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

A bank's internal audit review finds that the economic capital model is used for pricing and limit setting, but the model's assumptions, including correlations and diversification, were last approved by the business lines that benefit from them. Which governance weakness is most evident?

The weakness is insufficient independence in approving and validating the model. Because diversification and correlation assumptions lower the capital charged to the business lines, letting those lines approve them creates a conflict of interest. Good governance requires independent validation and senior management or board oversight of key assumptions.

  1. AExcessive reliance on regulatory capital
  2. BInsufficient independence in model validation and approval, creating a conflict of interestCorrect
  3. COverly conservative confidence level
  4. DLack of a standardized accounting framework

Explanation

Assumptions such as diversification directly reduce capital charged to business lines, so approval by beneficiaries creates a conflict of interest. Sound governance requires independent validation and senior management/board oversight of key assumptions. The other options are not indicated by the facts.

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