Module: | MODULE B: RISK MANAGEMENT
Q278: Consider the following statements regarding expected and unexpected losses in risk management:
1. Expected losses represent the anticipated average loss over a specific period, which banks typically manage through standard product pricing and provisioning.
2. Unexpected losses represent the adverse volatility of actual losses around the expected average, requiring the bank to hold economic capital as a buffer.
3. Under regulatory norms, economic capital is primarily designed to absorb expected losses, while current operational profits are used to absorb unexpected losses.
Which of the statements given above is/are correct?
2. Unexpected losses represent the adverse volatility of actual losses around the expected average, requiring the bank to hold economic capital as a buffer.
3. Under regulatory norms, economic capital is primarily designed to absorb expected losses, while current operational profits are used to absorb unexpected losses.
Which of the statements given above is/are correct?
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: Expected Loss (EL) is the normal cost of doing business.
Banks calculate historical averages and cover these losses directly through loan pricing (charging higher interest to riskier borrowers) and by creating standard provisions from current earnings.
Statement 2 is correct: Unexpected Loss (UL) measures the extreme volatility or worst-case deviation from the expected average.
Banks must maintain Economic Capital (or Risk Capital) specifically to act as a shock absorber against these severe, unforeseen losses.
Statement 3 is incorrect: The statement reverses the core doctrine of risk management.
Current operational profits and provisions absorb Expected Losses, whereas Economic/Regulatory Capital is strictly mandated to absorb Unexpected Losses to prevent bank insolvency.
Banks calculate historical averages and cover these losses directly through loan pricing (charging higher interest to riskier borrowers) and by creating standard provisions from current earnings.
Statement 2 is correct: Unexpected Loss (UL) measures the extreme volatility or worst-case deviation from the expected average.
Banks must maintain Economic Capital (or Risk Capital) specifically to act as a shock absorber against these severe, unforeseen losses.
Statement 3 is incorrect: The statement reverses the core doctrine of risk management.
Current operational profits and provisions absorb Expected Losses, whereas Economic/Regulatory Capital is strictly mandated to absorb Unexpected Losses to prevent bank insolvency.