Module: | MODULE B: RISK MANAGEMENT
Q279: Scenario: XYZ Bank extends a floating-rate term loan to a large infrastructure company, while simultaneously issuing a financial bank guarantee on its behalf. Later, the country experiences an economic downturn, leading to severe supply chain disruptions for the borrower. Based on RBI guidelines, consider the following statements regarding the correct risk identification and regulatory actions:
1. The floating-rate term loan exposes the bank to credit default risk, but completely eliminates all forms of interest rate risk.
2. The financial bank guarantee represents an off-balance sheet exposure, which must be converted to a credit equivalent amount to calculate potential credit risk.
3. The supply chain disruption affecting the borrower's cash flows increases migration risk, potentially leading to a downgrade in the internal credit rating.
Which of the statements given above is/are correct?
2. The financial bank guarantee represents an off-balance sheet exposure, which must be converted to a credit equivalent amount to calculate potential credit risk.
3. The supply chain disruption affecting the borrower's cash flows increases migration risk, potentially leading to a downgrade in the internal credit rating.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is incorrect: A floating-rate loan significantly reduces fair value interest rate risk, but it does NOT "completely eliminate all forms of interest rate risk". The bank is still exposed to Basis Risk (if the loan pricing benchmark differs from the funding benchmark) and Yield Curve Risk.
Statement 2 is correct: A financial bank guarantee is an Off-Balance Sheet (OBS) contingent liability.
To calculate the capital requirement, RBI mandates applying a Credit Conversion Factor (CCF) to determine the Credit Equivalent Amount (CEA), bringing it effectively onto the balance sheet for risk measurement.
Statement 3 is correct: Migration Risk (or Downgrade Risk) is a sub-type of Credit Risk.
As the borrower's cash flows deteriorate due to external shocks, the probability of default increases, naturally triggering a downward migration in the borrower's assigned internal risk rating scale.
Statement 2 is correct: A financial bank guarantee is an Off-Balance Sheet (OBS) contingent liability.
To calculate the capital requirement, RBI mandates applying a Credit Conversion Factor (CCF) to determine the Credit Equivalent Amount (CEA), bringing it effectively onto the balance sheet for risk measurement.
Statement 3 is correct: Migration Risk (or Downgrade Risk) is a sub-type of Credit Risk.
As the borrower's cash flows deteriorate due to external shocks, the probability of default increases, naturally triggering a downward migration in the borrower's assigned internal risk rating scale.