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Answer: If the confidence level (CI) for both banks is increased, the level of economic capital needed for Bank ABC and for Bank XYZ will both increase.
## Explanation This question deals with economic capital for credit risk and the impact of default correlation and confidence levels. ### Key Points: - Both banks have identical: credit asset exposure, duration, credit rating, and expected loss - Bank ABC has **lower** average pairwise default correlation than Bank XYZ - Both banks use the **same** confidence level ### Analysis: 1. **Economic Capital Definition**: Economic capital = Unexpected Loss (UL) at a given confidence level 2. **Impact of Default Correlation**: - Lower default correlation (Bank ABC) → More diversification benefits → Lower portfolio risk - Higher default correlation (Bank XYZ) → Less diversification → Higher portfolio risk - Therefore, at the same confidence level, Bank ABC should require **less** economic capital than Bank XYZ 3. **Impact of Changing Confidence Level**: - Increasing confidence level → Higher economic capital for **both** banks - This is because economic capital represents the capital needed to cover losses at a given confidence level - Higher confidence level means covering more extreme loss scenarios 4. **Evaluating the Options**: - **Option A**: Correct - Increasing CI increases economic capital for both banks - **Option B**: Incorrect - Decreasing CI would decrease economic capital for both banks - **Option C**: Incorrect - Increasing CI increases economic capital for both, not just one - **Option D**: Incorrect - With different default correlations, economic capital will differ even at same CI ### Conclusion: The correct answer is **A** because increasing the confidence level requires both banks to hold more capital to cover more extreme loss scenarios, regardless of their different default correlation structures.
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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 (CI) for both banks is increased, the level of economic capital needed for Bank ABC and for Bank XYZ will both increase.
B
If the CI 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 (CI) 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 CI for both banks is kept unchanged, the level of economic capital needed for Bank ABC and for Bank XYZ will be equal.