Learning Objectives: Describe the role of risk governance, risk appetite, and risk culture in the context of an enterprise risk management (ERM) framework. Explain and differentiate between regulatory capital and economic capital requirements as prescribed in Basel regulations.
Questions:
25.1.1. Following a thematic review from Financial Conduct Authority, Bobber Bank Plc is planning to enhance its operational risk management by implementing an enterprise risk management (ERM) framework using the three lines of defense model. The Chief Risk Officer (CRO) wants to ensure that the ERM framework not only integrates seamlessly but also aligns with the bank’s risk appetite and risk culture. Which of the following recommendations should the CRO make to achieve this integration most effectively?
a. The internal audit team, as the third line of defense, should periodically review the effectiveness of the ERM framework to ensure it meets the bank’s strategic objectives.
b. The bank should introduce qualitative risk culture assessments within its ERM framework to evaluate how well risk awareness and behaviors align with the bank’s overall risk management goals.
c. The risk management department, as part of the second line of defense, should conduct independent reviews of risk policies and procedures to confirm their alignment with the ERM framework and the bank’s strategic needs.
d. Business line managers, forming the first line of defense, should be empowered to manage risks directly within the limits set by the bank’s risk appetite, ensuring they are actively involved in the risk management process.
25.1.2. Boer Bank of South Africa has provided its capital adequacy measures for two consecutive years. The following table displays the risk-weighted assets (RWAs) for credit, market, and operational risks, along with the bank's capital figures for Common Equity Tier 1 (CET1), Tier 1, and Total Capital (Tier 1 + Tier 2).
Did Boer Bank of South Africa meet the Basel III minimum capital requirements in 2023 and 2024?
a. Bank was compliant with minimum capital requirements in 2023 and not in 2024
b. Bank was not compliant with minimum capital requirements in 2023 and complied in 2024
c. Bank was compliant with minimum capital requirements in both 2023 and 2024
d. Bank was compliant with minimum capital requirements in neither 2023 nor 2024
25.1.3. A bank uses an internal model to estimate economic capital for its credit portfolio, which is calculated as the 99.9% Value at Risk (VaR) over a one-year horizon. The bank’s internal estimates show:
a. Economic capital is higher than the regulatory capital requirement, indicating that economic capital can exceed regulatory minimums to better reflect the bank's specific risk profile.
b. Economic capital is lower than the regulatory capital requirement, indicating that the regulatory measures are overly conservative.
c. Economic capital is equal to the regulatory capital requirement, aligning the bank's internal risk assessment with its regulatory requirements.
d. Economic capital is lower than the regulatory capital requirement, suggesting that the bank underestimates risk compared to Basel standards.
Note: Exam questions are not usually this lengthy; however, the next question was intentionally designed to guide candidates through the practical aspects of economic and regulatory capital, ensuring comprehensive coverage of the Learning Objective (LOS).
25.1.4. ETA Bank aims to maintain an AA credit rating, requiring a 99.97% confidence level (≈0.03% default probability). However, its current economic capital model is based on 99.9% VaR, aligning closer to an A rating (≈0.1% default probability).
Key findings from the Review:
Regulators flagged the $3B shortfall, questioning how the bank will meet its AA solvency standard. The current model (99.9% VaR) yields a total economic capital of $16B after the diversification that the bank has available. To meet an AA 99.97% confidence standard, the model projects ~$19B would be needed, creating a $3B capital shortfall. Notably, raising the confidence level from 99.9% to 99.97% (to align with an AA rating) increases the required capital by about 20%. The regulator has flagged this gap, questioning how the bank will achieve its target rating solvency standard.
In response to the findings, which of the following is the most practical action for the bank’s risk manager to take to address the identified capital gap and align the economic capital model with an AA credit rating target?
a. Increase the bank’s available capital (e.g., retaining earnings or raising equity) or reduce risk exposures, so the 99.97% VaR economic capital requirement is fully covered.
b. Maintain the current 99.9% VaR standard and accept that the bank’s true credit profile aligns closer to an A rating, rather than increasing capital for an AA target.
c. Revise the model to assume greater diversification (e.g., using lower correlations between risk types) to artificially lower the required economic capital at the 99.97% confidence level.
d. Increase the internal target to a 99.99% VaR (AAA-equivalent) solvency standard, even though this would require substantially more capital than identified in the AA scenario.
Answers here:
Questions:
25.1.1. Following a thematic review from Financial Conduct Authority, Bobber Bank Plc is planning to enhance its operational risk management by implementing an enterprise risk management (ERM) framework using the three lines of defense model. The Chief Risk Officer (CRO) wants to ensure that the ERM framework not only integrates seamlessly but also aligns with the bank’s risk appetite and risk culture. Which of the following recommendations should the CRO make to achieve this integration most effectively?
a. The internal audit team, as the third line of defense, should periodically review the effectiveness of the ERM framework to ensure it meets the bank’s strategic objectives.
b. The bank should introduce qualitative risk culture assessments within its ERM framework to evaluate how well risk awareness and behaviors align with the bank’s overall risk management goals.
c. The risk management department, as part of the second line of defense, should conduct independent reviews of risk policies and procedures to confirm their alignment with the ERM framework and the bank’s strategic needs.
d. Business line managers, forming the first line of defense, should be empowered to manage risks directly within the limits set by the bank’s risk appetite, ensuring they are actively involved in the risk management process.
25.1.2. Boer Bank of South Africa has provided its capital adequacy measures for two consecutive years. The following table displays the risk-weighted assets (RWAs) for credit, market, and operational risks, along with the bank's capital figures for Common Equity Tier 1 (CET1), Tier 1, and Total Capital (Tier 1 + Tier 2).
Did Boer Bank of South Africa meet the Basel III minimum capital requirements in 2023 and 2024?
a. Bank was compliant with minimum capital requirements in 2023 and not in 2024
b. Bank was not compliant with minimum capital requirements in 2023 and complied in 2024
c. Bank was compliant with minimum capital requirements in both 2023 and 2024
d. Bank was compliant with minimum capital requirements in neither 2023 nor 2024
25.1.3. A bank uses an internal model to estimate economic capital for its credit portfolio, which is calculated as the 99.9% Value at Risk (VaR) over a one-year horizon. The bank’s internal estimates show:
- Expected loss (EL): $5 billion
- 99.9% unexpected loss (UL): $12 billion
- Regulatory capital requirement (under Basel): $10 billion
a. Economic capital is higher than the regulatory capital requirement, indicating that economic capital can exceed regulatory minimums to better reflect the bank's specific risk profile.
b. Economic capital is lower than the regulatory capital requirement, indicating that the regulatory measures are overly conservative.
c. Economic capital is equal to the regulatory capital requirement, aligning the bank's internal risk assessment with its regulatory requirements.
d. Economic capital is lower than the regulatory capital requirement, suggesting that the bank underestimates risk compared to Basel standards.
Note: Exam questions are not usually this lengthy; however, the next question was intentionally designed to guide candidates through the practical aspects of economic and regulatory capital, ensuring comprehensive coverage of the Learning Objective (LOS).
25.1.4. ETA Bank aims to maintain an AA credit rating, requiring a 99.97% confidence level (≈0.03% default probability). However, its current economic capital model is based on 99.9% VaR, aligning closer to an A rating (≈0.1% default probability).
Key findings from the Review:
- The bank accounts for risk diversification (credit, market, operational), reducing total required capital.
- Current economic capital (post-diversification): $16B (99.9% VaR).
- Target economic capital for AA (99.97% VaR): $19B → $3B shortfall.
- Increasing confidence from 99.9% to 99.97% raises required capital by ~20%.
Regulators flagged the $3B shortfall, questioning how the bank will meet its AA solvency standard. The current model (99.9% VaR) yields a total economic capital of $16B after the diversification that the bank has available. To meet an AA 99.97% confidence standard, the model projects ~$19B would be needed, creating a $3B capital shortfall. Notably, raising the confidence level from 99.9% to 99.97% (to align with an AA rating) increases the required capital by about 20%. The regulator has flagged this gap, questioning how the bank will achieve its target rating solvency standard.
In response to the findings, which of the following is the most practical action for the bank’s risk manager to take to address the identified capital gap and align the economic capital model with an AA credit rating target?
a. Increase the bank’s available capital (e.g., retaining earnings or raising equity) or reduce risk exposures, so the 99.97% VaR economic capital requirement is fully covered.
b. Maintain the current 99.9% VaR standard and accept that the bank’s true credit profile aligns closer to an A rating, rather than increasing capital for an AA target.
c. Revise the model to assume greater diversification (e.g., using lower correlations between risk types) to artificially lower the required economic capital at the 99.97% confidence level.
d. Increase the internal target to a 99.99% VaR (AAA-equivalent) solvency standard, even though this would require substantially more capital than identified in the AA scenario.
Answers here:
