FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks
A bank targets a AA credit rating with a one-year default probability of 0.03%. When calibrating its economic capital, which confidence level is most consistent with this target?
The consistent confidence level is 99.97%. Economic capital is calibrated so the probability of losses exceeding capital equals the target default probability of 0.03%, giving a solvency probability of one minus 0.0003, or 99.97% over the one-year horizon.
- A97.00%
- B99.97%Correct
- C99.00%
- D99.70% applied to expected loss only
Explanation
The bank is solvent with probability 1 minus the default probability. 1 - 0.0003 = 0.9997, or 99.97%. The 97% and 99% levels imply far higher insolvency probabilities (3% and 1%). Expected-loss-only coverage ignores the unexpected-loss tail.
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