, not banks and sovereigns. This statement is only partly true, therefore false. Retail loans and higher PD assets, generally have lower correlations.

6、Which of the following suggest higher capital based on the IRB credit risk weight function:

      I. Higher systematic risk factor.

     II. Higher EL.

    III. Higher LGD.

    IV. Higher M.

A) II and IV.  

B) II, III, and IV.

C) I, III, and IV.

D) I, II, III, and IV.

The correct answer is C

EL is covered by revenues or reserves. It does not raise required capital.

AIM 7: Define name and sector concentration and the related violation of the conditions for the IRB risk weight function.

1、Sector concentration represents a violation of which condition necessary for the ASRF IRB model?

A) Assumption that all borrowers in the same region and industry have a correlation of 0.5.

B) Systematic risk is defined by a single factor.  

C) Risk weights for each obligor depend upon the systematic risk specific to the portfolio. 

D) Portfolios are composed of granular assets.

The correct answer is B

Sector concentration risk represents an exposure to an industry or geography creating additional systematic risk factors.

AIM 8: Explain the granularity adjustment in Gordy and Lütkebohmert, discussing recent innovation and continued concerns.

1、Which model measuring name concentration estimates an upper bound to the granularity adjustment?

A) Gordy and Lütkebohmert.

B) Vasicek.  

C) Emmer and Tasche. 

D) BET.

The correct answer is A

Gordy and Lütkebohmert estimates an upper bound to the granularity adjustment.

2、Which of the following are problems with Gordy and Lütkebohmert?

      I. The granularity adjustment may not work well on small portfolios.

     II. The model ignores idiosyncratic recovery risk.

    III. The adjustment is inconsistent with the IRB model.

    IV. The model performs poorly.

A) I and II.

B) II and III.

C) I and III.

D) II and IV.

The correct answer is C

The Gordy and Lütkebohmert granularity adjustment may not work well on small portfolios. Fortunately, the adjustment errors on the conservative side and may still be useful. Second, the underlying model is inconsistent with the IRB model and therefore, cannot be tested.

3、Gordy and Lütkebohmert find that extending the cut-off point of exposures:

      I. creates a small change in the granularity adjustment.

     II. decreases the estimates of systematic risk.

    III. increases the bank’s exposure to credit losses.

    IV. reduces required capital.

A) I only.  

B) I and III.

C) II and III.  

D) I and IV.

The correct answer is D

Gordy and Lütkebohmert suggest that extending the ‘cut-off’ point of exposures creates a small change in the granularity adjustment and reduces required capital.

AIM 9: Explain the gap between real economic capital and ASRF performance.

1、Which of the following explain the gap between real economic capital and the estimation generated by ASRF IRB model?

      I. Inaccurate data.

     II. Business cycles.

    III. Correlation estimates.

    IV. Model structure.

A) I and III.  

B) II only. 

C) III and IV.  

D) IV only.

The correct answer is C

The primary shortcomings of the ASRF IRB model are only one systematic risk factor and omission of inter- and intra-sector correlation.

2、Which sector concentration risk measurement model introduced an infection parameter allowing credit risk correlation across exposures?

A) BET.  

B) Duellmann. 

C) Garcia Cespedes et al.  

D) Pykhtin.

The correct answer is B

Duellmann extends BET by allowing credit risk to be correlated across exposures measured by a third parameter, the ‘infection’ probability between exposures. This violates the IRB model condition of portfolio invariance.

AIM 10: Compare and contrast Pykhtin, binomial expansion technique, Duellmann, Duellmann and Masschelein, and Garcia Cespedes et al. models to estimate capital.

1、Which sector concentration risk measurement model requires a complete structure of intra and inter sector correlation?

A) Duellman.  

B) Garcia Cespedes et al.

C) Pykhtin.  

D) Duellmann and Masschlein.

The correct answer is C

Pykhtin requires a complete structure of intra and inter-sector correlations.

2、Which of the following statements regarding models to estimate economic capital is (are) TRUE?

      I. Pykhtin and Garcia Cespedes et al. rely on average values of intra condition sector correlations.

     II. Garcia Cespedes et al. is a default mode model and ASRF IRB is a marked to market model.

    III. Duellmann is a multifactor model including three systematic risk measures.

    IV. The out of sample performance of the Garcia Cespedes et al. model is extremely good.

A) II and IV.  

B) I and IV. 

C) I, II, and III.  

D) III only.

The correct answer is A

Duellmann and Garcia Cespedes et al. rely on average values of intra and inter sector correlations. Duellman is classified as a tractable closed form solution, not a multifactor solution.

AIM 12: Discuss the Basel II Accord’s standardized and IRB treatments of asset securitization.

1、According to Basel II, if an internal ratings-based (IRB) bank retains a first-loss position in an asset securitization:

A) the bank must deduct this position from capital.   

B) an adjustment is made to the estimated loss given default.  

C) an adjustment is made to the estimated probability of default.

D) higher risk weights are applied.

The correct answer is A

The full amount of any first–loss position in an asset securitization (losses the bank must absorb before other security holders hear losses) is deducted from regulation capital under Basel II.

2、The Internal Assessment Approach (IAA) for calculating capital requirements for securitized assets is:

A) acceptable as a means of addressing the risk of unrated assets.  

B) the most common way for banks to determine the capital required for securitized assets.  

C) entirely independent of any external rating system.

D) available to any bank using IRB risk weighting methods.

The correct answer is A

Both the IAA and the Supervisory Formula (SF) approaches can be used for unrated assets. The IAA is only used in limited situations, with specific permission from the regulatory authority. The IAA is based on systems used by external ratings agencies.

3、The Standardized Approach to operational risk links a:

A) static proportion to a static risk indicator variable.

B) dynamic proportion to a static risk indicator variable.

C) static proportion to a dynamic risk indicator variable.  

D) dynamic proportion to a dynamic risk indicator variable.

The correct answer is D

The Standardized Approach to operational risk allows banks to assign dynamic risk indicators across business lines and allows the proportions attached to each indicator variable to vary (be dynamic) across risk indicators.

AIM 13: Discuss the supervisory backtesting framework used in conjunction with an institution’s internal models, and describe the 3-zone supervisory framework for evaluating backtesting results.

1、According to the Basel Accord, if the number of exceptions to the back-testing of value at risk (VAR) models exceeds four at the 99 percent confidence level, which of the following may occur (given 250 data points)?

A) Regulators may decrease the multiplier.  

B) Banks may ignore the model for future VARs. 

C) Regulators may increase the multiplier.  

D) Risk managers may be decertified.

The correct answer is C

The Basel Accord established a scale by which the multiplier may be increased for the number of exceptions above four (or 100 given 5,000 data points). For example, if a model has 5 exceptions, the multiplier will increase by 0.40 to 3.40 (or similarity, the floor value of 3 will be multiplied by 1.13 to get 3.4). This in turn increases the amount of capital a bank must hold, and in turn lowers performance measures like return on equity.

2、If a supervisory backtest for a 1-year period results in 127 exceptions, then the bank’s exposure would be classified as:

A) Green zone, and an exposure multiplier of 1.0 would be applied.  

B) Yellow zone, and an exposure multiplier of 1.0 would be applied. 

C) Red zone, and an exposure multiplier of 1.33 would be applied.  

D) Yellow zone, and an exposure multiplier between 1.1 and 1.3 would be applied.

The correct answer is D

For 127 exceptions, the exposure multiplier would be 1.17, in the yellow zone.

AIM 14: Discuss the three methods for addressing operational risk under the Basel II Accord.

1、The most data intensive approach to assessing regulatory capital for operational risk is the:

A) basic indicator approach.  

B) standardized approach. 

C) foundation internal ratings based approach.  

D) advanced measurement approach. 

The correct answer is D

The most data intensive approach to assessing regulatory capital for operational risk is the advanced measurement approach. Note that the foundation internal ratings-based approach is used for assessing credit risk.

2、The Basel II Accord recommends basic methods for assessing operational risk that estimate the risk by:

A) applying a floating percentage to operating assets based on their risk profiles.  

B) adding a premium to the credit risk measures used by the bank. 

C) adjusting the required capital by a fixed percentage of total bank assets.   

D) multiplying annual gross income by a set percentage. 

The correct answer is D

The basic indicator approach and the standardized approach both multiply gross income by a set percentage to estimate operational risk.

3、Regulators have proposed several approaches to determining a bank’s operational risk exposure. One approach which would allow each bank to use its own internal loss data to calculate the capital charge is the:

A) basic indicator approach.  

B) proprietary risk approach.

C) advanced measurement approach.  

D) internal factor approach.

The correct answer is C

Under the advanced measurement approach, each bank would use their own internal loss data to calculate the capital charge within standards set by the supervisor.

4、An approach to assessing regulatory capital for operational risk that bases the capital charge upon a fixed percentage of some measure (e.g., gross income) of operational risk exposure is the:

A) standardized approach.  

B) internal measurement approach. 

C) basic indicator approach.  

D) loss distribution approach. 

The correct answer is C

A fixed percentage of gross income is used in the basic indicator approach.

5、Under the basic indicator approach to measuring operational risk capital proposed in the New Basel Accord, a bank will hold capital for operational risk equal to a fixed percentage of the bank’s:

A) average annual revenues over the prior two years.   

B) average annual gross income over the prior three years.  

C) average market risk and credit risk capital over the prior three years.   

D) market risk capital in the previous year. 

The correct answer is B

The basic indicator approach measures the capital charge on a firm-wide basis. Banks will hold capital for operational risk equal to a fixed percentage of the bank’s average annual gross income over the prior three years. The committee has proposed 15% as an initial proportion of operational risk for the indicator.

6、One criticism of the BIS definition of operational risk is that it does not directly address:

A) strategic or reputational risk.  

B) risk of natural disaster. 

C) risk of inadequate or failed processes.  

D) human mistakes.

The correct answer is A

The BIS definition of operational risk is the risk of losses due to inadequate or failed processes, persons, and systems that cannot protect a firm from outside events. The BIS definition focuses on actual direct/indirect losses and does not directly address strategic or reputational risk.

7、Basel II allows which of the following options for the calculation of operational risk?

Standardized risk.

Foundation IRB approach.

Basic indicator approach.

A) I only.

B) II and III only.  

C) I and III only.  

D) I, II, and III.

The correct answer is C

For calculating operational risk requirements, the three allowed approaches are (1) basic indicator approach, (2) standardized approach, and (3) advanced measurement approach. The foundation IRB approach is used for credit risk.

8、A bank that wishes to adopt a framework for determining regulatory operational risk capital must meet the most stringent criteria if it wants to adopt the:

A) Advanced standardized approach (ASA).  

B) Advanced measurement approach (AMA).  

C) Basic indicator approach (BIA).  

D) Standardized approach (SA). 

The correct answer is B

The most stringent criteria are for adoption of the advanced measurement approach (AMA).

AIM 15: Discuss the “evolutionary aspect” of the risk measurement procedures addressed in the Basel II Accord.

1、Risk measurement procedures under the Basel II Accord take on an “evolutionary aspect” in that:

A) enhanced supervisory control will lead to more consistent risk assessment and more comparable bank risk profiles.   

B) stricter adherence to standardized risk assessment procedures will allow banks more flexibility to take on non-traditional risks.  

C) banks should be able to use their own internal risk assessments to improve accuracy in assessing their risk exposure. 

D) less conservative risk measures such as downturn loss given default (LGD) will allow banks to take on more risky strategies. 

The correct answer is C

The evolutionary aspect of Pillar I arises from the desired goal of having banks move away from standardized risk measurement approaches to foundation IRB approaches, and ultimately on to advanced IRB approaches. Under the advanced IRB approach, banks will use internal risk assessment models to keep pace with changes in the marketplace. Enhanced supervisory controls or stricter adherence to standardized risk assessment would be counter to this goal. Note that downturn LGD is a more conservative risk measure.