CORES Basel Framework & Capital Requirements 5 — Questions and Answers
Question 1: Under Basel III, Additional Tier 1 (AT1) capital instruments must contain what feature that allows regulators to trigger loss absorption?
- A mandatory conversion to senior debt at the point of non-viability
- A write-down or conversion to common equity trigger at or before point of non-viability (PONV) (Correct answer)
- An automatic dividend suspension provision linked to earnings
- A required buyback clause exercisable by the issuing bank
Correct answer: A write-down or conversion to common equity trigger at or before point of non-viability (PONV)
AT1 instruments must include contractual triggers that allow write-down or conversion to CET1 at the point of non-viability to qualify as regulatory capital.
Question 2: Which Basel I concept was criticized for allowing significant regulatory capital arbitrage through securitization?
- The 8% minimum capital ratio applied to all assets uniformly
- The bucket-based risk weight system with limited differentiation within credit categories (Correct answer)
- The exclusion of off-balance-sheet items from capital calculations
- The use of book value rather than fair value for capital measurement
Correct answer: The bucket-based risk weight system with limited differentiation within credit categories
Basel I's crude bucket-based risk weights (0%, 20%, 50%, 100%) enabled banks to securitize high-quality assets and retain lower-quality ones with the same capital charge.
Question 3: The Basel FRTB framework introduced a P&L attribution test. What happens if a bank's trading desk fails this test?
- The desk must switch from the IMA to the SA for capital calculation purposes (Correct answer)
- The desk must immediately halt trading until models are recalibrated
- The desk receives a multiplier penalty applied to its VaR-based requirement
- The desk is required to obtain external model validation within 90 days
Correct answer: The desk must switch from the IMA to the SA for capital calculation purposes
Under FRTB, a trading desk that fails the P&L attribution test must use the Standardized Approach rather than the Internal Models Approach for capital purposes.
Question 4: Under Basel III, which of the following is NOT eligible for inclusion as High-Quality Liquid Assets (HQLA) in the Level 1 category?
- Central bank reserves
- Government securities with 0% risk weight
- Covered bonds rated AA- or higher (Correct answer)
- Coins and banknotes
Correct answer: Covered bonds rated AA- or higher
Covered bonds rated AA- or higher are classified as Level 2A HQLA, not Level 1, because they are subject to a 15% haircut.
Question 5: In the Basel III capital framework, what is the consequence for a bank whose CET1 ratio falls within the capital conservation buffer zone?
- The bank must immediately raise new equity capital within 30 days
- The bank faces restrictions on discretionary distributions such as dividends, buybacks, and bonuses (Correct answer)
- The bank is placed under formal supervisory intervention with potential receivership
- The bank must reduce its risk-weighted assets by at least 10% within one quarter
Correct answer: The bank faces restrictions on discretionary distributions such as dividends, buybacks, and bonuses
When CET1 falls into the conservation buffer zone (4.5%–7%), banks face restrictions on distributions to preserve capital.
Question 6: What was the key operational risk lesson from the 2008 financial crisis that influenced the Basel Committee's revision of the operational risk framework?
- External fraud losses were dramatically underestimated relative to internal fraud
- Banks using the AMA underestimated losses because their internal models were too conservative
- Conduct and mis-selling losses proved far larger than historical loss databases had captured, exposing backward-looking model limitations (Correct answer)
- Execution and delivery errors caused more losses than any other Basel event type
Correct answer: Conduct and mis-selling losses proved far larger than historical loss databases had captured, exposing backward-looking model limitations
The 2008 crisis revealed that conduct-related and mis-selling losses far exceeded what backward-looking AMA models predicted, leading to the SMA's adoption.
Question 7: Basel III introduced the concept of 'gone concern' loss absorption. Which capital tier is specifically designed to absorb losses when a bank is being resolved rather than as a going concern?
- Common Equity Tier 1 (CET1)
- Additional Tier 1 (AT1)
- Tier 2 (Correct answer)
- Tier 3
Correct answer: Tier 2
Tier 2 capital is designed to absorb losses in a gone-concern scenario (liquidation or resolution), subordinate to depositors and senior creditors.
CORES Basel Framework & Capital Requirements 5
Under Basel III, Additional Tier 1 (AT1) capital instruments must contain what feature that allows regulators to trigger loss absorption?