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FRM Part II Updated
What is TLAC, how does bail-in work mechanically, and why was it designed for G-SIBs?
TLAC requires G-SIBs to maintain minimum levels of equity and bail-inable debt (18% of RWA) so they can be resolved without taxpayer support. Bail-in writes down or converts TLAC instruments to equity in a waterfall from CET1 through AT1, Tier 2, and senior unsecured debt.
How is the exposure measure calculated for the Basel leverage ratio, and why does it include off-balance-sheet items?
The Basel leverage ratio exposure measure includes on-balance-sheet assets, derivative exposures under SA-CCR, securities financing transactions, and off-balance-sheet commitments with credit conversion factors. This broader measure captures risks that on-balance-sheet accounting misses.
How are risk-weighted assets calculated under the Internal Ratings-Based approach?
The IRB approach uses a regulatory formula that converts PD, LGD, EAD, and maturity into risk-weighted assets. The core concept is computing a conditional PD at the 99.9% confidence level, adjusted for asset correlation and maturity.
How does desk-level capital allocation work under the FRTB, and why does it matter?
Under the FRTB, the trading desk is the fundamental unit of capital computation. Each desk must independently qualify for the Internal Models Approach by passing backtesting and P&L attribution tests.
What is P&L attribution, and how does the risk-theoretical P&L compare to actual P&L?
P&L attribution decomposes actual trading profits into risk-factor-driven components using model sensitivities. The gap between risk-theoretical and actual P&L reveals model deficiencies and is a critical FRTB validation requirement.
Why is default correlation so important in credit portfolio management, and how is it measured?
Default correlation determines how likely borrowers are to default together. Even moderate correlation dramatically increases tail losses and capital requirements while leaving expected losses unchanged.
What is risk factor mapping and how is it used to measure portfolio market risk?
Risk factor mapping is the process of expressing every position in a portfolio as a function of a manageable set of underlying market risk factors. This dimensionality reduction is necessary before computing VaR because modeling every individual security directly is computationally infeasible.
How do external loss data consortia like ORX work?
The Operational Riskdata eXchange (ORX) is the largest global banking consortium for pooling operational loss data, with over 100 member banks sharing anonymized loss events...
How should a pension plan set asset allocation given its liabilities?
LDI allocation scales liability-hedging vs return-seeking with funded ratio, using a glide path anchored in sponsor risk tolerance.
What LGD floors does Basel III final impose and how do they vary?
Basel III final imposes LGD floors: secured corp 20-25%, unsecured corp 25%, retail mortgage 5%, QRRE 50%. Prevents overly optimistic internal estimates. Larchwood's CRE loan LGD flooring raises RWA 66%...
What is ring-fencing in banking, and how does structural separation improve resolvability?
Ring-fencing legally separates retail banking from investment banking within a banking group, creating a firewall so that losses in trading and wholesale activities cannot threaten essential retail services. The UK implemented full structural ring-fencing in 2019.
What is a resolution stay, and how does the ISDA Resolution Stay Protocol prevent disorderly unwinds during bank resolution?
A resolution stay temporarily suspends counterparties' rights to terminate derivatives and other financial contracts when a bank enters resolution. The ISDA Resolution Stay Protocol extends this cross-border by having parties contractually agree to recognize foreign resolution actions.
How does the FRTB Standardized Approach for market risk work?
The FRTB Standardized Approach is a sensitivity-based method with three components: the Sensitivities-Based Method (delta, vega, curvature across seven risk classes), the Default Risk Charge, and the Residual Risk Add-On. It uses three correlation scenarios to capture correlation instability.
How does the FRTB define the boundary between the trading book and banking book, and why was it redesigned?
The trading book/banking book boundary is one of the most fundamental concepts in bank capital regulation, and the FRTB redesigned it to close a major regulatory arbitrage that existed under Basel II/II.5.
How do regulators and banks validate market risk models through backtesting?
Backtesting validates VaR models by comparing exceptions (VaR breaches) to the expected rate. The Basel traffic light framework uses exception counts, while formal tests like Kupiec's POF and Christoffersen's conditional coverage assess both frequency and independence.
How does securitization create moral hazard, and what risk retention rules try to fix it?
Securitization creates moral hazard by separating origination from risk-bearing, reducing incentives for careful underwriting. Post-crisis regulations require 5% risk retention and enhanced disclosure, but concerns about sufficiency and regulatory arbitrage remain.
How do you use Greeks for risk management of an options portfolio?
Greeks-based risk management involves aggregating option sensitivities across the entire portfolio to understand and control exposure to each risk dimension. Portfolio Greeks are computed by summing position-level Greeks, and banks set limits on each to control directional, convexity, volatility, and time decay risks.
How do financial institutions measure and manage cyber risk, and why is it so hard to quantify?
Cyber risk is uniquely challenging to quantify because of limited loss data, extreme severity distributions, rapidly evolving threats, and systemic interconnections. Financial institutions use scenario analysis, factor-based models, and frameworks like FAIR to estimate losses, while managing risk through the identify-protect-detect-respond-recover cycle.
What are the standards for collecting internal operational loss data?
Internal Loss Data (ILD) collection is the foundational element of operational risk management. Basel and national regulators specify minimum standards while banks add enhancements...
What drives funding risk in a defined benefit pension plan?
Funded ratio moves with asset returns, liability discount changes, and actuarial experience — driving sponsor contribution volatility.
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