Expected Loss vs Unexpected Loss
A bank prices expected loss into the product margin but holds economic capital for unexpected loss. Which statement is most accurate?
Expected loss should be covered by economic capital.
Unexpected loss is the cost of doing business.
Expected loss is anticipated and typically provisioned or priced.
Unexpected loss is irrelevant if provisions exist.
Answer
Expected loss is anticipated and typically provisioned or priced.
Expected loss is a planned cost of lending or market-making. Economic capital exists for unexpected outcomes around that expected baseline.