FRM Exam Part II · Liquidity and Leverage

Funding Liquidity vs Market Liquidity and Liquidity Spirals

Updated 11 October 2026 · Fact-checked

Funding liquidity risk is the risk that a firm cannot meet its payment or collateral obligations when due without large losses. Market liquidity risk is the risk that an asset cannot be sold quickly near its fair price. They reinforce each other in liquidity spirals: funding stress forces sales, sales cut prices, and falling prices tighten funding.

Understand Funding Liquidity and Liquidity Risk Sources

Funding liquidity risk is about the liability side. Can you roll over borrowing, return deposits, and post margin when asked? If not, you must raise cash fast, often by selling assets or paying a high price for new funds.

Market liquidity risk is about the asset side. Can you sell a position quickly without moving the price? Wide bid-ask spreads, thin depth and a large price impact signal poor market liquidity. A position can be easy to value yet hard to sell in size.

Common causes of funding liquidity risk in banks are: reliance on short-term wholesale funding (repo, commercial paper), maturity mismatch between long assets and short liabilities, funding concentration in few counterparties or one currency, deposit runs, rating downgrades that trigger collateral calls, and off-balance-sheet commitments such as credit lines being drawn.

The two risks interact. Brunnermeier and Pedersen describe two spirals. In the loss spiral, a price fall causes losses and erodes a leveraged trader's capital, so the trader must sell, which pushes prices down further. In the margin (haircut) spiral, higher volatility makes lenders raise margins or haircuts, so the trader can hold less with the same capital, must sell, and prices fall again. Both spirals are stronger when many traders hold similar positions and when funding is short-term.

The key link is that traders' funding is tied to the market liquidity of the assets they hold. Market liquidity is low when funding liquidity is tight, and funding is tight when market liquidity is low. This also means liquidity can dry up suddenly, and risk is higher than normal models suggest. Liquidity is also a common factor across markets, so it creates commonality and contagion.

Key formulas to remember

Leverage: Leverage = Total assets ÷ Equity; Higher leverage means a given price fall wipes out more equity and forces larger sales.
Haircut and funding: Funding obtained = Collateral value × (1 − haircut); The equity you must supply per unit of asset equals the haircut. A rise in haircut forces deleveraging.
Maximum position under margin: Max position = Capital ÷ Margin rate; If the margin rate rises, the maximum position falls, which drives the margin spiral.
Funding gap: Funding gap = Cash outflows − Cash inflows over a horizon; A positive gap must be covered by buffers or new funding.

How to solve Funding Liquidity and Liquidity Risk Sources questions

Use this order for any question on funding liquidity, market liquidity or spirals.

1Identify which side the question is about: liabilities and collateral (funding) or asset sale and price impact (market).
2List the trigger: price fall, higher volatility, downgrade, deposit outflow, or margin call.
3Trace the transmission: loss of capital or higher margin, then forced sale or deleveraging.
4Decide which spiral applies: loss spiral if capital falls, margin spiral if margin or haircut rises.
5Check the feedback: do the sales push prices down and tighten funding again?
6Do any arithmetic needed with leverage, haircuts or margin, using equity as the base.
7Match the answer to the precise term and pick the option that fits the mechanism, not just a related word.

Quickest way: Trigger, channel, feedback

When to use it: Use for conceptual MCQs where options mix up funding and market liquidity or the two spirals.

Ask: is the problem raising cash (funding) or selling assets (market)?
Look for the word margin or haircut: that points to the margin spiral. Look for capital losses: loss spiral.
Eliminate options that say the two risks are independent.
For numbers, compute new maximum position as capital ÷ new margin rate, or equity after loss.

Common mistakes in Funding Liquidity and Liquidity Risk Sources

Treating funding liquidity and market liquidity as the same thing.
Both are called liquidity and both appear in crises.
Fix: Funding is about meeting obligations with cash or collateral. Market is about selling an asset near fair value.
Confusing the loss spiral with the margin spiral.
Both end in forced selling and falling prices.
Fix: Loss spiral starts with losses reducing capital. Margin spiral starts with higher margins or haircuts due to higher volatility or uncertainty.
Saying a liquid asset guarantees safe funding.
Students assume asset quality removes liability-side risk.
Fix: A bank with liquid assets can still fail if short-term funding vanishes faster than it can sell without loss.
Using total assets instead of equity as the base when computing a loss.
The price fall is quoted on assets, so equity is forgotten.
Fix: Compute the loss on assets, subtract it from equity, then recompute leverage.
Assuming deposits are always the unstable source of funding.
Bank runs are linked to deposits in textbooks.
Fix: Wholesale funding such as repo and commercial paper is often more run-prone than insured retail deposits.

Worked examples

Example 1

A fund holds assets of $200 million financed with $20 million equity and $180 million repo borrowing. The haircut rises from 10% to 12.5%. If assets are not sold at a loss, what is the maximum asset position the fund can finance with its equity, and how much must it sell?

Show the solution

Maximum position = Equity ÷ haircut.
Before: 20 ÷ 0.10 = $200 million, so the fund was fully used.
After: 20 ÷ 0.125 = $160 million.
Assets to sell = 200 − 160 = $40 million.
Repay $40 million of repo, leaving $140 million of borrowing against $160 million assets and $20 million equity. Check: 160 × 0.125 = 20.

Answer: The fund must sell $40 million of assets. This is the margin spiral: a higher haircut forces deleveraging, which can push prices down.

Example 2

A bank holds assets of ₹1,000 crore with equity of ₹100 crore. Asset prices fall 4%. What is the new leverage, and what asset sale is needed to restore the original leverage, assuming sales are at the new prices and proceeds repay debt?

Show the solution

Original leverage = 1,000 ÷ 100 = 10.
Loss = 4% × 1,000 = ₹40 crore, so equity = 100 − 40 = ₹60 crore.
Assets after loss = 960 crore, so leverage = 960 ÷ 60 = 16.
Target assets at leverage 10 = 10 × 60 = ₹600 crore.
Sale needed = 960 − 600 = ₹360 crore.

Answer: Leverage rises to 16, and the bank must sell ₹360 crore of assets. This is the loss spiral: a small price fall forces a large sale, which can lower prices further.

Exam tips

Read the first trigger in the vignette: losses mean loss spiral, margin or haircut increases mean margin spiral.
Expect questions linking short-term wholesale funding and maturity mismatch to funding liquidity risk.
Watch for answers claiming the two liquidity risks are independent. They are wrong in stress.
When computing forced sales, always base the calculation on equity after the loss.
Remember that Brunnermeier and Pedersen link market liquidity to traders' funding, so liquidity can vanish suddenly.

Practice questions from Liquidity and Leverage

Funding Liquidity and Liquidity Risk Sources in other exams

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

Funding Liquidity and Liquidity Risk Sources: frequently asked questions

What is the difference between funding liquidity risk and market liquidity risk?

Funding liquidity risk is the risk of being unable to meet cash or collateral obligations when due. Market liquidity risk is the risk of being unable to trade an asset quickly without a large price concession. One concerns liabilities, the other assets.

What are liquidity spirals in Brunnermeier and Pedersen?

They are feedback loops between market and funding liquidity. In the loss spiral, losses cut capital and force sales. In the margin spiral, higher margins force deleveraging. Both push prices down and tighten funding further.

What causes funding liquidity risk in banks?

Main causes are heavy use of short-term wholesale funding, maturity mismatch, funding concentration, deposit outflows, downgrades that trigger collateral calls and drawdowns on committed lines. Loss of confidence can make these outflows happen at once.

Why does higher volatility cause a margin spiral?

Lenders set margins and haircuts to cover possible losses. When volatility rises, they demand more margin, so each unit of asset needs more equity. Leveraged holders must sell, which can lower prices and raise volatility again.