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FRM Part II · FRM Exam Part II · Solvency, Liquidity and Other Regulation After the Global Financial Crisis

A risk manager at a large international bank is explaining why Basel III tightened the definition of regulatory capital compared with Basel II. Which of the following best describes the main change to the composition of the capital base?

Basel III raised capital quality by making Common Equity Tier 1 the dominant component of Tier 1, with stricter instrument criteria and regulatory deductions. Tier 2 remains, while Tier 3 was eliminated, so options suggesting the opposite are wrong.

  1. AGreater emphasis on common equity as the dominant component of Tier 1 capital, with stricter eligibility criteria for deductions and instrumentsCorrect
  2. BElimination of Tier 2 capital so that only Tier 1 capital counts toward requirements
  3. CIntroduction of Tier 3 capital to cover market risk with short-term subordinated debt
  4. DPermission to count unrealized gains on all assets in Common Equity Tier 1 without adjustment

Explanation

Basel III focuses on the quality of capital, requiring that common equity (shares and retained earnings) be the predominant form of Tier 1 capital and applying stricter deductions. Tier 2 was retained, not eliminated. Tier 3 was abolished rather than introduced.

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