medium · FRM Part 2 Credit Risk
A global bank utilizes the Internal Model Method (IMM) for counterparty credit risk capital. The quantitative team finds that their simulated EAD (Exposure at Default) consistently underestimates the true realized exposure during systemic stress events despite using stressed market factors. Under the current regulatory regime, the regulatory EAD is computed as α × EffEPE.
What is the primary structural justification for the α factor being set at 1.4?
- It accounts for the 'cliff effect' within the 30-day LCR liquidity horizon when high-quality liquid assets serve as pledged collateral.
- It serves as a regulatory buffer to account for model risk and general wrong-way risk (WWR) that standard EPE simulations fail to capture.
- It is a mathematical scaling constant required to convert 99% PFE quantile values into mean expected positive exposure figures for capital.
- It offsets the conservative 40% recovery rate assumption embedded within LGD calculations so regulatory capital covers the gross realized loss.
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