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FRM Exam Part I · Banks

Bank Regulation and Capital Basics for FRM Part I

Updated 11 October 2026 · Fact-checked

Banks are regulated because their failure harms depositors and the wider economy. Deposit insurance protects small depositors and prevents runs. Regulatory capital is the loss-absorbing funding banks must hold. Tier 1 absorbs losses while the bank operates; Tier 2 absorbs them mainly in failure. Solve questions by computing capital ÷ assets and comparing it to the requirement.

Understand Bank Regulation and Capital Basics

A bank funds long-term, illiquid loans with short-term deposits. If depositors fear losses, they all want their money back at once. The bank cannot sell its loans fast enough. This is a bank run, and it can spread to other banks.

This is why banks are regulated. Four reasons matter for the exam. Depositors are small and cannot judge a bank's health. A failure spreads to other banks (systemic risk). Banks fund themselves with a lot of borrowed money, so they have an incentive to take risk. And protecting depositors creates moral hazard, because insured depositors do not care how risky their bank is.

Deposit insurance is a government-backed scheme that guarantees deposits up to a limit. It stops runs because insured depositors have no reason to rush. The cost is moral hazard: the bank can take more risk because depositors no longer monitor it. Regulators respond with capital requirements, supervision and risk-based insurance premiums.

Regulatory capital is the funding a bank must hold that can absorb losses without the bank failing. Think of the balance sheet: assets = liabilities + equity. If loan losses reduce assets, equity falls first. Depositors are paid only after capital is used up. A bigger capital cushion means losses can be larger before the bank is insolvent.

Under the Basel framework, capital has tiers. Common Equity Tier 1 (CET1) is mainly common shares and retained earnings. It is the highest-quality capital. Additional Tier 1 (AT1) is other instruments that can absorb losses on a going-concern basis, such as perpetual instruments with loss-absorption features. Tier 1 = CET1 + AT1. Tier 2 is supplementary capital, such as certain subordinated debt, which absorbs losses mainly when the bank is failing (gone-concern). Total capital = Tier 1 + Tier 2. Capital is measured against risk-weighted assets (RWA), so riskier assets need more capital.

Key formulas to remember

Balance sheet identity
Assets = Liabilities + Equity
Losses reduce assets and hit equity first. If assets fall below liabilities, equity is negative and the bank is insolvent.
Total regulatory capital
Total capital = Tier 1 + Tier 2, where Tier 1 = CET1 + AT1
CET1 is the highest quality. Deductions (such as goodwill) apply before the ratios are calculated.
Capital ratio
Capital ratio = Capital ÷ Risk-weighted assets
Use CET1, Tier 1 or total capital in the numerator, depending on the ratio asked.
Risk-weighted assets
RWA = Σ (Exposure × Risk weight)
A higher risk weight means more capital is required against that exposure.
Loss absorption capacity
Loss before insolvency = Equity (capital) on the balance sheet
Insolvency occurs when losses exceed equity. Equity ÷ assets shows the percentage fall in asset value the bank can survive.

How to solve Bank Regulation and Capital Basics questions

Use this routine for conceptual and numerical questions on bank regulation and capital.

  1. 1Identify what is asked: a reason for regulation, a feature of deposit insurance, a capital tier, or a ratio calculation.
  2. 2For concept questions, link the answer to the core problem: runs, systemic risk, moral hazard or depositor protection.
  3. 3For capital tiers, classify each item: common equity and retained earnings are CET1; other going-concern instruments are AT1; subordinated gone-concern debt is Tier 2.
  4. 4Remove deductions the question mentions (such as goodwill) from capital before calculating.
  5. 5For RWA, multiply each exposure by its risk weight and add them up.
  6. 6Divide the correct capital measure by RWA and compare with the stated minimum.
  7. 7For loss absorption, subtract the loss from equity. If equity stays positive, the bank is solvent; otherwise it is insolvent.
  8. 8Check that the answer matches the wording: going-concern or gone-concern, Tier 1 or total capital.

Quickest way: Capital ratio and loss check in four moves

When to use it: Use when the question gives balance sheet or risk-weighted figures and asks for a ratio, a shortfall or a loss the bank can bear.

  1. Write down capital (with deductions) and RWA.
  2. Compute capital ÷ RWA as a percentage.
  3. Compare with the requirement. Shortfall = requirement × RWA − capital.
  4. For loss absorption, the bank survives while loss < equity; use equity ÷ assets for the percentage fall in assets.

Common mistakes in Bank Regulation and Capital Basics

  • Dividing capital by total assets instead of risk-weighted assets.

    Leverage ratios use total exposure, so the two ideas get mixed up.

    Fix: If the question says capital ratio or CET1 ratio, use RWA. Only use total assets or exposure if it says leverage.

  • Treating deposit insurance as having no downside.

    Its benefit, stopping runs, is easy to remember.

    Fix: Always pair it with moral hazard: insured depositors do not monitor risk, so banks may take more.

  • Placing subordinated debt in Tier 1.

    It ranks below deposits, so it seems like capital of the best kind.

    Fix: Tier 1 absorbs losses while the bank operates. Subordinated debt typically absorbs losses only in failure, so it is Tier 2.

  • Forgetting deductions such as goodwill.

    Candidates add all equity items and stop.

    Fix: Subtract any deductions the question lists before computing the ratio.

  • Confusing going-concern and gone-concern capital.

    Both phrases sound similar.

    Fix: Going-concern: absorbs losses while the bank keeps operating (Tier 1). Gone-concern: absorbs losses when it fails (Tier 2).

  • Thinking capital is cash the bank keeps in a vault.

    The word capital is read as a reserve of money.

    Fix: Capital is a source of funding (equity and similar), not an asset. Liquidity buffers are a separate topic.

Worked examples

Example 1

A bank has CET1 capital of $6 billion, AT1 of $1.5 billion and Tier 2 of $2.5 billion. Its risk-weighted assets are $80 billion. Calculate the CET1 ratio, the Tier 1 ratio and the total capital ratio.

Show the solution
  1. CET1 ratio = 6 ÷ 80 = 7.5%.
  2. Tier 1 capital = 6 + 1.5 = $7.5 billion. Tier 1 ratio = 7.5 ÷ 80 = 9.375%.
  3. Total capital = 7.5 + 2.5 = $10 billion. Total capital ratio = 10 ÷ 80 = 12.5%.

Answer: CET1 ratio 7.5%, Tier 1 ratio 9.375%, total capital ratio 12.5%.

Example 2

A bank has total assets of $200 billion, liabilities of $188 billion and equity of $12 billion. Loan losses of $9 billion occur, then a further $5 billion of losses. What is its position after each loss, and what fall in asset value could it absorb at the start?

Show the solution
  1. Start: assets = 188 + 12 = $200 billion. Equity ÷ assets = 12 ÷ 200 = 6%. The bank could absorb a 6% fall in asset value before equity is exhausted.
  2. After $9 billion loss: assets = 191, liabilities = 188, equity = 191 − 188 = $3 billion. The bank is still solvent.
  3. After the further $5 billion loss: assets = 186, liabilities = 188, equity = 186 − 188 = −$2 billion. The bank is insolvent.

Answer: It could absorb a 6% fall in assets at the start. It stays solvent after the first loss (equity $3 billion) but is insolvent after the second (equity −$2 billion), so depositors and other creditors bear the $2 billion shortfall unless insurance or authorities step in.

Exam tips

  • Expect short conceptual questions: why banks are regulated, what deposit insurance does, and the tier of a given instrument.
  • When deposit insurance appears, look for moral hazard as the drawback.
  • For ratio questions, check whether the denominator is RWA or total assets.
  • Rank capital by loss-absorbing quality: CET1, then AT1, then Tier 2.
  • Do the balance sheet in order: assets, liabilities, then equity as the balancing figure.

Practice questions from Banks

Bank Regulation and Capital Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Bank Regulation and Capital Basics: frequently asked questions

Why are banks regulated more heavily than other firms?

Banks hold public deposits, rely on short-term funding for illiquid assets and can spread failure to other institutions. Regulation aims to protect depositors and keep the financial system stable.

How does deposit insurance prevent bank runs?

It guarantees deposits up to a limit, so insured depositors have no reason to withdraw in a panic. The drawback is moral hazard, since depositors no longer monitor the bank's risk.

What is the difference between Tier 1 and Tier 2 capital?

Tier 1 (CET1 plus AT1) absorbs losses while the bank is still operating. Tier 2 is supplementary and absorbs losses mainly if the bank fails. CET1 is the highest quality of all.

How does bank capital absorb losses?

Losses reduce asset values and are charged against equity first. Depositors and other creditors lose money only after capital is used up, so more capital means a larger cushion.