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FRM Part II · FRM Exam Part II · Risk Capital Attribution and Risk-Adjusted Performance Measurement

A bank's risk management team is explaining the concept of economic capital to the board. Which statement best describes economic capital?

Economic capital is the internally modeled amount of capital needed to absorb unexpected losses at a chosen confidence level and horizon, typically tied to the bank's target credit rating. It differs from regulatory minimums, book equity and expected loss provisions.

  1. AThe amount of capital required by the regulator under the minimum Pillar 1 ratio
  2. BThe amount of capital the bank's internal models say is needed to absorb unexpected losses at a chosen confidence level over a given horizonCorrect
  3. CThe book value of shareholders' equity reported in the balance sheet
  4. DThe expected loss provision set aside for the loan portfolio

Explanation

Economic capital is an internal estimate of the buffer needed to cover unexpected losses at a target confidence level (linked to desired credit rating) over a horizon. Regulatory capital is set by rules, book equity is an accounting number, and expected losses are covered by pricing and provisions, not capital.

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