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

A risk officer is summarizing why the original 1988 Basel Accord was criticized in the years before the global financial crisis. Which feature of Basel I most directly allowed banks to reduce required capital without reducing true economic risk?

Basel I's crude risk-weight buckets, which treated all corporate loans alike at 100%, encouraged regulatory arbitrage. Banks could hold riskier assets or securitize the safest loans, cutting required capital without cutting real risk, because the capital rules did not distinguish borrower credit quality.

  1. ABroad risk-weight buckets that gave the same weight to all corporate loans regardless of borrower qualityCorrect
  2. BThe requirement that capital be held against operational risk using a standardized approach
  3. CA requirement to use internal VaR models for the banking book
  4. DA leverage ratio that applied to all off-balance-sheet exposures

Explanation

Basel I used a few crude risk buckets, with all corporate loans at 100%. Banks could therefore swap safer assets for riskier, higher-yielding ones within a bucket, or securitize the safer loans, lowering capital relative to true risk (regulatory arbitrage). The other options describe features Basel I did not have.

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