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Answer: Although banks theoretically do not need to set aside provisions when loan products are accurately priced, in realistic practice, banks should provision for expected losses.
## Explanation **Option D is correct** because: - **Expected Loss (EL)** represents the average loss that a bank expects to incur over a given period. While in theory, if loans are perfectly priced, the interest income should cover expected losses, in practice banks still need to set aside provisions for expected losses due to: - Regulatory requirements - Accounting standards - Prudent risk management practices - The fact that perfect pricing is rarely achievable in reality **Why other options are incorrect:** - **Option A**: Effective risk management cannot reduce expected loss to zero. EL represents the average loss that is expected to occur given the nature of the business. Risk management focuses on managing unexpected losses and tail risk, not eliminating expected losses. - **Option B**: This definition is incorrect. Expected loss is calculated as EL = EAD × LGD × PD (Exposure at Default × Loss Given Default × Probability of Default). The expected recovery rate is already incorporated in the Loss Given Default (LGD = 1 - Recovery Rate). - **Option C**: Both expected loss (EL) and unexpected loss (UL) are influenced by default correlation and portfolio granularity. Portfolio diversification (granularity) affects both the expected and unexpected components of loss. The key distinction is that expected losses are predictable and should be priced into products, while unexpected losses represent the volatility around expected losses and require capital allocation.
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According to GARP, one of the building blocks in risk management is a proper understanding of the difference between expected loss, unexpected loss, and extreme risk; also known as tail risk. In regard to this building block, which of the following statements is TRUE?
A
Effective risk management should reduce a credit portfolio's expected loss (EL) to approximately zero.
B
Expected loss is a product of (i) the probability of the risk event occurring; (ii) the severity of the loss if the risk event occurs, and (iii) the expected recovery rate.
C
While expected loss (EL) is a function of default correlation, unexpected loss (UL) is NOT influenced by portfolio granularity.
D
Although banks theoretically do not need to set aside provisions when loan products are accurately priced, in realistic practice, banks should provision for expected losses.
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