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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank takes financial collateral against a loan. Which feature most strongly increases the risk that the collateral will fail to mitigate loss when the borrower defaults?

Wrong-way risk, where collateral value is highly correlated with the borrower's credit quality, such as a borrower pledging its own shares, most undermines mitigation. The collateral loses value just when default occurs. Margining, haircuts and legal enforceability all improve protection.

  1. AHigh positive correlation between the collateral's value and the borrower's creditworthiness (wrong-way risk), such as a borrower pledging its own sharesCorrect
  2. BDaily mark-to-market with margin calls
  3. CA haircut applied to the collateral's market value
  4. DLegal enforceability of the security interest in the borrower's jurisdiction

Explanation

When collateral value falls as the borrower's credit deteriorates, as with the borrower's own shares, the collateral loses value precisely when needed. Daily marking, haircuts and enforceability all strengthen mitigation.

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