Credit Risk Management Practice Exam

Which of the following best describes economic capital in the context of a bank?

1. Funds allocated for daily operations

2. Reserves held to buffer against unexpected losses

3. Capital designated for investment in new technologies

4. Assets set aside for regulatory compliance

The correct answer is: Reserves held to buffer against unexpected losses

Economic capital refers to the amount of capital that a bank estimates is necessary to cover potential losses due to credit, market, operational, or other risks. It serves as a buffer against unexpected losses that may arise from the bank's exposure to various risk factors. This concept is essential for internal risk management, allowing financial institutions to identify, assess, and manage risks effectively. The selection of reserves held to buffer against unexpected losses accurately captures the essence of economic capital. It emphasizes the need for a financial cushion that aligns with the bank's risk profile, ensuring it can absorb shocks and maintain its operations without compromising solvency. In contrast, funds allocated for daily operations typically refer to working capital or liquidity resources rather than capital meant to mitigate risk exposures. Capital designated for investment in new technologies pertains to strategic allocations rather than risk management. Lastly, assets set aside for regulatory compliance focus mostly on meeting specific regulatory requirements rather than addressing the broader needs anticipated by economic capital. Thus, the correct answer aligns with the fundamental purpose of economic capital within a bank’s risk management framework.