Credit Risk Management Practice Exam

What approach is used to describe the economic capital needed to absorb credit losses?

1. The average loss expected over time

2. The distance between unexpected outcomes and expected outcomes

3. The total amount of capital reserved for all liabilities

4. The ratio of equity to total assets

The correct answer is: The distance between unexpected outcomes and expected outcomes

The approach that accurately describes the economic capital needed to absorb credit losses is focused on the distance between unexpected outcomes and expected outcomes. Economic capital is the amount of risk capital that a financial institution must hold to cover the potential losses from credit risk that exceed the expected losses. This distance indicates the amount of capital that is deemed necessary to remain solvent and stable in the face of adverse financial conditions and unexpected credit defaults. In credit risk management, expected losses are those anticipated based on historical data and calculated probabilities, while unexpected losses are those that exceed the expected loss projections. By measuring the difference between these two, organizations can gauge how much additional capital buffer is needed to handle scenarios that fall beyond ordinary expectations. This helps ensure that they can meet their obligations even when unexpected losses occur, thus promoting financial resilience and stability.