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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank has a loan portfolio with expected loss of USD 12 million and a credit VaR at 99.9% of USD 95 million total loss. It holds USD 20 million of loan loss provisions that cover expected loss and are priced into spreads, and wants economic capital to absorb unexpected loss only. Further, USD 8 million of the provisions are general reserves counted by management as available toward unexpected losses, but the risk team treats only the expected-loss coverage as provisioning. What economic capital should the risk team assign?

Economic capital is USD 83 million, being the 99.9% credit VaR of 95 million less expected loss of 12 million. Capital is held for unexpected loss; subtracting the full provisions or ignoring expected loss would misstate it.

  1. AUSD 83 millionCorrect
  2. BUSD 75 million
  3. CUSD 95 million
  4. DUSD 63 million

Explanation

Economic capital equals the tail loss minus expected loss: 95 − 12 = USD 83 million. The provisions beyond expected loss are not netted by the risk team, so subtracting 20 (giving 75) or 32 would be wrong. USD 95 million ignores that expected loss is covered by pricing and provisions.

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