CH 10 Current Issues in Financial Markets GX1MQW9LRI

FRM Part II Exam
By AnalystPrep
Questions with Answers - Current Issues in Financial Markets
Last Updated: Jul 8, 2023
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Table of Contents
153 - Machine Learning and AI for Risk Management 3

154 - Artificial Intelligence Risk & Governance 13
155 - Climate-related Risk Drivers and their Transmission Channels 24
156 - Climate-related Financial Risks – Measurement Methodologies 29
Principles for the Effective Management and Supervision of
157 - 48
Climate-related Financial Risks
158 - Inflation: A Look Under the Hood 55
159 - The Blockchain Revolution: Decoding Digital Currencies 62
160 - The Future Monetary System 83
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© 2014-2023 AnalystPrep.
Reading 153: Machine Learning and AI for Risk Management
Q.4945 A risk analyst is modeling the risk of loan repayment through machine learning regression.
Among the independent variables he's working with, there's (I) owns a house, (II) owns a car, and
(III) has bank savings. He believes that these variables are highly correlated and would like to
combine them into one common factor termed asset ownership. Which of the following techniques
will help him achieve this goal?
A. LASSO regression.
B. LARS regression.
C. Principal component analysis.
D. Ridge regression.
T he correct answer is C.
Supervised learning uses principal component analysis to reduce the number of variables by
combining variables and extracting common factors. T he goal is to find the "principal" components
that have the highest impact on the dependent variable. Principal components remove noise by
reducing a large number of features to just a couple of key components.
A i s i ncorrect. LASSO regression works by zero-weighting the independent variables with low
explanatory power.
B i s i ncorrect. LARs regression works by initially zero-weighting all variables and only adding
variables that are shown to have explanatory power.
D i s i ncorrect. Ridge regression works by giving lower weights to variables highly correlated with
other variables in a model.
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Q.4946 In what type of learning is labeled training data used?
A. Classification.
B. K-means clustering.
C. Deep learning.
D. Neural networks.
T he correct answer is A.
Classification (supervised machine learning) involves grouping data into labeled classes. For example,
when modeling the likelihood of default, we could have two categories: Potential defaulters and non-
defaulters. T he model would then be trained to classify the data into one of the two classes in an
accurate manner.
K-means clustering, deep learning, and neural networks are all unsupervised learning techniques.
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Q.4947 T he main difference between classification and regression is that:
A. Regression results in a single output, while classification results in multiple outputs.
B. Regression is a supervised machine learning technique, while classification is an

unsupervised technique.
C. Regression requires training data, but classification does not.
D. Regression always results in a single output, but classification always results in binary
categories.
Regression utilizes training data comprising at least one explanatory (input) variable, to produce a
single predicted output. T his is a probabilistic process that considersthe strength of the correlation
between the input variables. For example, a regression can help a bank forecast the price of a house
based on three key factors: location, size, and other finishing quality. On the other hand, classification
involves dividing data into categories based on certain characteristics. T hus, there are several
outputs.
B i s i ncorrect. Both regression and classification are supervised learning techniques.
C i s i ncorrect. As supervised learning techniques, both regression and classification require some
training data.
D i s i ncorrect. Under classification, we could have two output categories when dealing with binary
data, but we could also have more than two categories. In binary classification, the model works with
just two labels - 0 and 1 (yes and no). In the case of multi-class classification, the model classifies data
into more than one class.
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Q.4948 An analyst is trying to identify natural patterns in a set of deposit accounts. Her goal is to use
the k-means clustering technique. How many clusters is she targeting?
A. k - 1.
B. 1.
C. 2.
D. k.
T he correct answer is D.
Under k-means clustering, the desired number of clusters, k, is predetermined. T he algorithm is then
tasked with clustering the data into the k groups through an iterative process.
Q.4949 K-means clustering aims to partition n observations into k clusters in which each observation
belongs to the cluster with the nearest:
A. Standard deviation.
B. Mean.
C. Mode.
D. Median.
T he correct answer is B.
Under k-means clustering, the desired number of clusters, k, is predetermined. T he algorithm is then
tasked with clustering the data into the k groups through an iterative process. A larger k means
you've got smaller groupings with more granularity, while a lower k means larger groupings with less
granularity. Iteration is aimed at maximizing the difference in means between determined groups.
Each group or cluster has its own centroid (central focal point). If we have two clusters, A and B,
and a data point Y is closer to the centroid (mean) of A than B's, then Y is put in cluster A.
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Q.4951 Which of the following AI and machine learning challenges is of utmost concern to regulatory
authorities?
A. Unavailability of adequate skilled labor.
B. A lack of transparency around key decisions.
C. A lack of accuracy of some machine learning solutions.
D. Unavailability of adequate well-organized data.
As good as AI and machine learning tools can be, there seems to be a consensus that some of the
underlying solutions are not as transparent as firms and regulatory authorities would want. One of
the most contentious solutions is deep learning, where models work out the output in a black box
system. If a firm cannot clearly demonstrate how certain decisions are made, it would be difficult to
convince regulatory authorities that the models being used are valid and ethically sound.
Options A, C, and D all express valid shortcomings of AI and machine learning techniques, but they all
express problems for firms themselves, not regulatory authorities.
Q.4953 AI and machine learning help firms better manage market risk by:
A. Providing tools to stress test models.
B. Identifying hidden operational risk exposures.
C. Providing more accurate tools for the measurement of the probability of default.
D. Providing RegTech tools that pave the way for continuous monitoring of firm activities.
One of the risks of using models to analyze market risk is that such models can be incomplete, false,
invalid, or even incorrectly specified in terms of parameters. Machine learning can reveal whether
the models used have any of these issues. Machine learning techniques can also be used to scan for
unsuitable assets in trading models.
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Q.5180 In the context of supervised learning, a risk analyst employs Principal Component Analysis
(PCA) to model credit repayment risk. T he independent variables under consideration include (I)
owns a house, (II) owns a car, and (III) has bank savings. After performing PCA, the analyst derives a
principal component termed as "asset ownership." Which of the following implications of this
transformation is correct?
A. T he analyst has fully eliminated the need for original variables in the model.
B. "Asset ownership" encapsulates the common variance among the original variables.
C. Each original variable has an identical influence on the credit repayment risk.
D. T he principal component "asset ownership" solely and directly causes changes in credit
repayment risk.
Principal Component Analysis (PCA) is a statistical procedure aimed at reducing the dimensionality of
data while retaining as much meaningful information as possible. It achieves this by identifying the
shared variance among potentially correlated variables and combining them into fewer uncorrelated
variables - the principal components. In this scenario, the original variables (I) owns a house, (II)
owns a car, and (III) has bank savings have been synthesized into a single principal component: "asset
ownership". T his new component captures the common variance among the original variables,
hence reflecting the underlying construct that they collectively represent - in this case, the notion
of 'financial stability'.
Opti on A i s i ncorrect because PCA doesn't render original variables useless for subsequent
analyses. Instead, they are transformed into a set of uncorrelated principal components that retain
most of the data's variance while reducing the data's dimensionality.
Opti on C i s i ncorrect because, in PCA, each original variable's contribution to a principal
component depends on its correlation with the other variables, and thus they do not necessarily
contribute equally to the dependent variable.
Opti on D i s i ncorrect because PCA does not establish causal relationships. T he principal
component "asset ownership" indicates a shared variance among the original variables but does not
directly cause changes in the dependent variable, i.e., credit repayment risk.
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Q.5181 How does the K-means algorithm separate a sample into clusters?
A. By minimizing the distance between points within the same cluster.
B. By maximizing the distance between points in different clusters.
C. By minimizing the variance in the first cluster only.
D. By maximizing the variance between clusters.
T he K-means algorithm separates a sample into clusters by minimizing the sum of squared distances
between data points and the centroid of the cluster to which they belong. T he algorithm begins by
randomly selecting K initial cluster centers. It then assigns each point in the sample to the cluster
with the nearest center.
T he algorithm then recalculates the cluster centers as the mean of all the points in the cluster. It
repeats the process until the cluster assignments do not change or a maximum number of iterations
is reached. T he goal of the algorithm is to minimize the sum of the squared distances between each
point and its assigned cluster center, which results in clusters with points that are more similar to
each other.
C i s i ncorrect since K-means aims to minimize the variance within each cluster.
K-means minimizes rather than maximizes the distance, so B and D are i ncorrect.
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Q.5184 Consider a decision tree, which is an example of a supervised machine learning technique. In
the context of its most frequent applications and its assumptions about the relationships among
variables, how can we most accurately characterize decision trees?
A. T hey employ a linear regression-based approach for problem-solving.
B. T hey deploy non-linear regression methods to model relationships.
C. T hey utilize linear algorithms for classifying data into distinct categories.
D. T hey make use of non-linear classification methods to segregate data.
A decision tree is a popular algorithm under supervised machine learning, used extensively for
classification - problems where the goal is to predict a discrete label or category that an observation
belongs to. For example, a decision tree might classify emails as "spam" or "not spam." In addition,
decision trees do not assume a linear relationship between the input and output variables. Instead,
they make divisions in the feature space that allow for complex, non-linear relationships to be
modeled. In effect, they create a series of "if-then" decision rules, which can capture patterns that a
linear model might miss.
Options A, B, and C are incorrect because decision trees are not inherently linear models and are
typically associated with classification tasks.
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Q.5185 Which of the following accurately describes a major potential challenge related to the
implementation of AI and deep learning techniques in risk management?
A. AI and machine learning techniques are unable to effectively interpret and process data
formats common in financial services, such as Excel or SQL.
B. T hey are leading to a homogenization of trading models across different firms, potentially
increasing systematic risk.
C. AI and machine learning techniques struggle with the identification and processing of
complex unstructured data types, such as natural language or images.
D. T hey only require minimal human oversight in decision-making processes.
Option B correctly identifies one of the significant concerns regarding the implementation of AI and
deep learning techniques in risk management. T he convergence of models used by different firms on
similar optima could potentially lead to increased systematic risk and loss to the firm. T his is because
a problem affecting one firm's model is likely to affect other firms using similar models, potentially
leading to widespread financial distress.
Opti on A i s i ncorrect because AI and machine learning packages are capable of reading various
types of data, including from Excel and SQL. Similarly, opti on C i s i naccurate as these
technologies can effectively process natural language and images.
Opti on D i s mi sl eadi ng. While AI and machine learning techniques do automate parts of the
decision-making process, they do not eliminate the need for human oversight. In fact, as these
technologies become more advanced and complex, the importance of human oversight in monitoring
and verifying their decisions increases. For instance, full automation of processes from data
gathering to decision-making would require even more stringent human oversight to control
associated risks.
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Q.5186 Which of the following statements is the most accurate?
A. In reinforcement learning, the algorithm is trained on a smaller dataset, and it is expected

to generalize to new situations. On the other hand, in supervised learning, the algorithm is
trained on a larger dataset and is expected to perform well on the training data.
B. In reinforcement learning, the algorithm is given correct output values, similar to how
supervised learning algorithms are presented with labeled data.
C. Reinforcement learning is similar to supervised learning. In both cases, the algorithm must
learn through trial and error but is not presented with the correct output values for the
training set.
D. Reinforcement learning is not based on labeled training data, but rather it uses feedback in
the form of rewards or punishments to learn how to take actions in an environment to
maximize a reward.
Reinforcement learning is a type of machine learning that involves an agent that takes actions in an
environment in order to maximize a reward. In reinforcement learning, the agent is not presented
with labeled training data; rather, it receives feedback in the form of rewards or punishments based
on its actions. T he agent uses this feedback to learn which actions are most likely to lead to a
positive reward, and it adjusts its behavior accordingly.
C i s i ncorrect: Supervised learning algorithms are presented with labeled training data and use that
data to make predictions or classify new data.
A i s i ncorrect: Both reinforcement learning and supervised learning algorithms can be trained on
datasets of any size.
B i s i ncorrect: In reinforcement learning, the algorithm is not presented with correct output
values. Rather, it is given information on how well it performed in the previous iterations and it uses
this feedback to improve its decision-making strategy.
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Q.5187 Which of the following would be the most appropriate machine-learning algorithm for
predicting the value of a house price index in ten years?
A. Supervised learning.
B. Unsupervised learning.
C. Reinforcement learning.
D. All of the above.
Supervised learning aims to make predictions based on a labeled dataset, where the target variable
(the output) is known. In this case, the target variable is the value of the house price index in ten
years, and the goal is to make a prediction for this value based on the given data. T herefore, a
supervised learning algorithm would be appropriate for this problem.
B i s i ncorrect: Unsupervised learning algorithms do not use labeled data and are used for tasks
such as clustering and anomaly detection.
C i s i ncorrect: Reinforcement learning algorithms are used to solve sequential decision-making
problems, where the algorithm receives feedback on its actions and adjusts its strategy accordingly.
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Q.5188 In the field of Regulatory Technology (RegTech), Artificial Intelligence (AI) and machine
learning are increasingly employed to aid firms in meeting the growing demands of regulatory
compliance. Which of the following statements correctly describes the primary advantage of
applying machine learning in RegTech?
A. Machine learning can be employed to completely replace human involvement in

regulatory compliance, drastically cutting costs and ensuring full compliance.
B. T he use of machine learning allows for continuous monitoring of firm activities, providing
real-time insights to help avoid compliance breaches.
C. AI and machine learning can completely eliminate the need for regulatory capital, as they
are capable of better monitoring and preventing risk events.
D. Machine learning can entirely remove the non-compliance risk by automatically

interpreting regulatory documentation and ensuring absolute compliance with all aspects.
One of the key advantages of using machine learning in a RegTech sense is the ability to continuously
monitor firm activities, providing real-time insights. T his can potentially avoid compliance breaches
rather than deal with the consequences of breaches after they have occurred.
A i s i ncorrect: While AI and machine learning can greatly aid in regulatory compliance, they cannot
entirely replace human involvement. T here's a need for human oversight and interpretation in areas
such as decision-making, ethics, and complex problem-solving.
C i s i ncorrect: Although better monitoring due to machine learning might free up some regulatory
capital, it cannot completely eliminate the need for regulatory capital. T he risks associated with
financial activities cannot be entirely eradicated, and therefore, regulatory capital serves as a
necessary safety net.
D i s i ncorrect: While machine learning can be used for reading and interpreting regulatory
documentation, it cannot ensure absolute compliance. Ensuring full compliance involves many
aspects, including human judgment and decision-making, which cannot be fully automated.
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Q.5189 In the context of unsupervised machine learning techniques, K-means clustering is widely
used to group similar entities. Which of the following statements correctly describes the process of
K-means clustering?
A. T he number of cluster groups is determined post-clustering, and straight dividing lines are
drawn to distinguish groups.
B. T here is no need to predefine the number of cluster groups, as the model automatically
determines the optimal number during the iterative process.
C. T he dividing line in K-means clustering is always straight and aimed to maximize the
distance between points in different clusters.
D. T he number of cluster groups the data scientist wishes to arrive at is predetermined, and
the iterative process behind the technique aims to minimize the intra-cluster variance.
In K-means clustering, a predetermined number (k) of clusters is initially decided by the data
scientist. T he algorithm then selects 'k' data points from the dataset randomly as initial cluster
centroids. Every data point in the dataset is assigned to its nearest centroid, forming 'k' clusters
based on a distance measure like the Euclidean distance. T he centroids are recalculated typically by
finding the mean of all points within each cluster. T his process of assignment and recalculation
repeats until either the centroids stabilize, or the data points' assignment to clusters ceases to
change. T he ultimate goal of the K-means algorithm is to minimize intra-cluster variance, thus
forming compact and distinct clusters.
Opti on A i s i ncorrect as the number of cluster groups in K-means clustering is not determined
post-clustering. Instead, it is predetermined by the data scientist. Additionally, the dividing line drawn
to distinguish groups does not necessarily have to be straight.
Opti on B i s i ncorrect because one of the prerequisites of K-means clustering is that the data
scientist needs to specify the number of clusters (k) to be created before the algorithm starts. It
doesn't determine the optimal number of clusters on its own during the iterative process.
Opti on C i s i ncorrect because the statement that the dividing line in K-means clustering is always
straight is inaccurate. T he dividing line can take any form that best distinguishes between the groups.
Moreover, the primary goal of K-means is to minimize (not maximize) T he average distance and
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means between determined groups.
Q.5191 What is the primary challenge encountered when utilizing deep learning techniques in
machine learning?
A. Low transparency
B. high cost
C. High complexity
D. Limited scope of application
Deep learning, an aspect of machine learning, involves teaching artificial neural networks using large
datasets. Even though deep learning models can generate remarkably accurate forecasts, they often
do so in a way that is hard to decipher or interpret. T his "black box" characteristic or lack of
transparency is a significant drawback, as it obstructs the ability to fully comprehend and justify the
model's decision-making mechanism.
B i s i ncorrect: High cost can sometimes be a concern due to the computational resources needed
for training deep learning models, but it is not always a key limitation.
C i s i ncorrect: High complexity, could be considered a limitation in some contexts, especially
considering the skills and computational resources needed to develop and run deep learning models.
However, the complexity is also part of what allows these models to deliver powerful results.
D i s i ncorrect: Deep learning methods are applicable across a wide range of fields and data types,
including image recognition, natural language processing, and more.
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Q.5192 As AI and machine learning techniques continue to evolve in risk management applications,
firms face various challenges in their implementation. Which of the following statements presents a
significant hurdle in the implementation of these technologies??
A. T he high cost of buying AI and machine learning solutions.
B. T he management often resists the change to AI and machine learning.
C. T he lack of ready-to-use software applications for AI in risk management.
D. Low availability of skilled staff to implement these new techniques.
T he primary challenge in implementing AI and machine learning solutions in risk management, as
identified in a survey of the top 1000 firms in the United States, is the preparedness and ability of the
staff to understand and work with these advanced techniques. For example, Goldman Sachs has
developed a campus in India, a place with a higher prevalence of these skills, to mitigate this
problem. Investing in training and development for existing staff or strategically hiring new staff with
the required skills is imperative for firms wishing to successfully implement and utilize these
technologies.
A i s i ncorrect. Implementing AI and machine learning solutions can indeed be costly but many firms
view this as a worthwhile investment given the potential benefits these technologies can offer, such
as efficiency and accuracy improvements. Furthermore, a variety of solutions exist at different
price points, making it possible for firms of varying sizes and budgets to find a solution that fits their
needs.
B i s i ncorrect. While resistance to change can be a challenge in any technological transformation,
it's not the core issue with implementing AI and machine learning solutions. Management's role is to
drive change and they would typically be onboard with implementing solutions that can deliver long-
term benefits to their firm.
C i s i ncorrect. T here is a growing abundance of ready-to-use software applications for AI in risk
management, from large technology companies to specialized startups. T he problem lies not in the
availability of such applications, but in finding or training personnel who can skillfully employ these
tools.
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Q.5193 Which machine learning model is the most suitable for a data scientist who wants to split
2,000 customers into 20 distinct groups?
A. Clustering.
B. Regression.
C. Support vector machines (SVMs).
D. K-nearest neighbors.
Since the data scientist is not providing any labeled training data about the 2,000 customers, we have
to use an unsupervised learning algorithm.
Regression, SVMs, and K-nearest neighbors are all supervised learning algorithms. Clustering, an
unsupervised learning algorithm, is suitable for this task.
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Reading 154: Artificial Intelligence Risk & Governance
Q.5006 A banking firm has recently integrated AI technology to automate its credit approval process.
However, soon after the deployment, the bank started receiving complaints about potential
discrimination. After an initial review, it was found that the new AI system uses a variety of
traditional and non-traditional data inputs, including credit bureau attributes, utility payment history,
and customers' social media posting habits. Based on this information, which of the following could be
the most likely reason for the alleged discriminatory outcomes in the credit approval process?
A. T he AI system has been overfitting the data, resulting in biased credit decisions.
B. T he traditional data inputs, such as credit bureau attributes, are leading to unfairly biased
outcomes.
C. T he AI system uses non-traditional data inputs such as social media posting habits, which
may have led to potential discrimination.
D. T he AI system is correctly functioning, and complaints are likely due to customers' lack
of understanding about the AI credit approval process.
Non-traditional data inputs like social media posting habits can lead to discriminatory and/or unfairly
biased outcomes if they are not correctly processed and analyzed by the AI system. T hese data
sources might contain implicit or explicit information about protected class membership (e.g., race,
gender, age) that can inadvertently result in discrimination if they are used to make credit decisions.
Opti on A i s i ncorrect because although overfitting can be an issue in model performance, it does
not directly lead to discriminatory outcomes. Overfitting causes the model to perform well on the
training data but poorly on new, unseen data, which would likely lead to inaccurate, rather than
discriminatory, outcomes.
Opti on B i s i ncorrect because traditional data inputs, such as credit bureau attributes, are
generally thoroughly vetted and accepted for creditworthiness. T hey are less likely to raise disparate
impact concerns compared to non-traditional data inputs.
Opti on D i s i ncorrect. Even if the AI system is functioning as intended, it can still produce
discriminatory outcomes if it uses data inputs that can result in bias. T he complaints from customers
indicate a potential issue that should be investigated, not merely dismissed as a lack of understanding.
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Q.5007 In a presentation on Artificial Intelligence Risk & Governance, a candidate highlights
important points regarding potential AI/ML attacks. Which of the following is not true?
A. In a data privacy attack, an attacker has the potential ability to infer the data used to train
the AI/ML system.
B. Adversarial inputs are malicious inputs designed to bypass the AI system classifier.
C. Model extraction involves the contamination of the data used to train the AI/ML system.
D. None of the above.
Under model extraction, an attacker attempts to steal the model itself. T he stolen model could then
be used to create additional risks. With the unlimited ability to query the model, extraction could
easily occur at high speed without requiring a high level of technical sophistication.
Opti on A i s true: Under data privacy attacks, an attacker has the potential to infer the data used to
train the AI/ML system. T he attacker may infer sensitive data training information, thereby
compromising data privacy.
Opti on B i s true: Some AI systems use inputs from external systems or users. Such AI systems
interpret that input and undertake some actions, such as classifying the input data. An adversary is
able to use malicious inputs designed to bypass the AI system classifier. Such malicious inputs are
referred to as adversarial inputs.
Q.5008 FinTech Inc. is an innovative financial firm that leverages machine learning algorithms for
credit scoring based on customers' social media activity and online purchasing behavior. Recently,
FinTech Inc.'s AI system has been criticized for potential discrimination in its lending process, with
concerns raised about certain protected classes receiving unfavorable credit assessments. As a risk
manager evaluating this scenario, which of the following is the most accurate statement concerning
this situation?
A. Discrimination can only arise if the machine learning algorithm is intentionally

programmed to differentiate based on protected class membership.
B. T he fact that the AI system is statistically sound and accurately predicts creditworthiness
implies that it cannot be discriminatory.
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C. Even though the AI system may have produced unfavorable outcomes for certain
protected classes, there is no risk of discrimination if these outcomes are in line with the
historical credit performance of these groups.
D. T he AI system could potentially lead to discriminatory outcomes due to unintentional bias

in the data used or the complex relationships created by the algorithm.
AI systems, especially those relying on machine learning algorithms, could potentially lead to
discriminatory outcomes even unintentionally due to biased data or complex, non-linear relationships
created by the algorithms, which could unintentionally act as proxies for protected class
membership. In the scenario provided, FinTech Inc.'s use of social media activity and online
purchasing behavior data might inadvertently lead to discrimination against certain protected classes
due to complex and opaque algorithmic interactions, or biased data inputs.
Opti on A i s i ncorrect because discrimination does not arise from intentional programming only. AI
systems could unintentionally discriminate if the data used to train the system is biased or if the
system inadvertently creates proxies for protected class status. For example, certain social media
activity or online purchasing behavior could be more prevalent among members of a certain
protected class, leading the system to unintentionally discriminate against this group.
Opti on B i s i ncorrect because a statistically sound system does not necessarily mean it's non-
discriminatory. For instance, an AI system could accurately predict creditworthiness based on
certain factors that are also correlated with protected class membership, leading to disparate impact.
T he fairness of a system is assessed separately from its accuracy.
Opti on C i s i ncorrect as it suggests that historical credit performance justifies continued
unfavorable outcomes for certain groups. T his ignores the fact that historical credit performance
might itself be influenced by discriminatory practices or conditions. Moreover, regulatory standards
typically prohibit such justification for disparate impact. Even if certain groups have had historically
worse credit performance, it doesn't allow for an AI system to perpetuate this disparity without a
legitimate business need and absence of a less discriminatory alternative.
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Q.5010 FinTech Corp, a leading financial institution, has recently deployed an AI-driven credit scoring
model. T he model was trained on a large dataset that includes applicants' shopping behaviors. T he AI
model is found to yield a lower average credit score for applicants who frequently shop at discount
stores, which are predominantly located in minority neighborhoods. T he model's complexity
prevents a clear explanation of why this outcome occurs. Based on this situation, how would you
categorize the type of potential discrimination arising from this AI implementation?
A. Overt discrimination
B. Disparate treatment
C. Disparate impact
D. Given that the AI system is statistically sound and accurately predicts creditworthiness, it
cannot be discriminatory.
Disparate impact occurs when a seemingly neutral policy disproportionately affects a protected
class. In our scenario, the use of data related to shopping at discount stores, which are more
prevalent in minority neighborhoods, results in lower average credit scores for those individuals,
thus disproportionately impacting a protected class. Even though the policy appears neutral (i.e.,
assessing creditworthiness based on shopping behavior), its implementation results in a disparate
impact on a protected group.
Opti on A i s i ncorrect.Overt discrimination would be incorrect as this type of discrimination
implies an explicitly unfavorable treatment towards a protected class. An example would be rejecting
credit applications because the applicant is from a specific race or ethnicity. T his isn't the scenario
described in the question.
Opti on B i s i ncorrect. Disparate treatment happens when two similar individuals are treated
differently due to their class status. For instance, if two individuals with the same financial
background apply for a loan and one is denied simply due to their race or gender, this would be a case
of disparate treatment. In the scenario described, the AI model does not treat individuals differently
based on such factors.
Opti on D i s i ncorrect. A statistically sound AI system can still be discriminatory if it includes
features that disproportionately lead to unfavorable outcomes for a protected class. T he accuracy of
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the system is assessed separately from its potential for discrimination.
Q.5011 Which of the following statements about additional factors to be considered under the AI
framework is correct?
A. Monitoring and oversight are important since they provide exposure to the decisions made
and the opportunity to raise concerns or challenges appropriately.
B. T he deployment of AI/ML may involve the use of a third party which enables scalability,
increased power to compute, and increased access to vendors.
C. We have three lines of defense, including the front line, the second line, and the third line
of defense.
D. All of the above.
Other factors to be considered under the AI framework include monitoring and oversight, third-party
risk management, three lines of defense, and roles and responsibilities.
Moni tori ng and Oversi ght – A central monitoring process is important since it provides
exposure to the decisions made and the opportunity to raise concerns or challenges appropriately. It
is, therefore, necessary that the structure considers the changing needs of the organization as the
adoption of AI matures or as changes occur in the industry.
Thi rd-Party Ri sk Management – T he deployment of AI/ML may involve the use of a third party
which enables scalability, increased power to compute, and increased access to vendors. It is,
therefore, necessary that firms strengthen their third-party risk management (T PRM) capacities.
Rol es and Responsi bi l i ti es – An AI framework should clearly define the roles and responsibilities
regarding the organization's internal structure.
Three Li nes of Defense – A three-line-of-defense model includes the front line responsible for
business risk, the second line responsible for risk oversight and independent challenge, and the third
line is assurance.
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Q.5013 An AI framework should clearly define the roles and responsibilities of an organization's
internal structure. Which of the following roles and responsibilities should an organization consider
in AI implementation?
A. Ethics review board – Reviews all the AI operations.
B. Center of Excellence – Provides a platform for sharing knowledge, best practices, and the
creation of a collective view.
C. Data Science – Creates and maintains data sets used to train the AI system.
D. ML Operations – Help in managing AI system inventory and version control.
Opti on A i s i ncorrect: Ethics Review Board is responsible for reviewing AI projects with respect
to the ethical principle of the organization.
Opti on B i s correct: Center of Excellence – Provides a platform for sharing knowledge, best
practices, and creation of a collective view.
Opti on C i s i ncorrect: Data Science – In addition to their responsibilities, the Data Science team
helps manage AI system inventory and version control.
Opti on D i s i ncorrect: ML Operations – Create and maintain data sets used to train the AI system.
Q.5014 In a large investment banking firm, the compliance team has discovered an anomaly during a
routine audit. A certain portfolio management AI/ML system they use consistently recommends
risky investments for younger clients, and conservative investments for older clients. It has been
difficult to ascertain why the system behaves this way due to its complexity, raising questions about
its interpretability. Which among the following best characterizes the challenges and potential issues
posed by this situation?
A. Overfitting due to high complexity.
B. Inconsistent explanations within AI/ML systems.
C. Potential discriminatory decision-making patterns by AI/ML systems.
D. Model misspecification.
24
T he AI/ML system appears to consistently make investment recommendations based on the age of
clients, preferring risky investments for younger clients and more conservative investments for
older ones. T his could potentially be viewed as a discriminatory practice. T he lack of interpretability
exacerbates this issue because it's not clear whether the system has learned these patterns from
the data, or if it's a byproduct of the algorithm's complexity. For example, it's problematic if the
system denies mortgages to people from certain zip codes more frequently, and the firm cannot
explain why due to the model's opacity.
Opti on A i s i ncorrect. Overfitting occurs when a model captures noise along with the underlying
pattern in the data. In overfitting, the model would perform well on training data but would not
generalize well to new, unseen data. For instance, an overfitted model might predict stock prices
with 100% accuracy on past data but fail miserably when asked to predict future prices. However,
the situation described in the question does not directly indicate an overfitting problem.
Opti on B i s i ncorrect. Inconsistent explanations refer to situations where an AI/ML system can
produce different logical explanations for the same decision or outcome, typically a consequence of
retraining the system or using different models that fit the training data equally well. For example,
one system might deny a loan because of a low credit score while another because of lack of stable
income, yet both these systems might be equally accurate. In the given scenario, there's a
consistency in the AI's behavior but an opacity in its decision-making process, so it does not
primarily demonstrate an issue of inconsistent explanations.
Opti on D i s i ncorrect. Model misspecification is when the chosen model doesn't correctly reflect
the relationships among variables in the data, which often leads to incorrect or biased estimates. An
example of model misspecification would be using a linear regression model for data that exhibits a
non-linear relationship. While this could be a potential issue in any modeling scenario, the question
scenario does not provide enough information to suggest that model misspecification is the main
problem.
Q.5015 As the head of a compliance team in a financial institution that heavily uses AI systems for
credit lending decisions, you have been tasked with managing the risk of potential discrimination in
AI. A recent review of the AI system has revealed disparities in credit lending decisions which may
be due to discrimination bias. To best mitigate this risk, which of the following strategies should you
25
adopt?
A. Conduct an immediate overhaul of the AI system to ensure any and all bias is eliminated.
B. Implement a real-time anomaly detection system to monitor for any discriminatory

decisions.
C. Focus on enhancing AI interpretability and explainability, ensuring the AI system’s

decisions can be fully understood by all stakeholders.
D. Create a diverse review team to conduct manual examinations of the AI system for
potential discrimination bias while also leveraging mitigation algorithms to diminish
discrimination.
Implementing a combination of manual review by a diverse team and the use of mitigation algorithms
provides a robust approach to mitigating discrimination bias. A diverse review team brings various
perspectives to the evaluation process, which can better identify and understand potential biases in
the system. At the same time, mitigation algorithms work to systematically address and reduce the
discrimination within the AI system by modifying its predictions or decision-making process to
decrease biases. T his dual approach can be more effective in dealing with potential discrimination
bias and provides a more sustainable, long-term solution for bias mitigation in AI systems.
Opti on A i s i ncorrect. Conducting an immediate overhaul of the AI system might seem like a quick
fix to eliminate bias, but it doesn't necessarily ensure all potential biases are addressed. Bias in AI is
often a complex issue related to the data used for training and the way the algorithms process that
data. Additionally, an overhaul doesn't provide a long-term, sustainable solution for monitoring and
addressing bias in the future.
Opti on B i s i ncorrect. While a real-time anomaly detection system can be useful in many
situations to detect unusual patterns or outliers in the data, it isn't tailored to monitor or detect
discriminatory decisions. Discrimination in AI systems often occurs subtly through underlying biases
in the data or algorithms, which may not be immediately flagged as anomalies.
Opti on C i s i ncorrect. Enhancing AI interpretability and explainability is an important factor in the
overall transparency of an AI system, but it doesn't directly tackle the issue of discrimination bias.
Even if an AI system’s decisions can be fully understood, it does not guarantee that discriminatory
26
biases are being mitigated.
Q.5016 If not implemented appropriately, AI may lead to a discriminatory and biased outcome.
Sources of such poor implementation include the following except:
A. Biased data.
B. Inconsistent explanations.
C. Misuse of big data.
D. T he use of complex algorithms.
Inconsistent explanations are a source of interpretability/explainability, but they are not a source of
discrimination in AI.
Opti on A i s true: T he use of potentially amplifying implicitly biased data is also a matter of concern
in some situations. T he use of inaccurate or unreliable data in insurance underwriting, for example,
may cause harmful impacts to the insured.
Opti on C i s true: Misuse of big data may also lead to detrimental outcomes, for example, in data
mining credit card charges for services, lowering the credit limits of the cardholder.
Opti on D i s true: T he complexity and opacity of algorithms may lead to discriminatory outcomes.
Variable interactions and non-linear relationships created by some machine learning algorithms are
complex and difficult to understand. Such relationships may cause disparate treatment for protected
class status.
27
Q.5017 An investment firm uses an AI-based system for financial forecasting. Over the years, the
system performs well, contributing significantly to the firm's investment decisions. However, when
a rare event, not represented in the training data, occurs in the market, the AI system fails to
provide accurate predictions. T his unexpected failure causes substantial financial losses to the firm.
Which subcategory of "Testing and T rust" risk does this scenario best exemplify?
A. Bias
B. Incorrect output
C. Lack of transparency
D. Data privacy attack
T his scenario is representative of the "incorrect output" risk associated with the testing and trust of
AI systems. T he AI-based system was incapable of accurately predicting the outcome of a rare
event, not represented in the training data. As a result, the system produced incorrect output which
led to significant financial losses for the investment firm.
Opti on A i s correct :T he term 'bias' in this context typically refers to AI systems producing
results that unfairly favor certain groups or outcomes over others. T here's no indication of such an
issue in the provided scenario.
Opti on C i s correct: Lack of T ransparency refers to situations where the inner workings and
decision-making processes of an AI system are not easily understandable. In this scenario, the issue
was not about understanding how the AI system works, but rather about the system's ability to
accurately predict a rare event.
Opti on D i s correct: In this scenario, there's no mention of a data privacy attack or any threat to
the security of the AI system's data.
28
Q.5018 As the Risk Manager at a financial firm overseeing the company's AI systems for investment
recommendations, you've noticed a degradation in the AI's performance over time and the
emergence of discriminatory patterns in its recommendations. Considering your role and the risks
observed, which measures would you find most effective to mitigate these AI-related risks?
A. Rely on the existing AI system but carefully exclude specific variables that appear to
drive the observed discriminatory patterns, focusing primarily on the features creating bias.
B. Introduce random noise to the AI system's training data to ensure differential privacy,
primarily focusing on safeguarding the privacy of data.
C. Establish a robust oversight process that incorporates regular monitoring for accuracy
and data drift, employs mitigation algorithms to address discrimination, and enhances the
interpretability of the AI model.
D. Initiate a complete overhaul of the AI model to construct a new one from scratch, with a
primary focus on completely redesigning the model.
Regular monitoring for accuracy and data drift can maintain the AI system's performance over time
and detect changes in data characteristics. Implementing mitigation algorithms can address
discrimination issues. Enhancing the model's interpretability will improve trust in the AI system and
make its decision-making processes more understandable. T herefore, this approach is the correct
answer as it addresses all identified issues.
Opti on A i s i ncorrect. Simply excluding one or two variables that seem to drive discriminatory
patterns might not fully resolve the issue, especially in complex AI/ML systems. Moreover, this
option doesn't address the problem of the AI system's degrading performance over time.
Opti on B i s i ncorrect. While introducing random noise to the training data can enhance privacy,
this method doesn't resolve the issues of discriminatory patterns or decreasing model accuracy that
are currently observed.
Opti on D i s i ncorrect. Completely overhauling the AI model might not be necessary or cost-
efficient. Building a new model from scratch doesn't guarantee that the same issues won't appear
again. It's more effective to implement targeted measures that directly address the identified risks in
the current model.
29
Q.5019 To begin with, oversight through monitoring to validate the aspects of the system helps to
ensure the accuracy and efficiency of the AI system. Furthermore, monitoring helps to provide
insight into the "accuracy drift" of the model by estimating the model's accuracy. Finally, monitoring
helps to provide insight into the "data drift" by checking for the deviation of the input data from the
training data. However, it is important to distinguish between practices that address discrimination
and those that enhance interpretability. Which of the following practices would not help to address
discrimination in AI?
A. T he review of input variables and systems.
B. Ensuring quality explanations.
C. Variables that cause discrepancies are excluded from the systems.
D. T he use of recently researched mitigation algorithms.
Ensuring quality explanations would enhance interpretability and explainability.
Options A, C, and D would help to address discrimination in AI:
T he review of input variables and systems for evidence of discrimination in most lending
organizations is done by compliance, fair lending, and system governance teams. Technological
advances can enable most of these tasks to be automated. Nevertheless, a human-centric approach
may be required for a fair AI.
Variables that cause discrepancies are excluded from the systems, then replaced by other tested
variables. However, these methods have proven to have low rates of success in complex AI/ML
systems.
Several recently researched algorithms have proven to reduce class-control discrepancies while
maintaining the predictive quality of the system. In order to reduce these discrepancies, the
mitigation algorithms find the "optimal" system for a corresponding quality and measure of
discrimination.
30
Q.5365 An international financial institution uses an advanced AI/ML model to optimize its algorithmic
trading strategies. Recently, the institution noted an uncanny resemblance between its trading
patterns and those of a competitive firm. T he competing firm seems to be making trades almost
identical to the ones decided by the institution's AI model, suggesting that they may have gained an
understanding of the model's internal logic. T he institution fears that the competitive firm might have
used the publicly exposed API of its AI model to flood it with queries, studying the responses to gain
insights into its decision-making process. T his has led to potential losses and diminished advantage in
the market. Which of the following categories of potential AI/ML attacks is the institution most
likely facing?
A. Data privacy attack
B. T raining data poisoning attack
C. Model extraction attack
D. Adversarial inputs attack
Option C is correct because a model extraction attack involves an adversary replicating the AI/ML
model by submitting a large number of queries and studying the responses to understand its decision-
making process. In this scenario, the competitive firm appears to have exploited the publicly
exposed API of the AI model to mimic its trading strategies, which aligns with the characteristics of a
Model Extraction Attack.
Opti on A i s i ncorrect because a data privacy attack involves an attacker inferring sensitive
information from the training data set by analyzing the parameters or querying the model. T he
described scenario doesn't involve the extraction of sensitive data from the model.
Opti on B i s i ncorrect because a training data poisoning attack refers to a situation where the
AI/ML system's training data is manipulated, leading to compromised learning processes or outputs.
T he given scenario doesn't suggest any manipulation of the training data.
Opti on D i s i ncorrect because an adversarial inputs attack refers to an adversary intentionally
providing malicious inputs designed to confuse or mislead the AI system's classification or decision-
making mechanisms. T he scenario in question does not describe the provision of malicious inputs;
rather, the adversary has copied the model's decision-making process.
31
Reading 155: Climate-related Risk Drivers and their Transmission
Channels
Q.4999 On April 14, 2021, the Basel Committee on Banking Supervision (Basel Committee) published
a report, ‘Climate-related risk drivers and their transmission channels.’ In the report, the Committee
discusses at length the inherent risk in changing strategies, policies, or investments as society and
industry work to reduce their reliance on carbon and its impact on climate. T his describes:
A. Physical risk.
B. T ransition risk.
C. Climate risk.
D. Financial risk.
T ransition risk describes the risk that results from changing policies, practices, and technologies
that arise as societies work to decrease their reliance on carbon. In other words, transition risk
encompasses a large number of risks that can occur when moving towards a less polluting and
greener economy. During these transitions, some sectors of the economy may experience big shifts
in asset values or increased costs of doing business.
32
Q.5001 Due to climate change, the probability of wildfires in geographies such as California has
increased. In the context of the Basel Committee report published in April 2021, this describes an
example of:
A. T ransition risks.
B. Physical risks.
C. Financial risks.
D. Technology risk.
Physical risks are tied to weather and climatic changes that impact the economy. T hey can be
subdivided further into acute risks, which come about due to extreme weather events, or chronic
risks associated with long-term progressive shifts in climate. Acute physical risks include wildfires,
heatwaves, floods, storms, hurricanes, typhoons, and cyclones. Chronic physical risks include rising
sea levels, ocean acidification, and rising temperatures. Prolonged periods of high temperatures can
also lead to desertification.
33
Q.5002 According to the BCBS, there are two transmission channels: microeconomic and
macroeconomic. T hrough microeconomic transmission channels, the climate risk drivers affect:
A. Individual households.
B. T he overall economy.
C. Labor productivity.
D. Economic growth.
Microeconomic transmission channels refer to the causal chains by which climate risk drivers affect
the various individual counterparties doing business with banks, potentially exposing banks and the
entire financial system to climate-related financial risk. T hey also include the direct effects of
climate change on banks, particularly events that disrupt operations and the ability of banks to raise
funds for day-to-day business. However, they also include the indirect effects on name-specific
assets such as bonds, single-name CDS, and equities.
Macroeconomic transmission channels are the avenues through which climate risk drivers affect
macroeconomic factors such as inflation, labor productivity, GDP, and economic growth, which in
turn may have an effect on the economy in which banks operate.
34
Q.5003 According to the BCBS report "Climate-related Risk Drivers and T heir T ransmission
Channels," which of the following is an acute physical risk?
A. Rising sea levels.
B. Rising temperatures.
C. Floods.
D. Ocean acidification.
Physical risks are tied to weather and climatic changes that impact the economy. T hey can be
subdivided further into acute risks, which come about due to extreme weather events, or chronic
risks associated with long-term progressive shifts in climate. Acute physical risks include wildfires,
heatwaves, floods, storms, hurricanes, typhoons, and cyclones. Chronic physical risks include rising
sea levels, ocean acidification, and rising temperatures. Prolonged periods of high temperatures can
also lead to desertification.
Q.5004 An Indian bank has lent out money to an automobile producer based in Delhi. Due to rising
levels of smog that have forced the local authorities to shut down some schools and working spaces,
a law was passed recently requiring all automobile producers to ditch gas-dependent cars in favor of
electric models. T he bank fears that the producer doesn't have the capacity to adapt to the
underlying technologies required quickly enough, a situation that may result in higher losses on its
loans. How best can you describe this type of risk?
A. Market risk through macroeconomic channels.
B. Credit risk through microeconomic channels.
C. Operational risk through microeconomic channels.
D. Credit risk through macroeconomic channels.
First, it's important to note that the bank's concerns are centered around higher losses from its loan
business. T hat's credit risk (the risk of nonpayment of scheduled payments or default on an
obligation by the borrower). Second, we're dealing with a microeconomic transmission channel
because the risk affects an individual counterparty. Macroeconomic channels involve exposures to
macroeconomic factors such as interest rates, inflation, and labor productivity.
35
Q.5366 Walden, a fictional coastal country, has a thriving tourism industry that contributes
significantly to its GDP. T he country's government is also proactive in supporting renewable energy
and has committed to achieving a 70% reduction in greenhouse gas emissions by 2040. Given
Walden's situation and the threats posed by climate change, evaluate the following statements and
identify which one correctly represents the difference between physical and transition risk drivers
related to climate change:
A. Physical risk drivers in Walden would predominantly relate to increased investor

sentiment towards green energy, while transition risk drivers would involve potential damage
from extreme weather events such as hurricanes or rising sea levels.
B. Physical risk drivers for Walden could include potential damage from extreme weather
events such as hurricanes or rising sea levels, while transition risk drivers would primarily
be related to changes in policies, technologies, and consumer sentiment towards a greener
environment.
C. Physical risk drivers in Walden are largely associated with the government's initiatives to
reduce greenhouse gas emissions, while transition risk drivers are primarily concerned with
the impact of climate change on the tourism industry.
D. Physical risk drivers for Walden would mostly pertain to the changes in public sector
policies, while transition risk drivers would involve potential damage from extreme weather
events such as hurricanes or rising sea levels.
Physical risk drivers relate to the physical changes in the environment caused by climate change.
For a coastal country like Walden, these could be acute risks, such as damage from hurricanes, or
chronic risks like the gradual rise in sea levels due to the melting of ice caps, both of which could
severely affect its tourism industry.
T ransition risk drivers, on the other hand, arise from societal changes toward a low-carbon economy.
For Walden, these could include changes in policies, such as the government's commitment to
reducing greenhouse gas emissions, or shifts in technology towards renewable energy. It could also
involve changing investor and consumer sentiment, such as increased demand for sustainable tourism
or green energy.
Opti on A i s i ncorrect because it incorrectly swaps the definitions of physical and transition risk
drivers. Physical risks in Walden would be related to potential damage from extreme weather events
36
like hurricanes or rising sea levels, not increased investor sentiment towards green energy. T he
latter falls under transition risk drivers, which involve changes due to societal shifts towards a
greener economy.
Opti on C i s i ncorrect. Government initiatives to reduce greenhouse gas emissions are part of
transition risks, as they represent a policy-based shift towards a low-carbon economy. T he impact of
climate change on the tourism industry, given Walden's location and economy, would be considered a
physical risk, as it directly deals with the possible physical consequences of climate change.
Opti on D i s i ncorrect. Changes in public sector policies, such as initiatives to reduce greenhouse
gas emissions, are categorized as transition risks because they reflect the societal changes toward a
greener economy. Physical risks are related to the potential damage from extreme weather events,
not policy changes.
Q.5367 Zestin Bank, a leading commercial bank, is assessing its financial risks associated with climate
change. It has significant exposures to various sectors of the economy, including households,
corporates, and sovereigns. T he bank's main revenue sources include real estate loans in coastal
areas, loans to agricultural businesses, and holdings of government bonds from emerging economies.
Given the physical and transition risks due to climate change, which of the following scenarios
correctly outlines the potential microeconomic and macroeconomic impacts that Zestin Bank could
face due to climate risk?
A. Macroeconomic impact: T ransitioning to a low-carbon economy may lead to an increase in

technological adoption, raising the creditworthiness of the bank's corporate borrowers.
Microeconomic impact: Increased frequency of natural disasters, such as floods, could
reduce the value of collateral (real estate) pledged by households, increasing the bank's
credit risk
B. Macroeconomic impact: Natural disasters could increase the volatility in the stock options
of entities located in regions affected by climate risks, increasing Zestin Bank's market risk.
Microeconomic impact: T ransitioning to a low-carbon economy might impair the income of
sovereigns heavily dependent on fossil fuels, reducing their ability to service debt and
increasing the bank's credit risk.
C. Macroeconomic impact: T he transition to a low-carbon economy might impair the income

of sovereigns heavily dependent on fossil fuels, reducing their ability to service debt and
increasing the bank's credit risk. Microeconomic impact: Natural disasters could lead to
lower corporate sales, reducing their equity values and potentially raising the bank's credit
risk due to increased default possibilities.
D. Macroeconomic impact: Increased frequency of natural disasters, such as floods, could
37
reduce the value of collateral (real estate) pledged by households, increasing the bank's
credit risk. Microeconomic impact: T he transition to a low-carbon economy might impair the
income of sovereigns heavily dependent on fossil fuels, reducing their ability to service debt
and increasing the bank's credit risk.
In the given scenario, climate change affects Zestin Bank through both macroeconomic and
microeconomic transmission channels.
Macroeconomically, transitioning to a low-carbon economy could impair the income of sovereigns
heavily dependent on fossil fuels, causing them to have a reduced ability to service their debt. T his
would raise the bank's credit risk, as Zestin Bank holds government bonds from emerging economies,
which could be such fossil fuel-dependent sovereigns.
Microeconomically, Zestin Bank could face risks due to the physical impacts of climate change. If
natural disasters become more frequent, corporates, particularly those in the agricultural sector,
could face lower sales due to disruptions. T his would reduce corporate equity values, and given that
Zestin Bank has exposures to such businesses, this could lead to an increase in the bank's credit risk
due to higher possibilities of these corporates defaulting on their obligations.
Opti on A i s i ncorrect. It incorrectly assigns a macroeconomic impact to the transition risk related
to technological adoption. Technological adoption is a microeconomic channel as it impacts individual
corporates.
Opti on B i s i ncorrect because it misclassifies market risk from volatility in stock options as a
macroeconomic impact. Volatility in stock options is more of a microeconomic risk, as it primarily
affects specific entities.
Opti on D i s i ncorrect because it assigns macroeconomic impact to physical risk through collateral
devaluation due to floods. T his is a microeconomic risk as it affects individual borrowers
(households).
Q.5368 T he country of Ecomnia, highly dependent on its coal and oil reserves for both domestic
consumption and exports, is transitioning towards a low-carbon economy. T his policy change is
38
driven by international pressure and the rise of renewable energy technologies. Ecomnia's banking
sector has been historically robust, with banks providing loans to both individuals and corporations,
using fossil fuel reserves as collateral in many instances. Given this backdrop, which of the following
best captures the potential impact of microeconomic and macroeconomic drivers of climate risk on
Ecomnia's banking sector?
A. Macroeconomic drivers, such as the decline of the fossil fuel industry, may lead to a broad
decrease in asset values, posing significant credit risks to the banks, while microeconomic
drivers, such as technological changes, could increase profitability for corporations adopting
new technologies, thus reducing their credit risk.
B. Macroeconomic drivers, such as the decline of the fossil fuel industry, could lead to
reduced sovereign income and increase credit risk to banks from weakened counterparty
creditworthiness, while microeconomic drivers, such as technological changes, can cause
both reduction in profitability and credit quality for entities unable to adopt new
technologies, elevating banks' credit risk
C. Macroeconomic drivers, such as technological changes, could lead to reduced profitability

for corporations unable to adopt new technologies, while microeconomic drivers, such as
the decline of the fossil fuel industry, could lead to a decrease in sovereign income and
increase credit risk to banks.
D. Macroeconomic drivers, such as the decrease in the value of fossil fuel reserves used as
collateral, could increase the credit risk for banks, while microeconomic drivers, like
technological changes, could reduce credit risk to banks by increasing profitability for
corporations adopting new technologies.
Macroeconomic drivers in this scenario relate to the broader economic impacts of transitioning
away from fossil fuels. T his transition could lead to a decline in the fossil fuel industry, reducing
sovereign income and leading to potential stranded assets. In turn, this could weaken counterparty
creditworthiness, thereby increasing the credit risk for banks.
Microeconomic drivers here relate to the specific changes at the corporation level. T he adoption of
new technologies can be expensive, which may reduce the profitability of corporations unable to
adopt these new technologies. T his reduction in profitability can subsequently impact their credit
quality, resulting in elevated credit risk for the banks.
Opti on A i s i ncorrect as it suggests that technological changes (a microeconomic driver) could
reduce credit risk, which is not accurate in this scenario. Entities unable to adopt new technologies
face higher potential credit losses.
39
Opti on C i ncorrectl y classifies the decline of the fossil fuel industry as a microeconomic driver
and technological changes as a macroeconomic driver.
Opti on D i s i ncorrect because it inaccurately suggests that the decrease in value of fossil fuel
reserves used as collateral is a macroeconomic driver. In fact, it is a microeconomic driver linked to
specific loan agreements and their associated credit risks.
40
Q.5369 In the fictional country of Econia, government policies have resulted in a rapid transition
away from fossil fuels towards renewable energy resources. T his shift has led to a dramatic
decrease in the value of Econia's substantial fossil fuel reserves, leading to widespread asset
stranding. At the same time, the country is grappling with the effects of severe droughts, adversely
impacting agricultural output and leading to an increase in mortality rates. As a risk manager at a bank
with substantial exposure to Econia, which of the following risks would you be most concerned
about in the short to medium term?
A. Increased operational risk due to an expected increase in regulatory compliance.
B. Liquidity risk due to the bank's counterparties needing to access funds to manage the
transition to renewable energy.
C. Increased market risk due to volatility in exchange rates.
D. Elevated credit risk due to impaired asset values, higher debt costs, and weaker
counterparty creditworthiness.
T he scenario presents a classic case of the potential impact of different macroeconomic drivers of
climate risk on a bank's financial position. In the short to medium term, the most significant risk
stems from the impaired asset values due to the rapid transition away from fossil fuels, leading to
widespread asset stranding. T his event can weaken counterparty creditworthiness and challenge the
bank's exposure, thus elevating credit risk.
Higher mortality rates and lower agricultural output due to severe droughts could lead to lower
economic output. T his could further contribute to higher debt costs as entities in the country
struggle to service their debts, exacerbating credit risk.
While options A, B, and C could be potential concerns, the immediate and direct impact of the
situation described will most likely be on the bank's credit risk given the bank's ties to the
macroeconomic conditions of Econia.
41
Q.5370 Consider a senior risk manager at a multinational bank who is focusing on integrating climate-
related risk factors into the bank's risk assessment framework. T he risk manager categorizes
increased average global temperatures and incidences of wildfires as examples of acute physical risk
phenomena that could impact the bank's financial stability. Evaluating the accuracy of this risk
manager's categorizations, one could conclude that they are correct regarding:
A. T he classification of wildfires only.
B. T he classification of increased average global temperatures only.
C. T he classifications of both wildfires and increased average global temperatures.
D. Neither the classification of wildfires nor the increased average global temperatures.
T he risk manager's classification of wildfires as acute physical risks is indeed accurate. Acute
physical risks encompass extreme weather events or natural disasters that occur sporadically but
have immediate and severe impacts. Examples include wildfires, hurricanes, floods, and other severe
weather conditions. T hese events can cause direct damage to assets, disrupt supply chains, and
affect overall operational efficiency, thus creating financial risk for banks, especially those with
exposure to affected regions.
On the other hand, the categorization of rising global temperatures as acute physical risks is
incorrect. Rising global temperatures actually fall into the category of chronic physical risks, which
are associated with longer-term shifts in climate patterns. Chronic physical risks are a result of
sustained changes in the natural environment, such as rising temperatures, increasing sea levels, and
changing precipitation patterns. Over time, these shifts can lead to a variety of challenges for
financial institutions, including reduced agricultural productivity, decreased water availability, and
increased energy costs, all of which can affect the creditworthiness of borrowers and, consequently,
a bank's financial stability.
42
Q.5371 Apex Bank operates in the coastal region of Country X, which is increasingly prone to severe
weather events due to climate change. As part of its risk management strategy, Apex Bank wants to
minimize the impact of climate-related risks on its operations. Which of the following options would
likely provide the most effective mitigation against the combined impact of physical and transition
risk drivers?
A. Investing heavily in derivatives to hedge against weather-related risks.
B. Increasing capital buffers and reducing exposure to climate-sensitive assets.
C. Relying on government intervention to control the rise in insurance premiums.
D. Concentrating on diversification of its asset portfolio to spread the risks.
Option B presents a more comprehensive approach to risk management. By reducing exposure to
climate-sensitive assets, the bank decreases its susceptibility to both physical risks (such as damage
to collateral assets from extreme weather events) and transition risks (such as policy changes
affecting carbon-intensive industries). Increasing capital buffers provides additional financial
resilience in the face of any potential losses from these risks.
Option A, investing in derivatives to hedge weather-related risks, is not the most effective option.
While derivatives can provide protection against localized risks, they are less effective against global
climate risk events.
Option C, relying on government intervention to control the rise in insurance premiums, leaves the
bank's risk management strategy dependent on external actions. It does not proactively mitigate
risks.
Option D, concentrating on diversification of its asset portfolio, may be less effective in the face of
rising temperatures and extreme weather events. Climate risk is increasingly seen as a systematic
risk affecting all sectors, rather than an idiosyncratic risk that can be diversified away.
43
Reading 156: Climate-related Financial Risks – Measurement
Methodologies
Q.5216 A junior analyst at a bank is researching unique data needs inherent in climate-related risks.
T he analyst has collected enough data for his research and now wishes to categorize the data
according to the three main categories of data. Which of the following data categories should be
among the categories the analyst will use?
A. Data describing the vulnerability of exposures.
B. Data describing third parties.
C. Hazard event data.
D. Climate data.
We have three broad data categories needed to assess climate-related financial risk:
i. Data describing physical and transition risk drivers needed to translate climate risk drivers
into economic risk factors (i.e., climate-adjusted economic risk factors).
ii. Data relating to the vulnerability of exposures, linking climate-adjusted economic risk factors
to exposures.
iii. Financial exposure data is required to translate climate-adjusted economic risk into financial
risk.
B i s i ncorrect. T his category can be considered when we are talking of external and internal data
sources, but it is not among the broad data categories of climate-related risks.
C i s i ncorrect. Hazard event data is a sub-category under data describing physical and transition
risk drivers.
D i s i ncorrect. Climate data is also a sub-category under data describing physical and transition risk
drivers.
44
Q.5217 A risk manager is presenting to the board risk committee on unique data needs inherent in
the climate-related risks. Which of the following statements the manager makes falls under data
describing the vulnerability of exposures?
A. Data on portfolio composition and counterparties fall under this category.
B. T hese data facilitate the translation of climate-adjusted economic risk factors into financial
exposures.
C. T hese data types are the foundation for assessing the effects of climate-related risks on
banking exposure.
D. Government agencies and academic institutions usually supply these data.
Besides climate-adjusted economic risk factors, banks and supervisors need information about the
vulnerability of bank exposures to those risk factors. T hese data tend to include features specific to
those exposures, such as geospatial data for corporates, location data for mortgage collateral, or data
on the sensitivity of counterparties to energy prices. In addition to being used in measurement
approaches, these data facilitate the translation of climate-adjusted economic risk factors into
financial exposures. Generally, the relevant characteristics of these data differ according to the
climate risk driver under consideration.
A i s i ncorrect. Data on portfolio composition and counterparties fall under financial exposure data
required to translate climate-adjusted economic risk into financial risk.
C i s i ncorrect. Data describing physical and transition risk drivers form the foundation for
assessing the effects of climate-related risks on banking exposure.
D i s i ncorrect. T he data category that government agencies and academic institutions usually
provide is the data describing physical and transition risk drivers.
45
Q.5218 A project supervisor has asked a junior analyst to identify conceptual modeling and risk
measurement approaches that can be used to estimate climate-related financial risks. T he junior
analyst has highlighted some methodologies but is not sure how to describe them. Which of the
following candidate methodologies is correctly matched with its explanation?
A. Integrated assessment models (IAMs) combine energy and climate modeling approaches
with economic growth modeling.
B. Input-output models are a more transparent and stylized approach to analyzing long-term
macroeconomic evolution.
C. Overlapping generation (OLG) estimates how shocks affect a sector or region's economy
based on static economic linkages among sectors and geographical locations.
D. Computable general equilibrium (CGE) models make macroeconomic modeling even more
complicated, especially uncertainty in agent decision-making and endogenous technological
change.
Integrated assessment models (IAMs) combine energy and climate modeling approaches with
economic growth modeling. IAMs link projections of transition risk drivers and GHG emissions to
economic growth impacts.
B i s i ncorrect. Input-output models estimate how shocks affect a sector or region's economy
based on static economic linkages among sectors and geographical locations.
C i s i ncorrect. Overlapping generation (OLG) models are a more transparent and stylized approach
to analyzing long-term macroeconomic evolutions.
D i s i ncorrect. Computable general equilibrium (CGE) models allow policy experiments with
complex behavioral interactions between sectors and agents that cannot be solved analytically due to
their complexity.
46
Q.5220 A recently hired data analyst is presenting to the board of directors on measurement
methodologies of climate-related risk However, he is new in the field and does not know a lot about
these methodologies. Which of the following statements made by the manager aligns with transition
risk at the bank level?
A. Location-based risk scores have been developed for risk drivers such as heat stress,
wildfires, floods, and sea level rise.
B. As a proxy for transition risk, banks calculate the carbon footprint of their assets.
C. Some banks are using geospatial mapping to assess and monitor how risks may affect their
exposures.
D. Bank supervisors use indicators for the emissions intensity, carbon footprint, or
sensitivity to climate policies of banks' counterparties at the entity or sectoral level for
corporate portfolios, except for real estate exposures.
T he commonly observed transition risk practices among banks include the following:
T hrough assessing the possible sources of shocks and transmission mechanisms, banks
usually analyze reasons for and the extent to which a transition to a low-carbon economy
could impact a particular sector.
As a proxy for transition risk, banks calculate the carbon footprint of their assets.
Indicators of "greenness" of real estate and financial assets as proxies for transition risk,
as well as measures of alignment with climate targets. Portfolio alignment involves
measuring the gap between existing portfolios and a portfolio that meets a specific climate
target.
Analyzing the potential risk differential between "green" and "brown" activities is a
backward-looking analysis.
A i s i ncorrect. T his practice falls under physical risk.
C i s i ncorrect. Geospatial mapping is used to monitor and measure physical risks.
D i s i ncorrect. It refers to practice at the "bank supervisors level" and not specifically at the
"bank level."
47
Q.5222 A data analyst at a large bank wishes to identify and recommend the measurement approach
that would serve the bank appropriately. T he analyst will base their recommendation on the
strengths and weaknesses of the main types of measurement approaches. Which of the following
advantages the analyst has highlighted is specific to the computable general equilibrium (CGE)
approach?
A. Captures the effects of demand for goods and services on energy and resources.
B. Effectively captures feedback between socioeconomic and climate systems.
C. Analyzes interconnections across multiple sectors and agents of the economy.
D. Utilizes the role of prices to explain market distortions.
One of the key advantages of computable general equilibrium (CGE) is that it analyzes
interconnections across multiple sectors and agents of the economy.
A i s i ncorrect. T his is an advantage of the input-output approach.
B i s i ncorrect. T his is an advantage of the integrated assessment model (IAM).
D i s i ncorrect. T his is an advantage of the macro-econometric approach.
48
Q.5223 Before adopting any measurement approach, one must examine its advantages and
disadvantages. One particular approach is the Integrated Assessment Model (IAM), which effectively
captures feedback between socioeconomic and climate systems. And there is internal consistency in
the projections. Policies and assumptions can be accommodated in the model as well. However, the
model has disadvantages that limit its use. Which of the following is a disadvantage associated with
this approach?
A. Estimates are derived from past observations.
B. T ypically relies on limited damage functions, which do not adequately account for extreme
weather events.
C. Prices have a decisive role in limiting policy alternatives to price mechanisms (such as
taxes).
D. A chronic hazard is often left out of scenarios.
T he following are the key disadvantages of the integrated assessment model (IAM):
Highly aggregated.
T ypically relies on limited damage functions, which do not adequately account for extreme
weather events.
It is not resilient to imperfect information and endogenous events, such as changes in
technology and policy.
Finance, banking, and money are not modeled in most IAMs.
A i s i ncorrect. T his is a disadvantage of the macro-econometric approach.
C i s i ncorrect. T his is a disadvantage of the input-output approach.
D i s i ncorrect. T his is a disadvantage associated with scenario analysis.
49
Q.5237 Recently, the availability of data and information has been reported as a major challenge
hindering the development of climate risk measurement processes. Which of the following
challenges relates to the availability of appropriate data?
A. Ratings provided by third parties may not be fully reliable.
B. Capturing the specific impacts of climate scenarios is still a challenge. For this reason,
there is a need to continue developing modeling frameworks to capture the impacts of
climate scenarios, including stressed variants, within an integrated and tractable modeling
framework.
C. Banks and supervisors have to consider horizons longer than usual due to the long-term
nature of climate change, which makes stress testing exercises and forward-looking
assessments challenging.
D. Climate risk measurement requires adequate infrastructure, relevant human resources,

and/or sophisticated organizations. To assess its overall exposure to climate risks across all
its significant operations, banks need to be able to aggregate and manage large amounts of
data.
The correct answer i s A. T hird-party rating information – Ratings provided by third parties may
not be fully reliable since the users of the ratings may not be so sure about the accuracy of the data
the rated firms provide. Data users may find it difficult to identify the methodological approach data
providers adopt since most scores are based on proprietary models. In addition, the comparability of
indicators across vendors is also limited. T herefore, reconciling these approaches is often difficult.
B i s i ncorrect. T his is a challenge that relates to designing a modeling framework to capture
climate-related financial risks.
C i s i ncorrect. T his is a time horizon-related challenge.
D i s i ncorrect. T his is an example of operational complexity challenges in the measurement of
risk.
Q.5372 SunRise Bank, with Mr. Zephyr as the new Chief Risk Officer (CRO), is considering
integrating climate-related risks into its risk management framework. Aware of the mounting
concerns about climate change, Zephyr aims to weave unique data types and advanced methodologies
into their financial risk analysis. He proposes to use data from commercial third parties, academic
50
organizations, government agencies, and survey agencies. He also proposes a comprehensive
approach that involves assessing physical and transition risks, translating these risks into economic
factors, linking these factors to exposures, and then converting these exposures into potential
financial risks. In addition, he emphasizes the need to consider geographic and jurisdictional factors
and carbon sensitivities related to different economic sectors in their risk classification. However,
he's also wary of solely relying on traditional financial risk measures like leverage ratios, debt
service coverage ratios, and loan-to-value ratios, which might not adequately reflect the exposure to
climate-related risks. Considering the details of Mr. Zephyr's proposed plan and the unique nature of
climate-related financial risks, which of the following methodologies would provide the most
comprehensive and effective strategy for SunRise Bank?
A. Utilize a combination of government and academic data to quantify physical and transition
risks, integrating traditional financial risk measures into the risk management strategy while
relying primarily on historical data relationships to project future climate-related financial
implications.
B. Establish a climate risk classification scheme solely based on geographic location,

emphasizing physical risk differentiation. Simultaneously, use survey agency data to identify
geographic areas exposed to physical hazards while overlooking the vulnerabilities related to
transition risks.
C. Implementing an approach that links climate-adjusted economic risk factors to exposures,

translates them into potential financial losses, continuously adapts to evolving climate
impacts and technological advances, and includes sector-specific and jurisdiction-specific
considerations.
D. Prioritize the analysis of traditional financial risk measures such as leverage ratios, debt
service coverage ratios, and loan-to-value ratios, supplemented by geospatial counterparty
location data to determine bank exposure vulnerabilities to physical risks.
Option C reflects the most comprehensive approach since it highlights the need to not only consider
physical and transition risks but also the importance of linking these risks to exposures and
transforming them into potential financial losses. It also underlines the necessity of an adaptable
strategy, given the dynamic nature of climate impacts and technological advances. Further, it points
to the need to consider sector-specific carbon sensitivities and jurisdiction-specific regulations in
assessing transition risks, aligning it with the CRO's views.
Opti on A i s i ncorrect because it primarily relies on government and academic data, excluding
other vital data sources like commercial third-party and survey agencies. Also, over-reliance on
historical data relationships may not be sufficient to project future climate-related financial
51
implications due to the dynamics of climate change.
Opti on A i s i ncorrect as it suggests a climate risk classification scheme solely based on geographic
location. Although geographic factors are crucial in assessing physical risks, neglecting sectoral and
jurisdictional aspects would provide an incomplete view of transition risks.
Opti on A i s i ncorrect because it primarily focuses on traditional financial risk measures and
physical risks associated with geospatial counterparty location data. While these aspects are
important, this approach fails to account for unique exposures and vulnerabilities related to the
transition risks tied to counterparties' economic activities.
Q.5373 T hames Bank is a large global bank that recently pledged to align its loan portfolio with the
Paris Agreement. To accomplish this, it decided to build an internal model to quantify and manage
climate-related financial risks. T he bank is considering different methodologies, recognizing the need
to address unique challenges such as the lack of historical data, inconsistent time horizons, and the
range of impact uncertainties associated with climate-related risks. T he risk management department
presented a shortlist of possible methodologies that T hames Bank could implement:
1. Utilizing Integrated Assessment Models (IAMs) and Sensitivity Analysis to link projections of
greenhouse gas emissions to impacts on economic growth and illustrate the volatility of
projected losses.
2. Adopting an Agent-based Model (ABM) to better manage complexity and uncertainty, despite
its high data and computational demands.
3. Relying on stress testing and climate risk ratings to directly link bank portfolio risk to
various modeling approaches and rate climate risk exposures.
4. Performing a climate Value-at-Risk (VaR) assessment and scenario analysis to assess potential
balance sheet impacts and identify projected impacts on individual exposures and portfolios.
Which of the following methodologies would be the most comprehensive and appropriate for T hames
Bank, given its objectives and the nature of climate-related financial risks?
A. Integrated Assessment Models (IAMs) and Sensitivity Analysis
B. Agent-based Model (ABM)
C. Stress testing and climate risk ratings
D. Climate Value-at-Risk (VaR) and Scenario Analysis
52
D is the correct answer because, given the bank's pledge to align its portfolio with the Paris
Agreement, it needs a holistic approach. Climate VaR offers a balance sheet-focused risk assessment
that directly connects to the bank's financials. Meanwhile, scenario analysis helps identify projected
impacts on individual exposures and portfolios, covering physical and transition risk scenarios. T hese
methodologies offer a more comprehensive view of climate-related risks.
A i s i ncorrect because while IAMs and Sensitivity Analysis provide important insights into climate-
related risks, they have limitations. IAMs tend to understate severity associated with future climate
events and are not as useful in capturing extreme weather economic impacts. Sensitivity Analysis,
although useful in showing volatility, tends to underestimate tail events.
B i s i ncorrect because although Agent-based Models (ABMs) are useful for managing complexity
and uncertainty, they require significant computational resources and data, which may not be feasible
for a bank. Furthermore, the underlying mechanisms driving ABM outputs can be unclear, adding an
element of uncertainty that could hinder effective risk management.
C i s i ncorrect because while stress testing and climate risk ratings are useful tools, they may not
offer the comprehensive risk coverage needed by T hames Bank. Stress testing links portfolio risk to
climate scenarios, and climate risk ratings provide a snapshot of current risk exposure. However,
these methodologies may not fully capture the potential balance sheet impacts and the wide-ranging
exposure impacts that can occur under different climate scenarios.
53
Q.5374 Bank of Azure, a prominent regional bank, is assessing its climate-related financial risks. T he
Risk Management Department has recently introduced Integrated Assessment Models (IAMs) as one
potential tool for this purpose. IAMs have been used to link projections of greenhouse gas emissions
and transition risk drivers to impacts on economic growth. However, the team is mindful of some
limitations associated with IAMs, such as their inability to capture extreme weather economic
impacts accurately and their tendency to understate the severity associated with future climate
events. Considering the nature of IAMs and their application, which of the following scenarios would
most appropriately warrant the use of IAMs in assessing Bank of Azure's climate-related financial
risks?
A. T he bank seeks to understand the economic impact of frequent extreme weather events
on its agricultural loan portfolio.
B. T he bank is considering the financial risk associated with its holdings in the fossil fuel
industry, given the global transition to renewable energy sources.
C. T he bank aims to measure the impact of sudden regulatory changes on its exposure to
carbon-intensive industries.
D. T he bank is interested in estimating the economic fallout from a one-time catastrophic

climate event on its insurance portfolio.
B is the correct answer as IAMs are particularly suited to link projections of greenhouse gas
emissions and transition risk drivers to impacts on economic growth. In this scenario, the bank is
looking to understand the risks associated with a transition away from fossil fuels, a type of risk
IAMs can help assess.
A i s i ncorrect because IAMs do not accurately capture extreme weather economic impacts. T his
type of risk would be better evaluated using other models or risk assessment methods designed to
capture the economic impacts of extreme weather events.
C i s i ncorrect because while IAMs can model economic impacts of greenhouse gas emissions and
transition risk drivers, they are not best suited for modeling the impacts of sudden regulatory
changes. Other methods, such as sensitivity analysis, could be more appropriate for this purpose.
D i s i ncorrect because IAMs generally understate the severity associated with future climate
events and are less useful for one-time catastrophic events. A more suitable approach might involve
stress testing or scenario analysis that takes into account such extreme events.
54
Reading 157: Principles for the Effective Management and Supervision
of Climate-related Financial Risks
Q.5238 Which of the following ways should banks not manage climate-related financial risks?
A. Above the overall level of risk that the bank is willing to accept.
B. Proportionate to the nature, scale, and complexity of their activities.
C. With regard to the potential impacts of climate-related risk drivers.
D. According to the financial materiality of climate-related financial risks.
Banks should manage climate-related financial risk in a manner that is proportionate to the nature,
scale and complexity of their activities and the overall level of risk that each bank is willing to
accept. Additionally, banks should consider the potential impacts of climate-related risk drivers on
their individual business models and assess the financial materiality of these risks.
Q.5239 Which of the following is not a unique characteristic of climate-related risks?
A. T he complexity of the impact on the economy.
B. T he certainty related to climate change.
C. T he potential transmission channels.
D. T he potential interactions between physical and transition risks.
Climate-related risks have unique characteristics such as:
T he potential transmission channels.
T he complexity of the impact on the economy and financial sector.
T he uncertainty related to climate change.
T he potential interactions between physical and transition risks.
55
Q.5241 Within the internal control framework, what does the third line of defense predominantly
focus on?
A. Regulations and standards.
B. Day-to-day operational activities.
C. Technology security, sustainability, and quality assurance.
D. Risk analysis, internal audit, and data quality.
T he third line of defense within the internal control framework refers to the internal audit function.
T his function is responsible for providing an independent review and objective assurance of the
quality and effectiveness of the overall internal control framework and systems, as well as the
performance of the first and second lines of defense. In doing so, the internal audit function evaluates
risk assessments, internal audit processes, and the quality of underlying data.
A and B are i ncorrect. Day-to-day operational activities and regulations and standards are carried
out by the first line of defense.
C i s i ncorrect. Internal control, information and technology security, sustainability, and quality
assurance are carried out by the second line of defense.
56
Q.5242 Which of the following activities should the board and senior management not take according
to principle 2 of the Basel Committee on Banking Supervision principles on assigning responsibilities
and oversight?
A. Responsibilities for managing climate-related financial risks should be clearly assigned to

board members or committees.
B. Board and senior management should have an adequate understanding of climate-related

financial risks.
C. T he board is not required to have the necessary skills as is required of management.
D. Banks should clearly define and explicitly assign roles and responsibilities throughout the
bank’s organizational structure.
According to principle 2 of the Basel Committee on Banking Supervision principles on assigning
responsibilities and oversight, the board and senior management need to have an adequate
understanding, skills, and experience of climate-related financial risk management. Where necessary,
banks should build capacity and train the board and senior management. T his is in addition to:
Responsibilities for managing climate-related financial risks clearly assigned to board
members or committees.
T he Board and senior management having an adequate understanding of climate-related
financial risks.
Banks clearly define and explicitly assign roles and responsibilities throughout the bank’s
organizational structure.
57
Q.5243 What is the role of the risk function under principle 4 of the Basel Committee on Banking
Supervision principles?
A. Assessments during the client onboarding, credit application and credit review processes,
and in monitoring and engagement with clients.
B. Independently undertaking climate-related risk assessment and monitoring.
C. Ensuring adherence to applicable rules and regulations.
D. Providing an independent review and objective assurance of the quality and effectiveness
of the overall internal control systems.
T he risk function is responsible for undertaking climate-related risk assessment and monitoring
independently. T his includes challenging the initial assessment.
A i s i ncorrect. Assessments during the client onboarding, credit application, and credit review
processes, and in monitoring and engagement with clients is a role of the compliance function, the
first line of defense.
C i s i ncorrect. Ensuring adherence to applicable rules and regulations is a role of the compliance
function.
D i s i ncorrect. Providing an independent review and objective assurance of the quality and
effectiveness of the overall internal control systems is a role of the internal audit function, the third
line of defense.
58
Q.5244 According to principle 4 of the Basel Committee on Banking Supervision principles on
incorporating climate-related financial risks into their internal control frameworks, which of the
following activities banks perform is incorrect?
A. T he internal control framework should include a clear definition and assignment of

climate-related responsibilities.
B. Climate-related risk assessments may only be undertaken during monitoring and

engagement with clients.
C. T he risk function should be responsible for undertaking climate-related risk assessment

and monitoring independently.
D. T he internal audit function should provide an independent review and objective assurance
of the quality and effectiveness of the overall internal control framework and systems.
According to principle 4 of the Basel Committee on Banking Supervision principles on incorporating
climate-related financial risks into their internal control frameworks:
T he internal control framework should include a clear definition and assignment of climate-
related responsibilities and reporting lines.
Climate-related risk assessments may be undertaken during the client onboarding, credit
application, and credit review processes and in ongoing monitoring and engagement with
clients as well as in new product or business approval processes.
T he risk function should be responsible for undertaking climate-related risk assessment
and monitoring independently.
T he internal audit function should provide an independent review and objective assurance
of the quality and effectiveness of the overall internal control framework and systems.
59
Q.5245 Which of the following actions should banks not take under principle 5 of the Basel
Committee on Banking Supervision principles on identifying and quantifying material risks over
relevant time horizons?
A. Develop processes to evaluate the solvency impact of climate-related financial risks that
may materialize within their capital planning horizons.
B. Assess whether climate-related financial risks could cause net cash outflows or depletion
of liquidity buffers.
C. Banks should include climate-related financial risks assessed as material over relevant time
horizons.
D. Include relevant risks into stress testing programs to evaluate the bank’s financial position
under business-as-usual scenarios.
Banks should include relevant risks in stress testing programs to evaluate the bank’s financial
position under severe but plausible scenarios, both business as usual and stressed conditions.
Other actions that the ban should perform include:
Assess whether climate-related financial risks could cause net cash outflows or depletion
of liquidity buffers.
Banks should include climate-related financial risks assessed as material over relevant time
horizons.
Develop processes to evaluate the solvency impact of climate-related financial risks that
may materialize within their capital planning horizons.
60
Q.5246 Which of the following is not a risk mitigation option banks use to control or minimize
material climate-related credit risks?
A. Adjusting credit underwriting criteria.
B. Deploying targeted client engagement.
C. Higher loan-to-value limits.
D. Shorter-tenor lending.
Banks use a range of risk mitigation options to control or minimize material climate-related credit
risks. T hese include:
Adjusting credit underwriting criteria.
Deploying targeted client engagement.
Imposing loan limitations or restrictions such as shorter-tenor lending, lower loan-to-value
limits, or discounted asset valuations.
Setting limits to exposures to certain companies, regions, sectors, or products.
61
Reading 158: Inflation: A Look Under the Hood
Q.5247 Which of the following is not a characteristic of a low inflation regime?
A. Lower inflation persistence.
B. Inflation is susceptible to brief shocks.
C. Self-equilibrating.
D. Price adjustments in a single industry.
In a low inflation regime:
Inflation persistence is lower.
Inflation rate is susceptible to brief shocks.
T here are significant self-equilibrating characteristics.
Price adjustments in a single industry hardly ever occur.
Price adjustments have a short-lived impact on inflation.
62
Q.5248 T he distribution across prices being more subdued in an environment of low inflation is
visible in the following ways, except:
A. An index of such spillovers showing a decrease in intensity.
B. Outsized price rises are barely noticeable to be passed on.
C. Inflation persistence is higher in an environment of low inflation.
D. Important item price rises have less of an impact on total inflation.
Inflation persistence is actually lower in an environment of low inflation and the inflation rate is
susceptible to brief shocks.
T he distribution across prices becomes more subdued in an environment of low inflation and is
visible in the following ways:
An index of such spillovers shows a decrease in the intensity and prevalence of spillovers
across sectors.
Outsized price rises are barely noticeable to be passed on to core inflation.
Important item price rises have less of an impact on total inflation.
63
Q.5249 Which of the following is incorrect in regard to an environment of low inflation?
A. Both the response of prices to wages and wages to prices is more muted.
B. Wages have a looser correlation when inflation is low.
C. Prices and wages do not follow each other.
D. T he time it takes for salaries and prices to catch up is significant.
T he interplay between earnings and prices is the core of the inflation engine. In order for inflation to
persist, prices and wages must both chase each other.
In an environment of low inflation, the response of prices to wages and wages to prices is more
muted.
Wages and prices have a looser correlation when inflation is low. T he time it takes for salaries and
prices to catch up is significant.
Q.5250 A primary distinction between low-inflation and high-inflation environments is that:
A. High-inflation environments exhibit heightened sensitivity to relative price fluctuations.
B. High-inflation environments generally display self-balancing (self-stabilizing) tendencies.
C. Low-inflation environments typically experience consistent spillover effects across

individual price adjustments.
D. In a low-inflation environment, reduced inflation volatility stems from a decrease in the

volatility of individual price shifts.
High-inflation environments are not self-stabilizing and display increased sensitivity to significant
relative price fluctuations and currency depreciations, which may exacerbate inflation even more.
Low-inflation environments generally observe a diminishing level of spillover effects across
individual price adjustments. In a low-inflation environment, inflation is typically low not due to
decreased volatility in price shifts, but because of weaker correlations among them.
64
Q.5251 Which of the following is not one of the main factors used to explain the transitions from
low-to-high inflation regimes?
A. Structural forces.
B. Cyclical forces.
C. Monetary policy.
D. T he evolution of inflation.
Monetary policy consists of decisions and actions the Central Bank takes to ensure that the supply of
money in the economy is consistent with growth and price objectives the government sets. It
affects economic slack and shifts inflation.
T he three main factors that help explain the transitions from low-to-high inflation regimes are:
1. Structural forces: Include demography, technology, and political views with regard to how
market forces should operate in the economy.
2. Cycl i cal forces: T his is how the overall demand compares against the economy's capacity
for production.
3. The evol uti on of i nfl ati on: T his has an impact on incentives and, in turn, price power. It
is what makes transitions prone to self-reinforcement.
65
Q.5252 Which of the following actions is not taken by firms and employees to protect their interests
when inflation rate rises?
A. Centralization of wage formation.
B. Longer contracts.
C. More frequent price changes.
D. Labor unrest.
As inflation rises, it encourages economic agents to look for compensation for reductions in their
purchasing power or profit margins.
Since employees' and businesses' inflation expectations are backward-looking, higher inflation leads
to increased anticipated inflation. T his drives agents to seek compensation for future losses. Once
that occurs, the situation will worsen as:
Contracts become shorter.
Price changes are made more frequently.
Calls for more centralization of wage formation and labor unrest increase.
66
Q.5254 Economics with which of the following characteristics has the least risk due to the self-
reinforcing nature of transitions from low- to high-inflation regimes?
A. A long history of inflation.
B. Weak macroeconomic fundamentals.
C. Reputable central bank.
D. Significant currency depreciation.
Economies most at risk to the self-reinforcing nature of transitions from low- to high-inflation
regimes are those with the following characteristics:
A long history of inflation.
Weak macroeconomic fundamentals.
Experiencing significant currency depreciation.
67
Q.5255 Which of the following is not a factor that influences the effectiveness of monetary policy?
A. Its objective.
B. Degree of central bank’s independence.
C. Institutional foundations.
D. Wages and prices.
Wages and prices are not factors that influence the effectiveness of the monetary policy. Wages and
prices are what are influenced by monetary policy.
Factors that influence the effectiveness of monetary policy include:
Its objectives.
Its methods.
Its techniques.
Institutional foundations.
T he degree of the central bank's independence from the government.
68
Reading 159: The Blockchain Revolution: Decoding Digital Currencies
Q.5258 In the digital monetary system, the double-spend problem refers to the potential for someone
to duplicate digital currency and use it multiple times, thereby undermining the integrity of the
monetary system. Given this challenge, what is the traditional approach for solving the double-spend
problem in the context of digital money?
A. Peer-to-peer network with transaction confirmation emails.
B. Allowing each society member to have their own personal money-printing press.
C. Designing physical currency to make counterfeiting sufficiently expensive.
D. Using a digital ledger known as the blockchain.
Blockchain technology plays a pivotal role in resolving the double-spend problem. As a digital ledger,
the blockchain maintains a record of all transactions across a decentralized, distributed network.
Each transaction is bundled into a 'block' and added to a chronological 'chain' of previous
transactions. Blockchain's design ensures that once a block is added to the chain, it is nearly
impossible to modify, thereby making the replication or reversal of transactions extremely
challenging. T his characteristic, combined with the transparency of the network (where every
participant can verify transactions), provides a robust solution to the double-spend problem in digital
currency systems.
A i s i ncorrect.T his is not a secure approach for solving the double-spend problem because it relies
on email notifications for transaction confirmation, which can be easily manipulated and forged.
B i s i ncorrect. Allowing each society member to have their own personal money printing press
would likely lead to a chaotic monetary system and is unlikely to work successfully.
C i s i ncorrect. While physical currency can be designed to make counterfeiting sufficiently
expensive, it is not a solution to the double-spend problem in digital money systems.
69
Q.5261 T he underlying structure of cryptocurrency systems hinges on the collective efforts of
certain individuals or entities operating within the network. T hese individuals, commonly referred to
as 'miners', have a specific role that contributes to the functioning and security of the system.
Which of the following descriptions most accurately characterizes the principal responsibility of
miners in a cryptocurrency network?
A. To act as the central authority managing the entire record of cryptocurrency

transactions.
B. To define and control the usage parameters and protocols of the cryptocurrencies.
C. To generate new cryptocurrency units at their discretion.
D. To validate and chronologically order the transactions on the blockchain.
In the intricate realm of cryptocurrencies, miners fulfill a vital function. Utilizing high-performance
computing power, they tackle intricate mathematical tasks, which is a necessary step to verify and
log all cryptocurrency transactions on the blockchain. T hey function as a form of decentralized
auditors, safeguarding the blockchain's integrity and sequential order.
A i s i ncorrect because it contradicts the fundamental concept of cryptocurrencies, which is
decentralization. Miners, while integral to the functioning of the network, do not act as a central
authority. T hey are part of a decentralized network of peers, each of whom has a copy of the
complete transaction history. T heir main role is to validate new transactions and record them on the
blockchain.
B i s i ncorrect because the rules governing the operation and use of cryptocurrencies are pre-
defined in their underlying code. T hese rules are not controlled by miners; instead, they are enforced
by the consensus protocols of the cryptocurrency network..
C i s i ncorrect as miners do not have the discretion to create new cryptocurrency units whenever
they wish. T he creation of new units is a byproduct of the mining process, where miners are
rewarded with new cryptocurrency units for validating transactions and adding them to the
blockchain. However, this process is strictly regulated by the underlying algorithm of the
cryptocurrency, which determines the rate of new unit creation and the total supply.
70
Q.5262 T he double-spend problem arises in digital money systems because digital information can be
replicated and transmitted multiple times, making it possible for a single digital unit of value to be
spent more than once. One way to solve this problem is by using a reliable third party, such as a
bank, to mediate the movement of value between accounts in a ledger. How does the traditional
approach of using a reliable third party like a bank solve the double-spend problem in digital money
systems?
A. By creating new digital money units.
B. By controlling the rules of using digital money.
C. By mediating the movement of value between accounts in a ledger.
D. By utilizing sophisticated encryption techniques to secure digital money units.
T he traditional approach of using a reliable third party, such as a bank, solves the double-spend
problem in digital money systems by mediating the movement of value between accounts in a ledger.
T his ensures that each digital unit is spent only once by keeping track of all transactions and ensuring
that the same digital unit is not used multiple times.
A i s i ncorrect. Banks do not create new digital money units, they only facilitate the transfer of
existing units.
B i s i ncorrect. Banks do not control the rules of using digital money, they simply ensure that the
rules are followed by keeping track of transactions.
D i s i ncorrect. While encryption is indeed a crucial aspect of maintaining security in digital
transactions, it doesn't directly prevent the double-spend problem. T he issue of double-spending is
about ensuring a digital unit of value isn't spent more than once, not about securing the digital unit
itself.
71
Q.5270 Unlike traditional finance, which relies on intermediaries and centralized institutions,
decentralized finance (DeFi) uses smart contracts to enable transactions between parties without
the need for intermediaries, which can significantly reduce costs and give parties more control over
the terms of agreements. What is a smart contract?
A. A computational mechanism that predicts the outcome of financial transactions based on

historical data and trends.
B. A computer program that performs a set of predefined actions agreed upon by parties
C. A cryptographic tool that uses asymmetric encryption techniques to ensure the

confidentiality and integrity of transactions.
D. A digitized version of traditional contracts that are transcribed into binary format and
stored in a centralized database for ease of access and management.
A smart contract is essentially a digitized contract with its terms and conditions embedded into a
code. Residing on the blockchain, these contracts execute transactions automatically when the
stipulated conditions within the code are met. T his process eliminates the need for a middleman and
significantly reduces the potential for errors or manipulation.
Opti on A i s i ncorrect. Smart contracts do not predict outcomes based on historical data or trends.
Instead, they execute predefined actions automatically when certain conditions specified in the
contract's code are met.
Opti on C i s i ncorrect. While it's true that smart contracts, like many components of blockchain
technology, leverage cryptographic principles for secure operation, they are not cryptographic tools
per se. T heir primary function is not to encrypt or decrypt data, but to automate the execution of
contract terms embedded in the contract's code.
Opti on D i s i ncorrect. Smart contracts are not merely digitized versions of traditional contracts;
they are programmable and self-executing. Furthermore, smart contracts exist on a decentralized
network (blockchain), not in a centralized database. T he decentralization ensures transparency,
immutability, and trust among all parties involved.
72
Q.5271 AlphaArt, a renowned art auction house, is considering implementing decentralized finance
(DeFi) elements into their operations. T hey aim to introduce a system of tokenized art pieces,
allowing ownership of these pieces to be divided among multiple investors. T his system will utilize
smart contracts on a blockchain platform to enforce the terms of the tokenized ownership.
Additionally, they plan to create a decentralized autonomous organization (DAO) for governance
purposes and set up a decentralized exchange (DEX) for trading these tokenized assets. However,
the management is concerned about a few issues: the enforcement of property rights in the
blockchain for the physical art pieces, the potential counterparty risk if third-party escrow services
are required, and the authenticity of digital artworks represented by nonfungible tokens (NFTs).
Considering these concerns, which of the following would be the most effective way for AlphaArt to
implement the proposed system?
A. Tokenize the physical artworks and employ a third-party escrow service for collateral
management.
B. Create NFTs for each physical artwork, allowing the blockchain to confirm their
authenticity.
C. Set up a DAO with voting rights linked to the ownership of the tokenized assets.
D. Establish a DEX for trading the tokenized assets while maintaining a centralized structure
for governance.
A DAO would allow for decentralized control of the auction house and address the issue of
governance. It would permit token owners to have voting rights proportional to their token holdings,
effectively making them stakeholders in the organization. T his aligns with the nature of DeFi and
enhances the effectiveness of the proposed system.
Opti on A i s i ncorrect. While tokenizing the physical artworks is part of the plan, relying on a
third-party escrow service reintroduces centralized elements and potential counterparty risk into
the system, which goes against the DeFi principle of disintermediation.
Opti on B i s i ncorrect as it doesn't address the property rights issue related to physical artworks.
NFTs are excellent for certifying the authenticity of digital artworks. However, they don't provide a
solution for enforcing property rights of physical assets that are recorded on the blockchain.
Opti on D i s i ncorrect. Establishing a DEX aligns with the DeFi principle, but maintaining a
centralized structure for governance contradicts the decentralization aspect of DeFi. T his mixed
model could lead to conflicts and inefficiencies.
73
Q.5272 What is the difference between centralized exchanges (CEX) and decentralized exchanges
(DEX)?
A. CEXs operate through intermediaries, while DEXs do not
B. CEXs allow traders to keep custody of their funds, while DEXs do not
C. DEXs use order books to implement peer-to-peer trading, while CEXs do not
D. CEXs rely on smart contracts for trading, while DEXs do not
Centralized exchanges (CEXs) operate similar to traditional stock exchanges where there is a central
authority or intermediary that facilitates transactions. T his central body holds the traders' funds and
manages the order book. On the other hand, decentralized exchanges (DEXs) operate without
intermediaries and allow for direct peer-to-peer transactions through smart contracts on the
blockchain. T he users maintain custody of their funds, and transactions are conducted directly
between parties.
Opti on B i s i ncorrect. It's the other way around. DEXs allow traders to keep custody of their
funds, while CEXs do not. In CEXs, users' funds are kept in the exchange's wallets, while in DEXs,
users trade directly from their wallets.
Opti on C i s i ncorrect. Both CEXs and DEXs can use order books for trading. However, DEXs can
also use other mechanisms like liquidity pools in automated market makers (AMMs).
Opti on D i s al so i ncorrect. It's actually DEXs that rely on smart contracts for trading. T hese
contracts automate the exchange of assets directly between users, without an intermediary. CEXs,
on the other hand, use traditional digital systems to manage trades.
74
Q.5273 Smart contracts have the potential to fundamentally alter the way institutions are organized
and managed. T his is applicable to investment funds, corporations, as well as public goods and
services. One such application is the decentralized autonomous organization (DAO). Which of the
following is the correct definition of a DAO?
A. An organization governed by smart contracts on a blockchain
B. A type of financial transaction performed by intermediaries
C. A way to secure financial transactions by relying on signatures
D. A physical asset that can be traded
A decentralized autonomous organization (DAO) is an organization represented by computer code and
governed by smart contracts on a blockchain.
Opti on B i s i ncorrect because a DAO operates without intermediaries.
Opti on C i s i ncorrect because DAOs use smart contracts for secure transactions, not signatures.
Opti on D i s i ncorrect because a DAO is not a physical asset.
Q.5274 You are a financial risk management consultant for BankCorp, a major global bank. T he CEO
of BankCorp has approached you with concerns about the increasing popularity of a new stablecoin,
USDBlock, which has been gaining significant traction in the marketplace. While BankCorp
recognizes the potential efficiencies offered by blockchain technology, the CEO is concerned about
the potential risks associated with stablecoins. You have been asked to provide a detailed risk
assessment on the use of USDBlock. Which of the following is the most accurate advice to provide?
A. Given that USDBlock is a stablecoin pegged to the U.S. dollar, there is little risk associated
with its use, and it poses no systemic threat.
B. USDBlock, while attractive due to its potential efficiencies, could contribute to systemic
risk and fall under regulatory scrutiny, given its structure and wide adoption.
C. Stablecoins like USDBlock are entirely risk-free and have no regulatory concerns because
they utilize blockchain technology, making them more secure.
D. USDBlock's value is pegged to the U.S. dollar, making it immune to market volatility and
thereby eradicating any significant risk factors.
75
Stablecoins, like USDBlock, aim to address the price volatility of cryptocurrencies by tying their
value to a stable asset like the U.S. dollar. T his could offer efficiencies, especially for transactions
across international supply chains that would traditionally require multiple banking arrangements.
However, if a stablecoin like USDBlock became widely adopted and then failed, it could contribute to
systemic risk. Furthermore, stablecoins can attract regulatory scrutiny due to concerns over money
laundering, consumer protection, and overall financial stability. Opti on A i s i ncorrect. While
USDBlock is tied to a stable asset, this doesn't mean there is little risk or no systemic threat. Any
failure could still have a broad impact on the financial system, particularly if it's widely adopted.
Opti on C i s i ncorrect. T he assertion that stablecoins are entirely risk-free and have no regulatory
concerns is false. Despite utilizing blockchain technology, stablecoins can still carry various risks
and definitely attract regulatory attention. Opti on D i s i ncorrect. While the pegging of USDBlock's
value to the U.S. dollar could mitigate some market volatility, it doesn't eradicate significant risk
factors. Operational, credit, and systemic risks are among those that could still apply.
Q.5275 What is the main risk associated with U.S. dollar-based stablecoins?
A. T heir liability is tied to the U.S. dollar.
B. T hey are vulnerable to runs if their assets are of poor quality.
C. T hey may experience a bank run.
D. T hey are protected by federal deposit insurance.
Stablecoins based on the U.S. dollar are similar to money market funds in that the price of their
liabilities is tied to the U.S. dollar. However, unless fully backed by U.S. dollar reserves or bills, U.S.
dollar-based stablecoins may experience a bank run. T his happens if a stablecoin is unable to sell its
assets at reasonable prices or raise the funds required to meet its redemption promises, posing a risk
to stablecoin holders and the financial system as a whole.
Opti on A i s i ncorrect because the liability tied to the U.S. dollar is a characteristic of stablecoins,
not a risk.
Opti on B i s i ncorrect because this is a result of a bank run, not the main risk itself.
Opti on D i s i ncorrect because federal deposit insurance applies to traditional banks and not
stablecoins.
76
Q.5276 As the Chief Financial Officer of FinChain Corp, a leading fintech company exploring
advancements in blockchain technology, you're contemplating the introduction of stablecoins to
streamline cross-border transactions and reduce currency volatility risks. However, some board
members are uncertain about the nature and potential implications of stablecoins. T hey're
particularly concerned about how stablecoins maintain their value, how they could affect systemic
risk, and what regulatory considerations might come into play. Which of the following would be the
most accurate explanation to provide to the board about stablecoins?
A. Stablecoins are blockchain-based assets whose values fluctuate freely based on market
dynamics, providing opportunities for substantial financial gains.
B. Stablecoins are digital tokens that derive their value from an external asset or pool of
assets, and while they can streamline transactions, they may contribute to systemic risk and
attract regulatory attention.
C. Stablecoins are primarily used for trading and investment purposes in cryptocurrency
exchanges, and their value is intrinsically tied to the performance of those exchanges.
D. Stablecoins, being cryptocurrencies, are inherently immune to regulatory scrutiny and

systemic risk due to their decentralized nature.
Stablecoins are a type of cryptocurrency designed to maintain a stable value by being pegged to an
external asset or pool of assets, which could be a fiat currency like the U.S. dollar, a commodity, or
even another cryptocurrency. T heir primary purpose is to provide stability in the highly volatile
cryptocurrency markets and to enable efficient digital transactions. However, they could contribute
to systemic risk if a stablecoin that is widely used fails, which could have broader implications for
the financial system. T hey are also subject to regulatory scrutiny due to concerns about financial
stability, money laundering, and consumer protection.
Opti on A i s i ncorrect as it describes typical cryptocurrencies, not stablecoins. Stablecoins are
designed to have stable value, not to fluctuate freely based on market dynamics.
Opti on C i s i ncorrect because stablecoins are not primarily used for trading and investment
purposes, nor is their value tied to the performance of cryptocurrency exchanges. T hey are used as
a store of value or medium of exchange.
Opti on D i s i ncorrect because being a cryptocurrency doesn't make a stablecoin immune to
regulatory scrutiny or systemic risk. All financial instruments, including cryptocurrencies, can
77
contribute to systemic risk, and stablecoins can indeed attract regulatory attention.
Q.5277 T he Central Bank of Namaland, a small nation grappling with economic challenges, is
contemplating the implementation of a Central Bank Digital Currency (CBDC) to improve its financial
system's efficiency. As a financial risk manager consulting with the Central Bank, you're asked to
discuss the potential implications of this move, including the advantages, disadvantages, and potential
applications of CBDC in Namaland's unique context. How would you articulate the potential
implications of implementing a CBDC in Namaland?
A. A CBDC would guarantee absolute safety for large deposits, completely eliminating
counterparty risk. However, it could lead to disintermediation of parts of the money market.
B. T he introduction of a CBDC would instantly modernize the payment system, eliminating

the need for any further improvements to the existing infrastructure. It also carries no risk
of disintermediation of the money market.
C. Implementing a CBDC would increase the efficiency of the payment system and reduce
counterparty risk. However, it will completely eradicate the need for bank deposits and
could introduce new systemic risks.
D. CBDCs are the most efficient form of digital currency, guaranteeing improved payment
systems, elimination of counterparty risk, and no potential for disintermediation of the
money market or creation of systemic risk.
A CBDC, by nature, would indeed provide a high degree of safety for deposits as it represents a
liability of the Central Bank. T his eliminates the counterparty risk often associated with commercial
bank deposits. T his is true as CBDCs are a type of digital currency issued directly by the central
bank, which is why they can provide absolute safety for large deposits. However, this could lead to a
potential disintermediation of the money market because large corporations may prefer to hold
CBDCs over money market instruments due to the safety and convenience provided by CBDCs.
B i s i ncorrect because although CBDC can indeed modernize the payment system, it does not
eliminate the need for further improvements in the existing infrastructure. T he integration of
CBDCs would require significant infrastructure updates, and there could still be room for other
improvements, innovations, or services that complement the CBDC. Furthermore, the
implementation of CBDC could potentially lead to the disintermediation of the money market.
78
C i s i ncorrect. While CBDCs do have the potential to improve the efficiency of the payment
system and reduce counterparty risk, they wouldn't necessarily eradicate the need for bank deposits.
Bank deposits offer services such as lending, which are not offered by CBDCs, meaning they still play
an important role in the financial system.
D i s i ncorrect as it oversimplifies and overstates the benefits of CBDCs. While they could indeed
improve the efficiency of payment systems and eliminate counterparty risk, there's no guarantee
that they're the "most efficient" form of digital currency - this will depend on various factors,
including the specific design of the CBDC and the existing financial infrastructure. Furthermore, the
introduction of CBDCs could potentially lead to the disintermediation of the money market.
Q.5278 T he Republic of Optima, a rapidly developing economy, has been considering the
implementation of a Central Bank Digital Currency (CBDC) as part of its push towards digitization.
T he Central Bank of Optima (CBO) believes that a CBDC might enhance the efficiency of the
payment system, reduce counterparty risk and more effectively serve its booming retail sector.
However, it is concerned about the potential implications on the broader financial system and the
associated risks. As an external consultant brought in by the CBO, you have been asked to provide an
assessment of the potential advantages, disadvantages, and applications of a CBDC in Optima's
context. Which of the following statements is the most accurate assessment you would provide to
the CBO?
A. Implementing a CBDC would render traditional bank deposits obsolete and could risk the
stability of Optima's financial system due to the disintermediation of parts of the money
market.
B. A well-designed CBDC could offer efficiency gains and reduce counterparty risk for
corporations, but it might also disrupt parts of the money market and would be less attractive
if Optima's current payment system continues to evolve effectively.
C. Optima's CBDC would eliminate all counterparty risk, make the existing payment system
redundant, and would be immune to any regulatory constraints.
D. Adopting a CBDC would offer no tangible benefits over Optima's current payment system,
could introduce substantial systemic risk, and would likely face heavy regulatory scrutiny.
CBDCs, as digital liabilities of a central bank, have the potential to enhance the efficiency of the
payment system by enabling real-time transactions and reducing counterparty risk, particularly for
79
large corporations. However, if unrestricted in size, they could potentially disintermediate
(eliminate) parts of the money market, leading to financial instability. Additionally, the attractiveness
of a CBDC might diminish if the current payment system continues to evolve effectively to offer
similar benefits.
A i s correct. Although a CBDC could potentially disrupt parts of the money market, it doesn't
necessarily render traditional bank deposits obsolete. Banks could continue to play a vital role in the
financial system even with the introduction of a CBDC.
C i s correct. A CBDC could indeed reduce counterparty risk and improve the efficiency of the
payment system, but it doesn't necessarily make the existing payment system redundant or immune
to regulatory constraints. Regulatory bodies would likely play a crucial role in overseeing a CBDC's
operation.
D i s correct. While a CBDC could introduce new risks and would undoubtedly be subject to
regulatory considerations, it doesn't mean there are no tangible benefits over the existing payment
system. A well-designed CBDC could indeed offer efficiency gains and reduce counterparty risk.
80
Reading 160: The Future Monetary System
Q.5282 Which of the following statements represents a possible advantage of a monetary system
based on CBDCs?
A. CBDCs offer complete anonymity for users, ensuring privacy in transactions.
B. CBDCs can significantly speed up settlement and reduce counterparty risk.
C. CBDCs can only be accessed by domestic commercial banks, limiting competition.
D. CBDCs are built on a decentralized blockchain, ensuring full transparency.
A monetary system based on CBDCs has the advantage of significantly speeding up settlement and
mitigating counterparty risk. T ransactions can be settled using self-executing smart contracts,
where payments and delivery of assets occur simultaneously when predetermined conditions are
met. T his atomic settlement feature enables faster transaction processing and reduces the risk
associated with counterparty default.
A i s i ncorrect. While CBDCs can provide improved privacy features compared to traditional
payment systems, they are not designed to offer complete anonymity. CBDCs typically balance the
need for privacy with the necessity of compliance and accountability, often using cryptographic
techniques to preserve privacy while ensuring the integrity of the system.
C i s i ncorrect. One of the advantages of CBDCs is that they can be available to a much wider range
of intermediaries than just domestic commercial banks. Allowing non-bank Payment Service
Providers (PSPs) to transact in CBDCs can promote competition and vibrancy in the financial
ecosystem.
D i s i ncorrect. While CBDCs can leverage decentralized technologies like Distributed Ledger
Technology (DLT ) or blockchain, they are not necessarily built on a decentralized blockchain. T he
design of CBDCs can vary, and central banks can choose different levels of decentralization depending
on their specific requirements and goals.
81
Q.5283 PrismaChain is a cutting-edge, permissionless blockchain startup that aims to revolutionize
the financial sector by providing a new level of transaction processing capacity. T he founding team,
composed of seasoned blockchain developers, has been debating over the optimal design for their
network. T hey want to create a robust system that can handle a high volume of transactions
(scalability), is resistant to cyberattacks (security), and does not concentrate power in the hands of a
few nodes (decentralization). However, they are aware of a fundamental design challenge they need
to confront. Given the scenario, which of the following best describes the challenge that the
PrismaChain team is facing in its network design?
A. T he decentralization paradox, which states that a blockchain can be decentralized or

scalable but not both.
B. T he security dilemma, which claims that blockchains can be secure or decentralized but
cannot fully achieve both.
C. T he scalability trilemma, which suggests that permissionless blockchains cannot maximize

scalability, security, and decentralization simultaneously.
D. T he efficiency problem, which suggests that while blockchains can be scalable and
secure, they inherently lack operational efficiency.
T he term "scalability trilemma," popularized by Ethereum's co-founder Vitalik Buterin, refers to the
design challenges in blockchain systems. According to the trilemma, it's difficult to maximize all
three desirable attributes (security, scalability, and decentralization) in a single system. When a
blockchain system becomes larger, it often sacrifices either security or decentralization.
A i s i ncorrect. T he decentralization paradox presents a binary choice between decentralization
and scalability. While there can be trade-offs between these two attributes, it oversimplifies the
issue by leaving out security, which is a crucial part of the trilemma.
B i s i ncorrect. T he security dilemma suggests a binary choice between security and
decentralization, omitting scalability from the discussion.
D i s i ncorrect. While operational efficiency can be an issue in blockchain networks due to high
energy consumption or slow transaction times, it is not inherently part of the scalability trilemma,
which focuses specifically on the balance between security, scalability, and decentralization.
82
Q.5284 Ramon, a senior economist at the central bank, is evaluating the potential implications of
implementing a wholesale Central Bank Digital Currency (CBDC) system for the country's financial
infrastructure. T he system allows a wide range of intermediaries, including non-bank payment
service providers (PSPs), to transact in CBDCs. It's designed to foster competition and innovation in
financial services, and reduce counterparty risk through atomic settlements. Despite the potential
benefits, Ramon is aware that such a system might have certain drawbacks. Which of the following
correctly identifies a potential disadvantage of the proposed wholesale CBDC system?
A. T he use of CBDCs could heighten counterparty risk in financial transactions.
B. T he CBDC system would infringe on privacy by requiring the public posting of all
transaction histories.
C. T he implementation of a CBDC system could lead to the exclusion of smaller

intermediaries due to technical complexity.
D. T he use of cryptographic techniques for privacy assurance could expose transaction data
to malicious actors.
Wholesale CBDC systems are underpinned by intricate technologies such as distributed ledger
technology (DLT ), smart contracts, and cryptographic techniques. To interact effectively with these
systems, intermediaries need to possess advanced technical knowledge and resources. Smaller
intermediaries, such as local banks, credit unions, or small payment service providers, might not
have access to the necessary technical expertise or the financial resources to adapt their systems
and procedures to interact with a CBDC system. For instance, implementing and managing DLT
networks, developing or implementing smart contracts, and ensuring secure cryptographic
transactions require significant investment and highly specialized skills.
A i s i ncorrect. CBDCs wouldn't heighten counterparty risk. In fact, they could reduce it due to the
finality of payments and the ability to automate transactions with the use of smart contracts.
B i s i ncorrect. Privacy in a CBDC system is not infringed by the public posting of all transaction
histories. Instead, the system would rely on cryptographic techniques like zero-knowledge proofs to
ensure privacy while proving transaction validity.
D i s i ncorrect. T he use of cryptographic techniques like zero-knowledge proofs is intended to
enhance privacy and security in digital transactions, not expose data to malicious actors.
83
Q.5285 CentaBank, a central bank of a large economy, is considering the implementation of a
wholesale Central Bank Digital Currency (CBDC). T he bank has identified the need for a sophisticated
system that can facilitate faster and more efficient transactions among various intermediaries, not
just domestic commercial banks. T he proposal involves the introduction of self-executing smart
contracts, making transactions programmable and allowing finality in payments. Which of the
following is a potential advantage of implementing this wholesale CBDC system?
A. T he CBDC system would eliminate the need for intermediaries in the financial system.
B. T he CBDC system could unlock significant private sector innovation across a range of
financial services.
C. T he CBDC system would eliminate the risk of digital currency being used for illegal
activities.
D. T he CBDC system would automatically adjust the money supply according to economic
conditions.
With CBDCs, intermediaries can gain access to new capabilities not provided by reserves held at
commercial banks. T his is due to the programmability of CBDC transactions through self-executing
smart contracts, allowing transactions to be automated and settled when certain conditions are met.
Additionally, CBDCs' accessibility is not confined to domestic commercial banks, it can be extended
to non-bank Payment Service Providers (PSPs), which can enhance competition and diversification
in the financial ecosystem.
A i s i ncorrect. While the CBDC system can streamline processes, it doesn't necessarily eliminate
the need for intermediaries. Instead, it changes the role they play, potentially expanding the types of
intermediaries involved in financial transactions.
C i s i ncorrect. While the CBDC system can provide certain tools and measures to reduce illegal
activities, it cannot fully eliminate the risk of digital currency being used for such purposes. T he
effectiveness of these measures would also depend on other factors, such as regulatory policies and
the implementation of security protocols.
D i s i ncorrect. A CBDC system, including a wholesale one, doesn't automatically adjust the money
supply according to economic conditions. T his function remains under the purview of the central
bank's monetary policy.
84
Q.5286 In recent times, the National Bank of Country X has been considering the implementation of
a Central Bank Digital Currency (CBDC). T hey are particularly intrigued by the implications of
wholesale CBDCs on the national monetary system and its potential to revolutionize financial
services through the tokenization of financial instruments such as retail deposits. Country X's
central bank would issue these digital currencies, and they could be converted into central bank
money at par value. What could be a significant implication for retail investors if the National Bank of
Country X implements wholesale CBDCs and tokenized retail deposits?
A. T he potential for inflation would drastically increase as retail investors could convert
their deposits into and out of tokens at will.
B. Retail investors would face significant risks as the CBDCs would not be insured like
traditional deposits.
C. Retail investors could experience increased convenience and flexibility due to the
programmable and "always-on" nature of tokenized deposits.
D. T he reliance of retail investors on commercial banks would be drastically reduced as they

could directly deal with the central bank.
Tokenized deposits, unlike traditional deposits, are programmable and available 24/7. T his offers
retail investors increased convenience and flexibility as they can convert their deposits into and out
of tokens and exchange them for goods, services, or other assets.
A i s i ncorrect. T he ability of retail investors to convert their deposits into and out of tokens at will
does not automatically lead to inflation. Monetary policy and economic conditions have a more direct
impact on inflation.
B i s i ncorrect. Tokenized deposits would also be protected by deposit insurance, similar to
traditional deposits.
D i s i ncorrect. While it's true that CBDCs could reduce some dependencies on commercial banks,
retail investors would still interact with commercial banks, particularly since tokenized deposits
represent a claim on the depositor's commercial bank.
85
Q.5287 Which of the following characteristics of the future monetary system would facilitate
transactions between financial intermediaries and enable transactions to be conducted automatically
when predetermined conditions are met?
A. Programmability.
B. Composability.
C. Instant payments.
D. Interoperability.
Programmability in a monetary system would allow for transactions to be conducted automatically
when certain pre-set conditions are met. T his is a common feature of programmable money, such as
cryptocurrencies or smart contracts, where the terms of an agreement can be written into the code
of a transaction, and those conditions can trigger the execution of the transaction when they're met.
B i s i ncorrect. Composability refers to the ability of different systems or components to work
together, each part contributing to a system's overall functionality. While composability is an
important trait in a system and can certainly facilitate transactions, it does not directly enable
transactions to be conducted automatically when predetermined conditions are met.
C i s i ncorrect. T he speed of transactions, which while beneficial, doesn't directly relate to
automatic execution based on predetermined conditions.
D i s i ncorrect. While interoperability is important for seamless and efficient transactions across
different systems or networks, it does not allow for transactions to be conducted automatically when
certain conditions are met/p>
86
Q.5288 A new fintech startup is developing a decentralized payment platform that uses cryptographic
techniques to validate transactions. T he startup aims to allow users to verify the authenticity of a
transaction without revealing any other transaction details. Which cryptographic technique are they
most likely employing?
A. Digital tokenization
B. Atomic trading system
C. Zero-knowledge proof (ZKP)
D. Application Interface Programming (API)
Zero-knowledge proof (ZKP) is a cryptographic technique that allows one party (the prover) to
prove to another party (the verifier) that a given statement is true, without conveying any
information apart from the fact that the statement is indeed true. In this scenario, the startup is using
ZKP to validate transactions, allowing users to verify the authenticity of a transaction without
revealing any additional transaction details. It's a crucial component in many privacy-preserving
protocols and blockchain applications because it maintains privacy and security in a trustless
environment.
A i s i ncorrect. Tokenization is a method that replaces sensitive data with unique identification
symbols retaining all the essential information without compromising its security. T his is not
necessarily related to the revealing of information only in terms of the validity of the statement.
B i s i ncorrect. Atomic settlement refers to the process where transactions are settled on an 'all
or nothing' basis to prevent the partial completion of trades. T his term is unrelated to the concept of
not revealing additional information beyond the validity of a statement.
D i s i ncorrect. An Application Programming Interface (API) is a software intermediary that allows
two applications to communicate with each other. It is not a cryptographic technique and doesn't
relate to the concept of not exposing information beyond the validity of a statement.
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FRM Part II Exam

Questions with Answers - Current Issues in Financial Markets

Last Updated: Jul 8, 2023

prohibited. Infringers will be prosecuted in their local jurisdictions. ”

153 - Machine Learning and AI for Risk Management 3

C. Principal component analysis.

reducing a large number of features to just a couple of key components.

variables that are shown to have explanatory power.

other variables in a model.

A. Regression results in a single output, while classification results in multiple outputs.

B. Regression is a supervised machine learning technique, while classification is an

C. Regression requires training data, but classification does not.

B i s i ncorrect. Both regression and classification are supervised learning techniques.

into more than one class.

A. Unavailability of adequate skilled labor.

B. A lack of transparency around key decisions.

C. A lack of accuracy of some machine learning solutions.

D. Unavailability of adequate well-organized data.

express problems for firms themselves, not regulatory authorities.

A. Providing tools to stress test models.

B. Identifying hidden operational risk exposures.

unsuitable assets in trading models.

most of the data's variance while reducing the data's dimensionality.

Opti on C i s i ncorrect because, in PCA, each original variable's contribution to a principal

contribute equally to the dependent variable.

A. By minimizing the distance between points within the same cluster.

B. By maximizing the distance between points in different clusters.

C. By minimizing the variance in the first cluster only.

D. By maximizing the variance between clusters.

with the nearest center.

A. T hey employ a linear regression-based approach for problem-solving.

B. T hey deploy non-linear regression methods to model relationships.

D. T hey make use of non-linear classification methods to segregate data.

linear model might miss.

typically associated with classification tasks.

D. T hey only require minimal human oversight in decision-making processes.

leading to widespread financial distress.

technologies can effectively process natural language and images.

A. In reinforcement learning, the algorithm is trained on a smaller dataset, and it is expected

positive reward, and it adjusts its behavior accordingly.

data to make predictions or classify new data.

datasets of any size.

this feedback to improve its decision-making strategy.

D. All of the above.

supervised learning algorithm would be appropriate for this problem.

such as clustering and anomaly detection.

C i s i ncorrect: Reinforcement learning algorithms are used to solve sequential decision-making

A. Machine learning can be employed to completely replace human involvement in

D. Machine learning can entirely remove the non-compliance risk by automatically

such as decision-making, ethics, and complex problem-solving.

necessary safety net.

forming compact and distinct clusters.

to distinguish groups does not necessarily have to be straight.

D. Limited scope of application

model's decision-making mechanism.

C i s i ncorrect: High complexity, could be considered a limitation in some contexts, especially

including image recognition, natural language processing, and more.

A. T he high cost of buying AI and machine learning solutions.

B. T he management often resists the change to AI and machine learning.