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Explanation:
Economic capital is designed to act as a buffer against unexpected losses and is typically calculated as the Value at Risk (VaR) at a chosen confidence level minus the Expected Loss (EL). Irrespective of whether the asset default correlation within the portfolio is high or low, increasing the confidence level (e.g., from 95% to 99%) always means measuring losses further out into the tail of the distribution, which results in a higher VaR. Therefore, a higher confidence level will universally increase the economic capital required for both Bank PQR and Bank LMN.
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Q.59 A risk analyst at a financial institution is evaluating the economic capital for credit risk of two regional banks, Bank PQR and Bank LMN. Both banks have identical credit asset exposure, duration of credit exposure, credit ratings, and expected loss rates. However, the average pairwise default correlation between credit assets of Bank PQR is lower than that of Bank LMN. Both banks assess their risk appetite using the same confidence level. Which of the following statements is correct?
A
If the confidence level for both banks is increased, the level of economic capital required for Bank PQR and Bank LMN will both increase.
B
If the confidence level for both banks is decreased, the level of economic capital required will increase for Bank PQR but decrease for Bank LMN.
C
If the confidence level for both banks is increased, the level of economic capital required will decrease for Bank PQR but increase for Bank LMN.
D
If the confidence level for both banks remains unchanged, the level of economic capital required for Bank PQR and Bank LMN will be the same.