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

A bank's risk team estimates that, over a one-year horizon, its unexpected loss at the 99.9% confidence level is the difference between the 99.9th percentile portfolio loss and the expected loss. Which statement best describes how economic capital is conventionally derived from this measure?

Economic capital is set as unexpected loss at the chosen confidence level: the tail loss quantile minus expected loss. Expected loss is expected to be covered by pricing and provisions, while capital absorbs deviations beyond it, supporting the bank's target solvency standard.

  1. AEconomic capital equals the expected loss, since it is the average annual credit cost
  2. BEconomic capital equals the unexpected loss at the chosen confidence level, with expected loss covered by provisions and pricingCorrect
  3. CEconomic capital equals the 50th percentile of the loss distribution
  4. DEconomic capital equals the regulatory minimum capital ratio multiplied by total assets

Explanation

Economic capital is the buffer against unexpected losses at a target confidence level tied to the bank's desired solvency standard. Expected loss is handled through pricing and provisions. Expected loss alone is not a buffer against variability, and regulatory capital is a separate concept.

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