hard · FRM Part 1 Foundations of Risk Management
A commercial bank prices expected credit losses (EL) into loan spreads and loss provisions, sizes economic capital to absorb unexpected loss (UL) up to the 99.9th percentile, and separately holds a stress-capital buffer to absorb losses beyond that percentile under a severe but plausible scenario. A newly hired CRO proposes replacing all three layers with a single loss reserve sized only at the expected-loss level, arguing that provisioning already covers "the losses risk management should worry about."
Per the standard risk-taxonomy framework for loss-absorbing capacity, what is the most serious flaw in the CRO's proposal?
- It funds expected losses with capital rather than pricing them into spreads and provisions, reversing the loss hierarchy.
- It erases the line between unexpected loss, which capital absorbs, and stress loss, which needs a separate buffer beyond that confidence level.
- It assumes stress losses always move in lockstep with expected losses, so one EL-sized reserve would scale to cover any outcome.
- It wrongly assumes provisions and economic capital must be kept in legally segregated accounts, a separation Basel rules do not actually mandate.
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