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FRM Part II Updated
What is the regulatory PD floor and how does it affect bank capital?
Basel III final imposes 0.03% PD floor for most IRB portfolios. Prevents model uncertainty and level-plays with standardized. Hartwell's AAA modeled at 0.012% gets floored, raising RWA 60%...
How does deposit insurance create moral hazard, and what mechanisms are used to mitigate excessive risk-taking by insured banks?
Deposit insurance creates moral hazard by removing depositors' incentive to monitor bank risk-taking, allowing banks to fund risky activities with artificially cheap insured deposits. Mitigants include risk-based premiums, capital requirements, supervisory examination, and prompt corrective action.
What are the single-point-of-entry and multiple-point-of-entry strategies for cross-border bank resolution?
Single Point of Entry resolves a G-SIB only at the parent level, absorbing losses through bail-in of parent TLAC and keeping subsidiaries operating. Multiple Point of Entry resolves multiple entities simultaneously across jurisdictions. The choice depends on the group's organizational structure.
What is the Default Risk Charge under FRTB and how is it calculated?
The Default Risk Charge captures jump-to-default risk — the sudden loss when an issuer defaults. It is calculated by computing JTD amounts (notional times LGD), netting within the same obligor, applying rating-based risk weights, and aggregating with prescribed correlations.
How does SA-CCR compute exposure at default for derivative portfolios?
SA-CCR is the Basel Committee's standardized method for computing Exposure at Default (EAD) for derivative positions. The master formula is EAD = 1.4 x (RC + PFE), where RC is replacement cost and PFE is potential future exposure.
How should risk managers think about event risk — the kind that standard models completely miss?
Event risk involves sudden, severe market dislocations that standard VaR models cannot capture. Practical management combines stress testing, reverse stress testing, scenario analysis, and position limits — supplementing quantitative models with expert judgment.
What are covered bonds, and how do they differ from regular asset-backed securities?
Covered bonds differ from ABS through dual recourse — investors can claim against both the cover pool and the issuing bank. Assets stay on-balance-sheet with dynamic management and overcollateralization, making them structurally safer.
What are regime-switching models and how are they applied to market risk?
Regime-switching models assume that financial markets alternate between distinct states — typically a calm regime and a volatile crisis regime — each governed by different statistical parameters. They capture the abrupt shifts between market conditions that standard GARCH models miss.
Can you explain each of Basel's seven operational risk event types with examples?
Basel's seven operational risk event types provide a consistent taxonomy across banks globally. Here is each with illustrative examples...
How does a defined benefit pension fund approach enterprise risk management?
DB pension risk management is fundamentally ALM: funded-ratio volatility driven by rates, inflation, longevity, and contribution risk.
How does Basel set the correlation parameter R in the IRB formula?
Basel prescribes R: corporate formula interpolates 24% (low PD) to 12% (high PD). QRRE fixed at 4%, mortgage 15%. Higher credit quality = higher systematic correlation...
What is the Residual Risk Add-On (RRAO) under FRTB and which instruments trigger it?
The RRAO is a safety net for exotic risks not captured by the SbM or DRC. It applies at 1.0% of notional for instruments with exotic underlyings (weather, longevity) and 0.1% for complex payoff structures (barriers, digitals, correlation trading).
What is the output floor under Basel III finalization, and how does the phase-in schedule work?
The output floor ensures that banks using internal models cannot produce capital requirements less than 72.5% of what the standardized approach would require. It phases in gradually from 50% to 72.5% over several years.
What is correlation risk, and how does wrong-way risk amplify losses during market stress?
Correlation risk arises when dependency structures change unexpectedly, often spiking during crises. Wrong-way risk amplifies this by increasing exposure precisely when counterparty credit deteriorates, creating maximum loss at maximum default probability.
How do you assess sovereign credit risk, and what makes it different from corporate credit risk?
Sovereign credit risk assessment combines quantitative fiscal/economic metrics with qualitative political and governance factors. Unlike corporates, sovereign default involves willingness-to-pay considerations and lacks a bankruptcy framework for enforcement.
How do banks classify operational loss events for reporting?
Basel II/III defines seven operational risk event type categories, each with a precise scope and a set of Level-2 sub-categories...
What is the ASRF model and why is it the backbone of Basel IRB capital?
ASRF model assumes infinite granularity and single systematic factor. Conditional PD = Φ((Φ⁻¹(PD) + √R·Φ⁻¹(0.999))/√(1-R)). Portfolio invariance lets banks add capital per loan...
What is operational resilience and how does it differ from traditional operational risk management?
Operational resilience assumes failures will happen and focuses on the organization's ability to continue delivering critical services through disruption. Unlike operational risk management (which prevents failures), resilience sets impact tolerances and tests scenarios against them.
What is the ICAAP under Pillar 2, and how does it differ from Pillar 1 minimum capital?
The ICAAP is a bank's own comprehensive assessment of whether its capital is adequate for ALL material risks — not just the risks captured by Pillar 1 formulas. It covers IRRBB, concentration risk, business risk, and more.
What are the main strategies for hedging tail risk, and what are their costs and tradeoffs?
Tail risk hedging strategies range from protective puts (expensive but direct) to variance swaps (convex payoff), put spreads (cost-reduced), trend following, and dynamic hedging. Each involves a fundamental cost-protection tradeoff.
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