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FRM Part II · FRM Exam Part II · High-level Summary of Basel III Reforms

A regulator explains why the finalised Basel III reforms restrict the use of internal models for certain exposures, such as removing the advanced IRB approach for large corporates and banks. Which rationale is most consistent with the reforms?

The reforms restrict internal models for exposures like large corporates and banks because there is too little default data to model them reliably, and model use caused unwarranted variability in risk-weighted assets between banks. This reduces differences in capital ratios that do not reflect real risk.

  1. ASome exposures have insufficient data to model reliably, and model use contributed to unwarranted RWA variabilityCorrect
  2. BInternal models always produce higher capital than standardised approaches
  3. CInternal models cannot be validated under any circumstances
  4. DStandardised approaches are always more risk-sensitive than internal models

Explanation

The reforms limited model use where modelling is difficult, such as low-default portfolios, because it produced unwarranted variability in RWA across banks. Models do not always produce higher capital, and in practice they often produced lower capital. The reforms did not claim models are unvalidatable or that standardised approaches are always more risk-sensitive.

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