2025 FRM Exam Part I - 3. Financial Markets and Products

Learning Objectives

• After completing this reading, you should be able to:

  • Identify the major risks faced by banks and explain how these risks can arise.

  • Compare the characteristics and applications of 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.

  • Describe investment banking financing arrangements:

    • Private Placement

    • Public Offering

    • Best Efforts

    • Firm Commitment

    • Dutch Auction

  • Describe potential conflicts of interest among commercial banking, securities services, and investment banking divisions, and recommend solutions.

  • Distinguish between the banking book and trading book.

  • Explain the originate-to-distribute banking model and discuss its benefits and drawbacks.

The Role of Banks

• Banks are the cornerstone of the world's financial system.

• Activities can be subdivided into:

  • Commercial Banking: Receiving deposits and making loans.

    • Retail Banking: Transacting with individuals and small businesses.

    • Wholesale Banking: Transacting with large corporations, leading to lower administrative costs and smaller interest rate spreads.

  • Investment Banking: Activities include raising debt/equity capital, advising on mergers/acquisitions, and acting as broker-dealer for trading securities.

    • Historically, commercial and investment banks were separated (e.g., Glass-Steagall Act restrictions).

    • Post-2008 crisis regulations, e.g., restrictions on proprietary trading.

Major Risks in Banking

Market Risks

• Arise from exposure to fluctuations in market variables (e.g., exchange rates, interest rates, commodity prices).

• Affected by external events (e.g., Brexit influencing GBP, U.S. sanctions on Iran affecting oil prices).

Credit Risks

• Possibility of borrower defaults on debts, causing potential financial losses.

• Banks factor expected losses into loan pricing (e.g., net interest margin reflects expected losses).

• Operational challenges include calculating estimated losses and adjustments for derivatives.

Operational Risks

• Defined as losses from inadequate or failed internal processes, systems, or external events.

• Examples:

  • Internal fraud (rogue trading)

  • External fraud (cyberattacks)

  • Employment practices

  • Physical asset damage (natural disasters)

  • Business disruption (system failures)

Bank Regulation

Importance of Capital

• Equity Capital: Absorbs losses while the bank is active (going concern).

• Debt Capital: Only affected by losses when a bank is failed (gone concern).

• Distinction between regulatory capital (minimum capital requirement) and economic capital (internal risk assessment).

Basel Committee

• Established in 1974 to standardize international banking regulations.

• Basel I: Initial capital requirements focusing on credit risks.

• Basel II: Introduced operational risk capital requirements.

• Basel III: Enhanced requirements post-2008, increasing equity capital and liquidity ratios.

• Models used: standardized versus internal models, with emphasis on reducing reliance on internal models.

Trading Book vs Banking Book

• Trading Book: Assets/liabilities held for trading (market risk).

• Banking Book: Assets/liabilities held until maturity (credit risk).

Liquidity Ratios

• Importance highlighted during financial crises.

• Liquidity Coverage Ratio: Ensures funds to survive a 30-day financial stress.

• Net Stable Funding Ratio: Limits mismatches between assets and liabilities.

Deposit Insurance

• Introduced to protect depositors from bank failure losses.

• Can lead to moral hazard: banks taking more risks, knowing deposits are insured.

• Risk-based premiums help mitigate moral hazard effects.

Investment Banking

• Core activities include:

  • Capital raising through underwriting.

  • Types: Private placements vs. public offerings.

  • Best Efforts vs. Firm Commitment arrangements.

• Dutch Auctions: Market-driven price determination of shares, example of Google's IPO.

Conflicts of Interest

• Examples include pressure to sell securities, sharing confidential information, and creating favorable conditions for particular clients.

• Mitigated by Chinese walls.

• Regulatory changes post-crisis aimed at separating investment and commercial banking activities.

The Originate-to-Distribute Model

• Banks create and sell loans to outside investors.

• Used in mortgage markets where securities are created and sold, including subprime mortgages leading to the financial crisis.

• Facilitation of securitization allowed banks to offload risk but also contributed to the 2007-2008 crisis.