Explanation:
The correct answer is C.
To derive economic capital, the bank needs to estimate excess capital reserves required to cover unexpected losses. This is done subject to a predetermined confidence level which ensures that the bank is protected against adverse credit events to a specific degree of certainty. Expected losses are typically covered under operating cash flows, and it is the unexpected loss which economic capital aims to safeguard against.
A is incorrect. Economic capital is not based on the sum of expected and unexpected losses; it is focused on covering unexpected losses beyond expected operational losses.
B is incorrect. While it is crucial to account for unexpected losses, simply setting aside reserves equal to these losses without considering diversification benefits would likely result in an overestimation of required capital.
D is incorrect. Expected losses are generally managed within the normal operating cashflows and do not require separate capital allocation. Unexpected losses are the primary concern for economic capital allocation.
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Q.6191 A bank is estimating its economic capital for credit risk. The credit risk models are designed to estimate expected and unexpected losses over a one-year period. The bank wants to ensure that the capital reserves are set based on the credit risk present in its portfolio. How does the bank proceed with deriving economic capital based on the expected and unexpected losses as provided by its credit risk models?
A
By setting aside capital reserves equal to the sum of expected and unexpected losses
B
By setting aside capital reserves equal to the unexpected losses, assuming no diversification benefit
C
By estimating the excess capital reserves needed subject to a predetermined confidence level to cover unexpected losses
D
By allocating resources to manage expected losses and disregarding unexpected losses