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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

A risk manager is explaining how a bank should treat expected loss and unexpected loss. Which statement is most consistent with standard risk management practice?

Expected loss is treated as a cost of business and covered by loan pricing and provisions, while economic capital is held to absorb unexpected loss, which is the uncertain deviation of losses above the expected level. Reversing these roles is incorrect.

  1. AExpected loss is normally covered through pricing and provisions, while economic capital is held against unexpected lossCorrect
  2. BUnexpected loss is covered through loan pricing, while expected loss is covered by holding capital
  3. CBoth expected loss and unexpected loss should be covered by equity capital only
  4. DUnexpected loss is the average loss over the cycle and so needs no capital

Explanation

Expected loss is a predictable cost of doing business, so it is built into pricing and covered by provisions or reserves. Unexpected loss is the variability around that mean, and capital acts as the buffer against it. The reversed statement mixes up the roles.

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