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P2.T7.20.7. Capital regulation before the global financial crisis (1st of 2)

Nicole Seaman

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Learning objectives: Explain the motivations for introducing the Basel regulations, including key risk exposures addressed and explain the reasons for revisions to Basel regulations over time. Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines. Describe measures introduced in the 1995 and 1996 amendments, including guidelines for netting of credit exposures and methods to calculate market risk capital for assets in the trading book.

(Source: Chapter 19, 2020 FRM Part II: Operational Risk and Resiliency, 10th Edition. Pearson Learning Solutions )

20.7.1. The Basel regulatory framework has undergone several major renovations, but started in the late 1980s when the Basel Committee on Banking Supervision (BCBS at https://www.bis.org/bcbs/) published the first Basel accord, which is now called Basel I; this original Basel I was implemented in 1992. According to Carey (GARP Chapter 19), which BEST summarizes the motivation(s) of the original Basel?

a. To formalize regulatory capital requirements with a set of regulations (i.e., Basel) that would become legal requirements and therefore carried the force of law; i.e., the motivation was legal
b. Regulators realized that specific measures of short- and long-term liquidity were necessary given that liquidity crunches had been the essential common denominator of recent financial disasters; i.e., the motivation was liquidity
c. The growth of cross-border finance required both the solvency of banks during stressful periods and fair competition (aka, level playing field) between banks competing in each other's home countries; i.e., the motivations were bank safety and competitive concerns
d. In the wake of a global recession, there was a motivation to incentivize banks to increase their lending (which had been historically low) in order to grow the developed and emerging economies; i.e., the motivation was economic recovery especially of emerging economies

20.7.2. In regard to the original Basel I accord, each of the following is true EXCEPT which is false?

a. There are (were) only four risk weights: zero, 20%, 50%, and 100%
b. Total regulatory capital must exceed 8.0% of risk-weighted assets (RWA) and Tier 1 capital must exceed 4.0% of RWA
c. Traditional off-balance-sheet exposures were converted to a credit-equivalent (CE) that, in turn, was assigned a risk weight based on the counterparty
d. The credit equivalent (CE) for derivatives was their current market value such that out-of-the-money positions subtracted from the bank's RWA

20.7.3. The original Basel I accord is generally viewed as successful but deficient. Several of its deficiencies arguably owe to simplicity; these over-simplifications were subsequently cured with additional rules but at the cost of complexity. For example, the original Basel I accord was about 30 pages, while Basel II was 250 pages. One weakness of Basel I was that it gave almost no credit for the netting of derivatives contracts. The 1995 Amendment, as GARP explains, "allowed reductions in credit equivalent amounts when enforceable bilateral netting agreements were in place."

Shortly after the 1995 Amendment, the 1996 Amendment was a major milestone and revision to the original Basel I accord. Which of the following statements is TRUE about the implication of the 1996 amendment?

a. It introduced the third pillar, which was praised for giving supervisors a consistent rule-enforcing playbook
b. Conditional on meeting several criteria including daily backtesting, banks could now employ their own internal value at risk (VaR) model to determine capital requirements for market risk
c. To reduce regulatory arbitrage, it removed all internal approaches so that only standardized approaches could be applied to credit, market, and operational risk, which had the effect of reducing regulatory arbitrage
d. The 1996 amendment removed Tier 2 capital so that only Tier 1 capital remained, but Tier 1 capital was bifurcated into common equity (highest quality buffer) and non-common equity

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