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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 uses a 99.9% one-year VaR, but management notes that internal capital seems far more sensitive to the confidence level than to most other modeling choices for operational risk. What is the most plausible reason?

Capital is highly sensitive because operational loss severities are heavy-tailed, so extreme quantiles climb steeply as the confidence level rises, and sparse tail data makes those estimates uncertain. Under a normal assumption the increase would be modest.

  1. AOperational loss severity distributions are heavy-tailed, so extreme quantiles rise sharply as confidence increasesCorrect
  2. BOperational losses are normally distributed, so quantiles scale linearly
  3. CConfidence levels only affect expected loss, not unexpected loss
  4. DOperational risk capital is independent of the tail of the severity distribution

Explanation

Heavy-tailed severity distributions mean that moving to higher quantiles produces large increases in the estimated loss, and with few observations, extreme quantile estimates are also uncertain. Normal assumptions would imply modest changes. Confidence level directly drives unexpected loss and capital.

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