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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 team is reviewing its framework. Which statement best describes why validation of an economic capital model is generally harder than validation of a trading-book VaR model?

Economic capital is measured over about one year at very high confidence levels, so there are too few independent observations to backtest outcomes directly. Validators must rely on indirect methods such as benchmarking, sensitivity analysis and testing of inputs, unlike daily trading VaR, which can be backtested statistically.

  1. AEconomic capital uses a much longer horizon and higher confidence level, so few observations exist to backtest the output directlyCorrect
  2. BEconomic capital models never use any statistical assumptions, so there is nothing to test
  3. CTrading-book VaR models cannot be backtested because they use daily data
  4. DRegulators prohibit validation of economic capital models

Explanation

Economic capital is typically measured at a one-year horizon and a 99.9%+ confidence level, so direct comparison of losses with the output yields too few observations. Validation therefore relies on component testing, sensitivity analysis, benchmarking and stress tests. Trading VaR with daily data can be backtested statistically.

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