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FRM Part II · FRM Exam Part II · Credit Risk

A credit portfolio manager computes the one-year expected loss (EL) and the 99.9% credit VaR of a loan book. The bank's economic capital for credit risk is set to cover unexpected loss only. Which expression correctly gives the economic capital for the portfolio?

Economic capital for credit risk equals the 99.9% credit VaR minus expected loss. Expected loss is absorbed by provisions and loan pricing, so capital only needs to cover unexpected loss, the tail loss above the mean. Adding EL would double count it.

  1. ACredit VaR at 99.9% minus expected lossCorrect
  2. BCredit VaR at 99.9% plus expected loss
  3. CExpected loss multiplied by the 99.9% quantile of the standard normal distribution
  4. DExpected loss minus the standard deviation of portfolio losses

Explanation

Expected loss is covered by provisions and pricing, so capital covers the loss in excess of EL. Economic capital equals the loss quantile (credit VaR) less EL. Adding EL would double count the expected component.

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