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FRM Part II · FRM Exam Part II · Risk Measurement and Assessment

A bank's operational risk team runs a Risk and Control Self-Assessment (RCSA) in its payments unit. Business managers identify risks, rate the likelihood and impact of each risk before controls (inherent) and after controls (residual), and rate how well each control operates. Which statement best describes the relationship between inherent and residual risk in this process?

Residual risk is the exposure that remains after the effect of existing controls is considered. Inherent risk is the exposure before controls. An RCSA rates both so management can see how much risk the controls actually reduce and whether the remaining level is acceptable.

  1. AResidual risk is the level of risk remaining after the effect of existing controls is taken into accountCorrect
  2. BResidual risk is the level of risk before any controls are applied
  3. CResidual risk equals inherent risk plus the cost of controls
  4. DResidual risk is the loss recorded in the loss database in the prior year

Explanation

Inherent risk is the exposure before considering controls. Residual risk is what remains after the existing controls, given their design and operating effectiveness, are considered. The option describing pre-control risk simply defines inherent risk.

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