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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank's board raises its target credit rating from A to AA, with a corresponding lower annual default probability. Holding the portfolio unchanged, what is the most likely effect on economic capital?

Economic capital rises. A higher target rating means the bank tolerates a lower probability of insolvency, so capital is calibrated at a higher confidence level further into the loss tail. With an unchanged portfolio, the larger tail quantile requires more capital.

  1. AEconomic capital falls because a stronger rating implies less risk
  2. BEconomic capital rises because a higher confidence level moves further into the loss tailCorrect
  3. CEconomic capital is unchanged because expected loss is unchanged
  4. DEconomic capital falls because expected loss is deducted at a higher rate

Explanation

A better target rating corresponds to a lower tolerated default probability, hence a higher confidence level and a larger tail quantile. The portfolio is unchanged, so required capital must rise to support the stronger solvency standard.

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