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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 Let's analyze each option: **Option A: FALSE** - Effective risk management cannot reduce expected loss (EL) to zero. Expected loss is an inherent cost of doing business in lending and represents the average loss that should be expected over time. It's calculated as: EL = PD × LGD × EAD, where PD is probability of default, LGD is loss given default, and EAD is exposure at default. **Option B: FALSE** - Expected loss is actually calculated as: EL = PD × LGD × EAD. The formula mentioned in option B is incorrect because it includes "expected recovery rate" instead of loss given default (LGD). Note that LGD = 1 - recovery rate. **Option C: FALSE** - Both expected loss (EL) and unexpected loss (UL) are influenced by portfolio granularity. Unexpected loss is particularly sensitive to portfolio concentration and diversification effects. **Option D: TRUE** - This is the correct statement. While theoretically, if loans are perfectly priced, the interest income should cover expected losses, in practice banks need to provision for expected losses due to: - Regulatory requirements (Basel framework) - Accounting standards (IFRS 9) - Practical business considerations - Timing mismatches between income recognition and loss occurrence The Basel framework specifically requires banks to hold capital for unexpected losses while provisioning for expected losses through loan loss reserves.
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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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