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

A bank's risk committee is comparing economic capital with regulatory capital. Which statement best describes the defining feature of economic capital as used in the BCBS range-of-practices paper?

Economic capital is the bank's own estimate of the capital required to absorb unexpected losses at a chosen confidence level over a set horizon. It differs from regulatory capital, which follows supervisory rules, and from accounting equity or expected-loss provisions.

  1. AIt is the minimum capital set by supervisors using standardized risk weights applied to assets
  2. BIt is the bank's internal estimate of capital needed to absorb unexpected losses at a chosen confidence level over a given horizonCorrect
  3. CIt is the book value of shareholders' equity reported in the audited balance sheet
  4. DIt is the amount of capital needed to cover expected losses, which are priced into loan spreads

Explanation

Economic capital is an internally estimated buffer against unexpected losses, tied to a target confidence level (often linked to a desired credit rating) and a horizon, usually one year. Regulatory capital uses prescribed rules, and expected losses are covered by pricing and provisions.

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