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

A risk manager is asked which Basel II feature best explains why Pillar 3 is intended to strengthen the capital framework. Which statement is most accurate?

Pillar 3 strengthens the framework through market discipline: banks must disclose capital, risk exposures and risk assessment processes so market participants can judge their soundness and reward or penalize them accordingly. Add-ons are Pillar 2, and capital definitions belong to Pillar 1.

  1. AIt sets higher risk weights for banks that disclose less information
  2. BIt requires disclosures so market participants can assess a bank's capital and risk exposures, encouraging prudent behaviorCorrect
  3. CIt allows supervisors to impose capital add-ons for unmeasured risks
  4. DIt defines the eligible components of Tier 1 capital

Explanation

Pillar 3 uses public disclosure of capital structure, risk exposures and assessment processes so that investors and counterparties can reward or penalize banks. Capital add-ons belong to Pillar 2, and capital definitions and risk weights belong to Pillar 1.

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