Module: | MODULE B: RISK MANAGEMENT
Q380: Consider the following statements regarding Unexpected Loss (UL) and its treatment in credit risk management frameworks:
1. Unexpected Loss represents the standard deviation of the credit loss distribution over a target horizon.
2. Banks must cover Unexpected Loss primarily through standard loan loss provisioning and pricing mechanisms.
3. Economic Capital is specifically allocated by the bank to absorb Unexpected Loss during extreme stress scenarios.
Which of the statements given above is/are correct?
2. Banks must cover Unexpected Loss primarily through standard loan loss provisioning and pricing mechanisms.
3. Economic Capital is specifically allocated by the bank to absorb Unexpected Loss during extreme stress scenarios.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is correct: In credit risk modeling, Unexpected Loss (UL) is mathematically defined as the standard deviation of the loss distribution around the Expected Loss over a specified time horizon.
Statement 3 is correct: Economic Capital is the precise amount of risk capital held by a bank to absorb extreme, unanticipated losses (Unexpected Loss) to remain solvent at a given confidence level.
Statement 2 is incorrect: Expected Loss (EL) is treated as a standard cost of doing business and is absorbed through loan pricing, credit spreads, and standard loan loss provisioning.
Unexpected Loss (UL), however, can NEVER be covered by provisioning; it must strictly be absorbed by the bank's Economic Capital/Tier 1 Capital reserves.
Statement 3 is correct: Economic Capital is the precise amount of risk capital held by a bank to absorb extreme, unanticipated losses (Unexpected Loss) to remain solvent at a given confidence level.
Statement 2 is incorrect: Expected Loss (EL) is treated as a standard cost of doing business and is absorbed through loan pricing, credit spreads, and standard loan loss provisioning.
Unexpected Loss (UL), however, can NEVER be covered by provisioning; it must strictly be absorbed by the bank's Economic Capital/Tier 1 Capital reserves.