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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A bank's economic capital model targets a solvency standard consistent with an AA rating, which corresponds to an annual default probability of 0.03%. The bank therefore sets its economic capital at the 99.97th percentile of the one-year loss distribution. Which of the following is the most accurate interpretation?

Setting capital at the 99.97th percentile means the bank should stay solvent in about 99.97% of one-year outcomes, matching a 0.03% default probability. Capital is that quantile less expected loss, which represents unexpected loss, rather than a tail average.

  1. ALosses are expected to exceed capital in roughly 3 of every 100 years
  2. BEconomic capital equals the expected loss plus the standard deviation of losses
  3. CEconomic capital is the loss at the 99.97th percentile minus the expected loss, so the bank is expected to remain solvent in about 99.97% of one-year outcomesCorrect
  4. DEconomic capital is the average of all losses beyond the 99.97th percentile

Explanation

The confidence level is 1 minus the target default probability: 99.97%. Capital is the quantile less expected loss, covering unexpected loss. Option A misreads 0.03% as 3%, and D describes expected shortfall, not the VaR-based measure used here.

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