Credit Risk Management Practice Exam

What technique is commonly used to mitigate credit risk in a bank's portfolio?

1. Increasing interest rates on loans

2. Utilizing off-balance-sheet financing

3. Implementing stricter collateral requirements

4. Using credit derivatives such as credit default swaps

The correct answer is: Using credit derivatives such as credit default swaps

The technique of using credit derivatives, such as credit default swaps (CDS), is commonly employed to mitigate credit risk in a bank's portfolio. Credit derivatives act as a form of insurance against the default of a borrower. When a bank enters into a credit default swap, it can transfer the credit risk associated with a particular loan or bond to another party. In essence, if the borrower defaults, the party that sold the CDS compensates the bank for the loss, thus protecting the bank's financial position. This risk transfer mechanism allows banks to maintain a more stable portfolio by managing the potential impact of defaults, enabling them to take on additional risk without proportionately increasing their capital requirements. Furthermore, the use of credit derivatives aids in enhancing liquidity and can improve risk-adjusted returns, making them a valuable tool in comprehensive credit risk management strategies. While options like increasing interest rates or implementing stricter collateral requirements can influence a bank's risk profile, they don’t provide the same degree of risk transfer or flexibility that credit derivatives afford. Off-balance-sheet financing also doesn’t directly mitigate credit risk; instead, it can be used for purposes such as improving balance sheet metrics or managing capital ratios. Therefore, credit derivatives stand out as a proactive approach to directly address and