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

A risk manager at a bank reviews the original 1988 Basel Accord. Which feature of the Accord's credit risk capital treatment is most often criticised for encouraging regulatory capital arbitrage?

The Basel I risk weights were broad and insensitive to credit quality: all corporate loans got the same 100% weight whatever their rating. This let banks arbitrage capital by shedding low-risk assets and retaining high-risk ones, since the charge did not reflect true risk.

  1. ARisk weights were applied to broad asset categories, so loans of very different credit quality carried the same capital chargeCorrect
  2. BCapital requirements were based on banks' internal VaR models, which differed across institutions
  3. CThe Accord required capital to be held against operational risk at a fixed percentage of gross income
  4. DThe Accord set a minimum liquidity coverage ratio that distorted lending

Explanation

Basel I assigned the same 100% weight to, for example, all corporate loans regardless of rating. Banks could keep the high-risk loans and securitise or sell the low-risk ones, since the capital charge did not reflect risk. The other options describe features from the 1996 Amendment, Basel II, or Basel III.

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