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

A risk analyst reviewing the pre-crisis regulatory framework notes that Basel I applied a single 8% minimum capital charge to all corporate loans, whether to a AAA-rated multinational or a highly leveraged start-up. Which weakness of the pre-crisis framework does this best illustrate?

The flat 8% charge on all corporate loans shows insufficient risk sensitivity. Because safe and risky borrowers cost the same capital, banks gained by holding riskier loans and offloading safer ones, which encouraged regulatory arbitrage.

  1. AInsufficient risk sensitivity, which encouraged regulatory arbitrageCorrect
  2. BExcessive reliance on internal models for market risk
  3. COverly strict treatment of trading book positions
  4. DExcessive procyclicality caused by ratings-based risk weights

Explanation

A flat 100% risk weight on corporate exposures ignored differences in credit quality. Banks were thus motivated to hold riskier assets within a risk-weight bucket and to securitize or move out the safer assets, which is regulatory arbitrage. Procyclicality is a Basel II concern, not the point of a flat weight.

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