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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A bank's credit risk manager describes the loan loss reserve as covering the average credit loss the portfolio is anticipated to generate over a one-year horizon, while economic capital is held against a separate measure. Which pairing correctly matches the measure to its purpose?

Expected loss is the anticipated average loss and is covered through loan pricing and provisions, while unexpected loss, the variability of losses around that average, is absorbed by economic capital. Capital is not meant to fund predictable losses.

  1. AExpected loss is covered by pricing and provisions; unexpected loss is covered by capitalCorrect
  2. BExpected loss is covered by capital; unexpected loss is covered by provisions
  3. CBoth expected and unexpected loss are covered by provisions
  4. DNeither expected nor unexpected loss needs coverage if collateral is held

Explanation

Expected loss is the predictable average loss and is built into loan pricing and loss provisions. Unexpected loss is the volatility of losses around that mean, and capital is held to absorb it. Reversing the pairing confuses a predictable cost with a tail risk.

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