Skip to content

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

Before the crisis, a bank moved a pool of mortgage loans into an off-balance-sheet conduit supported by a liquidity line with maturity under one year, which carried a low credit conversion factor under Basel II's securitisation framework. Which weakness does this best illustrate?

It illustrates capital arbitrage. Short-maturity liquidity lines to off-balance-sheet conduits carried low conversion factors, so banks retained the risk with little capital. When funding markets seized, they had to support these vehicles, and losses returned to their balance sheets.

  1. ACapital arbitrage exploiting low charges on short-term liquidity commitments to off-balance-sheet vehiclesCorrect
  2. BOverly conservative capital treatment of residential mortgages
  3. CExcessive reliance on the leverage ratio
  4. DPenalising banks for holding high-quality liquid assets

Explanation

Short-term liquidity facilities attracted a very low conversion factor, so banks could keep the risk of vehicles like conduits while holding little capital. When funding markets froze, banks had to support the vehicles, bringing the risk back onto their balance sheets. The other options contradict this pattern.

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