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Explanation:
Economic capital is the amount of capital needed to ensure that a financial institution stays solvent over a certain time period and up to a given confidence level. It serves as a buffer against unexpected losses. Irrespective of the asset default correlation levels, an increase in the confidence level (e.g., from 99% to 99.9%) implies that the institution wishes to protect itself against more severe and rarer tail loss events. Therefore, an increase in the confidence level will lead to a higher requirement for economic capital 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.