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FRM Part II · FRM Exam Part II · Integrated Risk Management

A bank's risk function is explaining why it measures economic capital at a confidence level tied to the bank's target credit rating rather than at a regulatory ratio. Which statement best describes the primary purpose of economic capital in an integrated risk management framework?

Economic capital is the bank's own estimate of the capital needed to absorb unexpected losses across all risk types at a chosen confidence level and horizon, usually linked to its target credit rating. It differs from regulatory minimums, book equity and expected losses, which are covered by pricing and provisions.

  1. AIt is the minimum capital that the regulator requires the bank to hold under Pillar 1 rules
  2. BIt is the capital the bank estimates it needs to absorb unexpected losses across risk types at a chosen confidence level over a set horizonCorrect
  3. CIt is the accounting book value of shareholders' equity reported on the balance sheet
  4. DIt is the amount of capital needed to cover expected losses, which are priced into product margins

Explanation

Economic capital is an internal estimate of the buffer needed to absorb unexpected losses at a confidence level consistent with the target rating and a chosen horizon. Regulatory capital is set by rules, and book equity is an accounting figure. Expected losses are covered by pricing and provisions, so option D is wrong.

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