FRM Exam Part II · Liquidity Risk

Funding Liquidity Risk and Liquidity Crises Explained

Updated 11 October 2026 · Fact-checked

Funding liquidity risk is the risk that a firm cannot meet its cash and collateral obligations when due, or can only do so at a very high cost. It interacts with market liquidity. Falling asset prices raise margins and haircuts, which force sales, which push prices down further. This loop is a liquidity spiral.

Understand Funding Liquidity Risk and Liquidity Crises

Funding liquidity is your ability to raise cash or meet payment and collateral calls as they fall due. Market liquidity is your ability to sell an asset quickly without moving its price much. They are different risks, but they feed each other.

The link works through leverage and collateral. A leveraged trader borrows against the assets it holds. The lender sets a margin or haircut, which is the part of the asset's value the trader must fund with its own capital. When a trader's funding is tight, it must sell assets. When asset markets are illiquid, selling is costly. So weak funding hurts market liquidity, and weak market liquidity hurts funding.

Brunnermeier and Pedersen describe two liquidity spirals. In the loss spiral, a price fall causes losses on leveraged positions. Capital shrinks, so the trader has to sell to reduce leverage. The selling pushes prices down again. In the margin spiral, higher volatility or uncertainty leads lenders to raise margins. The trader must post more collateral or sell assets. Selling pushes prices down and raises volatility further. Both spirals can run at once.

Several features make a firm fragile: high leverage, short-term or rolled-over funding against longer-term or illiquid assets, funding that depends on collateral values, and crowded positions held by many similar traders. When many traders sell together, market liquidity dries up exactly when everyone needs it.

History gives the case studies. LTCM (1998) held large, highly leveraged convergence trades. After the Russian default, spreads widened instead of converging, and losses mounted. Its positions were large relative to the market and hard to exit, and counterparties demanded more collateral. A private rescue organised under the Federal Reserve of New York's supervision avoided a disorderly unwind. In 2007-2009, losses on mortgage-related assets and doubts over counterparties led to rising haircuts on repo, runs on wholesale funding, and drying up of securitisation and interbank markets. Central banks stepped in with emergency facilities. The lessons are to stress test liquidity, diversify funding, hold buffers, and watch collateral terms.

Key formulas to remember

Leverage ratio: Leverage = Assets ÷ Equity; Higher leverage means a smaller price fall wipes out equity and triggers forced selling.
Haircut and margin: Haircut = (Asset value − Loan) ÷ Asset value; The haircut is the share of the asset funded by the borrower's own capital. A higher haircut cuts the loan available per unit of asset.
Borrowing capacity: Loan = Asset value × (1 − Haircut); When the haircut rises, the same assets support less funding, so the firm must sell or post more cash.
Leverage and haircut link: Maximum leverage = 1 ÷ Haircut; A 5% haircut allows at most 20 times leverage on that asset. Margin spirals reduce this ceiling.
Spiral rule: Loss spiral: price ↓ → equity ↓ → forced sales → price ↓. Margin spiral: volatility ↑ → haircut ↑ → forced sales → price ↓; Know which trigger starts each spiral. They reinforce each other.

How to solve Funding Liquidity Risk and Liquidity Crises questions

Use this method for any question on funding liquidity, spirals or crisis cases.

1Identify what is being asked: funding liquidity (ability to meet cash and collateral calls) or market liquidity (ability to trade without price impact).
2Find the trigger: a price fall and loss of capital (loss spiral), or a rise in volatility or margins (margin spiral).
3Check the balance sheet: leverage, maturity mismatch, reliance on short-term or collateralised funding, and concentration of positions.
4If numbers are given, compute the loan as value × (1 − haircut), or the funding gap after a haircut increase, and the assets that must be sold.
5Trace the feedback: forced sales lower prices, which cause more losses or higher margins, and the loop repeats.
6Link to the case if named: LTCM means leveraged convergence trades and large positions; 2007-2009 means repo haircuts, wholesale runs and frozen markets.
7Pick the answer that matches the mechanism and the proper mitigant, such as buffers, diversified term funding, stress tests or lender-of-last-resort support.

Quickest way: Trigger, link, loop

When to use it: Use it for conceptual MCQs where four statements sound plausible.

Label each option as funding or market liquidity.
Ask whether the statement shows the link: funding stress forcing sales, or illiquid markets tightening funding.
Eliminate options that say liquidity risks are independent, or that higher haircuts help liquidity.
For numbers, use Loan = Value × (1 − Haircut) and compare before and after.
Choose the option that shows a self-reinforcing loop.

Common mistakes in Funding Liquidity Risk and Liquidity Crises

Treating funding liquidity and market liquidity as the same thing.
Both are called liquidity and both worsen in a crisis.
Fix: Funding liquidity is about meeting obligations with cash or borrowing. Market liquidity is about trading an asset without price impact. Then explain how they interact.
Saying a margin spiral starts with a price fall and a loss spiral starts with a margin rise.
Students mix up the two names.
Fix: The loss spiral works through losses and lower capital. The margin spiral works through higher margins or haircuts, often due to higher volatility.
Assuming higher haircuts reduce risk for the borrower.
Higher haircuts protect the lender, so students assume they are good for everyone.
Fix: For the borrower, a higher haircut means less funding per unit of asset. That forces sales or extra cash, which can set off a spiral.
Thinking LTCM failed because its strategies had no logic.
Summaries stress the collapse and ignore the structure.
Fix: Focus on high leverage, large positions that were hard to exit, spreads that widened after the Russian default, and collateral demands. It was a funding and liquidity failure as much as a market loss.
Computing the haircut effect on the wrong base.
Students apply the haircut to the loan instead of the asset value.
Fix: Haircut applies to asset value. Loan = Value × (1 − Haircut). Equity needed = Value × Haircut.

Worked examples

Example 1

A fund holds bonds worth $200 million financed by repo with a 5% haircut. The dealer raises the haircut to 10% after volatility jumps. How much extra cash or asset sale is needed if the bond price is unchanged?

Show the solution

Original loan = 200 × (1 − 0.05) = $190 million.
New loan = 200 × (1 − 0.10) = $180 million.
Funding shortfall = 190 − 180 = $10 million.
The fund must raise $10 million in cash or sell bonds to repay the shortfall.

Answer: $10 million. This is a margin spiral trigger: volatility rises, the haircut rises and forced sales may follow.

Example 2

A trader has equity of $10 million and assets of $100 million. Asset prices fall 4%. Which statement best describes the loss spiral if the trader restores leverage to 10 times by selling assets?

Show the solution

Initial leverage = 100 ÷ 10 = 10 times.
Assets after the fall = 100 × 0.96 = $96 million. Loss = $4 million.
Equity after the loss = 10 − 4 = $6 million.
Leverage now = 96 ÷ 6 = 16 times.
To return to 10 times, assets must be 6 × 10 = $60 million.
Required sales = 96 − 60 = $36 million.

Answer: The trader must sell $36 million of assets. If many traders do this, prices fall further, causing more losses. This is a loss spiral.

Exam tips

Expect applied scenarios. Name the spiral (loss or margin) before you choose an answer.
Use the formula Loan = Value × (1 − Haircut) for quick numerical questions, and double-check that you apply it to the asset value.
For LTCM, remember leverage, hard-to-exit positions and the Russian default; for 2007-2009, remember repo haircuts and wholesale funding runs.
Be ready to state mitigants: liquidity buffers, longer-term funding, diversified lenders, stress testing and contingency funding plans.
Reject any option that says funding and market liquidity are unrelated in stress.

Practice questions from Liquidity Risk

Funding Liquidity Risk and Liquidity Crises in other exams

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

FRM Part IBank Risks, Liquidity and Funding

Funding Liquidity Risk and Liquidity Crises: frequently asked questions

What is the difference between funding liquidity 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 that an asset cannot be sold quickly without a large price concession. In a crisis, each can trigger the other.

What is the Brunnermeier and Pedersen liquidity spiral?

It is a feedback loop between market liquidity and traders' funding. In the loss spiral, losses cut capital and force sales. In the margin spiral, higher margins force sales. Both push prices down and reinforce each other.

What are the main LTCM lessons for the FRM exam?

LTCM showed the danger of high leverage, large positions that are hard to exit, and reliance on spreads converging. Stress tests must include liquidity and widening spreads. Counterparties should monitor concentrated, leveraged exposures.

Why did funding liquidity dry up in 2007-2009?

Losses on mortgage-related assets and counterparty doubts made lenders raise haircuts or refuse to roll short-term funding such as repo and commercial paper. Firms had to sell assets into weak markets. Central banks then provided emergency liquidity.