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

In the Basel II IRB formula for corporate exposures, capital is derived from a conditional (stressed) default probability at a 99.9% confidence level using a single systematic risk factor. Which feature of this framework is most accurately described?

The IRB framework is portfolio-invariant: capital for each exposure depends only on its own PD, LGD, EAD and maturity, because it assumes a granular, well-diversified portfolio in which only a single systematic factor matters. Capital targets unexpected loss at 99.9%, with expected loss handled through provisions.

  1. ACapital is portfolio-dependent, so adding a loan requires re-estimating the correlation with all existing loans
  2. BCapital per exposure is portfolio-invariant, resting on the assumption of a well-diversified portfolio where only systematic risk mattersCorrect
  3. CCapital covers both expected and unexpected losses, with no separate provision treatment
  4. DCapital is computed using the 99% one-year VaR of the bank's trading book

Explanation

The IRB formula derives from the asymptotic single risk factor model (Vasicek), which makes capital for a loan independent of the rest of the portfolio, assuming granularity and a single systematic factor. Capital covers unexpected loss; expected loss is dealt with via provisions.

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