Chapter 12: Risks in Banking Business (CAIIB – Paper 2)

1. Which of the following is the most fundamental risk faced by banks?

• A. Operational Risk
• B. Legal Risk
• C. Credit Risk
• D. Market Risk

Credit risk is the risk of loss arising from a borrower failing to meet their obligations. It is considered the most fundamental risk for banks because lending is a core banking activity.

2. What does operational risk in banking primarily refer to?

• A. Loss due to market fluctuations
• B. Loss due to internal failures like systems, processes, or human error
• C. Loss due to borrower default
• D. Loss due to changes in interest rates

Operational risk arises from failures in internal processes, systems, or human errors, unlike credit or market risk which are external in nature.

3. Which of the following is an example of market risk?

• A. Loss due to adverse changes in interest rates or exchange rates
• B. Loss due to fraud by an employee
• C. Loss due to a borrower failing to repay a loan
• D. Loss due to regulatory non-compliance

Market risk refers to losses arising from changes in market variables like interest rates, foreign exchange rates, or equity prices.

4. Legal risk in banking occurs mainly due to:

• A. Fluctuation in interest rates
• B. Borrower default
• C. System failure
• D. Non-compliance with laws, contracts, or regulations

Legal risk arises when banks fail to comply with laws, contractual obligations, or regulatory requirements, leading to potential losses or penalties.

5. Which method helps banks in identifying risks in their business?

• A. Investing in high-risk instruments only
• B. Ignoring past loan defaults
• C. Risk assessment and risk mapping of operations
• D. Avoiding compliance reporting

Banks identify risks through systematic risk assessment, risk mapping, scenario analysis, and reviewing past incidents.

6. What is the first step in risk management in banking?

• A. Risk identification
• B. Risk mitigation
• C. Risk monitoring
• D. Risk transfer

Risk identification is the first and most crucial step in risk management, as it involves recognizing and categorizing all potential risks the bank may face.

7. Which of the following best describes the banking book?

• A. All securities held for trading purposes
• B. Assets and liabilities intended to be held until maturity
• C. Derivatives positions held for speculation
• D. Only short-term investments

The banking book consists of loans, deposits, and other assets/liabilities that are intended to be held to maturity. It is not marked to market like the trading book.

8. The trading book primarily contains:

• A. Customer deposits
• B. Long-term loans
• C. Fixed assets of the bank
• D. Financial instruments held for short-term resale or trading purposes

The trading book includes financial instruments such as bonds, equities, derivatives, and other securities that are actively traded for short-term gains.

9. Which risk is more relevant to the banking book compared to the trading book?

• A. Market risk
• B. Liquidity risk only
• C. Interest rate risk
• D. Operational risk only

The banking book is more sensitive to interest rate risk because loans and deposits have fixed or variable interest rates and are held to maturity.

10. Which risk is more associated with the trading book?

• A. Market risk due to price fluctuations
• B. Credit risk from long-term loans
• C. Liquidity risk from deposits
• D. Operational risk in core banking

The trading book is highly exposed to market risk because it contains securities and derivatives that are marked to market and actively traded.

11. The difference between the banking book and trading book is mainly based on:

• A. Ownership of assets
• B. The intent of holding assets (long-term vs. short-term)
• C. Accounting standards used
• D. Location of branch offices

The key distinction lies in the intent: banking book assets are held to maturity, while trading book assets are held for short-term trading and profit.

12. Which regulatory requirement is typically stricter for the trading book than the banking book?

• A. Market risk capital charges under Basel III
• B. Loan classification norms
• C. Reserve requirements on deposits
• D. KYC/AML compliance

The trading book faces stricter capital requirements for market risk under Basel III because of its exposure to price and interest rate volatility.

13. Which of the following is an example of an off-balance sheet (OBS) exposure?

• A. Fixed deposits with banks
• B. Term loans
• C. Letters of credit and guarantees
• D. Cash in hand

Off-balance sheet exposures include contingent liabilities like letters of credit, guarantees, and derivative contracts, which do not appear on the balance sheet but carry potential risk.

14. OBS exposures primarily expose banks to which type of risk?

• A. Market risk only
• B. Credit risk and contingent liability risk
• C. Operational risk only
• D. Liquidity risk only

OBS exposures carry credit risk because banks may have to fulfill the obligation if the counterparty defaults, making it a contingent liability.

15. Which of the following instruments is NOT considered an off-balance sheet exposure?

• A. Bank guarantees
• B. Letters of credit
• C. Derivative contracts like interest rate swaps
• D. Term loans

Term loans are recorded on the balance sheet, unlike letters of credit, guarantees, or derivative contracts which are off-balance sheet exposures.

16. How do off-balance sheet exposures impact a bank’s capital requirements?

• A. Banks must assign a risk-weight and calculate capital for potential exposure
• B. OBS exposures do not impact capital requirements
• C. OBS exposures only affect liquidity ratios
• D. OBS exposures are ignored for regulatory purposes

Regulatory frameworks require banks to assign credit conversion factors (CCF) to OBS items and calculate capital charges for potential exposure.

17. Which of the following best describes the nature of OBS exposures?

• A. They are fully liquid assets
• B. They are contingent liabilities that may become actual obligations
• C. They are long-term loans
• D. They are equity investments in other banks

OBS exposures are contingent because they only result in a liability if certain events occur, such as counterparty default.

18. Which regulatory measure ensures that OBS exposures are properly monitored?

• A. Maintaining cash reserve ratio
• B. Reporting liquidity coverage ratio only
• C. Assigning credit conversion factors (CCF) and including in capital adequacy calculations
• D. OBS exposures are exempt from regulatory reporting

Banks assign credit conversion factors to OBS items to estimate potential credit exposure and include them in capital adequacy ratios, as per Basel guidelines.

19. How is credit risk defined in banking?

• A. The risk of loss due to a borrower failing to meet contractual obligations
• B. The risk of loss due to fraud in internal processes
• C. The risk of loss due to interest rate fluctuations
• D. The risk of loss due to changes in liquidity

Credit risk arises when a borrower or counterparty fails to meet their financial obligations, which can lead to losses for the bank.

20. Operational risk in banking primarily refers to:

• A. Losses due to borrower default
• B. Losses due to failures in internal processes, people, or systems
• C. Losses due to market price fluctuations
• D. Losses due to regulatory changes only

Operational risk includes losses from inadequate or failed internal processes, human errors, system failures, or fraud.

21. Market risk is defined as:

• A. Risk due to internal fraud
• B. Risk of loan default
• C. Risk of loss due to changes in market prices, interest rates, or foreign exchange rates
• D. Risk of regulatory penalties

Market risk arises from fluctuations in interest rates, exchange rates, equity prices, and other market variables that affect the bank’s financial positions.

22. Liquidity risk in banking refers to:

• A. Loss due to credit default only
• B. Risk due to operational failures
• C. Risk due to market price volatility
• D. Risk that the bank cannot meet its short-term obligations without significant loss

Liquidity risk is the potential that a bank will not be able to fund its obligations as they come due, leading to the need to sell assets at a loss or borrow at high cost.

23. Legal risk in banking can best be described as:

• A. Risk due to market fluctuations
• B. Risk of loss due to non-compliance with laws, contracts, or regulations
• C. Risk due to interest rate changes
• D. Risk due to borrower default only

Legal risk arises when a bank suffers losses due to non-compliance with applicable laws, contracts, or regulatory requirements.

24. Reputational risk in banking is defined as:

• A. Risk of loss due to negative public opinion or perception affecting customer confidence
• B. Risk due to credit default
• C. Risk due to internal process failures only
• D. Risk due to interest rate volatility

Reputational risk arises when adverse events, failures, or public perception reduce customer trust, which can result in financial or business loss.

25. Which of the following is commonly used to measure credit risk in banking?

• A. Duration gap
• B. Probability of Default (PD) and Loss Given Default (LGD)
• C. Value at Risk (VaR) for trading portfolio
• D. Liquidity Coverage Ratio (LCR)

Credit risk is typically measured using Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD) to estimate potential losses.

26. Value at Risk (VaR) is primarily used to measure:

• A. Market risk in trading portfolios
• B. Operational risk
• C. Credit risk in banking book
• D. Reputational risk

VaR estimates the potential loss in value of a trading portfolio over a defined period for a given confidence level, and is a standard measure for market risk.

27. Liquidity risk can be measured by:

• A. Probability of Default
• B. Duration gap only
• C. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
• D. Value at Risk (VaR)

Liquidity risk is assessed using ratios such as LCR, which measures high-quality liquid assets to short-term obligations, and NSFR, which assesses stable funding over one year.

28. Which of the following is used to measure interest rate risk in the banking book?

• A. Credit Conversion Factor (CCF)
• B. Probability of Default (PD)
• C. Liquidity Coverage Ratio (LCR)
• D. Duration gap and Earnings at Risk (EaR)

Interest rate risk in the banking book is measured using duration gap analysis to assess sensitivity of assets and liabilities, and Earnings at Risk (EaR) to estimate impact on profits.

29. Which method helps banks assess operational risk quantitatively?

• A. Credit scoring models
• B. Loss distribution approach and Basel standardized approaches
• C. Duration gap only
• D. Market value of equity

Operational risk is quantified using approaches like Basic Indicator Approach, Standardized Approach, and Advanced Measurement Approach (AMA), often based on historical loss data.

30. What is the main purpose of risk measurement in banks?

• A. To quantify potential losses and determine capital adequacy
• B. To increase profitability without considering risk
• C. To reduce all banking operations
• D. To comply only with internal management rules

Risk measurement allows banks to quantify exposures, estimate potential losses, and maintain adequate capital to safeguard against unexpected losses.