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

Under the Basel II standardized approach, a bank takes eligible financial collateral against a loan. Which treatment best describes the comprehensive approach to credit risk mitigation?

The comprehensive approach applies supervisory haircuts to both the exposure and the collateral, computes a net exposure after haircuts, and applies the counterparty's risk weight to that net amount. It does not use full market value of collateral or wholesale risk-weight substitution.

  1. AThe exposure and collateral are both adjusted with supervisory haircuts, and the net exposure after haircuts receives the counterparty's risk weightCorrect
  2. BThe collateral's risk weight simply replaces the borrower's risk weight for the whole exposure regardless of value
  3. CThe collateral is ignored for capital but reduces the bank's expected loss provisions
  4. DCollateral reduces the exposure by its full market value with no haircuts

Explanation

In the comprehensive approach, the exposure is increased and the collateral value reduced by haircuts (for volatility and currency mismatch), giving E* = max(0, E(1+He) - C(1-Hc-Hfx)). The risk weight of the counterparty applies to E*. Substitution of the collateral's risk weight describes the simple approach and only to the covered part.

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