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

A bank's one-year credit loss distribution has an expected loss of USD 40 million and a 99.9th percentile loss of USD 340 million. Management holds provisions equal to expected loss and is pricing loans to recover it. What is the economic capital for credit risk under the standard unexpected-loss definition?

Economic capital is USD 300 million, the 99.9th percentile loss of USD 340 million less the USD 40 million expected loss. Expected loss is already covered by provisions and pricing, so capital only needs to absorb unexpected losses.

  1. AUSD 40 million
  2. BUSD 300 millionCorrect
  3. CUSD 340 million
  4. DUSD 380 million

Explanation

Economic capital = quantile loss minus expected loss = 340 - 40 = USD 300 million. USD 340 million ignores that expected loss is covered by provisions and pricing. USD 380 million adds EL instead of subtracting it.

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