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Answer: If the confidence level for both banks is increased, the level of economic capital needed for Bank ABC and for Bank XYZ will both increase.
## Explanation **A is correct.** When the confidence level is increased, economic capital needed would be higher since a higher capital multiplier is applied to the unexpected loss (UL). This applies to both banks regardless of their default correlation differences. **Key Concepts:** - **Economic Capital** = Expected Loss (EL) + Unexpected Loss (UL) × Capital Multiplier - **Capital Multiplier** increases with higher confidence levels - **Default Correlation** affects the volatility of unexpected loss (UL) **Analysis of Other Options:** **B is incorrect:** A lower confidence level implies a lower credit rating target (and a lower capital multiplier), and hence lower capital level is needed to cover credit assets, for both banks. The statement incorrectly suggests opposite effects for the two banks. **C is incorrect:** Similar to B, this incorrectly suggests that increasing confidence level would have opposite effects on the two banks. In reality, both banks would require more economic capital when confidence level increases. **D is incorrect:** Given the same exposures and EL, and since asset correlation (hence, the volatility of UL) for Bank XYZ credit assets is higher, economic capital needed for Bank XYZ will be higher than that for Bank ABC even if the confidence level is unchanged (i.e., the capital multiplier is unchanged). **Important Insight:** - Bank ABC has lower default correlation → less portfolio diversification benefit needed → lower economic capital - Bank XYZ has higher default correlation → more portfolio diversification benefit needed → higher economic capital - However, changes in confidence level affect both banks in the same direction
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A risk analyst at a credit ratings agency is evaluating the economic capital for credit risk of two competing regional banks, Bank ABC and Bank XYZ. The two banks have the same credit asset exposure, duration of credit exposure, credit rating, and expected loss. Assuming the average pairwise default correlation between credit assets of Bank ABC is lower than that of Bank XYZ, and the two banks assess their risk appetite at the same predetermined confidence level, which of the following statements would be correct?
A
If the confidence level for both banks is increased, the level of economic capital needed for Bank ABC and for Bank XYZ will both increase.
B
If the confidence level for both banks is decreased, the level of economic capital needed will increase for Bank ABC but will decrease for Bank XYZ.
C
If the confidence level for both banks is increased, the level of economic capital needed will decrease for Bank ABC but will increase for Bank XYZ.
D
If the confidence level for both banks is kept unchanged, the level of economic capital needed for Bank ABC and for Bank XYZ will be equal.