Statement I is incorrect. All the risks, except credit risk, are examples of market risk. Regulatory capital is calculated for three distinct risks: credit risk, market risk, and Basel II added the operational risk.
Statement II is incorrect. Operational risk capital is estimated based on a fixed percentage of the prior three years of annual gross income.
Statement III is correct. Legal risk, documentation risk, and liquidity risk are residual risk that may arise when credit risk mitigation (CRM) techniques are applied. For example, the inability to secure collateral would be a residual risk.
Statement IV is correct. The IRB method models credit risk as a function of debtor’s income, which, in turn, is correlated with the business cycle. Higher debtor’s income produces lower credit risk, and lower capital requirements promote easy credit in boom (or recovery). The opposite is true under recession (or trough), at which time lower debtor’s income produces higher credit risk, and higher capital requirements promote tighter credit.
