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P2.T7.401. Credit risk functions under Basel III

Nicole Seaman

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Describe and contrast the major elements of the three options available for the calculation of credit risk: Standardized Approach; Foundation IRB Approach; Advanced IRB Approach

Questions:

401.1. Which is true about the treatment of sovereign risk under the standardized approach to credit risk under Basel III?

a. Exposure to sovereigns is assigned a risk weight of zero (0%)
b. Exposure to sovereigns whose countries are members of organization for economic cooperation and development (OECD) are assigned a risk weight of zero (0%)
c. The risk weight for a sovereign exposure cannot exceed 100%
d. Due to differences across jurisdictions, applied sovereign risk weights vary (are different) among large international banks


401.2. Each of the following is true about the internal ratings-based (IRB) approaches to credit risk under Basel III, EXCEPT which is false?

a. In both approaches (FIRB and AIRB) each debt issuer is assigned a probability of default (PD) according to the bank's internal rating system
b. In both approaches (FIRB and AIRB) the goal is to compute a credit risk charge that supports unexpected credit losses at a 99.9% confidence level over a one-year horizon
c. In both approaches (FIRB and AIRB) the credit risk function is a multi-factor (APT) model which does not assume the credit portfolio is diversified
d. In the Foundation IRB approach, only default probability (PD) is assigned by the bank's internal model; but exposure at default (EAD) is based on credit conversion factors (CCF), LGD is set to either 45% or 75%, and residual maturity is generally fixed at 2.5 years


401.3. Which of the following is true about the correlation coefficient in the credit risk function of the internal ratings-based approach?

a. The correlation coefficient represents the correlation between default probability (PD) and loss given default (LGD)
b. For corporate and retail exposures, the correlation coefficient decreases as the default probability (PD) increases
c. In both approaches (FIRB and AIRB), the correlation coefficient is determined by the bank's internal model but it must be non-negative
d. As the correlation coefficient already incorporates PD, it does not depend on the exposure's asset class

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