FRM Exam Part II · The Investment Function in Financial Services Management

Accounting, Regulatory and Liquidity Considerations for Bank Investments

Updated 11 October 2026 · Fact-checked

A bank's securities portfolio is shaped by three constraints. Accounting classification (held to maturity, available for sale, trading) decides whether price changes hit earnings or equity. Regulatory capital sets risk weights and deductions. Liquidity rules like the LCR reward high quality liquid assets, and pledging locks securities up as collateral.

Understand Accounting, Regulatory and Liquidity Considerations

Every security a bank buys is judged three ways: how it is reported, how much capital it needs, and how easily it can be turned into cash. A good investment decision looks at all three, not only yield.

Accounting classification. Under the traditional US-style scheme, securities fall into three buckets. Held to maturity (HTM) securities are carried at amortised cost because the bank has the intent and ability to hold them to maturity. Market price swings do not appear in the balance sheet or earnings. Available for sale (AFS) securities are carried at fair value, with unrealised gains and losses going to other comprehensive income (OCI), which sits in equity, not in net income. Trading securities are carried at fair value, with changes going straight to earnings. Under IFRS 9 the buckets are different (amortised cost, fair value through OCI, fair value through profit or loss), and the choice depends on the business model and the cash flow test. Know which framework the question uses.

Regulatory capital. Securities carry risk weights under the Basel framework. Government securities in the home currency often have low or zero risk weight, while corporate bonds and securitisations carry higher weights. Securities held for trading sit in the trading book and attract market risk capital. Securities in the banking book attract credit risk capital, and rate risk is handled through the banking book interest rate framework. Unrealised AFS losses can reduce regulatory capital in some jurisdictions, depending on whether OCI filters apply. HTM securities avoid that effect, which is why banks like the label, but a sale can taint the classification.

Liquidity requirements. The Liquidity Coverage Ratio (LCR) requires a bank to hold enough high quality liquid assets (HQLA) to cover net cash outflows over a 30-day stress period. HQLA are split into Level 1 (cash, central bank reserves, qualifying sovereign debt, no haircut), Level 2A (15% haircut) and Level 2B (larger haircuts, such as 25% or 50% depending on the asset). Level 2 assets are capped: Level 2 in total cannot exceed 40% of HQLA, and Level 2B cannot exceed 15%. Assets must be unencumbered to count.

Pledging. Banks pledge securities as collateral for repo, central bank borrowing, derivatives margin and payment system access. Pledged securities are encumbered. They cannot be sold freely and generally do not count as HQLA for the LCR. The lender applies a haircut, so you must pledge more value than you borrow. HTM securities can still be pledged, which is why they are not truly dead weight, but they cannot be sold without consequences.

Key formulas to remember

Liquidity Coverage Ratio: LCR = Stock of HQLA ÷ Total net cash outflows over the next 30 calendar days ≥ 100%; Net outflows = outflows − min(inflows, 75% of outflows). Inflows are capped at 75% of outflows.
HQLA after haircuts: HQLA value = Level 1 + Level 2A × (1 − 15%) + Level 2B × (1 − haircut), subject to caps; Level 2B haircut is 25% for some assets (such as qualifying RMBS) and 50% for others (such as qualifying equities). Check the question.
Level 2 caps: Level 2 ≤ 2/3 × Level 1; Level 2B ≤ 15/85 × (Level 1 + Level 2A); These are the working forms of the limits that Level 2 is at most 40% of HQLA and Level 2B at most 15% of HQLA. Use the amounts after haircuts, and after adjusting for secured transactions maturing within 30 days. Use the 2/3 and 15/85 forms to compute the cap.
Collateral required with haircut: Collateral market value = Loan amount ÷ (1 − haircut); Haircut is a percentage of collateral value. With a 5% haircut, USD 95 of lending needs USD 100 of collateral (95 ÷ 0.95 = 100).
AFS fair value change: Unrealised gain or loss → OCI (equity); Trading change → net income; HTM → no fair value entry; Applies to the US-style three-bucket scheme.

How to solve Accounting, Regulatory and Liquidity Considerations questions

Use this order for any scenario question on securities, accounting, capital and liquidity.

1Identify the framework: US-style HTM, AFS and trading, or IFRS 9 business model. Note whether Basel LCR is also involved.
2Classify each security by intent and business model. Trading means short-term profit, HTM means intent and ability to hold, AFS is the remainder.
3Decide where the price change goes: earnings, OCI or nowhere. Then ask if it affects regulatory capital.
4Assign the Basel treatment: banking book or trading book, and the risk weight if given.
5For liquidity, sort assets into Level 1, 2A, 2B and exclude anything encumbered or pledged.
6Apply haircuts, then check the 40% and 15% caps before summing HQLA.
7Compute the ratio with net outflows, remembering the 75% inflow cap, and compare it with 100%.
8State the interpretation in one line: compliant or not, and what action (sell, reclassify, unpledge) changes the result.

Quickest way: Three-question screen

When to use it: Use it when a multiple choice question gives a short description and four conclusions.

Where does the gain or loss go? HTM none, AFS OCI, trading earnings.
Is the asset unencumbered and Level 1, 2A or 2B? If pledged, it is out of HQLA.
Apply the haircut, then test the caps and the 100% threshold. Eliminate options that ignore the pledge or the caps.

Common mistakes in Accounting, Regulatory and Liquidity Considerations

Putting AFS unrealised losses through net income.
Students mix AFS with trading, since both are at fair value.
Fix: Remember: trading to earnings, AFS to OCI, HTM no fair value entry.
Counting pledged securities as HQLA.
The security is high quality, so it feels eligible.
Fix: HQLA must be unencumbered. Remove assets pledged for repo or margin before computing the numerator.
Applying haircuts to Level 1 assets.
Students apply a haircut to everything.
Fix: Level 1 has no haircut. Level 2A is 15% and Level 2B is larger.
Forgetting the 75% cap on inflows.
Net outflows are treated as outflows minus all inflows.
Fix: Net outflows = outflows − min(inflows, 0.75 × outflows).
Treating HTM as free of consequences when sold.
HTM looks like a risk-free label.
Fix: A significant sale can call the intent into question and force reclassification of the portfolio to fair value, subject to the accounting rules.
Computing collateral as loan × (1 + haircut).
The haircut is read as a markup.
Fix: Divide the loan by (1 − haircut). A haircut cuts the collateral's value.

Worked examples

Example 1

A bank has USD 600 million of Level 1 assets, USD 200 million of Level 2A assets (market value) and USD 100 million of Level 2B assets (market value, 50% haircut). All are unencumbered. Net cash outflows over 30 days are USD 700 million. Ignoring secured-transaction adjustments, what is the LCR?

Show the solution

Level 1 = 600.
Level 2A after 15% haircut = 200 × 0.85 = 170.
Level 2B after 50% haircut = 100 × 0.50 = 50.
Uncapped total = 600 + 170 + 50 = 820.
Check Level 2B cap: Level 2B ≤ 15/85 × (Level 1 + Level 2A) = 15/85 × (600 + 170) = 15/85 × 770 ≈ 135.9. Level 2B is 50, so the cap does not bind.
Check Level 2 cap: Level 2 ≤ 2/3 × Level 1 = 2/3 × 600 = 400. Level 2 = 170 + 50 = 220, so the cap does not bind.
No cap binds, so HQLA = 820.
LCR = 820 ÷ 700 = 1.171, or about 117%.

Answer: LCR is about 117%, above the 100% minimum.

Example 2

The bank above pledges USD 150 million of its Level 1 securities (market value) to the central bank for a facility, and net outflows stay at USD 700 million. What happens to the LCR, and is the bank still compliant?

Show the solution

Pledged assets are encumbered, so remove USD 150 million of Level 1. Level 1 becomes 600 − 150 = 450.
Level 2A after haircut = 170 and Level 2B after haircut = 50, as before.
Uncapped total = 450 + 170 + 50 = 670.
Check Level 2B cap: Level 2B ≤ 15/85 × (Level 1 + Level 2A) = 15/85 × (450 + 170) = 15/85 × 620 ≈ 109.4. Level 2B is 50, so the cap does not bind.
Check Level 2 cap: Level 2 ≤ 2/3 × Level 1 = 2/3 × 450 = 300. Level 2 = 220, so the cap does not bind.
No cap binds, so HQLA = 670.
LCR = 670 ÷ 700 = 0.957, or about 96%.

Answer: LCR falls to about 96%, below 100%. The bank is not compliant until it unpledges assets, adds HQLA or reduces net outflows.

Exam tips

Read for the word unencumbered or pledged. It often decides the numerator.
Check which framework the question uses before placing gains and losses: US-style buckets or IFRS 9.
Do the haircuts first, then the caps, then the ratio. Most distractors come from skipping one step.
Interpret the answer. Questions often ask what action restores compliance, not just the number.
Quickly confirm the Level 2B haircut given in the question. Do not assume a single value.

Practice questions from The Investment Function in Financial Services Management

Accounting, Regulatory and Liquidity Considerations: frequently asked questions

What is the difference between HTM, AFS and trading securities?

HTM securities are held at amortised cost, with no fair value changes recorded. AFS securities are at fair value, with unrealised gains and losses in OCI. Trading securities are at fair value, with changes in earnings.

Why do pledged securities not count for the LCR?

HQLA must be unencumbered so the bank can sell or repo them freely in a stress. A pledged security is already committed to a counterparty, so it cannot be relied on to raise new cash.

How do banks use securities as collateral?

They pledge them for repo, central bank facilities, derivatives margin and payment system access. The lender applies a haircut, so the bank must post more collateral value than the cash it receives.

Does the classification of a security change its regulatory risk weight?

Not directly. Risk weight depends on the issuer and asset type, and on whether the position is in the banking book or trading book. Classification can affect capital through how unrealised losses flow into regulatory capital.