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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank's risk committee notes that its economic capital model shows lower capital need than regulatory capital for its mortgage book, while the reverse holds for its leveraged loan book. Which is the most likely explanation consistent with how economic capital differs from regulatory capital?

Economic capital reflects the bank's own portfolio risk, including correlation and concentration, while regulatory capital uses prescribed formulas and risk weights. Because the two methods measure risk differently, economic capital can fall below regulatory capital for one book, such as mortgages, and exceed it for another, such as leveraged loans.

  1. AEconomic capital is based on the bank's own portfolio risk, including concentration and correlation, while regulatory capital uses standardized formulas and fixed risk weights that may not reflect actual riskCorrect
  2. BEconomic capital always uses a lower confidence level than regulatory capital, so it must be lower for every portfolio
  3. CRegulatory capital is risk-sensitive to portfolio concentration, whereas economic capital ignores it
  4. DEconomic capital is calculated only for expected losses, whereas regulatory capital covers unexpected losses

Explanation

Economic capital is an internal, portfolio-specific measure reflecting actual risk, so it can differ in either direction from regulatory capital based on prescribed formulas. Confidence level is not always lower; the bank usually targets a high one tied to its rating. The other options reverse the roles of concentration or EL/UL.

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