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

A bank holds USD 400 million of loans to well-rated corporates and USD 400 million of loans to weakly rated corporates, all weighted 100% under Basel I, so capital is 8% x 800 = USD 64 million. Management shifts to replace weakly rated loans with equally sized, higher-yield, riskier loans while keeping the same capital ratio. Which statement best describes the weakness of Basel I this illustrates?

Basel I put all corporate loans in one 100% risk-weight bucket regardless of credit quality. Swapping into riskier, higher-yield loans therefore left required capital unchanged, creating an incentive for regulatory capital arbitrage and risk-taking that the framework did not capture.

  1. ABasel I's risk weights are insensitive to differences in borrower credit quality within a category, encouraging regulatory capital arbitrage toward riskier assetsCorrect
  2. BBasel I applies a 0% weight to corporate loans, understating required capital
  3. CBasel I requires capital to be held against market risk only, so credit risk is ignored
  4. DBasel I's Tier 2 cap causes banks to hold excessive Tier 1 capital against risky loans

Explanation

Basel I assigned broad buckets (e.g., 100% to all corporates regardless of rating), so riskier loans with higher yields required the same capital. This gives incentive to shift to riskier assets within a bucket and to arbitrage via securitization. Corporate loans were weighted 100%, not 0%, and the 1988 Accord targeted credit risk, so the other options misstate it.

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