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

A bank holds a portfolio of high-quality AA corporate loans, each carrying a 100% risk weight under Basel I. The bank securitizes the safest tranches, retaining only the riskiest portion, while its regulatory capital requirement falls sharply. Which Basel I weakness does this behavior best illustrate?

This illustrates regulatory capital arbitrage. Basel I applied the same 100% weight to loans of very different quality, so banks could securitize their safest assets, where required capital exceeded economic risk, and keep riskier ones, reducing regulatory capital without reducing true risk.

  1. ARegulatory capital arbitrage arising from risk weights that did not reflect true economic riskCorrect
  2. BOverly conservative treatment of off-balance-sheet derivatives
  3. CThe requirement to hold capital against trading book market risk
  4. DExcessive reliance on banks' internal models for credit risk

Explanation

Because Basel I risk weights were insensitive to actual risk, banks could securitize or sell low-risk assets, whose capital was overstated relative to economic risk, and retain high-risk ones. This is regulatory capital arbitrage. Basel I did not rely on internal credit models, and market risk was addressed only later by the 1996 Amendment.

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