Basel Capital Ratio Components

📈 FSA SECTION 1 — FORMULA TRAPS Basel Capital Ratio Components — What Belongs Where Correct: Total Tier 1 = Common Equity Tier 1 (common stock + retained earnings + AOCI − regulatory adjustments) + Additional Tier 1 (preferred shares, no fixed maturity, discretionary payments). Wrong: Including subordinated debt (fixed maturity) in Tier 1 — it belongs in Tier 2. Excluding preferred shares from Total Tier 1. Snippet: Common shares 12 + Retained earnings 187 + Preferred shares 17 = 216 Total Tier 1. Adding subordinated debt 23 gives 239 (wrong). Excluding preferred gives 199 (wrong). Exam trigger: "In calculating Total Tier 1 Capital, the analyst is incorrect in regard to..." Rating: VERY TESTABLE P&C Combined Ratio — Two Different Denominators Correct: Loss & loss adjustment expense ratio = (Loss expense + LAE) / Net premiums EARNED. Underwriting expense ratio = Underwriting expense / Net premiums WRITTEN. Combined ratio = sum of the two. Wrong: Using Net premiums written for both components, or earned for both. Snippet: Loss expense 38,467 / Earned 62,939 = 61.1%. Underwriting expense 23,960 / Written 49,241 = 48.7%. Combined = 109.8%. Using written for both gives 126.8% (wrong). Exam trigger: "The combined ratio is closest to..." when given both earned and written. Rating: VERY TESTABLE Average Return on Fixed-Income Assets — Scope of Numerator and Denominator FSA 1 Correct: Numerator = Interest income + Gains(losses) on fixed-income investments. Denominator = Average of (Loans and deposits + Debt securities). Wrong: Excluding gains/losses from numerator. Excluding loans/deposits from denominator (using only debt securities). Snippet: Interest 6,610 + Gains 300 = 6,910. Average fixed-income assets = (8,800+141,000 + 9,000+130,800)/2 = 144,800. Return = 4.8%. Excluding gains gives 4.6%. Excluding loans/deposits gives 5.1%. Exam trigger: "The average return on fixed-income assets is closest to..." Rating: VERY TESTABLE Provision for Credit Losses Impact on EBT Correct: Proportion of EBT increase from provision change = |Change in provision| / Change in EBT. Wrong: Change in provision / Level of EBT. Or Level of provision / Level of EBT. Snippet: EBT increased from 95,800 to 117,800 (change = +21,800). Provision decreased from 13,800 to 8,400 (change = −5,400). Attribution = 5,400 / 21,800 = 24.8%. 5,400/117,600 = 4.6% (wrong). 8,400/117,600 = 7.1% (wrong). Exam trigger: "The proportion of the increase in earnings before taxes that comes from the change in the provision..." Rating: VERY TESTABLE CET1 Ratio Improvement — Greatest Effect vs. Largest Percentage Change Correct: The component with the largest absolute dollar contribution to the numerator drives the ratio improvement, not the component with the highest percentage growth. Wrong: Picking AOCI because its negative balance improved 11.3% vs. retained earnings growing 9.9%. Or picking RWA because it had the largest dollar change (but it is the denominator and hurts the ratio). Snippet: Retained earnings +133,600 (9.9%) on base 1,355,000. AOCI +3,700 (11.3%) on base (32,700). RWA +815,600 (denominator, negative). Retained earnings has the greatest positive effect. FSA 2 Exam trigger: "The greatest effect on the improvement in the common equity tier 1 ratio... is best explained by..." Rating: VERY TESTABLE SECTION 2 — CONCEPTUAL DISTINCTIONS LCR vs. NSFR — Time Horizon and Purpose Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) Horizon 30-day stress scenario 1-year horizon Purpose Short-term liquidity sufficiency Long-term funding stability What it measures High-quality liquid assets / Net cash outflows over 30 days Available stable funding / Required stable funding Exam trap Confusing 30-day with 90-day or 1year. Reverse repos (30-day) affect LCR, not NSFR. Thinking NSFR is 90 days. Snippet: A 30-day reverse repo is a highly liquid asset → LCR. NSFR looks at stable funding over one year. Exam trigger: "Basel III requires a bank to have a minimum amount of stable funding relative to the bank's liquidity needs in a 90-day liquidity stress scenario." (This is false — it's 1 year.) Rating: VERY TESTABLE Freestanding vs. Hedged Credit Derivatives — Earnings Volatility FSA Freestanding Credit Derivatives Hedged/Embedded Credit Derivatives P&L treatment Fair value changes hit P&L immediately Fair value changes often deferred or matched to hedged item Earnings impact High volatility, unexpected swings Lower volatility Exam trap Reducing freestanding exposure reduces earnings volatility. Candidates think "less derivatives = less risk" without knowing the accounting classification drives the volatility. 3 Snippet: R-bank's freestanding credit derivative exposure peaked in 2008 and declined thereafter. Earnings volatility from credit derivatives decreased because fair value changes no longer flow directly to P&L. Exam trigger: "Exposure to freestanding credit derivatives declined... earnings volatility most likely..." Rating: MEDIUM VALUE Maturity Transformation vs. Contractual Maturity Mismatch Maturity Transformation Contractual Maturity Mismatch What it is The strategy of borrowing short and lending long to capture spread The resulting condition where asset maturities exceed liability maturities Exam trap The question asks for the name of the strategy. Candidates pick the descriptive result ("mismatch") instead of the technical term ("maturity transformation"). Snippet: Bank takes deposits (short-term) and makes mortgages (longterm). This strategy is maturity transformation. The resulting balance sheet condition is a contractual maturity mismatch. Exam trigger: "The value creation strategy is best described as..." Rating: MEDIUM VALUE P&C vs. L&H Insurance — Capital, Duration, and Investment Risk Property & Casualty (P&C) Life & Health (L&H) Claims predictability Low (lumpy, accidents, weather) High (mortality tables, large populations) Policy duration Short-term (usually < 1 year) Long-term (multiyear/decades) Capital requirements HIGHER (due to claim variability) LOWER (due to predictability) Lower equity % (need liquidity for claims) Higher equity % (long horizon, predictable claims) Investment allocation FSA 4 Property & Casualty (P&C) Exam trap Life & Health (L&H) Assuming P&C has lower capital requirements because policies are "simpler." Assuming L&H claims are shorter duration. Snippet: L&H can hold 20.6% equity vs. P&C lower because L&H claims are predictable AND long-duration. P&C requires MORE capital, not less. Exam trigger: "P&C insurers often have lower capital requirements and can also seek higher returns offered by riskier assets." (False — this describes L&H.) Rating: VERY TESTABLE CAMELS Coverage vs. Gaps Covered by CAMELS NOT Covered by CAMELS Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk Competitive environment, Currency exposure (unless embedded in sensitivity), Strategic positioning Exam trap "Competitive position" or "currency exposure" are common distractors. Governance is covered under Management. Funding concentration is covered under Liquidity. Snippet: A bank's competitive environment and foreign currency exposure are relevant to analysis but are not CAMELS components. Exam trigger: "One limitation of CAMELS is that it fails to address a bank's..." or "Which topic is least likely to be covered in a CAMELS analysis?" Rating: VERY TESTABLE SECTION 3 — WORDING & SCENARIO TRAPS "Constant Growth" vs. "Increasing Growth" in Net Interest Income A candidate sees positive growth every year and assumes "constant rate." The actual growth rates are 3.2%, 3.7%, 6.3%, 8.4% — clearly accelerating, not constant. Snippet: Net interest income growth: 2015 3.2%, 2016 3.7%, 2017 6.3%, 2018 8.4%. The rate is increasing, not constant. FSA 5 Exam trigger: "Net interest income has been growing at a constant rate over the period." (False — the growth rate itself is rising.) Rating: VERY TESTABLE Liquid Assets Absolute vs. Proportional Absolute liquid assets may increase while the liquid assets / total assets ratio declines because total assets grow faster. Candidates look at the absolute number and conclude liquidity improved. Snippet: Liquid assets 356,255 → 361,164 (up). Total assets 1,686,752 → 1,930,454 (up more). Ratio: 21.1% → 18.7%. Liquidity declined. Exam trigger: "Based only on Exhibit 2, asset composition indicates declining liquidity." Rating: VERY TESTABLE Impairment Allowances Track Past Due, Not Impaired Impaired assets declined (good), strong credit quality increased (good), yet impairment allowances increased. The allowances are building in anticipation of past-due-but-not-impaired assets becoming impaired. Snippet: Impaired assets down 5.8% YoY. Past due but not impaired up 22.0%. Impairment allowances up 22.2%. Allowances follow past due, not impaired. Exam trigger: "The trend in impairment allowances is reflective of the changes in..." Rating: MEDIUM VALUE Yield Curve Inversion → Net Interest Margin Decreases Banks borrow short (deposits) and lend long (loans). If the yield curve inverts, short-term funding costs rise above long-term asset yields. NIM compresses. Snippet: Short-term deposit rates rise above long-term loan yields. Funding costs increase faster than interest income. NIM falls. Exam trigger: "Given stronger-than-anticipated macroeconomic data, there is an imminent risk that the yield curve will invert... net interest margin will most likely..." Rating: VERY TESTABLE FSA 6 Reverse Repos and LCR (Not NSFR) A 30-day reverse repurchase agreement is a highly liquid asset (cash lent, collateral received, short maturity). It directly affects the Liquidity Coverage Ratio. It does not affect the Net Stable Funding Ratio because NSFR measures structural funding stability over one year, not short-term liquid assets. Snippet: 30-day reverse repo = HQLA → LCR numerator. Not relevant to NSFR. Exam trigger: "N-bank is very active in the 30-day reverse repurchase agreement market... the financial ratio most directly affected is..." Rating: VERY TESTABLE Currency Exposure Irrelevant for Domestic Regional Bank A regional bank serving only domestic clients in one geographic area has minimal foreign currency exposure. Its mission and competitive position are highly relevant; currency is not. Snippet: First West serves only the northwestern US. Currency exposure is least relevant. Mission (concentration risk) and competitive position (global entrants) are highly relevant. Exam trigger: "Which of the following non-CAMELS factors would be least relevant..." Rating: MEDIUM VALUE Allowance Quality Ratios — Allowance/Net Income Is Useless Useful allowance quality ratios: Allowance / Non-performing loans, Allowance / Net charge-offs, Provision / Net charge-offs. Allowance / Net income tells you nothing about reserve adequacy. Snippet: Comparing loan loss reserves to net income mixes the balance sheet (allowance) with the income statement (net income) and provides no insight into coverage of bad loans. Exam trigger: "The comparative ratio that Green is least likely to calculate is the ratio of the allowance for loan losses to..." Rating: MEDIUM VALUE SECTION 4 — COUNTERINTUITIVE RESULTS FSA 7 P&C Has HIGHER Capital Requirements Than L&H Intuition says property insurance is "simple" so it needs less capital. Reality: P&C claims are lumpy and unpredictable (accidents, weather), requiring higher capital buffers. L&H claims are actuarially predictable, allowing lower capital and higher risk investments. Snippet: L&H capital requirements are lower; P&C capital requirements are higher. Smith's statement that P&C has lower capital requirements is incorrect. Exam trigger: "Relative to L&H insurers, P&C insurers often have lower capital requirements..." (False.) Rating: VERY TESTABLE Banks Have Liquidity Risk Without Inventory Industrial companies face liquidity risk from inventory and receivables. Banks hold no inventory, yet face severe liquidity risk from the maturity mismatch between short-term deposits (liabilities) and longer-term loans (assets). A run on deposits can force asset fire sales. Snippet: No inventory, but deposits can be withdrawn on demand while loans cannot be called. Liquidity risk is central to banking. Exam trigger: "Because banks do not carry inventory, liquidity risks will be lower." (False.) Rating: MEDIUM VALUE CET1 Can Improve While Total Capital Weakens CET1 ratio strengthened (8.0% → 9.5%) while Total capital ratio declined (13.9% → 12.5%). This occurs when Tier 2 capital declines sharply while CET1 grows, or when RWA grows faster than total capital. The shift in capital composition matters more than the total. Snippet: First West CET1 improved 150 bps over 5 years. Total capital declined. CET1 is the most important metric, not total capital. Exam trigger: "Based on the most important metric... capital adequacy has..." (Answer: improved, based on CET1, despite total capital declining.) Rating: VERY TESTABLE Lower Trading Income % Means Better Earnings Quality FSA 8 Trading income is the least sustainable, most volatile revenue source. A decrease in its proportion of total income (from 20.7% to 19.3%) while net interest and fee income grow means earnings are MORE sustainable, not less. Snippet: Trading income flat in absolute terms but shrinking as % of total. Net interest + fee income growing. Earnings quality improves. Exam trigger: "Rossi's comment about BSB's earnings composition having become less volatile and more sustainable is..." (Correct.) Rating: MEDIUM VALUE Hard Insurance Market Attracts Competitors and Softens A hard market features high premiums, strict underwriting standards, and high profits. This profitability attracts new competitors who undercut on price and loosen standards, causing the market to soften. The cyclical shift from hard brings more competitors, not tighter standards. Snippet: Hard market → high profits → new entrants → lower premiums → soft market. Exam trigger: "In hard insurance markets... a cyclical shift is most likely to result in..." Rating: MEDIUM VALUE SECTION 5 — RECURRING EXAMINER PATTERNS Pattern: Earned vs. Written Premiums in the Same Question The examiner provides both Net premiums earned and Net premiums written. The loss ratio uses earned; the expense ratio uses written. The wrong answer always uses the wrong denominator for one or both. Pattern: 30-Day vs. 1-Year Horizon Confusion LCR = 30 days. NSFR = 1 year. The examiner constantly tests this by stating "90-day" or "short-term" in NSFR descriptions. Reverse repos (short-term) affect LCR. Pattern: Fixed Maturity Instruments in Tier 1 Other Tier 1 capital must have NO fixed maturity and NO mandatory payments. The examiner includes "instruments with a fixed maturity that FSA 9 are subordinate to depositors" as an item to include in Tier 1. This is wrong — fixed maturity disqualifies it from Tier 1 (makes it Tier 2). Pattern: Change Over Change for Provision Impact To find how much of an EBT increase is due to a lower provision, the examiner provides: (1) change in provision / level of EBT, and (2) level of provision / level of EBT. Both are wrong. The correct calculation is always |change in provision| / change in EBT. Pattern: Absolute vs. Relative for Asset Quality When assessing liquidity or asset quality, the examiner shows absolute numbers increasing but percentages decreasing. Candidates who do not calculate proportions choose "improved" when the correct answer is "declined." Pattern: Past Due as Leading Indicator for Allowances Impaired assets decrease (good news) but allowances increase (seems bad). The examiner tests whether the candidate looks at past-due-but-notimpaired assets, which drive the forward-looking allowance build. SECTION 6 — MASTER TRAP LIST (Ranked by Exam Likelihood) 1. P&C combined ratio uses earned premium for loss ratio, written premium for expense ratio — wrong answer uses same denominator for both. 2. Basel III LCR = 30-day stress; NSFR = 1-year horizon — 90-day distractor for NSFR. 3. Tier 1 capital excludes fixed-maturity instruments — subordinated debt with fixed maturity is Tier 2, not Tier 1. 4. CET1 ratio is the most important capital metric — total capital trend can diverge and is secondary. 5. Provision impact on EBT = |change in provision| / change in EBT — never use level/level or change/level. 6. Yield curve inversion compresses NIM — banks borrow short and lend long. 7. L&H has lower capital requirements and longer duration than P&C — P&C is lumpier and shorter. FSA 10 8. Reverse repos (30-day) affect LCR, not NSFR — short-term liquid asset classification. 9. Liquid assets must be assessed as % of total assets — absolute growth can mask proportional decline. 10. CAMELS does not cover competitive environment or currency exposure — governance is under M, funding concentration under L. 11. Freestanding credit derivatives = P&L volatility — hedged derivatives do not create the same earnings swing. 12. Average return on fixed-income assets includes gains/losses and loans/deposits — narrow denominator or numerator understates return. 13. Net interest income growth rate was increasing, not constant — positive growth does not mean constant growth. 14. Impairment allowances track past-due-not-impaired, not impaired assets — forward-looking reserve build. 15. Hard market attracts competitors → softening — cyclical shift brings lower standards and more entrants. 16. Maturity transformation is the strategy; mismatch is the result — do not confuse the term with the description. 17. Trading income % down = earnings quality UP — less reliance on volatile revenue improves quality. 18. Allowance / net income is a useless ratio — reserve adequacy is measured against NPLs or charge-offs. 19. P&C has higher capital requirements than L&H — counterintuitive due to claim variability. 20. CET1 improvement driven by largest absolute numerator change — not highest percentage change or denominator movement. FSA 11