CAIIB Paper 1 Module C Quiz 7

PD measures the likelihood of default over a defined period. It is distinct from loss given default (LGD) and exposure at default (EAD).

LGD reflects the loss severity after considering recoveries and associated costs, usually expressed as a percentage of exposure at default.

EAD estimates the exposure when default occurs, including relevant drawn amounts and potential future drawings under the applicable methodology.

External ratings are assigned by credit rating agencies under their methodologies. Banks may also use internal ratings for their own credit decisions and risk management.

Internal ratings provide a structured risk assessment that can inform approval, pricing, monitoring and portfolio management. Ratings are estimates, not guarantees.

Industry risk arises from factors such as competition, technology, regulation, input prices and demand that can affect many firms in a sector.

Risk-based pricing seeks to compensate the bank for funding, operating, expected loss and capital costs while considering competition and applicable regulations.

A common simplified expected-loss relationship is PD multiplied by LGD multiplied by EAD over a specified horizon, with model details depending on the framework.

Obligor risk concerns an individual borrower; portfolio risk includes concentration, correlation and aggregate exposure effects across borrowers and segments.

Ratings are opinions based on methodologies and available information. They may lag new developments, so banks should conduct their own analysis and ongoing monitoring.

Credit derivatives can transfer specified credit exposures, but introduce legal, counterparty, basis and operational risks. They do not eliminate all risks in the underlying relationship.

A CDS typically involves premium payments by the protection buyer and contingent payment by the protection seller following defined credit events, subject to contract terms.

Experienced management and sound governance can reduce execution, control and strategic risks. They complement financial and structural mitigants rather than eliminate risk.

Rating migration tracks movement between risk grades, helping assess deterioration, upgrades, portfolio quality and potential future credit losses.

Models require validation and sound inputs. A mismatch between model output and observed warning signs should prompt investigation, not blind reliance.

Correlated defaults can cause portfolio losses to exceed what independent borrower assumptions suggest, especially where exposures are concentrated in a common risk driver.

Credit information systems help lenders evaluate repayment history and aggregate indebtedness, subject to applicable law, reporting rules, data quality and permissible use.

Collateral may reduce loss severity if enforceable and realizable. Haircuts, time to recovery, legal costs and valuation uncertainty must be considered.

Financial distress in one connected entity can affect others through guarantees, common ownership or cash-flow dependence. Aggregate analysis is therefore essential.

A score supports consistent risk differentiation but should be interpreted with data quality, policy, qualitative factors, exceptions and new information.