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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

A bank sponsors an off-balance-sheet conduit that holds $5 billion of long-term asset-backed securities funded by asset-backed commercial paper (ABCP) with an average maturity of 30 days, backed by a liquidity line from the bank. In 2007 investors refuse to roll over the paper. Which outcome is most consistent with the crisis experience?

The sponsoring bank would draw on its liquidity guarantee and effectively bring the $5 billion of assets back onto its balance sheet. This raises funding needs and leverage, since the conduit's short-term funding of long-term assets collapses when commercial paper cannot be rolled over.

  1. AThe bank draws on its liquidity guarantee and takes the assets onto its balance sheet, raising its funding needs and leverageCorrect
  2. BThe conduit sells assets at par without any price impact because they are long-term
  3. CThe bank's capital ratio improves because the liabilities are removed
  4. DInvestors in the conduit absorb all losses with no effect on the sponsor

Explanation

The conduit faced a maturity mismatch: long-term assets funded by short-term paper. When rollover failed, the liquidity backstop obliged the sponsor to fund the conduit, so the assets and funding needs came back onto the bank's balance sheet, increasing leverage and stress. Sponsors also often supported conduits for reputational reasons.

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