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FRM Part II Updated
How does insurance reduce operational risk capital under Basel rules?
Insurance mitigation under Basel's Advanced Measurement Approach allows banks to reduce operational risk capital by up to 20% to recognize genuine loss transfer, subject to strict eligibility criteria...
What happens in a pension buy-out transaction?
A buy-out transfers pension liability to an insurer via group annuity, while a buy-in holds the policy as a plan asset.
What is the supervisory slotting approach for specialized lending?
Slotting applies to specialized lending (PF, OF, CF, IPRE, HVCRE) where PD/LGD data is insufficient. Banks slot into 5 categories: Strong 70%, Good 90%, Satisfactory 115%, Weak 250%...
Why do ESG ratings from different agencies diverge so much, and what does this mean for risk management?
ESG rating divergence stems from scope differences (what is measured), measurement differences (how it is measured), and weighting differences (what matters most). With correlations of only 0.38-0.71 between agencies, risk managers should use multiple sources and focus on sector-specific materiality.
How does cross-product netting reduce counterparty exposure, and what are the legal and operational prerequisites for it to work?
Cross-product netting extends close-out netting across different derivative types under a single ISDA Master Agreement, providing 20-40% additional exposure reduction beyond single-product netting. It requires consistent legal documentation and enforceability opinions across product types.
How is the G-SIB score calculated, and how does it determine the additional capital buffer a bank must hold?
The G-SIB score aggregates five equally-weighted indicator categories — size, interconnectedness, substitutability, complexity, and cross-jurisdictional activity — each scored relative to the banking system total. The resulting score places banks into buckets with CET1 surcharges from 1.0% to 3.5%.
How does the FAIR model quantify cyber risk in financial terms, and what makes it different from qualitative risk assessments?
The FAIR model quantifies cyber risk by decomposing it into loss event frequency (threat frequency times vulnerability) and loss magnitude (primary and secondary losses), then running Monte Carlo simulations to produce probabilistic dollar estimates. Unlike qualitative heat maps, FAIR enables cost-benefit analysis of security investments.
How does the countercyclical capital buffer work, and how do national regulators decide when to activate or release it?
The countercyclical capital buffer requires banks to hold 0-2.5% additional CET1 capital during excess credit growth, guided by the credit-to-GDP gap. It is built slowly during booms and released immediately during stress to support continued lending.
What is procyclicality in banking regulation, and how do risk-sensitive capital requirements amplify economic cycles?
Procyclicality means risk-sensitive capital requirements decrease during booms and increase during busts, amplifying economic cycles. Basel addresses this through countercyclical buffers, through-the-cycle PD calibration, stressed risk measures, and the leverage ratio backstop.
What is the conditional coverage test in VaR backtesting and how does it improve on Kupiec's test?
The Christoffersen conditional coverage test checks both whether the correct number of VaR exceptions occurs and whether exceptions are independent over time. It improves on Kupiec's test by detecting dangerous clustering of exceptions.
What is P&L attribution (P&L explain) and how does it relate to the risk-theoretical P&L in FRTB?
P&L attribution (P&L explain) is a critical model validation tool under the FRTB. It tests whether the risk model used for IMA capital can actually explain the desk's real profits and losses.
How do banks aggregate risk across trading desks, and what are the challenges with recognizing diversification benefits?
Banks aggregate desk-level VaR using correlation matrices, benefiting from diversification. However, correlations spike during crises, and regulators impose floors on aggregation benefits. The Basel FRTB framework uses ES with prescribed correlation parameters.
How is economic capital for credit risk calculated, and how does it differ from regulatory capital?
Economic capital covers unexpected credit losses at a chosen confidence level. It equals the loss quantile minus expected loss, reflecting the capital buffer needed beyond provisions to absorb tail risk events.
How does reverse stress testing work in practice and what makes it different from regular stress tests?
Reverse stress testing inverts the traditional approach: instead of asking how bad losses could get, it asks what would have to happen for the firm to fail. This methodology is uniquely powerful for uncovering hidden vulnerabilities.
What is the Fundamental Review of the Trading Book (FRTB), and how does it change market risk capital?
The Fundamental Review of the Trading Book (FRTB) is a major overhaul of market risk capital requirements. Key changes include replacing VaR with Expected Shortfall, introducing the sensitivities-based standardized approach (delta, vega, curvature), requiring desk-level model approval, and capitalizing non-modellable risk factors.
How does scenario-based capital assessment work under AMA?
Under the Advanced Measurement Approach (AMA), scenario analysis outputs directly inform the operational VaR at 99.9% confidence over a one-year horizon...
How does a pension glide path work mechanically?
A glide path uses funded-ratio triggers to shift allocation from return-seeking to liability-hedging as surplus grows.
What is the maturity adjustment in the IRB formula and why does longer maturity need more capital?
MA = (1 + (M-2.5)·b(PD)) / (1 - 1.5·b(PD)), where b(PD) = [0.11852 - 0.05478·ln(PD)]². 5Y loan gets 51.8% more capital than 2.5Y baseline. Captures migration risk...
What is double materiality, and how does it differ from the single materiality approach used in traditional financial reporting?
Double materiality requires assessing ESG topics from two perspectives: how they affect the company financially (outside-in) and how the company impacts society and environment (inside-out). Required by the EU CSRD, it broadens disclosure beyond traditional financial materiality to capture impact-only material topics.
What is CoVaR, and how does it measure the systemic risk contribution of individual financial institutions?
CoVaR measures the system-wide VaR conditional on a specific institution being in distress. DeltaCoVaR captures the marginal contribution of that institution to systemic risk, revealing hidden interconnectedness that individual VaR cannot detect. It is estimated using quantile regression and has influenced G-SIB capital surcharge calculations.
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