Regulatory Capital and Basel Flashcards

What are 'contingent convertible bonds' (CoCos) and what is their role in Basel III?

Answer: Hybrid instruments that automatically convert to equity or are written down when a bank's capital falls below a trigger level, absorbing losses on a going-concern basis

CoCos are designed to recapitalize a distressed bank automatically without government intervention; they qualify as Additional Tier 1 capital under Basel III when they have high-trigger (CET1 < 5.125%) conversion features.

What is the purpose of the 'Internal Capital Adequacy Assessment Process' (ICAAP)?

Answer: A bank's own internal process to assess whether its capital is adequate for all material risks it faces, including those not covered in Pillar 1

ICAAP (Pillar 2 requirement) requires banks to self-assess their capital needs across all risks — credit, market, operational, concentration, strategic, and reputational — and demonstrate sufficiency to their supervisor.

What is 'stress testing' under the Dodd-Frank Act (DFAST) for US banks?

Answer: A regulatory framework requiring large US banks to annually project their capital levels under baseline, adverse, and severely adverse macroeconomic scenarios

DFAST requires banks with $100B+ in assets to submit annual stress test results under Fed-prescribed scenarios, demonstrating they would remain adequately capitalized even in a severe recession.

Under the Basel standardized approach for credit risk, what risk weight is typically applied to unrated corporate exposures?

Answer: 100%

The Basel standardized approach assigns a 100% risk weight to unrated corporate claims, meaning a $100M unrated corporate loan requires $8M of regulatory capital (8% × 100% × $100M).

What is the 'output floor' introduced in Basel IV (Basel III finalization)?

Answer: A requirement that RWA calculated under internal models must be at least 72.5% of the RWA calculated under the standardized approach, limiting capital savings from internal models

The 72.5% output floor prevents banks from using sophisticated internal models to generate RWA far below standardized levels, ensuring a minimum level of capital across all banks regardless of modeling sophistication.

What is 'resolution planning' (living wills) under the Dodd-Frank Act?

Answer: A mandatory plan submitted by large financial institutions detailing how they could be wound down in an orderly manner without taxpayer support if they fail

Living wills (Title I of Dodd-Frank) require systemically important firms to maintain credible resolution plans so regulators can dismantle them quickly without bailouts or systemic disruption if they become insolvent.