Explanation:
When using a bottom-up approach to calculate economic capital, estimating potential losses over a standard one-year horizon is a common limitation. For illiquid credit assets, resolution often takes substantially longer than one year. Consequently, employing models designed primarily for one-year horizons struggles to accurately quantify the risks embedded in illiquid portfolios, representing a significant challenge.
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Q.60 Fusion Bank is applying a bottom-up approach to quantify its credit risk in order to derive economic capital. What challenge is Fusion Bank likely to face with this approach, particularly when it involves credit assets viewed as illiquid?
A
The approach may lead to an underestimation of credit losses due to an insufficient focus on portfolio diversification
B
The methodology often requires estimation of losses over a period longer than one year, although the models are typically designed for one-year estimates
C
The approach might require additional resources as it separates credit risk from market and operational risks, each managed independently
D
Illiquidity of assets implies that expected losses can be hedged, nullifying the need to calculate economic capital for those assets
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