Pass the GARP Financial Risk and Regulation 2016-FRR Questions and answers with CertsForce

The Chief Risk Officer (CRO) should report to the CEO or the Board of Directors. This ensures that the CRO maintains independence from the business units whose activities they are monitoring and managing, which is critical for unbiased risk assessment and management.

When a bank has loans in the "pipeline," it means these loans are in the process of origination but have not yet been originated. During this period, the bank is exposed to both interest rate risk and credit risk.

Interest Rate Risk:This risk arises because changes in interest rates can affect the bank's profitability on these loans. If interest rates change unfavorably between the time the loan terms are set and the time the loan is actually issued, the bank might end up earning less than expected. This is particularly relevant in a volatile interest rate environment.

Credit Risk:Even though the loans are not yet originated, the bank assesses the creditworthiness of the potential borrowers during the pipeline stage. If the financial condition of a borrower deteriorates before the loan is finalized, the bank faces the risk of having to deal with a higher probability of default.

These risks are inherent to the loan origination process and are present even before the loan is officially on the bank's books.

Skewness measures the asymmetry of the return distribution. Positive skewness indicates a distribution with a longer or fatter right tail, while negative skewness indicates a distribution with a longer or fatter left tail. It is the correct measure for describing the symmetry of a statistical distribution.

When a trader inadvertently books a trade with incorrect information and a subsequent market move results in a gain for the bank, the event should be included in the operational loss event data program because:

Indication of Control Failure (II):The gain indicates that a control failed or a process is flawed. Even if the outcome was a gain, the underlying issue was a mistake, pointing to a weakness in the bank's operational controls that needs to be addressed.

Recording the Event as a Loss (III):Although the event resulted in a gain, it should be included in the operational loss event data program and recorded as a loss. The principle behind this is to ensure that all operational risk events are tracked, irrespective of their financial outcome, to provide a complete picture of operational risk exposures and to improve risk management practices.

Including such events helps in identifying and correcting process flaws to prevent future incidents that could result in actual losses.

References

How Finance Works.pdf, Index section​

A drawdown quantifies the peak-to-trough decline of an investment over a known time period. This measure is used to understand the maximum loss an investment has suffered from a peak to a subsequent trough, which is critical for risk assessment.

Day 1:

Bank Milo has $4 million in cash.

$5 million in loans coming due with an expected default rate of 1%.

The proceeds from the loans will be $5 million * (1 - 0.01) = $4.95 million.

Total cash available at the end of Day 1 = $4 million + $4.95 million = $8.95 million.

No outflows on Day 1.

Cumulative liquidity = $8.95 million (positive).

Day 2:

No cash inflow.

$9 million is due for a securities purchase.

Cumulative liquidity = $8.95 million - $9 million = -$0.05 million (negative).

Day 3:

No cash inflow.

$8 million due for commercial paper pay off.

Cumulative liquidity = -$0.05 million - $8 million = -$8.05 million (negative).

Therefore, Bank Milo faces negative cumulative liquidity on Days 2 and 3.

When a bank has a large number of auto loans and finds it difficult to sell them individually, it can take the following steps to raise cash:

Packaging into a Securitized Vehicle:The bank can package these auto loans into a securitized vehicle, such as a collateralized loan obligation (CLO) or an asset-backed security (ABS). By doing so, the bank can create a portfolio of loans that can be sold as a single security.

Selling the Low-Risk Portion:Once the loans are securitized, the bank can sell the low-risk portion of the portfolio to investors. This part of the portfolio is more attractive to investors because it typically offers lower risk and stable returns, making it easier to sell compared to individual loans.

The Capital Asset Pricing Model (CAPM) equation used to calculate the required return on a stock is:Required return = risk-free return + beta × (market risk premium).

This formula helps determine the return an investor should expect for taking on additional risk compared to a risk-free asset.

Present Value of a Basis Point (PVBP) measures the change in the value of a bond when the yield changes by one basis point (0.01%). This measure helps quantify the interest rate risk of a bond by indicating how much its price will fluctuate with small changes in yield.

Comprehensive and Detailed In-Depth Explanation:

Basel II defines operational risk as "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events," explicitly including legal risk (e.g., lawsuits, regulatory fines) but excluding strategic and reputational risks. Pandemic risk (A) is an external event but isn’t separately categorized—it falls under operational risk only if it disrupts processes. Strategic risk (B) relates to business decisions, and reputational risk (C) affects perception, not direct losses. Legal risk (D) is a core component, often arising from operational failures (e.g., non-compliance).

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 644: "Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk."

GARP FRR Study Notes, Operational Risk Section: "Legal risk, encompassing losses from litigation or regulatory penalties, is explicitly included in Basel’s operational risk definition, unlike reputational or strategic risks, which are managed separately."