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

Which statement about a known weakness of Basel I risk weighting is correct?

Basel I applied a flat 100% risk weight to corporate loans whatever the borrower's credit quality. This ignored differences in risk and encouraged regulatory arbitrage, such as securitizing the safest loans while retaining riskier ones.

  1. AIt gave a lower weight to a loan to a AAA-rated corporation than to one rated B, differentiating by credit quality
  2. BIt applied the same 100% weight to all corporate loans regardless of credit quality, encouraging regulatory arbitrageCorrect
  3. CIt imposed a capital charge for market risk from inception in 1988
  4. DIt required banks to use internal ratings to set weights

Explanation

Basel I used broad buckets, so all corporate loans carried 100% regardless of rating. This created incentives to sell high-quality assets via securitization and keep riskier ones. Market risk was added by the 1996 amendment, and internal ratings came with Basel II.

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