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FRM Part II · FRM Exam Part II · Portfolio Credit Risk

A bank's credit portfolio has an expected loss of USD 30 million. The 99.9% quantile of the portfolio loss distribution is USD 210 million. Management defines economic capital as the amount needed to cover losses beyond expected loss at that confidence level. Which statement is correct?

Economic capital is the 99.9% loss quantile less expected loss, because expected loss is covered by pricing and provisions. Here it is 210 minus 30, giving USD 180 million. Treating the whole quantile as capital would overstate the buffer.

  1. AEconomic capital is USD 240 million, because expected loss is added to the quantile.
  2. BEconomic capital is USD 30 million, because it equals expected loss.
  3. CEconomic capital is USD 210 million, because the quantile is the capital.
  4. DEconomic capital is USD 180 million, because it is the quantile less expected loss.Correct

Explanation

Economic capital at a confidence level is the quantile loss minus expected loss, since expected loss is covered by provisions and pricing: 210 - 30 = USD 180 million. Using 210 ignores the EL offset; adding EL double counts it.

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