This approach – in which (1) the same amount of regulatory capital is assessed against all unsecured corporate loans and bonds regardless of actual risk, (2) all unsecured consumer credit card exposures are treated equivalently, and (3) almost all firstlien residential mortgage exposures are deemed equally risky – provides incentives for banking organizations to shed relatively low-risk exposures and acquire relatively high-risk exposures within each of these asset classes.
The existing Basel I rule also ignores important elements of credit-risk mitigation – such as most forms of collateral, many guarantees and credit derivatives, and the maturity and seniority of an exposure – and thus blunts bank incentives to reduce or otherwise manage risk.