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FRM Part I · FRM Exam Part I · Measuring Credit Risk

A bank estimates that its portfolio has an expected loss of USD 12 million, and the 99.9th percentile of the portfolio credit loss distribution is USD 95 million. Under the usual definition, what are the economic capital (credit VaR in excess of expected loss) and the interpretation of this figure?

Economic capital is USD 83 million: the 99.9th percentile loss of 95 million minus the expected loss of 12 million. Expected loss is covered by pricing and provisions, so capital only needs to absorb the unexpected portion up to the chosen confidence level.

  1. AUSD 83 million, the buffer for losses beyond expected loss at 99.9% confidenceCorrect
  2. BUSD 95 million, the buffer for losses beyond expected loss at 99.9% confidence
  3. CUSD 107 million, the total of the percentile and expected loss
  4. DUSD 12 million, the amount to be covered by provisions and pricing only

Explanation

Unexpected loss at the quantile = 95 - 12 = 83 million. This is the capital held against losses above expected loss, since expected loss is covered by pricing and provisions. USD 95 million ignores the EL deduction; adding EL double counts.

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