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FRM Part II · FRM Exam Part II · Capital Regulation Before the Global Financial Crisis

A bank under the Basel II IRB approach has a corporate exposure with PD of 2%, LGD of 40%, EAD of USD 50 million, and the bank's total eligible provisions are USD 0.3 million against this exposure. Expected loss is compared with provisions. What is the expected loss, and how are provisions treated under Basel II IRB if they fall short or exceed it?

Expected loss is 2% times 40% times USD 50 million, or USD 0.4 million. Provisions of USD 0.3 million leave a USD 0.1 million shortfall, which Basel II requires to be deducted from capital, half from Tier 1 and half from Tier 2.

  1. AEL = USD 0.4 million; the USD 0.1 million shortfall is deducted from capital (50% from Tier 1, 50% from Tier 2)Correct
  2. BEL = USD 0.4 million; the shortfall is ignored
  3. CEL = USD 1.0 million; the shortfall is deducted from capital
  4. DEL = USD 0.4 million; the shortfall is added to risk-weighted assets at 12.5 times

Explanation

EL = 2% x 40% x 50m = USD 0.4m. Provisions of 0.3m are below EL by 0.1m. Under Basel II, shortfalls are deducted from capital, 50% from Tier 1 and 50% from Tier 2; excesses may be recognized in Tier 2 up to 0.6% of credit RWA. The 1.0m figure ignores LGD.

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