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Answer: Economic capital is the amount of capital a bank needs to cover its expected losses, while regulatory capital is the amount of capital a bank needs to cover its unexpected losses.
## Explanation **Option C is incorrect** because: - **Economic capital** is actually designed to cover **unexpected losses** (losses beyond the expected level) - **Regulatory capital** is the minimum capital required by regulators to cover various risks - **Expected losses** are typically covered by provisions and reserves, not capital **Analysis of other options:** - **Option A**: Correct - Economic capital is typically calculated by summing capital for different risk types - **Option B**: Correct - Economic capital is sensitive to changes in PD, while regulatory capital follows fixed formulas - **Option D**: Correct - Economic capital models often incorporate correlations between different risk types **Key distinction:** Economic capital is an internal measure for unexpected losses, while regulatory capital is an external requirement that may not perfectly align with economic reality.
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Which of the following statements about economic capital and regulatory capital is incorrect?
A
Firm-wide economic capital is typically equal to the sum of the separately calculated capital amounts for credit risk, market risk, and operational risk.
B
An increase in the probability of default of a loan portfolio increases economic capital, while leaving regulatory capital unchanged.
C
Economic capital is the amount of capital a bank needs to cover its expected losses, while regulatory capital is the amount of capital a bank needs to cover its unexpected losses.
D
Firm-wide economic capital typically considers correlations between credit risk, market risk, and operational risk.
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