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FRM Part II · FRM Exam Part II · Risk Capital Attribution and Risk-Adjusted Performance Measurement

A bank's economic capital model estimates a one-year portfolio loss distribution with expected loss of 40 million and a 99.97th percentile loss of 400 million. The bank defines economic capital as the amount needed to cover unexpected losses at that confidence level. What is the economic capital, and how should the expected loss be treated?

Economic capital is 360 million, the 99.97th percentile loss of 400 million less the 40 million expected loss. Expected losses are treated as a cost of business covered by pricing and provisions, so capital is held only against unexpected losses beyond that level.

  1. A400 million; expected loss is ignored entirely
  2. B440 million; expected loss is added to the percentile loss
  3. C360 million; expected loss is covered by provisions and pricing rather than capitalCorrect
  4. D40 million; capital equals expected loss

Explanation

Economic capital is the percentile loss minus expected loss: 400 - 40 = 360 million. Expected loss is regarded as a cost of doing business covered by pricing and provisions, so capital covers only unexpected loss. Adding EL (440) double counts it.

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