Which of the following are conclusions that could be drawn from the shape of the statistical distribution of losses that a bank might incur over a future time period?

Which of the following are conclusions that could be drawn from the shape of the statistical distribution of losses that a bank might incur over a future time period?

I. In most years a bank would look more profitable than it will be on average.

II. Most of the time a sufficiently well capitalized bank will appear over-capitalized.

III. Bad years do not come along very often, but when they do they lead to enormous losses.
A . I, II
B . I, III
C . II, III
D . I, II, III

View Answer

Answer: D

Explanation:

From the statistical distribution of bank losses over a future period, several conclusions can be drawn:

I. In most years a bank would look more profitable than it will be on average: This indicates that most years will show better-than-average profitability because the distribution of losses includes infrequent but severe loss events.

II. Most of the time a sufficiently well-capitalized bank will appear over-capitalized: Because banks prepare for rare but significant losses, in normal years, their capital reserves may seem excessive.

III. Bad years do not come along very often, but when they do they lead to enormous losses: This reflects the heavy-tailed nature of the loss distribution, where extreme losses are rare but severe.

All three statements correctly reflect the characteristics of the loss distribution for banks.

References: How Finance Works, sections covering statistical analysis of losses and capital adequacy??.