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

Which feature of Basel II's treatment of external credit ratings in the standardised approach contributed to pre-crisis weaknesses?

Basel II's standardised approach tied risk weights to external ratings, including for securitisation tranches. Highly rated tranches received low capital charges, so when those ratings proved too optimistic and the tranches lost value, banks held far too little capital against them.

  1. AHeavy reliance on rating agency assessments, including for structured products, which gave low weights to highly rated tranches that later suffered large lossesCorrect
  2. BA requirement that all exposures receive a 150% weight
  3. CA prohibition on using ratings for sovereign exposures
  4. DA rule that capital be set entirely by banks' own subjective judgement without validation

Explanation

The standardised approach mapped external ratings to risk weights, so AAA-rated securitisation tranches attracted very low charges. When these ratings proved overly optimistic, capital held was inadequate. The other options misstate the framework.

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