Module: | MODULE B: RISK MANAGEMENT
Q260: Consider the following statements regarding the structural absorption of Expected Loss (EL) and Unexpected Loss (UL) in a bank:
1. Expected Loss represents the anticipated average financial loss over a specific period, which the bank calculates as a standard cost of doing business.
2. Banks are required by regulatory bodies to allocate their Tier 1 capital strictly to absorb the Expected Loss arising from their daily credit portfolios.
3. Expected Loss is strictly mitigated upfront by incorporating a risk premium into the loan pricing and setting aside adequate financial provisions.
Which of the statements given above is/are correct?
2. Banks are required by regulatory bodies to allocate their Tier 1 capital strictly to absorb the Expected Loss arising from their daily credit portfolios.
3. Expected Loss is strictly mitigated upfront by incorporating a risk premium into the loan pricing and setting aside adequate financial provisions.
Which of the statements given above is/are correct?
✅ Correct Answer: C
The correct answer is C. Statement 1 is correct: Expected Loss (EL) is the anticipated average loss that a bank expects to incur on a portfolio over a given time horizon.
It is statistically predictable based on historical default rates and is treated as a standard, routine cost of doing business.
Statement 3 is correct: Because EL is predictable, banks mitigate it entirely upfront.
They do this first by charging a risk premium in the interest rate (pricing it into the product), and second, by setting aside specific loan loss provisions from their operating income.
Statement 2 is incorrect: Regulatory Capital (like Tier 1 Capital) is NEVER allocated to cover Expected Loss.
Capital acts as the ultimate shock absorber specifically designed to cover Unexpected Loss (UL)—the worst-case, statistically improbable variations from the expected average.
Using capital for routine expected losses would rapidly lead to bank insolvency.
It is statistically predictable based on historical default rates and is treated as a standard, routine cost of doing business.
Statement 3 is correct: Because EL is predictable, banks mitigate it entirely upfront.
They do this first by charging a risk premium in the interest rate (pricing it into the product), and second, by setting aside specific loan loss provisions from their operating income.
Statement 2 is incorrect: Regulatory Capital (like Tier 1 Capital) is NEVER allocated to cover Expected Loss.
Capital acts as the ultimate shock absorber specifically designed to cover Unexpected Loss (UL)—the worst-case, statistically improbable variations from the expected average.
Using capital for routine expected losses would rapidly lead to bank insolvency.