FRM Part II · FRM Exam Part II · Credit Risk Management
A credit analyst compares two borrowers with identical expected loss. Borrower X has stable, low-variance losses; Borrower Y has a small chance of very large losses. Which statement best describes why the bank should hold more economic capital against Y?
Capital is held against unexpected loss, the volatility or tail of losses beyond the expected level. Since both borrowers share the same expected loss, which is covered by pricing and provisions, the borrower with fatter-tailed, more volatile losses requires more economic capital.
- AEconomic capital covers expected loss, which is higher for Y
- BEconomic capital covers unexpected loss, which is greater for Y because of its larger loss volatilityCorrect
- CEconomic capital is set only by the borrower's external rating, not by loss volatility
- DEconomic capital for Y is lower because expected losses are priced into spreads
Explanation
Expected loss is equal, and it is covered by pricing and provisions. Capital absorbs unexpected loss, measured by loss volatility and tail quantiles, which is larger for Y. The other options confuse expected and unexpected loss.
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