FRM Exam Part I · Banks

Bank Risks, Liquidity and Funding for FRM Part I

Q: What are the main risks banks face in FRM Part I?

The core four are credit, market, operational and liquidity risk. You must be able to classify an event into the right one and explain its cause.

Q: How do I calculate the bank leverage ratio?

Divide Tier 1 capital by the total exposure measure, which includes off-balance-sheet items. It is not risk-weighted. Basel III sets a 3% minimum.

Q: What causes a bank run?

A run starts when depositors or short-term lenders fear losses and withdraw funds at once. Uninsured balances, short-term wholesale funding and maturity mismatch make it more likely. Fire sales then deepen the problem.

Q: What is the difference between LCR and NSFR?

LCR tests whether a bank has enough high-quality liquid assets to cover net outflows over 30 days. NSFR tests whether stable funding supports assets and activities over one year. Both must be at least 100%.

Updated 11 October 2026 · Fact-checked

Banks face credit, market, operational and liquidity risk. Liquidity risk is the danger of being unable to meet cash obligations as they fall due. Funding choices, such as short-term wholesale debt, raise run risk. To solve questions, identify the risk type, then apply the ratio: leverage = Tier 1 capital ÷ exposure, or LCR = HQLA ÷ 30-day net outflows.

Understand Bank Risks, Liquidity and Funding

A bank takes deposits and other short-term funding and lends or invests for longer periods. This is maturity transformation. It earns a spread, but it creates risks you must be able to name and separate.

Credit risk is the loss when a borrower or counterparty fails to pay. Market risk is the loss from moves in interest rates, FX rates, equity prices or commodity prices, mostly in the trading book. Operational risk is the loss from failed processes, people, systems or external events, including fraud and legal events. Liquidity risk has two sides. Funding liquidity risk is being unable to raise cash to meet obligations. Market liquidity risk is being unable to sell an asset quickly without a large price drop.

Funding choices decide how fragile a bank is. Insured retail deposits are sticky. Uninsured corporate deposits and short-term wholesale funding, such as repo and commercial paper, can leave fast. A bank that funds long-term assets with overnight money must keep rolling that funding over. If lenders refuse, it must sell assets at fire-sale prices.

A bank run happens when depositors or lenders fear a loss and withdraw funds at once. Withdrawing is rational for each person, because those who leave first get paid in full. This makes the fear self-fulfilling. Runs are driven by doubts about solvency, a lack of deposit insurance, uninsured balances, and a reliance on short-term wholesale funding. Fire sales then lower asset values and fuel more doubt.

Regulation responds with capital and liquidity rules. The leverage ratio is a simple, non-risk-weighted backstop to risk-based capital. The Liquidity Coverage Ratio (LCR) tests 30-day survival. The Net Stable Funding Ratio (NSFR) tests whether longer-term assets have stable funding. Central bank lending and deposit insurance are the main public backstops.

Key formulas to remember

Basel III leverage ratio: Leverage ratio = Tier 1 capital ÷ Total exposure measure; Not risk-weighted. Basel III sets a minimum of 3%. Do not confuse with assets ÷ equity, which is the inverse idea.
Equity multiplier: Equity multiplier = Total assets ÷ Equity; A simple leverage measure. A 5% equity ratio means leverage of 20 times.
Liquidity Coverage Ratio: LCR = Stock of HQLA ÷ Total net cash outflows over 30 days ≥ 100%; Net outflows = outflows − min(inflows, 75% of outflows).
Net Stable Funding Ratio: NSFR = Available stable funding ÷ Required stable funding ≥ 100%; Covers a one-year horizon.
Funding gap: Funding gap = Loans − Deposits; A positive gap must be met by wholesale funding or asset sales.
Loan-to-deposit ratio: Loan-to-deposit = Loans ÷ Deposits; A high value signals reliance on non-deposit funding.

How to solve Bank Risks, Liquidity and Funding questions

Use this routine for any question on bank risks, liquidity or funding.

1Read the stem and name the risk: credit, market, operational, funding liquidity or market liquidity.
2Underline the cause. A borrower default is credit. A rate or price move is market. A failed process or fraud is operational. Inability to raise cash is liquidity.
3If the question is numeric, pick the ratio: leverage, LCR, NSFR, funding gap or loan-to-deposit.
4Write the formula, then place each number. Check that you use Tier 1 capital for leverage and HQLA for LCR.
5For LCR, cap inflows at 75% of outflows before subtracting.
6Compute and compare with the regulatory minimum (3% leverage, 100% LCR and NSFR).
7For conceptual questions, check each option for run triggers: uninsured funding, short maturity, loss of confidence, fire sales.
8Eliminate options that mix up risk types or reverse a direction, such as saying more short-term funding lowers run risk.

Quickest way: Label the risk, then plug into the ratio

When to use it: Use when you have about 90 seconds and the stem gives clear numbers or a clear event.

Name the risk in three words from the stem's trigger event.
For ratios, write numerator ÷ denominator and fill in at once.
For LCR, test the 75% inflow cap first. It is a common trap.
Compare with 3% or 100% and choose the option that matches.
For run questions, choose the answer that points to uninsured, short-term funding and loss of confidence.

Common mistakes in Bank Risks, Liquidity and Funding

Using risk-weighted assets as the denominator of the leverage ratio.
Capital ratios usually use RWA, so the habit carries over.
Fix: The leverage ratio uses total exposure, not risk-weighted. That is its purpose.
Counting all expected inflows against outflows in the LCR.
Students forget the cap.
Fix: Inflows are limited to 75% of outflows, so net outflows are at least 25% of gross outflows.
Mixing up funding liquidity and market liquidity.
Both use the word liquidity.
Fix: Funding liquidity is about raising cash. Market liquidity is about selling assets without moving the price.
Treating a bank run as only a result of insolvency.
It seems logical that only bad banks face runs.
Fix: A run can hit a sound bank because withdrawal is rational if others withdraw. It is self-fulfilling.
Counting any asset as HQLA.
Students treat HQLA as meaning any liquid-looking asset.
Fix: HQLA are unencumbered assets that can be easily converted to cash, such as cash, central bank reserves and high-quality government bonds.
Classifying a rogue trader's loss as market risk.
The loss shows up in trading positions.
Fix: If the root cause is fraud or a control failure, it is operational risk.

Worked examples

Example 1

A bank has Tier 1 capital of $6 billion, on-balance-sheet exposures of $190 billion and off-balance-sheet exposures of $20 billion after conversion. Compute the Basel III leverage ratio and compare it with the 3% minimum.

Show the solution

Total exposure = 190 + 20 = $210 billion.
Leverage ratio = Tier 1 ÷ total exposure = 6 ÷ 210.
6 ÷ 210 = 0.02857, or 2.86%.
Compare: 2.86% < 3%.

Answer: The leverage ratio is about 2.86%, below the 3% minimum, so the bank is non-compliant.

Example 2

A bank holds HQLA of $90 million. Over the next 30 days it expects gross outflows of $120 million and gross inflows of $100 million. Compute the LCR.

Show the solution

The inflow cap is 75% × 120 = $90 million.
Inflows counted = min(100, 90) = $90 million.
Net outflows = 120 − 90 = $30 million.
LCR = HQLA ÷ net outflows = 90 ÷ 30 = 3.0, or 300%.

Answer: LCR = 300%, well above the 100% minimum. Without the cap, net outflows would be $20 million and the LCR 450%, which is wrong.

Exam tips

Expect short numeric questions on leverage ratio and LCR. Memorise the 3%, 100% and 75% figures.
Questions often describe an event and ask you to classify it. Find the root cause, not the place the loss appears.
On bank run questions, look for uninsured deposits, wholesale funding and maturity mismatch.
Remember that LCR is a 30-day test and NSFR is a one-year structural test.
Use a calculator for ratios, but check that the result is sensible against the minimum.

Practice questions from Banks

Bank Risks, Liquidity and Funding in other exams

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

Bank Risks, Liquidity and Funding: frequently asked questions

What are the main risks banks face in FRM Part I?

The core four are credit, market, operational and liquidity risk. You must be able to classify an event into the right one and explain its cause.

How do I calculate the bank leverage ratio?

Divide Tier 1 capital by the total exposure measure, which includes off-balance-sheet items. It is not risk-weighted. Basel III sets a 3% minimum.

What causes a bank run?

A run starts when depositors or short-term lenders fear losses and withdraw funds at once. Uninsured balances, short-term wholesale funding and maturity mismatch make it more likely. Fire sales then deepen the problem.

What is the difference between LCR and NSFR?

LCR tests whether a bank has enough high-quality liquid assets to cover net outflows over 30 days. NSFR tests whether stable funding supports assets and activities over one year. Both must be at least 100%.