Chapter 23: Risk Management and Credit Rating (CAIIB – Paper 1)
1. What does credit risk primarily refer to in banking?
A. The risk of interest rate fluctuations
B. The risk of operational errors in transactions
C. The risk of loss due to borrower failing to repay
D. The risk of changes in foreign exchange rates
Credit risk is the possibility that a borrower may fail to meet their obligations, leading to financial loss for the lender.
2. Which of the following is a factor affecting credit risk?
A. Borrower’s repayment capacity
B. Bank’s branch location
C. Number of ATMs in the area
D. Type of bank’s software
Borrower’s repayment capacity, credit history, and financial health are key factors affecting credit risk.
3. What is the main purpose of credit rating?
A. To evaluate operational efficiency
B. To determine branch expansion potential
C. To monitor staff performance
D. To assess the creditworthiness of a borrower
Credit rating helps lenders and investors assess the likelihood that a borrower will repay their obligations.
4. Which of the following increases the credit risk for a bank?
A. High-quality collateral
B. Poor financial health of the borrower
C. Strong credit monitoring system
D. Diversification of loan portfolio
Credit risk increases when borrowers have weak financials, low repayment capacity, or poor credit history.
5. Which of the following is a method to mitigate credit risk?
A. Ignoring small defaults
B. Lending without assessment
C. Collateral and credit insurance
D. Providing loans to all applicants indiscriminately
Banks mitigate credit risk by requiring collateral, guarantees, and using credit insurance or risk-sharing arrangements.
6. Which agency is commonly known for providing credit ratings in India?
A. CRISIL
B. SEBI
C. RBI
D. NABARD
CRISIL is a leading credit rating agency in India that evaluates the creditworthiness of companies and financial instruments.
7. Which of the following best describes systemic credit risk?
A. Risk arising from a single borrower defaulting
B. Risk due to operational failures in one branch
C. Risk from internal staff misconduct
D. Risk affecting the entire financial system due to widespread defaults
Systemic credit risk refers to the risk that widespread borrower defaults can impact the stability of the entire financial system.
8. Which of the following is a common step banks take to mitigate credit risk?
A. Ignoring small overdue payments
B. Proper credit appraisal and assessment
C. Lending without collateral
D. Increasing interest rates arbitrarily
Banks mitigate credit risk by performing thorough credit appraisals, evaluating repayment capacity, and assessing borrower creditworthiness before sanctioning loans.
9. How does collateral help in mitigating credit risk?
A. Reduces operational errors
B. Ensures lower interest rates automatically
C. Provides security against borrower default
D. Eliminates market risk
Collateral serves as a security or guarantee that the bank can recover in case the borrower defaults, reducing potential credit losses.
10. What is the role of credit insurance in risk mitigation?
A. Transfers the risk of borrower default to an insurer
B. Eliminates the need for borrower assessment
C. Guarantees higher profits automatically
D. Reduces regulatory compliance requirements
Credit insurance allows banks to transfer the risk of borrower default to an insurance provider, protecting against potential losses.
11. Diversification of loan portfolio helps mitigate credit risk by:
A. Reducing operational expenses
B. Increasing interest income from all loans
C. Guaranteeing repayment of all loans
D. Spreading exposure across sectors and borrowers to reduce concentration risk
Diversification reduces the impact of a default by a single borrower or sector, lowering overall credit risk.
12. How does continuous monitoring of loans help in credit risk management?
A. Eliminates the need for credit appraisal
B. Allows early detection of potential defaults
C. Reduces interest income
D. Guarantees collateral recovery automatically
Regular monitoring of borrower performance and repayment behavior helps banks identify early warning signals and take preventive measures.
13. Which of the following financial instruments can banks use to mitigate credit risk?
A. Treasury bills only
B. Fixed deposits of unrelated parties
C. Guarantees, letters of credit, and credit derivatives
D. Operational manuals
Banks can use guarantees, letters of credit, and credit derivatives to transfer or mitigate potential losses arising from borrower default.
14. What is the main objective of credit rating?
A. To calculate interest rates for all loans automatically
B. To assess the profitability of a bank branch
C. To evaluate the creditworthiness of borrowers or instruments
D. To monitor staff performance in lending
Credit ratings assess the likelihood that a borrower or debt instrument will meet its financial obligations, helping banks manage credit risk.
15. Which of the following is an example of an external credit rating agency in India?
A. ICRA
B. RBI
C. NABARD
D. SEBI
ICRA is an external credit rating agency that evaluates the creditworthiness of companies and debt instruments in India.
16. Which of the following best describes internal credit rating?
A. Ratings provided by CRISIL or ICRA
B. Ratings assigned by a bank using its internal assessment models
C. Ratings based on global indices like S&P
D. Ratings decided by RBI for all borrowers
Internal credit ratings are assigned by banks using their own assessment systems and credit scoring models to evaluate borrower risk.
17. Which of the following is a key difference between internal and external credit ratings?
A. External ratings are free of cost, internal ratings are paid
B. Internal ratings are only for regulatory reporting
C. External ratings are qualitative, internal ratings are always quantitative
D. External ratings are provided by agencies outside the bank; internal ratings are developed within the bank
The main difference is that external ratings are provided by independent agencies, while internal ratings are assigned by the bank’s own credit assessment team.
18. Which of the following factors is commonly used in both internal and external credit ratings?
A. Number of bank branches
B. Borrower’s financial health and repayment capacity
C. Color of the company’s logo
D. Bank’s IT infrastructure
Both internal and external ratings heavily rely on borrower’s financial statements, repayment capacity, and overall creditworthiness.
19. Which of the following is a benefit of having internal credit ratings?
A. Eliminates the need for external audits
B. Guarantees zero NPA
C. Helps in portfolio management and risk-based pricing
D. Automatically improves the bank’s credit rating
Internal ratings allow banks to monitor loan quality, set risk-based pricing, and make informed portfolio management decisions.
20. External credit ratings are primarily used by:
A. Only the bank’s internal credit department
B. Government regulators exclusively
C. Only retail borrowers
D. Investors, lenders, and other stakeholders to assess creditworthiness
External ratings provide an independent assessment that investors, lenders, and stakeholders can use to make informed decisions regarding lending or investment.
21. Which of the following is usually the first step in the credit rating methodology?
A. Assigning a final rating symbol
B. Collection and analysis of borrower information
C. Monitoring of loan repayments
D. Portfolio diversification
The first step in credit rating is to collect and analyze detailed information about the borrower’s financials, business model, and repayment capacity.
22. Which component is critical in evaluating the creditworthiness of a borrower during rating?
A. Number of bank branches
B. Color of company logo
C. Location of ATMs
D. Financial performance and debt servicing capacity
Financial performance, profitability, liquidity, and ability to service debt are critical components in credit rating methodology.
23. What is a common quantitative tool used in credit rating?
A. Customer satisfaction survey
B. Branch expansion ratio
C. Financial ratios analysis like debt-equity and interest coverage
D. Number of ATMs per city
Quantitative analysis in credit rating typically uses financial ratios such as debt-equity ratio, interest coverage, profitability ratios, and liquidity indicators.
24. Which qualitative factor is often considered in credit rating methodology?
A. Management quality and corporate governance
B. Number of bank branches
C. Physical location of bank ATMs
D. Software used by the bank
Qualitative factors like the quality of management, corporate governance, industry position, and operational strategy are considered in credit rating methodology.
25. After analyzing quantitative and qualitative factors, what is the next step in credit rating methodology?
A. Loan disbursement
B. Assigning a rating grade or symbol
C. Portfolio diversification
D. Monitoring market trends only
After detailed analysis, a credit rating grade or symbol (such as AAA, AA, A) is assigned to indicate the creditworthiness of the borrower or instrument.
26. Which of the following ensures objectivity in credit rating methodology?
A. Using only past default history
B. Ignoring financial statements
C. Standardized rating frameworks and criteria
D. Assigning ratings randomly
Standardized frameworks, rating models, and predefined criteria ensure consistency and objectivity in assigning credit ratings.
27. What is the purpose of monitoring post-rating?
A. To increase loan interest rates automatically
B. To close the account immediately
C. To assign internal audit scores
D. To update ratings based on changes in financial performance or market conditions
Continuous monitoring ensures that credit ratings remain accurate and reflect any changes in the borrower’s financial health or market conditions.
28. What is the primary purpose of using credit derivatives in banking?
A. To increase interest income on all loans
B. To monitor operational efficiency
C. To transfer or hedge credit risk
D. To diversify branch locations
Credit derivatives are financial instruments that allow banks to transfer credit risk to other parties, reducing potential losses from borrower default.
29. Which of the following is a commonly used credit derivative?
A. Treasury bills
B. Credit Default Swap (CDS)
C. Fixed deposits
D. Commercial paper
A Credit Default Swap (CDS) is a credit derivative that allows a lender to transfer the risk of default on a loan to another party in exchange for a fee.
30. How does a Credit Default Swap (CDS) mitigate credit risk?
A. By increasing loan interest rates automatically
B. By monitoring borrower behavior
C. By diversifying loan portfolio geographically
D. By transferring potential loss from default to the CDS seller
In a CDS, the lender (protection buyer) pays a premium to the protection seller, who compensates the lender in case of borrower default, thereby mitigating credit risk.
31. Which of the following is a key advantage of using credit derivatives?
A. Eliminates the need for credit appraisal
B. Guarantees borrower repayment
C. Provides flexibility to manage or hedge credit exposure
D. Reduces operational compliance requirements
Credit derivatives provide flexibility for banks to manage specific credit exposures without selling the underlying loan, helping in risk management.
32. Which party in a credit derivative transaction bears the default risk?
A. Borrower only
B. Protection seller
C. Bank branch manager
D. RBI exclusively
In a credit derivative like CDS, the protection seller assumes the risk of borrower default in exchange for periodic premiums from the protection buyer.
33. Which of the following risks can credit derivatives help manage?
A. Operational risk only
B. Market risk only
C. Liquidity risk only
D. Credit risk primarily, and sometimes counterparty risk
Credit derivatives are mainly used to manage credit risk by transferring potential losses from borrower default; they can also expose parties to counterparty risk.
34. Which of the following is a potential limitation of credit derivatives?
A. They eliminate the need for credit monitoring
B. They guarantee 100% protection against all risks
C. Counterparty risk and complexity of contracts
D. Reduce borrower default probability directly
Credit derivatives are complex instruments and expose the bank to counterparty risk, so they require careful management and understanding.
35. Which of the following best describes a total return swap in credit risk management?
A. Transfer of operational responsibility
B. Only used for liquidity management
C. Guarantees repayment by borrower
D. Transfer of credit risk and returns of a reference asset to another party
In a total return swap, the credit risk and returns from a reference asset are transferred to a counterparty, allowing the bank to hedge credit exposure.
36. What is the primary objective of RBI guidelines on credit risk management?
A. To set interest rates for all loans
B. To manage operational efficiency of branches
C. To ensure banks identify, measure, monitor, and mitigate credit risk
D. To increase the number of borrowers in the system
RBI guidelines aim to provide a framework for banks to identify, assess, monitor, and mitigate credit risk to ensure financial stability.
37. Which of the following is a key aspect of RBI credit risk management guidelines?
A. Only focus on operational risk
B. Risk categorization, exposure limits, and monitoring of NPAs
C. Increasing bank branch expansion
D. Standardizing ATM locations
RBI guidelines include categorizing risk, setting exposure limits, proper documentation, and regular monitoring of Non-Performing Assets (NPAs).
38. What is the role of the Credit Information System in India?
A. To provide operational efficiency scores
B. To monitor branch expansion
C. To collect and share borrowers’ credit history among banks
D. To increase interest rates uniformly
The Credit Information System (like CIBIL, Experian, CRIF) collects and shares credit information of borrowers to help banks make informed lending decisions.
39. Which of the following is true about banks using credit information systems?
A. Banks are not allowed to share borrower information
B. Credit scores are ignored in lending decisions
C. Only operational data is shared
D. Banks use credit scores and history to assess borrower risk
Banks use information from credit bureaus, such as credit scores, repayment history, and past defaults, to evaluate borrower risk and make lending decisions.
40. Which regulatory body oversees the operation of credit information companies in India?
A. SEBI
B. IRDAI
C. Reserve Bank of India (RBI)
D. Ministry of Finance
The RBI regulates credit information companies in India, ensuring proper functioning, data accuracy, and security of borrower credit information.
