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

Which feature of the pre-crisis Basel II framework most directly contributed to concerns that required capital would rise in downturns and thereby amplify the economic cycle?

Risk-sensitive requirements based on point-in-time ratings or default probabilities caused procyclicality. In a downturn, borrower quality worsens and risk weights rise, so banks need more capital when it is hardest to raise, leading them to cut lending and deepen the downturn.

  1. AA fixed 8% minimum applied to risk-weighted assets
  2. BCapital requirements tied to point-in-time ratings or PD estimates that worsen as conditions deteriorateCorrect
  3. CThe use of a simple leverage ratio as a backstop
  4. DDeduction of goodwill from Tier 1 capital

Explanation

Under the ratings-based and IRB approaches, risk weights rise as borrower PDs and ratings deteriorate in a recession. Banks must then hold more capital just when it is scarce, so they cut lending, which amplifies the downturn. A fixed 8% minimum and goodwill deductions are not cyclical, and the leverage ratio was not a Basel II feature.

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