Quiz: Governance

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6 questions to check your understanding of the chapter “Governance”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   In the three lines model, which line is described as having independence as its defining feature?

   1. A.The first line
   2. B.The second line
   3. C.The third line
   4. D.Both the second and third lines
   Answer and explanation

   Answer: C

   Independence is the defining feature of the third line, which is internal audit. The third line checks whether the governance and risk management arrangements are sound, and gives objective assurance and advice to management and the governing body.

   The first line manages the business and its risks, and independence is not its defining feature. The second line is part of management, so however its reporting line is set up, it cannot be completely separated from management.

   Learn more: The Three Lines Model

2. Question 2

   As a hypothetical example, a financial institution sets up a primary reporting line from its risk management function to the governing body (the board of directors) to strengthen the independence of the second line. Who is responsible for managing risk?

   1. A.The head of the second line
   2. B.Management in the first line
   3. C.The governing body
   4. D.Internal audit in the third line
   Answer and explanation

   Answer: B

   Responsibility for managing risk stays with management in the first line, even where a second line exists. A reporting line from the second line to the governing body does not change this.

   The second line provides expertise and support in risk management, monitors, and challenges, but it does not take on the responsibility itself. The governing body oversees, and receives reports and assurance. Internal audit in the third line checks the adequacy and effectiveness of management from an independent position, and it does not bear responsibility for managing risk either.

   Learn more: The Three Lines Model

3. Question 3

   In the direction the Basel Committee set out in its principles in October 2010, how should the offering of a new product be handled when risk management arrangements are not yet in place?

   1. A.Postpone it until market conditions settle, even after the arrangements are in place
   2. B.Offer it once the risk management function has fed its assessment into the review
   3. C.Offer it once the systems are in place, without waiting for risk management
   4. D.Postpone it until the systems and risk management for the related business are in place
   Answer and explanation

   Answer: D

   This 2010 version says that while the risk management arrangements are insufficient, the new product should not be released. It should wait until the systems and risk management for that business are in place, and be offered after that.

   When the arrangements are not in place, the condition for postponement in this 2010 version is that the systems and risk management be in place. Market conditions are not part of the condition. The risk management function's assessment is, under the same principles, an input to the review. The timing of the offer depends on whether the systems and risk management are in place.

   Learn more: New Product Approval

4. Question 4

   As a hypothetical example, an interest rate desk has exceeded a soft limit, one kind of limit. What is expected of the desk?

   1. A.As with a hard limit, forcibly reduce or close the risk position
   2. B.Reconsider its market view and discuss its management policy
   3. C.Do not start a discussion until it passes an alarm point
   4. D.Keep the position without reviewing its market view
   Answer and explanation

   Answer: B

   A soft limit requires a review of the market view and a discussion of the management policy. It does not necessarily require positions to be reduced, so the desk can respond according to the situation, but keeping the position without a review is not the response that is expected.

   It is the hard limit that strongly requires positions to be reduced or closed. An alarm point is set at a level lower than the hard limit. It is a marker that draws attention and leads to a discussion. With a soft limit, the loss can grow if the market moves while the discussion is under way. As of September 2019, the Bank of Japan's assessment was that Japanese financial institutions often choose soft limits, and that, given the nature of market risk, using hard limits together with alarm points is desirable.

   Learn more: Limit Frameworks

5. Question 5

   On April 17, 2026, the Federal Reserve Board, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) issued revised guidance (attached to SR 26-2) that replaced SR 11-7 from 2011. What did it change?

   1. A.It narrowed the definition of a model, excluding simple spreadsheet calculations, and put forward an approach scaled to the size of the bank
   2. B.It required the same level of rigor for every model
   3. C.It became a binding standard, and a bank that does not follow it is subject to supervisory criticism
   4. D.It newly brought generative AI and agentic AI models into scope
   Answer and explanation

   Answer: A

   The revised guidance limits models to complex quantitative methods and removes simple spreadsheet calculations from scope. It also puts forward a risk-based approach that is scaled to the level of model risk and the size of the bank, among other factors.

   Requiring the same approach for every model runs against a risk-based approach. The revised guidance is not an enforceable standard, and it says that a bank that does not follow it will not be criticized for that (although supervisory action is still possible if, for example, a law is violated). Generative AI and agentic AI models were not brought into scope. They were left outside it.

   Learn more: Model Risk Management: SR 11-7 and the JFSA Principles

6. Question 6

   In its examination manuals dated February 1998 and April 2003, the Federal Reserve addressed independent price verification. When the difference between the book fair value and the independent price exceeds the standard set in the written policy, what did the manuals say to do first?

   1. A.The independent price is treated as correct, and the book fair value is changed to match it
   2. B.The trade that showed the difference is excluded from later verification
   3. C.The cause of the difference is investigated, and it is decided whether the financial reporting needs to be corrected
   4. D.The valuation model is replaced as soon as a difference appears
   Answer and explanation

   Answer: C

   When a difference exceeds the standard, the first step is to investigate its cause. Once the cause is known, it is decided whether the financial reporting needs to be corrected. Depending on the size and pattern of the difference, the pricing procedures or the model are also changed.

   The independent price is not always correct. The manual says a broker-dealer's quote may not represent the values that dealer uses internally, or other market or model-based values, so the firm must satisfy itself that the external valuation is appropriate. Excluding a trade from verification requires a reasonable justification in the policy. What is called for when a difference appears is to investigate the cause. A model change is also decided according to the size and pattern of the difference, so the model is not replaced as soon as a difference appears.

   Learn more: Independent Price Verification (IPV)