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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A risk manager notes that a bank's portfolio loan loss distribution is highly skewed with a long right tail. Which statement about credit VaR and unexpected loss for this portfolio is most accurate?

Credit loss distributions are skewed with fat right tails, so standard deviation understates extreme losses. Economic capital is better based on a high percentile of the loss distribution minus expected loss, rather than a normal-distribution multiple of standard deviation.

  1. AStandard deviation alone understates tail risk, so a high-percentile quantile is preferred for economic capitalCorrect
  2. BStandard deviation of loss fully describes tail risk, so multiples of it give accurate capital
  3. CExpected loss should be the basis for capital since it is the mean of the distribution
  4. DThe loss distribution is approximately normal, so VaR equals 2.33 standard deviations at 99%

Explanation

Credit loss distributions are skewed and fat-tailed, so normal-based multiples of standard deviation understate extreme losses. Capital is therefore set from a high quantile of the simulated or modeled distribution less expected loss. Expected loss is covered by pricing and provisions, not capital.

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