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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank buys credit protection from a single guarantor on a corporate loan. A risk manager is concerned about the residual risks that remain even though the loan is guaranteed. Which is a residual risk of credit risk mitigation?

Legal and documentation risk is a residual risk: the guarantee may be unenforceable or poorly drafted, leaving the bank unprotected. Mitigation shifts credit risk but does not eliminate concentration, change borrower PD, or remove operational risk.

  1. ALegal risk that the guarantee may prove unenforceable or documentation may be defectiveCorrect
  2. BElimination of all concentration risk because exposure moves to the guarantor
  3. CThe reduction of the borrower's PD to zero
  4. DA guaranteed loan carrying no operational risk

Explanation

Mitigation transfers or reduces credit risk but creates residual risks such as legal and documentation risk, guarantor concentration, and maturity or currency mismatches. It does not set borrower PD to zero or eliminate concentration.

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