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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

A bank has USD 200 million of Tier 1 capital and risk-weighted assets of USD 2,000 million, giving a 10% capital ratio. A loss of USD 40 million is incurred. The bank wants to restore a 10% ratio without raising new capital, by shrinking assets with a uniform 100% risk weight. By how much must it reduce risk-weighted assets, and what does this imply for credit supply as many banks act similarly?

The bank must cut risk-weighted assets by USD 400 million. Capital falls to USD 160 million, which supports only USD 1,600 million of assets at a 10% ratio. If many banks shrink simultaneously, lending contracts, which is procyclical and deepens the downturn.

  1. AUSD 400 million; a procyclical contraction in lendingCorrect
  2. BUSD 160 million; a procyclical contraction in lending
  3. CUSD 400 million; an expansion in lending as risk falls
  4. DUSD 200 million; no effect on lending

Explanation

Capital after the loss is 160. For a 10% ratio, RWA must be 1,600, a reduction of 400. A simple 40/10 check gives the same result. Reducing RWA 160 ignores the 10x multiplier. When many banks do this, credit supply contracts, reinforcing the downturn (procyclicality).

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