Capital Adequacy and Economic Capital

Introduction and context

Capital is the principal financial buffer protecting a bank against unexpected losses. It absorbs losses without imposing immediate claims on depositors, payment-system participants, or taxpayers. Capital also supports confidence, permits continued lending during stress, and constrains excessive leverage. For these reasons, capital adequacy is simultaneously a regulatory requirement, a risk-management discipline, a strategic planning issue, and a market signal.

The modern capital framework distinguishes between regulatory capital, which is defined by supervisory rules, and economic capital, which is the amount of capital that the bank internally estimates is necessary to cover unexpected losses at a chosen confidence level and time horizon. These measures overlap, but they are not identical. Regulatory capital promotes minimum resilience and comparability across institutions; economic capital supports risk-sensitive management, pricing, portfolio allocation, and performance measurement.

A bank may therefore satisfy its regulatory capital ratios and still have inadequate capital for its business model, risk concentration, liquidity profile, or stress vulnerabilities. Conversely, a bank may hold capital above regulatory minima because its internal risk assessment, rating objectives, growth strategy, or market expectations require a larger cushion.

Learning objectives

By the end of this chapter, the reader should be able to:

1. Explain the structure and purpose of regulatory capital.
2. Calculate risk-weighted assets (RWA), capital ratios, leverage ratios, and capital buffers.
3. Compare standardized and internal-model approaches to credit, market, and operational risk.
4. Explain the purpose and process of the Internal Capital Adequacy Assessment Process (ICAAP).
5. Estimate and allocate economic capital across businesses and risk types.
6. Evaluate capital adequacy under alternative strategies and stress scenarios.
7. Critically assess model risk, governance, procyclicality, and regulatory constraints.

1. The architecture of bank capital

1.1 Capital as loss-absorbing capacity

A bank’s balance sheet is funded by liabilities and equity. Deposits and wholesale funding are contractual claims, whereas common equity has the greatest capacity to absorb losses because it has no mandatory repayment date and distributions can generally be suspended. Capital performs four related functions:

• Loss absorption: it absorbs realized and recognized losses.
• Solvency support: it keeps assets greater than liabilities after losses.
• Confidence support: it reduces the probability of a destabilizing run or funding withdrawal.
• Incentive alignment: shareholders bear losses and therefore have an interest in prudent risk-taking.

Capital is not the same as cash or liquidity. A well-capitalized bank may fail if it cannot meet short-term payments, while a liquid bank may become insolvent if the value of its assets falls below its obligations.

1.2 Regulatory capital tiers

Under the Basel III framework, regulatory capital is generally organized into Common Equity Tier 1 (CET1), Additional Tier 1 (AT1), and Tier 2 capital. Exact implementation is jurisdiction-specific, and national authorities may apply additional requirements.

In simplified form:

The formula is an aggregation identity. It applies after all regulatory eligibility rules, limits, valuation adjustments, and deductions have been applied. It should not be interpreted as saying that every form of shareholders’ equity qualifies as CET1.

Typical deductions from CET1 include goodwill, certain intangible assets, deferred tax assets that depend on future profitability, and investments in financial institutions where required by regulation. These deductions reflect the limited availability of such items to absorb losses in a crisis.

1.3 Going-concern and gone-concern capital

CET1 and AT1 are primarily going-concern capital: they are intended to absorb losses while the bank continues operating. Tier 2 is principally gone-concern capital, available to protect creditors if the bank enters resolution or liquidation. This distinction matters because a bank needs high-quality capital before it reaches legal insolvency; waiting for liquidation capital to absorb losses may be too late to preserve confidence.

2. Risk-weighted assets and capital ratios

2.1 Why risk-weight assets?

A simple leverage measure treats every asset as equally risky. RWA instead assigns exposures risk weights intended to reflect differences in credit, market, and operational risk. A mortgage, sovereign exposure, unsecured corporate loan, and cash balance may have very different risk weights.

The general relationship is:

where each component is calculated according to the applicable regulatory method. In simplified exposure-based form:

Here, Eᵢ is exposure i measured in monetary units and wᵢ is its regulatory risk weight, expressed as a decimal. The equation assumes that risk weights can be applied independently and summed. Actual rules may require exposure-at-default measures, credit conversion factors, collateral recognition, netting, maturity adjustments, or model outputs.

2.2 Regulatory capital ratios

The principal risk-based ratios are:

The numerator and denominator must be measured on a consistent regulatory basis. For example, accounting equity cannot be inserted into the CET1 numerator without applying regulatory adjustments.

Illustrative calculation. Suppose a bank has CET1 of 9.0 billion, Tier 1 capital of 11.0 billion, total capital of 14.0 billion, and RWA of 100 billion. Its ratios are:

• CET1 ratio = 9.0 ÷ 100 = 9.0%
• Tier 1 ratio = 11.0 ÷ 100 = 11.0%
• Total capital ratio = 14.0 ÷ 100 = 14.0%

Whether these ratios are adequate depends on the minimum requirements, buffers, supervisory expectations, and the bank’s own risk profile.

2.3 Capital conservation and other buffers

Basel III supplements minimum ratios with buffers designed to ensure that banks build resilience in normal times and can draw on capital in stress. The capital conservation buffer is intended to absorb losses during periods of stress. If a bank’s capital falls into the buffer, automatic restrictions may apply to distributions such as dividends, share repurchases, and discretionary bonuses.

The countercyclical capital buffer may be increased when system-wide credit growth creates excessive cyclical risk and released during a downturn. A systemic risk buffer or additional surcharge may apply to systemically important institutions. Jurisdictions may also impose a Pillar 2 capital requirement based on institution-specific risks.

The effective management concept is not simply “capital above the minimum.” It is a hierarchy:

1. minimum regulatory ratios;
2. mandatory conservation and systemic buffers;
3. supervisory Pillar 2 requirements;
4. management buffer for uncertainty and growth;
5. capital needed to satisfy risk appetite, ratings, and market expectations.

3. The leverage ratio

Risk-weighted ratios can be influenced by the choice of risk weights and models. The leverage ratio provides a complementary, largely non-risk-sensitive constraint.

The leverage exposure measure generally includes on-balance-sheet exposures and specified off-balance-sheet items, with regulatory adjustments. It is not simply total assets in every jurisdiction.

Example. If Tier 1 capital is 12 billion and the leverage exposure measure is 300 billion:

The leverage ratio limits balance-sheet expansion even where risk weights are low. Its advantages are simplicity and protection against model error; its limitation is that it does not distinguish low-risk from high-risk assets. A bank must therefore manage both risk-based capital ratios and the leverage ratio.

4. Standardized and internal-model approaches

4.1 Standardized approaches

Under a standardized approach, regulatory parameters are prescribed by the supervisor. Credit-risk weights may depend on exposure class, collateral, maturity, external ratings where permitted, or prescribed formulas. Market-risk standardized methods use prescribed sensitivities, risk weights, and aggregation rules. Operational-risk requirements use standardized business indicators and loss components under contemporary frameworks.

Strengths include:

• comparability across banks;
• lower implementation complexity;
• easier supervisory validation;
• reduced dependence on institution-specific estimates.

Limitations include:

• less sensitivity to borrower-specific risk;
• possible risk-weight discontinuities;
• reliance on regulatory classifications;
• incentives to select exposures with favorable capital treatment rather than favorable economic risk.

4.2 Internal ratings-based and other internal models

Internal-model approaches allow qualifying banks to estimate some parameters using internal data and validated systems. For credit risk, common parameters include probability of default (PD), loss given default (LGD), exposure at default (EAD), and maturity. A basic expected-loss relationship is:

PD is a probability between 0 and 1; LGD is the proportion of exposure lost after recoveries; EAD is the exposure expected to be outstanding at default, measured in currency. The formula assumes a compatible portfolio segment and a consistent time horizon. It estimates average loss, not the full loss distribution and not necessarily the regulatory capital charge.

Internal models can improve risk differentiation and pricing, but they introduce model risk, data bias, parameter uncertainty, validation burden, and the possibility of inconsistent capital outcomes between banks. Post-crisis reforms have therefore constrained excessive variability in internal-model RWA and strengthened output floors and supervisory review in many jurisdictions.

4.3 Model governance

A credible internal-model framework requires:

• documented methodology and data lineage;
• independent validation;
• back-testing and benchmarking;
• conservative treatment of uncertainty;
• controls over overrides and expert judgment;
• change governance and version control;
• stress testing and sensitivity analysis;
• clear accountability to senior management and the board.

The board should understand material model limitations even when it does not approve technical code. A model is a decision instrument, not an objective fact.

5. ICAAP and the supervisory review process

5.1 Purpose of ICAAP

The ICAAP is the bank’s structured process for assessing whether it has adequate capital in relation to its risk profile, strategy, and forward-looking conditions. It is broader than calculating Pillar 1 ratios. It incorporates risks that may be incompletely captured by minimum formulas, such as concentration risk, interest-rate risk in the banking book, pension risk, strategic risk, reputational risk, model risk, and risks arising from interconnectedness.

ICAAP should be integrated with strategic planning, risk appetite, budgeting, recovery planning, stress testing, and remuneration. A document produced solely for regulatory submission is not an effective ICAAP.

5.2 Core stages

A robust ICAAP normally includes:

1. Business and risk-profile assessment: identify material risks arising from products, geographies, legal entities, and strategy.
2. Risk appetite definition: specify acceptable exposures, limits, capital thresholds, and escalation triggers.
3. Measurement: quantify risk using regulatory capital, economic capital, stress tests, and qualitative assessment.
4. Capital planning: project capital, RWA, earnings, distributions, funding, and strategic actions over a multi-year horizon.
5. Stress testing: examine severe but plausible scenarios and management actions.
6. Governance and challenge: obtain independent risk, finance, validation, audit, senior-management, and board challenge.
7. Monitoring and escalation: track actual capital against limits and trigger contingency actions.

The supervisory review process, often associated with Pillar 2, evaluates the quality of this process and may require additional capital or remedial action.

5.3 Stress testing and capital planning

A capital forecast can be represented conceptually as:

The equation is a planning identity. Profit may be negative under stress, distributions may be restricted, and adjustments may include valuation effects or regulatory changes. It is not a substitute for detailed accounting and regulatory projections.

The projected CET1 ratio is:

Stress testing must change both numerator and denominator. A recession can reduce earnings and capital while simultaneously increasing defaults, provisions, credit conversion factors, and RWA. A simplistic test that shocks losses but holds RWA constant may understate vulnerability.

Good scenarios include macroeconomic deterioration, sector concentration, interest-rate shocks, market illiquidity, cyber incidents, operational losses, deposit outflows, and management constraints. Severe scenarios should be plausible and linked to identifiable transmission channels.

6. Economic capital

6.1 Expected and unexpected loss

Economic capital focuses on the tail of the loss distribution. Expected loss (EL) is the average loss anticipated over a period and is normally reflected in pricing, provisions, or reserves. Unexpected loss (UL) is the variability around expected loss and is the principal target of capital.

If L denotes portfolio loss over a chosen horizon, then:

where E[·] denotes the expected value. At confidence level α, a simple value-at-risk measure is:

Economic capital may be defined as:

This is one convention, not a universal definition. Some institutions use a loss quantile without subtracting expected loss; others use expected shortfall, which averages losses beyond the selected quantile. The bank must state the confidence level, horizon, loss definition, diversification treatment, and whether EL is separately covered by provisions or pricing.

6.2 Economic capital by risk type

Economic capital may be estimated for:

• credit risk;
• market risk;
• operational risk;
• interest-rate risk in the banking book;
• business and strategic risk;
• pension, insurance, or conduct risk where material.

A simple sum of stand-alone capital charges is conservative but can double-count simultaneous diversification benefits. A correlation-based aggregation is often represented as:

ECᵢ and ECⱼ are stand-alone economic-capital amounts and ρᵢⱼ is the assumed correlation between risk components i and j. The formula requires a valid correlation matrix: symmetric, with diagonal elements equal to 1, and positive semidefinite. It is only an approximation when risks are non-linear, distributions are skewed, or correlations change during stress.

Illustrative calculation. Suppose credit economic capital is 80 million, market economic capital is 30 million, operational economic capital is 20 million. Let pairwise correlations be ρcredit,market = 0.20, ρcredit,operational = 0.10, and ρmarket,operational = 0.05. Then:

The stand-alone sum is 130 million, so the implied diversification benefit is approximately 34.9 million. This benefit is model-dependent and may shrink or disappear during systemic stress when correlations rise.

6.3 Allocation of economic capital

Economic capital allocation assigns the group’s capital requirement to business lines, products, customers, or legal entities. Allocation supports:

• risk-adjusted pricing;
• product approval;
• portfolio limits;
• performance measurement;
• strategic capital budgeting;
• incentive compensation.

A common allocation method is based on marginal contribution. If total economic capital is a function of exposure vector x, the marginal contribution of business i is the change in total capital from a small increase in xᵢ. Euler allocation uses:

This equality requires the capital function to be positively homogeneous and sufficiently differentiable. In practice, discrete approximations may be needed, and allocation results depend on the risk model and diversification methodology.

A business line’s risk-adjusted return on capital is often expressed as:

The numerator is a risk-adjusted profit measure and must be defined consistently across businesses. RAROC should not be compared across units when accounting recognition, capital horizons, or risk definitions differ materially.

7. Regulatory capital versus economic capital

Neither measure is inherently “correct” in every context. Regulatory capital is a legal constraint. Economic capital is a managerial model. Sound governance reconciles differences rather than concealing them.

8. Strategic capital planning under alternatives

Capital planning connects business growth to funding and risk capacity. Consider a bank choosing between:

• expanding unsecured consumer lending;
• increasing secured corporate lending;
• acquiring a payments business;
• returning capital to shareholders;
• retaining earnings to support resilience.

The analysis should consider expected return, RWA density, leverage exposure, economic capital, liquidity, stress losses, concentration, conduct risk, and execution capacity. A strategy with high accounting return may destroy value if it consumes disproportionate scarce capital or creates unacceptable tail risk.

A useful decision sequence is:

1. Forecast volumes, margins, costs, provisions, and capital generation.
2. Estimate regulatory RWA and leverage exposure.
3. Estimate economic capital and stress losses.
4. Test compliance with minimums, buffers, risk appetite, and management headroom.
5. Calculate risk-adjusted returns.
6. Examine qualitative risks and model uncertainty.
7. Select capital actions: retain earnings, issue capital, reprice, hedge, securitize, reduce exposures, or alter growth.

Illustrative strategic comparison

Assume two proposals each require 10 billion of assets.

Proposal A produces higher profit, but its profit after expected loss is 600 million, compared with 550 million for Proposal B. A simple return on economic capital is therefore approximately 42.9% for A (600 ÷ 1,400) and 78.6% for B (550 ÷ 700). Proposal B may be strategically superior if the bank’s scarce resource is capital, despite its lower gross profit. The decision would still require stress testing, liquidity analysis, customer-impact assessment, and consideration of diversification.

9. Governance, ethics, and contemporary issues

Capital adequacy is not merely a technical exercise. Management may be tempted to optimize reported ratios through asset sales, securitization, model changes, risk transfer, or restructuring that leaves economic risk substantially unchanged. Such actions may be legitimate, but they can become regulatory arbitrage if their principal purpose is to exploit measurement gaps.

Important governance principles include:

• transparent documentation of assumptions and exclusions;
• independent challenge by risk, finance, validation, and internal audit;
• board understanding of risk appetite and capital triggers;
• consistent treatment of capital across entities;
• prompt escalation of breaches;
• avoidance of incentives that reward short-term RAROC while ignoring tail losses;
• clear disclosure of model uncertainty and stress outcomes.

Technology can improve capital management through automated data lineage, near-real-time RWA calculation, scenario engines, and machine-learning monitoring. However, artificial intelligence can introduce instability, explainability problems, data drift, discriminatory outcomes, and unrecognized correlations. AI should support—not replace—model governance, expert judgment, and regulatory accountability. A model that predicts default accurately in normal conditions may fail under a structural break or unprecedented crisis.

Contemporary developments include stronger interest in output floors, standardized measurement, climate-related financial risk, operational resilience, resolution capital, stress capital buffers, and the interaction between capital and liquidity regulation. Climate risk illustrates the challenge: it may emerge through credit, market, operational, and strategic channels, so adding a separate capital charge without understanding transmission mechanisms can create double counting.

10. Limitations and implementation challenges

Measurement uncertainty

PD, LGD, correlations, recovery rates, and stress elasticities are estimates. Long periods of benign credit performance can produce overly optimistic parameters. Expert judgment should be documented and conservatively governed.

Procyclicality

If risk weights and internal estimates rise sharply during downturns, RWA can increase when capital is already falling. Buffers, through-the-cycle parameters, prudent provisioning, and countercyclical tools help reduce this effect, but cannot eliminate it.

Diversification risk

Historical correlations may understate dependence during systemic crises. Diversification benefits should be stressed, capped, or subjected to uncertainty adjustments where appropriate.

Data and aggregation

Legal-entity structures, inconsistent customer identifiers, missing collateral data, and delayed loss reporting can undermine group-wide capital measurement. Data governance is therefore a capital adequacy control, not merely an information-technology concern.

Multiple constraints

The binding constraint may be CET1, total capital, leverage, liquidity, large-exposure limits, stress capital, or market confidence. Optimizing one ratio can worsen another. Capital planning must identify the binding and near-binding constraints under both baseline and stress conditions.

Illustrative case: Northbridge Bank’s expansion decision

Background

Northbridge Bank is a fictional universal bank with CET1 of 8.4 billion, Tier 1 capital of 10.0 billion, total capital of 12.5 billion, and RWA of 80 billion. Its CET1 ratio is 10.5%, its Tier 1 ratio is 12.5%, and its total capital ratio is 15.625%. The bank’s board-approved risk appetite requires a minimum management CET1 ratio of 9.5% in the baseline plan and 8.5% after the severe stress scenario.

The bank is considering a 12-billion asset expansion in unsecured small-business lending. The business plan estimates additional RWA of 9 billion, expected annual profit before distributions of 900 million, and a severe-stress loss of 1.1 billion. Management estimates that the expansion would require 1.5 billion of economic capital.

Problem

The executive committee focuses on the projected profit and proposes a 600-million dividend. The chief risk officer argues that the expansion could reduce capital headroom and create concentration in a sector already showing weakening repayment performance.

Analysis

Before the expansion, CET1 equals 8.4 billion. If the bank retains 300 million of the projected profit after the dividend, CET1 becomes 8.7 billion, ignoring other adjustments. RWA becomes 89 billion.

The baseline ratio remains above the 9.5% management threshold but with limited headroom. Under the severe stress, assume the bank suffers the 1.1-billion loss and an additional 2-billion increase in RWA because of deterioration and exposure conversion. CET1 becomes approximately 7.6 billion and RWA 91 billion.

This falls below the 8.5% stress risk-appetite threshold. The result is not automatically a regulatory breach, but it indicates that the proposed growth and dividend are inconsistent with the board’s stated risk appetite.

Approach and solution

The bank considers four actions:

1. reduce the dividend and retain an additional 300 million;
2. tighten underwriting and reduce the expansion to 8 billion of assets;
3. price for higher expected loss and economic-capital consumption;
4. impose sector limits and establish an early-warning trigger based on delinquency and collateral trends.

The revised plan retains the additional 300 million and reduces the expansion. It also requires quarterly stress testing and board review. The bank does not reject unsecured lending, but it changes the growth rate and hurdle rate to reflect capital scarcity.

Outcome and learning points

The case demonstrates that capital planning must incorporate both numerator effects—profit, losses, distributions, and capital issuance—and denominator effects—RWA growth and stress migration. It also shows why economic capital and regulatory capital should be used together. A profitable strategy can be unacceptable when it consumes too much capital or breaches stressed risk appetite. Finally, a capital decision is inseparable from governance: limits, escalation, data quality, and management actions determine whether a ratio is useful in practice.

Best-practice checklist

A bank seeking high-quality capital management should:

• maintain a clear hierarchy of minimums, buffers, and internal targets;
• reconcile regulatory and economic capital regularly;
• use conservative assumptions where data are sparse;
• stress both capital and RWA;
• test correlations and diversification benefits under crisis conditions;
• integrate ICAAP with strategy, budgeting, recovery, and remuneration;
• identify the binding capital constraint;
• maintain independent model validation and effective board challenge;
• disclose uncertainty rather than presenting model outputs as precise facts;
• review capital allocation after major strategic, regulatory, or macroeconomic changes.

Chapter Summary

Capital adequacy protects a bank’s solvency, supports confidence, and constrains risk-taking. Regulatory capital is organized into CET1, AT1, and Tier 2, with CET1 providing the strongest going-concern loss absorption. Risk-based ratios relate eligible capital to RWA, while the leverage ratio provides a complementary constraint that is less dependent on risk weights. Buffers and supervisory requirements create capital headroom above minimum ratios.

Standardized approaches promote comparability and simplicity, whereas internal models can improve risk sensitivity but create model, data, and governance risks. ICAAP links risk identification, appetite, measurement, stress testing, capital planning, and board oversight. Economic capital estimates the resources required for unexpected loss at a chosen confidence level and horizon. It can be aggregated and allocated to business lines, supporting pricing, portfolio decisions, and RAROC, but diversification and correlation assumptions require careful challenge.

Effective capital management evaluates strategic alternatives under both baseline and severe conditions. It considers regulatory ratios, leverage, economic capital, liquidity, concentration, model uncertainty, and management actions. The central managerial principle is that capital is scarce: growth should be pursued only when its risk-adjusted return and resilience justify the capital it consumes.

Key Terms

Capital adequacy: The sufficiency of a bank’s capital relative to its risks and regulatory requirements.

CET1: Common Equity Tier 1 capital, the highest-quality regulatory capital.

AT1: Additional Tier 1 capital, generally perpetual instruments capable of going-concern loss absorption.

Tier 2 capital: Subordinated capital primarily providing gone-concern loss absorption.

Risk-weighted assets (RWA): Assets or exposures adjusted according to prescribed or modeled risk weights.

CET1 ratio: CET1 capital divided by RWA.

Leverage ratio: Tier 1 capital divided by the regulatory leverage exposure measure.

Capital conservation buffer: Additional capital intended to absorb losses and restrict distributions when drawn down.

Countercyclical capital buffer: A buffer that varies with system-wide cyclical risk.

Pillar 2: Supervisory review and institution-specific capital assessment beyond minimum requirements.

ICAAP: Internal Capital Adequacy Assessment Process.

Standardized approach: A regulatory method using prescribed risk parameters.

Internal model: A bank-developed risk measurement model approved or recognized for regulatory or internal use.

Expected loss: The average loss anticipated over a specified horizon.

Unexpected loss: Loss variability beyond expected loss, typically the focus of capital.

Economic capital: Internally estimated capital required for unexpected loss at a selected confidence level and horizon.

Value at Risk (VaR): A loss quantile at a specified confidence level.

RAROC: Risk-adjusted return on capital.

Output floor: A regulatory constraint limiting the reduction in standardized RWA achieved through internal models.

Model risk: The risk of adverse outcomes arising from model errors, misuse, data limitations, or inappropriate assumptions.

Review Questions

Short Answer Questions

1. What are the principal differences between CET1, AT1, and Tier 2 capital?
2. Why does a bank use both risk-based capital ratios and a leverage ratio?
3. What is the purpose of the capital conservation buffer?
4. Distinguish expected loss from unexpected loss.
5. Identify four core stages of an ICAAP.

Long Answer Questions

1. Explain how RWA are constructed and critically evaluate the benefits and limitations of standardized and internal-model approaches.
2. Discuss the role of stress testing in capital planning, including why both capital and RWA should be stressed.
3. Compare regulatory capital and economic capital in terms of purpose, measurement, governance, and managerial use.
4. Explain how economic capital can be aggregated and allocated across business lines. Discuss diversification and correlation risk.
5. Critically assess the governance and ethical risks associated with optimizing regulatory capital ratios.

Analytical / Application Questions

1. A bank has CET1 of 6 billion and RWA of 60 billion. It plans to distribute 200 million while expecting a 500-million stress loss and a 5-billion stress increase in RWA. Calculate the pre-stress and simplified post-stress CET1 ratios, assuming the distribution reduces CET1 and no other changes occur.
2. A portfolio has PD of 2%, LGD of 40%, and EAD of 25 million. Calculate expected loss and explain why the result is not an economic-capital requirement.
3. A business line generates 420 million of revenue, 90 million of expected loss, 160 million of operating costs, and uses 1.7 billion of economic capital. Calculate its RAROC and discuss at least three limitations of using that figure for strategic decisions.

Multiple Choice Questions with Answers

Question 1

Which component generally provides the highest-quality going-concern loss absorption?

A. Common Equity Tier 1

B. Additional Tier 1

C. Tier 2

D. Senior unsecured debt

Correct Answer: A. Common Equity Tier 1

Question 2

A bank has CET1 of 7 billion and RWA of 70 billion. What is its CET1 ratio?

A. 0.1%

B. 1%

C. 10%

D. 100%

Correct Answer: C. 10%

Question 3

What is the principal purpose of the leverage ratio?

A. To replace all risk-based capital ratios

B. To provide a complementary constraint less dependent on risk weights

C. To measure liquidity coverage

D. To calculate expected credit loss

Correct Answer: B. To provide a complementary constraint less dependent on risk weights

Question 4

Which expression represents a simplified expected-loss calculation?

A. PD + LGD + EAD

B. PD × LGD × EAD

C. PD ÷ LGD ÷ EAD

D. PD − LGD × EAD

Correct Answer: B. PD × LGD × EAD

Question 5

Which activity is most directly associated with ICAAP?

A. Assessing capital adequacy relative to the bank’s risk profile and strategy

B. Setting daily foreign-exchange rates

C. Calculating customer interest only

D. Replacing internal audit

Correct Answer: A. Assessing capital adequacy relative to the bank’s risk profile and strategy

Question 6

If expected loss is 40 million and the selected loss quantile is 100 million, under the convention in this chapter economic capital is:

A. 40 million

B. 60 million

C. 100 million

D. 140 million

Correct Answer: B. 60 million

Question 7

What is a major limitation of internal-model approaches?

A. They cannot use any historical data

B. They always produce higher capital than standardized methods

C. They create model risk and may reduce comparability

D. They eliminate the need for supervisory review

Correct Answer: C. They create model risk and may reduce comparability

Question 8

A bank has Tier 1 capital of 12 billion and leverage exposure of 300 billion. Its leverage ratio is:

A. 0.4%

B. 2.5%

C. 4.0%

D. 25%

Correct Answer: C. 4.0%

Question 9

Why can diversification benefits estimated in normal periods be unreliable during systemic stress?

A. Correlations may increase during crises

B. Capital becomes unrelated to risk

C. RWA necessarily become zero

D. Expected loss cannot be calculated

Correct Answer: A. Correlations may increase during crises

Question 10

A business earns 500 million after expected loss and costs and uses 2 billion of economic capital. Its RAROC is:

A. 4%

B. 25%

C. 40%

D. 250%

Correct Answer: B. 25%