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

A bank using the Basel II Standardized Approach holds a corporate loan secured by eligible financial collateral and applies the comprehensive approach for credit risk mitigation. Which statement best describes how the exposure is adjusted?

Under the comprehensive approach the bank applies supervisory haircuts to the exposure and to the collateral, including any currency mismatch haircut, and subtracts adjusted collateral from the adjusted exposure. The borrower's risk weight is then applied to the remaining net exposure, so collateral reduces risk-weighted assets only after haircuts.

  1. AThe collateral value is added to the exposure, then the risk weight is halved
  2. BBoth exposure and collateral are adjusted upward/downward with supervisory haircuts (including currency mismatch where relevant), and the risk weight applies to the net exposure after collateralCorrect
  3. CThe collateral substitutes the borrower's risk weight for the whole exposure regardless of value
  4. DCollateral is ignored unless it is a government bond rated AAA

Explanation

The comprehensive approach computes E* = max{0, E(1+He) - C(1-Hc-Hfx)}, applying haircuts for market price and FX volatility, then applies the counterparty risk weight to E*. The substitution idea applies to guarantees, not the comprehensive approach.

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