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

Before the crisis, a bank moved a portfolio of high-quality residential mortgages into an off-balance-sheet conduit supported by a liquidity line with a maturity under one year. Under the pre-crisis rules, such short-term commitments attracted a 0% credit conversion factor. What was the main weakness this exposed?

The weakness was that short-term liquidity support to conduits needed no capital under a 0% conversion factor. When commercial paper funding dried up, banks had to take the assets back onto their balance sheets, creating losses and liquidity pressure that capital had not covered.

  1. ABanks could hold little capital against contingent liquidity support yet bear substantial risk when the conduit funding failedCorrect
  2. BThe leverage ratio forced banks to consolidate all conduits
  3. CThe advanced approaches overstated operational risk
  4. DRisk weights for residential mortgages were set too high

Explanation

A 0% conversion factor for short-term liquidity facilities meant no capital was required for commitments. When asset-backed commercial paper markets froze in 2007, banks had to fund the conduits on balance sheet, producing large unexpected losses and liquidity strain.

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