FRM P1 Foundations of Risk Management: practice questions with answers

Question 1

Which statement best describes how a bank should treat expected and unexpected credit losses?

1. A Expected losses should be covered by loan pricing and provisions, while capital is held as a buffer against unexpected losses.
2. B Capital should be sized to cover expected losses, while unexpected losses are absorbed by loan pricing and provisions.
3. C Diversifying across many borrowers removes unexpected losses, so capital is needed only for expected losses.
4. D Both expected and unexpected losses should be covered entirely by loan pricing, so no capital buffer is required.

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Answer: A. Expected loss (EL) is the mean of the loss distribution (PD x LGD x EAD). Because it is anticipated, it is treated as a cost: it is built into the interest rate or fee and covered by provisions.

Unexpected loss (UL) is the amount by which losses may exceed EL at a chosen confidence level. Banks hold (economic or regulatory) capital to absorb UL so that they remain solvent in bad years. Diversification lowers UL but cannot remove the systematic part driven by correlated defaults.

Question 2

Which arrangement best supports the independence and effectiveness of a bank's risk management function?

1. A The CRO reports solely to the head of the largest trading business, so that risk advice stays aligned with revenue goals.
2. B The CRO reports directly to, and has unrestricted access to, a board risk committee made up mainly of independent directors.
3. C The board risk committee is chaired by the CEO, so that risk decisions are fully integrated with business strategy.
4. D Risk managers' bonuses are based mainly on the profits of the business lines they oversee, to keep them commercially focused.

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Answer: B. Good risk governance requires the risk function to be independent of the risk takers. Typical features are: a CRO with sufficient seniority and a direct line (and unrestricted access) to the board or its risk committee; a risk committee with a majority of independent, risk-literate directors; and compensation for risk staff that does not depend on the profits of the businesses they oversee. Integration with strategy is achieved through the risk appetite framework, not by removing independence.

Question 3

Which weakness of the originate-to-distribute model of lending is most widely cited as a contributor to the 2007-2009 financial crisis?

1. A Originators were required to keep every loan they made, which concentrated all mortgage losses in a few lenders.
2. B Securitization rules forced originators to keep the entire equity tranche, which made them too conservative in lending.
3. C Originators expected to sell loans on quickly, so they had weaker incentives to screen and monitor borrowers carefully.
4. D Credit risk transfer stopped losses from spreading beyond the original lenders, so investors ignored the warning signs.

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Answer: C. Under originate-to-distribute, banks and brokers make loans intending to sell them into securitizations rather than hold them. Because the originator no longer bears the credit loss, its incentive to apply strict underwriting standards weakens, and investors further down the chain may rely on ratings rather than their own analysis. In the run-up to the crisis this contributed to poor-quality subprime lending; the resulting losses then spread through structured products and short-term funding markets (ABCP and repo). Post-crisis reforms responded partly by requiring securitizers to retain some of the credit risk ('skin in the game').

Question 4

Ardent Holdings, a diversified financial group, currently manages credit, market, insurance and operational risk in separate silos. Which is the main benefit it can expect from adopting enterprise risk management (ERM)?

1. A Business-line risk limits are no longer needed, because all risks are now managed directly by a single central team.
2. B Risk resources are focused only on the largest single risk type, so that effort is not spread across minor risks.
3. C Quantitative risk measurement is replaced by qualitative judgment, because aggregated risks cannot be modelled.
4. D Risks are viewed together across the firm, so diversification and natural hedges are recognised and capital and appetite are set consistently.

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Answer: D. Silo-based risk management can double-count some risks, miss others that fall between silos, and ignore offsetting exposures. ERM integrates the management of all material risks so that the firm can: see aggregate exposures and concentrations; recognise diversification benefits and natural hedges, potentially lowering total capital and hedging costs; set a firm-wide risk appetite and allocate capital consistently; and improve disclosure to boards, regulators and rating agencies.

Question 5

The board of Fenwick Bank is assessing the bank's risk culture. Which observation is the strongest evidence of a weak risk culture?

1. A The board has approved a risk appetite statement that is translated into limits for each business line
2. B Risk models are validated by a unit that is independent of the desks that developed them
3. C Limit breaches by the highest-earning desks are routinely approved after the event without escalation, and staff who query them are sidelined
4. D Part of senior staff bonuses is deferred and can be reduced if risk or conduct failures emerge later

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Answer: C. Supervisors (for example the Financial Stability Board) point to four broad indicators of a sound risk culture: tone from the top, accountability, effective communication and challenge, and incentives.

Retrospectively approving breaches for star performers and sidelining those who raise concerns undermines accountability and challenge, and tells staff that profit matters more than risk limits. The other three observations are signs of a strong framework.