Skip to content

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

Before the crisis, a bank holds a portfolio of AAA-rated commercial loans and moves them to an off-balance-sheet conduit, retaining a liquidity guarantee that carried a low credit conversion factor. Under Basel I, what is the primary effect of this action?

Required capital falls substantially while economic risk largely remains with the bank. A liquidity guarantee with a low credit conversion factor cuts risk-weighted assets, yet the bank still bears the losses if the conduit fails, which is classic regulatory capital arbitrage under Basel I.

  1. ARequired capital falls substantially while much of the economic risk remains with the bankCorrect
  2. BRequired capital rises because off-balance-sheet items carry a 100% conversion factor
  3. CRequired capital is unchanged because the loans remain on the balance sheet
  4. DRequired capital is replaced by a market risk charge under the 1996 Amendment

Explanation

Moving assets to a conduit with only a low-conversion-factor liquidity line cut the risk-weighted assets, so capital fell, yet the bank still bore the risk through the line and reputational support. This is regulatory capital arbitrage. The assets were not moved into the trading book, so the market risk charge does not apply.

Did you get it right without looking?

One question tells you little. A timed set on Capital Regulation Before the Global Financial Crisis shows your real accuracy, how long you take and where you lose marks.

Practise Capital Regulation Before the Global Financial CrisisFree diagnostic mock

More Capital Regulation Before the Global Financial Crisis questions