Learning Outcomes
After studying this article, you will be able to explain the capital adequacy framework and liquidity requirements for banks and similar financial institutions, evaluate asset-liability management (ALM) implications for balance sheet stability, describe key regulatory concepts like the capital ratio and liquidity coverage ratio (LCR), and apply these principles to practical questions in the CFA Level 3 exam.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand how banks and other financial institutions manage their balance sheets with respect to ALM, capital adequacy, and liquidity risk. For revision, focus on:
- Describing regulatory capital requirements for banks and insurance companies.
- Explaining the function of capital as a buffer against unexpected losses.
- Evaluating key liquidity needs, including the role of the liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and liquidity stress testing.
- Analyzing the impact of asset-liability mismatches on risk management and required capital.
- Understanding how regulatory and internal constraints affect strategic asset allocation for banks and similar entities.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What does the capital adequacy ratio (CAR) measure, and why is it important for banks?
- Name two liquidity risk metrics calculated for regulatory purposes and briefly describe them.
- Explain the purpose of the net stable funding ratio (NSFR) in the context of bank risk management.
- Why do banks manage the maturity structure of their assets and liabilities so closely?
Introduction
The stability of banks and analogous financial institutions relies heavily on effective asset-liability management (ALM) and ongoing compliance with capital and liquidity regulations. The objective is to ensure that the institution maintains sufficient capital buffers and high-quality liquid assets to absorb unexpected losses and to meet obligations as they come due, even during periods of market disruption. These requirements are not just regulatory box-ticking—they are critical for maintaining trust in the wider financial system and for preserving franchise value.
Key Term: Asset-Liability Management (ALM)
The ongoing process of monitoring, measuring, and managing the risks arising from mismatches between the assets and liabilities of financial institutions, with the aim of maintaining balance sheet stability.
CAPITAL ADEQUACY: THE ROLE OF REGULATORY CAPITAL
Banks and insurers must hold a minimum amount of capital relative to their risk-weighted assets. This minimum is set by regulators to protect depositors, policyholders, and the broader economy from institutional failures. The major international framework is the Basel III Accord, which provides detailed definitions for various capital ratios and risk measurements.
Key Term: Regulatory Capital
The amount of capital that a bank or similar financial institution must hold, defined by regulators, to absorb losses and protect against insolvency.Key Term: Capital Adequacy Ratio (CAR)
The ratio of a bank's capital to its risk-weighted assets, used to assess the ability of the institution to withstand losses.
Banks’ capital is typically tiered:
- Tier 1 Capital: Core equity, including common shares and disclosed reserves.
- Tier 2 Capital: Subordinated instruments and hybrid capital with loss-absorbing features.
Global banking rules require maintenance of a minimum Total CAR, including buffers for cyclical stress and system-wide risks. Regulators also impose additional capital conservation and countercyclical buffers, especially for systemically important banks.
Worked Example 1.1
A regional bank has total risk-weighted assets of $100 billion. Its core equity (Tier 1) capital is $8 billion, and its total regulatory capital is $11 billion. Calculate the bank’s Tier 1 and Total CAR, and assess compliance if the regulatory minimums are 6% for Tier 1 and 8% for total capital.
Answer:
- Tier 1 CAR = $8 billion / $100 billion = 8%.
- Total CAR = $11 billion / $100 billion = 11%.
- Both the Tier 1 (8% > 6%) and Total (11% > 8%) CAR exceed the required minimums, indicating regulatory compliance.
LIQUIDITY NEEDS AND MANAGEMENT
A key vulnerability for banks is funding liquidity risk—the potential for a sudden inability to obtain the cash needed to meet obligations. Banks must balance maximizing returns with maintaining sufficient high-quality liquid assets (HQLA). Global standards set specific liquidity risk metrics.
Key Term: Liquidity Coverage Ratio (LCR)
The ratio of a bank’s stock of high-quality liquid assets to its expected total net cash outflows over a 30-day stress scenario.Key Term: Net Stable Funding Ratio (NSFR)
The ratio of available stable funding to required stable funding over a one-year horizon, designed to limit reliance on unstable short-term funding and reduce funding risk.
Liquidity metrics shape the strategic asset allocation of banks. Institutions optimize so that maturities of funding sources and assets are aligned or offset using liquid buffers.
Worked Example 1.2
A bank has $40 billion in HQLA and estimated 30-day net cash outflows of $35 billion under a stress test. What is its LCR, and does it comply with the Basel III minimum requirement?
Answer:
- LCR = $40 billion / $35 billion = 114%.
- Since the LCR must be at least 100%, the bank is above the minimum and thus compliant.
Exam Warning
A frequent exam error is to confuse LCR with NSFR. The LCR applies to short-term (30 days) acute liquidity stress, while the NSFR is a structural measure for stable funding over one year.
ASSET-LIABILITY MISMATCHES AND CAPITAL IMPLICATIONS
Mismatches in the timing and characteristics of assets and liabilities—such as funding long-term, illiquid assets with short-term wholesale funding—introduce market and liquidity risks.
Key Term: Maturity Mismatch
A situation in which the maturities of assets and liabilities differ significantly, increasing exposure to refinancing and market risks.Key Term: High-Quality Liquid Assets (HQLA)
Assets that can be rapidly and reliably converted to cash at little or no loss in value, as defined by regulators for liquidity coverage purposes.
A large maturity mismatch may increase:
- Interest rate risk exposure
- Funding costs in stress scenarios
- Regulatory capital requirements by raising risk-weighted assets
- The chance of regulatory action or market scrutiny
Banks use scenario analysis, stress tests, and contingency funding plans to manage these risks and inform capital planning.
Worked Example 1.3
A bank funds 10-year loans with 3-month deposits. If short-term rates increase sharply, what risks does the bank face and what ALM steps should be taken?
Answer:
- The bank’s interest expense could rise faster than asset returns, compressing margins or creating losses. There is heightened refinancing risk if depositors withdraw or funding dries up.
- The bank should either increase its long-term funding, raise HQLA holdings, or hedge interest rate exposures to reduce mismatch risk.
SETTING ALM POLICY: INTERNAL CONSTRAINTS AND BALANCE SHEET MANAGEMENT
Regulators require banks and insurers to have robust internal risk controls governing ALM, capital, and liquidity positions. Internal risk appetite statements set limits for:
- Overall gearing (assets/equity)
- Sector or product exposures
- Maximum permitted asset-liability gaps by maturity
- Concentration risk (e.g., large depositors or borrowers)
- Minimum capital and liquidity buffers above regulatory thresholds
The ALM framework must balance regulatory requirements, business strategy, and shareholder value. The ALM committee (ALCO) typically governs these processes, overseeing monitoring and management of all material balance sheet risks.
Key Term: ALM Committee (ALCO)
The senior management group responsible for setting, monitoring, and controlling the institution’s ALM strategy, risk appetite, and balance sheet structure.
ADVANCED TOPICS: STRESS TESTING AND LIQUIDITY BUFFERS
Stress testing is required by both regulators and prudent management to assess vulnerability to extreme scenarios. Stress test outputs drive decision making for buffer size and composition, contingency funding plans, and capital actions, such as dividend policies.
Revision Tip
Practical CFA questions often require you to link stress testing results to management actions: e.g., raising capital, increasing buffers, or adjusting risk exposures.
Summary
Banks and similar institutions must rigorously manage ALM, capital adequacy, and liquidity risks to ensure financial stability and regulatory compliance. The focus is on maintaining capital buffers above minimums, holding liquidity resources sufficient for stressed outflows, and managing maturity mismatches to reduce risk. Effective ALM policy includes both meeting regulatory requirements (such as minimum CAR, LCR, NSFR) and internal objectives that ensure the institution’s continued viability.
Key Point Checklist
This article has covered the following key knowledge points:
- Explain why capital adequacy is central to bank safety and regulatory policy
- Calculate and interpret capital ratios and liquidity risk metrics (CAR, LCR, NSFR)
- Identify and manage asset-liability mismatches and understand their risk consequences
- Distinguish LCR (short-term liquidity risk) from NSFR (structural funding risk)
- Use ALM limits and policies to align risk, profitability, and regulatory compliance
Key Terms and Concepts
- Asset-Liability Management (ALM)
- Regulatory Capital
- Capital Adequacy Ratio (CAR)
- Liquidity Coverage Ratio (LCR)
- Net Stable Funding Ratio (NSFR)
- Maturity Mismatch
- High-Quality Liquid Assets (HQLA)
- ALM Committee (ALCO)