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

A risk officer reviewing pre-crisis capital rules notes that Basel I assigned a 100% risk weight to nearly all corporate loans regardless of borrower quality. Which consequence of this feature most directly motivated the move to Basel II?

Because Basel I applied the same 100% weight to all corporate loans, capital did not reflect borrower risk, encouraging banks to hold riskier, higher-yielding loans for the same capital charge. This lack of risk sensitivity was a central motivation for Basel II.

  1. ABanks had an incentive to shift toward riskier corporate exposures within the same weight bucket, since capital did not vary with riskCorrect
  2. BBanks were forced to hold excessive capital against sovereign debt of all OECD countries
  3. CBanks were prevented from using any internal models for market risk
  4. DBanks had to deduct all unrealised gains from Tier 1 capital

Explanation

A flat weight means a high-quality and a low-quality corporate loan need the same capital, so banks earn more by holding the riskier, higher-yielding loan. This lack of risk sensitivity was a key motivation for Basel II. The other options describe features unrelated to the flat corporate weight.

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