FRM Exam Part II · Liquidity Risk Management

Funding Sources, Contingency Funding Plans and Lessons from Liquidity Crises

Q: What should a contingency funding plan contain?

It should include early warning indicators, escalation triggers, a crisis team with defined roles, contingent funding sources, and a communication plan. It should be tied to stress tests and reviewed regularly.

Q: Why are wholesale funding sources more run-prone?

Wholesale lenders are large, uninsured and quick to react to bad news. Short tenors mean funding must be rolled often, so a loss of confidence can cut it off fast.

Q: What was the main liquidity lesson from LTCM?

High leverage and large positions in illiquid trades make a fund vulnerable to margin calls. When spreads widen, it cannot exit without moving prices, so funding and market liquidity risk reinforce each other.

Q: How did the 2007-09 crisis show funding fragility?

Banks and dealers that relied on short-term wholesale and repo funding saw lenders raise haircuts or stop rolling. Interbank markets froze and central banks had to provide liquidity support.

Updated 11 October 2026 · Fact-checked

A contingency funding plan (CFP) sets out how a bank will raise cash in a liquidity stress: early warning indicators, triggers, sources of funds, roles and actions. To solve questions, identify the funding source, its stability, the stress trigger, and the right response. Crisis cases (2007-09, LTCM) show how runs, collateral calls and leverage drain liquidity.

Understand Funding Sources, Contingency Funding and Lessons from Crises

A bank funds long-term, illiquid assets with shorter-term liabilities. That maturity gap is why liquidity risk exists. Funding liquidity risk is the risk that you cannot meet cash obligations when due without large losses. Market liquidity risk is the risk that you cannot sell an asset at close to its fair price.

Funding sources differ in stability. Retail insured deposits are the stickiest. Wholesale funding (interbank loans, commercial paper, repo, large uninsured deposits) is cheaper but flighty. Secured funding depends on collateral value and haircuts. Unsecured funding depends on the lender's confidence in you. Concentration by counterparty, tenor, currency or product raises the risk of a sudden stop.

A contingency funding plan is the playbook for stress. It has early warning indicators (widening CDS spreads, falling share price, deposit outflows, rating downgrade, rising haircuts, losing access to markets), escalation triggers, a governance team with clear roles, a list of contingent sources (unencumbered collateral, committed lines, central bank facilities, asset sales), and a communication plan. It should be linked to liquidity stress tests and tested regularly. Central bank borrowing is a last resort, and use of it can signal weakness.

Runs happen when lenders fear others will withdraw first, so each has an incentive to run. In modern markets, runs hit wholesale funding: repo lenders raise haircuts or refuse to roll, and commercial paper investors stop buying. Higher haircuts force asset sales, which lower prices, which cut collateral value and trigger more calls. This is a liquidity spiral linking market and funding liquidity.

In 2007-09, banks and dealers relied on short-term wholesale funding and repo against securitised assets. When confidence fell, funding dried up, haircuts rose, and interbank markets froze. Bear Stearns and Lehman lost secured and prime brokerage funding quickly. Central banks stepped in with lending facilities and swap lines. LTCM used high leverage in convergent trades and held positions too large to exit. In 1998, spreads widened after the Russian default, margin calls and collateral demands rose, and it could not liquidate without moving prices. Lessons: stress test with higher haircuts, diversify funding, hold unencumbered liquid assets, and size positions against market depth.

Key formulas to remember

Funding gap: Funding gap = Cash outflows − Cash inflows over a horizon; A positive gap must be covered by the liquidity buffer or contingent sources.
Survival horizon: Survival horizon = time until cumulative net outflows exceed the liquidity buffer; Longer is safer. Compare it to the stress period required by policy.
Loan-to-deposit ratio: Loan-to-deposit ratio = Loans ÷ Deposits; A high ratio suggests reliance on wholesale funding.
Repo cash raised: Cash = Collateral market value × (1 − haircut); A higher haircut means less cash from the same collateral.
Leverage: Leverage = Total assets ÷ Equity; Higher leverage means smaller price falls can force asset sales and margin calls.

How to solve Funding Sources, Contingency Funding and Lessons from Crises questions

Use this sequence for any funding, CFP or crisis question.

1Identify the funding source: retail, wholesale unsecured, secured repo, or central bank.
2Judge its stability: insured or uninsured, secured or unsecured, short or long tenor, concentrated or diversified.
3Find the trigger: downgrade, haircut rise, market closure, margin call or outflow.
4Trace the transmission: funding loss leads to asset sales, price falls, collateral shortfall, more calls.
5If numbers are given, compute haircut cash, net outflow or buffer coverage step by step.
6Choose the response the CFP would use: use buffer, pledge unencumbered collateral, draw committed lines, then central bank facilities.
7Match to the case lesson (Bear Stearns, Lehman, LTCM) if the question is about a crisis.
8Check the answer addresses the question asked: cause, measure or remedy.

Quickest way: Source, stress, spiral

When to use it: For conceptual MCQs with four plausible options on funding or crisis lessons.

Ask: is the funding short-term and wholesale? If yes, expect run risk.
Ask: is collateral involved? If yes, think haircuts and margin spirals.
Eliminate options that treat central bank support as a normal funding source.
Eliminate options that say diversification or buffers are unnecessary when markets are calm.
Pick the option that links leverage, funding fragility and forced selling.

Common mistakes in Funding Sources, Contingency Funding and Lessons from Crises

Treating all deposits as equally stable.
Deposits look like one category on the balance sheet.
Fix: Separate insured retail from uninsured and wholesale deposits. Only retail, insured balances are typically sticky.
Confusing funding liquidity with market liquidity.
Both involve cash and sales.
Fix: Funding liquidity is about meeting obligations. Market liquidity is about selling assets at fair prices. They interact in spirals.
Calling a CFP a plan to use the central bank first.
Central bank facilities are prominent in crisis stories.
Fix: They are a last resort. The CFP uses the buffer and market sources first, and signalling risk matters.
Applying haircuts the wrong way round.
Students multiply by the haircut instead of one minus the haircut.
Fix: Cash raised = value × (1 − haircut).
Saying LTCM failed only because of losses.
Losses are the headline.
Fix: Add high leverage, large illiquid positions, margin and collateral calls, and inability to exit without moving prices.
Assuming a CFP needs no testing.
It is seen as a document.
Fix: It should be linked to stress tests, tested, reviewed and updated, with clear roles.

Worked examples

Example 1

A bank pledges ₹200 crore of bonds in repo with a 5% haircut. Stress raises the haircut to 15%. How much less cash can it raise, and what does this imply?

Show the solution

Cash at 5% haircut = 200 × (1 − 0.05) = ₹190 crore.
Cash at 15% haircut = 200 × (1 − 0.15) = ₹170 crore.
Reduction = 190 − 170 = ₹20 crore.
If the bank had borrowed ₹190 crore, it must find ₹20 crore elsewhere or sell assets.

Answer: It raises ₹20 crore less (₹170 crore versus ₹190 crore), creating a funding shortfall that may force asset sales and feed a liquidity spiral.

Example 2

A bank has a liquidity buffer of USD 600 million. Under stress, net cash outflows are USD 150 million per week. What is the survival horizon, and is it adequate against a 6-week policy requirement?

Show the solution

Survival horizon = buffer ÷ weekly net outflow.
= 600 ÷ 150 = 4 weeks.
Compare with the 6-week requirement: 4 < 6.

Answer: The survival horizon is 4 weeks, which falls short of the 6-week requirement. The bank needs a larger buffer, more contingent sources, or smaller outflows.

Exam tips

Expect case-style questions asking which funding source is most prone to a run. Choose short-term uninsured wholesale funding.
Know the CFP elements: early warning indicators, triggers, governance, contingent sources, communication, testing.
For LTCM, link leverage, margin calls and position size to forced liquidation.
For 2007-09, link repo haircuts, short-term wholesale funding and loss of confidence to funding collapse.
Show haircut arithmetic carefully: value × (1 − haircut).

Practice questions from Liquidity Risk Management

Funding Sources, Contingency Funding and Lessons from Crises in other exams

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

Funding Sources, Contingency Funding and Lessons from Crises: frequently asked questions

What should a contingency funding plan contain?

It should include early warning indicators, escalation triggers, a crisis team with defined roles, contingent funding sources, and a communication plan. It should be tied to stress tests and reviewed regularly.

Why are wholesale funding sources more run-prone?

Wholesale lenders are large, uninsured and quick to react to bad news. Short tenors mean funding must be rolled often, so a loss of confidence can cut it off fast.

What was the main liquidity lesson from LTCM?

High leverage and large positions in illiquid trades make a fund vulnerable to margin calls. When spreads widen, it cannot exit without moving prices, so funding and market liquidity risk reinforce each other.

How did the 2007-09 crisis show funding fragility?

Banks and dealers that relied on short-term wholesale and repo funding saw lenders raise haircuts or stop rolling. Interbank markets froze and central banks had to provide liquidity support.