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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

A bank's credit portfolio has an expected loss of USD 12 million. A new loan program raises the average pricing so that spreads fully cover expected loss, but the loss distribution's standard deviation is unchanged. What is the effect on the bank's required economic capital?

Economic capital stays unchanged. It is set by the unexpected loss, the variability of losses around the mean, and charging spreads to cover expected loss improves income but does not change that variability, so the capital buffer is still required.

  1. AEconomic capital is unchanged because it depends on unexpected loss, not on expected loss pricingCorrect
  2. BEconomic capital falls to zero because expected loss is covered
  3. CEconomic capital rises by USD 12 million to fund the expected loss
  4. DEconomic capital falls by USD 12 million because pricing reduces the loss distribution's variance

Explanation

Economic capital absorbs unexpected loss, which reflects the dispersion of losses. Pricing to cover expected loss affects earnings, not the dispersion, so the capital requirement stays the same. Capital does not fall to zero because the variability remains.

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