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FRM Part II · FRM Exam Part II · Credit Risk

Which statement best describes the relationship between a bank's expected loss and unexpected loss management?

Expected loss is the anticipated average credit loss and is recovered through loan pricing and provisions, whereas capital is held as a buffer against unexpected loss, meaning losses above the expected level. The reverse allocation is incorrect.

  1. AExpected loss is the main driver of capital, while unexpected loss is covered by loan pricing
  2. BBoth are covered only by regulatory capital, as pricing cannot recover credit losses
  3. CExpected loss is covered through pricing and provisions, while capital is held against unexpected lossCorrect
  4. DUnexpected loss equals the average annual credit loss and is therefore covered through provisions

Explanation

Expected losses are an anticipated cost of lending and are recovered through spreads and provisions. Capital is a buffer for losses exceeding expectations. The first option reverses this, and the last misdefines unexpected loss as the average loss.

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