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Answer: Economic capital is an internal risk measure that reflects the amount of capital needed to ensure a company remains solvent with a high level of confidence, given its risk profile.
D is correct. Economic capital is a bank's own estimate of the capital it requires. In both cases, capital can be thought of as funds that are available to absorb unexpected losses. A common objective in calculating economic capital is to maintain a high credit rating. Economic capital is allocated to a bank's business units so that they can be compared using a return on allocated economic capital metric. Option A is incorrect because the regulatory capital for credit risk is designed to be sufficient to cover a loss that is expected to be exceeded only once every thousand years, not every ten years as stated. Option B is incorrect as equity capital is sometimes referred to as going concern capital because it absorbs losses while the bank is a going concern (i.e., it remains in business), not regulatory capital. Option C is incorrect because the most important capital is equity capital, not regulatory capital. Regulatory capital is set by external regulatory bodies to ensure the stability of the financial system, while equity capital represents the ownership interest in the bank and is used to absorb losses and provide a buffer for unexpected events.
Author: LeetQuiz Editorial Team
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When preparing a report for the senior management team regarding their risk appetite discussions, which of the following statements should the analyst include for an effective comparison between regulatory capital and economic capital requirements?
A
The regulatory capital for credit risk is designed to be sufficient to cover a loss that is expected to be exceeded only once every ten years.
B
Regulatory capital is sometimes referred to as going concern capital because it absorbs losses incurred while the bank is still in business.
C
The most important capital for a bank is regulatory capital, which equals the bank's estimate of its expected losses.
D
Economic capital is an internal risk measure that reflects the amount of capital needed to ensure a company remains solvent with a high level of confidence, given its risk profile.
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