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

A bank's economic capital model estimates a one-year 99.9% credit loss quantile of USD 1,200 million on a loan portfolio whose expected loss is USD 300 million. Using the standard definition, how much economic capital should be held for credit risk, and why?

Economic capital is USD 900 million, the 99.9% quantile loss of 1,200 less expected loss of 300. Expected loss is covered through pricing and provisions, so capital is held only against unexpected losses beyond that level.

  1. AUSD 1,200 million, because capital must cover total losses at the quantile
  2. BUSD 300 million, because capital covers expected losses
  3. CUSD 1,500 million, because capital covers expected plus unexpected losses
  4. DUSD 900 million, because expected losses are covered by pricing and provisionsCorrect

Explanation

Economic capital is the quantile loss minus expected loss: 1,200 − 300 = USD 900 million. Expected losses are priced into loan spreads and covered by provisions, so capital addresses only unexpected loss. Holding 1,200 double counts expected loss; adding them (1,500) is wrong in sign.

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