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

A bank's operational risk economic capital model relies on internal loss data collected only above a reporting threshold of USD 50,000, and fits a severity distribution to these data without adjustment. What is the most likely consequence for the capital estimate?

Capital estimates will be biased. Data collected only above a USD 50,000 threshold are truncated, so fitting the severity distribution naively distorts the parameters and understates loss frequency, unless the model explicitly conditions on the reporting threshold.

  1. ACapital is biased because ignoring truncation distorts severity and frequency parameters, unless the threshold is explicitly modeledCorrect
  2. BCapital is unaffected because small losses never influence tail estimates in any model
  3. CCapital is always overstated because truncation adds extra large losses
  4. DCapital becomes exactly equal to the expected loss

Explanation

Losses below the threshold are missing, so the data are left-truncated. Fitting without accounting for this biases the severity parameters and understates frequency. Properly the likelihood should be conditioned on the threshold. Small losses can influence fitted parameters, so claiming no effect is wrong.

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