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

A bank's board wants to use economic capital for setting risk appetite. A risk manager notes that the economic capital model's confidence level is tied to the bank's target credit rating. Which statement best describes how the confidence level is typically chosen and used in governance?

The confidence level is calibrated to the bank's desired solvency standard, usually the default probability consistent with its target credit rating. A higher target rating means a higher confidence level and more economic capital. It is not fixed at 99% for everyone or chosen to flatter returns.

  1. AIt is set at the regulatory 99% level for all banks, regardless of target rating
  2. BIt is chosen to reflect the bank's desired solvency standard, such as the default probability implied by its target rating, and a higher target rating implies a higher confidence levelCorrect
  3. CIt is chosen to maximize reported return on economic capital, so lower confidence levels are preferred
  4. DIt is set independently of the target rating, since ratings relate only to liquidity risk

Explanation

Banks commonly calibrate the confidence level to the default probability consistent with a target rating, so a stronger rating implies a higher confidence level (e.g., 99.9% or above) and more economic capital. Choosing a lower level just to flatter returns defeats the solvency purpose.

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