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FRM Part II · FRM Exam Part II · Early Warning Indicators

A bank's contingency funding committee reviews several EWIs. Deposit outflows are stable and the bank's CDS spread is unchanged, but the committee notes that the share of the bank's assets that are encumbered has risen from 12% to 25% in six months, and the average haircut on its repo collateral has increased. Which interpretation is most appropriate?

Higher asset encumbrance and rising repo haircuts signal reduced contingent collateral capacity and tighter secured funding terms. This is a genuine vulnerability that merits escalation even when deposits and CDS spreads appear calm, because EWIs should be assessed collectively rather than waiting for one metric.

  1. ANo concern, since stable deposits imply no liquidity vulnerability
  2. BThe signals indicate shrinking unencumbered collateral capacity and tightening secured funding terms, a vulnerability that warrants escalation even though other indicators are quietCorrect
  3. CThe signals only matter if the bank's CDS spread also widens, so they should be disregarded until then
  4. DThe signals show improved liquidity because more assets are being used to raise funding

Explanation

Rising encumbrance reduces the pool of assets available as contingent collateral, and higher repo haircuts show secured lenders are demanding more protection. Both are leading signals of liquidity vulnerability and should be escalated regardless of whether other EWIs are quiet, as no single indicator is sufficient.

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