CHAPTER 1.

THE CREDIT DECISION AND CREDIT ANALYST

Question 1.1. Blackstone Credit, Inc., made a loan to a small start-up firm. The firm grew
rapidly, and it appeared that Blackstone had made a good credit decision. However, the firm
grew too fast and could not sustain the growth. It eventually failed. Blackstone had initially
estimated its exposure at default to be $1,200,000. Because of the firm’s rapid growth and
resulting increases in the line of credit, Blackstone ultimately lost $1,550,000. In terms of
credit risk, this is an example of:
A. default on payment for goods or services already rendered.
B. a more severe loss than expected due to a ratings downgrade by a rating agency.
C. a more severe loss than expected due to a greater than expected exposure at the time of a
default.
D. a more severe loss than expected due to a lower than expected recovery at the time of a
default.

Question 1.2. Sarah Garrison is a newly hired loan officer at Lexington Bank and Trust. Her
boss told her she needs to make five commercial loans this month to meet her sales goal.
Garrison tal
ks to friends and hears about a local businessperson with a great reputation. Everyone in
town says John Johnson is someone you want to meet. Garrison sets up a meeting with
Johnson and is immediately impressed with his business sense. They discuss a loan for a new
venture Johnson is considering, and Garrison agrees that it is a great idea. She takes the loan
application back to the bank and convinces the chair of the loan committee that Lexington
Bank and Trust is lucky to be able to do business with someone with Johnson’s reputation.
This is an example of:
A. historical analysis technique.
B. qualitative analysis technique.
C. quantitative analysis technique.
D. extrapolation analysis technique.

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Question 1.3. Stacy Smith is trying to forecast the potential loss on a loan her firm made to a
mid-size corporate borrower. She determines that there will be a 75% loss if the borrower does
not perform the financial obligation. This is the:
A. probability of default.
B. loss given default.
C. expected loss.
D. exposure at default.

Question 1.4. Bank of the Plain States has been struggling with poor asset quality for some
time. The bank lends primarily to large farming operations that have struggled in recent years
due to a glut of soybeans and corn on the market. Bank regulators have recently required that
the bank write off some of these loans, which has entirely wiped out the capital of the bank.
However, the bank still has some liquidity sources it can use, including a correspondent bank
and the Federal Reserve. Bank of the Plain States is:
A. an insolvent but not failed bank.
B. both a failed bank and an insolvent bank.
C. neither a failed bank nor an insolvent bank.
D. a failed bank but not an insolvent bank.

Question 1.5. Richard Marshall, FRM, is a rating agency analyst who is currently performing
financial statement analysis on a major bank. Which of the following financial statements would
be least useful for bank credit analysis?
A. Balance sheet.
B. Income statement.
C. Statement of cash flows.
D. Statement of changes in capital funds.

Question 1.6. Credit risk may be defined as the risk of monetary loss arising from any of the
following four circumstances, EXCEPT FOR which is inaccurate?
a. Default of a counterparty
b. An increased probability of default
c. Lower than expected exposure
d. Settlement risk
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 CHAPTER 2: EXTERNAL, INTERNAL CREDIT RATINGS AND MEASURING CREDIT RISK
Question 2.1. A Big Bank has two assets outstanding. The features of the loans are summarized
in table. Assuming a correlation of 0.3 between the assets, compute ELP and ULP as well as the
risk contribution of each asset.

Asset 𝐴 Asset 𝐵

EA $8,250,000 $1,800,000

PD 0.50% 1.00%

LGD 50.00% 40.00%

𝜎PD 2.00% 5.00%

𝜎LR 25.00% 30.00%

Question 2.2.Suppose a bank has booked a loan with the following characteristics: total
commitment of $2,000,000 of which $1,800,000 is currently outstanding. The bank has
assessed an internal credit rating equivalent to a 1% default probability over the next year. The
bank has additionally estimated a 40% loss rate (or loss given default) if the borrower defaults.
The standard deviation of PD and loss given default (LGD) is 5% and 30%, respectively.
Calculate the expected and unexpected loss for this bank

Question 2.4. A Bank is trying to forecast the expected loss on a loan to a mid-size corporate
borrower. It determines that there will be a 75% loss if the borrower does not perform the
financial obligation. This risk measure is the:
A. probability of default.
B. loss rate.
C. unexpected loss.
D. exposure amount.

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Question 2.5.Which of the following statements about expected loss (EL) and unexpected loss
(UL) is true?
A. Expected loss always exceeds unexpected loss.
B. Unexpected loss always exceeds expected loss.
C. EL and UL are parameterized by the exact same set of variables.
D. Expected loss is directly related to exposure.

Question 2.6. If the recovery rate (RR) increases and the probability of default (PD) decreases,
what will be the effect on expected loss (EL), all else equal?
RR Increase PD Decreas
A. Increase Increase
B. Decrease Increase
C. Increase Decrease
D. Decrease Decrease

Question 2.7. Big Bank has contractually agreed to a $20,000,000 credit facility with Upstart
Corp., of which $18,000,000 is currently outstanding. Upstart has very little collateral, so Big
Bank estimates a one-year probability of default of 2%. The collateral is unique to its industry
with limited resale opportunities, so Big Bank assigns an 80% loss rate. The expected loss (EL)
for Big Bank is closest to:
A. $68,000.
B. $72,000.
C. $272,000,
D. $288,000.

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 CHAPTER 3: CAPITAL STRUCTURE IN BANKS
Question 3.1. The following simplified credit rating transition matrix (aka, migration matrix)
displays one-year conditional probabilities for only two credits (A and B). For example, the A-
rated credit has an 80.0% probability of remaining A-rated at the end of the year, and a 20.0%
probability of being downgraded to B-rated, but is not expected to default within one year.
From year to year, migrations are independent; i.e., the matrix satisfies the Markov property.
A B D
A 80% 20% 0%
B 10% 70% 20%
D 0% 0% 100%
A bank has extended a three-year $15.0 million loan to a B-rated corporate borrower. The bank
assumes the exposure at default (EAD) is the principal amount of $15.0 million and estimates a
40.0% recovery rate. If the relevant default probability is the three-year cumulative default
probability, then what is the expected loss (EL)?
a) $1,800,000
b) $2,250,000
c) $3,978,000
d) $4,392,000

Question 3.2. A credit portfolio contains an adjusted exposure of $30.0 million with a default
probability of 4.0%. In regard to loss given default (LGD), the Portfolio Manager estimates an
(LGD) of 40.0% with a standard deviation, o(LGD), of 40.0%. What is the position's unexpected
loss (UL)?
a) $2.250 million
b) $3.360 million
c) $5.490 million
d) $7.810 million

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Question 3.4.Consider the following four short-term loans held by a bank: (*) Hazard rate (aka,
default intensity) which is by definition continous, but it is okay to assume discrete as difference
is not here material. Which loan has the highest expected loss in dollar terms?
Loan Remaining term Exposure at One-year Loss given Default
(in months) default Probability of
(millions) Default (*)
a 3 $100 4% 90%
b 6 $120 3% 60%
c 9 $150 2% 60%
d 12 $200 1% 50%

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