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FRM Part II · FRM Exam Part II · Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice

A bank estimates loan losses for a commercial portfolio using loss = PD × LGD × EAD. Under a stress scenario, the portfolio EAD is USD 400 million, the stressed PD is 5%, and the stressed LGD is 40%. What is the estimated stress loss?

The stress loss is USD 8.0 million. Multiply the stressed PD of 5% by the LGD of 40% to get a 2% loss rate, then apply it to USD 400 million of exposure at default. Omitting LGD would overstate the loss at USD 20 million.

  1. AUSD 2.0 million
  2. BUSD 16.0 million
  3. CUSD 8.0 millionCorrect
  4. DUSD 20.0 million

Explanation

Loss = 0.05 × 0.40 × 400 = USD 8.0 million. Dropping the LGD gives 0.05 × 400 = 20. Using PD × LGD with 40% mistaken as 0.4 × 0.1 gives other values; 16 results from 0.4 × 400 × 0.10 which is unsupported. Only 8.0 reconciles.

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