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FRM Part II · FRM Exam Part II · Case Study: Financial Crime and Fraud

A bank estimates that without controls, a payment-fraud scenario has an expected annual loss of USD 4.0 million. Preventive controls are rated as reducing the likelihood by 50%. Detective controls reduce the loss severity of the remaining events by 40%. The controls are independent and applied in sequence. What is the residual expected annual loss, and by what percentage have controls reduced the inherent loss?

Residual expected loss is USD 1.2 million, a 70% reduction. Preventive controls halve the frequency, giving 2.0 million, and detective controls cut severity by 40%, giving 2.0 x 0.6 = 1.2 million. Controls multiply rather than add, so a 90% reduction is incorrect.

  1. AUSD 1.2 million; 70% reductionCorrect
  2. BUSD 0.4 million; 90% reduction
  3. CUSD 1.6 million; 60% reduction
  4. DUSD 2.0 million; 50% reduction

Explanation

Preventive control leaves 50% of frequency: 4.0 x 0.5 = 2.0. Detective control leaves 60% of severity: 2.0 x 0.6 = 1.2 million. Reduction is 2.8/4.0 = 70%. Adding the percentages (90%) double counts the effects; 1.6 applies only the detective control.

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