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Which of the following statements are true:
1. Capital adequacy implies the ability of a firm to remain a going concern
2. Regulatory capital and economic capital are identical as they target the same objectives
3. The role of economic capital is to provide a buffer against expected losses
4. Conservative estimates of economic capital are based upon a confidence level of 100%
Statement I is true - capital adequacy indeed is a reference to the ability of the firm to stay a 'going concern'. (Going concern is an accounting term that means the ability of the firm to continue in business without the stress of liquidation.)
Statement II is not true because even though the stated objective of regulatory capital requirements is similar to the purposes for which economic capital is calculated, regulatory capital calculations are based upon a large number of ad-hoc estimates and parameters that are 'hard-coded' into regulation, while economic capital is generally calculated for internal purposes and uses an institution's own estimates and models. They are rarely identical.
Statement II is not true as the purpose of economic capital is to provide a buffer against unexpected losses. Expected losses are covered by the P&L (or credit reserves), and not capital.
Statement IV is incorrect as even though economic capital may be calculated at very high confidence levels, that is never 100% which would require running a 'risk-free' business, which would mean there are no profits either. The level of confidence is set at a level which is an acceptable balance between the interests of the equity providers and the debt holders.
Company A issues bonds with a face value of $100m, sold at $98. Bank B holds $10m in face of these bonds acquired at a price of $70. Company A then defaults, and the recovery rate is expected to be 30%. What is Bank B's loss?
The bank paid $7m for the bonds, and expected recovery is $3m (30% x $10m face). Therefore Bank B's loss is $4m ($7m - $3m). Choice 'b' is the correct answer. All other answers are incorrect.
Loss from a lawsuit from an employee due to physical harm caused while at work is categorized per Basel II as:
Choice 'a' is the correct answer. Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.
The probability of default of a security over a 1 year period is 3%. What is the probability that it would not have defaulted at the end of four years from now?
The probability that the security would not default in the next 4 years is equal to the probability of survival raised to the power four. In other words, =(1 - 3%)^4 = 88.53%. Choice 'b' is the correct answer.
Which of the following are a CRO's responsibilities:
1. Statutory financial reporting
2. Reporting to the audit committee
3. Compliance with risk regulatory standards
4. Operational risk
Statutory financial reporting is the responsibility of the Chief Financial Officer, not the Chief Risk Officer. The head of internal audit reports to the audit committee of the board, not the CRO. Therefore statements I and II are incorect.
The CRO is generally expected to drive risk and compliance with related regulatory standards. Market risk, credit risk and operational risk groups report into the CRO, so statements III and IV are correct.
