A regional bank holds $50 billion in deposits and lends most of it long. A life insurer holds $50 billion in policy reserves and matches them against bonds. A hedge fund holds $50 billion in assets and earns 2-and-20. Same balance-sheet size, three completely different risk profiles. The exam tests whether you know which risks each institution faces and how the regulatory frame responds to those risks.
A bank takes short-term deposits and writes long-term loans. That maturity transformation is the source of profit and the source of risk. Five risk classes show up on every FRM Part I question about banks.
- Credit risk: borrowers default. Largest single risk for most commercial banks.
- Market risk: trading-book positions lose value when rates, FX, or equity prices move.
- Operational risk: fraud, system failures, legal losses. Sits inside the Basel capital frame.
- Liquidity risk: depositors withdraw faster than the bank can sell assets without a fire-sale haircut.
- Business / strategic risk: fee income drops, a new entrant takes share, regulation shifts.
Common mistakes
- Confusing economic capital with regulatory capital. Economic capital is risk-sensitive and internal; regulatory capital is rule-based and floor-driven. Trap: a question gives a bank's 99.9% one-year loss distribution and asks for "the Basel-required capital": the answer is computed from RWAs and the 4.5% / 6% / 8% Basel ratios, not from the loss distribution.
- Reading combined ratio as profit margin. A 95% combined ratio is not a 5% profit margin. It is a 5% underwriting margin BEFORE investment income on reserves. Trap: candidate sees combined ratio 95% and concludes return on equity (ROE) = 5%; the actual operating ratio after investment income is materially better, and ROE depends on...
- Confusing DB and DC risk-bearing. DB plans put longevity and investment risk on the SPONSOR. DC plans put it on the EMPLOYEE. Trap: question describes a 401(k) and asks "who bears longevity risk?": answer is the employee, not the employer.
Bottom line
- Banks face credit, market, operational, liquidity, and business risk; capital absorbs unexpected loss; the banking book holds loans at amortized cost while the trading book is mark-to-market.
- Economic capital is internal and risk-sensitive at a confidence level; regulatory capital floors loss at Basel ratios; migrating positions between banking and trading books needs supervisor approval.
- Originate-to-distribute earns fees without holding loans but weakens screening incentives, a key driver of 2007-09; Dodd-Frank now requires 5% securitization risk retention.
- Insurers split into life (mortality + longevity) and P&C (catastrophe + underwriting); combined ratio = loss ratio + expense ratio; under 100% means underwriting profit before investment income.
Exam shortcut
When the question gives a P&C income statement, jump straight to combined ratio first: it is the cleanest summary of underwriting health, and the operating ratio takes one more step. When the question describes hedge fund returns, ask whether the high-water mark is binding before you multiply 20% by anything. For ETF questions, the right answer almost always involves the AP create/redeem mechanism, not direct fund flows.
The full lesson (about 3,206 words, 21 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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