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

A bank's risk team computes economic capital for the whole bank at the 99.97% confidence level over a one-year horizon. Which statement best describes what this economic capital figure represents?

Economic capital is the internally estimated buffer that absorbs unexpected losses at a confidence level tied to the bank's target credit rating. Expected losses are handled through pricing and provisions, while regulatory and accounting capital are separate measures that may differ from this internal estimate.

  1. AThe amount of capital required by the regulator under the standardised approach
  2. BThe buffer needed to absorb unexpected losses at the chosen confidence level, consistent with the bank's target credit ratingCorrect
  3. CThe amount of provisions needed to cover expected losses over the next year
  4. DThe book value of shareholders' equity shown on the balance sheet

Explanation

Economic capital is the internally estimated capital needed to absorb unexpected losses at a confidence level linked to the bank's target rating and solvency standard. Expected losses are covered by pricing and provisions, so option 2 is wrong. Regulatory and book capital are different measures.

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