Every financial disaster the FRM tests has a clean diagnosis. Barings: rogue trader plus broken segregation. LTCM: leverage plus model risk plus liquidity drying up at once. Lehman: funding liquidity collapse on a $600B repo book. The exam asks you to match each case to its primary risk class and the lesson the industry took away. Memorize the cases, then memorize the lessons.
Risk management as a discipline learns from failure. Most post-1990 reforms (netting, central clearing, SIFI capital surcharges, BCBS 239, Volcker rule, over-the-counter (OTC) clearing) trace to specific blow-ups. The FRM tests these cases because they encode the profession's current best practices.
Each case has the same structure. A specific risk class goes unmonitored. A trigger event exposes the exposure. The firm fails or requires a bailout. The industry adopts a reform addressing the root cause.
KEY: The exam asks "what risk class drove Barings?" not "what year did Barings fail?" Focus on the risk-class taxonomy and the reforms.
Common mistakes
- Treating disasters as random outliers. Every major case has a clean diagnosis and a specific risk class as the root cause. Trap: a question asks which risk class drove a case; choices that say "complexity" or "bad luck" are wrong.
- Confusing market and funding liquidity. Both contributed to LTCM and Lehman, but they are distinct. Market = salability; funding = cash obligations. Trap: a question describes one; the choice describing the other is wrong.
- Treating CDS as the cause of the GFC. CDS amplified the crisis by spreading mortgage credit risk to entities (insurance companies, hedge funds) lacking capital cushions. The underlying cause was origination and securitization complexity. Trap: "CDS caused the GFC" overstates the role of derivatives.
Bottom line
- Disaster cases group by risk class: interest rate (S&L), funding liquidity (Lehman, Continental Illinois, Northern Rock), hedge implementation (Metallgesellschaft), model risk (LTCM, Niederhoffer, London Whale), rogue trading (Barings), financial engineering (Bankers Trust, Orange County), reputation (VW), governance (Enron), cyber (SWIFT).
- The GFC of 2007-09 combined subprime origination, securitization complexity, ratings shopping, opaque CDOs, repo runs, and central-bank policy unwinding too slowly; removing any one link might have prevented collapse.
- Subprime plus CDOs transferred credit risk from originators to investors who could not analyze it, and correlation breakdowns destroyed the AAA assumption.
- Short-term wholesale funding (repo, ABCP, money-market funds) creates systemic fragility because confidence-sensitive funding can disappear overnight.
Exam shortcut
When a question describes a financial disaster, identify the primary risk class first: funding liquidity, model risk, rogue trading, financial engineering, reputation, governance, or cyber. The diagnostic class drives the right answer. For GFC questions, remember the five-link chain: origination, securitization, ratings, opacity, funding fragility.
The full lesson (about 2,789 words, 19 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 1
- 2
- 3
- 4
- 5
- 6
- 7
- 8
- 9
- 10
- 11
Browse all free FRM Part I lessons or jump into free FRM Part I practice questions.