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FRM Exam Part II · Capital Regulation Before the Global Financial Crisis

Basel I Weaknesses and the 1996 Market Risk Amendment

Updated 11 October 2026 · Fact-checked

Basel I set minimum capital at 8% of risk-weighted assets using crude risk buckets, which allowed regulatory arbitrage and ignored trading-book market risk. The 1996 amendment added market risk capital, using either a standardized approach or a bank's internal VaR model (10-day, 99%, multiplier of at least 3), and allowed Tier 3 capital.

Understand Basel I Weaknesses and the 1996 Market Risk Amendment

Basel I (1988) was the first international capital standard. It looked only at credit risk. Each on-balance-sheet asset got a risk weight, and off-balance-sheet items were converted to credit equivalents first. Banks had to hold total capital of at least 8% of risk-weighted assets (RWA), with Tier 1 at least 4%.

The weights were crude. Typical buckets were 0% for OECD government claims and cash, 20% for OECD banks, 50% for residential mortgages, and 100% for corporate loans and most other claims. Two corporate borrowers got the same 100% weight whether they were AAA or near default. Capital did not follow actual risk.

This created regulatory arbitrage. A bank could keep capital low while risk stayed high. It could sell or securitize its safest loans, where the regulatory capital charge exceeded the economic risk, and keep the riskier ones. It could swap low-risk assets for higher-yielding assets in the same bucket. It could use short-term commitments (under one year), which carried a 0% conversion factor. Securitization with retained first-loss pieces cut RWA while the bank kept most of the risk. Basel I also gave little credit for diversification, hedging or collateral.

Basel I also ignored market risk. Trading books grew fast in the 1990s, with derivatives and traded securities. The 1996 Market Risk Amendment (implemented by 1998) added a separate capital charge for market risk in the trading book, plus foreign exchange and commodity risk across the whole bank. Trading book positions are held for trading or to hedge other trading positions.

Banks could choose between two approaches. The standardized approach uses regulator-set rules for interest rate, equity, FX and commodity risk, with specific and general risk charges. The internal models approach (IMA) lets a bank use its own VaR model with regulatory approval. The parameters are a 10-day holding period, a 99% one-tailed confidence level, and at least one year of historical data. Capital is based on the higher of the previous day's VaR and the multiplier times the average VaR of the last 60 business days. The multiplier is at least 3 and rises to as much as 4 depending on backtesting exceptions. A specific risk charge is added unless the model captures it. Backtesting uses one-day VaR at 99% over the last 250 days. The amendment also allowed Tier 3 capital, short-term subordinated debt that can only support market risk. Basel I was eventually replaced by Basel II because of crude risk buckets and arbitrage.

Key formulas to remember

Basel I minimum capital
Total capital ÷ credit RWA ≥ 8%; Tier 1 ÷ RWA ≥ 4%
Credit risk only before 1996. RWA = Σ (exposure × risk weight).
Common Basel I risk weights
0% cash and OECD government; 20% OECD banks; 50% residential mortgages; 100% corporates
Weights depend on the borrower category, not on the credit quality of the individual borrower.
IMA market risk capital
Max(VaR(t−1), mc × average VaR over last 60 days) + SRC
VaR is 10-day, 99%. mc ≥ 3, up to 4 depending on backtesting. SRC is the specific risk charge if not covered by the model.
Market risk RWA equivalent
Market risk RWA = 12.5 × market risk capital charge
12.5 = 1 ÷ 8%. Lets market risk be combined with credit RWA in the 8% ratio.
Overall capital requirement with market risk
Capital ≥ 8% × credit RWA + market risk charge
Equivalent: 8% × (credit RWA + 12.5 × market risk charge).
Tier 3 limits
Tier 3 only for market risk; Tier 2 + Tier 3 capped; Tier 3 ≤ 250% of Tier 1 capital allocated to market risk
Original Tier 1 capital must be at least 28.57% of market risk capital; Tier 3 is short-term subordinated debt with a minimum original maturity of two years.

How to solve Basel I Weaknesses and the 1996 Market Risk Amendment questions

Use this method for both calculation and conceptual questions on Basel I and the 1996 amendment.

  1. 1Identify whether the question is about credit risk (Basel I) or market risk (1996 amendment).
  2. 2For Basel I, assign each exposure to its bucket and compute RWA = exposure × risk weight. Apply conversion factors to off-balance-sheet items first.
  3. 3For market risk, find the approach: standardized or internal models. Note the VaR parameters: 10-day, 99%.
  4. 4For IMA, take the larger of yesterday's VaR and the multiplier × 60-day average VaR, then add any specific risk charge.
  5. 5Convert the market risk charge to RWA by multiplying by 12.5 if you need a combined ratio.
  6. 6Check the capital composition: Tier 1 ≥ 4% of credit RWA, total ≥ 8%, and Tier 3 used only for market risk.
  7. 7For conceptual questions, name the flaw: crude buckets, arbitrage, no diversification credit, or no market risk. Then name the fix.
  8. 8Check that your answer's units, units of days and confidence levels match the question.

Quickest way: Bucket, charge, then 12.5

When to use it: Use this for numerical questions that ask for total capital or RWA with market risk.

  1. Compute credit RWA by weight bucket, then credit capital = 8% × RWA.
  2. Compute the market risk charge (max of VaR rule, plus specific risk).
  3. Add the two for total capital. Or multiply market charge by 12.5 and add to RWA.
  4. For concept questions, eliminate options that say Basel I covered market risk or that Tier 3 supports credit risk.

Common mistakes in Basel I Weaknesses and the 1996 Market Risk Amendment

  • Saying Basel I covered market risk

    Students merge Basel I with the 1996 amendment.

    Fix: Basel I (1988) covered credit risk only. Market risk came in 1996 and was implemented by 1998.

  • Using a 1-day or 95% VaR for IMA capital

    Many VaR examples use 1-day or 95%.

    Fix: Regulatory IMA VaR is 10-day and 99%. Backtesting uses 1-day 99% VaR.

  • Applying the multiplier to yesterday's VaR

    The max rule is easy to misread.

    Fix: The multiplier applies to the 60-day average VaR. Yesterday's VaR is not multiplied. Take the higher of the two.

  • Thinking Tier 3 can cover credit risk

    Students treat all tiers as general-purpose capital.

    Fix: Tier 3 supports market risk only, and it is short-term subordinated debt.

  • Describing arbitrage as breaking the rules

    The word suggests illegal behavior.

    Fix: Regulatory arbitrage is legal. Banks exploit the gap between regulatory and economic risk, for example by securitizing low-risk loans.

  • Forgetting to multiply the market charge by 12.5 before adding it to RWA

    Capital and RWA are mixed up.

    Fix: Capital charges are already in capital units. Multiply by 12.5 to get RWA, or just add capital charges to 8% of credit RWA.

Worked examples

Example 1

A bank has credit exposures of ₹400 crore to OECD governments, ₹200 crore to OECD banks, ₹300 crore in residential mortgages and ₹500 crore to corporates. Using Basel I weights, what is the minimum total capital? Ignore market risk.

Show the solution
  1. Governments: 400 × 0% = 0.
  2. OECD banks: 200 × 20% = 40.
  3. Mortgages: 300 × 50% = 150.
  4. Corporates: 500 × 100% = 500.
  5. RWA = 0 + 40 + 150 + 500 = ₹690 crore.
  6. Minimum total capital = 8% × 690 = ₹55.2 crore.

Answer: ₹55.2 crore

Example 2

A bank uses the IMA. Yesterday's 10-day 99% VaR was USD 20 million. The average over the last 60 days was USD 18 million. The multiplier is 3.4. The specific risk charge is USD 5 million. What is the market risk capital charge, and the equivalent RWA?

Show the solution
  1. Multiplier × average = 3.4 × 18 = USD 61.2 million.
  2. Compare with yesterday's VaR of USD 20 million. The higher is 61.2.
  3. Add specific risk charge: 61.2 + 5 = USD 66.2 million.
  4. RWA equivalent = 12.5 × 66.2 = USD 827.5 million.

Answer: Capital charge USD 66.2 million; RWA equivalent USD 827.5 million

Exam tips

  • Expect questions that ask which feature belongs to Basel I and which to the 1996 amendment. Anchor on credit-only versus market risk.
  • Memorize the IMA parameters: 10-day, 99%, at least one year of data, multiplier at least 3.
  • For arbitrage questions, pick the answer that exploits a gap between regulatory and economic risk, such as securitizing high-quality loans.
  • Tier 3 questions: short-term subordinated debt, market risk only.
  • Do not confuse the 1996 amendment with Basel 2.5 or FRTB; those came later and changed the market risk framework.

Practice questions from Capital Regulation Before the Global Financial Crisis

Basel I Weaknesses and the 1996 Market Risk Amendment: frequently asked questions

What did the 1996 market risk amendment change?

It added a capital charge for market risk in the trading book, and for FX and commodity risk across the bank. Banks could use the standardized approach or, with approval, their own VaR models.

What are the main weaknesses of Basel I?

Risk buckets were crude, so borrowers of very different quality had the same weight. It encouraged regulatory arbitrage and gave little credit for diversification, hedging or collateral. It also ignored market risk until 1996.

What is Tier 3 capital?

Tier 3 is short-term subordinated debt that can be used only to support market risk. It was introduced with the 1996 amendment and is subject to limits tied to Tier 1.

Why was Basel I replaced by Basel II?

Capital did not match actual risk, and banks used securitization and other arbitrage to cut capital. Basel II introduced risk-sensitive weights, internal ratings, operational risk capital and supervisory review and disclosure.