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Question 1Credit Risk

Under the Basel framework, which capital charge applies to credit risk arising from on-balance-sheet loans under the standardized approach?

  1. Gross income multiplied by a fixed operational beta
  2. Expected loss multiplied by the exposure default rate
  3. Risk-weighted assets multiplied by the minimum capital ratio Correct answer.
  4. Notional amount multiplied by the loss given default

Explanation

Credit risk capital is computed by assigning risk weights to exposures to derive risk-weighted assets, then applying the minimum capital ratio. The other formulas describe expected loss, exposure components, or the operational risk basic indicator approach rather than regulatory credit capital.

Question 2Credit Risk

A bank's loan portfolio has total exposure of 500 million, a probability of default of 2%, and a loss given default of 45%. What is the expected loss?

  1. 10.0 million
  2. 2.25 million
  3. 9.0 million
  4. 4.5 million Correct answer.

Explanation

Expected loss equals exposure at default times probability of default times loss given default. Multiplying 500 million by 0.02 and then by 0.45 gives 4.5 million.

Question 3Credit Risk

Which ratio is used to measure a borrower's capacity to service debt from operating earnings?

  1. Debt-to-equity ratio
  2. Interest coverage ratio Correct answer.
  3. Current ratio
  4. Dividend payout ratio

Explanation

The interest coverage ratio divides earnings before interest and taxes by interest expense, directly showing how many times operating earnings cover interest obligations. The other ratios measure liquidity, leverage, or shareholder distributions rather than debt-service capacity from earnings.

Question 4Credit Risk

What does a credit rating migration matrix primarily describe?

  1. The interest spread charged to new borrowers
  2. The probability that issuers move between rating grades over a period Correct answer.
  3. The recovery rate on defaulted exposures
  4. The regulatory risk weight for sovereigns

Explanation

A migration matrix reports transition probabilities, showing the likelihood that an obligor in one rating grade ends in another grade, including default, over a defined horizon. It is not a recovery, pricing, or risk-weight table.

Question 5Credit Risk

Which of the following is a key qualitative factor in a credit assessment of a corporate borrower?

  1. The number of shares outstanding
  2. The book value of the borrower's headquarters
  3. Quality of management and corporate governance Correct answer.
  4. The coupon rate on the borrower's existing bonds

Explanation

Qualitative credit analysis focuses on management competence, governance, strategy, and industry position, which influence willingness and ability to repay. Market pricing and share-count data are quantitative or market-based inputs rather than governance judgments.

Question 6Credit Risk

A bank holds a 100 million exposure to a counterparty rated BBB. Under a simplified scheme the risk weight is 50% and the minimum capital ratio is 8%. What is the required capital?

  1. 2 million
  2. 8 million
  3. 50 million
  4. 4 million Correct answer.

Explanation

Risk-weighted assets equal exposure times risk weight, here 100 million times 50% equals 50 million. Applying the 8% ratio gives 4 million of required capital.

Question 7Credit Risk

What is the primary purpose of a credit limit set for a counterparty?

  1. To set the interest rate charged on new facilities
  2. To fix the maturity of the loan agreement
  3. To determine the collateral valuation haircut
  4. To cap the maximum exposure the bank will accept from that counterparty Correct answer.

Explanation

A credit limit constrains the maximum exposure the bank is willing to have to a single counterparty or group, controlling concentration and single-name risk. Pricing, collateral haircuts, and maturity terms are separate decisions.

Question 8Credit Risk

Which event most directly constitutes a credit default under standard definitions?

  1. The obligor's credit rating outlook changes to negative
  2. The obligor fails to make a scheduled payment after the grace period Correct answer.
  3. The obligor issues new equity
  4. The obligor's share price falls sharply

Explanation

Default typically occurs when an obligor misses a material payment obligation beyond any grace period or otherwise triggers a credit event such as bankruptcy. Market price moves and outlook changes are warning signals but are not defaults by themselves.

Question 9Credit Risk

A borrower has current assets of 300 and current liabilities of 200. What is the current ratio?

  1. 2.0
  2. 1.5 Correct answer.
  3. 1.0
  4. 0.67

Explanation

The current ratio divides current assets by current liabilities, so 300 divided by 200 equals 1.5. A ratio above one indicates short-term assets exceed short-term obligations.

Question 10Credit Risk

Which statement best describes the role of collateral in credit risk mitigation?

  1. It eliminates the probability of default entirely
  2. It reduces loss given default by providing a recovery source if the borrower defaults Correct answer.
  3. It guarantees the borrower will not become delinquent
  4. It replaces the need for any credit assessment

Explanation

Collateral lowers the severity of loss on default by giving the lender a claim on assets, thereby reducing loss given default. It does not change the borrower's likelihood of default or remove the need for underwriting.

Question 11Credit Risk

A portfolio contains two loans each of 100 exposure, each with a 3% probability of default and 50% loss given default, and defaults are independent. What is the approximate probability that both loans default?

  1. 0.18%
  2. 0.30%
  3. 0.09% Correct answer.
  4. 6.00%

Explanation

For independent events the joint probability is the product of the individual probabilities, so 0.03 times 0.03 equals 0.0009, or 0.09%. Adding probabilities or doubling the single-name default rate would overstate the joint default likelihood.

Question 12Credit Risk

Why does portfolio concentration in a single industry increase credit risk?

  1. It removes the benefit of collateral
  2. It forces the bank to hold zero capital
  3. Defaults within the industry tend to be positively correlated during downturns Correct answer.
  4. It automatically raises each borrower's probability of default

Explanation

Borrowers in the same industry share common drivers, so their defaults are more likely to cluster in a recession, raising unexpected loss. Concentration does not mechanically change individual default probabilities, collateral value, or capital to zero.

Question 13Credit Risk

What does the distance-to-default concept measure?

  1. The time remaining until a loan matures
  2. The ratio of collateral to exposure
  3. The spread between loan and deposit rates
  4. How far asset value must fall before liabilities exceed assets Correct answer.

Explanation

Distance to default expresses, in standard deviations of asset returns, how much asset value can decline before the firm's assets fall below its default point. It is a structural credit measure, not a maturity, pricing, or collateral metric.

Question 14Credit Risk

A bank's exposure to a counterparty is 80 million drawn plus a 20 million undrawn commitment with a 50% credit conversion factor. What is the exposure at default?

  1. 110 million
  2. 90 million Correct answer.
  3. 80 million
  4. 100 million

Explanation

Exposure at default equals the drawn amount plus the undrawn commitment times its credit conversion factor. Here 80 million plus 20 million times 0.5 equals 90 million.

Question 15Credit Risk

Which practice best mitigates wrong-way risk in credit exposures?

  1. Assessing correlation between counterparty credit quality and exposure size Correct answer.
  2. Relying solely on historical default rates
  3. Ignoring collateral posted by the counterparty
  4. Increasing exposure when collateral values rise

Explanation

Wrong-way risk arises when exposure increases as counterparty credit quality deteriorates, so the key control is analyzing that correlation and limiting exposures accordingly. Historical averages, procyclical exposure growth, and ignoring collateral all worsen the problem.

Question 16Credit Risk

In credit scoring, what does a scorecard's discriminatory power refer to?

  1. Its ability to separate good borrowers from bad borrowers Correct answer.
  2. The speed at which it can be computed
  3. The number of variables it contains
  4. The average interest rate it produces

Explanation

Discriminatory power measures how well a scorecard ranks defaulters versus non-defaulters, often assessed with measures such as the Gini coefficient or AUC. Variable count, computation speed, and pricing outputs do not describe this separation ability.

Question 17Credit Risk

A loan of 200 has a 5% probability of default and a 40% loss given default. If default occurs, what loss amount is expected conditional on default?

  1. 10
  2. 4
  3. 80 Correct answer.
  4. 40

Explanation

Conditional on default, the loss equals exposure times loss given default, so 200 times 0.40 equals 80. The probability of default scales the unconditional expected loss but does not change the loss given default.

Question 18Credit Risk

Why do banks apply a margin of conservatism when estimating probability of default under internal models?

  1. To satisfy borrower requests for lower pricing
  2. To account for model uncertainty and data limitations Correct answer.
  3. To reduce the capital held against exposures
  4. To increase reported profits

Explanation

Conservative adjustments guard against underestimating risk when models are uncertain or data are sparse, supporting prudent capital. They do not serve profit reporting, capital reduction, or borrower pricing preferences.

Question 19Credit Risk

Which ratio would a credit analyst use to assess how much of a firm's capital structure is funded by debt?

  1. Interest coverage ratio
  2. Inventory turnover
  3. Return on assets
  4. Debt-to-equity ratio Correct answer.

Explanation

The debt-to-equity ratio compares borrowed funds with shareholders' equity, showing leverage in the capital structure. Coverage, profitability, and efficiency ratios measure different dimensions of performance.

Question 20Credit Risk

What is the main credit risk concern with a large undrawn revolving credit commitment?

  1. The commitment reduces exposure at default
  2. The commitment eliminates default risk
  3. The commitment always converts to equity
  4. The borrower may draw funds precisely when its credit quality deteriorates Correct answer.

Explanation

Undrawn commitments create contingent exposure, and borrowers are most likely to draw when their liquidity needs rise and credit quality falls, increasing exposure at default. Commitments do not convert to equity, remove default risk, or reduce exposure.

Question 21Credit Risk

A bank estimates a 1% probability of default for a portfolio of 1,000 identical independent loans. What is the approximate standard deviation of the number of defaults?

  1. About 10
  2. About 3.15 Correct answer.
  3. About 1
  4. About 100

Explanation

For independent identical loans the number of defaults is binomial, with variance equal to n times p times (1 minus p). That gives 1,000 times 0.01 times 0.99, about 9.9, whose square root is roughly 3.15.

Question 22Credit Risk

Which statement best explains why unexpected loss differs from expected loss in credit portfolios?

  1. Unexpected loss reflects volatility around the mean loss driven by default correlation Correct answer.
  2. Unexpected loss equals expected loss multiplied by the capital ratio
  3. Unexpected loss is always zero when defaults are independent
  4. Unexpected loss ignores loss given default

Explanation

Expected loss is the average anticipated loss, while unexpected loss is the dispersion around that average, driven largely by default correlation and loss volatility. It is not zero under independence, is not a fixed multiple of expected loss, and does depend on loss given default.

Question 23Credit Risk

A portfolio has two exposures of equal size with individual default probabilities of 4% and a default correlation that makes joint default probability 0.32%. What is the approximate joint default probability under independence, and how does correlation compare?

  1. 0.16% under independence, so correlation raises joint default above that Correct answer.
  2. 0.64% under independence, so correlation lowers joint default
  3. 0.32% under independence, so correlation has no effect
  4. 0.08% under independence, so correlation lowers joint default

Explanation

Under independence the joint probability is 0.04 times 0.04, equal to 0.16%. The observed 0.32% exceeds this, indicating positive default correlation that increases the chance of simultaneous defaults.

Question 24Credit Risk

Under the internal ratings-based approach, what is the primary role of the supervisory formula for risk-weighted assets?

  1. It sets the interest rate the bank may charge borrowers
  2. It translates probability of default, loss given default, and maturity into a capital requirement reflecting portfolio risk Correct answer.
  3. It determines the accounting provision for each loan
  4. It fixes the collateral haircut applied by regulators

Explanation

The IRB risk-weight formula combines probability of default, loss given default, exposure at default, and maturity into a risk-weighted asset figure that captures unexpected loss. It does not set lending rates, accounting provisions, or collateral haircuts.

Question 25Credit Risk

Which situation most clearly illustrates a sovereign ceiling constraint on a corporate credit rating?

  1. A strong exporter is rated no higher than its home government's rating in local currency Correct answer.
  2. A company is downgraded after an earnings miss
  3. A firm's rating improves after it issues more equity
  4. A bank's rating falls because its liquidity ratio declines

Explanation

The sovereign ceiling limits how far an obligor's rating can exceed the rating of the government of the country where it operates, reflecting transfer and convertibility risk. Equity issuance, liquidity deterioration, and earnings misses are firm-specific drivers, not sovereign ceiling effects.

Question 26Credit Risk

Which financial ratio is most directly used to assess a borrower's ability to meet short-term obligations?

  1. Return on assets
  2. Asset turnover
  3. Current ratio Correct answer.
  4. Debt-to-equity ratio

Explanation

The current ratio compares current assets to current liabilities and indicates whether short-term assets cover short-term debts. It is a standard liquidity measure used in credit analysis to gauge near-term repayment capacity.

Question 27Credit Risk

A firm has total debt of 400 and total equity of 600. What is its debt-to-equity ratio?

  1. 1.50
  2. 0.40
  3. 2.50
  4. 0.67 Correct answer.

Explanation

The debt-to-equity ratio is calculated as total debt divided by total equity. Here, 400 divided by 600 equals approximately 0.67, indicating that debt is two-thirds of equity.

Question 28Credit Risk

Which document typically specifies the key financial covenants a borrower must maintain?

  1. The prospectus
  2. The auditor's opinion
  3. The credit agreement Correct answer.
  4. The annual report

Explanation

The credit agreement is the legal contract between borrower and lender that sets out covenants, repayment terms, and default triggers. Financial covenants are binding obligations defined within this document.

Question 29Credit Risk

What is the primary role of a credit rating agency?

  1. To guarantee repayment of defaulted debt
  2. To regulate bank capital adequacy
  3. To provide an independent opinion on an issuer's creditworthiness Correct answer.
  4. To set interest rates for bank loans

Explanation

Credit rating agencies assess the likelihood of default and assign ratings that express an independent opinion on credit risk. Their ratings are used by investors and lenders but do not constitute guarantees or regulatory rules.

Question 30Credit Risk

Which of the following is a typical early warning sign of deteriorating credit quality in a corporate borrower?

  1. Increasing days sales outstanding Correct answer.
  2. Declining debt levels
  3. Rising cash reserves
  4. Stable operating margins

Explanation

Increasing days sales outstanding indicates that a company is taking longer to collect receivables, which can signal liquidity strain and weakening credit quality. Rising cash, declining debt, and stable margins are generally positive or neutral signs.

Question 31Credit Risk

What does a loan-to-value (LTV) ratio measure in a secured lending context?

  1. The borrower's equity relative to total assets
  2. The loan amount relative to the appraised value of the collateral Correct answer.
  3. The loan loss provision relative to the loan balance
  4. The interest income relative to the loan principal

Explanation

LTV compares the size of a loan to the value of the collateral securing it. A higher LTV indicates greater reliance on collateral value and typically higher credit risk for the lender.

Question 32Credit Risk

Which type of risk arises when a bank's exposure to a counterparty increases as the counterparty's credit quality deteriorates?

  1. Operational risk
  2. Wrong-way risk Correct answer.
  3. Market risk
  4. Liquidity risk

Explanation

Wrong-way risk occurs when exposure and counterparty credit quality are positively correlated, so that exposure grows precisely when the counterparty is more likely to default. This is a specific form of credit risk that requires careful mitigation.

Question 33Credit Risk

What is the main purpose of a credit scoring model in retail lending?

  1. To rank applicants by their likelihood of default Correct answer.
  2. To set the bank's overall capital adequacy ratio
  3. To determine the maximum loan amount allowed by regulation
  4. To calculate the bank's net interest margin

Explanation

Credit scoring models use borrower characteristics to estimate the probability of default and rank applicants accordingly. This helps lenders make consistent and efficient credit decisions.

Question 34Credit Risk

A borrower has a 2% probability of default and a 50% loss given default. What is the expected loss rate on the exposure?

  1. 2.0%
  2. 0.5%
  3. 1.0% Correct answer.
  4. 4.0%

Explanation

Expected loss is calculated as probability of default multiplied by loss given default. Here, 2% times 50% equals 1.0% of the exposure.

Question 35Credit Risk

Which of the following best describes a credit default swap (CDS)?

  1. A loan syndication agreement among multiple banks
  2. A regulatory capital instrument issued by central banks
  3. A type of equity investment in a distressed company
  4. A contract that transfers credit risk from one party to another Correct answer.

Explanation

A CDS is a derivative contract in which the protection buyer pays a premium to the protection seller in exchange for compensation if a specified credit event occurs. It effectively transfers credit risk between the parties.

Question 36Credit Risk

A bank has a $10 million exposure to a counterparty with a probability of default of 1% and a loss given default of 40%. What is the expected loss?

  1. $40,000 Correct answer.
  2. $4,000,000
  3. $400,000
  4. $100,000

Explanation

Expected loss equals exposure times probability of default times loss given default. Thus $10,000,000 × 0.01 × 0.40 = $40,000.

Question 37Credit Risk

Which of the following is a key limitation of using only financial ratios in credit analysis?

  1. They reflect past performance and may not predict future deterioration Correct answer.
  2. They are unaffected by accounting policy choices
  3. They are always based on audited and timely data
  4. They incorporate qualitative factors such as management quality

Explanation

Financial ratios are derived from historical financial statements and therefore are backward-looking. They may not capture emerging risks or qualitative factors that affect future creditworthiness.

Question 38Credit Risk

What is the effect of a first-loss piece in a securitization structure?

  1. It is guaranteed by the originating bank
  2. It receives the highest priority in cash flow distributions
  3. It is exempt from credit risk retention rules
  4. It absorbs initial losses before other tranches Correct answer.

Explanation

The first-loss tranche, often the equity piece, is subordinated and absorbs the earliest losses from the underlying assets. This provides credit enhancement to senior tranches.

Question 39Credit Risk

Which of the following best describes the concept of probability of default (PD) under the internal ratings-based approach?

  1. The maturity of the credit exposure
  2. The loss incurred if a borrower defaults
  3. The exposure at the time of default
  4. The likelihood that a borrower will default within a specified horizon Correct answer.

Explanation

PD is the estimated likelihood that a borrower will default over a given period, typically one year. It is one of the key risk parameters used in credit risk modeling.

Question 40Credit Risk

A company's operating cash flow is consistently negative while it reports positive net income. What is the most likely explanation?

  1. High depreciation expenses
  2. Increased dividend payments
  3. Early repayment of long-term debt
  4. Aggressive revenue recognition or working capital build-up Correct answer.

Explanation

Negative operating cash flow despite positive net income often signals that earnings are not being converted into cash, possibly due to aggressive revenue recognition or a build-up in working capital. This is a credit concern because cash is needed to service debt.

Question 41Credit Risk

Which of the following is an example of a qualitative factor in a credit assessment?

  1. The current ratio
  2. The experience and track record of management Correct answer.
  3. The debt-to-equity ratio
  4. The interest coverage ratio

Explanation

Qualitative factors are non-numerical considerations such as management quality, industry position, and corporate governance. Financial ratios are quantitative factors.

Question 42Credit Risk

What is the primary purpose of a stress test in credit risk management?

  1. To measure the bank's operational efficiency
  2. To calculate the expected loss under normal conditions
  3. To determine the optimal pricing of a loan
  4. To assess the impact of adverse scenarios on a portfolio Correct answer.

Explanation

Stress tests evaluate how a portfolio would perform under severe but plausible adverse scenarios, helping banks identify vulnerabilities and plan for capital adequacy. They are forward-looking risk management tools.

Question 43Credit Risk

Which of the following is a common credit risk mitigation technique that reduces exposure to a specific counterparty?

  1. Netting agreements Correct answer.
  2. Extending the loan maturity
  3. Increasing the credit limit
  4. Lowering the interest rate

Explanation

Netting agreements allow parties to offset mutual obligations, reducing the net exposure in the event of default. This is a standard credit risk mitigation method.

Question 44Credit Risk

A bank's loan portfolio is heavily concentrated in commercial real estate. Which risk is most elevated?

  1. Reputational risk
  2. Concentration risk Correct answer.
  3. Operational risk
  4. Foreign exchange risk

Explanation

Concentration risk arises when a portfolio is heavily weighted toward a single sector or borrower, making it vulnerable to sector-specific downturns. Commercial real estate concentration is a classic example.

Question 45Credit Risk

What does a credit default swap spread widening typically indicate?

  1. Improving credit quality of the reference entity
  2. Deteriorating credit quality of the reference entity Correct answer.
  3. A decrease in market liquidity
  4. An increase in the risk-free rate

Explanation

A widening CDS spread means investors are demanding more protection against default, which generally reflects perceived deterioration in the reference entity's credit quality. It can also be influenced by liquidity and market conditions, but the primary interpretation is credit risk.

Question 46Credit Risk

Which of the following best explains why banks use internal models to estimate credit risk parameters?

  1. To avoid regulatory capital requirements entirely
  2. To better reflect the risk profile of their specific portfolios Correct answer.
  3. To eliminate the need for collateral
  4. To guarantee lower loss rates

Explanation

Internal models allow banks to estimate PD, LGD, and EAD based on their own historical data and portfolio characteristics, which can be more risk-sensitive than standardized approaches. They do not eliminate regulatory capital requirements but can lead to more accurate capital allocation.

Question 47Credit Risk

In a credit portfolio, what is the effect of default correlation on the unexpected loss of the portfolio?

  1. Correlation only affects expected loss
  2. Higher correlation increases unexpected loss Correct answer.
  3. Higher correlation decreases unexpected loss
  4. Correlation has no effect on unexpected loss

Explanation

Higher default correlation means that defaults are more likely to occur together, increasing the volatility of portfolio losses and therefore unexpected loss. Expected loss is not affected by correlation.

Question 48Credit Risk

Which of the following is a key challenge in validating a credit risk model?

  1. Too frequent model updates
  2. Excessive regulatory guidance
  3. Overly simple model structures
  4. Limited default data for low-default portfolios Correct answer.

Explanation

Low-default portfolios, such as those for large corporates or sovereigns, have few observed defaults, making it difficult to statistically validate PD estimates. This is a recognized challenge in credit risk modeling.

Question 49Credit Risk

What is the primary rationale for the supervisory slotting approach for specialized lending?

  1. To calculate expected loss using market prices
  2. To assign exposures to categories with predefined risk weights Correct answer.
  3. To allow banks to use internal PD estimates for all specialized loans
  4. To exempt specialized lending from capital requirements

Explanation

The slotting approach assigns specialized lending exposures to supervisory categories, each with a predefined risk weight, because reliable PD estimates are often unavailable. It is a simplified method under the standardized approach.

Question 50Credit Risk

Which of the following best describes the impact of a decline in collateral value on a secured loan's loss given default?

  1. It has no effect on loss given default
  2. It decreases loss given default because the loan is overcollateralized
  3. It increases loss given default because recovery is lower Correct answer.
  4. It reduces the probability of default

Explanation

If collateral value falls, the lender can recover less in the event of default, which increases the loss given default. This is a direct relationship between collateral value and recovery rates.