Nicole Seaman

Director of FRM Operations
Staff member
Learning outcomes: Identify the major risks faced by banks and explain ways in which these risks can arise. Distinguish between economic capital and regulatory capital. Summarize the Basel Committee regulations for regulatory capital and their motivations. Explain how deposit insurance gives rise to a moral hazard problem.


21.1.1. Banks face three major risks: market, credit, and operational risks. Each of the following is true about these major risks faced by banks EXCEPT which statement is false?

a. Market risk arises from exposure to market variables (aka, risk factors) and banks are always exposed to some market risk
b. Although credit risk includes unexpected (UL) and expected loss (EL), EL does not meet the strict definition of a risk; banks typically provision for (i.e., subtract) EL from loan principal upon transaction initiation (per IFRS 9 or CELC) prior to incurring the losses
c. Operational risk, which does include cyber and legal risk, is the hardest to quantify and considered by many to be the greatest challenge to banks
d. Derivative contracts should only map to one of the major risk categories (i.e., credit, market, or operational) but a single contract should never map to multiple categories

21.1.2. When referring to a bank's capital, it helps to be specific because there are different types of capital. Equity capital (aka, going concern capital) is the bank's essential buffer. Leverage is a measure of debt-to-equity (or debt-to-assets) such that less equity implies higher leverage. There is also a key distinction between regulatory and economic capital. Regulatory capital is a minimum capital requirement that is externally imposed, while economic capital is an internal measure. In regard to regulatory and economic capital, which of the following statements is TRUE?

a. Since the crisis, the Basel Committee has increased the reliance on internal models
b. Regulatory capital is the denominator in the risk-adjusted return on capital (RAROC) metric
c. Regulatory capital for credit risk is designed to cover a loss that is expected to be exceeded only once every four years
d. From a bank balance sheet perspective, the net stable funding ratio (NSFR) evaluates the bank's liabilities, while the liquidity coverage ratio (LCR) evaluates its assets

21.1.3. Peter and Emily are having a friendly debate about regulatory policy and the implications of moral hazard. Mary contends that deposit insurance gives rise to a moral hazard problem. Peter asserts that moral hazard is merely theoretical; he says it is an academic concern but not a realistic concern in the marketplace. Mary points to Acme Bank as evidence of a moral hazard problem. If it is a true observation, which of the following observations offers the BEST EVIDENCE in favor of the existence of a genuine moral hazard problem that has not been addressed or resolved?

a. Acme pays higher premiums to its primary federal regulator due to the higher risk of its assets
b. Acme bank offers higher interest rates to depositors in order to fund additional loans with very high yields
c. Acme bank offers lower interest rates to depositors in order to fund additional loans with very low yields
d. Acme's shareholders decide to increase their cost of equity capital as compensation for Acme's higher leverage

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