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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 is calibrated to a 99.97% confidence level over one year. A senior manager proposes lowering it to 99.9% to reduce measured capital and improve unit RAROC. What is the most accurate assessment?

Lowering the confidence level reduces measured economic capital and mechanically lifts RAROC, but it accepts a higher insolvency probability and may conflict with the bank's target credit rating. The bank's actual risk is unchanged, so the improvement is only cosmetic.

  1. ALowering the confidence level reduces economic capital but also reduces the protection against insolvency, and is inconsistent with a target such as a high credit ratingCorrect
  2. BLowering the confidence level increases economic capital because more outcomes are covered
  3. CThe confidence level has no effect on economic capital since expected loss is unchanged
  4. DLowering the confidence level increases the bank's real solvency because RAROC rises

Explanation

A lower confidence level cuts the percentile loss, hence capital, which raises RAROC mechanically. But it implies a higher probability of insolvency and may undermine the target rating. Real risk is unchanged, so the improved RAROC is cosmetic.

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