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

Which statement best describes how the pre-crisis definition of regulatory capital contributed to the weaknesses revealed in the crisis?

Pre-crisis Tier 1 included hybrid instruments with limited ability to absorb losses while the bank continued operating. Reported ratios therefore looked strong while common equity was thin, which is why Basel III later focused on higher-quality common equity.

  1. ATier 1 included hybrid and other instruments with limited loss-absorbing capacity, so reported ratios overstated true going-concern strengthCorrect
  2. BTier 1 consisted only of common equity, which was too restrictive
  3. CCapital was defined without regard to risk-weighted assets
  4. DTier 3 capital was abolished before the crisis

Explanation

Pre-crisis Tier 1 allowed innovative hybrids and large deductions were not harmonized, so banks reported high Tier 1 ratios with a thin layer of common equity. Losses exposed that these instruments did not absorb losses on a going-concern basis. Basel III later emphasized common equity. Tier 3 still existed for market risk before the crisis.

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