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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A bank computes credit risk economic capital from a portfolio loss distribution. The expected loss is 40 million and the 99.9th percentile loss is 310 million. Reserves and pricing already cover expected loss. What is the economic capital for credit risk, and why?

Economic capital is 270 million. It equals the 99.9% loss quantile of 310 million minus the expected loss of 40 million, because expected loss is already covered by provisions and pricing, leaving capital to absorb only unexpected losses beyond that.

  1. A270 million, because capital covers unexpected loss, the quantile minus expected lossCorrect
  2. B310 million, because capital covers the full quantile loss
  3. C350 million, because expected loss is added to the quantile
  4. D40 million, because capital covers expected loss

Explanation

Economic capital = 99.9% quantile minus expected loss = 310 − 40 = 270 million, since expected loss is covered by provisions and pricing. 310 ignores that offset. 350 adds expected loss with the wrong sign. 40 is the expected loss itself, which is not what capital buffers.

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