9.1 Banks

Banks

Banks sit at the center of FMP–1 because almost every later market product—loans, deposits, underwriting, and trading—touches a bank balance sheet. FRM candidates must see banks as risk transformers: they borrow short (deposits, wholesale funding), lend long (mortgages, corporate credit), and warehouse market risk in trading books. Understanding which risks they take, how capital absorbs them, and how business models shift risk onto others is the backbone of this reading.

Core Bank Risks

A commercial bank’s risk map is broader than “borrowers may default.”

Credit risk is the classic franchise risk: probability of default (PD), loss given default (LGD), and exposure at default (EAD) determine expected loss, while unexpected loss drives capital. Market risk appears when positions are marked to market. Interest-rate risk in the banking book (IRRBB) is distinct from trading-book market risk: a bank can have little trading VaR and still suffer when deposit betas lag or fixed-rate mortgages reprice slowly. Liquidity risk has two faces—funding liquidity (can I roll liabilities?) and market liquidity (can I sell assets without a deep discount?). Operational risk covers people, systems, and external events.

These risks interact. A credit downgrade triggers mark-to-market losses, collateral calls, and funding-spread widening at once. Exam questions often ask which risk is primary in a scenario—and whether a second risk is being ignored.

Economic Capital Versus Regulatory Capital

Economic capital is the internal estimate of capital needed to absorb unexpected losses at a chosen confidence level (for example, enough to keep the one-year default probability of the bank consistent with a target rating). It is model-driven, risk-sensitive, and used for RAROC, limit setting, and performance measurement.

Regulatory capital is the amount supervisors require under Basel-style frameworks: risk-weighted assets (RWA) multiplied by minimum ratios (CET1, Tier 1, total capital), plus buffers. It is standardized for comparability and systemic safety, but it can diverge from a bank’s own view of risk.

Worked sketch

Suppose a loan portfolio has unexpected-loss economic capital of $800 million at the bank’s internal 99.9% standard, but Basel RWA capital for the same book is $1.1 billion. The binding constraint for growth is regulatory capital: the bank cannot expand that book freely just because economic capital looks lighter. Conversely, if economic capital were $1.4 billion against $1.1 billion regulatory, risk management should treat the portfolio as riskier than the rulebook implies and constrain it with internal limits.

Exam trap: equating “capital” with expected loss. Expected loss belongs in pricing and provisions; capital is primarily for unexpected and tail loss.

Basel Motivations (High Level)

Basel accords exist because bank failures create externalities—depositors, payment systems, and other banks suffer when one large bank collapses. High-level motivations include:

1. Minimum capital adequacy so equity and loss-absorbing instruments back credit, market, and operational risk.
2. Risk sensitivity (especially under internal models and later reforms) so capital rises with riskier books.
3. Level playing field across internationally active banks.
4. Supervisory review and disclosure (pillars beyond the minimum ratio) to catch model gaps and market discipline failures.
5. Liquidity standards (post-crisis LCR/NSFR-style ideas) because capital alone does not stop a run.

You do not need full Basel III/IV arithmetic in FMP–1, but you must know why regulators impose capital floors, buffers, and liquidity rules: private incentives underprice systemic risk.

Deposit Insurance and Moral Hazard

Deposit insurance (for example, FDIC-style schemes) protects insured depositors and reduces the incentive to run at the first rumor. That stability is valuable—but it creates moral hazard: if deposits are guaranteed, depositors monitor banks less carefully, and bank equity holders may take more asset risk because downside is partly socialized.

Supervisors respond with capital requirements, risk-based insurance premiums, activity restrictions, prompt corrective action, and resolution regimes. Without those offsets, insurance alone encourages risk-shifting.

Mini example

Bank A funds speculative CRE loans with insured deposits. Depositors stay put because balances are insured. Equity holders capture upside if CRE booms; taxpayers and the insurance fund absorb more of the downside if CRE crashes. Capital rules and supervision exist precisely to blunt that asymmetry.

Investment-Bank Financing Methods

Investment banks help issuers raise capital. Know the placement mechanics and who bears unsold inventory risk.

In a firm commitment, the investment bank’s trading/underwriting book can take a mark-to-market loss if the issue is mispriced or markets gap before distribution. In best efforts, the issuer may raise less capital than planned. Dutch auctions (used notably in some equity offerings) aim for transparent clearing prices rather than a negotiated fixed offer price.

Worked example: firm commitment vs best efforts

An issuer wants to sell 10 million shares. Under a firm commitment at $20, the underwriter pays $200 million (ignoring spreads) and must place the stock. If the market clears at $18, the underwriter’s inventory loss is roughly $2 per share on the unsold book—underwriting risk is real market risk. Under best efforts at a $20 target, if only 7 million shares clear at $20, the issuer raises $140 million and keeps the unmet funding gap—placement shortfall risk stays with the issuer.

Conflicts Across Banking Divisions

Universal and large banks house conflicting franchises:

• Lending wants credit exposure; trading may want to short the same name.
• Advisory/M&A learns nonpublic deal information; sales & trading must not misuse it.
• Research should be independent; investment banking may pressure for favorable coverage.
• Proprietary risk-taking can collide with client market-making and best execution.

Chinese walls, restricted lists, compliance surveillance, and compensation design are control responses—not guarantees. FRM questions often frame a conflict and ask which division’s incentive creates the agency problem.

Banking Book Versus Trading Book

The banking book holds positions intended to be held for the longer term—loans, deposits, and many AFS/HTM-style portfolios historically—valued under accrual or amortized-cost logic with impairment rules. The trading book holds positions for short-term profit from market moves, marked to market (or model) with market-risk capital.

Boundary games matter: booking a trading-intent position in the banking book (or vice versa) can change capital, P&L volatility, and governance. Regulators tightened trading-book definitions after crisis-era migration of risks. For the exam, link intent and liquidity to book assignment, and link book assignment to valuation and capital treatment.

Originate-to-Distribute (OTD)

In originate-to-distribute, banks originate loans (mortgages, corporates, consumer) and distribute them via syndication, whole-loan sales, or securitization rather than holding them to maturity. Benefits: fee income, balance-sheet velocity, and transfer of credit risk to investors. Costs: weaker incentives to screen and monitor if the originator keeps little risk (skin in the game problem), reliance on ratings and complex structures, and warehouse risk if distribution pipelines freeze.

OTD does not eliminate risk—it relocates and sometimes transforms it (into tranche, liquidity, and reputational risk). The GFC showed how OTD plus leverage and short-term funding produced systemic fragility.

Putting Bank Topics Together

A bank that expands CRE lending funded by insured deposits, books the loans in the banking book, holds thin economic capital relative to true UL, and plans to distribute via securitization is stacking credit, liquidity, moral-hazard, and OTD incentive risks. FMP–1 wants you to name each layer—not just say “the bank has risk.”