# LO 50.2: Describe practices that can result in a strong and effective capital

LO 50.2: Describe practices that can result in a strong and effective capital adequacy process for a BHC in the following areas: Risk identification
Corporate governance Capital policy, including setting of goals and targets and contingency planning Stress testing and stress scenario design Estimating losses, revenues, and expenses, including quantitative and
Assessing the impact of capital adequacy, including risk-weighted asset (KWA)
qualitative methodologies
and balance sheet projections
For this LO, we detail the seven key practices that can result in a strong and effective capital adequacy process for a BHC.
Risk Identification
BHCs should have a process in place to identify all risk exposures stemming from numerous sources, including stress conditions, changing economic and financial environments, on- and-off balance sheet items, and their impact on capital adequacy. In addition, BHCs should critically scrutinize underlying assumptions regarding risk reduction through risk mitigation or risk transfer techniques. Senior management should regularly update and review the risk identification plan with special consideration for how their risk profiles might change under stress scenarios. Risk identification techniques should be able to detect the changes in the overall risk profile as well as the signs of capital inadequacy in the early stages.
BHCs should integrate the identified risk exposures into their internal capital planning processes. Scenario-based stress testing may not capture all potential risks faced by BHCs, some risks are difficult to quantify or they do not fall into the integrated firm wide scenarios. However, such risks must be included and accounted for in the capital planning processes. These risks are categorized as other risks, and their examples include compliance, reputational, and strategic risks. There are a variety of methods which BHCs can employ, including internal capital targets to incorporate such risks.
Internal Controls
An internal audit team should carefully scrutinize the internal control data for accuracy before submitting to senior management and the board. BHCs should have efficiently running management information systems (MIS) for collecting and analyzing pertinent information set quickly and accurately.
In addition, BHCs should put in place a detailed and organized documentation system fully encompassing all dimensions of capital planning processes, including risk identification, loss estimation techniques, capital adequacy, and capital decision processes.
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There must be a thorough, independent, and regular review and validation of all models used for internal capital planning purposes, including assessment of conceptual soundness of models and verification of processes. A validation team should have a required technical skill set as well as complete independence from all business areas of the BHC and model developers. Such independence is crucial for the validation team to offer an unbiased, independent, and valuable verdict.
BHCs should maintain and update a list of all inputs, assumptions, and adjustments for the models used to generate final projections and estimates, such as income, loss expenses, and capital. These models should be validated for their effective use, not only under normal conditions, but also under stress conditions. BHCs should make full disclosure of their validation process and outcome, and should restrict the use of models which are not validated.
Governance
BHCs should have boards with sufficient expertise and involvement to fully understand and evaluate the information provided to them by senior management regarding their capital planning processes. The board should be furnished with comprehensive information with respect to risk exposures, loss estimates, determinants of revenues and losses, underlying models and assumptions, and weaknesses and strengths of capital planning processes. Also, the boards should be informed about the stress scenarios and any corrective measures undertaken as a result of stress testing outcomes.
Under the Capital Plan Rule, the management of BHCs is required to furnish key information to the board for its approval of internal capital adequacy plans. Such information should include underlying assumptions and results of stress testing and the outcome of internal audits, as well as model review and validation checks.
Senior management should evaluate the internal capital plan on an ongoing basis, focusing on key weaknesses, strengths, assumptions, scenarios, estimates, and models. In addition, senior management should make appropriate adjustments and remediation to the capital plan if the review process reveals shortcomings in the plan.
BHCs should maintain detailed minutes of board meetings, describing the issues raised and discussed, as well as the information used and the recommendations made in these meetings.
Capital Policy
A capital policy should clearly define the principles and guidelines for capital goals, issuance, usage, and distributions. The policy should also fully spell out the details of the BHCs capital planning processes, including the decision rules of capital usage and distribution, financing, and other policies. The capital policy should focus on the unique needs and financial situation of BHCs while taking into consideration the supervisory
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expectations. Policies regarding common stock dividends and repurchase agreements should include the following: Key metrics influencing the size, timing, and form of capital distributions. Materials used in making capital distribution decisions.
Specific scenarios that would cause a distribution to be reduced or suspended. Situations that would cause the BHC to consider replacing common equity with other Specific scenarios that would cause a distribution to be reduced or suspended. Situations that would cause the BHC to consider replacing common equity with other forms of capital.
Key roles and responsibilities of individuals or groups for producing reference materials,
making distribution recommendations and decisions, and reviewing analysis.
Capital goals developed by BHCs should be compatible with their risk tolerance, risk profile, regulatory requirements, and expectations of various stakeholders (e.g., shareholders, creditors, supervisors, and rating agencies). BHCs should establish specific goals for both the level and composition of capital under normal as well as stress conditions. Capital targets, which need to be set above the capital goals for capital adequacy under stress conditions, should take into consideration future economic outlooks, stress scenarios, and market conditions.
While setting capital distribution levels, BHCs must take into consideration numerous factors, including future growth plans (including acquisitions) and associated risk, current and future general economic conditions, in particular the impact of macroeconomic and global events during stress conditions, on their capital adequacy. Capital distribution decisions must be connected to capital goals or capital adequacy requirements.
BHCs should develop strong contingency planning offering numerous options to deal with contingency situations as well as their effectiveness under stress conditions. Contingency plans should be based on realistic assumptions and contain futuristic outlooks, rather than overly relying on history. Contingency actions should be feasible and realistic in the sense that they should be easy to implement when or if the contingency warrants. Capital triggers flagging the early warning of capital deterioration should be based on the projected results, regulatory requirements, and the expectations of various stakeholders, including creditors, shareholders, regulators, investors, and counterparties.
Stress Testing and Stress Scenario Design
Scenario design and stress testing should focus on unique situations of BHCs, their asset and liability mix, portfolio composition, business lines, geographical territory, and revenue and loss factors, while taking into consideration the impact of macroeconomic and firm- specific vulnerabilities and risks. That is, the stress test designing should go above and beyond the general guidelines established by the supervisory authority. Also, a BHCs scenario designing and testing should not employ optimistic assumptions benefiting the BHC.
BHCs should employ both an internal model and expert judgment, an outside experts opinion. If only a third-party model is used, it must be tailored to the unique risk profile and business model of a BHC. The designed scenarios should assume a strong strain on the revenue and income of BHCs.
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Stress testing models should be based on multiple variables encompassing all the risk exposures faced by BHCs on a firm-wide basis. For example, BHCs concentrated in a region, business, or industry should include relevant region, business, or industry-related variables. In addition, the scenarios should clearly spell out how they address specific risks faced by BHCs. The description should also provide explanations of how a scenario stresses specific BHC weaknesses and how variables are related to each other.
Estimating Losses, Revenues, and Expenses
Q uantitative an d Q ualitative Basis
BHCs should prefer using internal data to estimate losses, revenues, and expenses. However, in certain situations, it may be more appropriate to use external data. In these instances, it should be ensured that the external data reflects the underlying risk profile of their business lines, and necessary adjustments should be made to data input or output to make the analysis reflect a true picture of the BHCs unique characteristics.
A range of quantitative methods are available to BHCs for estimating losses, revenues, and expenses. Regardless of which method they use, the final outcome should be identification of key risk factors and impact of changing macro and financial conditions under normal and stress conditions on a firm-wide basis.
In addition, BHCs should segment their line of businesses and portfolios utilizing common risk characteristics showing marked differences in past performances. For example, a borrowers risk characteristics can be segmented by criteria such as credit score ranges. However, each risk segment should have sufficient data observations on losses, revenues, and expenses, (and underlying factors impacting losses, revenues, and expenses) in order to generate meaningful model estimates.
Past relationships between losses, revenues, expenses, and underlying driving factors, and their interrelationships may not hold in the future, thus, necessitating employment of sensitivity analysis (to answer what if questions) when using models based on historical underlying interactions.
BHCs sometimes use qualitative methodologies, like expert judgment or management overlay, as a substitute or a complement to quantitative methods. Qualitative techniques should be based on sound assumptions, and an external reviewer should find these approaches logical, reasonable, and clearly spelled out. A sensitivity analysis should be used for a qualitative approach as well. From a supervisory standpoint, BHCs are expected to use conservative assumptions, not favorable to BHCs, for estimating losses, revenues, and expenses under normal and stress conditions.
Loss Estimation M ethods
BHCs should employ loss estimation methods, which offer theoretical soundness and empirical validity. In addition to using general macroeconomic explanatory variables, the loss estimation models should use specific variables exhibiting a direct link to particular exposures and portfolios.
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BHCs should use uniform, reputable methods to aggregate losses across various lines of business and portfolios for firm-wide scenario analysis. They should also use automated processes, without manual intervention or managerial adjustments showing clear linkage from data sources to loss estimation and aggregation. For estimating retail loan losses, BHCs often use internal data, but for wholesale loss estimation, internal data is supplemented with external data. In the case using external data, BHCs should demonstrate that the data reflects their risk exposures, encompassing geographic, industry, and other key dimensions. Risk segmentation should be supported by the data capturing the unique characteristics of each risk pool.
BHCs can use either an economic loss approach (i.e., expected losses) or an accounting- based loss approach (i.e., charge-off and recovery) to estimate credit losses. For the expected loss approach, BHCs should categorize losses into probability of default (PD), loss given default (LGD), or exposure at default (EAD) and then identify the determinants of each component. Long run averages for PDs, LGDs, and EADs should not be used, as these averages reflect economic downturn and upturn periods not necessarily suitable for scenario testing under stress conditions. LGD should be linked to underlying risk factors, such as a fall in the value of collateralized assets under stress conditions, and it should be estimated at some level of segmentation, such as lending product or type of collateral. EADs should be modeled to exhibit variation depending on changes in macroeconomic conditions.
If BHCs are using rating systems as a key input to estimate expected losses under stress (e.g., on their wholesale portfolios), they should recognize the limitations in rating systems and their data and make necessary adjustments.
BHCs should utilize a robust time series with sufficient granularity while employing role- rate models to estimate the rate at which delinquent and non-delinquent accounts in the current quarter are expected to roll over into default or delinquent status in the next quarter.
If using charge-off models (i.e., accounting models), BHCs should include variables which represent the risk characteristics of an underlying portfolio while estimating the statistical relationship between charge-off rates and macroeconomic variables at the portfolio level.
O perational Risk
In order to determine operational risk, many BHCs estimate correlation between operational risk and macroeconomic factors. If they do not discover a statistically significant relationship between the variables, they employ other methods, including scenario analysis utilizing historical data and management input. BHCs should employ a combination of techniques to develop strong loss estimates under stress conditions, including past loss records, future expected events, macro conditions, and firm-specific risks.
BHCs using regression models to estimate loss frequency and loss severity under stress scenarios should provide statistical support for the period chosen for estimation purposes instead of arbitrary and judgmental selection.
A modified loss distribution approach (LDA) is also used by BHCs to estimate value at risk (VaR) to estimate operational risk losses at a chosen confidence interval (e.g., 90% or 95%).
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To generate a strong and effective process, BHCs should offer a sound justification for their choice and perform a sensitivity analysis around the chosen interval.
Some BHCs use scenario analyses in case they encounter model or data limitations in order to incorporate a wide range of risks (which is not possible otherwise due to data or model limitations). In such events, BHCs should provide a rationale for the chosen scenario in their loss estimation process.
M arket Risk an d Counterparty Credit Risk
BHCs, which are involved in trading, are subject to counterparty credit risk from changes in the value of risk exposure and creditworthiness of the counterparty due to changing macroeconomic conditions.
In order to estimate the potential loss resulting from market credit interaction, BHCs use probabilistic approaches (which produce a probability distribution of expected portfolio losses) and deterministic approaches (which yield point estimates of an expected portfolio loss).
BHCs using probabilistic approaches should clearly offer evidence that such methods can yield more severe risk scenarios compared to historical scenarios. BHCs should also explain how they utilize tail loss scenarios to detect and address firm-specific risks.
BHCs using deterministic approaches should demonstrate that they have employed a wide range of scenarios, adequately covering their key risk exposures, including mark-to-market positions in the event of firm-specific or market-wide stress conditions. In addition, BHCs should clearly spell out the underlying assumptions employed in stress testing scenarios for risk measurement purposes and corrective measures to fix the identified deficiencies.
Market shock scenarios do not directly incorporate the default of the counterparty. Some BHCs explicitly incorporate the scenario of default of key counterparties (including key customers) while using some sort of probabilistic approach involving some estimates of the PD, LGD, and EAD of counterparties. This method allows BHCs to focus exclusively on the defaults of counterparties to which BHCs have large risk exposure.
BHCs also use assumptions about risk mitigation in the future. Such assumptions, if used, should be conservative in nature. In stress scenarios, the ability of BHCs to take desired actions may be limited.
PPNR Projection M ethodologies
PPNR is pre-provision net revenue (i.e., net revenue before adjusting for loss provisions). While estimating revenues and expenses over a planning horizon under stressed conditions (the Capital Plan Rule requires forecasts over the next nine quarters), BHCs should not only take into consideration their current situation, but also the possible future paths of business activities and operational environments related to their on- and off-balance sheet risk exposures, underlying assumptions, and assets and liabilities.
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BHCs should also take into consideration the impact of regulatory changes on their performance and ability to achieve their stated targets and goals. Projections should be based on coherent and clearly defined relationships among numerous, relevant variables, such as revenues, expenses, and balance sheet items within a given scenario. For example, assumptions related to origination should be the same for projections related to loans, fees, costs, and losses.
Underlying assumptions for revenues, expenses, and loss estimates should be theoretically and empirically sound, and the central planning group as well as the corporate planning group should be engaged in aggregating projections on an enterprise-wide basis. In the case of limited data, BHCs should employ external data in conjunction with internal data.
Net interest income projections are not isolated projections; rather, they are entrenched with other items of a capital adequacy plan. Balance sheet assumptions should be consistent while projecting net interest income. For example, balance sheet assumptions for projecting net interest income should be the same when estimating loss. Methods employed for projecting net interest income should incorporate ongoing changes in current and projected balance sheet positions.
BHC projections under various scenarios, based on product characteristics (e.g., a change in deposit mix due to increased demand for time deposits), underlying assumptions, and rationale by product should be carefully explained.
BHCs linking loss projections to net interest income projections should clearly establish this link while using modeling approaches, which incorporate the behavioral characteristics of the loan portfolio.
Net interest income projections should be based on methodologies that incorporate discount or premium amortization adjustments for assets not held at par value that would materialize under different scenarios.
New business pricing projections and underlying assumptions, such as constant add-ons to a designated index value, should be compatible with past data, scenario conditions, and BHCs balance sheet projections.
BHCs should project non-interest income in light of stated scenarios and business strategies. Projection methods should fully encompass underlying major risk exposures and characteristics of a specific business line. For example, an asset management group should project non-interest income using various methods, including brokerage as well as money management revenues.
Additionally, BHCs with trading portfolios should establish a clear link between trading revenue projections to trading assets and liabilities and the compatibility of all the elements of stress scenario conditions.
BHCs with off-balance sheet business items should demonstrate the linkage between revenue projections and changes in on- and off-balance sheet items.
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BHCs should not assume perfect correlation between revenues (generated from trading or private equity activity) and broad indices. BHCs should estimate the sensitivity coefficients for changes in revenue as a result of changes in broad index movements.
Furthermore, BHCs holding mortgage servicing rights assets (MSRAs) should carefully design assumptions regarding default, prepayment, and delinquency rates, ensuring that these assumptions are robust and scenario specific. In addition, BHCs that hedge MSRA risk exposure should generate scenario specific assumptions.
For BHCs, projecting volume increases in mortgage loans while ignoring market saturation or other key factors would be an ineffective and weak process, whereas consideration of individual business models, client profiles, and capacity constraint (while projecting mortgage loan volume) would be an effective and strong capital adequacy process.
Macroeconomic relationships should be based on sound theoretical construct and supported by empirical evidence. For example, BHCs may experience a steep decline in credit card fee revenues in a strong recessionary period because of a decline in consumer spending. .Ail example of a weaker practice of a capital planning process is if a BHC does not show a sufficient decline in revenue in stressed conditions despite obvious macro relationships.
In addition, BHCs should utilize a wide set of explanatory variables to develop statistical relationships. BHCs should take into consideration the impact of macroeconomic conditions, such as an economic downturn, on their non-interest expense projections. Non interest expense projections, like all other projections, should be consistent with revenue and balance sheet estimates and should generate the same underlying strategic assumptions. If projections assume that a decline in revenue (e.g., due to an increase in credit collection costs in an economic downturn) can be offset by some mitigating strategies, BHCs should then clearly demonstrate the feasibility of such actions. Mitigation actions should not be supported by past relationships and actions only because future financial, macro, and global environments may not be as favorable to execute such strategies, as was the case in the past.
Estimation methods to project non-interest expense should focus on uncovering determinants (factors) of individual expense items and how sensitive those factors are to changing macro conditions and business strategies.
Assessing the Impact of Capital Adequacy
BHCs should have a well-defined and well-documented process of generating projections with respect to size and composition of on- and off-balance sheet items and risk-weighted assets (RWA) over a stress horizon period.
Projecting balance sheet items, such as changes in assets and funding, directly without consideration of underlying drivers (of such changes), would be a weak practice. BHCs should identify the impact of changes in key factors on changes in asset and liabilities. Projections should take into consideration these vital relationships.
BHCs should incorporate relationships between revenues, expenses, and balance sheet items into their scenario analyses. Projections about losses, revenues, expenses, and on- and
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off-balance sheet items should not be based on favorable underlying assumptions. These assumptions may not stand the trial of uncertain market conditions under stress conditions.
Projections for RWA should be consistent with the projections for risk exposures of on- and off-balance sheet items. All underlying assumptions used for balance sheet and RWA projections should be clearly documented and critically reviewed and validated.
BHCs with a strong process of implementation should form a centralized group responsible for aggregating loss, revenue, expense, on- and off-balance sheets, and RWA projections for enterprise-wide scenario analysis. In addition, BHCs should establish a strong governance structure to critically scrutinize assumptions, methods, and estimates generated in an enterprise-wide scenario analysis and offer needed adjustments. BHCs should carefully evaluate the validity and relevance of underlying assumptions across business lines, portfolios, loss, expense, and revenue estimates if an enterprise-wide scenario analysis produces post-stress results that are more favorable than the baseline conditions. The outcomes of such analyses should also be reconciled for regulatory as well as management reporting purposes.
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K e y C o n c e p t s
LO 50.1 The Federal Reserves Capital Plan Rule mandates all top-tier, U.S. domiciled bank holding companies with consolidated assets equal to or greater than $50 billion to develop and maintain an effective and robust internal capital plan for evaluating and assessing their capital adequacy. There are seven principles on which the Federal Reserve assesses the effectiveness of a BHCs internal capital planning, also known as the capital adequacy process (CAP). These seven principles are related to risk management foundation, resource and loss estimation methods, capital adequacy, capital planning and internal controls policies, and governance oversight. LO 50.2 BHCs should develop a process to effectively identify all of their risk exposures on a firm wide basis. BHCs should establish a mechanism for a comprehensive, independent, and regular review and validation of all the models used for capital adequacy planning purposes. BHCs should have boards actively involved in evaluating and approving their internal capital adequacy plans. BHCs should develop a capital policy that clearly defines the principles and guidelines for capital goals, issuance, usage, and distributions. Stress testing and stress scenario design should be based on a variety of factors encompassing all the risk exposures faced by BHCs on a firm-wide basis. With the option of utilizing various quantitative and qualitative methods, BHCs should carefully identify key risk exposures on a firm-wide scenario basis. BHCs should use loss estimation methodologies, which are based on sound theoretical and empirical foundations. BHCs should use a combination of inputs in order to develop loss estimates arising from operational risk. In order to estimate the counterparty credit risk, BHCs mostly use probabilistic or deterministic approaches. BHCs using a probabilistic approach should offer evidence of generating probable scenarios stronger than past observed events. BHCs using a deterministic approach should generate a wide range of stress scenarios. While estimating pro-provision net revenue (PPNR) projection methodologies, BHCs should pay particular attention to interrelationships among numerous relevant variables such as revenues, expenses, and on- and off-balance sheet items within a given scenario. Methodologies used for projecting net interest income should incorporate ongoing, current, and projected balance sheet positions. BHCs should project non-interest income in light of stated risk scenarios and business strategies. BHCs should have a well-defined process in place to develop projections of revenues, expenses, losses, on- and off-balance sheet items, and risk-weighted assets in an enterprise wide scenario analysis. Projections should be based on sound underlying assumptions, interactions, and factors (main drivers of change), and the estimates should be scrutinized, documented, and reported. 2018 Kaplan, Inc. Page 175 Topic 50 Cross Reference to GARP Assigned Reading – Board o f Governors o f the Federal Reserve System C o n c e p t C h e c k e r s 1. 2. 3. 4. 5. The seven principles of an effective capital adequacy process for bank holding companies (BHCs) subject to the Capital Plan Rule include which of the following? I. Oversight from peer BHCs II. Annual reporting to the stock exchange (where their stock is listed) A. I only B. II only. C. Both I and II. D. Neither I nor II. The Federal Reserves Capital Plan Rule requires BHCs to maintain an effective process for assessing their capital adequacy for: A. BHCs, U.S. or non-U.S. domiciled. B. BHCs with more than five years of operational history. C. BHCs with a net annual income of more than$5 billion. D. BHCs with total consolidated assets of $50 billion or greater. How many of the following statements is most likely correct? BHCs should have risk identification processes that evaluate: I. On- and off-balance sheet positions. II. Risk transfer and/or risk mitigation techniques. III. Changes in institutions risk profile due to portfolio quality. IV. Reputational risk. A. One statement. B. Two statements. C. Three statements. D. Four statements. Which of the following statements is most likely correct? A. The internal controls policy of BHCs requires that senior management should furnish the board of directors with sufficient information to comprehend the BHC risk exposures. B. A governance policy offers fundamental guidelines and principles to BHCs for the capital issuance, use, distribution, and planning purposes. C. Suspension or reduction in dividends or repurchase programs do not fall under the capital policy of BHCs. D. Designing and testing a scenario-related default of a major counterparty is an example of BHC stress testing and a stress scenario design policy. Which of the following statements is most likely correct? I. Under the expected losses methodologies, loss estimation involves three elements: probability of default, loss given default, and exposure at default. II. Net interest income projections should incorporate changing conditions for balance sheet positions, including embedded options, prepayment rates, loan performance, and re-pricing rates. A. I only. B. II only. C. Both I and II. D. Neither I nor II. Page 176 2018 Kaplan, Inc. Topic 50 Cross Reference to GARP Assigned Reading – Board o f Governors o f the Federal Reserve System C o n c e pt C h e c k e r A n sw e r s 1. D Oversight from peer BHCs and annual reporting to the stock exchange are not included in the seven principles of an effective capital adequacy process. 2. D BHCs with total consolidated assets of$50 billion or greater. The other answers are not part
of the requirements under the Capital Plan Rule.
3. D All of the statements are correct. BHCs should have risk identification processes effectively
identifying all risk exposures for assessing capital needs. Reputational risk, like strategic risk and compliance risk, falls under the category of other risks and are more difficult to quantify. Nevertheless, there are a wide range of methods BHCs employ to evaluate other risks.
4. D The first statement is the requirement of the governance policy and not the internal control
policy. The second statement falls under capital policy and not the governance policy. Regarding the third statement, capital contingency plans (e.g., suspension or reduction in dividends or repurchase programs) are a key part of capital policies of BHCs detailing the actions intended to be taken under deficiencies in capital position. The fourth statement is correct. Many different scenarios, including counterparty default, fall under the BHCs stress testing and scenario design policy.
5. C Both statements are correct. Loss estimation involves probability of default, loss given default, and exposure at default. Net interest income projections should incorporate changing conditions for balance sheet positions, including embedded options, prepayment rates, loan performance, and re-pricing rates.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Re pu r c h a s e A g r e e me n t s a n d FINANCING
Topic 51
E x a m F o c u s
Repurchase agreements, or repos, are short-term financing vehicles to borrow/lend funds on a secured basis. The most common repos are for overnight lending. This topic discusses the mechanics of repos, including settlement calculations, the motivations of market participants for entering into repos, as well as the risks (credit risk and liquidity risk) that arise from their use. It also discusses collateral types used in repos, including general collateral and special collateral. For the exam, focus on the characteristics of repo transactions and the primary motivations for using repos. Understanding these motivations should give you a good indication of how and why repos are used in the market, what risks repos hedge, what risks arise from repo trading, and how changes in the market environment affect repos.
M e c h a n i c s o f R e p u r c h a s e A g r e e m e n t s