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

A bank's economic capital model shows a 99.9% one-year credit loss quantile of USD 900 million and an expected loss of USD 250 million. Provisions already cover expected loss. The bank holds USD 700 million of equity allocated to credit risk. What is the best assessment?

Economic capital is the loss quantile minus expected loss: USD 900 million minus USD 250 million, or USD 650 million of unexpected loss. The USD 700 million allocated exceeds this, so capital is sufficient; using 900 would double-count expected loss already provisioned.

  1. ACapital is sufficient because it exceeds the expected loss of USD 250 million
  2. BCapital is short by USD 200 million, since economic capital is USD 900 million
  3. CCapital is short by USD 250 million, since expected loss is not covered
  4. DCapital is sufficient because it exceeds the unexpected loss of USD 650 millionCorrect

Explanation

Economic capital equals the quantile minus expected loss: 900 - 250 = USD 650 million, because expected loss is covered by pricing and provisions. Allocated equity of USD 700 million exceeds this by USD 50 million. Using the full 900 double-counts expected loss.

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