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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 team estimates economic capital with a loss distribution approach, combining a loss frequency distribution and a loss severity distribution per business line. Which statement best describes a key issue in the range of practices for this approach?

Banks supplement internal loss data with external data and scenario analysis, because extreme operational losses are rare and internal tail data are scarce. This makes severity estimation in the tail uncertain, and dependence across business lines must still be addressed when aggregating.

  1. AInternal loss data are abundant in the tail, so severity fitting is straightforward
  2. BBecause tail events are rare, banks supplement internal data with external data and scenario analysis to estimate severityCorrect
  3. CThe approach removes the need to consider correlation or dependence between business lines
  4. DFrequency is modeled with a normal distribution because losses are continuous

Explanation

Internal data have few extreme losses, so tail severity is uncertain and banks supplement with external data and scenarios. Tail data are scarce, not abundant. Dependence assumptions still matter for aggregation. Frequency is a count, typically modeled with Poisson or similar, not normal.

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