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

A bank's risk team states that its economic capital for the year is set at the level needed to absorb unexpected losses over a one-year horizon at a confidence level tied to its target credit rating. Which description of economic capital best fits this statement?

Economic capital is the internally estimated capital needed to absorb unexpected losses over a set horizon at a confidence level linked to the bank's target rating. It differs from regulatory minimums and book equity, and expected losses are handled through pricing and provisions.

  1. AThe minimum capital the regulator requires under the standardized approach
  2. BCapital held to cover unexpected losses at a chosen confidence level, determined by the bank's own internal risk measurementCorrect
  3. CThe book value of shareholders' equity on the balance sheet
  4. DCapital 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. Regulatory capital is set by rules, and book equity is an accounting figure. Expected losses are covered by pricing and provisions, not by economic capital.

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