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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A risk analyst at a bank estimates that its one-year portfolio loss distribution has an expected loss of USD 40 million and a 99.9% VaR of USD 400 million. The bank defines economic capital as unexpected loss at the 99.9% level. What is the economic capital, and what is the likely treatment of the USD 40 million expected loss?

Economic capital is USD 360 million, the 99.9% VaR of 400 million less the expected loss of 40 million. Expected loss is regarded as a cost covered by pricing and loan loss provisions, so capital only needs to absorb the unexpected portion of losses.

  1. AUSD 360 million, with expected loss covered by pricing and provisionsCorrect
  2. BUSD 440 million, with expected loss added to capital
  3. CUSD 400 million, with expected loss ignored entirely
  4. DUSD 40 million, with the VaR treated as a provision

Explanation

Economic capital = VaR minus expected loss = 400 - 40 = 360 million. Expected loss is treated as a cost of doing business, covered through pricing and provisions. Adding it (440) double counts; using 400 ignores the subtraction.

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