Financial Risk Management Regulatory Capital and Basel 2 — Questions and Answers
Question 1: What is the 'Liquidity Coverage Ratio' (LCR) under Basel III?
- Net Stable Funding / Total Assets ≥ 100%
- High Quality Liquid Assets / Net Cash Outflows over 30 days ≥ 100% (Correct answer)
- Tier 1 Capital / Short-term Borrowings ≥ 10%
- Cash and Equivalents / Total Deposits ≥ 20%
Correct answer: High Quality Liquid Assets / Net Cash Outflows over 30 days ≥ 100%
The LCR requires banks to hold enough High Quality Liquid Assets (HQLA) to survive a 30-day stress scenario of combined retail and wholesale funding outflows, ensuring short-term liquidity resilience.
Question 2: What is the 'Net Stable Funding Ratio' (NSFR) under Basel III?
- Available Stable Funding / Required Stable Funding ≥ 100% (Correct answer)
- Short-term Funding / Long-term Assets ≥ 80%
- Tier 2 Capital / Total Deposits ≥ 10%
- Liquid Assets / Total Liabilities ≥ 25%
Correct answer: Available Stable Funding / Required Stable Funding ≥ 100%
The NSFR requires banks to fund long-term, illiquid assets with stable, long-term funding sources, addressing structural funding mismatches that contributed to the 2008 crisis.
Question 3: What is the 'Fundamental Review of the Trading Book' (FRTB) under Basel IV?
- A comprehensive revision to trading book capital rules replacing VaR with Expected Shortfall, imposing stricter boundary rules, and introducing desk-level model approval (Correct answer)
- A new accounting standard requiring fair value measurement for all trading book instruments
- A review process where regulators audit trading books every three years
- A mandatory stress test for banks with trading assets exceeding $50 billion
Correct answer: A comprehensive revision to trading book capital rules replacing VaR with Expected Shortfall, imposing stricter boundary rules, and introducing desk-level model approval
FRTB (Basel IV) replaces 99% 10-day VaR with 97.5% ES, tightens the banking/trading book boundary to prevent regulatory arbitrage, and introduces granular desk-level internal model approval.
Question 4: What is 'Pillar 2' in the Basel framework?
- The minimum capital ratio requirement published in official Basel accords
- The supervisory review process where regulators assess bank-specific risks not fully captured in Pillar 1 and can impose additional capital requirements (Correct answer)
- The market discipline pillar requiring public disclosure of risk exposures
- The liquidity risk framework including LCR and NSFR requirements
Correct answer: The supervisory review process where regulators assess bank-specific risks not fully captured in Pillar 1 and can impose additional capital requirements
Pillar 2 gives supervisors the authority to require banks to hold capital above the Pillar 1 minimum if their risk profile (concentration risk, interest rate risk in the banking book, etc.) warrants it.
Question 5: What is 'Pillar 3' of the Basel framework?
- The operational risk capital calculation methodology
- Market discipline through mandatory public disclosure of capital, risk exposures, and risk management practices to enable external stakeholders to assess a bank's risk profile (Correct answer)
- The internal capital adequacy assessment process (ICAAP)
- The supervisory stress testing framework conducted by central banks
Correct answer: Market discipline through mandatory public disclosure of capital, risk exposures, and risk management practices to enable external stakeholders to assess a bank's risk profile
Pillar 3 harnesses market forces by requiring standardized disclosures so that investors, analysts, and counterparties can compare bank risk profiles and discipline excessive risk-taking through pricing.
Question 6: What does 'Tier 1 capital' consist of under Basel III?
- Only common equity (CET1), which includes retained earnings and paid-in capital
- Common Equity Tier 1 (CET1) plus Additional Tier 1 (AT1) instruments such as contingent convertible bonds (CoCos) (Correct answer)
- Subordinated debt, hybrid instruments, and general loan loss reserves
- Total equity plus long-term senior unsecured debt
Correct answer: Common Equity Tier 1 (CET1) plus Additional Tier 1 (AT1) instruments such as contingent convertible bonds (CoCos)
Tier 1 = CET1 (common shares + retained earnings) + AT1 (perpetual instruments with mandatory write-down or conversion triggers like CoCos); it forms the highest-quality going-concern capital.
Financial Risk Management Regulatory Capital and Basel 2
What is the 'Liquidity Coverage Ratio' (LCR) under Basel III?