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

A bank sets its economic capital at the 99.97% one-year confidence level, whereas a peer sets it at 99.90%. Which statement best describes the main reason many banks choose a confidence level in the 99.9%-99.98% range for economic capital?

Banks commonly pick the confidence level to reflect their target credit rating, because the tail probability corresponds to the one-year default probability consistent with that rating. It is a management choice, not a regulatory mandate, and higher levels actually make tail estimation less reliable.

  1. AIt is chosen to match the bank's target credit rating, since the confidence level approximates the desired one-year survival probability implied by that ratingCorrect
  2. BIt is chosen because regulators require all banks to use exactly 99.9% for internal capital models
  3. CIt is chosen because higher confidence levels always reduce the estimation error of the loss tail
  4. DIt is chosen so that economic capital equals expected loss

Explanation

Banks typically link the confidence level to the default probability consistent with a target rating, e.g. an AA-type rating implies a one-year default probability of a few basis points. Regulators do not mandate one level for internal models, and higher confidence levels worsen, not improve, tail estimation error. Economic capital covers unexpected loss, not expected loss.

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