A manufacturer that runs out of cash disappoints its suppliers. A bank that runs out of cash can freeze an economy, which is why bank analysis starts with regulatory capital rather than with revenue growth.
Three features separate financial institutions from industrials. First, systemic importance: banks intermediate between capital providers and capital users, creating interlinkages across households, firms, and governments, so one failure propagates. Systemic risk is the risk that impairment of part of the financial system spreads and damages the whole economy; financial contagion is that spread in action. Second, their productive assets are predominantly financial (loans and securities), not tangible, which creates direct exposure to credit, liquidity, market, and interest rate risk, and means carrying values sit near fair value.
Regulation exists to constrain risk taking that could cause failure, and it targets capital held, liquidity maintained, and riskiness of assets. The Basel Committee on Banking Supervision, hosted by the Bank for International Settlements, developed Basel III, whose three headline requirements are a minimum capital ratio against risk-weighted assets, a stock of high-quality...
Common mistakes
- Averaging the CAMELS components. Six ratings of 2 do not guarantee a composite of 2. Weighting is examiner judgment.
- Reading a ratio jump as strength. A CET1 ratio rising from 4.13% to 5.50% purely because RWA shrank from $1,065 million to $800 million reflects shrinkage, not capital building.
- Treating all assets as 100% weighted. Cash carries 0%, so $1,020 million of assets in Example 1 produce only $1,015 million of RWA, and past-due loans carry more than 100%.
Bottom line
- Distinctive features: systemic importance, deposit-dominated liabilities, and predominantly financial assets carried near fair value
- Basel III pillars: minimum capital versus risk-weighted assets, 30-day liquidity stress coverage, and one-year stable funding
- Capital minimums: CET1 4.5% of RWA, Total Tier 1 6.0%, Total Capital 8.0%
- Risk weights: cash 0%, corporate loans 100%, past-due and high-volatility CRE above 100%; off-balance-sheet exposures included
Exam shortcut
When a vignette hands you a capital table, compute RWA first and check three ratios in order: CET1 against 4.5%, Tier 1 against 6.0%, Total against 8.0%. The trap answer usually reports one ratio passing while a lower tier fails. If a ratio improves, always ask which side moved: numerator (real capital building) or denominator (deleveraging or migration). "Composite CAMELS is the average" is always wrong.
The full lesson (about 2,031 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- financial institutions
Browse all free CFA Level II lessons or jump into free CFA Level II practice questions.