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

A bank under Basel II uses an internal ratings-based approach and finds its regulatory capital requirement falls sharply in a boom and rises sharply in a downturn, as probabilities of default estimated from current conditions move with the cycle. What weakness is this describing?

This describes procyclicality. Risk-sensitive capital rules using current-condition default estimates lower required capital in booms and raise it in downturns, which encourages credit expansion when conditions are good and forces contraction when they are bad, amplifying the economic cycle.

  1. AProcyclicality of risk-sensitive capital requirementsCorrect
  2. BRegulatory arbitrage through the leverage ratio
  3. CDouble counting of operational risk
  4. DInsufficient granularity of standardised risk buckets

Explanation

When PDs are estimated point-in-time, measured risk is low in booms and high in busts, so required capital falls then rises. That amplifies the cycle by encouraging lending in booms and forcing contraction in downturns. The leverage ratio was not a Basel II feature and the other options do not describe cyclical movement.

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