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FRM Exam Part II · Credit Risk Management

Credit Risk Governance, Regulation and Capital for FRM Part II

Updated 11 October 2026 · Fact-checked

Credit risk governance sets who owns credit risk, the limits and the policies. Regulation turns credit exposure into capital: risk-weighted assets (RWA) = exposure × risk weight, and minimum capital is a percentage of RWA. The standardized approach uses prescribed weights. IRB uses the bank's own PD, LGD and EAD. RAROC prices loans against capital.

Understand Credit Risk Governance, Regulation and Capital

Start with the basic problem. A bank lends money and some borrowers will not repay. The bank needs a framework to decide who it lends to, how much, and at what price. That framework is credit risk governance: a board-approved risk appetite, written credit policies, exposure limits, independent risk oversight and regular reporting.

Limits are the working tools. A bank sets limits by single borrower, industry, country, rating grade and product. They stop concentration. Breaches are escalated, not ignored. The first line (business) takes the risk, the second line (risk function) challenges and monitors it, and the third line (internal audit) gives independent assurance.

Regulation then asks: how much capital must stand behind these loans? Basel converts each exposure into risk-weighted assets (RWA). Riskier exposures get higher weights, so they need more capital. Under the standardized approach (SA), the regulator sets the weights, usually based on external ratings or exposure type. Under the internal ratings-based (IRB) approach, the bank estimates its own risk parameters and a supervisory formula turns them into capital.

IRB has two forms. In foundation IRB (F-IRB) the bank estimates PD only; supervisors set LGD, EAD (through conversion factors) and maturity. In advanced IRB (A-IRB) the bank estimates PD, LGD, EAD and, in general, maturity. IRB capital is meant to cover unexpected loss at a 99.9% confidence level over one year. Expected loss is covered by provisions and pricing, not capital. The IRB formula rests on a single systematic factor (Vasicek) model, so portfolios are assumed granular, with one common risk factor.

For pricing, banks use RAROC: risk-adjusted return divided by economic capital. A loan creates value only if RAROC exceeds the bank's hurdle rate (cost of equity). Pricing must cover funding cost, operating cost, expected loss and a return on capital.

Key formulas to remember

Risk-weighted assets
RWA = Exposure × Risk weight
Use exposure after any credit risk mitigation recognised by the framework.
Minimum capital
Capital required = Capital ratio × Total RWA
Basel minimum total capital is 8% of RWA; buffers sit on top of that.
Implied RWA from IRB capital
RWA = 12.5 × K × EAD
K is the capital requirement per unit of exposure. 12.5 = 1 ÷ 8%.
Expected loss
EL = PD × LGD × EAD
Covered by pricing and provisions, not by capital.
RAROC
RAROC = (Revenue − Costs − Expected loss) ÷ Economic capital
Some versions add the return on capital and tax adjustments; follow the question's definition.
Risk-adjusted loan spread (break-even)
Required spread ≈ Funding cost + Operating cost + (PD × LGD) + Hurdle rate × Capital ratio − Return earned on capital
Simplified one-year view; the last term is often ignored if not given.

How to solve Credit Risk Governance, Regulation and Capital questions

Use this method for any question on governance, Basel credit capital or loan pricing.

  1. 1Identify what is asked: a governance principle, a capital figure, an approach comparison or a pricing result.
  2. 2List the data given: exposure, risk weight or rating, PD, LGD, EAD, capital ratio, costs, capital.
  3. 3For governance questions, name the line of defence or control (board, limit, policy, independent review) that answers the issue.
  4. 4For capital questions, find exposure, apply the risk weight, sum to RWA, then multiply by the capital ratio.
  5. 5For approach questions, ask who estimates which parameter: regulator or bank.
  6. 6For pricing questions, compute expected loss and the capital charge, then compare return to the hurdle.
  7. 7Check units: percent versus decimal, exposure before or after mitigation, RWA versus capital.
  8. 8Pick the option that matches your calculation and the correct Basel term.

Quickest way: Three-line shortcut

When to use it: Use when you have about two minutes per MCQ and the options look similar.

  1. Spot the keyword: RWA, F-IRB, A-IRB, limits, RAROC.
  2. For RWA, multiply exposure by weight first; capital comes second.
  3. For IRB, remember F-IRB = bank PD only; A-IRB = bank PD, LGD, EAD.
  4. For RAROC, subtract expected loss before dividing by capital.
  5. Eliminate options that confuse expected loss with capital or RWA with capital.

Common mistakes in Credit Risk Governance, Regulation and Capital

  • Reporting RWA when the question asks for capital.

    The calculation ends with a large number and it feels like the answer.

    Fix: Re-read the last line of the question. Capital = ratio × RWA.

  • Saying F-IRB lets banks estimate LGD.

    Students mix up foundation and advanced.

    Fix: In F-IRB only PD is bank-estimated. A-IRB adds LGD, EAD and maturity.

  • Thinking IRB capital covers expected loss.

    Total loss feels like a capital matter.

    Fix: Capital covers unexpected loss; expected loss is met by provisions and pricing.

  • Forgetting to deduct expected loss in RAROC.

    Students use accounting profit only.

    Fix: Use risk-adjusted return: revenue less costs less expected loss.

  • Applying the SA risk weight to the gross exposure when collateral is recognised.

    The mitigation detail is skipped.

    Fix: Check whether eligible collateral reduces the exposure the question wants weighted.

  • Treating limits as a front-office choice only.

    Business lines propose limits, so ownership seems theirs.

    Fix: The board sets appetite; the independent risk function monitors limits and breaches escalate.

Worked examples

Example 1

A bank has a ₹200 crore corporate loan with a 100% risk weight and a ₹100 crore residential mortgage with a 35% risk weight under the standardized approach. Total capital must be 8% of RWA. How much minimum capital is required?

Show the solution
  1. Corporate RWA = 200 × 100% = ₹200 crore.
  2. Mortgage RWA = 100 × 35% = ₹35 crore.
  3. Total RWA = 200 + 35 = ₹235 crore.
  4. Capital = 8% × 235 = ₹18.8 crore.

Answer: Minimum capital is ₹18.8 crore (RWA is ₹235 crore).

Example 2

A USD 10 million loan earns revenue of USD 700,000 a year. Operating costs and funding costs total USD 350,000. PD is 1%, LGD is 40%, EAD is USD 10 million. Economic capital is USD 1 million. What is the RAROC?

Show the solution
  1. Expected loss = 1% × 40% × 10,000,000 = USD 40,000.
  2. Risk-adjusted return = 700,000 − 350,000 − 40,000 = USD 310,000.
  3. RAROC = 310,000 ÷ 1,000,000 = 31%.

Answer: RAROC is 31%. If the hurdle rate is below 31%, the loan adds value.

Exam tips

  • Questions often test who estimates which parameter in F-IRB versus A-IRB; memorise the split.
  • Read whether the answer is RWA or capital; many wrong options are the other one.
  • Governance questions reward the answer that keeps independence: second-line challenge and board-approved limits.
  • In RAROC questions, check if expected loss is already netted in the given return.
  • Use approximate arithmetic to eliminate options before computing exactly.

Practice questions from Credit Risk Management

Credit Risk Governance, Regulation and Capital in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk Governance, Regulation and Capital: frequently asked questions

What is the main difference between the standardized and IRB approaches?

Under the standardized approach, regulators set risk weights, usually by external rating or exposure class. Under IRB, the bank's own models estimate risk parameters such as PD, and a supervisory formula converts them into capital. IRB is more risk-sensitive but needs supervisory approval and strong validation.

How are risk-weighted assets calculated for credit risk?

Multiply each exposure by its risk weight and add them up. Under IRB, RWA comes from the formula 12.5 × K × EAD, where K is the capital requirement per unit of exposure. Minimum capital is then a percentage of RWA.

What is the difference between foundation and advanced IRB?

In foundation IRB the bank estimates PD while supervisors set LGD, EAD conversion and maturity. In advanced IRB the bank estimates PD, LGD, EAD and generally maturity. Advanced needs more data and tighter validation.

How is RAROC used in credit decisions?

RAROC divides risk-adjusted profit by economic capital. If it exceeds the bank's hurdle rate, the loan or business line creates value. If not, the bank should reprice, reduce the exposure or decline.