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

A bank's risk team defines economic capital for its credit portfolio as the amount needed to absorb unexpected losses at a chosen confidence level. At the 99.9% confidence level, the portfolio's loss distribution gives a 99.9th percentile loss of USD 480 million, and the expected loss is USD 150 million. What is the economic capital under this standard definition?

Economic capital is USD 330 million. It equals the 99.9th percentile loss of 480 million minus the expected loss of 150 million, because expected losses are covered by pricing and provisions, and capital is held only against unexpected losses beyond that.

  1. AUSD 150 million
  2. BUSD 330 millionCorrect
  3. CUSD 480 million
  4. DUSD 630 million

Explanation

Economic capital covers unexpected loss, which is the percentile loss minus expected loss: 480 - 150 = 330. Expected loss is normally covered by pricing and provisions. Using 480 ignores that expected loss is already provisioned; 630 adds EL instead of subtracting it.

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