RISK MANAGEMENT MODULE A QUIZ 2

Reforms and greater market orientation exposed banks to more competition, market-based pricing, new products and cross-border links. These developments made systematic measurement, governance and control of credit, market, liquidity and operational risks increasingly important.

Risk transfer can reduce a particular exposure, but it may introduce counterparty, legal, basis or operational risks. The bank should assess whether the protection is enforceable and effective under stress and should not assume all residual risk disappears.

Business units generally own the risks arising from their activities and operate controls; an independent risk function provides oversight, challenge and frameworks; internal audit provides independent assurance. Exact structures vary, but clear accountability and independence are essential.

Internal audit is the third line and provides independent assurance on governance, risk management and controls. Management roles form the first and second lines in different ways; external audit and regulators are outside the internal Three Lines structure.

A risk policy sets the principles, roles, processes, authorities, reporting and controls for managing risk. It should align with strategy and appetite, be approved at the appropriate level, communicated to staff and reviewed as the business and risk environment change.

Risk tolerance and limits operationalise risk appetite into boundaries for particular objectives or exposures. Terminology can vary by institution, but a sector cap is a measurable constraint used to keep concentration within the approved risk-taking posture.

A KRI is a metric that signals changing risk exposure or control conditions. Examples include failed transactions, system downtime, overdue reconciliations or control exceptions. A KRI is different from a lagging loss measure, though the same metric may sometimes serve multiple purposes.

Stress testing evaluates how severe but plausible adverse scenarios affect a bank‘s financial condition, risk profile and resilience. Results can inform capital and liquidity planning, risk appetite, contingency plans and management action; they are not precise predictions.

Scenario analysis explores the impact of a specified set of events and assumptions, including severe or forward-looking conditions that may not be represented in historical averages. It complements statistical measures and depends on credible scenarios and assumptions.

Risk monitoring is continuous and should consider trends and leading indicators, not only current limit breaches. Deterioration may justify closer review, escalation or pre-emptive action before exposures breach limits or losses crystallise.

Liquidity is the ability to meet payment obligations when due. Solvency concerns whether the value of assets is sufficient to cover liabilities and whether capital is adequate. A bank can be solvent but face a short-term liquidity crisis, or liquid temporarily but fundamentally insolvent.

Funding liquidity risk is the risk that the bank cannot obtain cash or funding to meet obligations as they fall due. Forced asset sales can create losses and transmit liquidity pressure into market and capital risk.

Market liquidity risk is the risk that a position cannot be bought or sold quickly at a reasonable price due to limited market depth or disrupted trading. It can interact with funding liquidity risk through forced sales and price declines.

A contingency funding plan identifies potential liquidity stress events, escalation triggers, funding sources, responsibilities and communications. It prepares the bank to respond to unexpected cash outflows or impaired market access rather than improvising during a crisis.

The LCR is a short-term liquidity standard designed to ensure an adequate stock of unencumbered high-quality liquid assets (HQLA) to cover net cash outflows over a 30-calendar-day stress scenario, subject to the applicable regulatory framework.

The NSFR is a structural liquidity standard that compares available stable funding with required stable funding over a one-year horizon. It is intended to reduce excessive reliance on unstable short-term funding for longer-term assets.

Interest Rate Risk in the Banking Book (IRRBB) arises from adverse movements in interest rates affecting earnings or the economic value of banking-book positions. Repricing mismatches between assets and liabilities are a major source of this risk.

A positive repricing gap means rate-sensitive assets exceed rate-sensitive liabilities. If rates rise and the positions reprice as assumed, asset income tends to increase more than liability expense, so net interest income may rise. Actual results depend on timing, basis and customer behaviour.

Duration-gap analysis estimates the sensitivity of the economic value of equity to interest-rate changes by considering the duration of assets and liabilities and their relative values. It complements earnings-based repricing gap analysis, but relies on assumptions and approximations.

Back testing compares model estimates or forecasts with actual outcomes to assess performance and calibration. Findings may lead to model adjustment, revised assumptions, additional controls or supplementary stress testing; back testing does not prove future accuracy.