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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

Which of the following best describes why reliance on external ratings for regulatory capital purposes contributed to the crisis in structured products?

Regulatory capital charges depended on external ratings, so AAA structured tranches required little capital yet paid extra yield. Banks were thus encouraged to load up on them, a form of regulatory arbitrage that concentrated losses when the ratings proved unreliable.

  1. AHigher-rated tranches carried lower capital charges, encouraging banks to hold AAA-rated structured securities that offered extra yield for little regulatory capitalCorrect
  2. BRatings were not allowed to be used for capital requirements, so banks relied on internal models only
  3. CAAA structured tranches carried higher capital charges than corporate bonds, causing banks to avoid them
  4. DCapital charges depended solely on the maturity of the security, not its rating

Explanation

Capital rules tied risk weights to external ratings, so AAA tranches required little capital while paying higher yields than similarly rated corporates. This created strong incentives for regulatory arbitrage and heavy holdings of senior structured tranches. The other options contradict how rules operated.

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