Chapter 11: Risk and Basic Risk Management Framework (CAIIB – Paper 2)
1. What is the most accurate definition of 'risk' in banking?
A. The opportunity to earn higher profits
B. The certainty of returns from investments
C. The possibility of loss or adverse outcomes
D. A regulatory requirement
In banking, risk refers to the possibility that a bank may incur a loss or experience an adverse outcome due to internal or external factors.
2. Which of the following is a key objective of risk management in banks?
A. Minimizing potential losses while optimizing returns
B. Avoiding all banking activities with any uncertainty
C. Maximizing risk to earn higher profits
D. Ensuring profits without monitoring
The goal of risk management is to minimize losses while optimizing returns, not to avoid all risk or maximize risk indiscriminately.
3. Which type of risk arises due to changes in market prices such as interest rates, foreign exchange rates, or stock prices?
A. Operational Risk
B. Market Risk
C. Credit Risk
D. Liquidity Risk
Market risk arises from fluctuations in market variables such as interest rates, stock prices, and foreign exchange rates, impacting a bank’s trading and investment portfolio.
4. How does digitization impact risk management in international banking?
A. It eliminates all types of risks
B. It slows down transaction processing
C. It replaces the need for risk frameworks
D. It introduces new operational and cyber risks while improving monitoring
Digitization enhances efficiency and monitoring but introduces operational, cybersecurity, and system risks that must be managed within the risk framework.
5. Which of the following is considered the first step in a basic risk management framework?
A. Risk Identification
B. Risk Reporting
C. Risk Mitigation
D. Risk Monitoring
Risk identification is the first step, where potential risks to the bank’s operations and objectives are recognized before assessment and mitigation.
6. How is risk related to expected return in banking?
A. Higher risk always leads to lower return
B. Risk and return are unrelated
C. Higher risk usually requires higher expected return
D. Return is guaranteed regardless of risk
In banking and finance, there is a positive relationship between risk and expected return: investors and banks demand higher returns for taking on higher risks.
7. What is the primary purpose of capital in a bank’s risk management framework?
A. To absorb potential losses and ensure solvency
B. To maximize short-term profits
C. To replace the need for risk monitoring
D. To fund operational expenses only
Capital acts as a buffer to absorb losses from risky exposures, helping banks maintain solvency and confidence in the financial system.
8. Which ratio is commonly used to link risk and capital adequacy in banks?
A. Debt-to-Equity Ratio
B. Capital Adequacy Ratio (CAR)
C. Current Ratio
D. Return on Assets (ROA)
CAR measures the capital buffer of a bank relative to its risk-weighted assets and is a key regulatory measure linking risk and capital.
9. If a bank takes on higher credit risk, what is the implication for its required capital?
A. Required capital decreases
B. Capital requirement remains unchanged
C. Risk has no effect on capital
D. Required capital increases to cover potential losses
Higher credit risk increases the likelihood of losses, so regulators require banks to maintain more capital to absorb potential losses.
10. What is the relationship between risk, capital, and return in strategic bank management?
A. Risk and return are inversely related; capital is irrelevant
B. Capital provides a buffer against risk, and higher risk investments aim for higher returns
C. Return is fixed, regardless of capital or risk
D. Banks should avoid risk entirely to maximize return
In strategic banking, capital cushions potential losses, allowing banks to take calculated risks to achieve higher returns while staying solvent.
11. What is the primary purpose of risk management in banks?
A. To completely eliminate all risks
B. To maximize risk for higher profits
C. To identify, assess, and mitigate potential losses
D. To reduce operational costs only
Risk management aims to identify, assess, and mitigate potential losses, ensuring the bank remains solvent and maintains stakeholder confidence.
12. Why has risk management become increasingly important in modern banking?
A. Banks now face fewer regulatory requirements
B. Banking has become completely risk-free
C. To increase short-term profits only
D. Due to increased financial, operational, and cyber risks in a complex banking environment
Modern banking involves complex transactions, digital operations, and global exposures, increasing financial, operational, and cyber risks that require effective risk management.
13. Which of the following is NOT a benefit of effective risk management?
A. Enhanced regulatory compliance
B. Guaranteed elimination of all losses
C. Improved decision-making
D. Increased stakeholder confidence
While effective risk management reduces and mitigates risks, it cannot guarantee complete elimination of losses. It helps in compliance, better decisions, and stakeholder trust.
14. What is the link between risk management and bank profitability?
A. Effective risk management helps sustain profitability by preventing unexpected losses
B. Risk management always reduces profits
C. Risk management has no impact on profits
D. Profits are guaranteed only by increasing risk
By identifying and mitigating potential losses, risk management helps banks maintain steady profits and avoid unexpected financial shocks.
15. Which regulatory framework emphasizes the importance of risk management in banks?
A. Companies Act
B. Basel III norms
C. Income Tax Act
D. Consumer Protection Act
Basel III provides a global regulatory framework focusing on capital adequacy, stress testing, and risk management to enhance the resilience of banks.
16. What is the first step in a basic risk management framework?
A. Risk Identification
B. Risk Monitoring
C. Risk Mitigation
D. Risk Reporting
Risk identification is the first step where potential risks to the bank’s operations, financials, or reputation are recognized.
17. Which step of the risk management framework involves evaluating the potential impact and likelihood of identified risks?
A. Risk Identification
B. Risk Assessment or Measurement
C. Risk Reporting
D. Risk Mitigation
Risk assessment evaluates both the likelihood and potential impact of identified risks to prioritize mitigation efforts effectively.
18. What does risk mitigation involve in a basic risk management framework?
A. Ignoring low-probability risks
B. Reporting risks to regulators only
C. Implementing measures to reduce or control risks
D. Increasing risk exposure for higher profits
Risk mitigation involves taking proactive steps to reduce the likelihood or impact of risks, such as using hedging, insurance, or internal controls.
19. Which of the following is a key element of risk monitoring?
A. Ignoring minor operational issues
B. Reporting only at year-end
C. Avoiding risk measurement
D. Regularly tracking risk exposures and control effectiveness
Risk monitoring ensures that identified risks are continuously tracked and that mitigation measures are effective, enabling timely corrective actions.
20. Why is risk reporting an essential part of the risk management framework?
A. To avoid regulatory oversight
B. To inform management and stakeholders about risk exposures and mitigation status
C. To increase risk-taking opportunities
D. To reduce capital requirements
Risk reporting ensures transparency by providing management and stakeholders with accurate information on risk exposures and the effectiveness of mitigation measures.
21. Which of the following is the risk that a borrower may fail to meet their financial obligations?
A. Market Risk
B. Credit Risk
C. Operational Risk
D. Liquidity Risk
Credit risk arises when a borrower or counterparty fails to meet their contractual financial obligations, potentially causing losses to the bank.
22. Market risk in banking is primarily associated with:
A. Fluctuations in interest rates, foreign exchange rates, and market prices
B. Borrower defaults
C. Operational failures
D. Liquidity shortages
Market risk arises from changes in market variables such as interest rates, foreign exchange, equity prices, and commodity prices affecting the bank’s portfolio.
23. Operational risk includes losses due to:
A. Credit defaults
B. Market price fluctuations
C. Human errors, system failures, and fraud
D. Liquidity shortages
Operational risk results from inadequate or failed internal processes, people, systems, or external events including fraud and cyber threats.
24. Liquidity risk in a bank arises when:
A. Market prices fluctuate rapidly
B. Borrowers default on loans
C. Staff make operational errors
D. The bank cannot meet its short-term obligations due to insufficient cash or liquid assets
Liquidity risk occurs when a bank is unable to meet its payment obligations as they fall due because it does not have sufficient cash or liquid assets.
25. Which emerging risk is specifically associated with digitization in banking?
A. Credit Risk
B. Cybersecurity and IT risk
C. Market Risk
D. Liquidity Risk
With increasing digitization, banks face IT system failures, data breaches, and cyber-attacks, which are considered emerging operational and cybersecurity risks.
